Unit 1(Market System and Market Failure)

Economics: It is the study of scarcity (demand>Supply) i.e. the major problem of every economy is the scarce resources with alternative uses and unlimited wants.

Economics can be studied at micro level (small scale level- individual) and macro economics (large scale level – Group, as a whole).

PPF: Production possibility frontier is the curve stating various equal level of production possibility with scarce resources at opportunity cost (The next best foregone alternative cost).

Following PPF shows that A, B, C are the equal level combinationsI.e. A, B and C are full utilisation of recourses where as D is under-- Utilisation or unemployment and E shows growth in the economy. XPoint C shows higher living standard than A (More consumer goods).Movement along the PPf and shift PPF to in (Underutilised) and out (Growth) YCapital goods(X) used for further production (Investment) e.g. machines and consumer goods (Y) are End-Use goods such as food, car. (The nature of good depends on the use).

Demand: wants + money + readiness (A certain quantity which Consumer is ready to pay at particular price at given time). Ceteris Paribus, higher the prices will leadTo lower demand and lower the price will lead to higher demand. (-ve). P -ve slopeFactors affecting demand: taste, fashion, income, price of other goods etc. D QChange in Demand: The demand can be changed due to price (Movement) or other factors such as fashion or income (Shifting).

D D D D1 D1 D P P P P

Q Q Q Q Extension Contraction Increase Decrease

Supply: Supply is another important element i.e. market force. Supply SIs a certain quantity which producer is ready to sell at certain price at P Given time (+ Ve relationship between price and supply unlike demand) +ve slopeHigher the price more supply or vice - versa, ceteris Paribus. Q

Factors affecting supply: price, technology, government policy, objectives, factors of production, availability of raw material etc.

Change in Supply: The Supply can be changed due to price (Movement) or other factors such as technology, Factors of production, raw material etc. (Shifting).

P S S1 P S S S1 S

P

Q Q Q Q

Extension Contraction Increase Decrease N.B. Price equilibrium is a point where both market forces (Interrelationships of market)(Demand and supply) meet each other i.e. price determination. P (D = S)

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Above equilibrium can change if demand or supply shifts to right or left. QAbove shifts and movement also depends on the elasticity of the product.

Elasticity: It means Responsiveness- Elasticity of demand (Ed) or Elasticity of supply (Es). Ed: Elasticity of demand means responsiveness of quantity demanded due to change in price (Ped), Income (Yed) or Price of other goods (Xed). [Numerical: two are given- find out 3rd]

% Change in Qty % Change in Qty % Change in Qty XPed = ------------------------- Yed = --------------------------- Xed = ------------------------ % Change in Price % Change in Income % Change in Price Y

Price Elasticity of Demand: Responsiveness of quantity demanded due to change in Price of goods. Degrees (E=OO, E=1, E>1, E<1, E=0).P P P P P D D D

D D

Q Q Q Q QE=OO E>1 E=1 E<1 E=0

Income Elasticity of Demand: Responsiveness of quantity demanded due to change in Income of Consumers. Degrees (E= +ve, E= -ve, E=0).Y D Normal Goods D Giffen/Inferior Goods D Essential Goods

Y Y

Q Q Q E= +ve E= -ve E=0 Cross Elasticity of Demand: Responsiveness of quantity demanded X due to change in Price of goods Y. Degrees (E= +ve, E= -ve, E=0). Example: always two goods.Px Unrelated D Substitute D Complementary D Goods goods Px Px

Qy Qy Qy E= +ve E= -ve E=0 Price Elasticity of Supply: Responsiveness of quantity supplied due to change in Price of goods. Degrees (E=OO, E=1, E>1, E<1, E=0).P P P P S S S S

S P

Q Q Q Q Q E=OO E>1 E=1 E<1 E=0

(Dotted Lines are very important)Economic Statements: Positive Statements (Facts, this information can be proved with data) Normative Statements (value judgement, opinions (should) Rather than Factual information)

SConsumer’s surplus: Excess price which consumers are wiling to pay. P CS EProducer’s Surplus: Excess price which producers are actually charging. PS

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However the area of consumer surplus and producer surplus depends on the elasticity of the products. Lower the price means higher Consumer Surplus and lower Producer surplus.

Factors affecting Ed: Time, income level, price level, availability of substitute, type of goods, habit or addiction and use of the good.

Factors affecting Es: Time, natural goods, artistic goods, elasticity of factors of production.

Command Economy is when government keeps the control over factors of production and allocation of resources is decided by either state or central government. (E.g. Former Russia)Capital Economy is when government does not keep the control over factors of production and allocation of resources is decided by market forces i.e. demand and supply. (E.g. USA)Mixed Economy is where government intervenes up to a certain extent over production and allocation of resources is also decided by market forces i.e. demand & supply (E.g.UK, India)Transition Economy is when a Command (Planned) Economy is moving to Capital (free market) Economy (E.g. Former Russia, Poland, and Germany).

Positives of free market economy: Attracts FDI, higher living standard, choice, high competition and higher growth.

Negatives of Free market economy: inequality and unbalanced growth among economic sectors market failure and misallocation may cause market failure.

Specialisation: when the tasks are split and allocated on expertise basis i.e. division of labour. It increases the productivity and decrease the unit cost of production.

Absolute advantage: A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resources than another country.Comparative advantage: The principle of comparative advantage shows that what matters is not the absolute cost, but the opportunity cost of production. Therefore CA is when a country can produce at lower opportunity cost. (Not Detailed)

Factors of production: Land (Natural resources) - Rent, Labour (Mental and physical work) - wages/salaries, Capital (unnatural factor- Machines) - Interest, Enterprise (Investors) – Profit. Derived demand is indirect demand such as factors of production. Factors affecting supply of labour: migration, population, income tax, benefits, NMW or trade union power.

Joint demand is like complementary demand (CD and CD player). Composite demand means demand for two or more uses such as milk, electricity. Inferior goods means –VE Yed.

Government Intervention: Micro economy: Govt. could intervene by Tax - Direct e.g. tax on income and indirect tax i.e. tax on expenditure, tax can be ad valorem (%) or fixed (certain amount) and other intervention is subsidy (government spending e.g. benefits, grants, EMA):

Tax: VAT (indirect ad valorem tax) Subsidy (Govt. Spending)S1 D S

D S P S1

Consumer Incidence

Q QIncidence means the GAP between new equilibrium point and initial supply before shift. & Incidence of Tax or Incidence of subsidy= Incidence on consumer + incidence on producer.

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Remember, price change is consumer’s incidence and the leftover is producer’s incidence. However the area of incidence depends on the elasticity of the products.The revenue of the firm is also affected by Elasticity. If the product is elastic lower the price would increase firms’ revenue and if the product is inelastic, it means that higher the price will increase the firms’ revenue.

Renewable resources are effectively natural resources such as sunlight, wind, rain etc. these are used for sustainable growth of economy. Whereas non renewable resources are natural resource that cannot be re-made, re-grown or regenerated on a scale comparative to its consumption. It exists in a fixed amount, e.g. Fossil fuels (coal, petroleum and natural gas).

NB. When equilibrium changes, the excess supply, excess demand, consumer surplus and producer surplus area also changes along with the equilibrium. Students are expected to apply the equilibrium principle on commodity market and labour market.

Special Note: Detailed study of Transport market, health care, education, monopoly, environment, agriculture CAP, waste disposal and recycling etc.

Economic data: Primary or secondary research can be used to collect the information about the market. It has to be analysed and presented in reliable and accurate manner. Nominal values are unadjusted with inflation BUT real values are adjusted after inflation (Index). Interpretation of data: (Trends, %, Qualitative and Quantitative analysis)

Market failure: when allocation of the resources is not at efficient i.e. social optimum level and misallocation of resources. Market is a wider area where buyer and seller both are ready to sell and buy goods/services at a particular price at given time.

Market fails if: Externality is produced, under production of merit goods, over production of demerit goods, Undesirable Govt. Intervention, monopoly exists, imperfect knowledge, information lag, immobility of resources, inequality of income or misallocation of resources.

Externality: it means third party effect i.e. Positive (third party benefit) e.g. (Production) education, (Consumption) diet food; negative (third party cost) e.g. (Production) manufacturing pollution, (Consumption) smoking.

Abbreviations: M = Marginal, S = Social, B = Benefit, P = Private, E = External, C = Cost MPC+MEC=MSC if MSC>MPC (Market failure due to – ve Externality) e.g. Smoking.MPB+MEB=MSB if MSB>MPB (Market failure due to + ve Externality) e.g. education.

Efficiency: Productive Efficiency means the production at the lowest possible AC i.e. the AC can’t be decreased more. Allocative efficiency- To produce what is demanded by consumer i.e. allocation of the resources according to consumer demand (Consumer Sovereignty). Social Pareto Efficiency means the production can not be increased by even one unit without decreasing the production of other unit. (Social optimum/efficient level) i.e. MSC=MSB

Free market Equilibrium Social optimum equilibriumP

MSC MPC P

EE MPC+MEC= MSC

MPB+MEB= MSB MSB MPB

Q Q Market failure Market doesn’t fail

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+Ve Externality (MSB > MPB) -Ve Externality (MSC > MPC)P

MSC MPC=MSC P MPC

Welfare Loss Welfare gain

MSBMPB=MSB

MPBQ Q

Q Q1 Q1 Q

Merit goods should be produced Demerit goods should be produced more at higher value less at higher price Above diagram states that Q is free market equilibrium and Q1 is social optimum equilibrium.

Monopoly: Single seller or the industry dominated or over 25% owned by single seller. Monopoly is illegal in the UK, Especially when it is against public interest.

Disadvantages: dominate market, charge high price, exploit customers, price discrimination, less choice, high barrier to entry and exit and Allocative and productive inefficient.Advantages: Economies of scale, lower price (natural monopoly), reliable for economy.An industry is said to be a natural monopoly if one firm can produce a desired output at a lower social cost than two or more firms—that is, there are economies of scale.

Anti- Competitive strategies by Monopolies: Predatory pricing i.e. to charge less than AC and kick out competitors from the market; they could charge higher price once Competitors are out of the market. Limiting Pricing: To charge just above the average cost and stop the new entries and create high barriers to entries for new firms.

Economies of Scale: it can be enjoyed by any size firm expanding its scale of operation. Economies reduce the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right. It can be internal and external. However, if large scale size increases the Average cost, it’s known as diseconomies of scale.

Internal Economies: Purchasing (Bulk discount), Technical economies, specialisation, managerial and financial economies.(only to the firm not to whole industry)External Economies: Infrastructure, wider pool of labour and supplier, information benefits

Internal diseconomies of scale: Technology failure, managerial inefficiency, lack of communication and coordination, probably out of control, lack of specialisation. (Only Firm)External diseconomies: Competition, higher cost (Tax/fine), Government intervention.

Market and Resources allocation: Functions of price-Rationing- To allocate/ ration the resources to satisfy the consumers’ demand (NOT Wants) Signalling: It gives signal to buyers and sellers about buying and selling in the market.Incentives: Price gives incentive to buy and sell to buyer and seller. (More or less quantity)

Government intervention: To correct the market failure government intervenes if market fails due to –ve externality, +ve externality and monopoly.

If –ve externality: Regulation however time lag, Direct control however admin cost, persuasion however its not compulsory, Tradable permits however can be bought and sold, extending property right (OFCOM, OFTEL, OFGEM) however government failure, Taxation (Refer incidence of tax) however inelastic product, subsidy for cleaner alternative (refer incidence of subsidy) however imperfect information and how close substitute is this.

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If +ve externality: Provide goods with free rider problems however may be abused by public, provide public goods (non-rivalry & non-excludability) for social welfare however quasi public goods, subsidy (refer incidence of subsidy) however opportunity cost, education and training, free voucher however government failure, persuasion however it is not compulsory.

Other forms of Government Intervention: Buffer Stock- It is a certain quantity kept aside by Govt. to iron-out the fluctuations in the price and keep it stable between ceiling and floor price. (Diagram)

Evaluation: above government intervention could have side effects due to elasticity of product, government failure (mentioned below), time lag, magnitude, or students can prioritise the policy to show the effectiveness.

Government failure: lack of data and information, admin failing, time lag, undesirable effects, political conflicts, conflicts among objectives, external shocks, govt. self interest.

COBA/CBA: Cost benefit analysis- Government should compare the MSC with MSB before taking any final decision about taxation or subsidy. Ideally, MSB>MSC (selection) or NOT.

Limitations of CBA: Only quantitative figures, forecast only, difficult to find all costs and revenues, external factors and time lag.

Public goods: Non rivalry and non excludability (opposite to private goods) Street lightQuasi Public goods: these are non rivalry but excludability goods: beach, NHS beds, Roads

Other market Failure: imperfect market information (symmetric or asymmetric information), unstable commodity market i.e. fluctuations in the prices of commodity etc. and Buffer stock is a government measure to correct this market failure.

Labour Market: Demand for labour is derived demand i.e. indirect demand.Factors affecting Demand of labour: Wage rate, Productivity, demand for the final product, Qualification, available substitute, technology, complementary cost and season or occasions.Supply of Labour: wage, level of employment, working population (16-65), social culture, training, flexibility, location of firm, holidays, pleasantness of job, security, perks, taxation, minimum wage, government regulation, benefits, power of trade union and migration etc.

Labour immobility i.e. geographical and occupation immobility also fails the market as it is not efficient utilisation of scarce resources. Government measures to improve immobility such as training, infrastructure improvement, subsidies or regional policies etc are the ways to control over market failure due to labour immobility.

Exam Techniques: (Edexcel) Multiple choice questions: 1. never leave the answer blank and write down valid three points to raise other 3 marks under explanation section (1 key word from the question, 1 key word from the answer, 1 why is this particular option the right answer and ½ and ½ why the other two seems to be the wrong answer.

AQA: A bit about +/- of Monopoly and Economies of scale i.e. lower average cost due to large scale of production. e.g. Bulk discount, technology advance and marketing benefits.OCR: A bit about International Trade and Protectionism: International trade means trade across the boundaries. Protectionism means to protect the domestic economy from the international competition. It can be tariff (Tax) or non tariff (Quota, persuasion, subsidy to domestic industries, exchange rate and quality control etc.)

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BASIC EVALUATION FOR ALL BOARDS: GPMET- GOVERNMENT FAILURE (OPPORTUNITY COST), PRIORITISE, MAGNITUDE, ELASTICITY, TIME: SR/LR

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