WJEC AS Economics Revision Guide PDF

WJEC AS Economics Revision guide Copyright: Tejvan Pettinger, Economicshelp.org 27 June 2022 All rights reserved. No part of this publication may be reproduced, distributed, or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the Copyright owners. This guide may be distributed within an educational establishment, only if purchased with a corresponding network license. Table of Contents Unit 1 – AS Microeconomics....................................................................................... 4 Scarcity, choice and opportunity cost............................................................................... 4 Opportunity cost.............................................................................................................................................5 Production possibility frontiers (PPF).................................................................... 6 Possibility frontier and economic growth.........................................................................................7 Specialisation................................................................................................................................................ 10 Markets................................................................................................................................... 11 Demand.......................................................................................................................... 12 Shifts in the demand curve..................................................................................................................... 14 Supply............................................................................................................................. 15 Shifts in the supply curve........................................................................................................................ 16 Market equilibrium............................................................................................................. 17 Consumer surplus....................................................................................................... 21 Producer surplus......................................................................................................................................... 22 Elasticity........................................................................................................................ 23 Using knowledge of elasticity............................................................................................................... 25 The impact of elasticity on tax.............................................................................................................. 27 Income elasticity of demand (YED)................................................................................................... 29 Cross elasticity of demand..................................................................................................................... 30 Price elasticity of supply......................................................................................................................... 30 Tax............................................................................................................................................ 33 Wage determination............................................................................................................ 35 National minimum wage.................................................................................................... 39 Flexible labour markets........................................................................................................................... 41 Impact of net migration on UK labour markets.......................................................................... 43 Evaluation of net migration................................................................................................................... 43 How resources are allocated in a free market............................................................. 45 Market Failure.............................................................................................................. 48 Externalities and social efficiency...................................................................................................... 48 Negative externality................................................................................................................................... 49 Positive externality.................................................................................................................................... 51 Public good..................................................................................................................................................... 52 Information gaps......................................................................................................................................... 53 Merit good....................................................................................................................................................... 53 Demerit good................................................................................................................................................. 53 Government intervention to correct market failure.................................................. 54 Tax...................................................................................................................................................................... 54 Subsidy............................................................................................................................................................. 56 Maximum prices.......................................................................................................................................... 58 Problem of maximum prices................................................................................................................. 59 Minimum prices........................................................................................................................................... 60 Tradeable pollution permits................................................................................................................. 60 State provision of public services....................................................................................................... 61 Advertising / Information...................................................................................................................... 62 Regulation....................................................................................................................................................... 62 Policies of Welsh government.............................................................................................................. 63 Government failure.................................................................................................... 64 2 Unit 2 The UK Economy............................................................................................. 65 Circular flow of income....................................................................................................... 65 Injections......................................................................................................................................................... 66 Withdrawals (W) (leakages)................................................................................................................. 66 Multiplier effect............................................................................................................................................ 66 Aggregate demand...................................................................................................... 67 Consumer spending (C)........................................................................................................................... 68 Investment...................................................................................................................................................... 68 Government expenditure (G)................................................................................................................ 69 Net trade (X-M)............................................................................................................................................ 70 Aggregate supply (AS)................................................................................................ 70 Equilibrium national income................................................................................................................ 73 Government macro economic objectives....................................................................................... 75 Conflicts between objectives................................................................................................................. 76 Fiscal policy................................................................................................................... 78 The National Debt....................................................................................................................................... 80 Government spending.............................................................................................................................. 82 Taxation........................................................................................................................................................... 84 Supply side policies.................................................................................................... 86 Evaluation of supply side policies...................................................................................................... 87 Monetary Policy........................................................................................................... 89 UK monetary policy................................................................................................................................... 89 The role of the central bank.............................................................................................. 90 Exchange rates...................................................................................................................... 92 Factors that influence exchange rates.............................................................................................. 93 Appreciation in the exchange rate..................................................................................................... 93 Evaluation of an appreciation............................................................................................................... 94 Trade....................................................................................................................................... 96 Benefits of free trade................................................................................................................................. 97 Arguments for restricting trade.......................................................................................................... 98 3 Unit 1 – AS Microeconomics Scarcity, choice and opportunity cost Scarcity. These are resources that are limited. With scarce resources, we need to make choices about how to use and distribute them. Non-renewable resources. These are natural resources that are finite and scarce. Once used, they cannot be replaced. For example, coal, oil, precious metals, and gas are all finite. Renewable resources. Resources that can be replenished. Examples include wind, wood, fish, solar energy, and water. Semi-renewable resources. There are some resources that, in theory, are renewable, but if they are over-consumed they can become extinct and thus no longer available. For example, farmland should be renewable, but if we over-farm and use extensive quantities of chemicals, it could cause soil erosion. Economic good. A good which has a benefit (utility) to society, and also a good that has some degree of scarcity. Free good. A good which has benefit to society, but is available in an unlimited quantity. There is no opportunity cost in consuming it. Scarcity and choice Because of scarcity and unlimited wants, we need to make choices. For example, as a society, if we continue to over-fish, it means future generations may not be able to take any fish from the sea at all. As an individual, we need to decide how to use our limited income to purchase goods and services. Governments also have scarce resources (limited tax income). They need to make decisions about how to use tax revenue. Increasing government spending on the NHS means less potential for spending elsewhere. The fundamental economic problem The fundamental economic problem is the issue of scarcity and how best to produce and distribute these scarce resources. Because of scarcity and limited resources, economics is concerned with: What to produce? How to produce? For whom to produce? 4 Opportunity cost Opportunity cost is the next best alternative foregone. Examples of opportunity cost If the government spends tax income on defence spending, then this money cannot be spent on health care. If the government cuts tax, the opportunity cost is that they have less to spend (or use to reduce budget deficit). If we spend our time surfing the internet, we cannot spend this time studying economics. If firms spend all their money on advertising their new product, they cannot use that money to invest in developing new products. Importance of opportunity cost Opportunity cost means we have to make decisions about the best use of time, money and resources. Sometimes there are two options that are good, but we need to choose the relatively best option. Choice between study and leisure - Suppose we have 12 hours to spare. We can use these 12 hours for study or we can use the 12 hours for leisure. If we move from A to B, we can gain two hours study. But the opportunity cost is that we lose 2 hours of leisure. 5 Production possibility frontiers (PPF) A PPF shows the maximum output that an economy can produce if the economy is maximising the use of its resources and operating efficiently. Points on PPF Curve A or B = Productively efficient. C = impossible (without economic growth) D = inefficient, below potential This is a simplistic production possibility frontier that shows a choice between goods and services. If we produce more consumer goods, it leads to fewer resources available for producing services. We could use all our natural resources and have many consumer goods, or we could have only few goods and concentrate on producing services. Opportunity cost and production possibility frontier At point A, we have 22 goods / 21 services At point B, we have 18 goods / 27 services. If we move from point A to B, we gain an extra 6 units of services. However, the opportunity cost is that we have to forego 4 units of goods. 6 Possibility frontier and economic growth Short run economic growth. Moving from point A to B. This involves making better use of existing productive capacity. Long run economic growth. This requires a shift in the PPF curve to the right. This enables point C to be attained. Causes of long run economic growth A shift in PPF to the right can be caused by: Discovering more raw materials (e.g. discovering oil fields) Increase in the size of work force (e.g. immigration) Increase in capital stock (e.g. investment in new machines, factories) Increase in labour productivity (e.g. due to better educated workers or workers becoming more motivated) Improvements in technology which increases labour productivity Negative economic growth It is also possible for the PPF curve to shift inwards. This could occur due to: Declining population Firms closing down and stopping production 7 Choice between consumer and capital goods Consumer goods. Goods that we can use and enjoy. The things we buy in shops like food, clothes, etc. Capital goods. These are goods that are used in the productive process – for example, a machine. Capital goods involve investment in increasing productive capacity. If we move from B to A, there is a movement along the PPF curve enabling more capital goods to be produced (an extra 8). The opportunity cost is that there are less consumer goods (17 less). Increasing capital goods leads to lower living standards in the short term, but in the long term we may be able to produce more because of the investment in machines and factories, which enables higher output. Short term growth or long-term investment Devoting a higher proportion of resources to current consumption has an opportunity cost of less investment and less growth in the long run. Devoting a higher proportion of resources to capital investment has an opportunity cost of less consumption in the short run. There is a strong link between a PPF and the long run aggregate supply curve (LRAS). LRAS is a major determinant of economic growth (see: unit 2 macro-economics). 8 Rotation in PPF Curve In this PPF curve, we see a shift to the right of the PPF curve on the x-axis. In this case, we see an improvement in technology relating to capital goods, but not consumer goods. Therefore, we can produce more capital goods relative to consumer goods. If the economy is becoming more skewed towards capital goods. It may enable higher growth in the long-term because of increased investment. Diminishing returns vs constant returns The PPF on the left is concave to the origin. This is because of imperfect substitution, and diminishing returns to increasing goods / services. If we move from A to B, we gain 6 services, and the opportunity cost is only 1 good. But, if we move from C to D, we gain only 1 service and lose 3 goods. Therefore, the opportunity cost of producing more services is increasing. A PPF curve can be straight (diagram right) if there are constant returns. 9 Specialisation Specialisation occurs when a country or firm concentrates on producing a particular good or service. Countries will specialise in producing goods where they have a comparative advantage. For example, Japan specialises in producing hightech electronic goods. Cuba specialises in producing sugar. Division of labour Division of labour occurs when workers concentrate on different tasks within a firm. Rather than try to master all aspects of production, some workers will specialise at a particular job. For example, in a car-building firm, some will work on design, some on testing, and some workers will just do unskilled jobs such as painting the car. Productivity of labour This is defined as the output per worker, per period of time. For example, one worker, may pick 100 strawberries per hour. Specialisation may enable an increase in overall productivity because specialised workers can become more efficient. Advantages of specialisation in the production of goods The division of labour gives workers time to gain skills for one particular job. Overall, they need less time to be trained. With specialisation and the division of labour, firms can be more efficient when producing on a large scale; it enables economies of scale, and lower average costs. Without specialisation and the division of labour, one person may be unable to produce a car on his own. But the division of labour makes a big production task manageable by spreading the work out. Problems of specialisation The division of labour can make jobs highly specialised and repetitive, leading to boredom and possible diseconomies of scale. On an assembly line, if one person is absent, the whole production line may slow down if other people can’t cover their job. Therefore, there needs to be some flexibility. 10 Advantages of specialisation in trade World trade is highly specialised, with the growth in world trade enabling higher living standards, a greater choice of goods, and more competition. Specialisation means countries don’t have to produce every good they need, which would be impractical for small countries. Countries can make use of their best resources (e.g. low labour costs in India and China or advanced technology in Germany). It enables countries to import goods that they otherwise wouldn’t be able to produce (e.g. you can’t grow bananas in UK; African countries don’t currently have a viable car industry). Problems of specialisation in trade Concentrating on producing a small number of goods can make an economy vulnerable. For example, if sugar prices fall, countries that rely on sugar exports will see a fall in income. It may hamper development if countries stick to producing primary products, which have a low-income elasticity of demand. Markets A product market refers to how a good is bought and sold. For example, farmers (producers) sell potatoes at the market and consumers buy them. The market will determine the price and quantity sold. Rationality In economics we assume firms and consumers are rational. This means that they try to maximise their economic welfare and make decisions to enable this. Utility This is how much benefit people get from consuming a certain good. If we get high utility from eating at a restaurant, we will be willing to pay a large amount of money. We assume consumers wish to maximise their utility. For example, they will spend money on goods only if they believe the utility gained is greater or equal to the cost. Profit This is the amount of money a firm gains after subtracting costs from its total revenue (profit = total revenue – total costs). We often assume firms wish to maximise profit (either in the short run or long run). This might involve cutting costs or selling profitable goods. 11 Demand The individual demand curve illustrates the price people are willing to pay for a particular quantity of a good. The market demand curve illustrates the price consumers in the whole economy are willing to pay. Movement along the demand curve. A change in price causes a movement along the demand curve. A higher price reduces demand. A lower price increases demand. If there is an increase in price from £10 to £12, then there will be a fall in demand from 55 to 40. If price falls from £10 to £7m there will be an increase in Q.D. from 55 to 75. 12 Demand and diminishing marginal utility Marginal utility is the satisfaction that you gain from the last unit of consumption. The first chocolate bar of the day is likely to give the highest utility. The second chocolate bar usually gives less utility than the first. If you have already eaten three chocolate bars, you are unlikely to enjoy a fourth. Therefore, the utility from the fourth chocolate bar is much less than the first. As you consume more goods, the utility of the extra goods usually declines. This is why the demand curve is downward sloping. You wouldn’t want to pay as much for the fourth chocolate bar as the first. This is why an individual’s demand curve is downward sloping. They are willing to pay lower prices for a higher quantity. To encourage higher demand, lower prices are needed. Income and substitution effect If the price of a good changes, there are two factors which affect demand. 1. Income effect This looks at the effect of a price increase on disposable income. If the price of a good increases, then consumers will have relatively lower disposable income. For example, if the price of petrol rises, consumers may not be able to afford to drive as much, leading to lower demand. 2. Substitution effect This looks at the effect of a price increase compared to alternatives. If the price of petrol rises, then it is relatively cheaper to go by bus. 13 Shifts in the demand curve This occurs when, even at the same price, consumers are willing to buy a higher quantity of goods – for example, demand shifts from D1 to D2. A shift to the right in the demand curve can occur for a number of reasons: 1. An increase in disposable income, such as higher wages and lower taxes giving consumers more spending power. 2. An increase in the quality of the good. For example, mobile phones are now more versatile and powerful, making them more attractive. 3. Advertising can increase brand loyalty to goods and increase demand. 4. An increase in the price of substitutes. For example, if the price of O2 Mobile phone calls goes up, the demand for Vodafone mobiles will increase. 5. A fall in the price of complements. For example, a lower price for Apple apps will increase demand for Apple iPhones. Evaluation It depends on the type of good. A rise in income will not have any effect on demand for salt, but it will have a bigger effect on demand for luxury cars. Some goods will vary due to seasonal factors like the weather and time of year (e.g. scarves and air conditioners). 14 Supply The supply curve refers to the quantity of a good that the producer plans to sell in the market. Change in price and movement along supply curve If price changes, there is a movement along the supply curve. For example, an increase in the price from £40 to £50 causes an increase from 30 to 33. Why supply curve slopes upwards As price increases, firms have an incentive to supply more because at a higher price, they get extra revenue (income) from selling the goods. Also, as output rises, firms usually have higher marginal costs in the short run; it is more costly to increase output. Therefore, firms require higher prices to encourage more supply. Firms react to market prices in competitive markets. If a farmer tried to sell his produce above the market price, he wouldn’t be able to sell. We say firms are price takers. 15 Shifts in the supply curve An increase in supply occurs when more is supplied at each price, e.g. a shift in supply from S to S2. This could occur for the following reasons: A decrease in costs of production. This means that business can supply more at each price. Lower costs could be due to lower wages or lower raw material costs. An increase in the number of producers will cause an increase in supply. Expansion in the capacity of existing firms, e.g. investment to extend the size of a factory. An increase in the supply of a complementary good, e.g. beef and leather. Favourable climatic conditions, which are very important for agricultural products, e.g. good weather will give a good harvest. Improvements in technology, e.g. computers and the internet enables more to be produced for a lower cost. Lower taxes on the good, e.g. lower petrol tax. Government subsidies on the good (government paying part of the cost). Joint supply Joint supply occurs when two goods are supplied together from the same source. 16 Market equilibrium The price mechanism refers to how supply and demand interact to set the market price and the amount of goods sold. Market equilibrium occurs when supply = demand and there is no tendency for the price to change. Excess demand If the price is below equilibrium (p2), demand is greater than supply (Q2 – Q1) – causing a shortage. 17 Therefore, with consumers wanting to buy more firms will put up prices and supply more. As price rises, there will be movement along the demand curve and less will be demanded. Prices will rise until supply equals demand. Excess supply If the price is above equilibrium (p2), supply is greater than demand (Q2Q1) – causing a surplus. To sell the unsold goods, firms reduce the price and reduce supply (movement along supply curve). The lower price also encourages more demand. The price falls to P1 where supply equals demand. Impact of increase in demand If consumers saw an increase in income, we would see an increase in demand for goods like TV’s; the demand curve would shift to the right. Initially there would be a shortage, but the higher demand would cause the price to rise and suppliers to supply more. 18 The increase in demand causes an increase in price (P1 to P2) and an increase in quantity (Q1 to Q2). In the long-term, the higher prices may encourage more firms to enter the market and the supply curve will shift to the right. Fall in supply If the availability of oil decreased, we would see a fall in supply. The fall in the supply of oil causes the price to rise and a small fall in demand. Since demand for oil is inelastic, we see a relatively bigger increase in the price. 19 Impact of fall in supply in long term If the price of oil increased, it may start to make it profitable to produce oil from new places, such as Alaska and Antarctic. Previously it was too costly to produce oil from here, but the higher price may make it worthwhile. If the price of oil rises, in the long-term people may respond to higher prices by switching to other forms of transport which don’t use petrol. Factors that could explain a fall in the price of a good The price of a good, such as coffee, would fall if there was a fall in demand and/or an increase in supply. Fall in the price from P1 to P2 The demand for coffee could fall for various reasons such as: Lower incomes mean that consumers cannot afford to buy as much. Coffee becomes less fashionable. A fall in number of coffee shops. Health concerns about caffeine. The supply of coffee could increase for various reasons such as: An increase in the number of suppliers or countries producing coffee. Lower costs of production, e.g. lower wage rates in coffee-producing countries. Government subsidies, e.g. Latin American countries may wish to subsidies the coffee farmers. Higher labour productivity in producing coffee, which will decrease the costs of production. 20 Consumer surplus Consumer surplus is the difference between the price that consumers pay and the price that they would be willing to pay. For example, if a book costs £10, but the demand curve shows that they would have paid £16, the consumer surplus is £6. Consumer surplus tends to be higher when markets are competitive and prices are low. Consumer and producer surplus will be maximised in a free market where price is determined by supply and demand. A monopoly that can set higher prices will be able to reduce consumer surplus. For example, peak train fares are an attempt to charge higher prices to those commuters willing to pay the higher price – and capture consumer surplus. 21 Producer surplus Producer surplus is the difference between the price suppliers receive and the price that they would have been willing to supply the good at. If the market price is £10, and their supply curve shows that they would have supplied it at £8, they have a producer surplus of £2. Producer surplus after fall in supply In this case, supply shifts from S1 to S2, the market price rises from £25 to £30. Quantity falls from 100 to 80. In this case, we see a decline in consumer surplus. Producer surplus also falls. Calculating consumer surplus We can calculate a right angled triangle, using formula - 1/2 x height x base Price = £30, quantity equals 80. The maximum consumer surplus = £50-£30 = £20 To find the area of consumer surplus = (£20 × 80)/2 = £800 Calculating producer surplus The maximum producer surplus is £30-£15 = £15 The area of producer surplus = (£15 × 80)/2 = £600 22 Elasticity The price elasticity of demand measures the responsiveness of demand to a change in price. Price elastic demand Demand is price elastic if a change in price causes a bigger percentage change in demand. Example of elastic demand If the price of Tesco bread increases 5% and demand falls 15%, the PED is (-15/5) = -3.0. This is price elastic. Characteristics of elastic demand Luxury goods are sensitive to price because they represent a big percentage of disposable income, such as sports cars and foreign holidays. Competitive markets. Goods that have many substitutes and a very competitive market will be elastic - for example, if the price of Tesco bread increased, consumers could switch to several other varieties. Frequently bought. With goods that are bought frequently, we are more likely to compare prices, and switch if necessary. 23 Inelastic demand Demand is price is inelastic if a change in price leads to a smaller percentage change in Q.D. PED will be less than -1 (e.g. -0.5) Example of inelastic demand If the price of tobacco increases 10% and demand falls 2%, the PED = -0.2 Characteristics of inelastic goods Few substitutes. e.g. petrol and cigarettes have few close alternatives. Necessities, e.g. if you have to drive to work, you need to buy petrol. Addictive. If you are addicted you will pay higher price e.g. cigarettes, coffee. Small percentage of income – means you don’t worry if price rises. In the short term, demand is usually more inelastic because it takes time for consumers to find and switch to alternatives. Evaluation 1. Demand for a good like coffee is likely to be inelastic, as there are few substitutes to coffee. But demand for individual brands of coffee is likely to be more elastic, as there are substitutes to Starbucks coffee (e.g. Costa). 2. Elasticity may change over time. In the short term, demand for petrol is inelastic, but over time, people may be more willing to switch to alternatives, such as cycling to work, so that demand for petrol becomes more elastic with time. 24 Using knowledge of elasticity 1. Revenue and elasticity If demand is inelastic then increasing the price can lead to an increase in revenue. In this example, the price of oil rises from $110 a barrel to $190, and the quantity falls from 9 million to 8 million. Revenue was $110 × 9 = $990 million Revenue is now $190 × 8 = $1,520 million An increase in revenue of $530 million This is why OPEC tries to increase the price of oil, because higher oil prices are more profitable. What is the PED of oil in this example? % change in Q.D 1/9 = -0.11 (-11.1%) % change in price 80/110 = 0.727 (72.7%) Therefore, PED of oil = -11.1 / 72.7 = -0.15 (inelastic) 25 If demand was price elastic Price rises from £110 to £130 – (20/110) = 18% Quantity falls from 9 to 4 (5/9) = 55.5% Revenue was 110 × 9 = £990 Revenue has now fallen to 4 × £130 = £520 A fall of £470 PED of this example -55/18 = - 3.05 (elastic demand) 2. Advertising and elasticity Firms have an advantage if demand for their good is price inelastic. If demand is inelastic they can increase price and make more profit. This is why many firms spend money on advertising to create brand loyalty. Because of strong brand loyalty, Coca Cola can charge a higher price than other brands like Sainsbury Cola. Firms can make demand more inelastic by offering more add-on features and better quality products that stand out from the competition. 26 The impact of elasticity on tax In this example, the tax is £70 per unit. After tax is placed on the good, supply shifts to S2. Demand falls from 80 to 72. The price rises from £80 to £140. The total tax revenue equals 72 ×£70 = £5,040 Consumer burden of tax The tax is £70, and consumers end up paying an extra £60. In this case, consumers face most of the tax burden. Consumer burden = (60 × 72) = £4,320 Producer burden Producers get £10 less after the tax. Therefore, producer burden is (10 × 72) = £720. 27 Elasticity of a demand curve With a straight line demand curve the elasticity of demand varies. Between point A and B, demand is elastic. (-3.5) This is because the % change in quantity (4 to 6) is 2/4 = 50% The % change in price (14 to 12) = -2/14 = -14% Between points C and D, demand becomes inelastic. (-0.375) The % change in quantity 13 to 15 is just 2/13) = 15% The % change in price is greater 2/5 = 40% With a straight line demand curve, the elasticity is always changing. Demand is more elastic when Q is close to zero. As price falls closer to 0, demand becomes more inelastic. PED = 1 when the % change in demand is the same as % change in price (somewhere in middle of demand curve) 28 Income elasticity of demand (YED) Income elasticity measures the responsiveness of demand to a change in income. For example, if average income increases by 5% and the demand for mobile phones increases by 20%, and demand for Tesco value rice falls 2%. Then the YED for mobile phones = 20 / 5 = 4.0 (luxury good) The YED for Tesco value rice -2/5 = -0.4 (inferior good) Types of good Inferior good. This occurs when an increase in income leads to a fall in demand. Inferior goods will have a negative YED. Examples include clothes from charity shops and Tesco value rice. As your income increases, you buy better quality goods instead. Normal good. This occurs when an increase in income leads to an increase in demand for the good, therefore YED>0. Most goods are normal goods. Luxury good. This occurs when an increase in income causes a bigger percentage increase in demand, therefore YED >1. It means demand is income elastic. Examples include jewellery and sports cars. Income inelastic. This means an increase in income leads to a smaller percentage increase in demand. Therefore 0 > YED < 1. Importance of income elasticity of demand In a recession, with falling incomes, demand for luxury goods will fall significantly. Demand for inferior goods will increase. Budget pound shops may do well with falling incomes, but luxury car sales will not. Supermarkets may respond to a recession (falling income) by supplying more ‘inferior’ goods and cutting back on luxury goods. If incomes are rising, firms may seek to make their good more of a luxury good, e.g. car manufacturers may add more luxury items to cars, such as air conditioning to take advantage of the rising incomes. 29 Cross elasticity of demand Cross elasticity of demand measures how the demand for one good is affected by the price of another. For example, if the price of milk falls by 10%, demand for tea may increase 1%. Therefore XED = (1/-10) = -0.1 Substitute goods. These are two goods that could be used as alternatives. With two substitute goods, XED will be positive. Weak substitutes like tea and coffee will have a low XED. Tesco bread and Sainsburys bread are close substitutes so XED is higher. Complements goods. These are goods that are used together. Therefore XED is negative. For example, if the price of DVD players fall, then there will be an increase in demand for DVD discs. Unrelated goods. If the price of lamb increases, we would expect it to have no effect on the demand for beer or computers. If the price of lamb increases and demand changes for computers, it is just a co-incidence and not related. Price elasticity of supply This measures the % change in quantity supplied after a change in price. If the price of cars increase 10%, and supply increases 5%, o The PES = 5/10 = 0.5 If the price of tomatoes increase 10% and supply increases only 1% in the short term, o The PES = 1/10 = 0.1 30 Inelastic supply Inelastic supply means a change in price causes a smaller percentage change in supply (PES 1. Perfectly elastic supply means that at a given price, supply is unlimited. On the left: Price increase from 60 to 63 and Q increases from 50 to 60. % change in Q = 10/50 = 20% % change in price = 3/60 = 5% Therefore PES = 20/5 = 4.0 (elastic supply) Supply could be elastic for the following reasons: If there is spare capacity in the factory. If there are stocks available. If it is easy to employ more factors of production. Difference between long run and short run In the short run, supply is more likely to be inelastic because the firm does not have the ability to increase the size of the factory. But, in the long run, supply can be more elastic as the firm is able to invest in more capacity and therefore increase supply. 32 Elasticity calculation Suppose PES for computers is 2.0. When the price was £30, the firm supplied 4,000. If the price increased from £30 to £36, what will be the new Q? Price increases by £6. Therefore as a %, (6/30 =0.2) = 20% (PES) 2.0 = % change in QS 20 (% change in P) Therefore 40 = % change in QS Therefore new Q = 4000 *140/100 = 5,600 Tax Tax increases the cost of the good and shifts the supply curve to the left. In this example, the specific tax is £35 per unit (80-45). The tax increases the price from £50 to £80. Quantity falls from 90 to 82. The total tax revenue for the government will be: 82 × £35 = £2,870 33 The burden of tax The burden of the tax is shared between consumers and producers. The consumer burden shows the extra amount that they pay (how much tax raises price). Producers also lose out from tax because they get a lower price after paying tax to the government. Consumer and producer burden of specific tax If demand is inelastic, then most of the tax will lead to higher prices and consumer burden of the tax will be greater than the producer burden. In the diagram on the right, demand is price elastic and there is a proportionally smaller effect on price and consumers. Producers have a greater burden from the tax. Consumer burden is relatively less. Governments often increase tax on goods with inelastic demand because this leads to the biggest increase in tax revenue. Often tobacco manufacturers will be able to pass 100% of the tax increase onto consumers because demand is so inelastic. 34 Wage determination In competitive labour markets, the equilibrium wage rate in the industry is determined by the meeting point of the labour supply and demand curves (W1). In this example, the increase in demand for labour, leads to higher wages (W1 to W2), and a higher quantity of labour (Q1 to Q2). Factors affecting demand for labour Wages. Higher wages cause a movement along the demand curve. Productivity of workers. If workers are more productive and produce more, firms should be willing to pay higher wages. Demand for the good. Labour is a derived demand. If there is more demand for economics tuition, there will be more demand for economics tutors and this will push up the wage. Substitutes to labour. In some production processes, firms could substitute workers for machines (e.g. assembly lines). Non-wage costs. This includes paying national insurance, health insurance, and potential redundancy pay. 35 Elasticity of demand for labour The elasticity of demand for labour measures how responsive demand for labour is after a change in wages. Elasticity of demand for labour depends on: How essential is the worker? Can labour be substituted for capital? For example, with automated checkouts, workers can be substituted for machines and labour demand will be more elastic. Number of people with qualifications and skills. If only a small number of workers have qualifications, demand will be more inelastic. Time period. In the short term, demand for labour will be inelastic. However, over time, it becomes easier to substitute labour for capital, so demand becomes more elastic. Proportion of wage costs. If labour is a high % of total wage costs, the firm will be more sensitive to a rise in wages. Workers with inelastic demand are hard to replace. Therefore, they tend to have greater bargaining strength and can demand higher wages. The demand curve D2 is more inelastic than D1. The demand curve (D2) leads to a higher wage (W2). Workers with an inelastic demand curve are not easily replaceable and so get higher wages. 36 Factors that determine supply of labour Wage rate. Higher wages cause a movement along the supply curve. The number of qualified people and the difficulty of getting qualifications. For professions, such as lawyers and doctors, there are a limited number of people with sufficient qualifications. This limits supply and pushes up wages. The non-wage benefits (non-pecuniary) benefits of a job. This includes status, job security, danger of job, how enjoyable the job is, the length of holidays and other fringe benefits. E.g. if tube drivers have to start working nights, it may reduce supply of workers because it becomes a less attractive job. Population / demographics. Net immigration into the UK has increased the supply of nurses, cleaners, and other service sector workers. Elasticity of supply of labour The elasticity of supply measures how wage rates affect the responsiveness of the supply of labour. Supply will be inelastic if: Only a small number of workers have necessary qualifications (e.g. doctors). The job is unpopular / dangerous, making supply lower. If takes a long time to gain qualifications. S1 is more inelastic (e.g. lawyers). This leads to a higher wage of W2. S2 is more elastic (e.g. cleaners). This leads to lower wages of W1. 37 Wage inequality between regions We often see wage differentials between different regions. For example, differences between wages in Wales and the rest of the UK. Also there can be wage differentials within a region, e.g. wages higher in Cardiff, than rural parts of north Wales. Explaining wage differentials between Wales and London In Wales supply and demand are relatively more elastic. In London, supply is more inelastic and demand higher. Explaining relatively lower wages in Wales than S.E. England In London, firms are more profitable and able to pay higher wages. For example, in London, many financial firms are able to pay large bonuses due to profits. Higher unemployment in Wales. Due to the process of de-industrialisation Wales has experienced periods of higher unemployment. Unemployment tends to push down wages because there are more people willing to fill vacancies. Shortage of housing in London, limits supply of workers, pushing up wages. Greater concentration of workers with high levels of skills and qualifications in London compared to Welsh regions. 38 National minimum wage The national minimum wage is a government legislation which prevents firms from paying less than the statutory minimum. From October 2015, the national minimum wage will be £6.70 an hour for workers aged over 21. There are lower rates for young workers. The government has indicated it will significantly increase the minimum wage for adult workers to £9 an hour by 2020. This is an attempt to match the living wage – a level deemed necessary to deal with current living costs. Impact of a national minimum wage 1. Potential unemployment A minimum wage above the equilibrium could cause unemployment of Q3-Q1. This is because the minimum wage of W2 reduces demand for workers to Q1. This is particularly a concern for some industries where wages are a high percentage of costs, e.g. hairdressers or service sector workers, such as cleaners. A substantial rise in the minimum wage will be more likely to cause unemployment in low wage regions, such as the north. It will have less impact in London and the south. 39 2. Minimum wage and monopsony A minimum wage could counter-act the effect of a monopsony employer. A monopsony is an employer who has market power. This market power enables him to pay lower wages and employs fewer workers. Some jobs, like firemen, only have a government employer, so that is a classic example of a monopsony. In practise, many workers have little bargaining power because it is difficult to move jobs. 3. National minimum wage and elasticity of demand and supply If demand for labour is inelastic, a national minimum wage would cause little, if any, fall in demand for labour. For example, if wages increase for the whole service sector industry, they can pass the wage costs on to consumers. In this case, a NMW only causes a very small fall in demand for labour, from Q1 to Q2. 40 4. Case for regional minimum wages A minimum wage may be insufficient to provide a living wage in London because of higher living costs. But, in Wales, a UK national minimum wage may potentially be significantly higher than current wage levels. This will significantly increase the wages of the low-paid, but also could cause unemployment because employers may be unable to afford the higher wages. 5. Does a minimum wage reduce poverty? A minimum wage increases the income of low paid workers. However, the impact on relative poverty is not clear cut. The poorest sections of society tend to be out of work and receiving government benefits. They are not affected by a national minimum wage. Also, many who get the national minimum wage may be second income earners in a family so the impact on reducing poverty is limited. Flexible labour markets Flexible labour markets are characterised by: Wages set by market forces – supply and demand Low levels of regulation Mobility of workers Easy for firms to employ workers, and easy for workers to switch jobs Factors that have increased labour market flexibility in the UK Growth in part-time / temporary contracts. This means firms can employ workers for the time period needed. Growth in zero hour contracts. This means people are employed, but the firm is under no guarantee to offer a fixed number of hours. This means weekly wages can fluctuate significantly. Decline in trade unions and collective bargaining. This gives firms more power in determining wages. Increase in self-employment. Self-employment means workers need to continually gain business in order to gain income. This makes selfemployed workers more sensitive to changes in the market. Migration of workers from Europe. With the expansion of the European Union, many Eastern European workers have come to the UK to fill job vacancies, often jobs which are not easy to fill. Changes in welfare benefits. The government has made it harder for workers to get benefits, such as unemployment benefit and disability benefits. This has had an impact on increasing the supply of labour. 41 Impact of flexible labour markets Unemployment fell quickly after the 2008 recession. Firms were more willing to take on new workers. This suggests flexible labour markets may enable a lower rate of unemployment There has been a degree of under-employment, with people working fewer hours than they would like in part-time work. This means lower income for many part-time workers. Greater job insecurity. People have work, but there are fewer guarantees the job will last. This greater job insecurity could have negative effects, such as people becoming de-motivated because they have little attachment to the firm. But it could also encourage workers to try harder to retain their job. A flexible labour market could benefit workers who need to juggle looking after children and working from home. A flexible labour market can benefit those who have the skills to gain an income from new technology, such as the internet. However, a flexible labour market could be damaging to unskilled workers, who find it hard to get long-term job security. Government policies to increase labour market flexibility Reduce minimum wages. Firms can pay lower wages, but it would increase inequality and relative poverty. Make it easier to hire and fire workers. If it is cheaper to hire and fire workers, firms may be more willing to employ people in the first place, but it can lead to greater job insecurity. Better education and training. Training schemes would give workers more skills to be able to accept new job. A well trained workforce would reduce occupational immobility. Education and training is a good policy in theory, but can be hard to implement in practise; it would definitely take time to have an effect. Encourage immigration. Immigrants could take jobs where there are labour shortages, but immigration can create new problems, such as housing shortages and congestion. Reduce income tax rates, e.g. increasing income tax threshold. This would encourage workers to move into the work force, and making benefits relatively less attractive. Reduce power of trade unions. If governments make it difficult for unions to go on strike, there is less potential for workers disrupting wage settlements. It may also lead to firms gaining monopsony power and setting low wages. 42 Impact of net migration on UK labour markets In recent years, there has been a net inflow of workers into the UK. The effect of this net migration includes: Increase in supply of labour. The increased supply of labour has often filled gaps in jobs which firms have found difficult to fill, e.g. cleaning and fruit picking. Increase in demand for labour. Migrants increase the population and therefore increase overall demand in the economy. Firstly, migration causes an increase in labour supply. But, also in the long-term, a higher population should increase demand for labour. In this diagram, wages will stay at Q1 and quantity of labour increases from Q1 to Q3. Evaluation of net migration Skilled labour. The government has set criteria, making it easier for skilled labour to migrate. This has meant migration has played an important role in filling vacancies such as nurses and doctors. Offset the impact of an ageing population. The UK has an ageing population, which places greater strain on government finances (old pay, less tax and need more pensions and healthcare spending). Net migration 43 of young workers helps the government’s budget situation, because they are more likely to pay income tax and don’t receive pensions. Migrants can return to country of origin. In a period of rising unemployment, migrants often return home. Thus, migration can be a counter-cyclical factor in making UK labour markets more flexible. In recent years, many foreign workers have been attracted into the UK. Immigration accounted for 46% of net population growth in 2008. The Brexit vote in 2016, led to fall in EU migration, but this was offset by rise in non-EU migration. Problems of net migration Overcrowding. The UK experiences overcrowding, especially in parts like the south-east. Migration and a rise in the population places greater strain on already limited housing stock and public amenities. Underground economy. Migrants are more likely to work in the black market, avoiding regulations like minimum wages. o However, there is a big difference between illegal immigration and legal migration. Unemployment. Some people feel migrants take existing jobs from native workers because they are willing to accept lower wages. o However, it should be remembered migration also creates jobs, through the additional demand in the economy. 44 How resources are allocated in a free market In a free market, prices and profit act as signals to agents. This influences the allocation of resources. Rationing effect If there is a shortage of the good, the price will tend to increase. The higher price causes movement along the demand curve. Less is demanded at the higher price. This helps to ration the scarce demand. Higher price acts as a disincentive to buy, rationing demand. Incentive effect If there was increased demand for a new good (like phone apps), this would push up the price. This higher price makes the good more profitable. Therefore, in the long run, it acts as an incentive for producers to increase production. 45 In the long term, firms respond to higher prices (and more profit) by increasing supply. This is an example of how markets can respond to changing conditions. For example, the rising demand for mobile phones has led to significant increase in supply. Signalling The price mechanism can provide a signal to firms and consumers. If we see higher demand, prices will rise and this creates a signal to producers that there is high demand. A high wage for certain types of work can signal to workers that firms need to fill these jobs. Inter-related markets Derived demand. This occurs when the demand for a good depends on demand for another product / service. For example, the demand for trains depends on the demand for getting to work. If there was a rise in unemployment and less people working, demand for travel would fall. Composite demand. This occurs when a good has multiple different uses. Rising demand for one use rations the availability for use of any other purpose. For example, demand for wheat could be due to the use of wheat in either bread or as a biofuel. 46 If there is higher demand to use wheat as a biofuel, this will affect the price of bread. With more demand for biofuels, the price of wheat will rise causing the price of wheat for bread to also increase. Other examples of composite demand include: Land - used for either offices or for building houses. Steel - could be used for building guns or it could be used for building bicycles. Joint demand. This occurs when two goods are complementary and needed together. For example, if you buy a printer, you need to buy printing ink too. Therefore, higher demand for home printers will lead to higher demand for ink cartridges. Other examples of joint demand include: o iPhone and iPhone Apps o Camera and memory stick Rational behaviour In economics, we usually assume firms and consumers are rational. This means that they try to maximise their economic welfare and make decisions to enable this. Consumers try to place a value on a good depending on how much they enjoy the good / service. They may give this utility a monetary value like £10. We assume consumers wish to maximise their utility. For example, they will spend money on goods only if they believe the utility gained is greater or equal to the cost. The first chocolate bar may give high utility, and consumers are willing to pay 50p. However, the second chocolate bar has a lower marginal utility – you might feel sick if you eat too many. Are consumers rational? It can be difficult for consumers to evaluate the actual utility they get from a good. Consumers may not have the time to work out the marginal utility. Instead they may use ‘rules of thumb’ or buy according to previous spending patterns. Consumers are not always rational, but can be influenced by factors, such as advertising and impulse buying. Consumers may have poor information or lack the time to work out the best price / utility. In this case consumers may make use of habit buying or rules of thumb to get the best estimation. Consumers can be prone to irrational exuberance. For example, in a period of rising house prices, people may think this is a good one way bet, so they buy houses hoping prices will keep rising. 47 Market Failure Market failure occurs when there is an inefficient allocation of resources in a free market. Market failure implies there is a decline in producers / consumer surplus and a net welfare loss. Market failure can occur for various reasons. Externalities – a cost or benefit imposed on a third party, leading to under- or over-consumption. Information asymmetries – lack of complete knowledge by one party. E.g. people may under-estimate the benefits of education (merit good) or underestimate the costs of smoking (demerit good). Monopoly – When a firm has market power and can set higher prices. Monopolies may also be more inefficient because they face less competitive pressures. Immobilities – Geographical immobilities occur when it is difficult for people or firms to move to another area. E.g. unemployed coal miners in Yorkshire find it difficult to move to London because of housing costs. Occupational immobilities occur when it is difficult for people to retrain and get skills in new high-tech industries. Public goods – Goods that are non-rival and non-excludable. They tend to be under-provided or not provided in a free-market. Examples include law and order, national defence and street lighting. Merit and demerit goods – Goods where we make decisions based on poor information. Volatile prices – In agricultural markets, prices can be volatile causing problems for consumers and farmers. Income inequality – in a free market, there could be widespread inequality with some unable to afford important services. Externalities and social efficiency Social benefit Social benefit is the total benefit to society. Social benefit = private benefit + external benefits. Social marginal benefit (SMB) = the additional benefit to society of producing an extra unit. SMB = PMB (private marginal benefit) + XMB (external marginal benefit) Social cost Social cost is the total cost to society. Social Cost = private cost + external costs. Social marginal cost (SMC) = private marginal cost (PMC) + external marginal cost (XMC) 48 Negative externality A negative externality occurs when there is a cost imposed on a third party. For example, if a firm produces chemicals, the external cost is the pollution that causes damage to the river and the lost earnings for fishermen. If you drive into a town centre, the negative externality is the congestion and pollution that affects other people in the town. With a negative externality, the social marginal cost is greater than the private marginal cost. Diagram: negative externality of production In a free market, the equilibrium will be at Q1, P1, where supply (S) = demand (D). However, at Q1, the SMC is greater than the PMC. Q1 is socially inefficient because the SMC is greater than the SMB – this illustrates an area of deadweight welfare loss. In this example, there is overconsumption of the good with negative externalities. The socially efficient level of output would be at Q2, where SMC=SMB. 49 Negative consumption externality Negative externalities can also occur in consumption. For example, if we drive inefficient petrol cars, the consumption of petrol causes excess CO2 emissions and pollution. This is a cost to the rest of society. Other people will experience pollution and perhaps ill health because of our decision to drive. If we drink alcohol to excess, we may turn up late to work on Monday morning, leading to lower productivity and lower economic growth. With a negative consumption externality, the social marginal benefit is less than your private marginal benefit. In a free market, the equilibrium will be at Q1 (D=S). But, the socially efficient level is at Q2 (where SMB = SMC). Therefore, in a free market, there is overconsumption of this good with a negative externality. 50 Positive externality A positive externality in consumption occurs when there is a benefit to a third party from your consumption. For example, if you cycle to work (rather than drive), other people benefit from reduced congestion and pollution. Diagram of positive externality in consumption In a free market, the equilibrium will be at Q1, P1, where Supply (S) = Demand (D). However, this is socially inefficient. At Q1, the SMB is greater than the SMC, leading to an area of deadweight welfare loss. With a positive externality, there is under-consumption. Social efficiency occurs at Q2, where SMB=SMC. Positive externality in production When producing a good causes a benefit to a third party. For example, if you keep bees, then a nearby apple farmer benefits because your bees help to pollinate his apple trees. 51 Private good A private good is a good where the benefits accrue to the individual and others are prevented from consuming it. The private good is rivalrous and excludable. If you eat an apple, no one else can eat it. Public good A public good, by contrast, has two characteristics: Non-rivalry. When a good is consumed, it doesn’t reduce the amount available for others, e.g. street lighting. Non- excludability. This occurs when it is not possible to provide a good without it being possible for others to enjoy, e.g. national defence. Public goods suffer from the free-rider problem. The free rider problem means that people can enjoy the goods without paying for it. Therefore, there is no incentive for firms to provide goods because it is difficult to charge consumers for using it. The consumer can enjoy it for free. Public goods usually require the government to provide the good directly and pay for it out of general taxation. Quasi—public goods. Some goods have part of the characteristics of public goods, e.g roads are to an extent non-rivalrous and non-excludable, but not completely, e.g. if too many people use roads, it causes congestion. Some people are not qualified to drive. Some public goods can be provided by the free market. For example, someone may provide a beautiful garden and not mind if people enjoy it for free. Exam tip: Be careful - not all goods provided by the public sector (government) are public goods. For example, the NHS is provided by the public sector (government). But, it is not a public good, because resources are limited (waiting lists) – so there is rivalry and excludability. If you see a doctor, no one else can have an appointment at that same time. The NHS would be considered a merit good – people may underestimate the benefits of getting vaccinations and a healthy workforce has positive externalities. 52 Information gaps Symmetric information means both parties share the same knowledge. For example, if you go to a market, you can see the price of apples and also look at their quality. Asymmetric information occurs when one party has more information than other parties. For example, if selling a car, a car dealer may know it is a faulty engine that won’t last. But, as a consumer, you may not know this. Problem of asymmetric information People may be reluctant to buy second hand cars if they don’t trust what they are buying. This leads to lower prices for all second hand cars. People make the ‘wrong’ decisions and reduce their economic welfare. Merit good A merit good occurs where people may underestimate or be unaware of the benefits of consuming a good. For example, students may underestimate the benefits of studying and therefore leave school early. Or people may be reluctant to get a vaccination from diseases. Merit goods often have a positive externality as well. Merit goods are under-consumed in a free market. Demerit good A demerit good occurs where people under-estimate or ignore the costs of consuming a good. For example, people may not be aware of the dangers of smoking – or they may be aware, but choose to ignore them. Demerit goods often have negative externalities as well (e.g. passive smoking effect to others). Demerit goods are over-consumed in a free market. 53 Government intervention to correct market failure Tax Tax shifts the supply curve to the left and makes the good more expensive. This will reduce demand. The government can use tax for demerit goods and goods with negative externalities. Specific tax A specific tax places a certain per unit tax on the good. It is the same whatever the price, for example, tobacco duty or alcohol excise duty. In this case the specific tax is £15, and it reduces the quantity from Q1 to Q2. The price rises from £52 to £60. 54 Ad valorem tax An ad valorem tax places a certain percentage on the good. For example, VAT in the UK is 20%. The higher the price of the good, the more tax is paid. Tax to overcome market failure The ideal tax would be equal to the external marginal cost. This makes consumers pay the full social marginal cost. Tax shifts the supply curve to S2 and reduces demand to Q2, which is the socially efficient level (SMC=SMB). 55 Advantages of taxes Raises revenue for the government to spend on alternatives. Internalises the externality (tax makes people pay the full social cost). Creates incentives in the long-term to encourage firms to reduce pollution or provide alternatives. Tax can also alter consumer behaviour in the long-term. For example, higher petrol tax may encourage consumers to buy a bicycle to avoid fuel duties. Evaluation of taxes If demand is very inelastic, tax will only have a minimal effect in reducing demand. This may occur if there are no alternatives to the good, e.g. petrol, tobacco. High taxes may encourage tax evasion, e.g. cigarette tax encourages cigarettes to be smuggled on the black market. A tax on rubbish may encourage fly-tipping. High specific taxes will be regressive. They take a higher percentage of income from the poor than high-income earners. There may be administration costs in implementing new taxes, e.g. it would be difficult to implement a congestion charge for driving into small cities, like Oxford or Cambridge. It can be difficult to measure the external cost and how much tax should be increased. Electronic road pricing is a way to try and place a tax equal to the external cost of driving, e.g. if you drive in city centres and peak times, the costs of congestion are far greater than driving in off-peak times. Subsidy A subsidy means the government pays a part of the cost of a good. For every good sold, the government will give firms a proportion of the cost. The aim of subsidies is to encourage consumption of goods which are underprovided / under-consumed in a free market. A subsidy shifts supply to the right and reduces the price. 56 In this case, the subsidy is £10 per unit. The subsidy increases Q from 90 to 98. The total cost to the government is 98 × 10 = £980. Why subsidise goods? 1. Goods that have positive externalities (benefits to other people) are subsidised to create more social efficiency. a. For example, taking the train to work helps reduce congestion. The government may wish to make trains cheaper, and therefore reduce traffic congestion. 2. To make important public services available to those on low income, e.g. people may not be able to afford dental treatment without subsidies from the government. 57 Subsidy to overcome market failure In this example, the free market equilibrium is at Q1, P1 (S=D). A subsidy of P0-P2 shifts the supply curve to S2 and reduces price to P2. At this price, the quantity demanded is Q2. This is a socially efficient level because at Q2, SMB=SMC. Evaluation of subsidies Cost to the government. Subsidies will be expensive and will require higher taxes on other goods. Elasticity. If demand is inelastic, a subsidy will be ineffective in increasing demand. For example, a subsidy on train travel may be ineffective if it is a poor substitute to driving a car. Effect of subsidy on firm. A firm that receives a subsidy is more likely to be inefficient, as they become reliant on the government subsidy. Subsidies may keep inefficient firms in business. There may be government failure, e.g. the government has poor information about who to subsidise. Combination of policies. Subsidies may be most effective if combined with other policies, e.g. tax on driving and using money to provide alternatives to driving into town, e.g. cheaper buses. 58 Maximum prices A maximum price occurs when the government sets a price limit and prevents prices from rising above that level. For example, if renting a house in London is £120 a week, the government may decide to have a maximum price of renting of £100 a week to make housing more affordable. Problem of maximum prices The problem of a maximum price is that if the price is set below the equilibrium, we get a shortage. At Max Price, demand is greater than supply (Q3-Q1). This leads to waiting lists and encourages a black market. The extent of the shortage depends on the elasticity of demand and supply. If supply is inelastic, there will be little reduction in availability. Note: If the maximum price was placed above the equilibrium, it would have no effect. 59 Minimum prices A minimum price occurs when the government sets a price floor, and doesn’t allow prices to go below that level. With minimum prices, the government may be committed to buying the surplus. The problem of a minimum price is that we get a surplus. At Min price, supply is greater than demand (Q3-Q1). To maintain the Min price, the government has to buy the surplus. Note: A minimum price below the equilibrium would have no effect. Tradeable pollution permits These involve giving firms a legal right to pollute a certain amount, e.g. 100 units of carbon dioxide per year. If the firm produces less pollution, it can sell its permits to other firms. However, if it produces more pollution, it has to buy permits from other firms. There will be a market for pollution permits. If firms pollute a lot, there will be low supply and high demand; therefore the price will be high for permits. Therefore, there is a financial incentive for firms to cut pollution. 60 Problems of Tradeable Permits Difficult to know how many permits to give in the first instance. It may be difficult to accurately measure pollution levels. There is an incentive for firms to hide pollution. In most markets, it requires global co-operation to make it effective, otherwise the industry will move to countries with lower environmental legislation. Also, pollution is very much a global problem requiring global solutions. High administration costs of measuring pollution and enforcing permits. State provision of public services For some merit goods and public goods, the most efficient solution for market failure is for the government to provide services directly. For example, the government could subsidise private doctors to treat people, but there are advantages to the government paying for a national health service directly: It ensures everyone has access to this important merit good and provides greater equality in society. A national health service may be able to benefit from economies of scale, leading to lower average costs than small independent hospitals. For services like health and education, workers do not need the same profit motive of a private manufacturing firm. Therefore, there is less likely to be government failure due to a lack of incentives. Public goods like law and order may not be provided at all in a free market. Advantages of the private sector providing public services 1. Increased demands are being placed on the public sector due to demographic changes. If more people went private, this would enable the National Health Services to have shorter waiting lists. 2. Provides consumers with more choice. 3. If less people use the NHS, it would enable the government to lower taxes and reduce borrowing. 4. The private sector has a profit incentive to cut costs and provide a more efficient service, e.g. public bodies may have over-staffing because of political fears about job cuts. 5. Possible diseconomies of scale in the National Health Service. Disadvantages of the private sector 1. It is difficult to introduce a profit motive into public services such as health care; for example, it is not practical to give performance related pay to nurses / doctors. Also, the private sector may cut costs by reducing the quality of service, e.g. cutting back on cleaning. 61 2. May increase inequality. People on low incomes cannot afford private health. 3. Health is a merit good and will be underprovided in a free market. Therefore there is a justification for government subsidy. Advertising / Information The government may seek to overcome market failure through providing information about certain goods. For example, the government may run campaigns to warn about the health dangers of tobacco and alcohol. These are demerit goods, where people may not know the costs of consumption. Providing information can help overcome information asymmetries. Evaluation Government advertising campaigns will cost money and require higher taxes. There is no guarantee people will listen or take note of government campaigns. Young people may choose to ignore campaigns about the dangers of alcohol because they enjoy a sense of rebelliousness. However, over time, people have become aware of the dangers of tobacco and long-term smoking rates have been falling. Regulation To overcome market failure, the government may use laws and regulations to prohibit certain behaviour. For example, rather than try and tax cocaine to make people pay the full social cost, they may just prohibit its production and consumption. Alternatively, the government may ban certain chemicals because they are too dangerous. Evaluation Regulation is simple and can be effective in preventing damaging goods and services from being produced. However, sometimes no pollution is not the most efficient level of production in society. Cars create negative externalities, but it is not desirable to ban cars completely. It depends on the enforceability. For example, when the US prohibited alcohol, it was very hard to enforce. People kept drinking but organised crime became more powerful and more successful because illegal alcohol was in high demand. 62 Policies of Welsh government Free NHS prescriptions NHS prescriptions could be considered to be a merit good. People may underestimate the benefits of taking a prescription drug. If they have to pay, they may be unable or unwilling to take. Free prescriptions, which have been introduced in Wales helps overcome this market failure. Free prescriptions also makes sure everybody can afford to get necessary health care, and can help reduce inequality. However, demand for prescriptions is likely to be very inelastic because most people would pay to get better health. There is an opportunity cost of offering free prescriptions. It will require higher taxes or lower government spending in other areas. Free prescriptions will go to everyone, including the quite wealthy, who could easily afford it anyway. Charging for plastic bags Since 2011, there is a compulsory charge of 5p per plastic bag / paper bag. When plastic bags are free, consumers use large quantities, wasting resources. Charging for plastic bags encourages people to reuse their bags and cut down on wasted resources. A plastic bag also has negative externalities. They cause litter, use up valuable resources and can take a long time to degrade. By charging 5p, consumers are made to pay the full social cost of the plastic bag. The downside is the administration costs in charging for bags. But, making it universal means shoppers come to expect the cost. Policies to reduce inequality Within Wales there is significant income inequality between different regions. Some areas like Cardiff are more prosperous than valley regions in the south and areas in the north of Wales. There is a high level of unemployment in the south Wales former mining communities, which have struggled to adapt to change in economic activity. In rural areas in the north, low paid work is more of a problem, with many receiving in-work benefits. Policies to overcome poverty include tax and benefit system (set for whole UK, not devolved to Welsh government). Policies to attract new investment and realignment of the economy. For example grants to depressed areas to help promote economic development and diversification into new industries and economic sectors, such as tourism and the service sector. But, only so much the government can do to reduce poverty, e.g. private sector determining wages and de-industrialisation is hard to reverse. 63 Government failure Government failure occurs when government intervention in the economy causes a net welfare loss. People also refer to government failure when efforts to overcome market failure do not succeed. Causes of government failure 1. Lack of incentives working for the government. Government bodies do not have the same profit motives of private companies. Therefore managers and workers may feel no incentive to work hard or cut costs. The result can be government agencies that are inefficient, with higher costs and not producing what people need. To some extent, this can be overcome by rewarding government workers with performance targets. Incentives may be less important in services like health care, where doctors value patient health. 2. Unintended consequences. Often government intervention tries to solve one problem, but another problem is created. For example: Minimum prices in agriculture were an attempt to stabilise farmers’ incomes. However, the unintended consequence of guaranteed minimum prices was that it encouraged over-production. Farmers used chemicals to maximise yields – knowing the government would buy any surplus. This proved expensive and inefficient. By increasing taxes on tobacco, the government made it more profitable for people to smuggle cigarettes from Europe. A maximum price on renting property could lead to a decline in available housing for renting – worsening the housing crisis rather than helping. Higher income tax may discourage people from working. 3. Lack of information. Government bodies can suffer from a lack of knowledge about how to intervene, just as we can get a lack of information in a free market. For example, it can be difficult for a government body to calculate the net external costs of a new airport or nuclear power. Governments may fail to predict future trends, e.g. the impact of minimum prices on incentives in the long-term. 4. Administration costs. Any government intervention is likely to have some administration costs and bureaucracy. For example, setting up a congestion charge for small cities could be difficult because the costs of administering the scheme will be relatively high. With some new taxes, the cost of bureaucracy may be close to the revenue gained. 64 Unit 2 The UK Economy Circular flow of income The circular flow of income is a basic model of the economy. In the circular flow of income: Money flows from households to firms (to buy goods). Then firms pay households wages to produce goods. Money can flow out of the circular flow of income to abroad or to government. The circular flow of income shows three ways to calculate GDP (Gross Domestic Product). Three methods of calculating GDP 1. Total national income (wages, dividends, profit) 2. Total national expenditure (consumption and investment) 3. Total national output (value of goods and services produced) 65 Injections This is an increase of expenditure into the circular flow of income, leading to an increase in aggregate demand (AD). Injections can include: 1. Exports (X) – spending from abroad on domestic goods. 2. Government spending (G). 3. Investment (I) – spending on capital goods by firms. Withdrawals (W) (leakages) Withdrawals are a reduction of money in the circular flow. Withdrawals can include: Saving (S) – depositing money in banks. Imports (M) – spending on foreign goods. Taxation (T) – the Government raising money from consumers and firms. Multiplier effect The multiplier effect occurs when a change in injections causes a bigger final change in real GDP. For example, if the government increased G (government spending) by £10 billion, and this led to an increase in real GDP of £16bn, we say the multiplier effect is 16/10 = 1.6. Why do we get a multiplier effect? Suppose we have a depressed economy with spare capacity and unemployed workers. If the government spends £10 billion on building roads, they will employ workers. Income and spending will rise by £10bn. But, the unemployed will now have extra money to spend. They will buy products from shops, and shopkeepers will now see improved incomes and also spend more. In other words, the initial spending doesn’t just stay with one person. There are knock on effects. Higher spending leads to more income for others, and therefore further rounds of spending. 66 Aggregate demand Aggregate demand (AD) is the total demand for goods and services in the economy. AD = C+I+G+(X-M) C = Consumer expenditure on goods and services (60%) I = Gross capital investment (spending on capital goods, e.g. machines) G = Government spending X = Exports M = Imports Shift in AD and movement along the AD curve An increase in the price level (P1 to P2) causes movement along the AD curve. At a higher price level, ceteris paribus, consumers have less disposable income (money to spend). At a higher price level, UK exports will be relatively less competitive, leading to lower export demand. A shift in the AD curve would occur if there was a change in factors like real income; higher income would shift AD to the right. Consumers would buy more at the same price level. 67 Shift in AD If there was an increase in income, the AD curve would shift to the right (AD1 to AD2). AD could shift to the right if there was a rise in investment, exports or government spending. Consumer spending (C) Consumer spending is the biggest component of AD (approx. 60-65% of AD). Consumer spending is determined by: Disposable income. This is income after taxes and benefits. Rising real wages would increase disposable income and shift AD to the right. Saving. The alternative to spending disposable income is to save. If income stays constant, but consumers want to increase their savings, then consumption will fall. Consumer confidence. If consumers are pessimistic about the future, they will prefer to save, pay off debt and reduce their current spending. Low confidence will shift AD to the left. High confidence will encourage spending. House prices / wealth. Rising house prices tend to increase consumer spending through a positive wealth effect. In the UK, many people own their houses. If house prices rise, they could gain equity withdrawal – remortgaging the house and taking money to spend. They will also feel more confident if their house is worth more. Income tax / VAT. A cut to income tax will increase consumers’ disposable income, encouraging spending. Interest rates. Lower interest rates reduce the cost of borrowing encouraging spending. Lower rates also make consumption more attractive than saving in a bank. Cost of living. If wages stay the same, but the cost of living goes down (e.g. a fall in petrol prices), people will have more disposable income and spend more. (This factor causes movement along the AD curve.) Investment Investment means expenditure on capital goods – factors that increase the productive capacity of the economy, e.g. machines and factories. Investment accounts for about 15% of AD. Investment affects both AD and AS. Investment is relatively more volatile and is strongly influenced by confidence and changes in the rate of economic growth. 68 Factors that affect investment Confidence. If businesses are optimistic about future demand, they will need to increase productive capacity and start to invest now. If businesses face uncertainty, they will cut back on risky investment. Animal spirits. Keynes said investment was heavily influenced by the ‘animal spirits’ of businessmen – did people expect their business to grow? This confidence can quickly change depending on the state of the economy. Interest rates. Investment is often financed by borrowing or using savings. Lower interest rates make it cheaper to finance investment and make more projects worthwhile. Availability of finance. Businesses may wish to borrow and invest, but access to credit is a big issue. Banks may be reluctant to give a small business a loan because it is a risky investment. In this case it may depend on businesses finding other sources of credit, such as the stock market or private investors. Government regulation. Some businesses may put off investment because of the heavy cost of regulation, e.g. the need to meet environmental standards and labour regulation. On the other hand, governments could encourage investment through offering regional subsidies. Economic growth. A key factor in determining investment is the rate of economic growth. Improvements in the rate of growth and AD will tend to increase investment. Also important is the demand from overseas and the demand for exports. Government expenditure (G) Government spending includes transfer payments (e.g. benefits) and direct spending, such as capital investment on public roads. In 2013/14, the UK government spent a total of £722.9 billion (44% of GDP). Government spending is influenced by: Fiscal policy. The government may choose to use fiscal policy to try and influence AD, e.g. in a recession, the government could borrow more and spend on capital investment, such as building new roads and railways. Economic cycle. In a period of high economic growth, tax revenues tend to rise; this gives the government more money to spend on services like the NHS. Political cycle. Government may cut spending after an election to try and reduce budget deficit, but then increase spending shortly before an election. 69 Net trade (X-M) The UK’s main trading partner is the EU (60% of trade). Though the proportion of trade with developing economies, like China and India, is rising. Factors that affect (X-M) Exchange rates. If there is a depreciation of the exchange rate, exports will be cheaper and imports more expensive. This will tend to increase (XM) and increase AD. Economic growth. If UK growth is relatively higher than other countries, we will see a rise in import spending and this will reduce net (X-M). But, if there is strong growth in Europe, this will lead to higher (X-M) and higher AD. Competitiveness. If the UK has a lower inflation rate than our competitors, then UK exports will become relatively cheaper. Improved competitiveness could be due to lower wages or higher productivity. Non-price factors. In addition to price, the quality and desirability of UK goods and services will be important. If UK firms can produce better quality goods and services with unique selling points, demand for UK exports will rise and demand will be more inelastic. Tariffs and protectionist measures. If a country faced high tariffs on exports, this would reduce demand. For example, if the UK left the EU, it may find that there are higher costs / tariffs on exports to Europe. Aggregate supply (AS) Aggregate supply (AS) is the total productive capacity of the economy. It is the sum of all the individual supply curves for particular goods. The AS curve shows maximum potential output; there is a strong correlation with a Production Possibility Frontier (PPF), which also shows the maximum potential of an economy. 70 Long run aggregate supply (LRAS) In the diagram there is a shift in AD. This causes a higher price level (P1 to P2) and a movement along the AS curve. In the short run there can be spare capacity and LRAS is elastic. But, LRAS also becomes inelastic at Y2. This means that firms cannot increase capacity beyond this point of ‘full employment’ without increased investment. Factors affecting LRAS In the long run, AS is determined by the quantity of factors of production and the productivity of labour / capital. (Labour productivity means output per worker.) Population. A rise in the number of working age people will increase the labour force and increase productive capacity. The working age population can be affected by birth rates and net migration. The UK labour force has increased due to net migration in the past decade. Technology. Technological improvements are one of the biggest factors affecting labour productivity, e.g. the Internet makes it easier for firms to check costs and prices. Investment. If firms or the government invest in increasing the capital stock, we will see higher AS in the long run. Education and skills. Improved education and vocational skills enables workers to be more productive and offer higher added value, increasing productive capacity. Infrastructure. Improved transport links reduce the cost of transport and encourage trade; this is important for boosting productive capacity. 71 Government policies. The government can affect LRAS by its supply side policies on education, competitiveness and regulation. For example, privatisation and deregulation may increase efficiency and competitive pressure in industries like gas and electricity. o Note: There is a limit to how much the government can influence productive capacity. Most technological improvements come from the private sector. Attitudes to enterprise. A stable economic and political climate may encourage entrepreneurs to invest and develop business. Shift in LRAS If there is an increase in productivity or an increase in factors of production, the LRAS will shift to the right. This can cause higher real GDP. Government supply side policies, such as privatisation and deregulation, could lead to an improvement in productive capacity and shift LRAS to the right. Supply side policies will also shift the PPF curve to the right. 72 Equilibrium national income Equilibrium national income occurs where AD=AS. In this example, there is a fall in AD, leading to a change in equilibrium national income. Real GDP falls from Y1 to Y2, and there is a fall in the price level. Rise in AD If there is spare capacity in the economy, then a rise in AD will lead to higher real GDP. 73 Demand side factors that can increase economic growth could include: Lower interest rates – reducing the cost of borrowing and leading to higher investment and higher consumption. Rising house price – leading to a positive wealth effect, encouraging consumer spending. Lower taxes – increasing disposable income. Higher confidence in the economy – encouraging spending and investment. Multiplier effect on AD and GDP In this case, we get a rise in injections (e.g. rising investment levels). Initially this causes AD to increase to AD2. But, because of the multiplier effect and further rounds in spending, we get another increase in AD to AD3 causing a bigger final increase in real GDP. In this example, initially, there was a lot of spare capacity at Y1. At Y3, the economy is close to full capacity. 74 Government macro economic objectives The primary economic objectives of a government are likely to be: 1. Economic growth. Most governments would try to maximise sustainable economic growth to increase living standards and help create employment. 2. Low inflation. The government’s inflation target is currently CPI 2% (+/1). The government wishes to avoid both high inflation and also avoid the threat of deflation. Problems of inflation include: o Creates instability reducing investment o High UK inflation reduces UK competitiveness o Can reduce the real value of savings. o Low inflation is considered best environment for encouraging investment and sustainable economic growth. 3. Low unemployment. Most governments will aim for full employment. Unemployment creates high personal, social and economic costs, such as stress and relative poverty for the unemployed. Governments also lose tax revenue from the unemployed. 4. Satisfactory current account / balance of payments. A large current account deficit could be an economic concern (e.g. weak export growth, reliance on capital flows, finance deficit). Therefore, governments may wish to have a reasonable low deficit/surplus, 5. Low government borrowing. Governments often commit to fiscal targets for both annual borrowing, and total debt (public sector net debt). 6. Stable exchange rate. A rapid depreciation in the exchange rate could cause inflationary pressures and instability. Therefore, governments may prefer a stable exchange rate (e.g., a fixed exchange rate system). Other minor objectives Issues of equality. High economic growth may be at the expense of income inequality. Making sure growth is fairly distributed may be an objective of some governments. Environment. High economic growth could cause environmental problems and issues for long-term sustainability. Looking after environment may require some sacrifice in terms of economic growth. 75 Conflicts between objectives A government will struggle to meet all the macro-economic objectives at once. Unemployment vs. inflation If the government pursued demand side policies to reduce unemployment, we could see a fall in unemployment, higher economic growth, but also a rise in inflation. Diagram: expansionary fiscal policy If the government increased spending (G), we would see an increase in AD. This leads to a rise in real GDP (Y1 to Y2). As output increases, firms will hire more workers. Real GDP rises from A to B, and we get higher inflation (P1 to P2). There may be other trade-offs as well: Higher AD could cause a bigger current account deficit because of higher import spending, and higher inflation reducing the competitiveness of exports. Expansionary fiscal policy (higher G / lower tax) will lead to a bigger budget deficit. The trade-off can work in reverse. If we reduce AD (e.g., higher interest rates), we can get lower inflation, but we may cause unemployment. 76 Deflationary fiscal policy Fall in AD leads to lower inflation, but also causes lower real GDP and rising unemployment. Evaluation In the long run, it may be possible to achieve higher growth and lower unemployment, without causing inflation. For example, if AD increases at the same rate as LRAS, we can get economic growth without inflation. If we also use supply side policies, we can reduce structural unemployment, without causing any inflation. Other potential policy conflicts Higher economic growth may cause environmental problems. For example, the overuse of scarce limited resources acts as a constraint on future living standards. Lower income tax and corporation tax may provide a boost to growth, but may also increase inequality because high earners benefit most from these tax cuts. Cutting down benefits may provide an incentive for the unemployed to get a job, but it may cause increased inequality. Policies to reduce a current account deficit (deflationary fiscal policy) may cause lower economic growth and higher unemployment. 77 Fiscal policy Fiscal policy refers to changes in taxation and government spending and the fiscal position of the government. Demand side fiscal policy attempts to influence aggregate demand (AD). The aim could be to: 1. Stimulate economic growth in a period of a recession 2. Maintain low inflation Supply side fiscal policy attempts to influence productivity and the supply side of the economy, e.g. spending on education to improve labour productivity. Expansionary fiscal policy (loose fiscal policy) This involves lower tax rates and/or higher government spending, with the aim to increase AD. Effect of expansionary fiscal policy Expansionary fiscal policy will increase AD and increase the size of the budget deficit. It may also cause inflation. 78 Deflationary fiscal policy (tight fiscal policy) This involves higher tax rates and/or lower government spending. The aim of deflationary fiscal policy is to decrease AD and inflation. Deflationary fiscal policy will also improve the budget deficit. Evaluation of fiscal policy 1. Poor information may reduce the accuracy of forecasting future economic growth and inflation. Therefore, the government may be unsure whether they need to boost AD or reduce AD. In practise, governments find it difficult to ‘fine tune’ the economy with fiscal policy. 2. It depends on other components of AD. For example, if the government cut income tax to increase AD, it may be ineffective if consumer confidence is low and people just save the extra income. 3. Disincentives to work. Higher income tax to reduce inflation can create disincentives to work, reducing productivity and AS. 4. Time lag involved in influencing AD. If the government wanted to increase AD, they could commit to more government spending. But, there will be delays in actually implementing higher spending, and then delays in this spending affecting the wider economy. 5. Budget deficits. Expansionary fiscal policy (higher spending, lower tax) will increase government borrowing. This could lead to higher interest rates in the long term or even cause markets to lose confidence in debt levels. 6. Crowding out. If the government spend more by borrowing from private sector, it may reduce the amount of money the private sector has to spend. 79 The national debt National debt (public sector debt) is the total (cumulative) amount of debt that the government owes the private sector. In April 2022, UK public sector net debt was £2,347.7 billion or 95.7% of GDP. Government borrowing 80 The previous diagram shows public sector net borrowing (budget deficit) in the UK. The budget deficit is the annual amount the government need

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