Economics Chains of Reasoning

advantage of specialisation / division of labour

- tasks separated in production process

- workers gain more practice in specific tasks

- skills improve + productivity rises

- lower unit costs

- firms can set lower prices - consumer welfare improves/surplus analysis

- or just make more profit - potential for dynamic efficiency

disadvantage of specialisation / division of labour

- tasks separated in production process

- workers repeat same task the whole time

- workers get bored + feel alienation (don't feel part of the final product)

- increased levels of absenteeism and inactivity / high turnover rates

- higher unit costs

conditions of demand

- disposable income (normal +ve / inferior -ve)

- price of substitutes/complements

- changes in taste/fashion (may be seasonal)

- population

- advertising

EG: increase Yd > rise in effective demand > D1 to D2 > excess demand > extension of supply (firms raise prices to P2 > contraction of demand > new equilibrium P2

conditions of supply

- production costs / technology / determinants of unit cost

- external factors: weather, strikes, lockdowns

- producer subsidies / indirect taxes (affect AVC)

EG: increase production costs > lowers supply at any given price > S1 to S2 > excess supply > suppliers lower price to clear stock P2 > contraction of supply; extension of demand > new equilibrium P2

price mechanism (rise in P)

information about conditions > signals scarcity to producers > re-allocate FoP to good

higher profit (assuming constant costs) > incentivises producers > re-allocates FoP to good

lowers consumers' effective demand > rations the good to those most willing and able to purchase the good

externalities

- 3rd party effects of production/consumption

- not included in private decisions

- divergence between private and social costs/benefits

- misallocation of resources by price mechanism

- over/under production/consumption

- partial market failure

- reduced allocative efficiency (deadweight loss)

public goods (market failure)

- non-excludability/rivalry

- firms cannot charge prices and profit (free-rider problem)

- goods and services not provided

- missing market

- complete market failure

- misallocation of resources

- reduced allocative efficiency

information failure (goods with positive externalities)

EG healthcare

- consumers don't possess/ignore relevant information

- under-consumption of goods with positive externalities

- MPB < MSB

- partial market failure

- reduced allocative efficiency (deadweight loss)

utility maximisation

- consumers aim to maximise welfare

- acquire the bundle of goods/services that provide maximum utility

- consumer to point of satiation of a wide variety of goods/services

CONSTRAINTS

- limited income

- set of prices

- limited time

- limited information

marginal returns (short run)

- at least one FoP is fixed in SR

- increases other FoP (eg labour)

- diminishing marginal returns

- total output rises at slowing rate

- marginal product falls

- marginal cost rises

returns to scale (long run)

- all FoP are variable

- if inputs double but output less than doubles

- decreasing returns to scale

- total output rises by less than total inputs

- unit costs rise

economies of scale (long run)

sources include: bulk buying, managerial, financial, technical, marketing, risk-bearing

EG: bulk buying > lowers per unit input costs > reduced LRAC as output rises

profit maximisation (MC=MR)

- quantity of output where MC=MR

- maximum profit

- no incentive to change production level

- re-invest profit into R&D

- innovate and invest

- dynamic efficiency

- lowers prices/increase profits in LR

- supernormal profit

- incentives for firms to join industry

- increases competition (depends on barriers to entry)

- increases industry supply

- lowers market price

- lowers AR for firm

- supernormal profits competed away (to normal if PC or monopolistic)

revenue maximisation (MR=0)

- managerial pay and rewards may be linked to revenue (eg market share)

- increase revenue

- increase monopoly power

- can raise price in future

- increase future profit

sales maximisation (AC=AR)

may be necessary for a start-up firm to survive

- increase sales

- economies of scale

- lower unit costs

- increase brand loyalty

- increase market share

- increase monopoly power

- raise prices in future

- increase future profit

perfect competition (AR/MR curves)

- consumers and firms have perfect information

- demand is perfectly elastic

- any price above equilibrium not sold (consumers switch supplier)

- AR curve is horizontal

- AR for every good sold is equal to market price and MR as constant

- TR is positive, linear curve

perfect competition (SR supernormal profits)

- in SR firms can make supernormal profits

- new firms incentivised to join industry

- freedom of entry so they join

- increases industry supply (S1 to S2)

- reduces industry price (P1 to P2)

- reduces AR for firms until AR=AC (minimum)

- normal profits in LR

perfect competition (SR losses)

- in SR firms can incur a loss

- firms producing where AR < AVC shutdown (in SR) or leave industry (if AR < ATC in LR) due to freedom of exit

- reduces industry supply (S1 to S2)

- raises industry price (P1 to P2)

- increases AR for firms until AR=AC (minimum)

- normal profits in LR

monopoly (AR/MR curves)

- market Qd inversely proportional to P

- pure monopoly is single seller so D=AR

- increase quantity sold monopoly must reduce price

- if AR is falling then MR must fall at faster rate

sources of monopoly power

- economies of scale

- lower unit costs of production for monopolist (falling LRAC as output rises)

- can set lower price than small firm

- attract consumers

- puts up barriers to entry

- advertising/branding

- increase inelastic PED

- difficult for new firms to attract enough consumers

- monopolist can charge higher price to increase revenue/profit

monopoly market failure

- monopoly power

- restricts output to MC=MR

- raises prices above allocatively efficient level (P=MC)

- lowers output below productively efficient level (min LRAC)

- captures CS; increases PS

- deadweight loss of societal welfare

monopoly (advantage)

- economies of scale

- lower production costs

- increases supernormal profits (profit max)

- may re-invest in R&D

- innovation and investment

- higher dynamic efficiency

- lowers LRAC and improve quality

- increased choice and variety of goods for consumers at lower prices

- CS increases in LR

oligopoly: price rigidity (kinked demand theory)

- if a firm increases price, assume other firms would keep their price the same to stay competitive > consumers switch to other firms > relatively elastic PED > revenue falls

- if a firm lowers price, assume other firms would also lower their price to stay competitive > relatively inelastic PED > revenue falls

- no incentive to compete on price in oligopolies (stable prices)

oligopoly (uncertainty)

- competitor firms could take a number of actions in response to price cut

- firms don't know how competitors will behave

- they could match price reduction or start a price war or do nothing

- uncertainty leads to inaction and focus on non-price competition

maximum price (price ceiling)

- reduced price

- contraction of supply and extension of demand

- transfer PS to CS

- encourages firms to be more efficient to reduce production costs

tax on profits > decreases incentive to collude

negative outcome

- interdependence

- collusion (join-profit maximisation)

- agree quotas to restrict output to industry profit max (MC=MR)

- raises prices for consumers

- CS falls

efficiency in competitive markets

- profit maximising firms produce MC=MR

- supernormal profit

- incentivises new firms joining

- increase industry supply

- reduces industry price

- lowers firms' AR and increases output towards where P=MC (more allocatively efficient) and minimum of AC (more productively efficient)

market contestability

- reduce barriers to entry or exit

- increased threat of competition

- firms behave as if there is competition

- increase output and lower price to AR+AC (normal profits) to prevent incentive for new firms joining and protect monopoly power

- increases productive and allocative efficiencies

competition policy for natural monopolies

- natural monopoly

- high barriers to entry

- no need to pass on lower unit costs to consumers (keep prices higher)

- abuse of monopoly power

- reduced consumer welfare

third degree price discrimination

- firms identify different groups of buyers with different PEDs and keep them separate at low cost

- produce output where MC=MR overall

- sets MC=MR in sub groups (higher price to inelastic group)

- increase supernormal profit compared to single price

benefit to consumers:

- priced into market

- some buyers pay less (elastic group)

determinants of consumption

- increase in disposable income

- fall in taxation

- positive wealth effect (and negative)

- consumer confidence

- interest rates (lower)

- availability of credit

- inflation expectations

- fall in savings ratio

increase in consumption

- increasing personal allowance (eg 2019 £12,500)

- increases Yd

- increase in consumption (by keyensian consumption function

- increase in AD

- increase in real GDP

- SR economic growth

government spending

causes of expansionary fiscal stance:

- recessionary pressure

- war/terrorism

- natural disasters

- politics

CoR

- issues gilts in primary capital markets

- raise finance to fund budget deficit

- increase demand for goods/services

- injection into circular flow of income

- AD increase

- derived-demand for labour

- fall in unemployment

investment

causes of rise in investment:

- fall in interest rates

- fall in cost of capital

- increase in technological progress

- increase in business expectations

- fall in interest rates

- lowers cost of borrowing for firms

- increase in marginal efficiency of capital

- increase in investment

- increase in demand for capital goods

- increase in productive capacity of economy (LRAS shift out)

- LR economic growth

net exports (X-M)

causes of rise in export revenue:

- fall in exchange rates

- improved economic performance of trading partners

- relatively lower inflation rates

- reduction in base rate (IR)

- reduction in return for domestic savings

- outflow of hot money

- increase money supply of GBP (S1 to S2)

- depreciation of sterling

- UK exports cheaper

- UK imports more expensive

- Qd for exports rises, for imports falls

- (X-M) rises

- improvement in current account of the BoP

EV: Marshall-Lerner condition must be satisfied for (X-M) to rise

positive multiplier effect

any increase of injection (or decrease of withdrawal) from the circular flow of income

- EG increase in investment

- increase in demand for capital goods

- injection into circular flow

- initial increase in AD

- increase in derived-demand for labour

- increase in Yd

- increase in demand in a different market

- secondary rounds of spending increasing due to higher income

- AD2 to AD3 (rise)

- more income flows back to firms / real output rises again (Y1 to Y3)

negative multiplier effect

any decrease in injection (or rise in withdrawal) from the circular flow of income

- EG rise in exchange rate

- lower cost of imports

- increase demand for imports relative to domestic goods

- reduced demand for UK exports

- initial fall in AD

- fall in derived-demand for labour

- rise in unemployment

- fall in Yd

- fall in C - decrease in demand in other markets

- AD2 to AD3 (fall)

- additional fall in real output (Y1 to Y3

accelerator affect

- expansionary demand-side policy

- rise in rate of economic growth

- firms close to full capacity increase capital expenditure in anticipation of future increases in demand for goods

- higher proportional increase in rate of investment

- injection into circular flow

- increase in AD

- demand pull inflation

causes of productivity gap in G7

- low investment

- lower R&D

- worse education / skills of labour force

- over-regulation

- EG: relatively low levels of investment

- less up to date capital machinery/technology

- less innovation

- reduced output per input

- reduced labour productivity

- higher per unit cost

- less international competitiveness

supply side policies

- labour markets: education/training, infrastructure, transport affect geo and occ mobility

- labour markets: lower tax / benefits affect work incentives

- labour markets: trade union reform to improve flexibility

- product market: privatisation / deregulation / competition policy

- capital market: lower taxation to encourage investment in R&D, regulation and deregulation of financial markets

- EG: government reforms education (GCSE/A Levels)

- increase human capital

- increase in labour's productive potential

- increase in potential output in economy (LRAS shift out)

- LR economic growth

fiscal policies

expansionary:

- reducing direct taxation (income tax/national insurance)

- reducing indirect taxation (eg VAT)

- increase in current / capital spending

- budget deficit

- EG: reduction in direct taxation (eg income tax)

- increase in household Yd

- C rises (according to Keynesian consumption function)

- AD rises

- increase in national income (real GDP) Y1 to Y2

- SR economic growth

financial crowding out

government incurs budget deficit

- issues more gilts in primary capital market

- increases demand for loanable funds

- govt must increase coupon rate on gilts to attract investors/savers seeking balanced portfolio

- commercial banks must raise interest rates in response to attract savers

- higher cost of borrowing

- lowers borrowing and spending by consumers/firms

- financially crowds out private sector

- offsets increased G via lower C and I

- reduced increase in AD

- limits economic growth

loose monetary policy

- fall in base rate

- lowers cost of borrowing for commercial banks

- lowers mortgage interest rates

- increase demand for mortgage credit

- increases demand for houses (D1 to D2)

- increase in house prices

- increase in positive wealth effect

- increase in consumer spending

- increase in AD

- increase in demand-pull inflation

tight monetary policy

- rise in base rate

- increases reward for saving

- attracts international hot money flows

- increase in demand for sterling (D1 to D2)

- appreciation in sterling

- price of exports rise and imports fall

- Qd X falls, M rises

(X-M) falls

- AD falls

- real GDP falls

- slowdown in economic growth

EV 1: Marshall-Lerner condition

EV2:

- lowers cost of importing raw materials and part finished goods for firms

- lowers cost of production

- increases domestic supply (AS1 to AS2)

- reduction in cost-push inflation

- may offset fall in AD

quantitative easing (QE)

- BoE creates digital money

- purchases back previously issued gilts and targeted private sector bonds form large financial institutions like pension funds

- increases demand and hence price of these debt instruments

- increases liquidity (broad money) and lower yield in secondary capital markets

- lowers coupon rate needed to be offered by private sector firms who wish to raise capital in primary capital markets

- lowers cost of borrowing for firms

- increases private sector investment

- increases demand for capital goods

- increases AD

- increases real GDP (Y1 to Y2)

- SR economic growth

Phillip's curve

- expansionary demand side policy

- increase demand for goods and services

- increase in AD

- increases derived-demand for labour

- lowers unemployment

- when economy is close to full capacity workers and trade unions exploit labour shortage and increase wages

- higher costs of production

- AS shift left

- cost-push infaltion

price instability

- uncertainty about costs, prices, revenue

- caution

- inaction

- reduced consumer spending (big ticket items) to increase consumer surplus

- reduced investment (to protect profits)

- reduced AD

- lower derived-demand for labour

- falling national income

- reduced economic growth

cost-push inflation causes

- fall in exchange rate / imported inflation (costs of raw materials / part-finished goods)

- rise in raw material costs

- tight labour market

- rise in indirect taxation

benign deflation

- fall in cost of capital

- increases investment rate of return

- increases investment

- increases productive capacity (LRAS)

- fall in price level (P1 to P2)

- benign deflation

comparative advantage

- each country specialises in production of goods/services with lower opportunity cost

- agree terms of trade that lie between internal trade-off ratio

- trade occurs between economies with higher total consumption of goods and services

- increased social welfare

why is trade deficit bad

- value of imports greater than exports

- (X-M) is negative, and component of AD

- AD falls

- fall in real output (Y1 to Y2)

- slowdown in economic growth

- fall in standard of living

FURTHERMORE

- net imports in withdrawal from circular flow

- negative multiplier effect

- reduced national income reduces further rounds of spending

- AD falls more (AD2 to AD3)

- lower derived-demand for labour

- additional rise in unemployment

- fall in standard of living

expenditure reducing policy (contractionary fiscal/monetary)

- increase taxation

- Yd falls

- C and I fall

- AD falls

- national income falls (Y1 to Y2)

- imports are income elastic (UK has high MPM 35%)

- demand for imports will fall

- M falls

FURTHERMORE

- deflationary policy (P1 to P2)

- domestic goods are more export competitive since other currencies have more purchasing power of the inflated sterling

- so demand for exports rises

- X rises

EV: economic slowdown may reduce business confidence

- UK firms may put off investments and so reduce output

- exports fall

- unemployment side effect (negative output gap)

expenditure switching policy

- aim to switch spending towards domestic goods not imports

- protectionist measures - tariffs

- tariff model - price of importing rises

- domestic goods more competitive

- consumers substitute in favour of the relatively cheaper good

- M falls, domestic consumption rises

- (X-M) rises

FURTHERMORE

- positive multiplier effect - reduced withdrawal

- more income flowing around circular flow

- firms producing more output

- labour is derived-demand (increase)

- less unemployment

EV: retaliation / geopolitics / trade blocs

- consumers losing out from cheaper exports

globalisation

- increase in international trade

- increase in competition among suppliers

- greater choice of a variety of goods/services at lower prices for consumers

- increased social welfare

- increase in labour supply

- increase in productive capacity (LRAS)

- lower wage costs

- benign deflation

- increase in potential markets

- increase in output

- economies of scale

- lower LRAC

- higher profits

- increased investment and innovation (R&D)

- increase in AD

- SR economic growth

FURTHERMORE

- investment is injection into circular flow

- positive multiplier effect

- AD rises more

benefits of single market and customs union

- free trade in goods, services

- free movement of labour and capital

- economies of scale / increased efficiency / lower production costs

- increased trade / economic growth / lower unemployment

- trade creation / consumer welfare

- increased competition / lower inflation

- specialisation / improved trade balance

- no trade deflection

benefit of trade blocs (market size/specialisation increases Y)

- tariff free access to 500m consumers

- provides scope to exploit comparative advantage and specialise (UK in financial services)

- EoS (eg marketing)

- lowers average fixed costs of production

- increases profits

- increases investment in R&D

- increase in derived-demand for labour

- increase in Yd

- increase in C

- increase in AD

- economic growth (rise in real GDP)

trade diversion

- have to set common external tariff to non-EU members

- loses non-member tariff free or low tariff trade partners (NEW ZEALAND)

- Tariff model

- UK consumers switch to cheaper EU suppliers (higher price than previous

- reduced consumer welfare (surplus analysis)