Microeconomics theme 1

Scarce resources that must be allocated efficiently to best solve the basic economic problem

Capital, enterprise, land, and labour

Capital, enterprise, land, and labour (CELL)

The 4 factors of production

Response to the basic economic problem

Choices must be made over what to produce, how to produce, and who to produce for

What to produce in response to basic economic problem

Determined by consumer demand in a free market economy

How to produce (in response to the basic economic problem)

Chosen by businesses/firms based on what is most cost effective and profitable to minimise use of scarce resources

Determined by the income of consumers

Who to produce for in response to basic economic problem

Whether choices made have been good or bad

What does opportunity cost measure in an economy

Any point on the curve

Productive efficiency on a PPF diagram

Law of increasing opportunity cost

The more that is produced of one product, the more production of another product that has to be given up (illustrated by PPFs concave nature)

Firms improving the quality or quantity of their factors of production

How the PPF curve can be shifted outwards

Income effect and substitution effect

Explanation for the law of demand

Income effect

Causes the law of demand because the purchasing power of incomes increases as prices decrease, causing demand to extend

Substitution effect

Causes the law of demand because as prices increase, other products become more price competitive, so consumers switch their demand, causing demand to contract

Population (growth increases demand), advertising, price of substitutes, income, fashion/tastes, interest rates (mainly for expensive goods that require borrowing), price of complements

(Non price) factors that shift the demand curve (PASIFIC)

Profit motive (incentive to supply more at higher prices)

Explanation of the law of supply

Output per worker per time period

Productivity of labour

Productivity, indirect tax, number of firms in the market (more firms = more supply), technology (advancements), subsidies, weather, any other factors affecting CoP (e.g. oil prices, raw material costs etc.)

(Non price) factors that shift the supply curve (PINTS WC)

Involve costs of production (as then impacts firms willingness and ability to supply)

Trend of (non price) factors that shift supply curve

Free market

Anywhere that buyers meet suppliers to exchange goods/services FREE from government intervention

Prices and their signalling function, rationing function, and incentive function

Natural causes of the efficient allocation of scarce resources in a free market

There has been excess demand and more resources are needed

Higher prices signal to producers that (signalling function)

Decrease their output to make more profit (leave the market)

Lower prices incentivise producers to (incentive function)

Encouraging consumption of products in surplus

Lower prices ration scarce resources by (rationing function)

Consumer surplus

Area below the demand curve and above the price line

Producer surplus

Area above the supply curve and below the price line

Law of demand

Reason why PED is always negative

Steepens

Effect of supply or demand being price inelastic on their curves

Substitutes (more substitutes = more elastic), percentage of income (5% increase in apple prices = more insignificant and inelastic than 5% increase in car prices), luxury (or necessity), addictive, time period (LR = more elastic, more time to find alternatives)

Factors affecting PED (SPLAT)

Law of supply

Reason why PES is always positive

Identical

PES measurements vs PED measurements (e.g. <1 = inelastic)

Production lag, stocks, spare capacity, substitutability of factors of production, time period (LR = more elastic as in SR at least one factor of production is fixed)

Factors affecting PES (PSSST)

Substitutes

When XED is positive

Complements

When XED is negative

Relationship between 2 products increases

As XED increases

Normal good

Positive YED

Inferior good

Negative YED

YED = 0

When there is no relationship whatsoever between income and QD

Inverted (becomes supply curve)

Effect on demand curve when products are inferior goods or substitutes

Supply shifts left (S1 + tax)

Impact of indirect tax on a diagram

PED (inelastic = consumers, elastic = producers)

Who carries the greatest burden of an indirect tax between consumers depends on

Solve market failure, encourage affordability of necessities

Uses of subsidies

Supply shifts downwards (to S1 + sub, gap indicates subsidy per unit)

Impact of a subsidy on a diagram

Subsidies

Causes increased producer revenue, increased consumer surplus/savings, increased society surplus, but a deadweight welfare loss

How it is funded - opportunity cost

Benefit of subsidies for consumers depends on

Protect producers from price volatility (usually agricultural and commodities) and solve market failure

Uses of a minimum price (price floor)

QD contracts, QS extends, an excess supply (surplus) occurs (solved by intervention buying), deadweight welfare loss (to the left of equilibrium)

Impact of a minimum price on a diagram

Intervention buying

When the government buys up excess supply caused by a minimum price

Regressive, taxpayer pays for intervention buying, encourages shadow economy growth

Evaluation of minimum prices

Increase affordability of necessities, solve market failure

Uses of a maximum price (price ceiling)

QD extends, QS contracts, an excess demand (shortage) occurs, deadweight welfare loss (to the left of equilibrium)

Impact of a maximum price on a diagram

Benefit if they can access the market

Impact of a maximum price on consumers

Free market equilibrium

Where there is an efficient allocation of scarce resources

MPC (private costs) and MSC (social costs)

Externalities illustrated by the supply curve on a diagram

MPB (private benefits) and MSB (social benefits)

Externalities illustrated by the demand curve on a diagram

Maximisation of society surplus and net social benefit (MSB=MSC) (where resources perfectly follow consumer demand - D=S)

Traits of allocative efficiency (equilibrium)

Many buyers/sellers in the market, perfect information (for both producers and consumers), no barriers to entry or exit, firms are profit maximisers and consumers are utility maximisers

Allocative efficiency is the perfect way of solving the basic economic problem as long as key assumptions are made

Positive/negative externalities, merit/demerit goods, public goods, common access resources (tragedy of the commons), income inequality (inequity), monopoly power (defies many key assumptions of allocative efficiency), and factor immobility (inability of firms to meet increases in demand due to FoP)

Causes of market failure

Examples of negative externalities in production

Resource depletion/degradation, deforestation, air pollution

MSC>MPC

Negative externality in production on a diagram

MSB<MPB

Negative externality in consumption on a diagram

MSB>MPB

Positive externality in consumption on a diagram

MPC>MSC

Positive externality in production on a diagram

Always points to social optimum

Deadweight welfare loss on an externalities diagram

Self interest

Reason why firms or producers ignore externalities causing market failure

Examples of negative externalities in consumption (de-merit goods)

Smoking (3rd party inhale smoke), alcohol (3rd party = health and police services)

Examples of positive externalities in consumption (merit goods)

Healthcare (increased productivity), education (higher skills)

Examples of positive externalities in production

In-work training (more skilled labour force), R+D (technology advancements)

Imperfect information (information failure)

Main cause of merit and de-merit goods

Asymmetric information (firms withhold information on how harmful product is)

Main type of information failure causing de-merit goods

Non-excludable, non-rivalrous, non rejectable

Pure public goods traits

Firms are not incentivised to fund public goods meaning without government funding there is a missing market (complete market failure)

Impact of free rider problem

Could allow private provision to take place

Impact of quasi public goods

Eliminating non-excludability by finding ways to cost effectively price

Impact of technological advancements on public goods

Too costly and cost inefficient to exclude other producers from accessing the resource

Why there is no private ownership of common access resources

Loss of income and resources for future generations

Impact of tragedy of the commons market failure

Mass overproduction and overconsumption generating massive negative externalities in consumption in the form of resource depletion

Analysis of tragedy of the commons market failure - how it is illustrated on an externalities diagram

Information failure, cost of implementation, unintended consequences, regulatory capture

Dominant causes of government failure (ICUR)

Inaccurately valuing externalities (hard to quantify and often long term impacts)

Common cause of information gaps causing government failure

Examples of administrative costs (which can cause government failure)

Cost of subsidies, state provision, regulation of policy

Examples of unintended consequences of government intervention (causing government failure)

Growth of shadow economy/black market, impact on the poor (regressive policies), impact on firms (strict policy reducing output and hence employment)

Shifts MPC left towards the social optimum (MPC+tax, parallel if specific, not if ad valorem)

How indirect tax is used to solve market failure involving an overproduction and overconsumption

Internalises externality (polluter pays - externality accounted for in the price) allowing the price mechanism to allocate resources at QSO, eliminating overproduction and overconsumption, allocative efficiency is achieved while generating government revenue (can be reinvested into solving other market failure - hypothecated tax)

Analysis of how indirect tax solves market failure

Depends on PED (must be elastic, many goods with NEs in consumption are addictive and very price inelastic)

Main evaluation of indirect tax as a solution to market failure

Assumes government has perfect information (unrealistic), regressive, encourages shadow economy growth, paternalistic

Other evaluation of indirect tax used to solve market failure

Impact of imperfect information when governments set indirect tax

Overtaxing and undertaxing is very likely - many issues with both, especially overtaxing as it encourages shadow economy boom and puts huge pressure on firms causing unemployment and decreased output, will be extremely regressive and promote poverty. Government failure

Goods provided will likely have worse externalities (exacerbates market failure - therefore government failure), requires more policing (costly), lost tax revenue

Impact of shadow economy growth as a consequence of government intervention

Impedes consumer freedom, liberty, and choice

Impact of paternalistic government interventions

Decreases price and increases output, causing the price mechanism to allocate resources at QSO, eliminating the underconsumption and underproduction, and causing allocative efficiency and a welfare gain

Analysis of how subsidies solve market failure

Very expensive to implement (need to be evenly distributed across entire markets/industries) and may not be effective (depending on PED)

Main evaluation of subsidies as a solution to market failure

Price elastic demand (as product is underconsumed due price rather than non price factors)

Main condition for a subsidy to be effective in solving market failure

Imperfect information, subsidy dependency (from firms), subsidy may not be used to lower CoP (significant government failure)

Other evaluation of subsidies as a solution to market failure

Leaving inefficiencies unaddressed

Impact of firms becoming dependent on subsidies

Regulation

Non market based approach to solving market failure that doesn’t involve the price mechanism, and hence does not depend on PED like most other solutions and does not require a diagram

Regulation command

Bans, limits, compulsory requirements of production etc.

Incentivises economic agents to change behaviour and move quantity towards QSO, causing allocative efficiency without addressing the price mechanism

Analysis of how regulation solves market failure, if command and control are strong and effective

Very costly (mainly through control, if not affordable regulation will be useless as incentive is weak)

Main evaluation of regulation as a solution to market failure

Imperfect information (can cause regulation to be too strict causing unintended consequences such as firms leaving the market and shadow economy growth), potential for firms to cheat/bypass command, paternalistic

Other evaluation of regulation as a solution to market failure showing its significant risk of government failure

Tradable pollution permits

Innovative policy used to solve market failure caused by negative externalities in production due to air pollution. Common in developing countries to decrease emissions

Uneven burden on firms (depending on how much their industry/production relies on fossil fuels etc.)

Tradable pollution permits are a market friendly approach to solving pollution based market failure using elements of regulation, but overcoming some of the major issues of blanket regulation such as

Governments set a national pollution cap at the socially optimal level of pollution

Initial stage of tradable pollution permits - regulation (command)