mock exam

Micro Opportunity cost; PPFs; Factors influencing Demand and Supply Market Equilibrium Price and Output; changing equilibriums Consumer and Producer Surplus Price, Income and Cross Price Elasticity of Demand Price Elasticity of Supply -Market Failure (to be confirmed after next week's lessons - definitely all types of externalities; and, likely merit & demerit goods) Macro -The Circular Flow of Income Model -The Components of Aggregate Demand -The AD function -Aggregate Supply (AS) -Macroeconomic Equilibrium - AD/AS Analysis -Fiscal Policy

PED DEFINITION

measures the responsiveness of demand to a change in price

ped > 1

elastic demand - % change in quantity demand is more than the % change in price

ped< 1

inelastic demand - % change in quantity demanded is less than the % change in price

ped = 1

unitary elasticity - % change in quantity demanded= % change in price

revenue formulate

price x quantity supplied

impact of revenue on inelastic demand

an increase in price leads to an increase in revenue but other factors can influence revenue

impact of revenue on elastic demand

lower prices leads to an increase in revenue but other factors can influence revenue

factors influencing PED INELASTIC

• Products which have few substitutes - petrol

• products which are necessities

• products which have brand loyalty

• habit forming products

• products which represent small proportion of income

factors influencing ped elastic

• luxuries

• non branded products

• products with substitutes

• time - the longer consumers have to adapt the more elastic

• products which represent large proportion of income

cross elasticity XED

measures the responsiveness of demand for good a following a change in price for good b

when the XED is negative

this means that the goods are complements

when the XED is positives

this means the goods are substitutes

what the size of XED means

the bigger the number from 0 the closer the complement/substitute relationship

income elasticity YED definition

measure the responsivness of demand following a change in income

YED Meanings

positive = normal goods

>1 = normal luxuries

<1= normal necesscities

negative = inferior goods

influences of YED

• pricing decisions

• recessions/ booms change consumption patterns

• trends in consumption

who incidence of tax passed on to

the consumer when demand is inelastic

PES definition

measures the responsiveness of a change in supply to a change in price

when PES>1 price elastic means

firms can increase output quite easily, without much of a time delay and a relatively small impact on overall costs

when PES<1 price inelastic means

firms find it hard to change production in a given time period and therefore find it difficult to respond to a change in demand

when PES=infinity, perfectly elastic means

firms able to increase supply to meet any changes in demand without an increase in price

when PES= 0 perfectly inelastic means

firms unable to change supply

factors making pes elastic pes>1 (vice versa)

• a supplier has plenty of spare capacity

• has high stock levels available

• can switch between labour and capital easily when producing goods

• short production times

• the longer the time period for a firm to adjust production levels

agriculture goods momentary period

pes may be perfectly inelastic PES=0

agriculture goods short run

• the long growing/production period

• perishability of most produce so inability to store makes it difficult for firms to respond quickly to a change in price PES <1 PRICE INELASTIC

agriculture goods long run

• a farmer may commit additional land to production which will lead to a larger crop PES>1 Price elastic

• but it may take years to bear fruit ripe for harvest

• crops may be imported making supply more elastic

housing short run

supply is inelastic PES<1 in the short run

• long production period

• legal time delays

• planning process

housing long run

supply is elastic PES>1 in the long run

• technological advances to speed up production

• government policies to train more trades people

• government loan guarantees to property developers

OPPURTUNITY COST DEFINITION

this is the cost interns of the benefits of the next best or highest valued alternative forgone

production possibility frontier

a PPF shows the different combinations of economic goods which an economy is able to produce if all resources in the economy are fully and efficiently utilised

any point which lies within the ppf

represents the insufficient use of resources or resources that remain unemployed

any point which lies outside of the ppf

represents a level of output that is currently beyond the maximum level of the economy. these production levels are attainable in the future only if there is economic growth

any point along the length of the ppf

pareto optimal which means its impossible to increase the production of one good without reducing production of the other n

ppf with increasing oopitunity cost (diminishing returns)

as the economy produces more of a particular good less and less suitable resources devoted to the production of the other good

PPF with constant opportunity cost

in order to produce more of one the economy will need to reduce its production of the other this opportunity cost remains the same throughout the the whole length of the ppf

any ppf that is drawn as being a downward sloping straight line

follows the assumption that all resources in the economy are as productive in one use as they are in the other

what causes an outward parallel shift PPF

• the introduction of new technology or advances in the techniques of production (division of labour) lead to improvements in productivity and efficiency

• additional factors of production being made available to the economy (an increase in the size of the working population, new factories have been built)

what causes a non parrelleL shift PPF

changes in factor of production or in new technology benefit the production of one good/ industry only

skills tip for explaining the impact of a shift in a production possibility

must comment on how it affects the productive capacity and potential of an economy

an inward Parallel or non parallel shift is caused by PPF

• natural disaster occurring

• a war arises which destroys part of an economy’s productive base

• a depletion of resources

• impact of a deep prolonged economic recession - closure of businesses, scrapping of. capital equipment, unemployed workers skills becoming redundant

a recession shown as a point further away from the frontier

in the real world an economy is unlikely to operate on its frontier

• at all times there will still be some resources such as labour not fully utilised

• during a recession even less resources will be fully utilised and the economy would move even further away from the frontier

a recession shown as a inward shift of the PPF

a deep recession occurs in the economy could cause a shift in the ppf if

• net investment is negative - the level of investment is insufficient to compensate for capital depreciation o that capital levels (factories, machinery) fall in the economy is able to produce less goods and services in the future as a result - the economies productive potential falls

• the recession leads to unemployed workers who leave the labour market permanently or whose skills decline so that the productive capacity of the economy is lowered

what does economic growth look like on ppf

• during an economic recovery higher demand and output means a fall in the amount of spare capacity which will produce closer to the PPF

• macroeconomic policies from the government will shift a PPF outwards as they increase the productive capacity

demand curve may shift rightwards

1. a rise in the price of a substitutes (competitive demand) or a fall in the price of a complement (joint demand)

2. an increase in consumers’ income or their wealth

3. changing consumers taste and preferences in favour of their product

4. a fall in interest rates

5. a general rise in consumer confidence and optimism

demand and supply diagram explanations must have

1. state what has affected the market and the impact on demand and or supply

2. outline the impact on demand or supply (shift inwards or outwards) and state WHY the curve has shifted in detail

3. using annotation, explain the process to the new equilibrium and impact on price and quantity

writing about diagrams

1. reference to specific labels on the diagram

2. clear explanation as to why curves have shifted

3. clear explanation of how new equilibrium points are reached

4. clear explanation of how new equilibrium points are reached

exceptions to the law of demand

1. ostentatious consumption - some luxurious items satisfaction comes from knowing the price of the good and being able to flaunt consumption of it to other people

2. speculative demand - buyers are interested in the potential rise in market price leading to a capital gain or profit

reasons for a downward sloping demand curve

• the income effect - when the price of a good falls because the consumer can maintain current consumption for less expenditure

• the substitution effect - when the price of a good falls because the product is now relatively cheaper than alternative item

• diminishing marginal utility - as consumers consume more a product their marginal utility diminishes - firms lower prices to encourage people to buy more

supply curve may sift outwards

1. a fall in the costs of production

2. a government subsidy to poroducers that reduces their costs per unit

3. favourable climatic conditions csusinhg higher than expected yields for agriculture commodities

4. a fall in price of a substitute in production

5. an improvement in production technology leading to a higher productivity and efficiency in the production process and lower business costs

reasons for an upward sloping supply curve

• profit motive - when the market price increases it becomes more profitable for businesses to increase their output

• marginal costs rise - when output expands the marginal cost of production increases therefore higher price is needed to cover the extra costs

• new businesses decide to come into the market - higher prices create incentive for businesses to enter the market leading to an increase in supply

ad valorem tax - vat

• described as “diverging shift”

• the gap shows the more expensive the product the higher the tax

unit /specific tax

• described as “parallel shift”

• the gap is the size of the tax

increase in demand due to rises in income - changes in equilibrium prices

1. a cut in income tax leads to an increase in demand for coffee

2. this is shown as a shift to the right of the demand curve from MD1 TO MD2 ceteris paribus as this leads to an increase in disposable income for consumers who can afford to buy more coffee at each and every price, at the original price there is now excess demand and this puts upward pressure on price

3. over time there will be an expansion of supply as more coffee is grown imported or enter the market as a result of a rising price this process continues until anew equilibrium is reached at P2Q2 with an increase in both price and quantity traded

increase in supply due to fall in labour costs - change in equilibrium prices

1. a fall in labour costs leads to an increase in the supply for coffee

2. this is shown as a shift to the right of the supply curve from MS1 to MS2 ceteris paribus as firms have lower costs per unit and as a result are prepared to supply more at each price. at the original price at PE there is now excess supply and this puts downwards pressure on price

3. overtime there will be an expansion of demand as consumers purchase more coffee at lower prices. this continues until a new market price equilibrium is eventually reached at P2Q2 with a decrease in equilibrium price and an increase in quantity traded

market surplus

this is when supply exceeds demand therefore creating an excess supply. this will exert downwards pressure on price until market equilibrium is once again achieved

market shortage

this is when demand exceeds supply therefore creating an excess demand. this will exert upward pressure on price until market equilibrium is once again achieved

consumer surplus

is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the actual price paid (the market price for a product)

how to find the consumer surplus

shown by the area under the demand curve and above the ruling market price

regressive impact consumer surplus

when price increases consumer surplus falls but there will be a greater negative impact upon lower income houses

progressive impact - consumer surplus

when price decreases consumer surplus increases leading to a greater positive impact upon lower income households

producer surplus

the difference between what producers are willing and able to supply a good for and the price they actually receive

market failure definition

the misallocation of resources caused by unrestricted operation of the free market and or it causes a net welfare loss to society

market failure overview - markets generally work well

price mechanism: competitive markets allocate resources efficiently through the forces of supply and demand and setting the relative prices of goods

market failure overview - sometimes markets fail

market fail ocurs when markets fail to produce desirable outcomes either because the allocation of resources is not efficient or because the outcome is unfair

market failure overview - this may justify government intervention

government may respond to market failure through intervention

market failure overview - government failure sometimes occurs

government failure may occur if there are negative consequences to their policies to address market failure

types of market failure - externalities

third party effects arising from the production of goods or services which no appropriate compensation is paid

costs - market failure

• private cost- cost of an activity to a consumer or a firm

• external cost - negative third party effect which can arise in production or consumption

• social cost - the cost of an activity that includes all private costs and external costs

• social costs = private costs + external cost

benefit - market failure

• private benefit - pleasure or satisfaction gained from consumption to production

• external benefit - a positive third party effect which can arise in production or consumption

• social benefit - the benefit of an activity to society that includes all private benefit and external benefit

• social benefit = private benefit + external benefit

social optimum level of production and consumption

marginal social costs = marginal social benefit

negative production externalities

• if social costs are greater than private costs then a negative externality is said to exist this leads to the level of output being greater than the optimum point

• the market fails as the individual consumer or producer does not take the effects of externalities into their calculations resulting in too many resources being allocated to the production of a good

• air pollution from factories, noise pollution, methane emissions

negative consumption externalities

• negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit

• the market fails as consumers do not take into account the loss of benefits to others leading to overconsumption

• vehicle pollution, litter, congestion, alcohol consumption

externalities and the absence of property rights

• negative externalities may occur because of the absence of clearly defined property rights

• if an asset is unowned no one has an economic incentive to protect it from abuse

• market failure can occur as it can lead to the overuse of common land, fish stocks which can lead to long term permeant damage to stock of natural resources this is known as “tragedy of the commons”

positive externalities in consumption

• the total benefit to society may far exceed the benefit received by the individual hence if social benefit is greater than private benefit a external benefit is said to exist

merit goods

• are goods which are socially desirable but are under provided in a market economy

• merit goods which are associated with positive externalities are provided by the market where producers feel that they can charge and make profit for their provisions

• education, healthcare, pensions

why are merit goods such as education under provided by the market

• education would be under provided in a free Market economy because the social benefits are greater than the private benefits due to information failure and ignoring external benefits

1. the external benefits of education which is able to increase productivity and thus compete globally therefore increase living standards would not be taken into account by individuals when deciding whether to Pay for education

2. individuals might underestimate the private benefits of education -higher earnings potential an example of information failure

3. individuals may misjudge the private benefits of education because the benefits occur largely in the future

basic circular flow model

• Resources: The factors of production that are used by firms to produce output. Labour, Land,Capital, Enterprise.

• Income: The income that is received for using factors of production. Wages, Rent, Interest,Dividends, Profits.

• Output: Goods and services that satisfy the wants and needs of households.

the multiplier process

• an injection (J) into the economy, the multiplier process explains why national income will rise by more than that initial

  injection.

• the money from the injection helps to employ more factors of production (such as labour) and provide additional income for households. Households then spend a proportion of that additional income (depending on their MPC) on output. This drives demand for more goods and services and, consequently, more demand for labour. This leads to more income for households and more demand for output. The cycle continues.

• if injections are greater than withdrawals than national income will increase

• if withdrawals are greater than injections than national income will decrease

• if injections and withdrawals are equal than national income is in equilibrium

GDP (national income) - can be calculated using circular flow model

the value of all output in a country in a year

measuring national income - GDP (EXPENDITURE)

• the sum of aggregate demand (expenditure) for uk produced goods and services

• AD= C+I+G+(X-M)

measuring national income - GDP (INCOME)

• sum of the final incomes earned through production of goods and services

• included - income from jobs, profits from public and private sector

• not included - transfer payments, black economy

measuring national income - GDP (OUTPUT)

• value of output produced by each of the industrial sectors in the economy

• primary - farming, fishing

• secondary - manufacturing and construction

• tertiary - services, retail, tourism

gross national product GNP

measures the final value of output produced by uk owned factors of production whether they are located in the uk or overseas

gross domestic product GDP

measures the output produced by all firms in the uk including foreign based firms

the multiplier ratio

total change in GDP = injection x multiplier

components of aggregate demand

AD = C+I+G+(X-M)

• c- consumers expenditure on goods and services

• I- investment spending by companies on capital goods

• g- government spending on publicly provided goods and services including public and merit goods

• x- exports sold overseas are an inflow of demand into the circular flow of income

• m - imports are a withdrawal from the circular flow of income

why the AD curve slopes downwards

• real income effect - as the price levels fall the real value of incomes and consumers are able to buy mote of what they want or need

• balance of trade - a fall in the relative price of country x could make foreign produced goods and services more expensive causing a rise in uk exports and a fall in imports

• interest rate effect - if price inflation is low and this lads to reduction in interest rates - there is a lower reward to save this may lead to a rise in consumption and a rise in investment as the cost of borrowing is cheaper

shifts in AD

Anything that will shift a component of AD

• income inflation, taxation, interest rates

aggregate supply

measures the volume of goods and services produced each year. AS represents the ability of an economy to deliver goods and services to meet demand

neo-classical sras (cost of production) curve analysis

• a rise in the price level causes an expansion of SRAS

• a fall in the price level causes a contraction of SRAS

• the short run AS curve is upward sloping because newer firms want to invest as its now profitable and incumbunt firms ramp up production

shifts in short run aggregate supply SRAS

1. Changes in unit labour costs - unit labour costs are wage costs adjusted for productivity. a rise in unit labour costs might be due to higher wages or a fall in the level of labour

2. changes in other production costs- the cost of fertiliser

3. commodity prices - changes to raw material costs and other components

4. exchange rates - change in exchange rates cause fluctuations in the price of imported products

5. government taxation and subsidy- changes to the business taxes and subsidies levied by the government as part of their fiscal policy have effects on the costs of nearly every producer

external factors affecting SRAS

• world oil/ gas price/ energy prices/ cost - uk is a net importer of oil and energy

• minerals/ metal prices- rubber, iron ore

• food prices - international prices of fresh foods

• import tariffs / quotas

Long run aggregate supply (LRAS - Q2CELL)

• SHAPE - yfe is the estimated potential level of real national output in the long run

• shift - an outward shift of LRAS shows a rise in productive potential

• the LRAS is vertical (perfectly inelastic) as there is a maximum level of physical output that the economy can produces

why there will be unemployment

• structural unemployment - skills mismatched - coal miners

• voluntary unemployment - benefits

• frictional unemployment - people between jobs

factors affecting LRAS(Q2CELL)

• high productivity of labour and capital

• increased labour market participation

• gains from innovation and enterprise

• capital investment

what causes a shift in LRAS (Q2CELL)

• Changes in labour supply - more people joining the work force - changes to retirement, migrant labour

• changes in capital stock - tax incentives and subsidies

• improve occupational and geographical mobility - reduce structural unemployment snd occupational mobility caused by decline of specific industries

• increase business efficiency - promote greater competition within markets through privatisation

• faster pace of invention and innovation - in the long term it can promote Lower production costs and improve competitive position of uk companies

keynesian aggregate supply curve

• when spare capacity exists in the economy aggregate supply will be elastic as output can be increased in response to a rise in aggregate demand without a significant change in price level

• as output increases the AS curve will become more inelastic as the amount of spare capacity declines, resource shortages. an outward shift in ad causes a sharp rise in general price level

• when AS is perfectly inelastic the economy is at full capacity - further increases in AD above yfe are purely inflationary in the short run with little extra real output

fiscal policy

the use of government expenditure and taxation to try and influence the level of economic activity to achieve the main economic objectives of

• low and stable inflation

• high employment

• sustainable economic growth

• sustainable balance of payments

key roles of fiscal policy

• redistribution of income and wealth

• instrument of microeconomic government intervention to correct market failure

• respond to economic shocks

• financing govt spending