AS Economics Unit 1: Markets and Market Failure Syllabus, Key Terms & Charts

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1 AS Economics Unit 1: Markets and Market Failure Syllabus, Key Terms & Charts 10.1 The Economic Problem The Nature and Purpose of Economic Activity The central purpose of economic activity is the production of goods and services to satisfy needs and wants. They should appreciate that economists take a broad view of production and consumption activities including, for example, self provided goods and services and the benefits derived from the natural environment. Economic Resources Candidates should understand the economists classification of economic resources into land, labour, capital and enterprise. Factors of Production: Land: Labour: Capital: resources we have available to produce goods and services. all of the natural physical resources the human input into the production process investment in capital goods that can then be used to produce other consumer goods and services The Economic Objectives of Individuals, Firms and Governments Understand the normal maximising assumptions upon which traditional economic models are based. Command economy: Free market: Mixed economy: the price mechanism plays little or no active role in the allocation of resources. Prices decide allocation of resources A mixture of command and free market systems Scarcity, Choice, and the Allocation of Resources Appreciate that the decisions of individuals and organisations are likely to be influenced by both economic and non-economic considerations. Candidates should know that the environment is an example of a scarce resource, which is affected by economic decisions. 1

2 Opportunity Cost, the Margin, Trade-offs and Conflicting Objectives Understand production possibility diagrams and be able to use this basic model to illustrate the different features of the fundamental economic problem. Production possibility frontier (PPF): is a curve or a boundary which shows the combinations of two or more goods and services that can be produced whilst using all of the available factor resources efficiently. Opportunity cost: measures the cost of any choice in terms of the next best alternative foregone Value Judgements, Positive and Normative Statements Distinguish between positive and normative statements. They should understand how value judgements influence economic decision-making and policy. Positive statements: Normative statements: Objective statements that can be tested or rejected by referring to the available evidence. express an opinion about what ought to be. They are subjective statements rather than objective statements 10.2 The Allocation of Resources in Competitive Markets The Determinants of the Demand for Goods and Services Candidates should know that the demand curve shows the relationship between price and quantity demanded, and understand the causes of shifts in the demand curve. Effective Demand: Ceteris paribus: The Income Effect: The Substitution Effect: Movement along the curve: Shift in demand: Joint demand: Ostentatious consumption: when a consumers' desire to buy a product is backed up by an ability to pay for it all factors are held constant except the price of the product itself. when an increase in real income is used by consumers to buy more of this product. When the price of a good falls and consumers switch their spending from other goods to this product. caused by change in price Caused by factors other than price Two complements goods The higher the price the higher the demand 2

3 Price, Income and Cross Elasticities of Demand Candidates should be able to calculate elasticities of demand and understand the factors that influence elasticities of demand. They should also understand the relationship between price elasticity of demand and total revenue. Price Elasticity of measures the responsiveness of demand for a product following Demand: a change in its own price. Price Elasticity of Percentage change in quantity demanded divided by the Demand formula: percentage change in price Price Inelastic: If Ped is between 0 and 1 Price elastic: If Ped is greater than 1 Unit elasticity: If Ped is = 1 Income elasticity of measures the relationship between a change in quantity demand: demanded for good X and a change in real income. Normal goods: have a positive income elasticity of demand so as consumers income rises, so more is demanded at each price level Inferior goods: have a negative income elasticity of demand. Demand falls as income rises Cross price elasticity: measures the responsiveness of demand for good X following a change in the price of good Y (a related good). Substitutes: an increase in the price of one good will lead to an increase in demand for the rival product. Cross price elasticity for two substitutes will be positive. Complements: when there is a fall in the price of one complement we expect to see more of the other complement bought. The cross price elasticity of demand for two complements is negative 3

4 Price Elasticity of Demand Formula PED= % Change in Quantity Demanded/% Change in Price) Interpret * If Ped = 0 then demand is said to be perfectly inelastic. * If Ped = < 1 then demand is inelastic. * If Ped = 1 then demand is unit elastic. * If Ped = >1 then demand is elastic. Implications * When demand is inelastic a rise in price leads to a rise in total revenue * When demand is inelastic a rise in price leads to a rise in total revenue Income Elasticity of Demand Formula YED= % Change in Quantity Demanded/% Change in income Interpret * If Normal goods = positive income elasticity of demand. As consumers income rises, so more is demanded. * If Inferior goods = negative income elasticity of demand. As consumers income rises, so less is demanded. Implications * Normal goods are usually necessities and luxuties * Inferior goods are usually staple or low value goods Cross Elasticity of Demand Formula CED= % Change in Quantity Demanded of good A/% Change in price of good B Interpret * If a substitute good = positive cross elasticity of demand. * If compliment good = negative cross elasticity of demand. Implications * If you produce a substitute and compliment good you can react to a price change in the price of other goods Price Elasticity of Supply Formula PED= % Change in Quantity Supplied/% Change in Price) Interpret * If Pes = 0 then supply is perfectly inelastic. * If Pes = <1 then supply is price inelastic * If Pes = >1 then supply is price elastic Implications * Government taxation * Exploiting monopoly power in a market * Effects on housing market * Effects on energy and commodity markets The Determinants of the Supply of Goods and Services Candidates should be aware that, other things being equal, higher prices imply higher profits and that this will provide the incentive to expand production. They should understand the causes of shifts in the supply curve. Law of supply: Shift in Supply: is that as the price of a commodity rises, so producers expand their supply onto the market Change in factors other than price cause a shift in supply Price Elasticity of Supply Candidates should be able to calculate elasticity of supply and understand the factors that influence elasticity of supply. Price elasticity of supply: measures the relationship between change in quantity supplied and a change in price. 4

5 The Determination of Equilibrium Market Prices Candidates should understand how the interaction of demand and supply determines equilibrium prices in a market economy. Equilibrium price: point at which consumer demand meets firms supply Invisible hand: Adam Smith s description of the hidden hand of the market which operates in a competitive market through the pursuit of self-interest to allocate resources in society s best interest. Price mechanism: The means by which decisions taken each day by consumers and businesses interact to determine the allocation of scarce resources between competing uses. Causes of Changes in Equilibrium Market Prices Candidates should understand the significance of elasticities of demand and supply in influencing the extent of any fluctuations in market prices. Applications of Demand and Supply Analysis to Particular Markets Candidates should be able to apply their knowledge of the basic model of demand and supply to markets, such as commodity markets, agriculture, health care, housing, sport and leisure. Oil Price Corn Price House Prices The Interrelationship Between Markets Candidates should be aware that changes in a particular market are likely to affect other markets. They should, for example, be able to explore the impact of the introduction of a new product and a new supplier in a competitive market. Candidates should understand the implications of composite demand, derived demand and joint supply. Composite demand: where goods or services have more than one use so that an increase in the demand for one product leads to a fall in supply for another. 5

6 Derived demand: The demand for a product X might be strongly linked to the demand for a related product Y Joint supply: an increase or decrease in the supply of one good leads to an increase or decrease in supply of another How Markets and Prices Allocate Resources Candidates should understand the rationing, incentive and signaling functions of prices in allocating resources and co-ordinating the decisions of buyers and sellers in a market economy. They should also be able to use the economists model of the market mechanism to assess the effectiveness of markets in allocating resources. The rationing function: Signalling function: when there is a shortage of a product the price is bid up market prices will adjust to demonstrate where resources are required and where they are not Monopoly Monopolies and The Allocation of Resources Candidates should understand that monopolies have market power and that the basic model of monopoly suggests that higher prices, inefficiency and a misallocation of resources may result. Candidates should understand the potential benefits from monopoly, for example, economies of scale and possibly more invention and innovation. Pure monopoly: Working monopoly: Oligopoly: Duopoly: Barriers to entry: an industry where this is a single seller. any firm with greater than 25% of the industries' total sales. characterised by the existence of a few dominant firms the majority of market sales are taken by two dominant firms. means by which potential competitors are blocked Production and Efficiency Specialisation, Division of Labour and Exchange Candidates should understand the benefits of specialisation and why specialisation necessitates an efficient means of exchanging goods and services. Production and Productivity 6

7 Candidates should understand the meaning of productivity (including labour productivity) and the factors that determine productivity. Short run production: Long run production: Labour productivity: is a period of time when there is at least one fixed factor of input all of the factors of production can change Actual rate of output or production per unit of time worked. Economies of Scale Candidates should be able to give examples of economies of scale, recognise that they lead to lower unit costs and may underlie the development of monopolies. Economies of scale: Diseconomies of scale: As business expand their scale of production their long run average (unit) costs of production fall Firms eventually experiencing a rise in long run average costs Economic Efficiency Candidates should understand that any point on the production possibility boundary is productively efficient but that allocative efficiency is only achieved when the goods and services produced match peopleís needs and preferences Market Failure Positive and Negative Externalities in Consumption and Production Candidates should understand that externalities exist when there is a divergence between private and social costs and that negative externalities are likely to result in over-production. Externalities: Negative externalities: Positive externalities: Social Cost: Social Benefit: third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid. the production and/or consumption of a good or a service creates external benefits which boost social welfare. Private Cost + External Cost Private Benefit + External Benefit Public Goods Candidates should understand that public goods are non-rival and nonexcludable and recognise the significance of these characteristics. Candidates should understand the difference between a public good and a private good. Private good: Public good: Quasi-Public good Good that is excludable and rival A good that is non-rivralrous (your consuming it does not prevent me consuming it) and non-exclusive (there is no way of preventing you from consuming it). A good is a near-public good i.e. it has many but not all the characteristics of a public good Merit and Demerit Goods Candidates should understand that the classification of merit and demerit goods depends upon 7

8 a value judgement and that such products may also be subject to externalities. Merit good: Demerit goods: goods and services that the government feels that people will underconsume and possibly be under-provided. Those that cause negative externalities Market Imperfections Candidates should understand that the existence of monopolies, the immobility of factors of production and imperfect knowledge are likely to result in a misallocation of resources. Pure monopoly Near/Working monopoly Oligopolistic industry: Duopoly: Cartel an industry with a single seller any firm with greater than 25% of the industries' total sales existence of a few dominant firms the majority of market sales are taken by two dominant firms. A group of producers who enter a collusive agreement to restrict output in order to raise prices and profits. Inequalities in the Distribution of Income and Wealth Candidates should understand that, in a market economy, an individuals ability to consume goods and services depends upon his/her income and wealth and that an unequal distribution of income and wealth may result in an unsatisfactory allocation of resources Government Intervention in the Market Rationale for Government Intervention Candidates should understand the reasons for government intervention in a market economy. Methods of Government Intervention to Correct Distortions in Individual Markets Candidates should be able to use basic economic models to analyse and evaluate the use of indirect taxation, subsidies, price controls, buffer stocks, pollution permits, state provision and regulation to correct market failure. Indirect taxation: tax, such as value added tax, that is levied on goods or services rather than individuals Subsidies: Money given by government to lower prices or increase supply 8

9 Maximum price: legally imposed price in a market that suppliers cannot exceed in an attempt to prevent the market price from rising above a certain level. Minimum price: A minimum price is a legally imposed price floor below which the normal market price cannot fall. Buffer stock: schemes that seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low. Pollution Permits: rights to sell and buy actual or potential pollution in artificially created markets. Government Failure Candidates should appreciate that government intervention does not 9

10 necessarily result in an improvement in economic welfare. Governments may create rather than remove market distortions. Inadequate information, conflicting objectives and administrative costs should be recognised as possible sources of government failure. Government failure: intervention distorts markets still further leading to a further loss of allocative efficiency The Impact of Government Intervention on Market Outcomes Candidates should be able to apply economic models to assess the role of markets and the government in areas such as health care, housing, agriculture and the CAP, transport and the environment. 10

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