my course book
TRANSCRIPT
HL Economics Fact Guide
Nicholas Sim Wei Sheng
September 27, 2011
Preamble
This document is not intended as a learning resource. It is intended toeffectively state and review, without grammatical or factual inaccuracies orambiguity, the facts in the IBDP HL Economics syllabus1 to one who wouldbe familiar with the content.
Economics for the IB Diploma, Standard and Higher Level by Ellie Tra-gakes was referred to extensively in the writing of this document. Addition-ally, the coursebooks Anglo-Chinese School (Independent) Economics 2011,Higher and Standard Level were used in the writing of this document. Noquotes have been used in an attempt to produce the concise, elegant, andunequivocal writing contained in this document.
Note that throughout this document the phrase including refers to in-cluding, but not limited to. This and other contractions are necessary toensure the brief and neutral phrasing of the document. It is best, therefore,that readers are able to understand the contents in detail.
This document has be largely written from the point-of-view of a math-ematics student. While every effort has been made to make the writing asreadable as possible to beginning economics students, no guarantee can bemade as to this property. Additionally, no guarantee can be made as to itsaccuracy, although there exists the reassurance that the author does intendto use this as a complete reference for the topics listed, and that it has beenproofed in varying degrees of detail by others.
1As of 2011.
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Contents
1 Introduction to Economics 6
1.1 Basic requirements . . . . . . . . . . . . . . . . . . . . . . . . 6
1.1.1 Positive and Normative Economics . . . . . . . . . . . 6
1.1.2 Ceteris paribus . . . . . . . . . . . . . . . . . . . . . . 6
1.2 Scarcity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.1 Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.2 Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.3 Factors of Production . . . . . . . . . . . . . . . . . . 7
1.2.4 Economic and free goods . . . . . . . . . . . . . . . . 7
1.2.5 Capital and consumer goods . . . . . . . . . . . . . . 8
1.3 Production Possibilities Curve (PPC) . . . . . . . . . . . . . 8
1.3.1 Law of increasing opportunity cost . . . . . . . . . . . 9
1.3.2 Shifts of the PPC . . . . . . . . . . . . . . . . . . . . . 9
1.4 Efficiency in resource allocation . . . . . . . . . . . . . . . . . 9
1.4.1 Productive efficiency . . . . . . . . . . . . . . . . . . . 9
1.4.2 Allocative efficiency . . . . . . . . . . . . . . . . . . . 9
1.5 Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . 10
1.5.1 Causes of economic growth . . . . . . . . . . . . . . . 10
1.5.2 Investment-Consumption Choice . . . . . . . . . . . . 11
1.5.3 Potential and actual economic growth . . . . . . . . . 11
1.6 Economic Development . . . . . . . . . . . . . . . . . . . . . 12
1.6.1 Relation of economic growth and economic development 12
1.6.2 Causes of economic development . . . . . . . . . . . . 12
1.7 Types of economies . . . . . . . . . . . . . . . . . . . . . . . . 13
1.7.1 Free Market System . . . . . . . . . . . . . . . . . . . 13
1.7.2 Centrally Planned Economy . . . . . . . . . . . . . . . 14
1.7.3 Mixed Economy . . . . . . . . . . . . . . . . . . . . . 14
2 Demand and Supply 15
2.1 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.1.1 Market Structures . . . . . . . . . . . . . . . . . . . . 15
2.2 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2.1 Law of demand . . . . . . . . . . . . . . . . . . . . . . 16
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2.2.2 Factors affecting demand . . . . . . . . . . . . . . . . 17
2.2.3 Substitution effect . . . . . . . . . . . . . . . . . . . . 18
2.2.4 Income effect . . . . . . . . . . . . . . . . . . . . . . . 18
2.2.5 Exceptions to the law of demand . . . . . . . . . . . . 18
2.3 Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.3.1 Law of supply . . . . . . . . . . . . . . . . . . . . . . . 19
2.3.2 Factors affecting supply . . . . . . . . . . . . . . . . . 20
2.4 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 21
2.4.1 Effects of changes in demand and supply . . . . . . . . 21
2.4.2 Equilibrium of free goods . . . . . . . . . . . . . . . . 22
2.5 Consumer and producer surpluses . . . . . . . . . . . . . . . . 23
2.5.1 Consumer surplus . . . . . . . . . . . . . . . . . . . . 23
2.5.2 Producer surplus . . . . . . . . . . . . . . . . . . . . . 24
2.5.3 Price signals and efficiency . . . . . . . . . . . . . . . 24
2.6 Government intervention . . . . . . . . . . . . . . . . . . . . . 25
2.6.1 Price controls . . . . . . . . . . . . . . . . . . . . . . . 25
2.6.2 Commodity agreements and buffer stock schemes . . . 26
3 Elasticities 27
3.1 Price elasticity of demand . . . . . . . . . . . . . . . . . . . . 27
3.1.1 Varying of the PED over a demand curve . . . . . . . 27
3.1.2 Relative elasticity . . . . . . . . . . . . . . . . . . . . 28
3.1.3 Range of the PED . . . . . . . . . . . . . . . . . . . . 28
3.1.4 Factors affecting the PED of a good . . . . . . . . . . 29
3.1.5 PED and total revenue . . . . . . . . . . . . . . . . . . 30
3.2 Cross-elasticity of demand . . . . . . . . . . . . . . . . . . . . 31
3.2.1 Sign and magnitude of the XED . . . . . . . . . . . . 31
3.2.2 Pricing decisions based on XED . . . . . . . . . . . . 31
3.3 Income elasticity of demand . . . . . . . . . . . . . . . . . . . 32
3.3.1 Value of the YED . . . . . . . . . . . . . . . . . . . . 32
3.3.2 Factors affecting the YED of a good . . . . . . . . . . 33
3.3.3 Sectoral change . . . . . . . . . . . . . . . . . . . . . . 34
3.4 Price elasticity of supply . . . . . . . . . . . . . . . . . . . . . 34
3.4.1 Factors affecting the PES of a good . . . . . . . . . . 35
3.5 Incidence of taxes and subsidies . . . . . . . . . . . . . . . . . 35
3.6 Elasticity of primary products . . . . . . . . . . . . . . . . . . 37
3.6.1 Short-run price fluctuations . . . . . . . . . . . . . . . 37
3.6.2 Long-run decline in prices and producer income . . . . 37
4 Market Failure 39
4.1 Social efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.2 Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.2.1 Methods of intervention . . . . . . . . . . . . . . . . . 40
4.3 Merit and demerit goods . . . . . . . . . . . . . . . . . . . . . 41
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4.3.1 Methods of intervention . . . . . . . . . . . . . . . . . 424.4 Public goods . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
4.4.1 Marginal cost for non-rivalrous goods . . . . . . . . . 434.4.2 Free rider problem . . . . . . . . . . . . . . . . . . . . 434.4.3 Provision of public goods . . . . . . . . . . . . . . . . 43
4.5 Imperfect competition . . . . . . . . . . . . . . . . . . . . . . 434.6 Other causes of market failure . . . . . . . . . . . . . . . . . . 43
5 Theory of the Firm 445.1 Costs and production . . . . . . . . . . . . . . . . . . . . . . 44
5.1.1 Explicit and implicit costs . . . . . . . . . . . . . . . . 445.1.2 Short run and long run . . . . . . . . . . . . . . . . . 455.1.3 Law of diminishing marginal returns . . . . . . . . . . 455.1.4 Types of costs . . . . . . . . . . . . . . . . . . . . . . 45
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Chapter 1
Introduction to Economics
This is an introduction to the study of economics.
1.1 Basic requirements
1.1.1 Positive and Normative Economics
Briefly, positive economics describes what is, was, or will be, based on knownfacts. Normative economics suggests or prescribes what should be, based onsome qualitative judgement, not necessarily involving any facts.
1.1.2 Ceteris paribus
Latin for “all else being equal”. Denotes the assumption that on the con-sideration of one variable, other variables are assumed to remain constant.
1.2 Scarcity
The study of Economics is important due to scarcity. This is the conditionwhere there is insufficient resources to fulfill all the wants of society.
1.2.1 Utility
Utility is the benefit that consumers derive from consuming a good. This isnot the same for all consumers, and will vary by quantity consumed.
1.2.2 Choice
Choice is necessary as human wants are not limited, but resources are lim-ited. Therefore choices must be made in the usage of resources.One will find that
many topics inEconomics will
eventually attemptto answer these three
questions. Keepthem in mind while
analysing each topic.
There are three basic questions that determine resource allocation:
1. What, and how much to produce.
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2. How (with what resources) to produce.
3. For whom to produce.
Opportunity cost
Opportunity cost is the value of the next best choice forgone, with respectto the choices taken. If the choice taken does not derive the most utility, itis the value of the choice that derives the most utility.
Rational Choice
Economics assumes that consumers (and societies) wish to choose to con-sume goods in a way that derives the maximum utility at the lowest possiblecost.
1.2.3 Factors of Production
There are four basic categories of scarce resources, “factors of production”:
Land refers to all natural resources used to produce goods; land includesore, oil, and actual land area. Receives rent.
Labour refers to physical and mental efforts made by humans in the pro-duction of a good. Receives wages.
Capital or physical capital refers to assets used to produce more goods;this includes machinery, buildings, and roads.1 Receives interest.
Entrepreneurship/management refers to individuals who possess theability to innovate, take risks2, and to organise the other factors ofproduction. Receives profit.
1.2.4 Economic and free goods
An economic good is a resource that is scarce, thereby having opportunitycost. They usually have a positive price, but may have zero price.3
A free good is a good that is not scarce, thereby having no opportunitycost. It is available in quantities sufficient to fulfill all human wants forthem. An example is
saltwater by the sea,not readily availableinland (presumingthere is a want forit).
1These examples are of fixed capital, which can be reused; there also exists circulatingcapital, which refers to partially complete goods to be used in the production process ofanother good, such as plastic in the production of calculators.
2Risks are necessarily uninsurable.3Public goods have zero price. See Section 4.4.2 for the free rider problem.
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1.2.5 Capital and consumer goods
Capital goods are those which can be used in the production of other goods.Consumer goods are those which consumers may, for the lack of a betterword, consume to derive utility.
1.3 Production Possibilities Curve (PPC)
A Production Possibilities Curve or Frontier shows the maximum combina-tion of two goods that may be produced by an economy within a certainperiod, when all its resources are fully and efficiently employed. These twogoods should use similar resources, or they would be unrelated and PPCcannot be drawn.
By utilising resources in an economy to produce at a point on the curve,all resources are necessarily efficiently employed. Production at pointswithin imply that resources are not fully and efficiently employed (wastage);production at points beyond is simply unattainable.
Thus in the PPC:
Scarcity is seen in unattainable combinations.
Choice is seen in the many points that can be produced at.
Opportunity cost is seen from the downward slope.
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-
u
u
u
Capital goods (units)
Consumer goods (units)
A
B
C
Figure 1.1: A typical PPC
In Fig. 1.1,
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A shows wastage of resources.
B shows an unattainable point for production.
C shows production with full and efficient use of resources.
1.3.1 Law of increasing opportunity cost
The law of increasing opportunity cost states that in order to get an equalmarginal increase in the production of one good, an economy must sacrificeever increasing quantities of another good. This is reflected by the concavecurve of the PPC.
Note that the PPC is not always necessarily visibly concave. Goodsthat use resources identically, such as basketballs and volleyballs, do notexperience the law of increasing opportunity cost by a significant amount.4
1.3.2 Shifts of the PPC
Shifts of the PPC are due to changes in an economy’s productive capacity,frequently due to economic growth, which will be covered in the next section.
Another possible shift of the PPC is the pivotal shift, or a shift occuringin one axis (see Fig. 1.2). This shows that an economy can produce moreof one good with the same resources than previously, generally caused by atechnological enhancement in the production of a good.
1.4 Efficiency in resource allocation
As resources are scarce, economies have to make choices in resource al-location (the three basic questions). Therefore an economy should aim toproduce the best combination of goods and services as demanded by society.This requires full and efficient use of resources.
1.4.1 Productive efficiency
Productive efficiency occurs when production is made such that it is notpossible to produce more of one good without producing less of anothergood. All points along the PPC are productively efficient. Productive efficiency
is reached whenAC = MC.1.4.2 Allocative efficiency
Allocative efficiency occurs when resources are allocated such that no one canbe made better off without another being made worse off. The requirement
4There are situations when the PPC will be convex. This occurs when the resourcesare more suited to producing either or both of the goods, than a combination of the two.This will be covered in greater detail in Theory of the Firm.
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6
-
-
Good X
Good Y
Figure 1.2: A pivotal shift of the PPC, showing increased possible produc-tion of Good X with the same resources.
for this is the cost of producing a good is exactly equal to the utility derivedfrom consuming that good.Allocative efficiency
is reached whenP = AC = MC.
The requirements for allocative efficiency are productive efficiency andmaximum utility derived by consumption of goods by population in an econ-omy, based on their tastes and preferences.
Note that society’s preferences also depend on other factors; a societyfacing war is likely to prefer that resources be allocated to defence.
1.5 Economic Growth
Economies must produce output in the form of goods and services. Increasesin the quantity of output indicate economic growth. Decreases in the quan-tity of output indicate economic contraction. These are easily seen usingthe PPC.
1.5.1 Causes of economic growth
There are three main causes of economic growth, broadly classed into threecategories:
Increase in available resources Working population growth; discoveryof new minerals, ores; reclamation of land; increase in capital stock.
Improvement in quality of resources Trained workers; better manage-ment; better equipment; better methods of production; better tech-nology.
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Improvements in technology More efficient methods of producing goods.
1.5.2 Investment-Consumption Choice
Investment refers to the obtaining Note that theinvester need notproduce the capitalgoods. They can beeasily obtained bypurchase.
of capital goods within a specified period.Since capital goods are used to produce other goods, production of capitalgoods will increase the productive capacity of an economy in a future period,for both capital and consumer goods.
As a result, the choice to produce greater quantities of capital goods overconsumer goods will increase the productive capacity of an economy at agreater rate.
1.5.3 Potential and actual economic growth
Potential growth refers to the increase in the productive capacity of an econ-omy, illustrated in Fig. 1.3 as an outward shift of the PPC. It is necessaryto achieve indefinite increases in the amount of goods or services producedin future periods.
6
-
-
6
Capital goods (units)
Consumer goods (units)
Figure 1.3: PPC indicating economic growth.
Actual growth Potential growthneed not be utilised,and thus might notresult in actualgrowth.
is the increase in the amount of goods or services producedby an economy, achieved by either making the production more efficient (byproducing closer to the curve where production is currently at a point withinthe curve, such as point A in Fig. 1.1), or taking advantage of an increasein potential growth.
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1.6 Economic Development
Economic development must be sufficiently differentiated from economicgrowth. It refers to the standard of living in the population of economy, andcan be measured quantitatively from the availability of merit goods5 andother factors, such as improved income distribution or employment oppor-tunities. Thus economic development can improve from increased provisionof services including healthcare and education.
Therefore economic development is extremely important for the welfareof a society. It may indirectly contribute to economic growth.
1.6.1 Relation of economic growth and economic develop-ment
Economic growth generally allows an economy to have economic develop-ment, as it will have more capital to improve these aspects of the popula-tion’s life. However, it is possible that it will not cause economic develop-ment. For instance, all of this capital might be used to allow for furthereconomic growth. It might also be used on aspects that do not cause eco-nomic development, such as manufacturing of arms in a nation not facingimminent war.6
However, economic development is likely to cause economic growth, asit frequently leads to one of the three causes in subsection 1.5.1.
1.6.2 Causes of economic development
Sound banking system
Financial institutions are important in economies as they, in effect, allowsavers (those with money) to lend to borrowers. Loans enable new firms toenter markets more easily.
The state may establish government-owned banks to ensure that capitalis available to borrowers from the onset, should there be no banks withsufficient funds for investment.
Education
Education improves labour, a factor of production. Additionally, it enablesthe educated to participate in society as an individual who is literate andable to communicate. Finally, it improves health, as individuals know howto prevent the spread of diseases.
5Merit goods are discussed in Section 4.3.6Arguably this causes economic growth, due to the improved provision of national
security. However, if a nation does not face imminent war, it is unlikely to make asignificant difference.
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Healthcare
Greater healthcare not only increases the quality of life in a country; it alsoimproves the availability of labour as people are able to work for a greaterproportion of their lives.
Infrastructure
Infrastructure is necessary for the transportation of factors of production.It also includes the facilities that make communications, potable water, andelectricity available. Reliable infrastructure attracts firms to invest in anarea, and improves entrepreneurship.
Political stability
For a firm, particularly those with large amounts of fixed capital, to work ef-fectively in an area, regulations must be enforced strictly and not be subjectto unpredictable revisions. Political stability assures firms that they wouldnot suffer adverse effects as a result of regulation or lack of enforcement.7
1.7 Types of economies
Strictly, there are two types of economies: free market economies and cen-trally planned economies. They are drastically opposed and most economiesare a mix of both.
1.7.1 Free Market System
The free market economy has no government intervention, and is based onthe premise of the invisible hand. It relies completely on the market forcesof demand and supply for resource allocation.
Simply, all economic decisions are the responsibility of the individuals inthe economy. This enables them to compete for and privately own resourcesand goods. Competition is present for all aspects of the economy, and con-sumers determine the production of goods through the price mechanism(Consumer sovereignty).8
An exception to the rule of the lack of goverment intervention is theprovision of basic, critical services to society, such as law enforcement andnational defence.
7Corruption is a major factor in determining enforcement of regulations.8The price mechanism is explored in greater detail in Section 2.4.
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1.7.2 Centrally Planned Economy
The command economy relies completely an government direction and con-trol. This control extends to both the production and consumption of goods.
The state owns all resources and factors of production, excluding labour,thus having no incentive for profit, enabling high income equality. It mustestimate the needs and wants of consumers and allocates resources accord-ingly. It sets the prices of goods and services.
1.7.3 Mixed Economy
A mixed economy utilises aspects of both systems.
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Chapter 2
Demand and Supply
Demand and supply within the context of a competitive market studies theinteractions of individual buyers and sellers. This is a part of Microeco-nomics.
2.1 Markets
A market is the means by which potential buyers and sellers exchange goodsand services at agreed prices. It need not necessarily be based on location,although it frequently is. A market for a good can be of any size.
Product markets
Where goods and services are exchanged.
Factor markets
Where resources (labour, machinery, iron) are exchanged.
2.1.1 Market Structures
There are four basic market structures:
1. Perfect Competition
2. Monopoly
3. Oligopoly
4. Monopolistic competition
These will be examined in Theory of the Firm. This topic, Demand andSupply will examine the first structure: Perfect Competition. This topicassumes understanding of this structure.
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2.2 Demand
Demand is the quantity of goods a group of consumers in a market is willingand able to buy at various prices over a certain period, ceteris paribus.
Individual demand quite obviously refers to the demand (as definedabove) of an individual consumer. In a perfectly competitive market, theindividual consumer is unable to influence prices of a good.
Market demand refers to the demand of all the consumers in a market.
A demand schedule is a table that shows the data of the demand, linkingcertain quantities and prices. It describes the demand curve.
The demand curve is a representation of the demand schedule. An ex-ample is shown in Fig. 2.1.
6
-
QQQQQQQQQQQQQQQQQQ
DD
Price of Good X ($)
Quantity of Good X demanded
Figure 2.1: Market demand for Good X
Note that the price of the good is on the vertical axis, while the quantityof the good demanded is on the horizontal axis.
2.2.1 Law of demand
The law of demand states that there is an inverse relationship between theprice of a good and the quantity demanded over a certain period, ceterisparibus. This is illustrated by the downward slope of the demand curve.
Put simply, the higher the price of a good, the less of it is demanded ina market.
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2.2.2 Factors affecting demand
A change in demand is reflected by a shift of the demand curve. A changein price is reflected by a shift along the demand curve, which is a change inquantity demanded, rather than demand.
Number of buyers
A change in the number of buyers will result in a proportional change ofquantity of a good demanded at all price points, shifting the demand curveto the right or left. This is attributed to the definition of market demand:a summation of individual demands.
This also applies to age of a population, for goods with age-related de-mand, such as medical services.
Consumer taste and preference
If consumer preferences change in favour of a product, demand increases;contrariwise, if preferences change in favour of other products, demand de-creases.
Consumer income
Refer to Section 3.1, Price Elasticity of Demand.
Prices of substitutes
Refer to Section 3.2, Cross Elasticity of Demand.
Price of complements
Refer to Section 3.2, Cross Elasticity of Demand.
Expectation of future income
If consumers expect their future income to change, they will tend to behaveaccording to that expectation. Refer to Section 3.3, Income Elasticity ofDemand for more information.
Expectation of future price changes
If consumers expect the price to increase in future periods, demand willincrease in the present period; if consumers expect the price to decrease infuture periods, demand will decrease in the present period.
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Legislation
Governments can require that consumers consume certain goods, for in-stance anti-pollution equipment and retaining bars on lorries.
Weather/Climate/Season
If the climate changes such that a place becomes cooler/warmer, demand forheating and air-conditioning will be affected. Additionally, common holidaydestinations are affected by seasonal tourism.
Derived demand
In this situation, the production of a good requires the use of another good.When the quantity supplied of the former increases, the demand for thelatter increases.
2.2.3 Substitution effect
Assuming a decrease in the price of a good, in most cases consumers willchoose to substitute other goods for the good which has had a decrease inprice; the quantity of this good demanded increases at all price points.
2.2.4 Income effect
Considering the same decrease in price, then the consumer’s purchasingpower has increased.1 If it is a normal good, quantity demanded will increaseas consumers are more able to buy greater quantities of the good. However,if the good is an inferior good, the quantity demanded will fall, as more ofthe consumer’s income is available to buy normal goods.
2.2.5 Exceptions to the law of demand
Consumerexpectations also
cause exceptions tothe law of demand.
If a consumer hasexpectations of
drastic changes offuture income or
price of the good, theexpectation might beso great as to create
an exception.
Giffen goods
This unproven phenomenon is relevant to inferior goods. As noted above,changes in price produce a result determined by the substitution effect andthe income effect. A Giffen good is an inferior good for which the incomeeffect is greater than the substitution effect, causing a decrease in price tolead to a decrease in quantity demanded and therefore an increase in priceresulting in an increase in quantity demanded. Otherwise, if the incomeeffect is not greater than the income effect, the good is not a Giffen good.
1Not absolutely, but in relation to that one good.
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Veblen goods
Veblen goods are ostentatious goods that allow a consumer to derive sat-isfaction from simply being able to own the good, pretentiously impressingothers. As the price of the good increases, there is therefore more satisfac-tion derived from owning the good, therefore they exhibit a positive demandcurve.
2.3 Supply
Supply is the quantity of goods a group of producers in a market is willingand able to sell at various prices over a certain period, ceteris paribus.
Individual supply refers to the supply of an individual producer. In aperfectly competitive market, the individual producer is unable to influenceprices of a good.
Market supply refers to the supply of all the producers in a market.A supply schedule is a table that shows the data of the supply, linking
certain quantities and prices. It describes the supply curve.The supply curve is a representation of the supply schedule. An example
is shown in Fig. 2.2.
6
-������������������
SS
Price of Good X ($)
Quantity of Good X supplied
Figure 2.2: Market supply for Good X
2.3.1 Law of supply
The law of supply states that there is a positive relationship between theprice of a good and the quantity supplied over a certain period, ceterisparibus. This is illustrated by the upward slope of the demand curve.
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Thus as the price of a good increases, the market is willing to supplymore of that good.
2.3.2 Factors affecting supply
As with demand, a change in supply is reflected by a shift of the supplycurve. A change in price is reflected by a shift along the supply curve,which is a change in quantity supplied, rather than supply.
Number of sellers
A change in the number of sellers will result in a proportional change of thequantity of a good supplied at all price points. In a perfectly competitivemarket, this changes when it does not earn normal profit.
Cost of production
If the cost of production decreases, firms will be more willing to supply moreunits of the good at each price point, since in a perfectly competitive market,all firms earn normal profit.
This is often influenced by the cost of resources and other factors ofproduction.
State of technology
Similar to changes in the cost of production.
Prices of other goods a firm can produce
If the firm finds that another good it can produce is currently earning greaterprofits, the firm may switch production to that good, decreasing the supplyof the good it initially produced.
Expectation of future price changes
If producers expect the price of a good to increase in future periods, it maydecrease supply in the current period in order to sell it in the future period.
Taxes and subsidies
Taxes and subsidies effectively change the cost of production for firms pro-ducing a certain good, and they will act accordingly. For more information,refer to the section on Taxes and Subsidies.
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Supply shocks
Supply shocks are unanticipated events that affect the supply of resourcesneeded to produce a good. An adverse supply shock may be trade em-bargoes; a beneficial supply shock might be an unusually good harvest (inagriculture).
2.4 Market Equilibrium
Equilibrium is a balance between two or more forces, with no tendency tochange. It occurs at the point where the demand and supply curves in amarket coincide, such that the quantity supplied and demanded at a certainprice are equal. The price is known as the equilibrium price (Pe) or market-clearing price, and the quantity is known as the equilibrium quantity (Qe).
At other prices, there is market disequilibrium, and the market forces ofdemand and supply put upward or downward pressure on the price towardthe equilibrium. This is illustrated in Fig. 2.3.
6
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QQQ
QQk
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DD
SS
Pe
Qe
Price of Good X ($)
Quantity of Good X
Figure 2.3: Market for Good X
2.4.1 Effects of changes in demand and supply
The effects of changes in demand and supply on the market equilibrium aredescribed by Table 2.1 and Fig. 2.4.
21
Demand Supply Price Quantity
Increases No change Increases IncreasesDecreases No change Decreases DecreasesNo change Increases Decreases IncreasesNo change Decreases Increases DecreasesIncreases Increases Uncertain IncreasesIncreases Decreases Increases UncertainDecreases Increases Decreases UncertainDecreases Decreases Uncertain Decreases
Table 2.1: Changes in equilibrium price
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Quantity of Good X
Figure 2.4: Changes of demand and supply in the market for Good X
2.4.2 Equilibrium of free goods
Thus far, the demand and supply curves have been illustrated to intersect,indicating that market equilibrium exists. This applies for economic goods,where there will always be a demand that is greater than supply at somepoint.
Recall that a free good has supply that far exceeds demand. Therefore,the graph indicating the market of a free good looks like that in Fig. 2.5.
Thus we can see there is excess quantity supplied even when the price iszero, making it a free good.
22
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Quantity
Figure 2.5: Market for a free good
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DD=MPB
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PS
CS
Pe
Price
Quantity
Figure 2.6: Surpluses in a PC market
2.5 Consumer and producer surpluses
2.5.1 Consumer surplus
Consumer surplus (CS) is the difference between the prices that consumersare willing and able to pay for a unit of good and the price that they pay(equilibrium price). It represents the difference between the benefit con-
23
sumers derive from consuming a good (MPB2) and how much they pay forit (Pe). It is marked CS in Fig. 2.6.
Consumer surplus exists as many consumers were willing to pay a pricehigher than the equilibrium for a unit of good, yet got that unit paying onlythe equilibrium price, thus deriving the extra benefit over what was paid.This is the consumer surplus.
In Chapter 3, Elasticities, we will see that a good with a low PED has agreater consumer surplus than one with higher PED.
2.5.2 Producer surplus
Similarly, producer surplus (PS) is the difference between the prices thatproducers are willing and able to receive for a unit of good and the pricethat they receive. It represents the difference between the cost of producinga unit of good (MPC3) and how much they receive for it (Pe). It is markedPS in Fig. 2.6.
2.5.3 Price signals and efficiency
Resource allocation in a market is determined by the demand and supplyof the goods in that market. Knowing that the demand curve shows MPBand the supply curve shows MPC, then the equilibrium price occurs wherethey are equal; where they intersect, resource allocation is efficient in thatmarket.
The equilibrium then occurs as when MPB>MPC, then the benefit de-rived from consuming an additional unit of good is greater than the cost ofproducing it, and so additional units should be produced until MPB=MPC.On the other hand, when MPB<MPC, then the benefit derived from con-suming the last unit of the good is less than the the cost of producing it,and so the last units should not be produced, where the condition remains.At any other point, consumer and producer surplus is not maximised. Thusallocative efficiency is achieved in that market at MPB=MPC.4
Since allocative efficiency is attained, productive efficiency must alsohave been attained. This can be proven:
Suppose that there are some firms that are not productively efficient,i.e. not producing at the lowest possible cost. Then there are firms whichare producing at a lower cost. As firms in a PC market are price takers5,increasing amounts of resources will be allocated to the firms with lowercosts of production, since they are able to sell their goods at a lower price.
2Marginal Private Benefit. See Chapter 4, Market Failure.3Marginal Private Cost. See Chapter 4, Market Failure.4CS+PS must be maximised for allocative efficiency.5Market structures will be covered in detail in Theory of the Firm.
24
This increases producer surplus. This continues to occur until all firms areproducing at the lowest possible cost, which maximises producer surplus.
When allocative efficiency is achieved in all markets, then it has beenachieved for the economy as a whole. This would mean that economicefficiency has be attained.
Note that efficiency can only arise in an entirely ideal perfectly com-petetive market, and therefore is extremely unlikely to occur in the realworld.
2.6 Government intervention
Sometimes, the government may choose to intervene in a market to achievecertain objectives. These are often related to market failure and other prob-lems.
2.6.1 Price controls
Price controls are regulations set by goverments that attempt to keep amarket in some form of disequilibrium.
Price floors
A price floor Goods that are oftensubject to pricefloors includeagriculture andlabour. In the case ofagriculture, pricefloors are known asprice supports.
is a legally set minimum price that a good may be traded at.It creates an excess in supply as long as it manages to keep the market indisequilibrium, since as long as the market is in disequilibrium, the quantitysupplied at the price floor is necessarily greater than the quantity demanded.Price floors often attempt to protect the incomes of producers.
In order to circumvent price floors, producers may attempt to sell theirgoods in black markets, or illegal markets created for the intention of avoid-ing the price floor. This is against the intention of the price floor. In orderto prevent this, governments may attempt to buy up all the excess supply,which would be extremely expensive, or otherwise attempt to remove theblack market, which is also likely to be costly.
Price floors may also cushion inefficiency as producers that are inefficientdo not have incentives to cut costs, as the high sale price protects themagainst firms that produce at lower costs. This causes inefficiency throughthe overallocation of resources.
Price ceilings
A price ceiling is a legally set maximum price that a good may be traded at.It creates an excess in demand as long as it manages to keep the market indisequilibrium, since as long as the market is in disequilibrium, the quantity
25
supplied at the price ceiling is necessarily less than the quantity demanded.Price ceilings often attempt to protect the interests of consumers.
Apart from the problem of black markets, price ceilings suffer from theproblem of underallocation of resources, since the lower price means thatthe quantity supplied is lower than the demands of society. This results ininefficiency of resource allocation.
2.6.2 Commodity agreements and buffer stock schemes
A commodity is a standardised product, usually produced by the primarysector.
Commodity agreements are agreements that attempt to increase or sta-bilise the prices of commodities, to protect producers of these commodities.Buffer stock schemes are a type of commodity agreement that attempt tostabilise prices, in order to protect consumers and producers from price fluc-tuations.
In a buffer stock scheme,Buffer stock schemeswere particularly
popular in the1960s-1980s, thoughmost of them failed.
the operator of the scheme would attempt tobuy excess stock when prices fall below a certain threshold, and sell themwhen prices exceed another threshold. This has certain problems.
Firstly, it is extremely costly to operate a buffer stock scheme, due tothe high costs of storage, particularly of perishable agricultural products.There is also no assurance that the stock will not run out during a poorharvest.
It is also very difficult to pick a suitable price band, as this requires theoperator to accurately predict the future prices which arise from changingdemand and supply.
Income is also not stable, since prices remain relatively consistent, butthe quantity may change within the band.
Finally, it is unable to stop the long-term decrease in prices (Section 3.6.2).As this causes market prices to fall in the long term, then there will be suc-cessive false surpluses, which become extremely costly to purchase.
26
Chapter 3
Elasticities
3.1 Price elasticity of demand
Price elasticity of demand is a measure of the degree of responsiveness ofthe quantity of a good demanded to changes of its price.
The law of demand states that they share an inverse relationship, PEDshows how much quantity demanded changes to changes in price.
PED We notice that thisvalue of PEDdepends on theinitial price-quantitycombination chosen.To estimate PED ata point, we shouldtake the samplechange in price andquantity spreadequally on both sidesof that point.
=∆Q× P0
∆P ×Q0(3.1)
With the exception of Giffen and Veblen goods, the sign of the PEDmust be negative. Therefore we are concerned only with the absolute valueof the PED.
3.1.1 Varying of the PED over a demand curve
This and future sections concern themselves with the absolute value of thePED, assuming the sign to be negative.
In all the demand curves we have examined so far, there has been aslope. Along this slope, the PED will vary. This is a result of the use ofpercentage change of price and quantity demanded in calculating the PED.1
There are three exceptions to this rule: perfectly elastic demand, perfectlyinelastic demand, and unitary elastic demand, all of which will be coveredin Section 3.1.3.
This variation is explained below with the help of Fig. 3.1.
Let us define ∆P = PB − PC and ∆Q = QC −QB.
The midpoint A is defined at ∆P∆Q = P
Q . This gives us ∆PP = ∆Q
Q . There-fore at A, the PED is 1.
1On a completely irrelevant note, were absolute change to be used, PED would notvary along a straight sloped demand curve.
27
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r
r
r
B
A
C
Price
Quantity
Figure 3.1: Variation of PED
At the length between A and B, the price is high and the quantity islow, relative to A. Since ∆P
∆Q is constant, the PED between A and B must behigher than that at A (Eqn. 3.1). Therefore above the midpoint, PED>1.
Similarly, below the midpoint, PED<1.
3.1.2 Relative elasticity
Two demand curves on the same axes may be compared. The steeper curveindicates less elastic demand. If the two curves are parallel, they must notbe compared.
This generalisation holds since over a similar price range, the steepercurve will haver a smaller change in quantity demanded. Using Eqn. 3.1, wecan see that this will result in a lower value for PED at all price points.
3.1.3 Range of the PED
PED=0
Demand is perfectly price inelastic: it is completely unresponsive to price.This occurs when there are no substitutes for a good, for instance, a severedrug addiction.
PED<1
Demand is price inelastic; a change in price will result in a less than pro-portional change in quantity demanded.
28
PED=1
Demand is price unit elastic; a change in price will result in a proportionalchange in quantity demanded.
PED>1
Demand is price elastic; a change in price will result in a more than propor-tional change in quantity demanded.
PED=∞
Demand is perfectly price inelastic: demand is completely dependant onprice. A price increase will cause quantity demanded to fall to zero, other-wise consumers attempt to buy as much as they can obtain.
3.1.4 Factors affecting the PED of a good
Availability of substitutes
The greater the availability of substitutes and the closer their substitutes2,then the greater the PED.
There is not necessarily a close substitute for every good, for instancethe use of oil in plastic and other primary products, or petrol for cars; thussome goods are less price elastic.
Degree of necessity
If a good is more crucial to consumers, it will tend to be less price elastic.Staple foods are often less price elastic. On the other hand, luxuries such asdiamonds tend to be more price elastic. By definition, necessities have noclose substitutes.
Addiction
Addiction forms necessity.
Proportion of income spent on good
The larger the proportion, A car makes up aconsiderable portionof a consumer’sincome; consumerstend to spend moretime contemplatingwhat car they want,or if they indeedwant a car. This isan example of howdemand for cars isrelatively priceelastic.
the more price elastic the demand of the good.This is because items that make up a small proportion of income are viewedby consumers as not worth finding substitutes for, as any price increaseswould still only make up a small amount of a consumer’s income. Conversely,for items that make up a large portion of a consumer’s income, considerableeffort may be expended to find substitutes as the absolute difference in priceis larger.
2See XED (Section 3.2).
29
Period
The longer the time period, the more price elastic the demand. More timeallows consumers to get information on substitutes, or decide whether theywish to consume the good.
3.1.5 PED and total revenue
Total revenue is the amount of money that firms receive for selling a good,and is calculated by TR = P ×Q.
A change in the price of a good will change its quantity demanded,illustrated in Fig. 3.2 with change from A to B.
6
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A
BPA
QA
PB
QB
loss in TR
gain
Price
Quantity
Figure 3.2: Changes in TR as a result of a change in price
When demand is price elastic, a decrease in price will lead to a more thanproportional increase in the quantity demanded. Thus TR will increase asprice decreases.
When demand is price inelastic, an increase in price will lead to a lessthan proportional decrease in quantity demanded. This TR will increase asprice increases.
When demand in price unit elastic, a change in price will not affectTR. However, as price decreases from the midpoint, the demand will bemore price inelastic, thus TR will be maximised by increasing the price.Similarly, as price increases from the midpoint, the demand will be moreprice elastic, thus TR will be maximised by decreasing the price. Thereforein order to maximise total revenue, price should be set to the midpoint ofthe demand curve, or where PED=1.
30
3.2 Cross-elasticity of demand
Cross-elasticity of demand is a measure of the degree of responsiveness ofthe quantity of a good demanded to changes in the price of another good.
This therefore indicates how much the demand curve of one good wouldshift with a change in the price of another good.
XEDXY =∆QX × PY
∆PY ×QX(3.2)
Note that the sign for XED may not be ignored, unlike PED.
Also, XEDXY 6= XEDY X .
3.2.1 Sign and magnitude of the XED
Positive value
A positive XEDXY indicates that for a change in the price of good Y, therewill be a similarly-signed change in the demand for good X. This indicatesthat the two goods are substitutes. Common substitutes
include Pepsi R© andCoca-Cola R©.
If the value of the cross-elasticity of demand is above 1, the goods areclose substitutes, since an increase in the price of the first good will resultin a greater than proportional increase in the demand of the second good.
Negative value
A negative XEDXY indicates that for a change in the price of good Y,there will be an oppositely-signed change in the demand for good X. Thisindicates that the two goods are complements. Two complements
are cars and petrol.When goods are complements, a decrease in the price of the first goodwill lead to an increase in the demand of the second good.
Zero
Goods are unrelated. Examples includeconcrete and apples,and anything youcare to think of.3.2.2 Pricing decisions based on XED
Firms that produce similar products may wish to collaborate in a way thatdecreases competition between the two products. This is generally not ben-eficial to consumers and opposed by governments.
Firms that produce complements may also wish to collaborate, especiallyfor strong complementary products, such as aeroplanes and jet fuel.
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3.3 Income elasticity of demand
Income elasticity of demand is a measure of the degree of responsiveness ofthe quantity of a good demanded to changes in consumer income.
This indicates whether a good is normal or inferior.
Y ED =∆QX × Y
∆Y ×QX(3.3)
where Y is income.
3.3.1 Value of the YED
The YED of a good will show how much the demand curve will shift to theright with an increase in income.
YED<0
A negative income elasticity of demand indicates that for an increase inincome, there will be a decrease in the quantity of a good demanded at allprice points. This good is thus an inferior good, which people wish to switchaway from as their income increases.Examples of inferior
goods are broken riceand used cars.
Figure 3.3 describes this.
6
-
Income
Quantity demanded
Figure 3.3: How quantity of an inferior good demanded varies with income.
This shows that while for a certain increase in income, there will be anincrease in the quantity demanded, though there will be a point where thequantity demanded decreases as the consumer switches to normal goods.
32
YED=0
These goods are extremely necessary to daily use, yet no additional benefitis derived from consuming extra units of the good. These are completelyincome inelastic.
0<YED<1
Goods with a positive YED are known as normal goods. When the mag-nitude of the YED is less than one, these goods are income inelastic andclassified as necessities. Necessities include
water and soap.This is described by Figure 3.4.
6
-
Income
Quantity demanded
Figure 3.4: How quantity of a necessity demanded varies with income.
This shows that up to a certain income, the quantity demanded willincrease, though there will be a point where the consumer will not wish toconsume more of the necessity. You can only eat so
much rice, after all.
YED>1
These are luxuries, which are income elastic. Luxuries includediamonds.
These fall under normal goods,which people wish to consume more of as income increases, described byFig 3.5.
3.3.2 Factors affecting the YED of a good
This assumes that we are not discussing inferior goods.
33
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Income
Quantity demanded
Figure 3.5: How quantity of a luxury demanded varies with income.
Degree of necessity
The more necessary a good, the lower its YED.
Income level
Income determines whether a good is a necessity or a luxury. As incomechanges, the definitions of goods changes as well. For instance, with in-creasing income, coffee, which might be considered a luxury, may become anecessity.
3.3.3 Sectoral change
A sector is a part of an economy. There are three main sectors: primary,secondary and tertiary. Their expansion at any given point is likely to bedetermined by the YED of the goods and services they produce.
As an economy develops, the consumers tend to have increasing incomes.As such, consumers tend to move away from inferior goods to normal goods,and from normal goods to necessities. This causes the sectors producinggoods with higher YEDs to expand faster. It also tends to decrease theYED of most goods.
3.4 Price elasticity of supply
Price elasticity of supply is a measure of the degree of responsiveness of thequantity of a good supplied to changes in its price.
34
PES =∆Q× P0
∆P ×Q0(3.4)
Price elasticity of supply is intuitively similar to price elasticity of de-mand.
3.4.1 Factors affecting the PES of a good
Period
The longer the time period, the more price elastic the supply. This is becauseproducers have more time to adapt to the price change. Similarly, in theshort run the supply is less price elastic; in the immediate term supply caneven be perfectly price inelastic. Goods with perfectly
price inelastic supplyin a short periodinclude agriculture(one harvest), ortickets for a concert.
Spare capacity
Firms may have spare capacity to produce goods that is not utilised atcertain price points. These firms will allow the price elasticity of supply tobe lower. Note that shortages of factor inputs will cause the supply to beless elastic.
Factor mobility
The higher the factor mobility, the more elastic the supply.
Availability of stocks
If firm is able to store goods easily, it is able to do so or release it in a laterperiod, increasing the elasticity of supply.
3.5 Incidence of taxes and subsidies
This section focuses on the levying of indirect taxes. Indirect taxes are paidby suppliers, rather than consumers.
We are concerned with two types of taxes. The first is a specific tax,levied as a fixed amount on each unit of a good sold, regardless of price.This causes a vertical shift of the supply curve.
The other is the ad valorem tax, which is levied as a fraction of the priceof the good. This causes a pivotal shift of the supply curve. Taxes always
increases themarginal cost ofproduction.
Tax incidence is the burden on each party of a tax, and allows us to seewho pays how much of the tax. We will first consider the case of elasticdemand in Fig. 3.6.
Suppose the initial price paid by consumers and received by producers isP0, at the quantity Q0. The tax levied by the government causes a vertical
35
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Consumers
Price
Quantity
Figure 3.6: Incidence of tax on a good with elastic demand
parallel shift of the supply curve to SS′, and now the quantity sold is Q′. Theprice Pp that producers receive is determined by the MPC curve. Consumerspay Pc. Therefore the burden falls as marked on the figure, with producersbearing most of the burden.
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Price
Quantity
Figure 3.7: Incidence of tax on a good with inelastic demand
With similar calculations, we find that with relatively inelastic demand,the consumers now bear most of the burden. This is fairly intuitive as withless elastic demand, the consumers would not decrease consumption by a
36
significant amount, only causing a slight drop in quantity demanded.
In the same way, goods with elastic demand will result in the consumerreceiving most of the benefit of a subsidy, while goods with inelastic demandwill result in the producer receiving most of a subsidy.
The most benefit is derived by the party which is able to change itsdecision to consume or produce the easiest.
3.6 Elasticity of primary products
Primary products are products that come directly from the earth, such asraw materials and food. Demand for these tends to be price inelastic asthere are no close substitutes for them, particularly crops as a whole.
Supply for primary products is also rather inelastic, as there is a longgestation period for crops, and the expansion of mines takes a long time.
There are two problems associated with primary products: large shortrun fluctuations in price, and long run decline in prices and producer income.
3.6.1 Short-run price fluctuations
Demand for primary products is price inelastic. Therefore, a small changein the quantity supplied will result in a relatively larger change in the price,since consumers are less willing to buy lower quantities of the good. Thiscauses the prices to be extremely volatile.
Additionally, the supply for primary products tends to be relatively in-elastic, particularly over shorter periods of time. This is due to the factthat producers of primary products are unable to respond to price changesquickly. Agriculture is also subject to seasons, which makes the supply moreinelastic and less certain.
The seasonal nature of agriculture, with other factors, such as naturaldisasters, make the supply of agriculture extremely uncertain, as these fac-tors are beyond the control of producers. Thus a small change in supply,which is extremely likely, would cause a large change in price. A bumperharvest will cause prices to fall drastically; a poor harvest will cause pricesto increase in the same way. Additionally, since all harvest is either sold orgoes to waste, producers will attempt to sell it for however much buyers arewilling to pay. Therefore, supply is extremely inelastic.
Governments may attempt to intervene in this market in order to keepprices stable.
3.6.2 Long-run decline in prices and producer income
This can be largely explained as an application of the concept of incomeelasticity of demand (Section 3.3).
37
As an economy develops, the average income in society will tend toincrease. This leads to consumers spending a larger proportion of theirincome on luxuries, which are relatively income elastic. This prompts growthin these industries. As agricultural products are income inelastic, demandfor these rises at a slower pace.
As the demand for these luxuries increases, prompting development, theyrequire an ever-increasing amount of raw material to manufacture each unit,and so they have increasing cost of production compared to agriculture.
Additionally, due to improvements in technology, supply of agriculturalproducts is able to increase at a much faster pace than demand for them.As such, prices for agricultural products will decrease drastically.
Combined, these factors cause a long-term decrease in prices of agricul-tural products and producer income.
38
Chapter 4
Market Failure
In the free market, there are many situations in wich the free market cannotallocate resources efficiently. Market failure refers to the failure of the freemarket system to allocate resources efficiently, or to provide the optimumquantity and combination of goods and services mostly wanted by society.
There are four main causes of market failure:
1. Externalities
2. Absence of public goods
3. Merit and demerit goods
4. Imperfect competition
The condition for economic efficiency1 is known as Pareto Optimality.
4.1 Social efficiency
Since market failure is dependent on what is mostly wanted by society, wemust first understand social efficiency.
Social efficiency is significantly different from economic efficiency. It isattained when the Marginal Social Benefit (MSB) is equal to the MarginalSocial Cost (MSC). This is only possible when there are no externalities, asexternalities will cause these to be unequal.
For goods without externalities, MPC=MSC and MPB=MSB, thereforethe optimal point is the same for individuals and society.
4.2 Externalities
Externalities are spillover effects on third parties, whose interests are notconsidered, in the production or consumption of a good. They create a
1See Section 2.5.3
39
divergence in the private and social costs or benefits of a good.Positive externalities in production include freely available R&D. In con-
sumption, vaccines. Negative externalities in production, pollution fromfactories. In consumption, smoking.
Externalities are represented by the following equations:
These equations aremathematically
acceptable, if oneconsiders benefit tosimply be negative
cost and vice versa.Otherwise, such a
relation should notproperly exist.
MSB = MPB + MEB (4.1)
MSC = MPC + MEC (4.2)
Since the free market system determines the price and quantity of goodsconsumed based on choices of the consumer and producer only, externalitiesare uncorrected, and can be noted on a diagram.
6
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SS=MPC
MSC
Pe
Qe
Ps
Qs
MEC
L
Cost/benefit
Quantity
Figure 4.1: Welfare loss due to negative externality in production
The welfare loss for a negative externality will be indicated by the trian-gle (L).The welfare loss for a
negative externalityis indicated by an
inward-pointingtriangle; the welfare
loss for a positiveexternality is
indicated by anoutward-pointing
triangle.
This is because there is a difference in the socially optimal quantityand the equilibrium quantity that is demanded by consumers, who ignorethe interests of third parties. This results in allocative inefficiency.
On the other hand, the welfare loss for a positive externality will beindicated by a triangle pointing outward. This is a loss because the sociallyoptimum quantity is not reached, but should be reached.
4.2.1 Methods of intervention
Taxes and subsidies
The government may attempt to correct the market failure caused by exter-nalities by imposing tax or providing subsidies. By doing so, the government
40
hopes to change the quantity consumed to the socially optimal quantity.The government will set this tax or subsidy to the marginal external cost orbenefit.
Legislation
Legislation can be used, such banning the use of certain pollutive chemicals,setting a limit on the amount of pollution generated by a firm, or makingeducation compulsory until a certain age.
Tradable pollution permits
Tradable permits are permits that allow firms to pollute a certain amount,and can be traded. This allows an enforcing organisation to regulate theamount of pollution that is generated. This allows the free market to deter-mine the amount that firms wish to pollute over a certain period. However,it is difficult to decrease the amount of permits in future periods, or indeedchoose how much is an acceptable pollution level in the first place. It mustalso be strictly enforced.
Education and persuasion
Education and persuasion can be used to inform consumers about the socialcosts of using certain products, and to encourage them to use energy-efficienttechnology, including cars and lightbulbs.
International agreements
International agreements can be made to reduce externalities that have in-ternational repercussions. An example is the Kyoto Protocol.
Externalities for goods that have externalities in consumption can becorrected in the same ways as merits and demerit goods.
4.3 Merit and demerit goods
Merit goods are goods that are believed to be beneficial to consumers, butwhich are underprovided by the market. This underprovision can be causedby:
Presence of positive externalities Here, underprovision is caused by themarket failing to allocate resources in an socially desirable manner.These include education and vaccinations.
Poverty Some consumers may be unable to afford some of these meritgoods. For this reason, demand of the good (willing and able) may betoo low. Healthcare and education fall into this category.
41
Ignorance Consumers may be unaware of the benefits of merit goods. Ed-ucation is again an example, alongside annual health check-ups.2
Conversely, demerit goods are goods that are believed to be undesirablefor consumers and are overprovided by the market. This overprovision maybe caused by negative externalities and ignorance.
4.3.1 Methods of intervention
Direct provision
Merit goods can be directly provided by the government to consumers tosupplement provision by the market, or contract firms to provide the short-fall. When the government directly provides the good, it often does so at avery low or nonexistant price. Examples include education and healthcare.
Subsidies and taxes
This effectively changes the marginal cost of producing a good, allowing themarket to determine exactly how much of the good to be consumed, whileallowing it to be consumed at a more optimal level for the consumer.
Education and persuasion
Governments may attempt to persuade consumers to consume more meritgoods or less demerit goods. In either case, the objective is to encourageconsumers to consume a more desirable amount of the good.
Legislation
Governments may impose regulations to ensure that a certain amount ofmerit good is consumed, or a certain amount of demerit good is not con-sumed. For instance, compulsory education and smoking in public areas.
4.4 Public goods
A public good has two properties:
Non-rivalry means that the consumption of the good does not significantlyimpact the ability of another to consume it.
Non-excludability meas that it is very difficult or impossible to preventany particular party from consuming the good.
2If you dislike “Ignorance”, “Information failure” may be suitable.
42
4.4.1 Marginal cost for non-rivalrous goods
As the cost for an additional person to consume the good is zero, themarginal cost incurred by the provider for allowing another person to con-sume it is zero. For allocative efficiency to exist (otherwise there would bemarket failure), P=MC must be fulfilled. Thus the price charged for thegood will be zero. Therefore no private firm would be willing to supply thegood, as producers are profit-motivated.
4.4.2 Free rider problem
This is caused by the property of non-excludability, as it is possible for a per-son to consume a non-excludable good without having to pay for it. Thereis therefore an incentive for potential consumers to hide their preference forthe good.
As such, there will be a missing market for the good as no consumers arewilling to pay for it, resulting in no resources allocated for the production ofthis good. Therefore the property gives rise to market failure. The provisionof the good by the government as a public good enables all to consume thisgood, rather than leaving it as a missing market.
4.4.3 Provision of public goods
The goverment should therefore produce public goods for consumption byall in society, funded by tax revenue, and therefore by everyone in society.It is therefore important for governments to produce only goods with highamounts of social benefit as public goods, owing to the limited tax resources.
4.5 Imperfect competition
We note that for economic efficiency, allocative efficiency must be attained inall markets, requiring P=MC to hold true in all markets. However, as firmstend to be profit-motivated, where possible, they will attempt to set P>MC.While this is not possible for perfectly competitive markets in the long run,the existance of other market systems enable this, therefore enabling marketfailure.
4.6 Other causes of market failure
Imperfect information, co-ordination failures (demand for factors of produc-tion), weak or missing market institutions, and policy failure. Conspicuouslyunelaborated.
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Chapter 5
Theory of the Firm
This chapter examines the behaviour of rational firms. For the most part,it is assumed that the main objective of firms is profit.
5.1 Costs and production
Firms must use factors of production to produce goods and services. Byusing these resources, the incur costs of production. Costs of productionare what a firm gives up in order to use these resources. Production occursuntil consumption begins, therefore the distribution of goods is included inthe production process.
There are two different types of costs that a firm may incur. Resourcesmay belong to either the firm or others, and this determines how the costsare considered.
5.1.1 Explicit and implicit costs
Explicit costs
Explicit costs are costs that the firm incurs when it pays outsiders for re-sources.This includes paying
the wages of labour.Therefore, the opportunity cost of using these resources is equal to
the amount paid to use them. These are also known as accounting costs, asthese are usually recorded by accountants.
Implicit costs
Implicit costs, therefore, are the opportunity costs of using the factors ofproduction that the firm owns.This may be the
possible rental of abuilding the firm
uses.
These are implicit as they do not involvepayment to others.
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Economic profit
Therefore, since the total revenue as made up of a combination of the eco-nomic profit and implicit and explicit costs, it is important to note that theeconomic costs consist of both the explicit and implicit costs.
5.1.2 Short run and long run
The short run and long run are distinguished by the presence or absence offixed factors. In the short run, there is at least one fixed factor, in the longrun, all factors are variable. In the long run, firms
may enter or exit theindustry.
There is no specific length of time defining short run and long run.
5.1.3 Law of diminishing marginal returns
The law of dimishing marginal returns states that as increasing amountsof variable factor are added to one or more fixed factor, there will come apoint where each additional unit of variable factor will add less to the totalphysical product (TPP) than the last.1
There are three stages of varying marginal physical product (MPP)2
with increases in the amount of variable factor employed.
With the first few units of variable factor, there will be too little of thevariable factor employed, and so the MPP will increase for each additionalunit.
However, at a certain point MP will begin to decrease, as overcrowdingbegins. Therefore each unit of factor will be less efficient. The MPP willcontinue to decrease, and finally becomes negative, when additional unitssimply reduce the total amount of output.
Note that MPP will cut the APP at its turning point. This is because atMPP=APP, then APP is at its maximum, since after that, MPP decreases,causing APP to decrease (albeit at a slower rate). Before this point, MPPis higher than APP, causing APP to to increase.
5.1.4 Types of costs
Fixed costs
Fixed costs are costs that are incurred from the use of fixed factor, whichcannot be varied in the short run. These exist in the same amount regardlessof the output of a firm.
1Note that the level of technology should be held constant.2MPP = ∆TPP
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Variable costs
Variable costs are costs that vary with the amount of output, as they areincurred from the use of variable factor.
Total costs
Sum of fixed and variable costs.
Average costs
Each of the costs divided by the number of units of the good produced.
Marginal cost
Additional cost incurred from producing the last unit of a good. It can becalculated by
MC =∆TV C
∆Q
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Bibliography
Anglo-Chinese School (Independent) (2011). Economics 2011.
Tragakes, E. (2009). Economics for the IB Diploma. Cambridge, UK: Cam-bridge University Press.
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