HL Economics Fact Guide

Nicholas Sim Wei Sheng September 27, 2011

Preamble
This document is not intended as a learning resource. It is intended to eectively state and review, without grammatical or factual inaccuracies or ambiguity, the facts in the IBDP HL Economics syllabus1 to one who would be familiar with the content. Economics for the IB Diploma, Standard and Higher Level by Ellie Tragakes was referred to extensively in the writing of this document. Additionally, the coursebooks Anglo-Chinese School (Independent) Economics 2011, Higher and Standard Level were used in the writing of this document. No quotes have been used in an attempt to produce the concise, elegant, and unequivocal writing contained in this document. Note that throughout this document the phrase including refers to including, but not limited to. This and other contractions are necessary to ensure the brief and neutral phrasing of the document. It is best, therefore, that readers are able to understand the contents in detail. This document has be largely written from the point-of-view of a mathematics student. While every eort has been made to make the writing as readable as possible to beginning economics students, no guarantee can be made as to this property. Additionally, no guarantee can be made as to its accuracy, although there exists the reassurance that the author does intend to use this as a complete reference for the topics listed, and that it has been proofed in varying degrees of detail by others.

As of 2011.

Contents
1 Introduction to Economics 1.1 Basic requirements . . . . . . . . . . . . . . . . . . . . . . . . 1.1.1 Positive and Normative Economics . . . . . . . . . . . 1.1.2 Ceteris paribus . . . . . . . . . . . . . . . . . . . . . . 1.2 Scarcity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.1 Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.2 Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.3 Factors of Production . . . . . . . . . . . . . . . . . . 1.2.4 Economic and free goods . . . . . . . . . . . . . . . . 1.2.5 Capital and consumer goods . . . . . . . . . . . . . . 1.3 Production Possibilities Curve (PPC) . . . . . . . . . . . . . 1.3.1 Law of increasing opportunity cost . . . . . . . . . . . 1.3.2 Shifts of the PPC . . . . . . . . . . . . . . . . . . . . . 1.4 Eciency in resource allocation . . . . . . . . . . . . . . . . . 1.4.1 Productive eciency . . . . . . . . . . . . . . . . . . . 1.4.2 Allocative eciency . . . . . . . . . . . . . . . . . . . 1.5 Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . 1.5.1 Causes of economic growth . . . . . . . . . . . . . . . 1.5.2 Investment-Consumption Choice . . . . . . . . . . . . 1.5.3 Potential and actual economic growth . . . . . . . . . 1.6 Economic Development . . . . . . . . . . . . . . . . . . . . . 1.6.1 Relation of economic growth and economic development 1.6.2 Causes of economic development . . . . . . . . . . . . 1.7 Types of economies . . . . . . . . . . . . . . . . . . . . . . . . 1.7.1 Free Market System . . . . . . . . . . . . . . . . . . . 1.7.2 Centrally Planned Economy . . . . . . . . . . . . . . . 1.7.3 Mixed Economy . . . . . . . . . . . . . . . . . . . . . 2 Demand and Supply 2.1 Markets . . . . . . . . . . 2.1.1 Market Structures 2.2 Demand . . . . . . . . . . 2.2.1 Law of demand . . 6 6 6 6 6 6 6 7 7 8 8 9 9 9 9 9 10 10 11 11 12 12 12 13 13 14 14 15 15 15 16 16

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2.2.2 Factors aecting demand . . . . . . . . . . . . . 2.2.3 Substitution eect . . . . . . . . . . . . . . . . . 2.2.4 Income eect . . . . . . . . . . . . . . . . . . . . 2.2.5 Exceptions to the law of demand . . . . . . . . . Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Law of supply . . . . . . . . . . . . . . . . . . . . 2.3.2 Factors aecting supply . . . . . . . . . . . . . . Market Equilibrium . . . . . . . . . . . . . . . . . . . . 2.4.1 Eects of changes in demand and supply . . . . . 2.4.2 Equilibrium of free goods . . . . . . . . . . . . . Consumer and producer surpluses . . . . . . . . . . . . . 2.5.1 Consumer surplus . . . . . . . . . . . . . . . . . 2.5.2 Producer surplus . . . . . . . . . . . . . . . . . . 2.5.3 Price signals and eciency . . . . . . . . . . . . Government intervention . . . . . . . . . . . . . . . . . . 2.6.1 Price controls . . . . . . . . . . . . . . . . . . . . 2.6.2 Commodity agreements and buer stock schemes

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17 18 18 18 19 19 20 21 21 22 23 23 24 24 25 25 26 27 27 27 28 28 29 30 31 31 31 32 32 33 34 34 35 35 37 37 37 39 39 39 40 41

3 Elasticities 3.1 Price elasticity of demand . . . . . . . . . . . . . . . . 3.1.1 Varying of the PED over a demand curve . . . 3.1.2 Relative elasticity . . . . . . . . . . . . . . . . 3.1.3 Range of the PED . . . . . . . . . . . . . . . . 3.1.4 Factors aecting the PED of a good . . . . . . 3.1.5 PED and total revenue . . . . . . . . . . . . . . 3.2 Cross-elasticity of demand . . . . . . . . . . . . . . . . 3.2.1 Sign and magnitude of the XED . . . . . . . . 3.2.2 Pricing decisions based on XED . . . . . . . . 3.3 Income elasticity of demand . . . . . . . . . . . . . . . 3.3.1 Value of the YED . . . . . . . . . . . . . . . . 3.3.2 Factors aecting the YED of a good . . . . . . 3.3.3 Sectoral change . . . . . . . . . . . . . . . . . . 3.4 Price elasticity of supply . . . . . . . . . . . . . . . . . 3.4.1 Factors aecting the PES of a good . . . . . . 3.5 Incidence of taxes and subsidies . . . . . . . . . . . . . 3.6 Elasticity of primary products . . . . . . . . . . . . . . 3.6.1 Short-run price uctuations . . . . . . . . . . . 3.6.2 Long-run decline in prices and producer income 4 Market Failure 4.1 Social eciency . . . . . . . . . 4.2 Externalities . . . . . . . . . . 4.2.1 Methods of intervention 4.3 Merit and demerit goods . . . . 4

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4.5 4.6

4.3.1 Methods of intervention . . . . . . . . Public goods . . . . . . . . . . . . . . . . . . 4.4.1 Marginal cost for non-rivalrous goods 4.4.2 Free rider problem . . . . . . . . . . . 4.4.3 Provision of public goods . . . . . . . Imperfect competition . . . . . . . . . . . . . Other causes of market failure . . . . . . . . .

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5 Theory of the Firm 5.1 Costs and production . . . . . . . . . . . . 5.1.1 Explicit and implicit costs . . . . . . 5.1.2 Short run and long run . . . . . . . 5.1.3 Law of diminishing marginal returns 5.1.4 Types of costs . . . . . . . . . . . .

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Chapter 1

Introduction to Economics
This is an introduction to the study of economics.

1.1
1.1.1

Basic requirements
Positive and Normative Economics

Briey, positive economics describes what is, was, or will be, based on known facts. Normative economics suggests or prescribes what should be, based on some qualitative judgement, not necessarily involving any facts.

1.1.2

Ceteris paribus

Latin for all else being equal. Denotes the assumption that on the consideration of one variable, other variables are assumed to remain constant.

1.2

Scarcity

The study of Economics is important due to scarcity. This is the condition where there is insucient resources to fulll all the wants of society.

1.2.1

Utility

Utility is the benet that consumers derive from consuming a good. This is not the same for all consumers, and will vary by quantity consumed.

1.2.2

Choice

Choice is necessary as human wants are not limited, but resources are limOne will nd that ited. Therefore choices must be made in the usage of resources. many topics in There are three basic questions that determine resource allocation: Economics will 1. What, and how much to produce. eventually attempt to answer these three 6 questions. Keep them in mind while analysing each topic.

2. How (with what resources) to produce. 3. For whom to produce. Opportunity cost Opportunity cost is the value of the next best choice forgone, with respect to the choices taken. If the choice taken does not derive the most utility, it is the value of the choice that derives the most utility. Rational Choice Economics assumes that consumers (and societies) wish to choose to consume goods in a way that derives the maximum utility at the lowest possible cost.

1.2.3

Factors of Production

There are four basic categories of scarce resources, factors of production: Land refers to all natural resources used to produce goods; land includes ore, oil, and actual land area. Receives rent. Labour refers to physical and mental eorts made by humans in the production of a good. Receives wages. Capital or physical capital refers to assets used to produce more goods; this includes machinery, buildings, and roads.1 Receives interest. Entrepreneurship/management refers to individuals who possess the ability to innovate, take risks2 , and to organise the other factors of production. Receives prot.

1.2.4

Economic and free goods

An economic good is a resource that is scarce, thereby having opportunity cost. They usually have a positive price, but may have zero price.3 A free good is a good that is not scarce, thereby having no opportunity cost. It is available in quantities sucient to fulll all human wants for them. An example is saltwater by the sea, 1 These examples are of xed capital, which can be reused; there also exists circulating not readily available capital, which refers to partially complete goods to be used in the production process of inland (presuming another good, such as plastic in the production of calculators. 2 there is a want for Risks are necessarily uninsurable. 3 Public goods have zero price. See Section 4.4.2 for the free rider problem. it). 7

1.2.5

Capital and consumer goods

Capital goods are those which can be used in the production of other goods. Consumer goods are those which consumers may, for the lack of a better word, consume to derive utility.

1.3

Production Possibilities Curve (PPC)

A Production Possibilities Curve or Frontier shows the maximum combination of two goods that may be produced by an economy within a certain period, when all its resources are fully and eciently employed. These two goods should use similar resources, or they would be unrelated and PPC cannot be drawn. By utilising resources in an economy to produce at a point on the curve, all resources are necessarily eciently employed. Production at points within imply that resources are not fully and eciently employed (wastage); production at points beyond is simply unattainable. Thus in the PPC: Scarcity is seen in unattainable combinations. Choice is seen in the many points that can be produced at. Opportunity cost is seen from the downward slope.

Capital goods (units)

T uB

uA

uC

E Consumer goods (units)

Figure 1.1: A typical PPC In Fig. 1.1, 8

A shows wastage of resources. B shows an unattainable point for production. C shows production with full and ecient use of resources.

1.3.1

Law of increasing opportunity cost

The law of increasing opportunity cost states that in order to get an equal marginal increase in the production of one good, an economy must sacrice ever increasing quantities of another good. This is reected by the concave curve of the PPC. Note that the PPC is not always necessarily visibly concave. Goods that use resources identically, such as basketballs and volleyballs, do not experience the law of increasing opportunity cost by a signicant amount.4

1.3.2

Shifts of the PPC

Shifts of the PPC are due to changes in an economys productive capacity, frequently due to economic growth, which will be covered in the next section. Another possible shift of the PPC is the pivotal shift, or a shift occuring in one axis (see Fig. 1.2). This shows that an economy can produce more of one good with the same resources than previously, generally caused by a technological enhancement in the production of a good.

1.4

Eciency in resource allocation

As resources are scarce, economies have to make choices in resource allocation (the three basic questions). Therefore an economy should aim to produce the best combination of goods and services as demanded by society. This requires full and ecient use of resources.

1.4.1

Productive eciency

Productive eciency occurs when production is made such that it is not possible to produce more of one good without producing less of another good. All points along the PPC are productively ecient. Productive eciency is reached when AC = M C. 1.4.2 Allocative eciency Allocative eciency occurs when resources are allocated such that no one can be made better o without another being made worse o. The requirement
There are situations when the PPC will be convex. This occurs when the resources are more suited to producing either or both of the goods, than a combination of the two. This will be covered in greater detail in Theory of the Firm.
4

Good X
T

E E Good Y

Figure 1.2: A pivotal shift of the PPC, showing increased possible production of Good X with the same resources. for this is the cost of producing a good is exactly equal to the utility derived Allocative eciency from consuming that good. is reached when The requirements for allocative eciency are productive eciency and P = AC = M C. maximum utility derived by consumption of goods by population in an economy, based on their tastes and preferences. Note that societys preferences also depend on other factors; a society facing war is likely to prefer that resources be allocated to defence.

1.5

Economic Growth

Economies must produce output in the form of goods and services. Increases in the quantity of output indicate economic growth. Decreases in the quantity of output indicate economic contraction. These are easily seen using the PPC.

1.5.1

Causes of economic growth

There are three main causes of economic growth, broadly classed into three categories: Increase in available resources Working population growth; discovery of new minerals, ores; reclamation of land; increase in capital stock. Improvement in quality of resources Trained workers; better management; better equipment; better methods of production; better technology. 10

Improvements in technology More ecient methods of producing goods.

1.5.2

Investment-Consumption Choice
Note that the invester need not produce the capital goods. They can be easily obtained by purchase.

Investment refers to the obtaining of capital goods within a specied period. Since capital goods are used to produce other goods, production of capital goods will increase the productive capacity of an economy in a future period, for both capital and consumer goods. As a result, the choice to produce greater quantities of capital goods over consumer goods will increase the productive capacity of an economy at a greater rate.

1.5.3

Potential and actual economic growth

Potential growth refers to the increase in the productive capacity of an economy, illustrated in Fig. 1.3 as an outward shift of the PPC. It is necessary to achieve indenite increases in the amount of goods or services produced in future periods.

Capital goods (units)

T

E E Consumer goods (units)

Figure 1.3: PPC indicating economic growth. Actual growth is the increase in the amount of goods or services produced by an economy, achieved by either making the production more ecient (by producing closer to the curve where production is currently at a point within the curve, such as point A in Fig. 1.1), or taking advantage of an increase in potential growth. 11 Potential growth need not be utilised, and thus might not result in actual growth.

1.6

Economic Development

Economic development must be suciently dierentiated from economic growth. It refers to the standard of living in the population of economy, and can be measured quantitatively from the availability of merit goods5 and other factors, such as improved income distribution or employment opportunities. Thus economic development can improve from increased provision of services including healthcare and education. Therefore economic development is extremely important for the welfare of a society. It may indirectly contribute to economic growth.

1.6.1

Relation of economic growth and economic development

Economic growth generally allows an economy to have economic development, as it will have more capital to improve these aspects of the populations life. However, it is possible that it will not cause economic development. For instance, all of this capital might be used to allow for further economic growth. It might also be used on aspects that do not cause economic development, such as manufacturing of arms in a nation not facing imminent war.6 However, economic development is likely to cause economic growth, as it frequently leads to one of the three causes in subsection 1.5.1.

1.6.2

Causes of economic development

Sound banking system Financial institutions are important in economies as they, in eect, allow savers (those with money) to lend to borrowers. Loans enable new rms to enter markets more easily. The state may establish government-owned banks to ensure that capital is available to borrowers from the onset, should there be no banks with sucient funds for investment. Education Education improves labour, a factor of production. Additionally, it enables the educated to participate in society as an individual who is literate and able to communicate. Finally, it improves health, as individuals know how to prevent the spread of diseases.
Merit goods are discussed in Section 4.3. Arguably this causes economic growth, due to the improved provision of national security. However, if a nation does not face imminent war, it is unlikely to make a signicant dierence.
6 5

12

Healthcare Greater healthcare not only increases the quality of life in a country; it also improves the availability of labour as people are able to work for a greater proportion of their lives.

Infrastructure Infrastructure is necessary for the transportation of factors of production. It also includes the facilities that make communications, potable water, and electricity available. Reliable infrastructure attracts rms to invest in an area, and improves entrepreneurship.

Political stability For a rm, particularly those with large amounts of xed capital, to work effectively in an area, regulations must be enforced strictly and not be subject to unpredictable revisions. Political stability assures rms that they would not suer adverse eects as a result of regulation or lack of enforcement.7

1.7

Types of economies

Strictly, there are two types of economies: free market economies and centrally planned economies. They are drastically opposed and most economies are a mix of both.

1.7.1

Free Market System

The free market economy has no government intervention, and is based on the premise of the invisible hand. It relies completely on the market forces of demand and supply for resource allocation. Simply, all economic decisions are the responsibility of the individuals in the economy. This enables them to compete for and privately own resources and goods. Competition is present for all aspects of the economy, and consumers determine the production of goods through the price mechanism (Consumer sovereignty).8 An exception to the rule of the lack of goverment intervention is the provision of basic, critical services to society, such as law enforcement and national defence.
7 8

Corruption is a major factor in determining enforcement of regulations. The price mechanism is explored in greater detail in Section 2.4.

13

1.7.2

Centrally Planned Economy

The command economy relies completely an government direction and control. This control extends to both the production and consumption of goods. The state owns all resources and factors of production, excluding labour, thus having no incentive for prot, enabling high income equality. It must estimate the needs and wants of consumers and allocates resources accordingly. It sets the prices of goods and services.

1.7.3

Mixed Economy

A mixed economy utilises aspects of both systems.

14

Chapter 2

Demand and Supply

Demand and supply within the context of a competitive market studies the interactions of individual buyers and sellers. This is a part of Microeconomics.

2.1

Markets

A market is the means by which potential buyers and sellers exchange goods and services at agreed prices. It need not necessarily be based on location, although it frequently is. A market for a good can be of any size. Product markets Where goods and services are exchanged. Factor markets Where resources (labour, machinery, iron) are exchanged.

2.1.1

Market Structures

There are four basic market structures: 1. Perfect Competition 2. Monopoly 3. Oligopoly 4. Monopolistic competition These will be examined in Theory of the Firm. This topic, Demand and Supply will examine the rst structure: Perfect Competition. This topic assumes understanding of this structure. 15

2.2

Demand

Demand is the quantity of goods a group of consumers in a market is willing and able to buy at various prices over a certain period, ceteris paribus. Individual demand quite obviously refers to the demand (as dened above) of an individual consumer. In a perfectly competitive market, the individual consumer is unable to inuence prices of a good. Market demand refers to the demand of all the consumers in a market. A demand schedule is a table that shows the data of the demand, linking certain quantities and prices. It describes the demand curve. The demand curve is a representation of the demand schedule. An example is shown in Fig. 2.1.

Price of Good X ($)

T DD E Quantity of Good X demanded

Figure 2.1: Market demand for Good X Note that the price of the good is on the vertical axis, while the quantity of the good demanded is on the horizontal axis.

2.2.1

Law of demand

The law of demand states that there is an inverse relationship between the price of a good and the quantity demanded over a certain period, ceteris paribus. This is illustrated by the downward slope of the demand curve. Put simply, the higher the price of a good, the less of it is demanded in a market. 16

2.2.2

Factors aecting demand

A change in demand is reected by a shift of the demand curve. A change in price is reected by a shift along the demand curve, which is a change in quantity demanded, rather than demand. Number of buyers A change in the number of buyers will result in a proportional change of quantity of a good demanded at all price points, shifting the demand curve to the right or left. This is attributed to the denition of market demand: a summation of individual demands. This also applies to age of a population, for goods with age-related demand, such as medical services. Consumer taste and preference If consumer preferences change in favour of a product, demand increases; contrariwise, if preferences change in favour of other products, demand decreases. Consumer income Refer to Section 3.1, Price Elasticity of Demand. Prices of substitutes Refer to Section 3.2, Cross Elasticity of Demand. Price of complements Refer to Section 3.2, Cross Elasticity of Demand. Expectation of future income If consumers expect their future income to change, they will tend to behave according to that expectation. Refer to Section 3.3, Income Elasticity of Demand for more information. Expectation of future price changes If consumers expect the price to increase in future periods, demand will increase in the present period; if consumers expect the price to decrease in future periods, demand will decrease in the present period. 17

Legislation Governments can require that consumers consume certain goods, for instance anti-pollution equipment and retaining bars on lorries. Weather/Climate/Season If the climate changes such that a place becomes cooler/warmer, demand for heating and air-conditioning will be aected. Additionally, common holiday destinations are aected by seasonal tourism. Derived demand In this situation, the production of a good requires the use of another good. When the quantity supplied of the former increases, the demand for the latter increases.

2.2.3

Substitution eect

Assuming a decrease in the price of a good, in most cases consumers will choose to substitute other goods for the good which has had a decrease in price; the quantity of this good demanded increases at all price points.

2.2.4

Income eect

Considering the same decrease in price, then the consumers purchasing power has increased.1 If it is a normal good, quantity demanded will increase as consumers are more able to buy greater quantities of the good. However, if the good is an inferior good, the quantity demanded will fall, as more of the consumers income is available to buy normal goods.

2.2.5
Consumer expectations also cause exceptions to the law of demand. If a consumer has expectations of drastic changes of future income or price of the good, the expectation might be so great as to create an exception.

Exceptions to the law of demand

Gien goods This unproven phenomenon is relevant to inferior goods. As noted above, changes in price produce a result determined by the substitution eect and the income eect. A Gien good is an inferior good for which the income eect is greater than the substitution eect, causing a decrease in price to lead to a decrease in quantity demanded and therefore an increase in price resulting in an increase in quantity demanded. Otherwise, if the income eect is not greater than the income eect, the good is not a Gien good.
1

Not absolutely, but in relation to that one good.

18

Veblen goods Veblen goods are ostentatious goods that allow a consumer to derive satisfaction from simply being able to own the good, pretentiously impressing others. As the price of the good increases, there is therefore more satisfaction derived from owning the good, therefore they exhibit a positive demand curve.

2.3

Supply

Supply is the quantity of goods a group of producers in a market is willing and able to sell at various prices over a certain period, ceteris paribus. Individual supply refers to the supply of an individual producer. In a perfectly competitive market, the individual producer is unable to inuence prices of a good. Market supply refers to the supply of all the producers in a market. A supply schedule is a table that shows the data of the supply, linking certain quantities and prices. It describes the supply curve. The supply curve is a representation of the supply schedule. An example is shown in Fig. 2.2.

Price of Good X ($)

T   SS

              

E Quantity of Good X supplied

Figure 2.2: Market supply for Good X

2.3.1

Law of supply

The law of supply states that there is a positive relationship between the price of a good and the quantity supplied over a certain period, ceteris paribus. This is illustrated by the upward slope of the demand curve. 19

Thus as the price of a good increases, the market is willing to supply more of that good.

2.3.2

Factors aecting supply

As with demand, a change in supply is reected by a shift of the supply curve. A change in price is reected by a shift along the supply curve, which is a change in quantity supplied, rather than supply. Number of sellers A change in the number of sellers will result in a proportional change of the quantity of a good supplied at all price points. In a perfectly competitive market, this changes when it does not earn normal prot. Cost of production If the cost of production decreases, rms will be more willing to supply more units of the good at each price point, since in a perfectly competitive market, all rms earn normal prot. This is often inuenced by the cost of resources and other factors of production. State of technology Similar to changes in the cost of production. Prices of other goods a rm can produce If the rm nds that another good it can produce is currently earning greater prots, the rm may switch production to that good, decreasing the supply of the good it initially produced. Expectation of future price changes If producers expect the price of a good to increase in future periods, it may decrease supply in the current period in order to sell it in the future period. Taxes and subsidies Taxes and subsidies eectively change the cost of production for rms producing a certain good, and they will act accordingly. For more information, refer to the section on Taxes and Subsidies. 20

Supply shocks Supply shocks are unanticipated events that aect the supply of resources needed to produce a good. An adverse supply shock may be trade embargoes; a benecial supply shock might be an unusually good harvest (in agriculture).

2.4

Market Equilibrium

Equilibrium is a balance between two or more forces, with no tendency to change. It occurs at the point where the demand and supply curves in a market coincide, such that the quantity supplied and demanded at a certain price are equal. The price is known as the equilibrium price (Pe ) or marketclearing price, and the quantity is known as the equilibrium quantity (Qe ). At other prices, there is market disequilibrium, and the market forces of demand and supply put upward or downward pressure on the price toward the equilibrium. This is illustrated in Fig. 2.3.

Price of Good X ($)

T   SS         s C   Pe  E   Q k         DD   E Quantity of Good X

Qe Figure 2.3: Market for Good X

2.4.1

Eects of changes in demand and supply

The eects of changes in demand and supply on the market equilibrium are described by Table 2.1 and Fig. 2.4. 21

Demand Increases Decreases No change No change Increases Increases Decreases Decreases

Supply No change No change Increases Decreases Increases Decreases Increases Decreases

Price Increases Decreases Decreases Increases Uncertain Increases Decreases Uncertain

Quantity Increases Decreases Increases Decreases Increases Uncertain Uncertain Decreases

Table 2.1: Changes in equilibrium price

Price of Good X ($)

T SS1      SS2                      DD2   DD   1 Quantity of Good X   E

Figure 2.4: Changes of demand and supply in the market for Good X

2.4.2

Equilibrium of free goods

Thus far, the demand and supply curves have been illustrated to intersect, indicating that market equilibrium exists. This applies for economic goods, where there will always be a demand that is greater than supply at some point. Recall that a free good has supply that far exceeds demand. Therefore, the graph indicating the market of a free good looks like that in Fig. 2.5. Thus we can see there is excess quantity supplied even when the price is zero, making it a free good. 22

Price
T e e e e e e e e e e SS e DD e E Quantity

Figure 2.5: Market for a free good

Price
T   SS=MPC

CS Pe PS

        

 

   

DD=MPB E Quantity

Figure 2.6: Surpluses in a PC market

2.5
2.5.1

Consumer and producer surpluses

Consumer surplus

Consumer surplus (CS) is the dierence between the prices that consumers are willing and able to pay for a unit of good and the price that they pay (equilibrium price). It represents the dierence between the benet con23

sumers derive from consuming a good (MPB2 ) and how much they pay for it (Pe ). It is marked CS in Fig. 2.6. Consumer surplus exists as many consumers were willing to pay a price higher than the equilibrium for a unit of good, yet got that unit paying only the equilibrium price, thus deriving the extra benet over what was paid. This is the consumer surplus. In Chapter 3, Elasticities, we will see that a good with a low PED has a greater consumer surplus than one with higher PED.

2.5.2

Producer surplus

Similarly, producer surplus (PS) is the dierence between the prices that producers are willing and able to receive for a unit of good and the price that they receive. It represents the dierence between the cost of producing a unit of good (MPC3 ) and how much they receive for it (Pe ). It is marked PS in Fig. 2.6.

2.5.3

Price signals and eciency

Resource allocation in a market is determined by the demand and supply of the goods in that market. Knowing that the demand curve shows MPB and the supply curve shows MPC, then the equilibrium price occurs where they are equal; where they intersect, resource allocation is ecient in that market. The equilibrium then occurs as when MPB>MPC, then the benet derived from consuming an additional unit of good is greater than the cost of producing it, and so additional units should be produced until MPB=MPC. On the other hand, when MPB<MPC, then the benet derived from consuming the last unit of the good is less than the the cost of producing it, and so the last units should not be produced, where the condition remains. At any other point, consumer and producer surplus is not maximised. Thus allocative eciency is achieved in that market at MPB=MPC.4 Since allocative eciency is attained, productive eciency must also have been attained. This can be proven: Suppose that there are some rms that are not productively ecient, i.e. not producing at the lowest possible cost. Then there are rms which are producing at a lower cost. As rms in a PC market are price takers5 , increasing amounts of resources will be allocated to the rms with lower costs of production, since they are able to sell their goods at a lower price.
2 3

Marginal Private Benet. See Chapter 4, Market Failure. Marginal Private Cost. See Chapter 4, Market Failure. 4 CS+PS must be maximised for allocative eciency. 5 Market structures will be covered in detail in Theory of the Firm.

24

This increases producer surplus. This continues to occur until all rms are producing at the lowest possible cost, which maximises producer surplus. When allocative eciency is achieved in all markets, then it has been achieved for the economy as a whole. This would mean that economic eciency has be attained. Note that eciency can only arise in an entirely ideal perfectly competetive market, and therefore is extremely unlikely to occur in the real world.

2.6

Government intervention

Sometimes, the government may choose to intervene in a market to achieve certain objectives. These are often related to market failure and other problems.

2.6.1

Price controls

Price controls are regulations set by goverments that attempt to keep a market in some form of disequilibrium. Price oors A price oor is a legally set minimum price that a good may be traded at. It creates an excess in supply as long as it manages to keep the market in disequilibrium, since as long as the market is in disequilibrium, the quantity supplied at the price oor is necessarily greater than the quantity demanded. Price oors often attempt to protect the incomes of producers. In order to circumvent price oors, producers may attempt to sell their goods in black markets, or illegal markets created for the intention of avoiding the price oor. This is against the intention of the price oor. In order to prevent this, governments may attempt to buy up all the excess supply, which would be extremely expensive, or otherwise attempt to remove the black market, which is also likely to be costly. Price oors may also cushion ineciency as producers that are inecient do not have incentives to cut costs, as the high sale price protects them against rms that produce at lower costs. This causes ineciency through the overallocation of resources. Price ceilings A price ceiling is a legally set maximum price that a good may be traded at. It creates an excess in demand as long as it manages to keep the market in disequilibrium, since as long as the market is in disequilibrium, the quantity 25 Goods that are often subject to price oors include agriculture and labour. In the case of agriculture, price oors are known as price supports.

supplied at the price ceiling is necessarily less than the quantity demanded. Price ceilings often attempt to protect the interests of consumers. Apart from the problem of black markets, price ceilings suer from the problem of underallocation of resources, since the lower price means that the quantity supplied is lower than the demands of society. This results in ineciency of resource allocation.

2.6.2

Commodity agreements and buer stock schemes

Buer stock schemes were particularly popular in the 1960s-1980s, though most of them failed.

A commodity is a standardised product, usually produced by the primary sector. Commodity agreements are agreements that attempt to increase or stabilise the prices of commodities, to protect producers of these commodities. Buer stock schemes are a type of commodity agreement that attempt to stabilise prices, in order to protect consumers and producers from price uctuations. In a buer stock scheme, the operator of the scheme would attempt to buy excess stock when prices fall below a certain threshold, and sell them when prices exceed another threshold. This has certain problems. Firstly, it is extremely costly to operate a buer stock scheme, due to the high costs of storage, particularly of perishable agricultural products. There is also no assurance that the stock will not run out during a poor harvest. It is also very dicult to pick a suitable price band, as this requires the operator to accurately predict the future prices which arise from changing demand and supply. Income is also not stable, since prices remain relatively consistent, but the quantity may change within the band. Finally, it is unable to stop the long-term decrease in prices (Section 3.6.2). As this causes market prices to fall in the long term, then there will be successive false surpluses, which become extremely costly to purchase.

26

Chapter 3

Elasticities
3.1 Price elasticity of demand

Price elasticity of demand is a measure of the degree of responsiveness of the quantity of a good demanded to changes of its price. The law of demand states that they share an inverse relationship, PED shows how much quantity demanded changes to changes in price. (3.1) We notice that this value of PED With the exception of Gien and Veblen goods, the sign of the PED depends on the must be negative. Therefore we are concerned only with the absolute value initial price-quantity combination chosen. of the PED. To estimate PED at a point, we should 3.1.1 Varying of the PED over a demand curve take the sample This and future sections concern themselves with the absolute value of the change in price and quantity spread PED, assuming the sign to be negative. In all the demand curves we have examined so far, there has been a equally on both sides slope. Along this slope, the PED will vary. This is a result of the use of of that point. percentage change of price and quantity demanded in calculating the PED.1 There are three exceptions to this rule: perfectly elastic demand, perfectly inelastic demand, and unitary elastic demand, all of which will be covered in Section 3.1.3. This variation is explained below with the help of Fig. 3.1. Let us dene P = PB PC and Q = QC QB . P P The midpoint A is dened at Q = Q . This gives us P = Q . ThereP Q fore at A, the PED is 1.
On a completely irrelevant note, were absolute change to be used, PED would not vary along a straight sloped demand curve.
1

P ED =

Q P0 P Q0

27

Price
T r

B
rA C r E Quantity

Figure 3.1: Variation of PED At the length between A and B, the price is high and the quantity is P low, relative to A. Since Q is constant, the PED between A and B must be higher than that at A (Eqn. 3.1). Therefore above the midpoint, PED>1. Similarly, below the midpoint, PED<1.

3.1.2

Relative elasticity

Two demand curves on the same axes may be compared. The steeper curve indicates less elastic demand. If the two curves are parallel, they must not be compared. This generalisation holds since over a similar price range, the steeper curve will haver a smaller change in quantity demanded. Using Eqn. 3.1, we can see that this will result in a lower value for PED at all price points.

3.1.3

Range of the PED

PED=0 Demand is perfectly price inelastic: it is completely unresponsive to price. This occurs when there are no substitutes for a good, for instance, a severe drug addiction. PED<1 Demand is price inelastic; a change in price will result in a less than proportional change in quantity demanded. 28

PED=1 Demand is price unit elastic; a change in price will result in a proportional change in quantity demanded. PED>1 Demand is price elastic; a change in price will result in a more than proportional change in quantity demanded. PED= Demand is perfectly price inelastic: demand is completely dependant on price. A price increase will cause quantity demanded to fall to zero, otherwise consumers attempt to buy as much as they can obtain.

3.1.4

Factors aecting the PED of a good

Availability of substitutes The greater the availability of substitutes and the closer their substitutes2 , then the greater the PED. There is not necessarily a close substitute for every good, for instance the use of oil in plastic and other primary products, or petrol for cars; thus some goods are less price elastic. Degree of necessity If a good is more crucial to consumers, it will tend to be less price elastic. Staple foods are often less price elastic. On the other hand, luxuries such as diamonds tend to be more price elastic. By denition, necessities have no close substitutes. Addiction Addiction forms necessity. Proportion of income spent on good The larger the proportion, the more price elastic the demand of the good. This is because items that make up a small proportion of income are viewed by consumers as not worth nding substitutes for, as any price increases would still only make up a small amount of a consumers income. Conversely, for items that make up a large portion of a consumers income, considerable eort may be expended to nd substitutes as the absolute dierence in price is larger.
2

See XED (Section 3.2).

29

A car makes up a considerable portion of a consumers income; consumers tend to spend more time contemplating what car they want, or if they indeed want a car. This is an example of how demand for cars is relatively price elastic.

Period The longer the time period, the more price elastic the demand. More time allows consumers to get information on substitutes, or decide whether they wish to consume the good.

3.1.5

PED and total revenue

Total revenue is the amount of money that rms receive for selling a good, and is calculated by T R = P Q. A change in the price of a good will change its quantity demanded, illustrated in Fig. 3.2 with change from A to B.

Price
T

PA PB

A B s loss in TR

gain QA QB

DD E Quantity

Figure 3.2: Changes in TR as a result of a change in price When demand is price elastic, a decrease in price will lead to a more than proportional increase in the quantity demanded. Thus TR will increase as price decreases. When demand is price inelastic, an increase in price will lead to a less than proportional decrease in quantity demanded. This TR will increase as price increases. When demand in price unit elastic, a change in price will not aect TR. However, as price decreases from the midpoint, the demand will be more price inelastic, thus TR will be maximised by increasing the price. Similarly, as price increases from the midpoint, the demand will be more price elastic, thus TR will be maximised by decreasing the price. Therefore in order to maximise total revenue, price should be set to the midpoint of the demand curve, or where PED=1. 30

3.2

Cross-elasticity of demand

Cross-elasticity of demand is a measure of the degree of responsiveness of the quantity of a good demanded to changes in the price of another good. This therefore indicates how much the demand curve of one good would shift with a change in the price of another good. XEDXY = QX PY PY QX (3.2)

Note that the sign for XED may not be ignored, unlike PED. Also, XEDXY = XEDY X .

3.2.1

Sign and magnitude of the XED

Positive value A positive XEDXY indicates that for a change in the price of good Y, there will be a similarly-signed change in the demand for good X. This indicates that the two goods are substitutes. Common substitutes If the value of the cross-elasticity of demand is above 1, the goods are include Pepsi R and close substitutes, since an increase in the price of the rst good will result Coca-Cola R . in a greater than proportional increase in the demand of the second good. Negative value A negative XEDXY indicates that for a change in the price of good Y, there will be an oppositely-signed change in the demand for good X. This indicates that the two goods are complements. Two complements When goods are complements, a decrease in the price of the rst good are cars and petrol. will lead to an increase in the demand of the second good. Zero Goods are unrelated. Examples include concrete and apples, and anything you care to think of.

3.2.2

Pricing decisions based on XED

Firms that produce similar products may wish to collaborate in a way that decreases competition between the two products. This is generally not benecial to consumers and opposed by governments. Firms that produce complements may also wish to collaborate, especially for strong complementary products, such as aeroplanes and jet fuel. 31

3.3

Income elasticity of demand

Income elasticity of demand is a measure of the degree of responsiveness of the quantity of a good demanded to changes in consumer income. This indicates whether a good is normal or inferior. Y ED = where Y is income. QX Y Y QX (3.3)

3.3.1

Value of the YED

The YED of a good will show how much the demand curve will shift to the right with an increase in income. YED<0 A negative income elasticity of demand indicates that for an increase in income, there will be a decrease in the quantity of a good demanded at all price points. This good is thus an inferior good, which people wish to switch Examples of inferior away from as their income increases. Figure 3.3 describes this. goods are broken rice and used cars. Income
T

E Quantity demanded

Figure 3.3: How quantity of an inferior good demanded varies with income. This shows that while for a certain increase in income, there will be an increase in the quantity demanded, though there will be a point where the quantity demanded decreases as the consumer switches to normal goods. 32

YED=0 These goods are extremely necessary to daily use, yet no additional benet is derived from consuming extra units of the good. These are completely income inelastic. 0<YED<1 Goods with a positive YED are known as normal goods. When the magnitude of the YED is less than one, these goods are income inelastic and classied as necessities. This is described by Figure 3.4. Necessities include water and soap.

Income
T

E Quantity demanded

Figure 3.4: How quantity of a necessity demanded varies with income. This shows that up to a certain income, the quantity demanded will increase, though there will be a point where the consumer will not wish to consume more of the necessity. You can only eat so much rice, after all. YED>1 These are luxuries, which are income elastic. These fall under normal goods, Luxuries include which people wish to consume more of as income increases, described by diamonds. Fig 3.5.

3.3.2

Factors aecting the YED of a good

This assumes that we are not discussing inferior goods. 33

Income
T                  E Quantity demanded

Figure 3.5: How quantity of a luxury demanded varies with income. Degree of necessity The more necessary a good, the lower its YED. Income level Income determines whether a good is a necessity or a luxury. As income changes, the denitions of goods changes as well. For instance, with increasing income, coee, which might be considered a luxury, may become a necessity.

3.3.3

Sectoral change

A sector is a part of an economy. There are three main sectors: primary, secondary and tertiary. Their expansion at any given point is likely to be determined by the YED of the goods and services they produce. As an economy develops, the consumers tend to have increasing incomes. As such, consumers tend to move away from inferior goods to normal goods, and from normal goods to necessities. This causes the sectors producing goods with higher YEDs to expand faster. It also tends to decrease the YED of most goods.

3.4

Price elasticity of supply

Price elasticity of supply is a measure of the degree of responsiveness of the quantity of a good supplied to changes in its price. 34

P ES =

Q P0 P Q0

(3.4)

Price elasticity of supply is intuitively similar to price elasticity of demand.

3.4.1
Period

Factors aecting the PES of a good

The longer the time period, the more price elastic the supply. This is because producers have more time to adapt to the price change. Similarly, in the short run the supply is less price elastic; in the immediate term supply can even be perfectly price inelastic. Goods with perfectly price inelastic supply in a short period Spare capacity include agriculture Firms may have spare capacity to produce goods that is not utilised at (one harvest), or certain price points. These rms will allow the price elasticity of supply to tickets for a concert. be lower. Note that shortages of factor inputs will cause the supply to be less elastic. Factor mobility The higher the factor mobility, the more elastic the supply. Availability of stocks If rm is able to store goods easily, it is able to do so or release it in a later period, increasing the elasticity of supply.

3.5

Incidence of taxes and subsidies

This section focuses on the levying of indirect taxes. Indirect taxes are paid by suppliers, rather than consumers. We are concerned with two types of taxes. The rst is a specic tax, levied as a xed amount on each unit of a good sold, regardless of price. This causes a vertical shift of the supply curve. The other is the ad valorem tax, which is levied as a fraction of the price of the good. This causes a pivotal shift of the supply curve. Tax incidence is the burden on each party of a tax, and allows us to see who pays how much of the tax. We will rst consider the case of elastic demand in Fig. 3.6. Suppose the initial price paid by consumers and received by producers is P0 , at the quantity Q0 . The tax levied by the government causes a vertical 35

Taxes always increases the marginal cost of production.

Price
T

SS

    T   SS=MPC    Pc  Consumers    P0    DD=MPB  Producers     Pp          E Quantity 

Q0

Figure 3.6: Incidence of tax on a good with elastic demand parallel shift of the supply curve to SS , and now the quantity sold is Q . The price Pp that producers receive is determined by the MPC curve. Consumers pay Pc . Therefore the burden falls as marked on the gure, with producers bearing most of the burden.

Price
T e     T 

SS

e  SS=MPC e   e   Pc    e   e  Consumers  e  DD=MPB   e  P0   e Producers Pp    e   e e   E Quantity 

Q Q0 Figure 3.7: Incidence of tax on a good with inelastic demand With similar calculations, we nd that with relatively inelastic demand, the consumers now bear most of the burden. This is fairly intuitive as with less elastic demand, the consumers would not decrease consumption by a 36

signicant amount, only causing a slight drop in quantity demanded. In the same way, goods with elastic demand will result in the consumer receiving most of the benet of a subsidy, while goods with inelastic demand will result in the producer receiving most of a subsidy. The most benet is derived by the party which is able to change its decision to consume or produce the easiest.

3.6

Elasticity of primary products

Primary products are products that come directly from the earth, such as raw materials and food. Demand for these tends to be price inelastic as there are no close substitutes for them, particularly crops as a whole. Supply for primary products is also rather inelastic, as there is a long gestation period for crops, and the expansion of mines takes a long time. There are two problems associated with primary products: large short run uctuations in price, and long run decline in prices and producer income.

3.6.1

Short-run price uctuations

Demand for primary products is price inelastic. Therefore, a small change in the quantity supplied will result in a relatively larger change in the price, since consumers are less willing to buy lower quantities of the good. This causes the prices to be extremely volatile. Additionally, the supply for primary products tends to be relatively inelastic, particularly over shorter periods of time. This is due to the fact that producers of primary products are unable to respond to price changes quickly. Agriculture is also subject to seasons, which makes the supply more inelastic and less certain. The seasonal nature of agriculture, with other factors, such as natural disasters, make the supply of agriculture extremely uncertain, as these factors are beyond the control of producers. Thus a small change in supply, which is extremely likely, would cause a large change in price. A bumper harvest will cause prices to fall drastically; a poor harvest will cause prices to increase in the same way. Additionally, since all harvest is either sold or goes to waste, producers will attempt to sell it for however much buyers are willing to pay. Therefore, supply is extremely inelastic. Governments may attempt to intervene in this market in order to keep prices stable.

3.6.2

Long-run decline in prices and producer income

This can be largely explained as an application of the concept of income elasticity of demand (Section 3.3). 37

As an economy develops, the average income in society will tend to increase. This leads to consumers spending a larger proportion of their income on luxuries, which are relatively income elastic. This prompts growth in these industries. As agricultural products are income inelastic, demand for these rises at a slower pace. As the demand for these luxuries increases, prompting development, they require an ever-increasing amount of raw material to manufacture each unit, and so they have increasing cost of production compared to agriculture. Additionally, due to improvements in technology, supply of agricultural products is able to increase at a much faster pace than demand for them. As such, prices for agricultural products will decrease drastically. Combined, these factors cause a long-term decrease in prices of agricultural products and producer income.

38

Chapter 4

Market Failure
In the free market, there are many situations in wich the free market cannot allocate resources eciently. Market failure refers to the failure of the free market system to allocate resources eciently, or to provide the optimum quantity and combination of goods and services mostly wanted by society. There are four main causes of market failure: 1. Externalities 2. Absence of public goods 3. Merit and demerit goods 4. Imperfect competition The condition for economic eciency1 is known as Pareto Optimality.

4.1

Social eciency

Since market failure is dependent on what is mostly wanted by society, we must rst understand social eciency. Social eciency is signicantly dierent from economic eciency. It is attained when the Marginal Social Benet (MSB) is equal to the Marginal Social Cost (MSC). This is only possible when there are no externalities, as externalities will cause these to be unequal. For goods without externalities, MPC=MSC and MPB=MSB, therefore the optimal point is the same for individuals and society.

4.2

Externalities

Externalities are spillover eects on third parties, whose interests are not considered, in the production or consumption of a good. They create a
1

See Section 2.5.3

39

divergence in the private and social costs or benets of a good. Positive externalities in production include freely available R&D. In consumption, vaccines. Negative externalities in production, pollution from factories. In consumption, smoking. Externalities are represented by the following equations: M SB = M P B + M EB (4.1) These equations are mathematically M SC = M P C + M EC (4.2) acceptable, if one considers benet to Since the free market system determines the price and quantity of goods simply be negative consumed based on choices of the consumer and producer only, externalities cost and vice versa. are uncorrected, and can be noted on a diagram. Otherwise, such a relation should not properly exist. Cost/benet MSC
    TMEC   SS=MPC   c        L Ps      Pe           DD=MPB   E Quantity T

Qs

Qe

Figure 4.1: Welfare loss due to negative externality in production The welfare loss for a negative externality will be indicated by the triangle (L). This is because there is a dierence in the socially optimal quantity and the equilibrium quantity that is demanded by consumers, who ignore the interests of third parties. This results in allocative ineciency. On the other hand, the welfare loss for a positive externality will be indicated by a triangle pointing outward. This is a loss because the socially optimum quantity is not reached, but should be reached.

The welfare loss for a negative externality is indicated by an inward-pointing triangle; the welfare loss for a positive externality is indicated by an 4.2.1 Methods of intervention outward-pointing triangle. Taxes and subsidies

The government may attempt to correct the market failure caused by externalities by imposing tax or providing subsidies. By doing so, the government 40

hopes to change the quantity consumed to the socially optimal quantity. The government will set this tax or subsidy to the marginal external cost or benet. Legislation Legislation can be used, such banning the use of certain pollutive chemicals, setting a limit on the amount of pollution generated by a rm, or making education compulsory until a certain age. Tradable pollution permits Tradable permits are permits that allow rms to pollute a certain amount, and can be traded. This allows an enforcing organisation to regulate the amount of pollution that is generated. This allows the free market to determine the amount that rms wish to pollute over a certain period. However, it is dicult to decrease the amount of permits in future periods, or indeed choose how much is an acceptable pollution level in the rst place. It must also be strictly enforced. Education and persuasion Education and persuasion can be used to inform consumers about the social costs of using certain products, and to encourage them to use energy-ecient technology, including cars and lightbulbs. International agreements International agreements can be made to reduce externalities that have international repercussions. An example is the Kyoto Protocol. Externalities for goods that have externalities in consumption can be corrected in the same ways as merits and demerit goods.

4.3

Merit and demerit goods

Merit goods are goods that are believed to be benecial to consumers, but which are underprovided by the market. This underprovision can be caused by: Presence of positive externalities Here, underprovision is caused by the market failing to allocate resources in an socially desirable manner. These include education and vaccinations. Poverty Some consumers may be unable to aord some of these merit goods. For this reason, demand of the good (willing and able) may be too low. Healthcare and education fall into this category. 41

Ignorance Consumers may be unaware of the benets of merit goods. Education is again an example, alongside annual health check-ups.2 Conversely, demerit goods are goods that are believed to be undesirable for consumers and are overprovided by the market. This overprovision may be caused by negative externalities and ignorance.

4.3.1

Methods of intervention

Direct provision Merit goods can be directly provided by the government to consumers to supplement provision by the market, or contract rms to provide the shortfall. When the government directly provides the good, it often does so at a very low or nonexistant price. Examples include education and healthcare. Subsidies and taxes This eectively changes the marginal cost of producing a good, allowing the market to determine exactly how much of the good to be consumed, while allowing it to be consumed at a more optimal level for the consumer. Education and persuasion Governments may attempt to persuade consumers to consume more merit goods or less demerit goods. In either case, the objective is to encourage consumers to consume a more desirable amount of the good. Legislation Governments may impose regulations to ensure that a certain amount of merit good is consumed, or a certain amount of demerit good is not consumed. For instance, compulsory education and smoking in public areas.

4.4

Public goods

A public good has two properties: Non-rivalry means that the consumption of the good does not signicantly impact the ability of another to consume it. Non-excludability meas that it is very dicult or impossible to prevent any particular party from consuming the good.
2

If you dislike Ignorance, Information failure may be suitable.

42

4.4.1

Marginal cost for non-rivalrous goods

As the cost for an additional person to consume the good is zero, the marginal cost incurred by the provider for allowing another person to consume it is zero. For allocative eciency to exist (otherwise there would be market failure), P=MC must be fullled. Thus the price charged for the good will be zero. Therefore no private rm would be willing to supply the good, as producers are prot-motivated.

4.4.2

Free rider problem

This is caused by the property of non-excludability, as it is possible for a person to consume a non-excludable good without having to pay for it. There is therefore an incentive for potential consumers to hide their preference for the good. As such, there will be a missing market for the good as no consumers are willing to pay for it, resulting in no resources allocated for the production of this good. Therefore the property gives rise to market failure. The provision of the good by the government as a public good enables all to consume this good, rather than leaving it as a missing market.

4.4.3

Provision of public goods

The goverment should therefore produce public goods for consumption by all in society, funded by tax revenue, and therefore by everyone in society. It is therefore important for governments to produce only goods with high amounts of social benet as public goods, owing to the limited tax resources.

4.5

Imperfect competition

We note that for economic eciency, allocative eciency must be attained in all markets, requiring P=MC to hold true in all markets. However, as rms tend to be prot-motivated, where possible, they will attempt to set P>MC. While this is not possible for perfectly competitive markets in the long run, the existance of other market systems enable this, therefore enabling market failure.

4.6

Other causes of market failure

Imperfect information, co-ordination failures (demand for factors of production), weak or missing market institutions, and policy failure. Conspicuously unelaborated.

43

Chapter 5

Theory of the Firm

This chapter examines the behaviour of rational rms. For the most part, it is assumed that the main objective of rms is prot.

5.1

Costs and production

Firms must use factors of production to produce goods and services. By using these resources, the incur costs of production. Costs of production are what a rm gives up in order to use these resources. Production occurs until consumption begins, therefore the distribution of goods is included in the production process. There are two dierent types of costs that a rm may incur. Resources may belong to either the rm or others, and this determines how the costs are considered.

5.1.1

Explicit and implicit costs

Explicit costs Explicit costs are costs that the rm incurs when it pays outsiders for reThis includes paying sources. Therefore, the opportunity cost of using these resources is equal to the wages of labour. the amount paid to use them. These are also known as accounting costs, as these are usually recorded by accountants.

Implicit costs Implicit costs, therefore, are the opportunity costs of using the factors of This may be the production that the rm owns. These are implicit as they do not involve possible rental of a payment to others. building the rm uses. 44

Economic prot Therefore, since the total revenue as made up of a combination of the economic prot and implicit and explicit costs, it is important to note that the economic costs consist of both the explicit and implicit costs.

5.1.2

Short run and long run

The short run and long run are distinguished by the presence or absence of xed factors. In the short run, there is at least one xed factor, in the long run, all factors are variable. In the long run, rms may enter or exit the There is no specic length of time dening short run and long run. industry.

5.1.3

Law of diminishing marginal returns

The law of dimishing marginal returns states that as increasing amounts of variable factor are added to one or more xed factor, there will come a point where each additional unit of variable factor will add less to the total physical product (TPP) than the last.1 There are three stages of varying marginal physical product (MPP)2 with increases in the amount of variable factor employed. With the rst few units of variable factor, there will be too little of the variable factor employed, and so the MPP will increase for each additional unit. However, at a certain point MP will begin to decrease, as overcrowding begins. Therefore each unit of factor will be less ecient. The MPP will continue to decrease, and nally becomes negative, when additional units simply reduce the total amount of output. Note that MPP will cut the APP at its turning point. This is because at MPP=APP, then APP is at its maximum, since after that, MPP decreases, causing APP to decrease (albeit at a slower rate). Before this point, MPP is higher than APP, causing APP to to increase.

5.1.4

Types of costs

Fixed costs Fixed costs are costs that are incurred from the use of xed factor, which cannot be varied in the short run. These exist in the same amount regardless of the output of a rm.
1 2

Note that the level of technology should be held constant. M P P = T P P

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Variable costs Variable costs are costs that vary with the amount of output, as they are incurred from the use of variable factor. Total costs Sum of xed and variable costs. Average costs Each of the costs divided by the number of units of the good produced. Marginal cost Additional cost incurred from producing the last unit of a good. It can be calculated by T V C MC = Q

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Bibliography
Anglo-Chinese School (Independent) (2011). Economics 2011. Tragakes, E. (2009). Economics for the IB Diploma. Cambridge, UK: Cambridge University Press.

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