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Section One The Basic Economic Problem

The basic economic problem is the fundamental problem from which all others arise. There are scarce resources and infinite wants. The problem of scarcity forces people to make choices. Economists therefore ask 3 questions in order to try to answer this problem. 1. What to produce? Economists need to decide what to produce and in what quantities. 2. How to produce? Since resources are scarce in relation to unlimited wants, managers and economists need to consider how resources are used so that the best outcome arises. The decision to maximise output and satisfy more wants would need to consider the full impact on the environment and any potential long-term health risks. 3. For who to produce? Decisions have to be taken concerning how many of each persons wants are to be satisfied. In some economies deliberate attempts to create a more equitable society exist through the use of taxation to redistribute wealth from rich to poor.

Factors of Production
Resources can be categorised into four factors of production 1. Land: This is the natural resource 2. Labour: This is the human resource, the basic determinant being the size of the population. 3. Capital Goods: These are man-made aids to help in the production process. Capital goods help land and labour produce more units of output. These three factors of production are organised into units of production by firms. 4. Entrepreneurship: This factor carries out two functions a. This factor organises the units of production b. Entrepreneurs take the risks of production, which exists in free enterprise.

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Economies that have a large amount of high quality factors of production are referred to as having good factor endowments. Resources will be combined during the production process to create goods and services. The process through which individuals use up goods and services is known as consumption. Goods used quickly or instantly are known as non-durable goods. Those that last longer, such as a washing machine or computer are referred to as durable goods. Peoples wants develop and expand over time, yet these are rarely fully satisfied, thus the basic economic problem of scarcity remains. People constantly are faced with making choices.

Specialisation & Exchange

Through the process of specialisation greater amounts of goods and services can be produced. Individuals, firms, regions and countries concentrate on the production of certain goods and services, which they are best at producing. As they improve, they will be able to produce a surplus beyond their needs, which they can exchange for the surpluses of others. In early economies, exchange would have taken place through a barter system which saw goods exchanged for each other. As this was inefficient and reduced trade, money was developed as a medium of exchange. With the expansion of the use of money and the development of markets, the benefits of specialisation become more apparent.

Choice & Opportunity Cost

Choices are necessary given the fact that resources are limited yet wants remain infinite. This can be expressed through opportunity cost. Opportunity cost is defined as the benefit of the next best alternative foregone.

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Production Possibility Frontiers

The number of goods and services an economy produces is determined by the size and quality of its factor endowments. The diagram shows the combination of Guns (Military Goods) and Butter (Consumer Goods) produced by an economy with the resources available to it. The point A shows a situation in which resources are not fully utilised, they are unemployed. The economy can move to either points B or C, and find that they are using resources fully. At point B more Guns are produced, with the same amount of Butter, whereas with point C the same amount of Guns are produced but a greater amount of Butter is available to the economy. However although the point D looks like it is the most desirable, it is beyond the PPF, and thus unobtainable with the present combination of factors of production this economy is endowed with. The concept of opportunity cost can be identified on figure one. A movement from B to C will result in a gain of 25 units of Butter, but at a cost of 10 units of Guns. Thus the opportunity cost of 1 unit Butter is the benefit foregone i.e. .4 units of Guns. Resources have to be switched from producing military goods to producing butter. In reality society needs to decide how to allocate these resources in the best possible way. The extent to which resources can be reallocated is known as factor mobility. If it were assumed that the economy is producing at P then to produce 700 units of Manufactured goods and 150 units of Non-manufactured goods it would have to move from P to Q, this would entail giving up 50 units of manufactured goods. As resources are reallocated the least productive resources will be given up first and allocated to the production of nonmanufactured goods. Thus each unit of non-manufactured goods will cost 1 unit of manufactured goods. A

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movement from R to S will only result in a gain of 25 units of non-manufactured goods but at the cost of 75 units of manufactured goods, thus each unit gained costs 3 units of manufactured goods. This is a result of the most productive resources having to be reallocated to the production of non-manufactured goods. This illustrates the concept of Diminishing Returns, i.e. the returns being gained from further reallocation of resources are declining.

Shifts in the PPF

The PPF is drawn on the assumption that quality and quantity of resources remain the same. However, through time, economies can gain or lose resources, the quality of resources, and the state of technology can change. Such gains will cause the PPF to shift to the right (figure three), signifying economic growth, and losses will result in a shift to the left. A shift to the left might be the result of a decline in the population or some natural resources becoming exhausted. As consumer goods are produced they use up capital goods. This is known as capital consumption or depreciation. These need to be replaced and this is done through investment, which can be described as any production not for current consumption. The more consumer goods produced, the greater the standard of living in the present time period. However the standard of living in the future may decline if the capital goods used up are not replaced. If capital goods are produced in large quantities these can result in additional consumer goods and thus standard of living in the future.

Section Two Competitive Markets and how they work.

The essence of any market is trade somebody has to sell, and somebody must be willing to buy the product being offered. The market thus is a term used by economists to describe the process through which products, which are fairly similar, are bought and sold.

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Demand
Demand relates to the buying side of the market, from the point of view of the consumer. Demand can be defined as the desire for a product backed up by the willingness and ability to pay for it. This describes a situation which is effective demand, because it relates to demand backed up by the ability to buy the good, this is important because companies are not interested in demand unless that person can buy the product. For the sake of simplicity it is assumed that all other factors, except for price remain constant. This is known as the Ceteris Paribus assumption. The table below can be used to plot a demand curve. This will show the number of Manchester United shirts bought at a given price. Table One Price of Man Utd shirt () 75 65 55 45 35 This can be illustrated in Figure 4
Figure Four 80 70 60 50 40 30 20 10 0 10
Demand

Quantity Demanded per week 000 10 12.5 15 17.5 20

Price

Demand

12.5

15

17.5

Quantity '000

20

Point to note When price goes up, there is a decrease in the quantity demanded. When price goes down, there is an increase in quantity demanded i.e. when

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there is a change in price there is an immediate change in quantity demanded. Figure Four can illustrate the total expenditure by consumers on goods or services. In addition this shows us the level of revenue a firm gets at a given price. For example if the price is 55 then the demand curve suggests that Manchester United would sell 15000 shirts. The revenue or total expenditure would be 55 * 15000 = 825000.

Consumer Surplus
Consumer Surplus occurs when consumers would be willing to pay more for a product than the actual price, apart from the last unit purchased. Consumer surplus is the area above the price paid and below the demand curve i.e. the shaded are in Figure 5 at a price of P2. This can be illustrated by looking at the quantity demanded at Q1. The consumer would be willing to pay P1, but only needs to pay P2, therefore gains P1-P2. Therefore if the price changes the consumer surplus will also change, if price was to rise the consumer surplus would contract, as the number of people willing to buy the product at the higher price will decline.

Shifts in the Demand Curve

Price is not the only factor that can change, indeed changes in the ceteris paribus factors cause shifts in the demand curve. A shift to the right indicates an increase in demand at each and every price level. A shift to the left indicates a decline in demand at each and every price level.

Causes of Shifts in the Demand Curve

Generally shifts in the demand curve can be attributed to 3 factors. 1. The financial ability to pay 2. Attitude towards the product 3. Price, availability and quality of substitutes and complements.

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1. Financial ability to pay The ability to pay is clearly influenced by the amount of disposable income (after deducting tax and adding benefit) a person has, in addition to the ease with which a person can obtain loans or credit and the interest rate associated. An increase in disposable income, or ease with which loans may be obtained, or decline in interest rates will increase an individuals purchasing power causing the demand curve to shift to the right i.e. D1 to D3 in figure 6. With most goods there is a positive relationship between income and product demand. So as income rises, demand rises, and vice versa. These goods are referred to as normal goods. However for some goods demand falls and income rises, for example the demand for black & white TVs has fallen as average incomes have risen. These goods are characterised by a negative relationship between income and demand, and are known as inferior goods. 2. Attitude towards the Product People are clearly also influenced by individual desires, peer pressure and branding. These work to increase demand at each and every price for some goods, and also to reduce demand. 3. Price, availability and quality of Substitutes and Complements. a. Substitute products are alternatives products that are similar, and that satisfy the same wants and needs. The range of substitutes can be fairly narrow, for example in terms of different brands: JVC or Sony televisions. It can also be broad for example different type of music format: Vinyl, CD, Minidisc, Cassette or MP3. A rise in price will cause an increase in the demand for the substitute product. b. Complements are products which go hand in hand with another product. For example roast beef and horseradish, turkey and cranberry sauce or tennis rackets and balls. A rise in price will cause a decline in demand for the main good, and as a result also for the complementary good.

Other factors which influences demand

Each product has unique factors that affect the demand for it. For example the demand for ice cream, or swimwear may be affected by the weather. If house prices or share prices are expected to rise in the future, this may cause demand to rise.

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Supply
Supply refers to the quantity of a good or service a supplier is willing to make available for sale at a given price. The profit motive is likely to be the major influence on company behaviour. The higher the price the more likely a firm is going to make increased profits.

The Supply Curve

The supply curve can represent the supply curve of one individual firm, or those of a number of firms representing the industry. The supply curve is upward sloping. So an increase in the price that a product may be sold for would cause a firm to increase the amount of a good or service it offered for sale. As price falls, supply falls as the possibilities for profit decline.

Producer Surplus
Producer surplus is from the viewpoint of the supplier. At prices between B and P1 the firm is willing to supply the market, but not to the same extent as at P1. At a price of B no units will be supplied. The producer surplus is the area P1AB and represents the excess above the amount the firm needs to supply the product. Therefore although the firm is willing to accept a much lower price then P1, it is receiving this as payment, and thus a surplus exists.

Shifts in Curve

the

Supply

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Companies supply intentions are often influenced by more than just price, such factors can be illustrated by shifts in the supply curve. A shift to the right indicates an increase in supply, whilst a shift to the left signifies a decline in supply at each and every price.

There are 3 main causes of shifts in the supply curve 1. Costs 2. The size of the industry 3. Legislation and taxation 1. Costs: Since the firm exists in a competitive market, it cannot exist indefinitely sustaining losses, companies will have to make decisions on how much to supply on the basis of the price they can get for selling the product. If a factor of production rises in price, and so raises the costs of production, there is likely to be a shift to the left in the supply curve. From S1 to S2 in figure nine. If the factor of production falls in cost there is likely to be a shift to the right i.e. from S1 to S3 2. The size of the industry: If profits can be made in an industry it is clear that firms both in and outside the industry will react. Firms currently in the industry will invest to increase production, possibly by purchasing capital goods. Firms outside the industry may attempt to enter the industry and set-up businesses so as to take advantage of these profit opportunities. The ease with which new firms can establish in the industry is dependent upon the size of barriers to entry. However if the size of the industry grows, supply is also likely to increase. If firms now start to compete more the likely impact is that the supply curve will shift to the right as the firms compete away any profits that exist and reduce price. 3. Legislation and Taxation: Legislation designed to protect consumers or workers may impose additional costs upon companies, causing the supply curve to shift to the left. Government may impose indirect taxes, such as VAT, this can either result in an increase in price, or decline in supply at the given price as indicated by a shift in the supply curve to the left. On the other hand subsidies will increase and cause the supply curve to shift to the right.

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Other factors influencing Supply

1. Weather: In agricultural markets in particular this can influence the size of yields. 2. Expectations: In markets such as the stock market, expectations of future performances can result in additional supply being made available by shareholders.

Bringing Demand & Supply together

Equilibrium refers in this instance to the point where demand and supply cross. In general it refers to a state of rest, where things do not have a tendency to change. In Figure 10 this occurs at a price of P1. If the market operated at P2, then the market would be in disequilibria, with supply outstripping demand at this high price. Thus a situation of excess supply would exist. The firm would thus not be selling all of its output and instead be adding to stocks. This would be irrational in the long-run, it is likely that firms would cut prices, and reduce their output. As the price starts to fall, more people are tempted back into the market, thus the gap between supply and demand narrow. This should eventually return to equilibrium, whether through analysis or guesswork. If prices were set at P3, the market would again be faced with disequilibria, this time however demand is greater than supply, in other words excess demand exists. Consumers are keen to purchase what they consider to be bargains. Given the low price, supply is smaller than demand. However profit-seeking businesses will see these opportunities to sell more goods, and raise price whilst increasing supply. Once again the market would be expected to return to equilibrium.

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Changes in Demand
If there is an increase in demand from D1 to D2, then at the original price of P1, there is a disequilibrium, with an excess demand equal to A- B. Suppliers will identify this opportunity and raise prices, and supply until equilibrium is returned to at a price of P2, with a higher quantity bought and sold.

Changes in Supply
If there is an increase in supply from S1 to S2 in Figure 12, then at the price P1 there is disequilibrium equal to C-E. Firms will find that stocks are building up, and so reduce price, eventually causing the market to return to equilibrium now at P2Q2.

Changes in Supply & Demand

In figure 13 equilibrium is at a price of P1 where D1 and S1 cross. There is an increase in demand from D1 to D2, whilst simultaneously there is a shift in the supply curve S1 to S2, as a consequence the price remains unchanged, whilst the quantity bought and sold rises to Q2.

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Section Three Elasticity Price Elasticity of Demand

Formula % Change in Quantity Demanded % Change in Price % in QD % in P

Price elasticity of demand can be defined as the responsiveness of quantity demanded to a change in price. If demand is elastic then a small change in price will result in a larger change in quantity demanded i.e. Responsive If demand is inelastic then a large change in price will result in a smaller change in quantity demanded i.e. Unresponsive For example Holidays Abroad 25% rise in QD = -2.5 10% fall in P Responsive Elastic

Cigarettes

10% fall in QD = -0.22 Unresponsive 45% increase in P Inelastic

In both cases, and indeed all situations of Price Elasticity of Demand a negative figure is calculated. This is because of the inverse relationship between price and quantity demanded, i.e. as price falls the quantity demanded rises. (Economists ignore this sign) For holidays abroad a value greater than one (2.5) is obtained, this suggests that the product is responsive or relatively elastic. For cigarettes a value of less than one (0.22) is obtained, this suggests that the product is relatively unresponsive or inelastic to price changes. Where a product is bought in the same quantity irrespective of the price charged, such as in figure 14, it is referred to as being perfectly inelastic. 0% fall in QD 55% rise in P =0 Perfectly inelastic

Therefore when PED is equal to 0, demand is perfectly inelastic.

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However if price falls in figure 15 from P1 to P2, so that D becomes infinite, i.e. people will buy all that is available, then the product is deemed to be perfectly elastic, i.e. responsive to changes in price.

% fall in QD = 25% rise in P

Perfectly Elastic

Thus if the PED is equal to

then the good is perfectly elastic.

Unitary Elasticity
If the rise in price is matched by an equal fall in quantity demanded, then the PED is equal to - 1. When PED is equal to 1 it is said to have a unitary elasticity over that price range.

Factors that influence Price Elasticity of Demand

There are 4 key factors that influence price elasticity of demand. 1. The range and attractiveness of substitutes The greater the number of substitutes, and the greater the closeness of these substitutes, the more responsive economists would expect consumers to be to a price change. In other words they will buy alternative products when the price rises. Branding can reduce the closeness of substitutes, and thus the PED will be reduced. 2. Necessity or Habit Forming The degree to which people consider the product to be a necessity, and whether the product has any addictive properties, i.e. whether it is habit forming. The greater these properties the more likely the product is to be price inelastic.

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3. Proportion of Income taken by Product A rise in price will reduce the purchasing power of an individual. The larger the proportion of someones income a product makes up, the more responsive an individual will be to a price change. On the other hand, a product representing a small proportion of income will not be responsive to a change in price. For example a box of matches rise by 30 per cent in price, from 10p to 13p, demand would not fall by as much. Thus the product is relatively inelastic. 4. Time In the short-term, for example weeks or months, people or firms might find it hard to react to a change in price, as they are trying to find new suppliers. However if the price goes up and remains high, then consumers will be more inclined to find alternatives suppliers.

Income Elasticity of Demand

Income elasticity of demand is defined as the responsiveness of quantity demanded to a change in income. If demand is responsive, then goods are described as Income elastic, and if they are not then they are described as being unresponsive or income inelastic. Formula % Change in Quantity Demanded % Change in Income % in QD % in Income

If an increase in income leads to an increase in quantity demanded, there exists a positive relationships and the product is classified as normal. The IED is positive. Some goods will react differently, some will see demand rise by a greater rate than any rise in income. These goods, known as luxury goods have an IED greater than 1. Those goods which are necessities have an elasticity of between 0 and 1. They will rise in demand as income rises, but not by as fast a rate as income. Those goods whose demand actually falls as income rises are referred to as inferior goods, and have a negative IED. Holidays to Australia Toilet Paper % % % % % % in QD in Y in QD in Y in QD in Y +8 +2 +2 +6 -4 +6 =4 Luxury good Necessity

=0.33

Economy Bread

= - 0.66

Inferior

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The Engels curve depicted in figure 16 illustrates the expenditure associated with the numerical values from IED calculations. Luxury goods see spending rising at a faster rate than income, whilst inferior goods see a decline in spending as income rises.

Cross Price Elasticity of Demand

Cross price elasticity of demand (XpED) measures the responsiveness of quantity demanded of good A to a change in the price of good B Formula % Change in Quantity Demanded of Good A % Change in Price of Good B % % in QD of Good A in P of Good B

Products that are substitutes for each other will have positive values for XpED calculations. Those goods that are complements will have negative values for XpED. Substitutes: If the price of Dell laptops rises, it is likely people will stop buying Dell and increase their demand for substitute products like Sony or Compaq. % in QD of Sony % in P of Dell +16% +9% = +1.778

Complements: If the price of roast beef rises, then it is quite likely the demand for roast beef will decline, coupled with this will be a decline in the demand for Horseradish, a complement to beef.

% in QD of Horseradish % in P of Roast Beef

- 6% +12%

= - 0.5

Note the negative symbol indicates that the goods are complements

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Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of quantity supplied to a change in price. Formula % Change in Quantity Supplied % Change in Price % in Q S % in P

Since a rise in price causes a rise in supply, the relationship between quantity supplied and price is positive. Thus a value greater than 1 indicates a good is relatively price elastic, and a value of less than 1 is relatively unresponsive to a price change and so is inelastic

S1 = Perfectly inelastic Value = 0 (Any vertical line will have the same elasticity) S2 = Relatively inelastic: Value between 0 and 1 (Any line originating from the X axis) S3 = Unitary Elasticity Value = 1 (Any line from the origin) S4 = Relatively elastic Value 1 to (Any line originating from the Y axis) S5 = Perfectly Elastic Value = (Any horizontal line originating from the Y axis)

Factors influencing Price Elasticity of Supply

1. The ease with which the firms can vary stocks Stocks allow companies to meet variations in demand through changes in supply rather than price. The greater the scope for holding stock, the greater the price elasticity of supply

2. The ease with which production can rise Firms with spare capacity will tend to have high price elasticity of supply. However if a firm is unable to increase output because of

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shortages of factors of production then it is likely to have an inelastic price elasticity of supply. 3. Time Over time a company can increase its manufacturing capacity by investing in capital equipment. This means that they can increase supply and so in the long-run firms will tend to be price elastic.

Business relevance of Elasticity

Variations in the price elasticity of a good can lead to large price volatility. For example in Figure 18, a change in price from P1 to P2 can be seen to have a greater impact on quantity demanded, where the demand is price elastic (D1) compared to where it is price inelastic (D2)

Price Elasticity of Demand and Total Revenue

Figure 19 shows the relationship between total revenue and price elasticity. When the firm operates on the elastic part of its demand curve, it has an incentive to cut price to P1 in order to maximise total revenue. On the other hand if the firm were operating on the inelastic part of their demand they would benefit from raising price to P1 to maximise revenue.

Income Elasticity of Demand

If the IED for a normal good is greater than 1 then the good is a luxury. Thus demand rises at a faster rate than income, this will help firms plan their output during periods of economic growth. However during a recession demand for luxuries will fall, whilst demand for goods with a negative IED will

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rise, inferior goods will become more popular in part because of their low prices. Firms will be able to prepare for such eventualities by monitoring economic forecasts.

Cross Price Elasticity of Demand

Positive XpED suggests that the goods are substitutes. There will be a large amount of interdependence between the firms price and a price cut will be monitored closely. Companies will attempt to tie consumers to a particular product through branding and advertising. This will attempt to ensure that consumers buy not only their product but also a complimentary good e.g. Indesit washing machines and Persil Automatic. XpED will help a firm identify an appropriate price level to maximise revenue. Although elasticity appears to be very useful to firms, it is important to note that there are always going to be statistical problems calculating such figures. Data may be available from market surveys, or questionnaires, but this can be both expensive and prone to inaccuracies.

Factor Markets
Labour earns rewards, as all other factors of production, in the form of wages, and salaries. At one extreme Roy Keane earns 52 000 per week, and at the other a nurse starts on 287.50 a week or just under 15 000 a year. Why does this occur? Demand and supply can help explain the difference, Roy Keane is very difficult to replace and so the supply is limited, fortunately nurses are not as hard to replace, because their supply is greater so they need not be paid as much to keep them in their present position. Labour is described as possessing the properties of Derived Demand, i.e. to produce a good or service labour needs to be employed. Therefore the demand for labour is derived from the demand for the final product. The market supply curve for labour is dependent upon the elasticity of supply of labour. Changes in wages will attract a few, or a lot of workers depending upon the elasticity. The elasticity of demand for labour will be dependent upon the ease with which labour can be substituted for capital when wages rise, and also the proportion of total cost which labour takes up.

Money Market
Money can be regarded as anything which can be used to settle a debt, it must however be accepted as a medium of exchange whilst possessing other characteristics; store of value, unit of account, and standard for deferred payment.

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The demand for money can be classed as the desire to hold notes and coins. If the supply curve is inelastic, and the demand curve downward sloping as in figure 20, the equilibrium point is the rate of interest. This is the amount to be paid to borrow money, and bring forward consumption. It is also the amount that is paid to the lender to compensate them for lending their money, and losing the ability to use it.

Section four Efficiency in economics

To judge whether an economic system is doing a good job, economists try to identify the extent to which it is delivering economic efficiency. If economics attempts to answer the question of how scarce resources may be used to meet infinite wants, then efficiency is to do with the use of those scarce resources in the most effective way possible to meet the highest possible level of wants.

Productive Efficiency
Productive efficiency looks at the use of resources in such a way as to maximise output with the least amount of inputs. In other words production at the lowest possible average cost.

Allocative Efficiency
To achieve full economic efficiency it is not enough to produce goods at their lowest average cost. Instead the economy must also be capable of producing goods that people or society needs.

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Allocative efficiency is therefore to do with the production of those goods that are most wanted by society. It will exist when the selling price is equal to the cost of production of the last unit of output. i.e. the marginal cost of output. In this situation the price paid by the consumer will be equal to the true cost of production. If the cost of production is less than the price placed on it by the consumer, then clearly there is scope for further output. If on the other hand, the cost of production is greater than the price or value placed on the good then output should be reduced. Thus output is allocatively efficient when in Figure 21 D=S or P=MC.

Pareto Optimality
Wilfredo Pareto first suggested the concept of Pareto optimality. This is said to exist when one person cannot be made better off without another person being made worse off. If this situation exists then productive efficiency is said to be evident, as the implication would be that if the economy was not productively efficient then output could be increased without making someone else worse off, in other words without taking away resources from another output. It also implies that Allocative efficiency exists because, if it didnt, then resources could be reallocated to make consumers better off, without necessarily making anyone worse off.

Efficiency and the PPF

On the PPF (Figure Twentytwo), point P can be considered productively efficient, as can any other point on the point on the boundary of the PPF. At this point, nothing more can be produced in total than is currently being produced, resources are said to be at their most productive. Equally P can be considered Pareto optimal, as it is only possible to increase output of manufactured goods by reducing the output of nonmanufactured goods and so make someone worse off. On the other hand point X is neither productively nor allocatively efficient, output can be increased without reducing output of either product.

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Competition and Efficiency

Productive Efficiency Competition in the market place could lead to productive efficiency as it provides firms with an incentive to produce things at the lowest possible cost. The incentive is that if the firm can operate at a lower cost than its rival firms then it will be able to increase its profits. If at the other end of the spectrum the firm has higher average costs than its competitors, then it will be unable to sell its products as they are uncompetitive or will sustain loses whilst attempting to make their product competitive. Allocative Efficiency If the firm wants to maximise its profits then by implication it will only do so if consumers demand the products it produces. Equally, if they were to produce a good that no one wanted they would soon go bankrupt, this forces firms to produce goods which are demanded, and thus be allocatively efficient. Pareto Optimality The free market automatically leads to Pareto Optimality. This is the case because people will only trade with each other if they believe that trading is mutually beneficial. It will thus not be possible to improve on the situation described by making someone better off without making someone worse off.

Section five Market Failure

Defining Market Failure Market Failure is said to exits when the market fails to deliver economic efficiency. Market failure exists any and every time that a free market, minus any government intervention, fails to provide the optimum use of scarce resources.

Externalities
Defining Externalities If the market system is to work well and lead to economic efficiency, it is important that the people who make economic decisions are the ones who are affected by them. However a problem arises when a group, not party to the economic transaction, is affected by the transaction. This is known as an externality.

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An externality is said to exist when a cost or benefit arises from an economic transaction that affects a party not involved in that economic transaction.

Private & Social Cost

An externality can also be defined as any divergence between private and social costs or benefits. The social cost of any action includes all the costs associated with the action. The private costs are those costs, which are borne by the parties to the action.

Negative Externality
Private and social costs may not be equal to each other. This is because private costs do not take into account the further costs that might be imposed as a result of an economic transaction. In this case a negative externality, or external cost is said to exist, this may include environmental damage, or pollution or congestion. Private costs remain part of social costs, however do not equate to total social costs, the difference is represented by the external cost. Social Cost = Private Cost + External Cost

Private & Social Benefit

The social benefits of a decision are all of the benefits that accrue from an economic decision. The private benefits are those that accrue solely to the parties involved in the economic transaction

Positive Externalities
If the social benefits exceed the private benefits then an external benefit or positive externality is said to exist. For example the benefit one gets from having a beautiful garden is deemed as a private benefit, but the benefit others gain from looking at and enjoying someone elses garden is known as an external benefit.

Problems created Externalities

by

Externalities will lead to an inappropriate amount of the product being produced; the free market will lead to either too much or too little production.

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A factory will have costs it will need to meet as part of the production process; these will include labour, raw materials and fuel costs. These costs will form part of the firms private costs. However there are likely to be further costs involved. These might include any dumping of chemical waste, which in itself creates clean-up costs, ill health and congestion as a result of the transportation of any chemical waste. Unfortunately the problem is that only the private costs of production are taken into account when the firm makes the price decision. The further external costs, which are the real costs to society, will not be taken into account. Thus the negative externality will lead to too much of a product being produced. The price that occurs in the market will be P1, where the private costs are equal to social benefit, at an output of Q1. However if costs took account of the negative externality, then the point where social costs equal social benefits would equate to P2 at an output of Q2. Thus the negative externality has led to oversupply equal to Q1 Q2. The market has failed because too many scarce resources are being allocated to production. Conversely the opposite problem is true of positive externalities, too few products are being produced. If only the private benefits, and not the social benefits, are considered, then there will be under production. Figure twenty-four shows private benefit indicated by MPB, and so if only these are taken into account output is equal to Q1 at a price of P1. However, if the positive externality were to be taken into account then output would be Q2 where social benefit is equal to social cost at a price of P2. Thus as a result of the positive externality there is under-production of Q1 Q2. Insufficient resources are being devoted to the production of the good or service, so the market fails once more.

Public Goods Defining Public Goods

There are three characteristics that a good must possess for it to have the qualities of a public good.

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1. Non-excludable : This means that once the good has been provided for one consumer, it is impossible to stop other consumers from benefiting from the good. The marginal cost of this additional output is 0 2. Non-rivalrous/Non-Diminishable : As more and more people consume the product, the benefit to those already consuming the product does not diminish 3. Non-Rejectable : Once the product is available it may not be rejected, by those in a position to benefit from it. Examples of Public goods include: Defence, Judiciary, Street Lighting and Light Houses This is in contrast to private goods which are excludable, through price, and rivalrous one persons use of the good will reduce anothers benefit. An individual may refuse to take-up the benefits on offer, because the product is excludable. Once a lighthouse is built to warn one ship of the presence of rocks, by its very nature all ships passing these rocks will automatically benefit from its service. It is non-excludable. Equally the fact that another ship uses the light provided by the lighthouse, does not diminish the benefit that any one ship may experience, it is thus non-rivalrous. In addition if a ship passes a lighthouse it may not refuse the benefit provided by the lighthouse, even if they choose to ignore it, the service has been provided, it is thus non-rejectable.

The problems caused by Public Goods

The market may fail to produce them at all. Even though there may be demand for these goods the free market may have no mechanism for guaranteeing their production. If an allocatively efficient firm prices at the point where price is equal to marginal cost, then by definition after the first person has paid for the product, future consumers should be charged 0. This is because the marginal cost of producing a public good is 0, as a result of it being non-diminishable. Consumers will attempt to gain a free ride on the back of others purchases of the public good, as a result of its non-excludable properties once a consumer has purchased the product, all other consumers cannot be prevented from benefiting from that product. For example once one individual has paid for street lighting to be provided outside his house, then all other residents in close proximity will benefit equally. However they do not have to pay for this street lighting. They have received a free ride on the back of someone elses purchase. The logical thing would be for all residents to sit back and wait for someone to provide the street lighting and allow all the other to free ride. Unfortunately it is unlikely that anyone will make the effort to provide the lighting.

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A group of residents may decide to join together and provide the service themselves, however there is no compulsion on all residents to pay for the service. One resident can refuse to pay for the product yet still benefit equally, and so free ride on the efforts of others.

Failures in the Labour Market The mobility of labour

If markets are to work efficiently, then labour markets must function well. Labour must be mobile. There are two types of labour mobility. 1. Occupational mobility: Workers should be able to move quickly and easily from one occupation to another. A ship builder made redundant should be able to move rapidly into a new form of employment. However, workers may not be able to move from one form of employment to another. Even though it would make economic sense for a ship builder to move from ship building into a growth industry like telesales, he may possess few if any of the necessary skills, thus hindering his move. Structural unemployment like this represents a very clear failure of the market; labour, as a scarce resource is not being used. 2. Geographical Mobility: Labour should be able to move quickly and easily from one part of the country to another. However workers may not easily move from employment in one region to employment in another. Family and social ties may keep someone in a particular area. In addition house prices can differ greatly between regions, making it difficult for workers to move from low cost to high cost regions.

Section six Government Intervention

The justification for intervention is usually given under two broad headings. To minimise market failure and to achieve a equitable distribution of resources in an economy. The first intervention occurs when markets do not allocate resources efficiently and the second is concerned with ensuring that all members have fair access to goods and services. However, governments may not succeed in removing these distortions and indeed create them.

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Methods of Intervention
Regulation: Legislation can be used to control the quality and quantity of goods and services produced and consumed. The government may regulate the sale of certain drugs by making them only available on prescription. The Food Standards Agency sets minimum standards for food production and sale, whilst there may be controls on shop opening hours, or the setting of a minimum age at which a person can buy certain products such as alcohol, cigarettes or lottery tickets. In addition the government has the power to control monopoly abuse through regulatory bodies such as the competition commission, which ruled that Interbrew could not takeover Bass brewer in January of 2001, because it would create too dominate a firm. This can only work if government sets the pollution cost to society of producing one more unit of unit of output (i.e. MSC) with the benefit to society of consuming that good (MSB) This can be difficult to police from a practical point of view, often HMIP find they are up against businesses quite prepared to pollute and pay the fines as the private benefit to them exceeds the private cost (Fines). There is no incentive to become more efficient and reduce emissions to below the maximum level set. Extending Property Rights: Through the extension of property rights water companies (and the Environmental Protection Agency) are able to seek compensation from companies and individuals which pollute rivers. This is a means by which the problem of the externality is internalised, and so eliminating the problem by bringing it back into the market mechanism. However if there is no way of enforcing ones property rights it may make sense to pay the polluter to stop. The World Bank has given $110 m to 11 developing countries to encourage them to reduce their emissions. A further $760m is being used to reduce these countries dependency on certain harmful chemicals. Often the extension of property rights to individuals or small groups of people will require enforcement at possibly great cost to the owners. Often the rich are able to buy better justice and defeat the property owners or influence legislators when decisions of ownership are being made. The process of compensation through the courts might be a very time consuming process. In addition it can be difficult to place an agreeable monetary value on the loss to society which results from pollution. Environmental Taxes: Government assesses the cost to society of pollution. It then sets a tax rate on polluters so that the tax is equal to the value of the externality. As a result of costs of production rising output declines and with it so does pollution. This allows the market mechanism to decide how resources should best be allocated given that some pollution is a necessary part of production. Those businesses, which

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are heavy polluters, will cut their output and pollution or face increased costs. Light polluters can expand output to a point where marginal private cost equals the marginal tax rate and so benefit society. Government often finds it difficult to establish the appropriate tax level because it is difficult to set a monetary value on pollution. To work properly a tax rate must be set that is equal to the marginal pollution cost. It is administratively expensive to set up different tax rates for different businesses throughout an offending industry. The use of taxation will not get rid of the pollution problem but attempt to reduce it. Tradable Permits: Government sets the desired level of pollution. It then allocates permits to firms and polluters. These permits can then be traded between polluters in return for money. The advantage of this scheme is that if it is possible a firm will reduce emissions, and so be able to sell spare permits. Post Kyoto (1997) attempts have focused on trying to reduce world output of pollutants. One suggestion has been to create an international market to trade the right to emit greenhouse gases. Thus countries which need to emit more than their quota can buy those rights from those countries which have been proficient in working below their quota. The developing world continues to argue that it must pollute in order to allow it to grow. For them to cut their emissions would reduce economic growth and make them poorer still. Often they feel they are being made scapegoats for the past sins of the developed world. It is argued with some merit that those countries polluting most are growing and so unable or unwilling to pay for permits. Financial Intervention: Government to influence production, prices of commodities, incomes or the distribution of wealth in an economy also uses financial tools such as taxes and subsidies. For example, in the case of public transport government gives a partial subsidy, and in the case of eye tests, and dental care a total subsidy for those still in full time education under the age of 19. Government also provides the finance needed to produce some goods and services for example universities and schools. State Production: In addition to providing the finance it is also possible for a government to take over the production of a good or service, either in whole or in part. These nationalised industries in many countries include electricity, coal mining, and other utility services. Income and other transfers: Income transfers are used by government as a means of redistributing income from certain groups in society to others. The justification for this being an attempt by government to achieve an equitable distribution of income in the economy. These transfers of income may be in the form of a cash benefit paid by government to those with low incomes, such as income support or job seekers allowance. Other cash benefits are tied to specific areas of spending, for example housing benefit can only be used by those eligible to help pay for housing.

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Finally in-kind transfers occur when some people in society are given a service free whilst others must pay. For example, eye tests for those on low incomes.

The Impact of Government Intervention

Public Goods: Public goods such as defence must be paid through taxation. Externalities: Government will often use regulation to set minimum standards to overcome market failures caused by externalities. For example the government may intervene by setting standards, which restrict the amount of pollution that can be legally dumped. The government would then need to regulate and regularly inspect the polluters to ensure they conform to the standards set. It can do this through fines. The problem with this sort of regulation is that it relies on Her Majestys Inspectorate of Pollution to ensure that legislation is not broken. This is time-consuming, and an expensive process that can never be 100 per cent perfect because of the lack of inspectors. Government can intervene financially to regulate the impact of externalities. These can take the form of a tax or subsidy. By using these methods the external cost or benefit can be brought back in the market system, in other words it can be internalised. In figure twenty-five, before government intervention the equilibrium point is at E, where marginal private cost (MPC) is equal to marginal social benefit (MSB). However the inclusion of external costs sets social cost at MSC. The vertical distance between these two is equal to the external cost. Thus the socially optimal level of output is Q2 where the marginal social cost cuts the marginal social benefit. The government will therefore intervene and impose a tax equal to the distance A-B, which

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represents the external cost. This tax is added to the cost of production, so that the cost of production is now equal to the marginal private cost plus the tax. The price of the product is now sold for is P2 up from P1, this difference is less than the tax imposed. This is because the producer has agreed to bear part of the tax and take a cut in price received from P1 to P3. The total tax paid is equal to P2ABP3, where the consumers pay P2ACP1, and the producer P1CBP3. When the government intervenes to correct market failures caused by positive externalities, these take the form of subsidies (Figure twenty-six). The equilibrium before government intervention occurs at the point Z where MPC = Marginal Private Benefit (MPB). When external benefit is added to the private benefit, marginal social benefit is represented, which indicates societys demand curve for the product i.e. Q2 where MPC = MSB. If the government subsidies production of this product then the supply curve represented by the MPC shifts to the right, which represents MPC less the subsidy. The marginal private cost of supplying this product is reduced by the amount of the subsidy X-Y. Thus the equilibrium after the subsidy is given at a price of P3 where MPC-subsidy =MPB, and Q2 is sold. If education is accepted as a product which provides external benefit, then a solution to under-consumption would be to provide a subsidy for education. The government subsidies the cost of education from P2 to P3. The system used to pay for university education in the UK can be represented in the diagram, with the students paying 0P3, and the government paying the remainder up to P2. Information failure: Consumers do not have perfect information about every good or service that is available in the market. Government therefore intervenes to ensure that it is a legal requirement for shops and other suppliers to provide the consumer with information about the price of a product and the product itself. For example food products are clearly labelled with their weight, ingredients and nutritional content.

Over Consumption of a Product

Regulation: Drugs such as heroine or tobacco are overconsumed for a number of reasons, of which a lack of understanding of the true extent of the harm that is caused is one. The government can employ a number of measures to limit the amount consumed. It can for example impose legal regulations on the market such as an outright ban, or limit the

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market by restricting sales to certain age groups such as in the case of alcohol and tobacco. The government could also engage in an advertising campaign to inform the consumer of the dangers of taking drugs, and allowing them to make a more informed decision. An example of this is evident on the side of cigarette packets. Thus the government attempts to control the behaviour of consumers through the provision of information. Financial intervention: Another option, which a government could employ, is to impose a tax on the good, shifting the supply curve to the left. To reduce consumption of both cigarettes and alcohol the government imposes excise duties. Figure twenty-seven illustrates this situation. Demand is at D1, which represents demand without perfect information; with this information demand would be at D2. Therefore, demand is at Q1, rather than at Q2. The government intervenes shifting the supply curve from S1 to S2 through the imposition of a tax, consumers demand declines to Q2 at a higher price of P2, which is the correct level of consumption that would have been consumed had there been perfect information.

Under-consumption of a product
Regulation: If a consumer underestimates the benefits of a good, and under consumes then the government may intervene to make demand compulsory. For example all workers are made to contribute to the National Health Service through their national insurance contributions, because the government suggests that left to their own devices people will under consume. In addition it is legal requirement for all children aged 5-16 to receive education. The government deems it necessary to use legislation to compel people to attend school because otherwise they will under-consume the service on offer. Financial Intervention: To encourage consumption of a product the government can intervene with subsidies or tax incentives. For example to support the governments aim of encouraging saving the government has created a tax-free vehicle to save i.e. Individual Savings Accounts (ISA)

Mixed Goods & Intervention

It is likely that many of the goods that government feels compelled to intervene in have both externality and imperfect information problems. These goods are referred to as mixed goods. Smoking not only affects the smoker, but also has external costs associated with it through passive smoking. Therefore, the government intervenes by providing information and through the use of taxation to correct for the market failure.

Equity & Redistribution

The government intervenes in the economy to ensure a fair distribution of income in an economy. More specifically they may intervene to eliminate poverty, by ensuring

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a minimum standard of income, to eliminate unacceptable inequalities in the distribution of income and wealth, to ensure equal access, regardless of a persons income to certain goods and services such as health, housing and education. Finally they may intervene to protect people from sudden and unexpected loss of income, for example when someone is unable to work because of illness.

Redistributive taxes
Taxes can be divided into two types. Those which take a larger proportion of a persons income as it rises, known as progressive, and alternatively taxes which take a larger proportion of income from the poor, known as regressive taxes. To explain how a regressive tax system works, an example can be used which illustrates VAT at work. If it is assumed that person A earns 10 000 a year and person B earns 200 000 per year, they will both spend different amounts. Person A spends 8 000 of his income, and so pays 1 400 in VAT, while person B spends 90 000 a year on goods and services. Person Bs VAT bill is therefore 15 750, although this is a larger sum it still represents a much smaller proportion of person Bs income (7.875% paid as tax) than the VAT bill of 1 400 which equated to 14% of income. So a regressive tax hurts the poorest in society more than a progressive tax. Income 10 000 200 000 Expenditure 8 000 90 000 VAT 1 400 15 750 Proportion of Income 14 % 7.875%

Person A Person B

VAT in its present form in the UK is generally considered to be progressive because it is not imposed on food. The poorest will spend a greater proportion of their income on food than the rich, and so are able to avoid VAT. On the other hand as the poor will spend a greater proportion of their income on cigarettes and alcohol, the excise duties imposed will be regressive in their nature.

Redistributive Social Security Benefits

The government uses a number of social security payments to redistribute wealth from the wealthiest to the poorest. Social security benefits used to transfer income from high-income earners to those on low-incomes are usually referred to as means tested benefits; this is because they are targeted at certain groups of society. There is a major problem with this type of benefit system. A considerable amount of information is required about an individuals financial situation and the complicated claim form often puts people off applying. This means the benefit is administratively expensive to manage, and there is a stigma attached to any request for help. To overcome the stigma attached the government uses other methods to target benefits, for example universal benefits such as child benefit, which is available to everyone regardless of income.

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Redistributive Benefits in-kind

In-kind benefits are not in the form of cash but instead in the form of an entitlement to a good or service without the need for payment. Thus eye tests and dental care are given free of charge to children and pensioners. This benefit is targeted at certain age groups. Some in-kind benefits are given to every person in the country. For example everyone is entitled to access free medical care from the National Health Service. Government gives these benefits as they value their importance.

Government Failure
Governments can also fail, for example in an economy where the government makes all the economic decisions, all prices, production levels and the allocation of all resources are decided by the central planning authority. If planners make errors in determining production levels and demand exceeds supply at the government set price then queues will form. Although used extensively by Communist countries, such as the former Soviet Union, Bulgaria and China, this method of central planning has largely been abandoned. If a government makes a mistake when intervening in a market or mixed economy either through the size, type or extent of the intervention, the government will create a more inefficient distribution of resources. It will take time to change government policy, and so if there is a sudden change in the market, government may not be able to react quickly enough. For example taxes are usually only adjusted at the time of the annual budget. Although government may use the best information available at any given time that a policy was taken, the policy in itself will have unpredictable results, causing behaviour to alter. The government may not accurately be able to predict the effect of its policy change. Finally a government will have political as well as economic objectives to fulfil. With regular elections and the negative implications of some policies, such as those involving increasing taxes, or changes in public spending priorities, the government may shy away from taking necessary difficult economic decisions for fear of losing votes and a general election. Thus it can be argued that government is more likely to introduce unpopular changes at the beginning of a term in office rather than the end.

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