Table of Contents

Scarcity and Choice .......................................................................................................................... 2 Economic Resources ........................................................................................................................ 6 Factor Rewards ............................................................................................................................... 10 The Production Possibility Frontier ................................................................................................. 14 Specialisation and Trade ................................................................................................................ 18 Positive and Normative Statements ................................................................................................ 22 Markets: Understanding Demand ................................................................................................... 23 Markets: Understanding Supply ...................................................................................................... 30 Markets: Finding an Equilibrium Price ............................................................................................ 36 Price Elasticity of Demand .............................................................................................................. 42 Price Elasticity of Supply ................................................................................................................. 49 Income Elasticity of Demand .......................................................................................................... 53 Cross Price Elasticity of Demand .................................................................................................... 56 Functions of the Price Mechanism .................................................................................................. 59 Price Volatility in Markets ................................................................................................................ 65 Inter-relationships between Markets ............................................................................................... 73 Consumer Surplus .......................................................................................................................... 76 Producer Surplus ............................................................................................................................ 80 Markets in Action: The Market for Oil .............................................................................................. 83 Markets in Action: The Market for Copper ...................................................................................... 89 Markets in Action: The Market for Coffee ....................................................................................... 92 Markets in Action: The UK Housing Market .................................................................................... 96 Markets in Action: The Labour Market .......................................................................................... 101 Markets in Action: Economics of Health Care ............................................................................... 112 Background to Supply: Production and Costs .............................................................................. 119 Economies and Diseconomies of Scale ........................................................................................ 124 Productivity ................................................................................................................................... 129 Economic Efficiency ...................................................................................................................... 132 Introduction to Causes of Market Failure ...................................................................................... 136 Competition and Monopoly in Markets .......................................................................................... 137 Negative Externalities ................................................................................................................... 144 Positive Externalities ..................................................................................................................... 151 Public Goods and Private Goods .................................................................................................. 153 Merit Goods .................................................................................................................................. 157 Demerit goods............................................................................................................................... 160 Factor Immobility ........................................................................................................................... 164 Imperfect Information .................................................................................................................... 167 Poverty and Inequality in Resource Allocation .............................................................................. 170 Government Intervention in the Market ......................................................................................... 173 Indirect Taxation ........................................................................................................................... 179 Producer Subsidies ....................................................................................................................... 182 Maximum Prices ........................................................................................................................... 185 Minimum Prices ............................................................................................................................ 189 Buffer Stock Schemes .................................................................................................................. 193 Government Failure ...................................................................................................................... 195 Exam Technique ........................................................................................................................... 201

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Scarcity and Choice
Road space throughout the world is becoming increasingly scarce as the demand for motor transport increases each year – what do you think are some of the best solutions to reducing the problem of congestion on our roads?

The Economist's Dictionary of Economics defines economics as "The study of the production, distribution and consumption of wealth in human society" Another definition of the subject comes from the economist Lionel Robbins, who said in 1935 that "Economics is a social science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. That is, economics is the study of the trade-offs involved when choosing between alternate sets of decisions." It is this idea that economics is a social science that is so intriguing – we can never be sure how people, businesses and governments will respond to certain situations and policies. The purpose of economic activity It is often said that the central purpose of economic activity is the production of goods and services to satisfy our changing needs and wants. The basic problem is about scarcity and choice. All societies face the problem of having to decide: (i) What goods and services to produce: Does the economy uses its resources to operate more hospitals or hotels? Do we make iPhones or double-espressos? Does the National Health Service provide free IVF treatment for childless couples? How best to produce goods and services: What is the best use of our scarce resources? Should school playing fields be sold off to provide more land for affordable housing? Should coal be produced in the UK or is it best imported from other countries? Who is to receive goods and services: Who will get expensive hospital treatment and who not? Should there be a minimum wage? If so, at what level should it be set?

(ii)

(iii) Scarcity

If the supply of a good or service is low, the market price will rise, providing there is sufficient demand. Whenever there is excess supply in a market, we expect to see prices falling. The development of virtually every type of society can be described as the uncovering of new wants and needs - which producers attempt to supply by using the available factors of production.

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For a perspective on the achievements of countries in meeting people‘s basic needs, the Human Development Index produced by the United Nations is worth reading. IKEA sells to millions of consumers throughout the world – does it meet our needs and wants?

Making choices Because of scarcity, choices have to be made by all consumers, firms and governments. Over six million people travel into London each day. They have to make choices about when to travel, whether to use the bus, the tube, to walk or cycle – or whether to work from home. Millions of decisions are being taken, many of them are habitual – but somehow on most days, people get to work on time and they get home too! This is a remarkable achievement, and for it to happen, our economy must provide the resources and the options for it to happen. Trade-offs when making choices Making a choice made normally involves a trade-off - in simple terms, choosing more of one thing means giving up something else in exchange. 1. Housing: Choices about whether to rent or buy a home – a huge decision to make and one full of uncertainty given the recent volatility in the British housing market! There are costs and benefits to renting a property or in choosing to buy a home with a mortgage. Both decisions involve a degree of risk. People have to weigh up the costs and benefits of the decision. 2. Working: Do you work full-time or part-time work? Is it worth your while studying for a degree? How have these choices been affected by the introduction of university tuition fees? 3. Transport and travel: The choice between using Euro-Tunnel, a speedy low-cost ferry or an airline when travelling to Western Europe. Your choices about which modes of transport to use to get to and from work or school each day. Basic cost-benefit analysis In many of these decisions, people consider the costs and benefits of their actions – economists make use of the „marginal‟ idea, for example what are the costs of consuming a little extra of a product and what are the costs. People are often likely to go ahead with a purchase if they estimate that the marginal benefits are greater than the marginal costs. Consumer welfare and rationality What makes people happy? Why despite several decades of rising living standards, surveys of happiness suggest that people are not noticeably happier than previous generations?

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Typically we tend to assume that, when making decisions in the market place, people aim to maximise their welfare. They have a limited income and they seek to allocate their money in a way that improves their standard of living. Of course in reality consumers rarely behave in a perfectly informed and rational way. We will see later that often decisions by people are based on imperfect or incomplete information which can lead to a loss of welfare not only for people themselves but which affect other and our society as a whole. As consumers we have all made poor choices about which products to buy. Behavioural economics is an exciting strand of the subject that looks at whether we are rational in our everyday decisions. Opportunity Cost There is a well known saying in economics that ―there is no such thing as a free lunch!” Even if we are not asked to pay a price for something, scarce resources are used up in the production of it and there must be an opportunity cost involved. Opportunity cost measures the cost of any choice in terms of the next best alternative foregone. Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost wages foregone. If you are being paid £6 per hour to work at the local supermarket, if you choose to take a day off from work you might lose £48 of income. Government spending priorities: The opportunity cost of the government spending nearly £10 billion on investment in National Health Service might be that £10 billion less is available for spending on education or the transport network. Investing today for consumption tomorrow: The opportunity cost of an economy investing resources in new capital goods is the current production of consumer goods given up. Making use of scarce farming land: The opportunity cost of using arable farmland to produce wheat is that the land cannot be used in that production period to harvest potatoes. Economic Systems An economic system is best described as a network of organisations used by a society to resolve the basic problem of what, how much, how and for whom to produce. 1. Traditional economy: Where decisions about what, how and for whom to produce are based on custom and tradition. Land is typically held in common i.e. private property is not well defined. This BBC news article looks at the traditional economy of Vanuatu. 2. Free market economy: Where households own resources and free markets allocate resources through the workings of the price mechanism. An increase in demand raises price and encourages firms to switch additional resources into the production of that good or service. The amount of products consumed by households depends on their income and household income depends on the market value of an individual‘s work. In a free market economy there is a limited role for the government. Indeed in a highly free market system, the government limits itself to protecting the property rights of people and businesses using the legal system, and it also seeks to protect the value of money or the value of a currency. 3. Planned or command economy: In a planned or command system typically associated with a socialist or communist economic system, scarce resources are owned by the state (i.e. the government). The state allocates resources, and sets production targets and growth rates according to its own view of people's wants. The final income and wealth

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agriculture. Quaternary sector: The quaternary sector is involved with information processing e.tutor2u. 4. Guardian.g. November 2006) Counting the cost of the Iraq War (BBC news. Tertiary sector: the tertiary sector provided services such as banking. Suggested reading on opportunity cost and trade offs Could scrapping Trident save the planet? (Guardian. fishing. quasi-public and merit goods and intervenes in markets to correct perceived market failure.g. education and travel and tourism 4.net .g. The bulk of our income and employment comes from the service sector. Sectors of Production Production of goods and services takes place in different sectors. education. some resources are owned by the public sector (government) and some resources are owned by the private sector. manufacturing and the construction industry 3. i. June 2008) © Tutor2u Limited www. In such a system. The public (or state) sector typically supplies public. April 2008) Scarcity in an age of plenty (Joseph Stiglitz. finance.e. insurance. Mixed economy: In a mixed economy. Secondary sector: This involves the production of goods in the economy. These sectors are as follows: 1. forestry. transforming materials produced by the primary sector e. retail. when added together they give us a figure for a nation‘s gross domestic product (GDP). market prices play little or no part in informing resource allocation decisions and queuing rations scarce goods. Primary sector: This involves extraction of natural resources e.-5- distribution is decided by the state. research and development Manufacturing industry in the United Kingdom only accounts for 15 per cent of national output. March 2008) Cuban reforms create goodwill (BBC news. and mining 2. quarrying.

The Worldwide Fund for Nature has claimed that the natural world is being degraded "at a rate unprecedented in human history" and has warned that if demand continues at the current rate. © Tutor2u Limited www.number of workers. Other countries are reliant on importing these resources. machines. acres of land and reserves of oil and other natural resources on the earth. we cannot produce an unlimited number of different goods and services. Some nations are richly endowed with natural resources and then specialise in the their extraction and production – for example – the development of the North Sea oil and gas in Britain and Norway or the high productivity of the vast expanse of farm land in Canada and the United States and the oil sands in Alberta. It is inevitable that some workers are more productive than others because of the education. Environmental pressure groups such as Friends of the Earth and Greenpeace seek to highlight the permanent damage to the stock of natural resources available throughout the world and the dangers from economic development and global warming. Labour: Labour is the human input into the production process. training and work experience they have received.tutor2u. Canada. Resources are being consumed faster than the planet could replace them One issue is the threat posed by the shortage of water as the world‘s demand for household and commercial use continues to grow each year. Because most resources are finite. At the heart of improving resource sustainability is the idea of de-coupling – a process of trying to increase the efficiency with which resources are used and breaking the link between increasing demand and resource depletion.or limited . By supplying more for an ever-growing population we are in danger of destroying the natural resources of the planet. For more on the pressures facing the global environment see this special BBC online report – Planet under Pressure Factors of Production Factors of production are the resources we have available to produce different goods and services.net . Land: Land includes all of the natural physical resources – for example the ability to exploit fertile farm land. two planets will be needed to meet global demand by 2050. Our ecological footprint will affect the long-term sustainability of economies and have huge implications for our living standards.-6- Economic Resources Finite resources and sustainability There are only a finite . the benefits from a temperate climate or the harnessing of wind power and solar power and other forms of renewable energy.

telecommunications e.-7- An increase in the size and the quality of the labour force is vital if a country wants to achieve sustained growth. improved technology in farming has vastly increased productivity and allowed millions of people to move from working on the land into more valuable jobs in other industries. For example. The fast-growing Indian economy is often cited as a country whose growth prospects are being limited by weaknesses in national infrastructure. buildings or technology are used to enhance the productivity of labour. In recent years the issue of the migration of labour has become important. Can migrant workers help to solve labour shortages? What are the long-term effects on the countries who suffer a drain or loss of workers through migration? Capital: Capital goods can be used to produce other consumer goods and services in the future.net . Infrastructure Infrastructure is the stock of capital used to support the entire economic system. airports & docks. new technology. Examples of critical infrastructure include road & rail networks. equipment.g. Fixed capital includes machinery. New items of capital machinery. cables and satellites to enable web access. © Tutor2u Limited www. The World Bank regards infrastructure as an essential pillar for economic growth in developing countries. The oil and gas industry uses a huge amount of capital to get crude oil to the refineries and processing stages.tutor2u. Working capital means stocks of finished and semi-finished goods (or components) that will be either consumed in the near future or will be made into consumer goods ready to buy. factories and other buildings.

November 2007) Arctic 'has 90bn barrels of oil' (BBC.tutor2u.-8- Infrastructure is vital in achieving sustained economic growth Entrepreneurship An entrepreneur is an individual who seeks to supply products to a market for a rate of return (i. fish stocks or forestry that is inexhaustible or replaceable over time by new growth providing that the rate of extraction of the resource is less than the natural rate at which the resource renews itself. July 2008) Benidorm. Amazon is disappearing fast (BBC. Finite resources cannot be renewed. oxygen. May 2008) Climate Change (Independent) Environmental news (The Times) Ethical Living (The Guardian) Green Living (Independent) Humanity is the greatest challenge (BBC news. Suggestions for further reading on economic resources and sustainability The articles below have been selected because they are relevant to the issue of finite and renewable resources and the sustainability of production. Renewable and Finite Resources Renewable resources are commodities such as solar energy.net . This is becoming an important issue in environmental economics.e. natural gas and other items produced from fossil fuels. the new face of eco-tourism (BBC. biomass. coal. crude oil. no mechanisms exist to replenish them. to make a profit). and the global risks of permanent water shortages resulting from rising use of ground water stocks. Their main reward is the profit made from running the business. November 2007) © Tutor2u Limited www. for example the over-extraction of fish stocks. Entrepreneurs will usually invest their own financial capital in a business and take on the risks. For example with plastics.

July 2008) Wind power – the future? (BBC news.tutor2u.net .-9- Hydrogen refuel station unveiled (BBC news. June 2008) © Tutor2u Limited www.

creates a flow of income. savings in bank and building society accounts and contributions to pension schemes.. It is important to distinguish between income and wealth.g. 4. bonds. Dividends from share ownership. Wealth Wealth is defined as a stock of assets that. o o o Financial wealth – examples include stocks and shares. 2. or by making contributions to a pension fund then you are accumulating wealth. Each factor used in production can expect some reward: Income The main sources of income for people are: 1. The government can affect people‘s disposable income by taxing incomes and issuing welfare benefits to households on low wages or to those who are out of work. Likewise. rare antiques and fine wines. you will be paid interest. Social capital – an important part of our national wealth including social infrastructure such as transport systems. Wages and salaries from work often boosted by overtime and productivity bonuses.10 - Factor Rewards Factors of production are used to create output to be sold in markets. There has been a huge expansion in recent years in the buy-to-let sector of the housing market with hundreds of thousands of people buying properties and then letting them out. if you own properties you can rent it out to tenants.net . Interest from savings 3. Marketable wealth – this includes consumer durables that can be sold for a price e. © Tutor2u Limited www. this adds to your monthly income and if this is saved in a bank.tutor2u. Rent income from the ownership of property. For example. And if you have money in a savings account. if you receive a higher wage or salary. schools and hospitals. Being wealthy can generate income for if you own shares in companies you expect to receive dividend income perhaps once or twice a year. in turn.

but a problem of housing affordability for people looking to enter the housing market for the first time.tutor2u. Labour and Wages In industries and jobs where labour is not scarce. The Housing Boom Ends .. the housing boom in the UK came to an abrupt halt in 2007 and in the first half of 2008 there was a sharp fall in property prices as the housing market went into recession. Is this fair? What are the consequences of a high level of inequality? Should the government intervene to change the distribution of income? These are really important questions for economists.net . In 2006 the United Nations reported that the World's richest 1% own 40% of all wealth. Millions of people must rely on relatively low incomes with little opportunity to accumulate wealth. For example. Millions of workers in the UK are paid hourly wages well below the national average. wages tend to be lower. In the UK in recent years we saw a boom in the housing market leading to sharp rises in prices. The minimum wage seeks to address © Tutor2u Limited www.11 - The value of financial wealth can fluctuate over time.Will Shares Follow? FTSE 100 index (bottom pane) Average UK house price (top pane) 200000 180000 160000 £s House Prices 200000 180000 160000 140000 120000 100000 80000 FTSE 100 7000 6500 6000 5500 5000 4500 4000 3500 3000 140000 120000 100000 80000 7000 6500 6000 5500 Index 5000 4500 4000 3500 3000 01 02 03 04 05 06 07 08 Source: Reuters EcoWin Inequality in income and wealth It is a fact of life that the distribution of income and wealth in the UK and in many other countries is highly unequal and there is a huge gap between the richest and poorest households. As we see in the chart below. The result was a jump in housing wealth for people with mortgages. particularly in London and the South East. the latest data shows that 94% of the total wealth in Britain is held by 50% of the population.

There is also a growing interest in the concept of social enterprises. Capital and Interest Businesses often need to borrow money to fund capital investment. Labour Capital Enterprise An entrepreneur risks financial capital and organises land labour & capital to produce output in the hope of profit Source: adapted from Richard Young. it becomes less worthwhile to borrow money because any project will have to make more money than before to be profitable since more interest is now being paid. On the other hand. Summary on factors of production and factor rewards Factor Land Description all natural resources (gifts of nature) including fields. ethical businesses. mineral wealth. skilled or unskilled Man made goods used to produce more goods including factories (plant). by brain. Taxes then have to be paid to the government. The rise of consumer power in influencing the decisions of businesses is part of this trend. social and environmental impacts.12 - some of the problems associated with low pay. Interest rates can of course go up or down. The reward for investing money is called interest. and the entrepreneur takes what is left. “Markets Question and Answer”. Unsuccessful firms make losses. Enterprise and Profit In return for having innovative business ideas and taking the risk in putting funds into a business the entrepreneur takes any money that the business has left after the other factors of production have received their rewards. This is called gross profit. But this is not always the case! Some businesses are looking to achieve a rising market share and increasing market share might mean having to sacrifice some profits in the short run by cutting prices and under-cutting rival suppliers in the market. Business Objectives Economists often assume that one of the main objectives of a business is to achieve maximum profits. If the interest rate is high. This after-tax profit is called net profit. and fishing stocks The physical and mental work of people whether by hand. and these people will command high salaries in the labour market.tutor2u.. and corporate social responsibility where the traditional assumption of firms driven solely by the profit motive is being challenged and where businesses are encouraged to take account of their economic. Tutor2u Suggestions for extra reading on factor rewards © Tutor2u Limited www. machines and roads. Reward The reward for landlords for allowing firms to use their property is rent The reward for workers giving up time to help create products is wages or salaries The reward for creditors lending money to firms to invest in buildings and capital equipment is interest The reward for individuals risking funds and offering products for sale is profit. some people have skills that are rare.net .

13 - More children living in poverty (BBC news. May 208) Wealth rise boosts unequal Britain (BBC news..net . June 2008) Peru's poor left behind as growth soars (BBC news. January 2008) Health inequality gap widening (BBC news. March 2008) UK super-rich are getting richer (BBC news.tutor2u. April 2008) © Tutor2u Limited www.

as more resources are allocated towards Good Y the extra output gets smaller – so more of Good X has to be given up in order to produce Good Y. A or B. Producing more of both goods would represent an improvement in economic welfare providing that the products are giving consumers a positive satisfaction and therefore an improvement in what is called allocative efficiency © Tutor2u Limited www. We normally draw a PPF on a diagram as concave to the origin i. We could increase total output by moving towards the PPF and reaching any of points C.tutor2u.net .14 - The Production Possibility Frontier A production possibility frontier (PPF) is a boundary which shows the combinations of two or more goods and services that can be produced whilst using all available factor resources efficiently. Point D is unattainable at the moment because it lies beyond the PPF. A country would require an increase in factor resources. This is the law of diminishing returns and it occurs because not all factor inputs are equally suited to producing items. As we shall see a little later. A PPF shows the different combinations of goods and services that can be produced with a given amount of resources in their most efficient way Any point inside the curve – suggests resources are not being utilised efficiently Any point outside the curve – not attainable with the current level of resources Output of Y C D A X B Output of X PPF and economic efficiency Combinations of the output of goods X and Y lying inside the PPF happen when there are unemployed resources or when the economy uses resources inefficiently – point X is an example of this. international trade between countries also allows nations to consume beyond their domestic PPF.. an increase in the productivity or an improvement in technology to reach this combination of Good X and Good Y.e. as we move down the PPF.

net .tutor2u. © Tutor2u Limited www. If we increase our output of Good X (moving along the PPF from point A to point B) then fewer resources are available to produce Good Y. then we draw the PPF as a straight line. Output of Capital Goods B C2 C1 A X2 X1 Output of Consumer Goods If the opportunity cost for producing two products is constant. The gradient of that line is a way of measuring the opportunity cost between two goods.. if the law of diminishing returns holds true then the opportunity cost of expanding output of X measured in terms of lost units of Y is increasing.15 - Opportunity cost and the PPF Reallocating scarce resources from one product to another involves an opportunity cost.

there is an improvement in technology which shifts the PPF outwards.16 - Output of Good A A straight line PPF shows a constant opportunity cost between two products Increasing output of good B from 60 to 90 units implies giving up 90 units of good A The marginal opportunity cost for each extra unit of good B is 30 units of Good A A 200 B 160 60 90 Output of Good B Shifts in the Production Possibility Frontier The PPF will shift when: o o There are improvements in productivity and efficiency perhaps because of the introduction of new technology or advances in the techniques of production More factor resources are exploited perhaps due to an increase in the size of the workforce or a rise in the amount of capital equipment available for businesses In the diagram below..net . © Tutor2u Limited www.tutor2u.

Output of Capital Goods PPF1 B C2 PPF2 C C3 A C1 X2 X1 X3 Output of Consumer Goods Free Goods Free goods are not scarce and no cost is involved when consuming them.17 - An outward shift in the PPF shows that there has been either an improvement in productivity or an increase in the total stock of resources available to produce different goods and services. the labour involved in its design. distribution and maintenance and the energy used up in powering the system. With air conditioning.tutor2u. scarce resources are used up in providing the ―product‖ – for example the capital machinery and technology that goes into manufacturing the air conditioning equipment. And. Cool air might appear to be free – but in fact it is often an expensive product to supply! © Tutor2u Limited www. The outward shift represents an improvement in economic efficiency. Is fresh air an example of a free good? Usually the answer is yes – yet we know that air can become contaminated by pollutants. shops and schools. airconditioning systems cool the air before it is ―consumed‖. production. in thousands of offices.net ..

net . © Tutor2u Limited www.tutor2u. Workers begin to take less pride in their work and quality suffers. Variety. Who gains from specialisation? By concentrating on what people and businesses do best rather than relying on self sufficiency: Higher output: Total output of goods and services is raised and quality can be improved. This gain in productivity helps to lower cost per unit. the result may be a problem of diseconomies of scale.18 - Specialisation and Trade Specialisation is when we concentrate on a particular product or task. keep prices down and therefore maintains low inflation The Division of Labour Specialisation occurs in nearly every business – from manufacturing to restaurants The division of labour occurs where production is broken up into many separate tasks each performed by one person or by a small group of people. Another disadvantage is that mass-produced standardized goods tend to lack variety. Limitations of division of labour Perhaps the greatest downside is that unrewarding. Surplus products can then be exchanged and traded creating the potential for gains in welfare for all parties. Some workers receive a narrow training and may not be able to find alternative jobs if they find themselves out of work (they may suffer structural unemployment). repetitive work lowers motivation and productivity. A bigger market: Specialisation and global trade increase the size of the market offering opportunities for economies of scale. Consumers have access to a greater variety of higher quality products.. The division of labour raises output per person as people become proficient through constant repetition of a task – ‗practice makes perfect‘ – or ―learning by doing‖. Competition and lower prices: Increased competition acts as an incentive to minimise costs.

e. comparative advantage exists when a country has a „margin of superiority‟ in the supply of a product i.net . Output of X Country A Country B 180 200 Output of Y 90 150 Output of Good X 400 360 200 180 PPF for Country B PPF for Country A 90 150 180 300 Output of Good Y In this example. the cost of production is lower. With a given amount of resources. Countries will usually specialise in and then export products.19 - The concept of comparative advantage First introduced by David Ricardo in 1817. The dynamic Asian economies including China have focused their resources in exporting low-cost manufactured goods which take advantage of much lower labour costs. But although country A has an absolute disadvantage. It is 9/10ths as efficient at producing good X but it is only 3/5ths as efficient at producing good Y.. In highly developed countries. country B has an absolute advantage in both products. which they are most abundantly endowed. So for example the Canadian economy which is rich in low cost land is able to exploit this by specializing in agricultural production. which use intensively the factors inputs. Absolute advantage occurs when a country or region can create more of a product with the same factor inputs. the comparative advantage is shifting towards specializing in producing and then exporting high-value and high-technology manufactured goods and highknowledge services. in fact it has a comparative advantage in the production of good X.tutor2u. © Tutor2u Limited www. The PPF and Specialisation Two countries are producing two products (X and Y).

There are gains to be had from country A specializing in the supply of good X and country B allocating more of their resources into the production of good Y. For the United States the same decision has an opportunity cost of 2. i. For example. If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. the production possibilities are as shown in the table below. Consider two countries producing two products – digital cameras and vacuum cleaners.20 - Comparative advantage exists when a country has lower opportunity cost. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner.3 units of good X. Thus the United States has a comparative advantage in producing digital cameras because its opportunity cost is lowest.. for country A.. With the same factor resources evenly allocated by each country to the production of both goods. © Tutor2u Limited www. The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners. Pre-specialisation UK United States Total Digital Cameras 600 2400 3000 Vacuum Cleaners 600 1000 1600 Working out the comparative advantage To identify which country should specialise in a particular product we need to analyse the opportunity costs for each country. In our example above. the UK has a comparative advantage in vacuum cleaners. Output after Specialization Digital Cameras UK United States Total 0 (-600) 3360 (+960) 3000 3360 o o Vacuum Cleaners 1200 (+600) 600 (-400) 1600 1800 The UK specializes totally in producing vacuum cleaners – doubling its output to 1200.e.4 digital cameras. Another worked example of comparative advantage In this second example. were the UK to shift more resources into higher output of vacuum cleaners. the opportunity cost of each vacuum cleaner is one digital television. we will work through an example of comparative advantage and also show some of the benefits that might flow from specialisation and trade. Therefore.net . every extra unit of good Y produced involves an opportunity cost of 2 unit of good X. an additional unit of good Y involves a sacrifice of only 4. For country B. it gives up less of one product to obtain more of another product.tutor2u.

We have seen in this chapter how specialisation and trade based on the idea of comparative advantage can lead to an improvement in economic welfare. output of both products has increased .net . July 2008) © Tutor2u Limited www..representing a gain in economic welfare.tutor2u. The Battle over Trade (BBC news special reports) New exotic fruit to hit the UK shops (BBC news. Suggestions for further reading on the gains from specialisation and trade Each of the following articles has been chosen because they are relevant to the topic of international trade between nations. the two nations have to agree an acceptable rate of exchange of one product for another. consumers in both countries now have an increased supply of both goods to choose from. For mutually beneficial trade to take place.21 - o As a result of specialisation according to the principle of comparative advantage. There are gains from trade between the two countries. the post-trade position will be as follows: o o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras The USA exports 840 digital cameras and imports 420 vacuum cleaners Post trade output / consumption Digital Cameras UK United States Total 840 2520 3360 Vacuum Cleaners 780 1020 1800 Compared with the pre-specialisation output levels. If the two countries trade at a rate of exchange of 2 digital cameras for one vacuum cleaner.

e. The government is right to introduce a ban on smoking in public places. Their articles carry value judgements where they are trying to persuade you of the particular merits or demerits of a policy decision. the person writing an article has a particular argument to make and will include subjective statements about what ought to be or what should be happening. The government ought to provide financial subsidies to companies manufacturing and developing wind farm technology. Positive economics deals with objective explanation and the testing and rejection of theories. The retirement age should be raised to 75 to combat the effects of our ageing population. The government should enforce minimum prices for beers and lagers sold in supermarkets and off-licences. These articles may be lacking in objectivity. Positive Statements Positive statements are objective statements that can be tested or rejected by referring to the available evidence. Cut-price alcohol has increased the demand for alcohol among teenagers Normative Statements Normative statements express an opinion about what ought to be. The rising price of crude oil on world markets will lead to an increase in cycling to work A reduction in income tax will improve the incentives of the unemployed to find work. For example: The level of duty on petrol is unfair and penalizes motorists. © Tutor2u Limited www.net . they carry value judgments. Poverty in the UK has increased because of the fast growth of executive pay. The London congestion charge for drivers of petrol-guzzling cars should increase to £25 The government should increase the minimum wage to £6 per hour to reduce poverty.. For example: A fall in consumer incomes will lead to a rise in demand for motor scooters If the government raises the tax on beer.tutor2u. A rise in average temperatures will increase the demand for sun screen products. Often. They are subjective statements rather than objective statements – i.22 - Positive and Normative Statements Detecting bias in arguments Whenever you are reading articles on current affairs it is important to be able to distinguish where possible between objective and subjective statements. this will lead to a fall in profits of the brewers.

It exists when there is willingness to buy among people for a good or service. For example. Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product.. This is important background to understanding the determination of prices in competitive markets.net .23 - Markets: Understanding Demand In this chapter we consider the economics of the law of demand. Demand Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. Derived Demand The demand for a product X might be linked to the demand for a related product Y – giving rise to the idea of a derived demand. Latent Demand Latent demand is probably best described as the potential demand for a product. Latent demand is affected by advertising – where the producer is seeking to influence consumer tastes and preferences.tutor2u. linked usually to the enjoyment or usefulness that we expect from consuming it. © Tutor2u Limited www. Effective demand and willingness to pay Demand in economics must be effective is when a desire to buy a product is backed up by an ability to pay. but where consumers lack the purchasing power to be able to afford the product. what price are you willing to pay for a ticket for the opening ceremony of the London 2012 Olympics or to watch Federer play Nadal in the Wimbledon final? There has been a huge growth in demand for live events such as pop festivals and other concerts – when people buy tickets for these they reveal their preferences for the types of goods and services they are willing and able to buy.

24 - For example. the demand for steel is strongly linked to the demand for new vehicles and other manufactured products. the sharp rise in the price of steel will affect demand for substitutes to steel. Steel is a cyclical industry which means that the total market demand for steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate.net . World Prices for Different Types of Steel US dollars per tonne 1100 1000 900 800 1100 1000 900 800 700 600 500 400 300 200 01 02 Cold Rolled Coil 03 04 05 Hot Rolled Plate Source: Reuters EcoWin 06 07 08 US dollars per tonne 700 600 500 400 300 200 Hot Rolled Coil The demand for new bricks is derived from the demand for the final output of the construction industry.. so the market demand for bricks will increase © Tutor2u Limited www. so that when an economy goes into a recession. so we would expect the demand for steel to decline likewise. This is because of rising global demand for steel which itself is derived from the demand for new buildings and the rapid growth of manufacturing especially in far-east Asian emerging countries. As we shall see.tutor2u.when there is a boom in the building industry. Recently the world price of steel has been surging to new heights as our chart indicates below.

When drawing a demand curve. Provided that the good is normal.tutor2u. we see an expansion of demand. 1. economists assume all factors are held constant except one – the price of the product itself. The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and some consumers switch their spending from the alternative good or service.. there will be a contraction of demand. 2. There are two reasons why more is demanded as price falls: 1. As prices fall.25 - The Law of Demand There is an inverse relationship between the price of a good and demand.net . Demand Curve A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. the demand curve will be non-linear! Indeed. The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain the same consumption for less expenditure. no business © Tutor2u Limited www. some of the resulting increase in real income is used to buy more of this product. A change in a factor being held constant invalidates the ceteris paribus assumption. Price P2 Rising price contraction of demand Falling price expansion of demand P1 P3 Demand Q2 Q1 Q3 Quantity Demanded The demand curve is normally drawn in textbooks as a straight line suggesting a linear relationship between price and demand but in reality. If price rises. Ceteris paribus assumption Many factors can be said to affect demand. 2.

net . then consumer demand will be sensitive to price changes. When this happens. Changes in the Conditions of Demand – Shifts in Demand There are two possibilities: either the demand curve shifts to the right or it shifts to the left. 2.g. Changing price of a complement Two complements are said to be in joint demand – e.26 - has a perfect idea of what the demand curve for a particular product looks like. 1. Many other factors can affect total demand . less is demanded at each price. When this happens. the demand curve can shift. A movement from D1 – D2 would be termed an inward shift of the demand curve (or decrease in demand).tutor2u. When it is easy and cheap to switch. Price P1 D1 to D3 – an outward shift of demand D1 to D2 – an inward shift of demand D2 D1 D3 Q2 Q1 Q3 Quantity Demanded The conditions of demand for a product in a market can be summarised as follows: Changing prices of a substitute good Substitutes are goods in competitive demand and act as replacements for another product. a rise in the price of Esso petrol should cause a substitution effect away from Esso towards competing brands such as Shell.when these change. D1 – D3 would be an example of an outward shift of the demand curve (or an increase in demand). DVD players and DVDs. more is demanded at each price. they use real-time evidence from markets to estimate the demand conditions and their accumulated experience of market conditions gives them an advantage in constructing demand-price relationships. © Tutor2u Limited www. This is explained below.. iron ore and steel. For example.

We consider these briefly – ostentatious consumption and the effects of speculative demand. This has eaten into the discretionary incomes of millions of households across the UK. The demand for housing is affected by changes in mortgage interest rates. But when incomes fall there will be a decrease in the demand for most goods. A fall in the price of a complement to Good Y should cause an increase in demand for Good Y.tutor2u. Goods of ostentatious © Tutor2u Limited www. Changes in the income of consumers Most of the things we buy are normal goods. and this causes an outward shift in the demand curve. Market demand Market demand is the sum of the individual demand for a product from each consumer in the market. A higher price may be regarded as a reflection of product quality and some consumers are prepared to pay this for the “snob value effect”. and top of the range cars.net . Examples of ―interest sensitive‖ products include household appliances. especially. designer clothes. Therefore if the Bank of England decides to raise interest rates – the demand for many goods and services may fall. For example an increase in the cost of flights from London Heathrow to New York would cause a decrease in the demand for hotel rooms in New York and also a fall in the demand for taxi services both in London and New York. Exceptions to the law of demand There are two possible reasons why more might be demanded even when the price of a good or service is increasing. The discretionary incomes of people suffering from fuel poverty have become a major current issue. An increase in interest rates often means an increase in monthly mortgage payments reducing demand. If more people enter the market and they have the ability to pay for items on sale. Examples might include perfumes.27 - A rise in the price of a complement to Good X should cause a fall in demand for X. And in recent years we have seen a sharp rise in the cost of utility bills with a series of hikes in the prices of gas and electricity. new furniture and motor vehicles. thus the demand for them may be sensitive to the rate of interest charged by the lender. Interest rates and demand Many products are bought on credit using borrowed money. When income goes up. For example a reduction in the price of the new iPhone should lead to an expansion in demand for the iPhone and a complementary increase in demand for download applications. (a) Ostentatious consumption Some goods are luxurious items where satisfaction comes from knowing both the price of the good and being able to flaunt consumption of it to other people! The demand for the product is a direct function of its price. mortgage repayments. electronic goods. then demand at each price level will rise. our ability to purchase goods and services increases.. except for inferior goods (see the chapter on income elasticity of demand). Discretionary income is disposable income less essential payments like electricity & gas and.

The speculative demand for housing and for shares might come into this category and we have also seen. Speculation drives the prices of commodities to fresh highs World commodity prices have reached new highs this year helped by an increase in the rate of economic growth in the global economy. Prices have risen quickly because commodity producers are unable to raise output sufficiently to meet unexpectedly strong demand. but also the potential rise in market price leading to a capital gain or profit.tutor2u. For example. in the last few years. Many market experts believe that the demand for commodities has been spurred by heavy speculator activity.net . Source: adapted from news reports. July 2006 The non-linear demand curve and the idea of price points Price of mountain bikes (£s) 1000 900 800 700 600 500 400 300 200 100 0 0 100 200 300 400 500 600 700 800 Weekly sales of mountain bikes A B © Tutor2u Limited www. adding to the upward pressure on prices. zinc. gold and platinum. strong speculative demand for many of the world‘s essential commodities. pension funds and hedge funds have been investing in commodity mutual funds over recent years leading to increased demand for precious metals. Among the metals that have achieved record price levels are copper.. prompting sceptics to question how much longer prices can continue rising.28 - consumption are known as Veblen Goods and they have a high-income elasticity of demand. That is. speculative demand may grow. (b) Speculative Demand When there is speculative demand potential buyers are interested not just in the satisfaction they may get from consuming the product. demand rises more than proportionately to an increase in income or an increase in price. When prices are rising.

There may be psychological effects at work. Price points can be justified in a number of ways: 1. Many price-demand relationships are non-linear and an example of this is provided in the previous chart. 2. They are simplifications of reality. Customers may have become used to paying a certain price for a type of product and if they see a further price rise. 3. As with many aspects of economic theory. used to illustrate the idea of price-points. November 2006) © Tutor2u Limited www. Suggestions for Further Reading on the Theory of Demand All of these articles relate to some of the causes of changes in the market demand for different goods and services. Another price point might exist at B.net .99 somehow seems cheaper than £3.Healthy trends eat into sales at Burger King (Guardian. Key point for the exam For AS level economics. cutting the price below £400 leads to a large expansion of demand.tutor2u.29 - In many markets an assumption of a linear relationship between price and quantity demanded is not realistic. From selling 250 bikes per week increasing the price to £700 leads to sales dipping to 175 per week..00 despite the tiny price difference. thin man (BBC Money Programme. price-demand relationships can be complex and often a business does not have enough information about the behaviour of consumers for them to actually construct an accurate demand curve. consider some of the conditions of demand covered in this chapter and how they link in to the particular story.£2. March 2007) Nigella effect sees goose fat sales soar (Guardian. we are constructing curves to illustrate economic relationships. But it is important to realise that in the real world of business. you will be expected to draw and use linear demand curves in your basic analysis. Consider price point A where raising the selling price of the mountain bike above £650 causes demand to decline quite quickly. Looking at this in a slightly different way. this may cause them to revalue how much satisfaction they get from buying and consuming something. leading to a decline in demand. A price rise at the price point may make the product more expensive than a close substitute causing consumers to change their preferences.Priciest champagne set to sparkle (BBC November 2006) Tastes and preferences . Bottled water popularity rising (BBC May 2008) Demand for Polish beer in Britain (BBC October 2006) Demand for slimming treatments – Fat man. When reading through them. supermarkets for example know the importance of avoiding price points . December 2006) Rising cost of renting a property (BBC May 2008) Sales lose fizz for Magners maker (BBC February 2008) Speculative demand . Price points are points on the demand curve where a small change in price may cause a sizeable contraction in demand leading to a loss of total revenue for the producer. In technical terms we say that the price elasticity of demand is higher at a price just above the price point.

30 - Markets: Understanding Supply Definition of Supply Supply is defined as the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period. we move along a supply curve. so businesses expand their supply onto the market. producer and seller have the same meaning. The basic law of supply is that as the price of a product rises. If the market price falls from P1 to P3 there would be a contraction of supply in the market.net .if the price of the good varies. In the diagram above. Note: Throughout this study companion. © Tutor2u Limited www. Businesses are responding to price signals when making their output decisions. Supply – the amount producers are willing to offer for sale at various prices Supply – reflects the costs of the resources used in production and the profits required Supply P2 Expansion of supply P1 Contraction of supply Price P3 Q3 Q1 Q2 Quantity supplied A supply curve is drawn assuming ceteris paribus .tutor2u. The profit motive: When the market price rises following an increase in demand. A supply curve shows a relationship between the price and quantity a firm is willing and able to sell.. business. as the price rises from P1 to P2 there is an expansion of supply. Explaining the Law of Supply There are three main reasons why supply curves are drawn as sloping upwards from left to right giving a positive relationship between the market price and quantity supplied: 1. the terms firm. it becomes more profitable for businesses to increase output. Higher prices send signals to firms that they can increase their profits by satisfying demand in the market.

A fall in the exchange rate causes an increase in the prices of imported components and raw materials and will lead to a decrease in supply. For example a magazine publisher might see a reduction in the cost of its imported paper and inks.tutor2u. therefore a higher price is needed to cover these extra costs of production.net . for example following a rise in the price of raw materials or a firm having to pay higher wages to its workers. If the supply curve shifts to the right (from S1 to S2) this is an increase in supply. there is a decrease in supply meaning that less will be supplied at each price Price Changes in any of the factors other than price cause a shift in the supply curve A shift in supply to the left – the amount that producers offer for sale at every price will be less A shift in supply to the right – the amount producers wish to sell at every price S3 increases S1 S2 Decrease in Supply Increase in Supply P1 Q3 Q1 Q2 Quantity Changes in the costs of production Lower costs of production mean that a business can supply more at each price. then businesses cannot supply as much at the same price and this will cause an inward shift of the supply curve. and higher prices for paints imported from Eastern Europe.31 - 2. These cost savings can then be passed through the supply chain to wholesalers and retailers and may result in lower market prices for consumers.. If the supply curve moves inwards from S1 to S3. a firm‘s production costs tend to rise. Shifts in the Supply Curve The supply curve can shift position. New entrants coming into the market: Higher prices may create an incentive for other businesses to enter the market leading to an increase in supply. then it becomes more expensive for British car manufacturers to import their rubber and glass from Western European suppliers. more is provided for sale at each price. Production and costs: When output expands. If the costs of production increase. For example if the pounds falls by 10% against the Euro. © Tutor2u Limited www. 3.

Because of the tax.400 over the past decade. Source: Adapted from news reports. The result is an increase in the market price and a contraction in demand to a new equilibrium output of Q2 Price Supply (post-tax) Supply (pre-tax) P2 Size of the tax per unit P1 Demand Q2 Q1 Quantity Metal prices and the supply of cans The world's biggest maker of drink cans.tutor2u. says it will raise prices to offset an unprecedented increase in the cost of aluminium that has hit profits..325) a tonne in recent months from an average $1. The amount of the tax is shown by the vertical distance between the two supply curves. Government taxes and subsidies A tax increases the costs faced by producers.32 - Changes in technology Production technologies can change quickly and in industries where change is rapid we see increases in supply and lower prices for the consumer. less can be supplied at each price level.net .500 (£1. Prices of the metal have risen to $2. August 2006 © Tutor2u Limited www. Rexam. The British firm spends about £1bn a year on aluminium to make 50bn cans a year for customers such as Coca-Cola and Carlsberg.

destroying fruit worth $300 million and leaving up to 4. lower yields and therefore a decrease in supply. Changes in climate can therefore have an effect on prices for agricultural goods such as coffee. The storm ruined 200. Queensland produces about 95 per cent of Australia's bananas. will feed through to increased prices for banana smoothies in shops and cafes. Cyclone destroys the Australian banana crop and sends prices soaring Cyclone Larry has devastated Australia's banana industry. Source: Adapted from news reports. Australians now face a shortage of bananas and likely price rises after the cyclone tore through the heart of the nation's biggest growing region. the effect of climatic conditions can exert a great influence on market supply. Higher coffee prices for example can lead to an increase in the price of coffee-flavoured cakes..000 tonnes of fruit and market supply shortages will be severe because Australia does not allow banana imports because of the bio-security risks in doing so. The extent of the subsidy per unit is shown by the vertical distance between the two supply curves.000 people out of work. Favourable weather will produce a bumper harvest and will increase supply. tea and cocoa. And higher banana prices as we see in the article below. April 2006 © Tutor2u Limited www. Bananas are grown throughout the year in north Queensland. a change in the supply of one can affect the supply and price of another product. Because these commodities are often used as ingredients in the production of other products. with the fruit having a growing cycle of around two months. Unfavourable weather conditions including the effects of drought will lead to a poorer harvest.33 - A government subsidy encourages an increase in supply at each price level because the subsidy provides a reduction in a firm‘s costs of production. Price S1 Supply + Subsidy P3 P1 Subsidy per unit P2 Demand Q1 Q2 Quantity Changes in climate For commodities such as coffee.tutor2u. oranges and wheat.net .

tutor2u. April 2008) Hurricanes bring orange growers a windfall (Guardian. Take the example of barley. A topical example of this is the diversion of land used in supplying food to producing bio-fuels and the impact this has had on global food prices.5bn into broadband (BBC news. June 2008) Expensive oil makes food prices go up (BBC news. The profit motive may cause farmers to grow more wheat rather than barley. labour and capital. July 2008) Grain prices are squeezing bakers (BBC news. The number of producers in the market and their objectives The number of sellers in an industry affects market supply.net . November 2006) Dry cleaners facing rising costs (BBC news. August 2006) Drought boost for Oz wine prices (BBC news. supply increases causing downward pressure on price. Farmers can change their crops if expectations of future price movements also change More reading on conditions of supply Each of these links provide short case studies on how changes in supply affect prices and profits BT to pump £1. December 2006) Milk costs hit Stilton producers (BBC news.. Competitive supply Goods and services in competitive supply are alternative products that a business could make with its factor resources of land. An increase in the price of wheat makes wheat growing more financially attractive. July 2007) © Tutor2u Limited www. When new businesses enter a market. July 2008) Cadbury‘s plans to increase prices (BBC news.34 - Change in the prices of a substitute in production A substitute in production is a product that could have been produced using the same resources. February 2008) Coffee prices leap on fear of beans shortage (The Guardian.

.35 - Milk shortages feared as supply is squeezed across Europe (The Times.net . July 2008) USA and EU urged to cut bio-fuels (BBC news.tutor2u. July 2008) © Tutor2u Limited www. May 2008) Rio Tinto 'beats' iron ore record (BBC news.

. Price Supply P3 P1 Equilibrium point – a ―market clearing‖ point where supply = demand P2 Demand Q1 Quantity (Q) Equilibrium means a state of equality or a state of balance between market demand and supply.36 - Markets: Finding an Equilibrium Price The Concept of Market Equilibrium Market price is set by the interaction of supply and demand. the quantity demanded and supplied at price P1 are equal. supply exceeds demand and at P2. In the diagram above. The weekly demand and supply schedules for T-shirts (in thousands) in a city are shown in the next table: © Tutor2u Limited www. Prices where demand and supply are out of balance are termed points of disequilibrium.net . Changes in the conditions of demand or supply will cause changes in the equilibrium price and quantity in the market. demand exceeds supply.tutor2u. At price P3. Demand and supply schedules can be represented in a table. Without a shift in demand and/or supply there will be no change in price. The example below provides an illustration of the concept of equilibrium. Equilibrium price is the price at which the quantity demanded by consumers and the quantity that firms are willing to supply of a good or service are the same.

000 units 5. If the current market price was £8 – there would be excess supply of 12.000 units 2.. If the current market price was £3 – there would be excess demand for 8. Assuming that the supply schedule remains unchanged.000 units 4.000 units 3.000 at each price. The next row of the table shows the higher level of demand.37 - Price per unit (£) Demand (000s) Supply (000s) New Demand (000s) New Supply (000s) 8 6 18 10 26 7 8 16 12 24 6 10 14 14 22 5 12 12 16 20 4 14 10 18 18 3 16 8 20 16 2 18 6 22 14 1 20 4 24 12 1. The equilibrium price is £5 where demand and supply are equal at 12.000 T-shirts at each price. The new equilibrium price becomes £4 with 18.net . Firms in the market will sell more at a higher price and therefore receive more total revenue. the new equilibrium price is £6 per tee shirt with an equilibrium quantity of 14. The entry of new producers into the market causes a rise in supply of 8. © Tutor2u Limited www.000 units bought and sold Changes in Market Demand and Equilibrium Price An Inward Shift in Demand Price Supply Supply Price An Outward Shift in Demand P3 P1 P1 P2 D3 D1 D1 D2 Q2 Q1 Quantity Q1 Q3 Quantity The outward shift in the demand curve causes an expansion along the supply curve and a rise in the equilibrium price and quantity. A rise in income causes demand to rise by 4.tutor2u.

38 - The reverse effects will occur when there is an inward shift of demand.tutor2u.net .. A shift in the demand curve does not cause a shift in the supply curve! Demand and supply factors are assumed to be independent of each other although some economists claim this assumption is no longer valid! Changes in Market Supply and Equilibrium Price An Inward Shift in Supply Price Price An Outward Shift in Supply S2 S1 S1 S3 P2 P1 P1 P3 D1 D2 Q2 Q1 Quantity Q1 Q3 Quantity Rising costs feed through to higher bread prices © Tutor2u Limited www.

The equilibrium price and quantity in a market will change when there shifts in both market supply and demand.. March 2008 Important note for the exams: A shift in the supply curve does not cause a shift in the demand curve. 800g White loaf.3m to 1. source: Office of National Statistics. Instead we move along (up or down) the demand curve to the new equilibrium position.39 - Wheat and Bread Prices Monthly data.4m tonnes of wheat a year. For Hovis. It is another example of how agri-flation is feeding through to the prices of processed foods. sliced.tutor2u. Two examples of this are shown in the next diagram: © Tutor2u Limited www. Source: Adapted from news reports. The effect on demand will depend on how other bread manufacturers respond and also the price elasticity of demand for bread in the market. In other words. wheat is an important variable cost. Premier needs to raise bread prices to recover further increases in raw material costs. Premier Foods buys about 1. 800g Source: Reuters EcoWin Premier Foods has announced that the price of its Hovis and Mothers Pride branded breads will rise following the surge in world wheat prices.net . unwrapped. it is banking on an ability to raise price to protect their profit margins. price in pence per loaf 800 700 Wheat price index Index of world wheat prices 800 700 600 500 400 300 200 100 120 110 100 millions 600 500 400 300 200 100 Price of bread in pence (millions) 120 110 100 90 80 70 60 50 40 00 01 02 03 04 05 06 07 08 90 80 70 60 50 40 Bread: white loaf.

but the rise in costs forces up the market price. we see an inward shift of supply together with a fall in demand. The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2.. Both factors lead to a fall in quantity traded. Moving from one equilibrium to another Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand outlined in the diagrams in previous pages are reflective of changes in conditions in the market. Regulated prices © Tutor2u Limited www.40 - An Inward Shift in Demand and a fall in Supply Price Price An Outward Shift in Demand and a Rise in Supply S2 S1 S1 S2 P2 P1 P1 P3 D3 D1 D1 D2 Q2 Q1 Quantity Q1 Q2 Quantity In the left-hand diagram above. We tend to use these diagrams to illustrate movements in market prices and quantities – this is known as comparative static analysis. So an outward shift of demand (depending upon supply conditions) leads to a short term rise in price and a fall in available stocks.tutor2u. many businesses have imperfect knowledge about their demand curves – they do not know precisely how consumer demand reacts to changes in price or the true level of demand at each and every price. Likewise. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market. The reality in most markets and industries is more complex.net . For a start. constructing accurate supply curves requires detailed information on production costs and these may not be readily available. The higher price is an incentive for suppliers to raise their output (termed as an expansion of supply) causing a movement up the short term supply curve towards the new equilibrium point.

July 2008) Rent prices rise (BBC news. PostComm is the regulator which controls how much the Royal Mail can charge for postage stamps. In the rail market. some of the fares are unregulated allowing train operating companies to set their own prices. Suggestions for further reading on changes in equilibrium prices Each of the articles below has been selected because it relates to a change in the conditions of supply and/or demand which bring about movements in market prices. May 2008) Strong demand for homes to rent (BBC news. But around half of the fares charged for UK rail travellers are determined by the rail regulator which applies an RPI+1% formula – this means that fares can rise by the rate of retail price inflation plus 1% each year. July 2008) © Tutor2u Limited www. May 2008) Cut in subsidy raises fuel prices in Vietnam (BBC news. June 2008) Taxi fares in Belfast to rise by 25% (BBC news. a number of prices are influenced by the decisions of industry regulators – two good examples are rail fares and the cost of postage stamps. May 2008) The market for allotments (Tutor2u Blog.41 - Not all prices are set by the pure forces of market supply and demand. July 2008) Fares hikes to cover fuel costs (BBC news.tutor2u. July 2008) Why have oil prices been falling? (BBC news. February 2008) Cut price tickets for the 2008 Edinburgh tattoo (BBC news. Coal prices surge to record high (BBC news.net . The extra 1% is designed to provide extra revenue for investment in improving rail infrastructure and new rolling stock. July 2008) What shifts the demand and supply curves (Tutor2u blog. In the British economy for example..

4. The time period allowed following a price change – demand tends to be more price elastic. If Ped is between 0 and 1 (i. the more elastic is demand because consumers can easily switch their demand if the price of one product changes relative to others.e. economists usually do not bother to put in the minus sign. The cost of switching between products – there may be significant costs involved in switching between products. demand tends to be relatively inelastic. In this case. 2. For example a 20% increase in the price of a good might lead to a 30% drop in demand. If Ped = 1 (i. the percentage change in demand from A to B is smaller than the percentage change in price). This means that demand does not change at all when the price changes – the demand curve will be drawn as vertical. The number of close substitutes for a good – the more close substitutes in the market. then demand is inelastic.e. 5.net Demand for rail services At peak times. We are more concerned with the co-efficient of elasticity of demand. For example. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level. mobile phone service providers may insist on 12 or 18-month contracts being taken out. the demand for rail transport becomes inelastic – and higher prices are charged by rail companies who can then achieve higher revenues and profits . Understanding values for price elasticity of demand 1. The % of a consumer‟s income allocated to spending on the good – goods and services that take up a high proportion of a household‘s income will tend to have a more elastic demand than products where large price changes makes little or no difference to someone‘s ability to purchase the product. © Tutor2u Limited www. then demand is said to unit elastic. If Ped = 0 demand is said to be perfectly inelastic.42 - Price Elasticity of Demand Ped measures the responsiveness of demand for a product following a change in its own price. the percentage change in demand is exactly the same as the percentage change in price). 4. then demand responds more than proportionately to a change in price i. 2.e. The degree of necessity or whether the good is a luxury – goods and services deemed by consumers to be necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.tutor2u. 3.5.. 3. The formula for calculating the co-efficient of elasticity of demand is: Percentage change in quantity demanded divided by the percentage change in price Since changes in price and quantity usually move in opposite directions. If Ped > 1. demand is elastic. 6. Whether the good is subject to habitual consumption – when this occurs. The price elasticity of demand for this price change is –1. the longer that we allow consumers to respond to a price change. What Determines Price Elasticity of Demand? 1. the consumer becomes less sensitive to the price of the good in question because their default position is to buy the same products at regular intervals.

the higher is the price elasticity of demand for Wi-Fi connections – often a customer can take their pick of several coffee stores each offering the service. At present airports and hotels can charge high prices because in many cases a Wi-Fi service provider has exclusivity in that location. in places. © Tutor2u Limited www. Demand curves with different price elasticity of demand Relatively Inelastic Demand Price Price Relatively Elastic Demand P2 P2 P1 P1 P3 P3 Demand Demand Q2 Q1 Q3 Q2 Q1 Q3 Elasticity of demand and total revenue for a producer The relationship between elasticity of demand and a firm‘s total revenue is a very important one. high hourly charges. The more Wi-Fi providers there are in the market-place. However the price of connecting to the internet through Wi-Fi services is set to fall as competition in the heats up. but users often complain about the high price of accessing the internet. demand is often inelastic.demand tends to be price inelastic at peak times and more elastic at off-peak times. But specific brands of petrol or beef are likely to be more elastic following a price change. But demand is being held back by the limited availability of services and. However the supply of Wi-Fi services is more competitive on the high street and prices are falling as restaurants..net .tutor2u. Nearly all new laptops now come with wi-fi connections and many public areas are being equipped with hotspots. The breadth of definition of a good or service – if a good is broadly defined. i.43 - 7. coffee shops and fast-food outlets are using low-priced or free Wi-Fi access as a means of attracting customers. Mini Case Study – Wi-Fi and Price Elasticity of demand From airports to hotels to conference centres. the demand for petrol or meat. From inter-city rail services to sports stadiums and libraries. Peak and off-peak demand . more people are demanding wireless internet connections for personal and business use.e. 8.

25) When demand is elastic – a fall in price leads to a rise in total revenue .tutor2u.for example a 10% fall in price might cause demand to expand by only 25% (Ped = +2..44 - Relatively Inelastic Demand Price Price Relatively Elastic Demand P2 P1 P1 P2 Demand Demand Q2 Q1 Q1 Q2 When demand is inelastic – a rise in price leads to a rise in total revenue – for example a 20% rise in price might cause demand to contract by only 5% (Ped = -0. The % change in demand = 13.e.net . In this situation when demand is price elastic.3% following a 20% fall in price – giving a co© Tutor2u Limited www. the total revenue initially increases. quantity demanded and total revenue. a fall in price leads to higher total consumer spending / producer revenue Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit. The % change in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i. As price falls. highly elastic). Price £ per unit 20 18 16 14 12 10 8 6 Quantity Units 200 280 360 440 520 600 680 760 Total Revenue £s 4000 5040 5760 6160 6240 6000 5440 4560 13 9 5 1 -3 -7 -11 Marginal Revenue £s Consider the elasticity of demand of a price change from £20 per unit to £18 per unit. in our example the maximum revenue occurs at a price of £12 per unit when 520 units are sold giving total revenue of £6240.5) The table below gives an example of the relationships between prices.

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efficient of elasticity of – 0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a reduction in total revenue. Change in the market Ped is inelastic and a firm raises its price. Ped is elastic and a firm lowers its price. Ped is elastic and a firm raises price. Ped is -1.5 and the firm raises price by 4% Ped is -0.4 and the firm raises price by 30% Ped is -0.2 and the firm lowers price by 20% Ped is -4.0 and the firm lowers price by 15% Elasticity of demand and indirect taxation Many products are subject to indirect taxes. Good examples include the excise duty on cigarettes (cigarette taxes in the UK are among the highest in Europe) alcohol and fuels. Here we consider the effects of indirect taxes on a producers costs and the importance of price elasticity of demand in determining the effects of a tax on market price and quantity.
A Tax When Demand is Price Elastic Most of the tax is paid by producer
Price S + Tax Price

What happens to total revenue? Total revenue increases Total revenue increases Total revenue decreases Total revenue decreases Total revenue increases Total revenue decreases Total revenue increases

A Tax when Demand is Price Inelastic Most of the tax is paid by the consumer
S + Tax

S1 S1

P2 P1

P2

D1

P1

D1 Q2 Q1 Quantity Q2 Q1 Quantity

A tax increases the costs of a business causing an inward shift in supply. The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier may be able to pass on some or all of this tax to the consumer by raising price. This is known as shifting the burden of the tax and this depends on the elasticity of demand and supply.

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Consider the two charts above. In the left hand diagram, the demand curve is drawn as price elastic. The producer must absorb the majority of the tax itself (i.e. accept a lower profit margin on each unit sold). When demand is elastic, the effect of a tax is still to raise the price – but we see a bigger fall in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand. In the right hand diagram, demand is drawn as price inelastic (i.e. Ped <1 over most of the range of this demand curve) and therefore the producer is able to pass on most of the tax to the consumer through a higher price without losing too much in the way of sales. The price rises from P1 to P2 – but a large rise in price leads only to a small contraction in demand from Q1 to Q2. The usefulness of price elasticity for producers Firms can use PED estimates to predict: The effect of a change in price on the total revenue & expenditure on a product. The likely price volatility in a market following changes in supply – this is important for commodity producers who may suffer big price movements from time to time. The effect of a change in an indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer. Information on the PED can be used by a business as part of a policy of price discrimination (also known as ‗yield management‘). This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many of our domestic and international airlines. Habitual spending on cigarettes remains high but sales are falling Sales of cigarettes are falling by the impact of higher taxes mean that smokers must spend more to finance their habits according to new research from the market analyst Mintel. Total sales of individual sticks for the UK in 2006 were 68 billion, eleven billion lower than in 2001. Over a quarter of cigarettes are brought into the UK either duty free or through the black market. In the past, increases in the real value of duty (taxation) on cigarettes has had had little effect on demand from smokers because demand has been inelastic. There are signs that a tipping point may have been reached. Sales of nicotine replacement therapies such as patches, lozenges and gums have boomed by nearly 50% over the past five years to around £97 million. But for every £1 spent on nicotine replacement, over £130 is spent on cigarette sticks. Nearly half of smokers tried to kick the habit last year. According to the Mintel research, smokers under the age of 34 are the most likely to stop smoking, with people aged 65 and over the least likely to try quitting. A ban on smoking in public places comes into force in England, Northern Ireland and Wales in the spring of 2007, the same ban became law in Scotland in March 2006. Sources: Adapted from Press Association reports, March 2007 Price elasticity of demand and changing market prices The price elasticity of demand will influence the effects of shifts in supply on the equilibrium price and quantity in a market. This is illustrated in the next two diagrams. In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward shift of supply – which leads to a large rise in equilibrium price and quantity and only a relatively small change in the market price. In the right hand diagram, a similar increase in supply is drawn together with an inelastic demand curve. Here the effect is more on the price. There is a sharp fall in the price and only a relatively small expansion in the equilibrium quantity.

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An outward shift of supply when demand is price elastic (Ped > 1)
Price S1 Price

An outward shift of supply when demand is price inelastic (Ped < 1)
S1

S2

S2

P1 P2 D1

P1

P2

D1 Q1 Q2 Quantity Q1 Q2 Quantity

Mini Case Study: Airlines to cut supply of seats to force fare prices up Faced with a looming financial disaster, the U.S. airline industry is turning to basic economics principles for its salvation: supply and demand. The airlines are hoping that major cut-backs in their flying schedules will allow them to create a scarcity of seats sufficient to drive up the average price of an airline ticket, particularly on domestic routes. The Air Transport Association predicts that U.S. airlines will spend $61 billion on jet fuel in 2008, up $20 billion from last year. But will airlines be able to increase fares enough to cover their additional fuel costs? Nine of the 10 major carriers have announced reductions in their domestic systems, ranging from fairly small – a 5 percent cutback at Air Tran Airways – to rather significant – 13.5 per cent to 14.5 per cent by United Airlines Inc. American, the world's largest airline, is planning to cut its domestic capacity by 12 per cent. So far, airlines are still filling their airplanes as they push out fare increases. According to the Air Transport Association, the average passenger paid 15.42 cents per mile for a ticket in May, up 6.8 percent from May 2007. Through the first five months of 2008, fares were up 6.7 percent. But there are fears that, as prices climb higher, the needle will move as consumers look to fly less frequently or search longer for better deals on fares. Source: Adapted from news reports June 2008 Suggested reading on price elasticity of demand Each of these articles relates to stories in the news where prices have changed and where we might expect a change in demand. In each case consider the likely price elasticity of demand. ASDA starts selling 2p sausage (BBC news, June 2008) BA raises fuel fees for premium seats (BBC news, June 2008) Budget car parking charges in London (BBC news, June 2008) Microsoft cuts European X-box price (BBC news, March 2008)

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Petrol price increases - Britain changes its behaviour (Independent, June 2008)

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© Tutor2u Limited www.net . In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before. and also climatic conditions. When Pes = infinity. When Pes < 1. supply is perfectly elastic following a change in demand What factors affect the elasticity of supply? (1) Spare production capacity If there is plenty of spare capacity then a business should be able to increase output without a rise in costs and therefore supply will be elastic in response to a change in demand. firms find it hard to change production in a given time period.supply will be elastic. When Pes = 0. dwindling supplies force prices higher because of scarcity in the market. If supply is elastic. when there is plenty of spare labour and capital resources. supply is perfectly inelastic 4. When Pes > 1. The formula for price elasticity of supply is: Percentage change in quantity supplied divided by the percentage change in price 1. (4) Time period involved in the production process Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. The supply of goods and services is most elastic in a recession.. (2) Stocks of finished products and components If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand . then supply is price inelastic 3. Conversely when stocks are low. which affect the production yield. A good example might be a printing press which can switch easily between printing magazines and greetings cards. producers can increase output without a rise in cost or a time delay If supply is inelastic.tutor2u. (3) The ease and cost of factor substitution If both capital and labour resources are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily and quickly be switched.49 - Price Elasticity of Supply Price elasticity of supply measures the relationship between change in quantity supplied and a change in price. then supply is price elastic 2.

50 - An empty restaurant – plenty of spare capacity to meet any rise in demand! When networks get congested at peak times. elasticity of supply becomes low Stocks in a warehouse – businesses with plentiful stocks can supply quickly and easily onto the market when demand changes For many agricultural products there are time lags in the production process which means that elasticity of supply is very low in the immediate or momentary time period If Pes is inelastic: it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic – supply can react quickly to changes in price Price Perfectly elastic supply Price An elastic supply curve P1 S S D1 Q1 Q2 D2 D1 D2 Q2 Quantity Quantity Q1 © Tutor2u Limited www.net .tutor2u..

. June 2008) © Tutor2u Limited www.51 - Perfectly inelastic supply: Pes = zero (supply cannot respond to a change in demand / price) – often associated with the momentary period with agricultural products Price Perfectly inelastic supply Price Inelastic Supply Curve P2 P1 D1 D2 D1 Q1 Q1 Q2 D2 Quantity Quantity The non-linear supply curve Price P5 Pes < 1 P4 Supply D5 P3 P2 P1 D3 Pes > 1 D2 D1 D4 Q1 Q2 Q3 Q4 Q5 Quantity Suggestions for further reading on price elasticity of supply French change rules to exploit the huge bucks to be made from fizz (Guardian. March 2008) Oil and Food Prices Expected to Ease Only Moderately (IMF report.tutor2u. July 2008) Oil summit calls for supply boost (BBC news.net .

.tutor2u.52 - Whisky industry booms as Asia cries for more (The Times. June 2008) © Tutor2u Limited www.net .

Demand is rising less than proportionately to income. vegetables and frozen foods. low-priced own label foods in supermarkets and the demand for council-owned properties. The formula for calculating income elasticity is: % change in demand divided by the % change in income Normal Goods Normal goods have a positive income elasticity of demand so as consumers‘ income rises more is demanded at each price i.4. The income elasticity of demand is usually strongly positive for Fine wines and spirits.. There is a general downward trend in the income elasticity of demand for many products. Normal necessities have an income elasticity of demand of between 0 and +1 for example. there are changes in tastes and preferences.25. Lindt) and luxury holidays overseas. if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.e. However the income elasticity of demand varies within a product range. Examples include the demand for cigarettes. Consumer durables . 3G mobile phones and designer kitchens. In contrast. What might have been considered a luxury good several years ago might now be regarded as a necessity? How many of you regard a Sky sports subscription as a pure necessity? © Tutor2u Limited www. there is an outward shift of the demand curve 1.53 - Income Elasticity of Demand Income elasticity of demand measures the relationship between a change in quantity demanded for good X and a change in real income. Beer and takeaway pizza! Income elasticity of demand is negative (inferior) for cigarettes and urban bus services. Mass transport (bus and rail). Inferior Goods Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises. income elasticity of demand is lower for Staple food products such as bread.tutor2u. Product ranges and longer term trends. Luxury goods and services have an income elasticity of demand > +1 i.audio visual equipment. One reason is that as a society becomes richer.net . The income elasticity of demand in this example is +1. high quality chocolates (e.g. Typically inferior goods or services tend to exist where superior goods are available if the consumer has the money to be able to buy it.e. 2. For example the Yed for own-label foods in supermarkets is less for the high-value ―finest‖ food ranges that most major supermarkets now offer. Sports and leisure facilities (including gym membership and sports clubs). demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise in the demand for restaurant meals. particularly foodstuffs.

How do businesses make use of estimates of income elasticity of demand? Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle on sales.19 0.2 0.gov.45 n/a Income elasticity of demand (Yed) 0.37 All Foods Source: DEFRA www.1 Fruit juices Tea Instant coffee Margarine 0.54 - How high is the income elasticity for fine wines? Income elasticity for baked beans? Likely to be low but positive as beans are a staple food Income elasticity for cigarettes? According to some estimates.19 0.37 -0.17 0.defra.net .55 -0.03 Price elasticity of demand (Ped) n/a -0.45 -0..02 0. cigarettes are inferior goods What of the income elasticity of demand for private executive air travel? The table below shows the estimated price and income elasticity of demand for a selection of foods: Product Share of budget (% of household income) 15.16 -0.g. for margarine) and likewise the own price elasticity of demand for most foodstuffs is also inelastic.uk The income elasticity of demand for most types of food is pretty low – occasionally negative (e. Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the cycle © Tutor2u Limited www.tutor2u.

55 - Since the early 1990s the British economy has enjoyed a run of many years of sustained growth and rising real living standards. bases its winning formula on no-frills stores which stock just 1. For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises. 25% above the previous year's figure.7m. Consumers head to discount retailers The budget food retailer Aldi has reported sales for the last three months up 21% on the same period last year. compared with 25. with only a handful of branded products. Source: Adapted from news reports.000 product lines. But the income elasticity of demand will also affect the pattern of demand over time. Aldi. which promises to save customers £30 on a £100 weekly shop. we can afford to increase our spending on different goods and services. so as incomes rise. including the £1. May 2008) Rolls-Royce and rivals face challenging times (BBC news. the share or proportion of their budget on these products will fall Suggestions for further reading on income elasticity of demand A new love affair with Aldi (The Times. Burberry sales and profits are up The luxury goods company Burberry has reported rising profits despite what it calls "challenging times". By concentrating on so few products.tutor2u. For normal luxury goods . And as we become better off. Clearly what is happening to the relative prices of these products will play a key role in shaping our consumption decisions. Pre-tax profits for the year to the end of March 2008 came in at £195. But in 2008 the economy headed into turbulent territory with reports of a large decline in people‘s real disposable income. the proportion of a consumer‘s income spent on that product will go up.595 Knight bag. as consumers grapple with the rising cost of the weekly shop. But there was also plenty of evidence emerging in the summer of 2008 that luxury retailers were doing well despite mounting economic worries. The slowdown and probable recession will undoubtedly affect the pattern of demand for different goods and services – in general.. June 2008 Income elasticity and the pattern of consumer demand Over time we expect to see our real incomes rise. June 2008) Five signs of the economic storm (BBC news. but buying in large quantities.000 in a traditional supermarket.income elasticity of demand exceeds +1.net . Most are own-brand. producers of goods and services towards the lower end of the price chain will tend to do better as consumers tighten their purse strings and look to make savings. Burberry said its growth had been driven by sales of luxury handbags. June 2008) © Tutor2u Limited www. discounters are able to offer lower prices.

two or more airlines competing with each other on a given route will have to consider how one airline might react to its competitor‘s price change. For example. We are looking here at the effect that changes in relative prices within a market have on the pattern of demand. The cross price elasticity for two substitutes will be positive. Will many consumers switch? Will they have the capacity to meet an expected rise in demand? Will the other firm match a price rise? Will it follow a price fall? Pricing strategies for complementary goods: For example. the higher is the co-efficient of crossprice elasticity of demand. Likewise when there is a strong complementary relationship between two products. sales of traditional music CDs are declining at a steep rate. Unrelated products have a zero cross elasticity. an increase in the price of one good will lead to an increase in demand for the rival product. the cross-price elasticity will be highly negative. pop corn costs pennies to make © Tutor2u Limited www. The CPED for two complements is negative.. The stronger the relationship between two products. With cross elasticity we make a distinction between substitute and complementary products: Substitutes: With substitute goods such as brands of cereal. firms use estimates of cross-price elasticity to predict the effect on the quantity demanded and total revenue of their own product.e. Complements: Complements are in joint demand. Sales of digital music downloads have been soaring with the growth of broadband and falling prices for downloads.56 - Cross Price Elasticity of Demand Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the price of a related good Y. Pricing strategies for substitutes: If a competitor cuts the price of a rival product. popcorn.net . For example. the cross-price elasticity will be strongly positive. soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements. Popcorn has a high mark up i.tutor2u. the iPhone now provides genuine competition for the Blackberry in providing users with ‗push technology‘ to send all emails through to a mobile device. For example with two close substitutes. As a result. But how many Blackberry users will switch? Many have become addicted to their machines! Another good example is the cross price elasticity of demand for music.

When consumers become habitual purchasers of a product. This reduces the size of the substitution effect following a price change and makes demand less sensitive to price. Allotments peaked in popularity in the immediate post-war years as people looked to grow their own food and avoid the effects of rationing.net . Advertising and marketing: In highly competitive markets where brand names carry substantial value. For some movie theatres. But gradually the number of allotments declined as the food availability improved. Relationship between two close complements Price Of Good Y Price of Good B Relationship between two substitutes An increase in the price of good Y leads to a decrease in demand for good X P2 P2 An increase in the price of good B leads to an increase in demand for good A (a substitute) Demand for Good A P1 P1 Demand for Good X Q2 Q1 Quantity Q1 Q2 Quantity Cross elasticity of demand: Food prices and the demand for allotments From Wrexham to Eastbourne the demand for allotment space is rising faster than local councils can supply. The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into the cinema. of a two-for-one cinema ticket offer on the demand for popcorn. drinks and other refreshments can generate as much as 40 per cent of their annual turnover.tutor2u. If firms have a reliable estimate for CPed they can estimate the effect. The result is that firms may be able to charge a higher price. increase their total revenue and achieve higher profits. © Tutor2u Limited www.. real prices fell and the number of supermarkets expanded. By the 1980s using an allotment was widely regarded as the preserve of the ‗Good Life‘ crowd and those in retirement wanting a way to pass the time. say.57 - but sells for more than a pound. the revenue from concessions stalls selling popcorn. the cross price elasticity of demand against rival products will decrease. including attempting to shift out the demand curve for a product (or product range) and also build consumer loyalty to a brand. There are many aims behind this. many businesses spend huge amounts of money every year on persuasive advertising and marketing.

Source: Tutor2u economics blog. the market approach would be to raise the annual rent or perhaps introduce an auction system for allotment land as it becomes available.00 for the whole year depending upon the size of the plot.net . In some towns there are no allotments at all as land has been sold to private property developers by local councils strapped for cash. many councils will want to make more land available. However charging market prices might have equity considerations especially when a large number of people tending their plots are elderly and on low incomes. In Harlow in Essex for example.58 - But now the cumulative effects of rising food prices. July 2008) Oil prices and the demand for scooters (Tutor2u blog.. Looking ahead. June 2008) Price of oil and the demand for camels! (Greg Mankiw‘s blog. If demand is running well ahead of supply. Sadly the supply of plots is inelastic and lengthy waiting lists have remained the method of choice for balancing supply and demand. Councils are legally obliged to provide 15 allotments per 1. May 2008) © Tutor2u Limited www. growing concerns over the environmental impact of food miles and demand for locally-grown organic produce has prompted a fresh wave of demand for scarce allotment space.000 households and under current rules no more than six people are allowed to be waiting for a plot at any one time. One approach has been to divide up allotment space into smaller plots. June 2008) Impact of rising oil prices in India (BBC news. with concessions given for pensioners or those on benefit. Another has been to give beginners smaller areas of land.tutor2u. the cost of renting a plot is typically about £18. July 2008) Oil prices and the demand for new aircraft (Tutor2u blog. July 2008 Suggestions for further reading on cross price elasticity of demand Cross-Price Elasticity: Consumers Respond (Mark Perry‘s Blog. if food prices look like remaining high. June 2008) Falling demand for Chelsea Tractors! (BBC news. for example by turning brown-field land in urban areas back into land that is available for cultivation.

.59 - Functions of the Price Mechanism The invisible hand – the workings of the price mechanism Adam Smith. prices and signals Decline in North Sea fish stocks has led to a large fall in supply and rising prices (but declining revenues for trawler businesses). The high prices of scarce resources such as oil and gas are the market‘s response to huge shifts in supply and demand. This remains the central view of free-market economists who believe in the virtues of an economy with minimal government intervention.ft. The market is right.g. This sends a signal to several stakeholders in the market: Fish consumers Suppliers in competing markets e. So.‖ Source: Adapted from Martin Wolf.tutor2u. The price mechanism plays three important functions in any marketbased system: The signalling function Firstly. Prices rise and fall to reflect scarcities and surpluses. and where they are not.net . He described how the hidden hand of the market operated in a competitive market through the pursuit of self-interest to allocate resources in society‘s best interest. prices perform a signalling function. one of the Founding Fathers of economics once described ―invisible hand of the price mechanism‖. if market prices are rising because of high and rising demand from consumers. farmed fish Manufacturers of equipment for the ocean fishing industry Scarcity and market prices “We are no longer living in an age of abundant resources. The market is saying that we must use more wisely resources that have now become more valuable. for example. This means that prices will adjust to demonstrate where resources are required. Fish stocks. this is a signal to suppliers to expand their production to meet the higher demand. The price mechanism is a term used to describe the means by which the millions of decisions taken each day by consumers and businesses interact to determine the allocation of scarce resources between competing uses.com accessed May 14th 2008 © Tutor2u Limited www. Financial Times www.

then the market supply contracts. consumers are able through their expression of preferences to send information to producers about the changing nature of needs and wants. Total revenue is higher at price P2 and output Q2 Price of Computer Games Price of Digital Cameras In this diagram.e. there is no single body responsible for deciding what is to be produced and in what quantities. the market responds to the individual decisions of millions of consumers and producers. i.. We are assuming here that producers do actually respond to these price signals! One of the features of a free market economy is that decision-making in the market is decentralised in other words.60 - Higher demand signals to producers to step up production – if they are driven by the profit motive. an increase in market supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve Conversely.net . higher market prices act as an incentive to raise output because the supplier stands to make a higher profit. This is a remarkable feature of an organic market system. The transmission of preferences Through the signalling function. When there is a shortage of a product. while consumers will react to the resulting higher price by reducing demand for the good or services. When demand is strong. an increase in supply leads to lower market prices – a signal to consumers that their real income has increased – they can afford to buy more S1 S2 S1 P2 P1 P1 D2 D1 P2 D2 Q1 Q2 Quantity Q1 Q2 Quantity In the example on the right. a rise in the costs of production will induce suppliers to decrease supply. When demand is weak. the price is bid up – leaving only those with sufficient willingness and ability to pay with the effective demand necessary to purchase the product.tutor2u. The rationing function Prices serve to ration scarce resources when demand in a market outstrips supply. Be it the © Tutor2u Limited www.

Market failure occurs when the signalling and incentive functions of the price mechanism fail to operate optimally leading to a loss of economic and social welfare.61 - demand for tickets among England supporters for an Ashes cricket series or the demand for a rare antique. A change in the pattern of demand in the vehicle market Britain's demand for powerful top-end cars is running out of steam. Sales of sports cars have fallen by 15% in the last year and sales of 4x4s are down by nearly 20% over the same period.net . According to a recent survey there are more than 50 © Tutor2u Limited www. General Motors and Ford have both moved to close car plants and plough more resources into producing smaller cars. but also a non-market sector. Instead planning directs resources to where the state thinks there is greatest need. the market price acts a rationing device to equate demand with supply.. how to produce and for whom. Demand is also being affected by a worsening economic climate leading to a decline in real disposable incomes and a dip in consumer confidence. consumers and producers) must respond to appropriate price signals in the market. Prices and incentives Incentives matter enormously in our study of microeconomics. Source: Adapted from news reports. In the UK. In a state run command economy. For competitive markets to work efficiently all ‗economic agents‘ (i. The price mechanism is the only allocative mechanism solving the economic problem in a free market economy. Following the collapse of communism in the late 1980s and early 1990s. vehicle excise duty from 2010 will impose a £950 charge for the most polluting cars. how much to produce. the price mechanism plays little or no active role in the allocation of resources. Our individual preferences may also be distorted and shaped by the effects of persuasive advertising and marketing to create artificial wants and needs. Perhaps the best example is the secondary market in tickets for concerts and sporting-events. the market may fail to take into account the external costs and benefits arising from production and consumption. libraries and health. Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision to buy and consume a product. For example. The pain of higher fuel prices is being compounded by the effects of increasing taxes on vehicles that have a high level of CO2 emissions per kilometre travelled. comprising not only a market sector. The reality is that planning has more or less failed as a means of deciding what to produce. June 2008 Secondary markets Secondary markets occur when buyers and sellers are prepared to use a second market to re-sell items that have already been purchased. The popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market.e. Fleet sales are also down this year. roads and merit goods such as education.tutor2u. where the government (or state) uses the planning mechanism to provide public goods and services such as police. However. the market-based economy is now the dominant system – even though we are increasingly aware of imperfections in the operation of the market. most modern economies are mixed economies.

. Government intervention in the market mechanism Often the incentives that consumers and producers have can be changed by government intervention in markets.tutor2u. © Tutor2u Limited www.62 - online secondary ticket agencies operating in the UK and more than 800 in the US.net . The market is worth hundreds of millions of pounds every year. For example a change in relative prices brought about by the introduction of government subsidies and taxation.

In this case the justification may be a desire to correct for negative externalities.63 - Indirect Taxes An indirect tax increases the relative price of a product and should cause a contraction of demand. The government is intervening in the market because it wants to changes the price signals and incentives of producers and consumers. expand the labour supply and contribute to the country‘s productive potential.net .. The justification could be to encourage more young mothers to actively seek work. Price Price Government Subsidies A subsidy to consumers to cover some of the costs of buying child care or employing nannies is designed to reduce the relative cost of this and therefore increase demand. S + Tax Supply S1 P2 P1 P2 P1 D1 D1 D2 Q2 Q1 Quantity Q1 Q2 Quantity © Tutor2u Limited www.tutor2u.

The “law of unintended consequences” encapsulates the idea that government interventions can often be misguided of have unintended consequences! Suggestions for further reading on the functions of the price mechanism Grain traders buzz as prices soar (BBC news.net . May 2008) © Tutor2u Limited www. June 2008) Struggle for first time buyers (BBC news. September 2007) Slump in the number of new homes (BBC news. April 2008) The invisible hand is shaking (New York Times.tutor2u. March 2008) NHS rationing rife say doctors (BBC news.64 - Agents may not always respond to incentives in the manner in which textbook economics suggests..

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Price Volatility in Markets
We often find that prices in markets rise and fall by large amounts over a short time period. In this chapter we look at some of the causes and consequences of price volatility. Price stability Not all markets experience volatile prices. They tend to be markets with products where the conditions of supply and demand are stable from year to year and where the price elasticity of demand and the elasticity of supply are both high. We can see this in the diagram below. When demand is highly elastic, shifts in the supply curve have little effect on the market equilibrium price, although market quantities will change. In the example below, there is a fall in market supply with conditions of demand remaining unchanged.
Price S2 Price

When supply is highly elastic, shifts in demand again have little impact on the market equilibrium price. In the example below we see the effects of an outward shift in the market demand curve.

S1

P2 P1

P2 P1 D1

S

D1

D2

Q2

Q1

Quantity

Q1

Q2

Quantity

Stable prices The price of milk is pretty stable over time. Partly this is due to intense competition between the leading supermarkets but the conditions of market demand and supply are also relatively stable and predictable. The recent increase in milk prices is the result of sharply rising costs of wholesale milk.

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Average Price of Pasteurised Milk
per pint, measured at current Prices
41 40 39 38 41 40 39 38 37 36 35 34 33 32 31 30 29 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Pence per pint (millions)

37 36 35 34 33 32 31 30 29

Source: Reuters EcoWin

Price volatility Products with unstable conditions of supply and demand will experience price fluctuations from year to year. For example, for many products there are big seasonal variations in demand which cause prices to rise sharply at peak times and then fall back during the off-peak periods. Seasonal demand is particularly strong in the tourism and leisure industries. You will find that the prices of hotel rooms and the prices of package holidays are always higher during the school holidays because hoteliers and travel businesses know that, during peak demand, the demand is price inelastic and families will have to pay higher prices. Agricultural prices and prices of other traded commodities Agricultural prices tend to be volatile (unstable) because: Supply changes from one time period to the next because of variable weather conditions which affect the size of the harvest When supply falls short of planned output, for a given demand, price will rise When actual output is in excess of planned output, for a given level of demand, market price will fall The effects of changes in supply can be amplified by a price-inelastic demand, for raw materials and components where the buyer sees them as essential to their production processes they must buy at whatever the prevailing market price is. Price volatility can be magnified because of the activity of speculators who are betting on future price changes. We have noticed this in many of the world‘s commodity markets during the recent boom in international commodity prices. Hedge funds and
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millions

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pension funds together with other speculators have been buying into ―hard commodities‖ such as copper, nickel, tin and ―softs‖ such as rubber and coffee because they expect market prices to remain high. Their demand has the effect of driving prices higher at times when stocks of these commodities are low. Speculation is also rife in the property market. In 2007, the Spanish government passed a law designed to deter property speculators who the government blamed for spiralling house prices.

Inelastic demand and shifts in supply When the price elasticity of demand is low, volatile shifts in market supply causes large changes in the market equilibrium price, although the equilibrium quantity traded may not change that much.
Price S2 Price

Inelastic supply and demand We then consider shifts in demand when the price elasticity of demand is low. If Ped and Pes are both low then the scene is set for big changes in the market equilibrium price. E.g. a fall in supply from S1 to S2 and an increase in demand from D1 to d2 causes market price to jump from P1 to P4
S2

S1 P4

S1 S3

S3

P2

P2

P1

P1

P3

P3 D2 D Q2 Q1 Quantity Q2 Q1 D1 Quantity

Many economists regard price volatility as a source of market failure. Problems arising from price volatility in markets can include the following: Risk: Makes incomes and profits for producers more unpredictable and may inhibit investment spending because suppliers are concerned about their expected profits (returns). Poverty: Sharp falls in prices and incomes can cause hardship and poverty and also unemployment, especially in regions and countries dependent on cash from exporting. Balance of Payments: Big swings in prices can cause large changes in export revenues for major exporters of primary commodities - affecting their balance of payments and their ability to finance essential imports of food and technology.

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The Surge in World Commodity Prices In recent years we have seen a sharp rise in the prices of many internationally traded commodities such as oil, gas, iron ore, palm oil, rubber, copper and many foodstuffs. There are many factors at work here as this IMF report makes clear: The food price surges since 2006 reflect a confluence of factors. Demand growth has generally outstripped supply growth for many food commodities over the past 10 years or so, particularly for edible oils and major grains—including corn, rice, soybeans, and wheat. Correspondingly, global stocks of these crops have declined to relatively low levels last seen in the mid-1970s over the past several years. The upward pressure on prices has been increased through the effects of unfavourable weather conditions in a number of countries which reduced crop production in 2006-07, particularly wheat. Second, the demand for corn increased sharply in 2006-07 as a result of the sharp increase in corn-based ethanol production. On top of this, the rising oil prices over the past year and a half have added substantial broad cost pressures. In a seller's market, such cost increases are passed on fully to producer prices. Finally, a growing number of countries have imposed export restrictions in response to rising food prices, which added to international price pressures. As usual, these developments not only pushed up the prices of the foods directly affected, but also those of close substitutes. In addition, rising food prices have led to cost pressures elsewhere along the food chain, notably poultry and meats Source: Adapted from an International Monetary Fund report, July 2008 1. Strong GDP growth in emerging market countries including China, India, Brazil, Russia, Indonesia, Vietnam et al (see the Goldman Sachs analysis on the BRICS and N-11) a. The China effect: i. Huge rise in manufacturing output (the workshop of the world) ii. Massive infrastructural spending including preparations for the Olympics iii. Rising per capita incomes – driving demand higher for food especially meat – which then increases the demand for grain (income elasticity of demand relevant here!) b. Many other emerging market countries are booming i. Strong derived demand for fuels e.g. oil and gas ii. High derived demand for materials and components e.g. cement, copper wiring, steel and energy iii. Many have accumulated high trade surpluses and can therefore afford to pay high prices for the imports they need 2. Impact of some extreme weather events cutting supply for a range of commodities a. Australian drought b. Drought in China c. Floods in the UK d. Hurricane Katrina in the USA
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net . a. The IMF believes that speculation plays a part in the explanation for the price boom When explaining the price changes – one useful distinction to make is between Fundamental factors e. Big shifts of scarce resources towards bio-fuels e.g. 1/3rd of US wheat production now goes into meeting demand for bio-fuels – taking supply out of the food chain and causing agflation. urbanisation. Speculative demand for commodities a. globalisation. 6. Previous lack of investment in supply capacity e. speculative activity. The Credit Crunch has amplified this effect with the Fed Reserve slashing interest rates – creating expectations that the dollar will fall further 7.g.g. industrialisation of emerging economies – fuelling increased demand Cyclical factors e.tutor2u. Supply constraints from war and geo-political tensions and the effects of cartel behaviour by energy producers including OPEC 4.. affecting the oil and gas industry 5.g. short term volatility of exchange rates and interest rates The Economist Commodity Price Index Index of Prices 2000=100 325 300 275 250 225 200 175 150 125 100 75 50 00 01 02 03 04 05 06 07 08 325 Industrial Metals 300 275 250 All Commodities 225 200 175 150 Index Food 125 100 75 50 Source: Reuters EcoWin © Tutor2u Limited www. The fall in the external value of the US dollar – most commodities are priced in dollars. strong demand from countries in the boom phase of their economic cycle Short term factors e.69 - 3. Weak stock markets and recession in property is causing hedge funds and other investors to go long on commodities c.g. so a weaker dollar makes them cheaper for consumption. Many soft and hard commodities now seen as an asset class in their own right b.

. A stimulus to the North Sea oil and gas industry and related sectors Mini Case Study: Rice Prices Hit Curry Lovers Devotees of their local curry house should make a point of checking the menu next time they pop out for a hot one. This may be damaging to lower income groups and especially those with little/no wage bargaining power. and Vietnam and Egypt have taken their exports off the market altogether. Thailand and China have deliberately reduced their exports. encourage car manufacturers to invest more in improving fuel efficiency / change the pattern of demand towards smaller cars. Worsening trade deficit: The UK is a net importer of foodstuffs and also now a net importer of oil! A trade deficit is a leakage from the circular flow – causing a slowdown in AD Benefits 1. Will rising food prices contribute to less obesity? Or have the reverse impact? 3. © Tutor2u Limited www. Higher food price inflation (agflation) – perhaps brings an end to the era of cheap food. Costs 1. There is possible damage to export businesses if rising costs worsen competitiveness and the risk of stagflation 5. India and China are concerned that their fast-growing populations and rising incomes which have encouraged a switch in demand towards higher quality rice may leave them with insufficient rice to feed their own people. Boost too for sectors such as renewable energy and if fuel prices remain high this may have important environmental benefits – e.tutor2u. The cost of the fragrant basmati rice . 4.70 - Consequences of the commodity price boom Changes in commodity prices are often called ―external shocks‖ and they have direct and indirect effects on consumers and producers across many different parts of the economy.has almost doubled leaving curry houses with little choice but to pass some of this onto their customers! It is a mixture of supply and demand-side factors help explain the steep increase in world prices. More expensive commodities may accelerate trend towards outsourcing production to lower cost countries and it also makes it more costly to transport products around the world. (That said.one of the most popular in the UK . Higher input costs for businesses: Hits profits especially if manufacturers cannot pass on to final consumers. farming contributes less than 1 per cent of UK GDP!) 2. Rising cost of essential foodstuffs and energy has caused a fall in real incomes and less income available to spend after ‗essentials‘ such as food and utilities This in turn has negatively affected consumer confidence and risks causing an economic recession. 3. but the largest producers such as India.g. 95 per cent of the world's rice is consumed in the country in which it is produced. Higher food prices are good for our farming sector which has suffered from years of declining real prices and real incomes.net . The notes below trace some of the costs and benefits mainly from a UK perspective. Rise in input costs (variable costs) – leading to surge in producer price inflation – now showing through in a rise in consumer price inflation 2.

The rising cost of shipping rice around the world is another reason for the price increases. Bangkok FOB Feb Mar Apr May Jun 08 Jul 300 Source: Reuters EcoWin Global demand for rice has been rising steadily in both advanced and emerging market countries.there are fears about how big price hikes will hit this particular group.Thai Dollars per tonne 1100 1100 1000 1000 900 900 800 800 USD/Ton 700 700 600 600 500 500 400 400 300 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan 07 White 5% Bangkok FOB White 100% 1st-A.000 tonnes of rice every year.71 - The supply-potential of the major rice growing nations has also been affected by a switch in the use of farming land away from food production towards bio-fuels. where rice is becoming an increasingly important food crop. World Rice Prices . And floods and cyclones in Bangladesh have devastated large parts of their rice crop. the impact is serious. Demand for rice in Asia is expected to continue to rise in the future as its population expands even though per capita consumption might decline above a certain income level. According to the International Rice Research Institute: 'China provides an example — rice area decreased by almost 3 million hectares between 1997 and 2006 because of this economic pressure. We are the largest importer of rice in the European Union buying in around 200.. June 2008) Financial Times special reports on the commodity price boom Malnutrition costs economies (BBC news. Source: EconoMax.tutor2u. For people whose dependence on rice as part of their essential diet is high.' Rice fields are also being given over to property developments in countries such as The Philippines and Vietnam. Additional demand is likely to arise from Africa. March 2008 Suggestions for further reading on price volatility Corn prices surge to record high (BBC news. July 2008) © Tutor2u Limited www. Britain is directly affected by big movements in world prices. We also have a sizeable Bangladeshi community whose staple diet is rice .net .

June 2008) Varied harvest adds to grain price volatility (The Scotsman. July 2008) Q&A on rising world food prices (BBC news. July 2008) © Tutor2u Limited www.72 - Oil prices drop in volatile market (BBC news..net . April 2008) Time to intervene in commodities markets (New York Sun.tutor2u.

package holidays for example). The result is a reduction in the real price of flights to short-haul destinations in Europe.tutor2u. Assuming that British tourists can choose to holiday at home or overseas and regard the two products as substitutes. June 2008 © Tutor2u Limited www. The remaining 60% is exported around the world with increasing demand notable from Russia. Saudi Arabia. The UK collects around 15m tonnes of used metal each year and uses only 40% of it. A fall in the price of airline flights increases the market demand for overseas holidays (short city breaks.73 - Inter-relationships between Markets Supply and demand analysis can be used to explain and inter-relationships between different markets and industries. Unintended consequences of market price volatility! The price of scrap metal has been soaring and this has led to a rise in criminal activity! Thieves seem prepared to steal lead from church roofs and railway yards have also been targeted. India and South America. profit margins and leading to the risk of excess capacity in the UK tourist industry.net . The market supply of flights has shifted out to the right as lost cost airlines have entered the market and existing airlines have expanded their route network and fleet capacity. Airline Ticket Prices Price of Domestic Holidays S2 S1 S1 P1 P2 P1 P2 D2 D1 D2 D1 Q1 Q2 Quantity demanded of holidays in the UK Quantity demanded (Million passenger km per year) In the first example we consider an increase in the supply of low-cost flights available from airports across the United Kingdom. Source: Adapted from news reports. then the effect is to reduce the demand for holidays in the UK – putting downward pressure on prices. Thieves can currently get £120 a tonne for steel and between £500 and £600 a tonne for scrap aluminium.. China.

Suggestions for further reading on market inter-relationships © Tutor2u Limited www. the construction of new buildings and many manufactured products. common land and so forth. The most commonly quoted example is that of milk which can be used for cheese. butter and other products. farming. A contraction in supply of lamb will reduce the supply of wool. the demand for labour is derived from the demand for the goods and services that we employ labour to produce. cream. leisure facilities. yoghurts. Composite demand Composite demand exists where goods or services have more than one use so that an increase in the demand for one product leads to a fall in supply of the other. Joint supply Joint supply describes a situation where an increase or decrease in the supply of one good leads to an increase or decrease in supply of another..tutor2u. the demand for steel is strongly linked to the market demand for new cars. residential properties. In factor markets.74 - Consider how rising oil prices can feed through to related markets Increasing demand for crude oil forces up the world market price (P1 – P2 – P3) Crude oil is used as a raw material in producing heating oil for central heating systems – the higher price of crude causes an increase in costs and reduction in the market supply of heating oil at each price level (shown in the right hand diagram) Crude Oil Prices ($ per barrel) P3 P2 P1 P2 P1 D3 D2 D1 D1 Price of Heating Oil S1 S2 S1 Q1 Q2 Q3 Q2 Q1 Quantity demanded Of crude oil (millions of barrels per day) Quantity demanded of heating oil Derived demand The demand for a product X might be strongly linked to the demand for a related product Y. For example an expansion in the volume of beef production will lead to a rising market supply of beef hides. For example.net . Another good example is land – land can be developed in many different ways – for commercial property.

March 2008) © Tutor2u Limited www.tutor2u.75 - Inter-related markets and climate change (Tutor2u blog.net ..

. © Tutor2u Limited www. the market price for the product).net . then the concept of consumer surplus becomes a useful one to look at.tutor2u. Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i. The level of consumer surplus is shown by the area under the demand curve and above the price as in the diagram below. or a measure of the benefits they derive from the exchange of goods. Consumer surplus is the difference between the price that a consumer is prepared to pay and the actual price paid Price Supply Consumer Surplus P1 Equilibrium Point Demand Q1 Quantity Consumer surplus and price elasticity of demand When the demand for a good or service is perfectly elastic.e. consumer surplus is zero because the price that people pay matches precisely the price they are willing to pay.76 - Consumer Surplus When there is a difference between the price that you pay in the market and the value that you place on the product. This is most likely to happen in highly competitive markets where each individual firm is a „price taker‟ in their chosen market and must sell as much as it can at the ruling market price. Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services.

Relatively Inelastic Demand Price Relatively Elastic Demand Supply Supply P1 Demand Demand Q1 Quantity Demanded Q2 Quantity Demanded Changes in demand and consumer surplus Outward Shift in Demand (Higher consumer surplus) Outward Shift in Supply (Higher consumer surplus) S1 S2 Price Price Supply P2 P1 P1 P2 D2 Consumer Surplus D1 Demand Q1 Q2 Quantity Q1 Q2 Quantity When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity.tutor2u. Demand is totally invariant to a price change. Are there any examples of products that have such a low price elasticity of demand? The majority of demand curves are downward sloping. when demand is perfectly inelastic.. In the © Tutor2u Limited www. Whatever the price. there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. the quantity demanded remains the same. When demand is inelastic.77 - In contrast.net . This is shown in the diagram below. consumer surplus is infinite. then the level of consumer surplus will alter. This is shown in the diagrams above.

In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply. his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher. As a result. and exploiting variations in elasticity of demand for different types of passenger service. following an increase in demand from D1 to D2. the price they are willing to pay.‖ Reding said. Sources: Adapted from EU Commission press releases and newspaper reports. ―EU citizens should be free to text across borders without being ripped off. If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products. Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge.5 billion roaming messages sent every year by mobile users in the EU and they cost over 10 times more than the messages they send when at home. The nearer the time to take-off.11. Airlines are expert at practising this form of yield management.British holidaymakers in Spain can pay up to €0. Suggestions for further reading on the concept of consumer surplus Have a look at Price Line and consider whether sites such as this affect your consumer surplus! © Tutor2u Limited www. there is an increase in consumer welfare shown by a rise in consumer surplus. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-flow together with the guarantee of a seat being filled. July 2008 Price discrimination and consumer surplus Producers often take advantage of consumer surplus when setting prices. There is a higher level of consumer surplus because more is being bought at a higher price than before. You will always get a better deal / price with airlines such as EasyJet and Ryan Air if you are prepared to book weeks or months in advance. the equilibrium market price rises to from P1 to P2 and the quantity traded expands. ―Roaming charges have already drained the wallets of mobile customers too much. We shall consider the issue of monopoly in more detail when we come on to our study of markets and industries. EU Telecoms commissioner Viviane Reding has decided that such charges are unjustified and should be capped at €0. a lower price and an increase in the quantity traded in the market.29 in the 27-member EU. extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day.net .tutor2u. thereby turning consumer surplus into extra revenue.63 for a message home. extracting consumer surplus from buyers and increasing profit margins at the same time. the higher the price. down from an average price of €0.. One of the main arguments against firms with monopoly power is that they exploit their monopoly position by raising prices in markets where demand is inelastic. then sellers may engage in price discrimination – the aim of which is to extract from the purchaser. Text calls and consumer welfare The EU Competition Commission is set to cap the cost of mobile phone text messages as complaints rise that consumers are being ripped off. If a businessman is desperate to fly from Newcastle to Paris in 24 hours time. Their research finds that texting across borders carries a big price tag in Europe .78 - left hand diagram.‖ 2.

. June 2008) Most paid nothing for new Radiohead album (BBC news.tutor2u.net .79 - Dartford toll discounts for local residents (BBC news. July 2008) © Tutor2u Limited www. November 2007) Supermarkets fire new shots in price war (Telegraph.

80 - Producer Surplus Producer surplus is a measure of producer welfare. It is measured as the difference between what producers are willing and able to supply a good for and the price they actually receive. The level of producer surplus is shown by the area above the supply curve and below the market price and is illustrated in the diagram above. Producer surplus is the difference between the market price received by the seller and the price they would have been prepared to supply at Price Supply Equilibrium Point P1 Producer Surplus Demand Q1 Quantity Producer surplus and changes in demand and supply We first consider the effects of a change in market supply – for example caused by an improvement in production technology or a fall in the cost of raw materials and components used in the production of a good or service © Tutor2u Limited www.tutor2u..net .

tutor2u. June 2008) © Tutor2u Limited www..net .81 - An outward shift of supply causes a fall in market price and a rise in equilibrium quantity The result is an increase in the total level of producer surplus Price Supply (1) Supply (2) C P1 P2 PS1 D Producer surplus at price P1 = area P1CA Producer surplus at price P2 = area P2DB A Demand B Q1 Q2 Quantity We now consider the effects on producer surplus of a rise in market demand An outward shift in demand causes a rise in both equilibrium price and quantity The result is an increase in the total level of producer surplus Price Supply C P2 P1 PS1 B Producer surplus at price P1 = area P1BA Producer surplus at price P2 = area P2CA Demand (2) Demand (1) A Q1 Q2 Quantity Suggestions for further reading on producer surplus Music firms tune into new deals (BBC news.

net ..tutor2u.82 - Remote oil becoming profitable (BBC news. July 2008) © Tutor2u Limited www.

one month futures price.net . not just for Britain but for the global economy too. The Demand for Oil 1. manufacturing and service industries. China overtook Japan as the world's second-largest consumer of oil five years ago and is closing in on the USA. There is a positive relationship between world GDP and total demand for crude. Rising living standards: Undoubtedly the sustained rise in living standards in many countries that has accompanied a decade or more of globalisation has contributed to increasing demand for energy and other oil-related products. Cyclical demand: When global economic growth is strong. A basic study of the oil market is a useful application of the principles of supply and demand analysis and a way of understanding the interconnections between the microeconomics of the oil market and their macroeconomic consequences. with demand for oil growing by more than ten per cent a year. Fast-growing emerging market countries have provided the bulk of the extra demand for crude in recent years although the world‘s biggest economy – the United States – has also added to total demand. Fluctuating prices have important effects for oil producers/exporters and the many countries that remain dependent on oil as a key input in their energy. the demand for crude oil increases.tutor2u.what determines crude oil prices? West Texas Intermediate Crude Oil US dollars per barrel. Market theory in action . Transport provides an important © Tutor2u Limited www. NYMEX 150 150 125 125 100 100 USD/Barrel 75 75 50 50 25 25 0 00 01 02 03 04 05 06 07 08 0 Source: Reuters EcoWin Oil is one of the most heavily traded commodities in the world. 2.83 - Markets in Action: The Market for Oil The effects of changes in the price of oil traded on the petroleum exchanges can be farreaching..

affecting the demand for heating oil.84 - clue to unparalleled demand for crude oil. the nations that make up the Organisation of Economic Cooperation and Development. 2. External shocks: The effects of production shocks e. the short-run supply of crude oil is affected by a series of different factors 1.tutor2u. If. But a rising share of oil demand is coming from the emerging market economies including China.net . This is because oil is priced in dollars – so overseas investors holding other currencies can buy more barrels of oil as the dollar declines. Speculation involves risk.g. bitumen etc The supply of oil Oil supply can be viewed either in the short-run or in the long-run. Other: lubricants. Russia and India. In short. they will have made a large profit. Prices of substitutes: Demand for crude oil affected by the relative prices of and availability of economically viable oil substitutes.g. © Tutor2u Limited www. OPEC forecast that world demand for oil would grow by 50% between now and 2030 as people in developing countries drive more cars. loss of output from rig closures or disruption of oil supplies due to war and terrorist attacks. Middle Distillates e. In July 2008. power and shipping 6. Supply is a flow concept – what matters for the international oil market is how many barrels of oil per day are being extracted from reserves and how much of that is able to be refined for different uses. 3. Indeed one of the features of the most recent spike in oil prices has been the high level of demand by hedge funds and other investors pouring into the international petroleum exchanges to buy up surplus oil futures contracts. diesel – used in vehicles and other motors/engines and jet fuel 3. Gasoline: used in motor spirit/petrol 2. Heating Oil 5. then the price of crude rises as the USA and Canadian economies raise their demand to fuel household heating systems and workplaces 5.g. Kerosene – cooking/heating 4. Fuel Oil: boiler fuel for industry. Profit motive: The production decisions of OPEC and Non-OPEC countries. 4..e. 3. in the longer term. Derived demand for oil Crude oil is bought not for its own sake (although speculators might disagree) but for its uses including: 1. It is often said that if the winter in North America is fierce. Market speculation: There is always a speculative demand for oil. Brazil. prices can do down as well as up. Spare capacity: The level of spare production capacity in the oil sector. then we might expect to see a shift in demand away from crude oil towards the emerging substitutes. Nearly two thirds of global crude oil production is consumed by the leading industrialised nations – i. The scale of speculative activity has been open to question – some of it has been encouraged by the depreciation in the value of the US dollar. They hope that by the time the contracts are ready to be fulfilled. reliable and relatively cheaper substitutes for oil can be developed. Changes in climate – e. Stocks: The level of crude oil stocks available for immediate supply from the refineries 4.

even though these may not come on stream for some years. When oil prices are high and are expected to stay strong. The interaction between oil demand and supply in the short run Higher oil demand matched against an inelastic short run supply invariably drives prices higher – this is shown in the diagram below. the long run world oil supply is linked to 1. Reserves: Depletion of proven oil reserves – the faster that demand grows.net . An increase in demand causes a fall in stocks at refineries and pushes prices higher. the quicker the expected rate of depletion. finding and exploiting new oil reserves. Exploration: Investment spending on exploring. However there are time lags between a change in price and extra supplies coming on stream. This combination of an inelastic demand and supply helps to explain some of the volatility in world oil prices. Oil Price $ Per barrel Supply Supply P3 P2 P1 D2 D1 P2 P1 D3 D2 D1 D3 Q1 Q2 Oil Output Million barrels per day Q3 Oil Output Million barrels per day OPEC A producer cartel founded in 1960 – now has thirteen members although several other countries are considering becoming members (and Indonesia‘s place in under threat) Controls around 45% of world crude oil output (compared to 55% in the mid 1970s) and just over half of world oil exports © Tutor2u Limited www. Technology: Technological change in oil extraction which affects the costs of extraction and the profitability of extracting and then refining the oil. This acts as a signal to suppliers to expand production. The demand for oil is also price inelastic at least in the short term. Peak oil theory claims that the world has long since past the peak of new discoveries of oil and that most oil producing nations will see a long-term decline in crude oil output in the years ahead.85 - Taking a longer-term perspective.tutor2u. 2.. it makes financial sense to invest in exploring for new reserves. 3.

The producer cartel needs to tread a fine line – too low a price for oil and their balance of payments and fiscal balances suffer especially for those countries highly dependent on oil exports.. Oil is produced in nearly every corner of the world. But if world crude prices stay at super-charged levels for too long.86 - But has a larger share of world crude oil reserves (long run importance?) Controls it‘s own supply through a system of output quotas Many of the OPEC nations have accumulated huge FX reserves as the world price of oil has soared – contributing to the growing power of sovereign welfare funds UK is a net importer of oil.0771M Total World 71. Non-OPEC countries (including the UK and Norway) still account for the largest portion of total supply.net millions . a steady income to producers and a fair return on capital to those investing in the petroleum industry.4823M 80 70 World Production 60 70 60 Barrel/Day (millions) 50 50 40 40 30 OPEC countries 20 30 20 10 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 OPEC countries Total World 10 Source: Reuters EcoWin © Tutor2u Limited www. along with Norway and the USA it is not part of OPEC OPEC's declared mission is to coordinate and unify the petroleum policies of Member Countries and ensure the stabilization of oil markets in order to secure an efficient. This includes Europe. demand will fall away because the economic incentives for finding oil substitutes become increasingly strong. OPEC and World Crude Oil Production Millions of barrels per day 80 OPEC countries 32. where Norwegian oil companies are achieving a rapid increase in extraction and Russia now one of the world‘s largest oil suppliers. economic and regular supply of petroleum to consumers.tutor2u.

The increase in costs causes a profit maximising firm to increase price and reduce the equilibrium level of output. For those industries that use oil as an input into their production process. May 2008) Background reports on the oil industry FT Special Reports on Oil Global oil industry in figures (BBC news. July 2008) What is keeping oil prices so high? (BBC news. July 2008) High fuel prices – good or bad (BBC news. May 2008) Non-Opec oil could peak in two years (Times. then the supplier may choose to pass on some or all of any rise in variable costs to the consumer of the final product. This affects many industries and has direct and indirect effects on consumers. July 2008) Guardian Special Reports on Oil and Petrol Oil reserves – a brief guide (Guardian) Oil institutions © Tutor2u Limited www. For consumers. If demand is price inelastic. higher gas and electricity bills and a reduction in their real incomes. higher oil prices has led directly to more expensive fuel at the pumps. For example.net . Suggestions for reading on the world oil market Here are some suggestions for wider reading. June 2008) India hit by oil price rises (BBC news.tutor2u. then a rising price acts as a supply-side shock – leading to a rise in their variable costs of production. July 2008) The end of the budget airline (Guardian. The oil market is going through a particularly turbulent time at the moment so check out the relevant section of the Tutor2u Economics blog Causation Does OPEC have too much power? (Independent. the world economy has had to come to terms with the prospect that the era of cheap oil is now over. a controversial issue has been the decision by many (although not all) of the airlines to increase their fuel surcharges to customers. in the last few years. The super-spike in world oil prices in 2008 has increased the risk of stagflation and the chances of a recession in the world economy. June 2008) Economic effects of high oil prices A380 'to benefit from oil prices' (BBC news. The extent to which a business is able to pass on an increase in costs depends on the price elasticity of demand for their products. July 2008) Oil is making food prices go up (BBC news.87 - Microeconomic effects of higher oil prices After a long period of low oil prices..

tutor2u.net .88 - Organisation of Petroleum Exporting Countries (OPEC) © Tutor2u Limited www..

stocks of copper have been in decline in the last few years and it is this scarcity that has driven prices higher as commodities traders out-bid each other as they scramble for available supplies.6 .0 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 World Price of Copper .US dollars per tonne 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 USD/Ton 01 02 03 04 Month and Year 05 06 07 08 Source: Reuters EcoWin Discoveries of copper have raised global reserves by less than 1 per cent a year since 1925 but usage has risen at 3. the price of copper has heading higher again climbing towards $9.tutor2u.3 per cent per annum.0 Stocks of Copper . The world supply of and demand for copper Most copper ore is mined or extracted as copper sulfides from open pit mines.8 0. As our chart indicates. Copper – an example of derived demand Because copper is malleable and ductile.89 - Markets in Action: The Market for Copper Copper is a commodity that measures the pulse of the global economy. Much of the steep rise in price has been due to demand-side factors. Over 40 per cent of world supply comes from North and South America. Like most metals the demand for it is derived from the demand for products that use copper as an © Tutor2u Limited www. Chile is far and away the world‘s largest supplier of copper with around 35% of the total. The world price nearly trebled between the start of 2005 and the summer of 2006 and.4 0. after a dip in prices in the early months of 2007.million tonnes 0.000 a tonne in the summer of 2008. Global demand for copper has been rising much faster than the growth in market supply that flow from new discoveries of copper and increased extraction rates of known reserves.0 0.6 0. there is a huge industrial demand for copper..2 0. The World Market for Copper .Stocks and Prices Source: London Metal Exchange 1. India and other emerging market economies.8 Ton (millions) 1.net millions 0.0 0. And demand is growing strongly on the back of phenomenal growth in China.4 0. 31 per cent from Asia and 21 per cent from Europe.2 0.

And higher prices should stimulate an expansion of copper ore production. The effects of rising copper prices The demand for copper will continue to remain strong provided that the global industrial sectors continue to expand production. A typical electric hybrid car might use around 2 times the current usage of copper in extra cabling and windings for electric motors. July 2008) © Tutor2u Limited www. Little surprise that emerging market countries such as China and India are spending billions of dollars from their trade surpluses to secure supply contracts for copper ore from producers such as Peru and Chile. copper can be recycled although the costs of doing so are often high and there are fears concerning the negative externalities arising from the pollution created by trying to recycle used copper. Supply is usually unresponsive to price movements in the short term because of the high fixed costs of developing new extraction plants which involve lengthy leadtimes. The take off in wireless technology and fibre optics will also have an impact. But as with any market. Low elasticity of supply The elasticity of supply of copper is low. For a start. an average new car contains 27. if the price is high enough suppliers will eventually respond! Suggested reading on the world copper market London Metal Exchange New fight for the Congo‘s riches (Guardian..90 - important component or raw material – notably the construction and electrical sectors. And in the medium term new technologies may cause a shift in demand away from copper based products. Plastics provide lower material and installation costs for businesses. If existing copper mining businesses are working close to their current capacity then a rise in world demand will simple lead to a reduction in available stocks. These external costs include atmospheric emissions from recycling plants and waste products dumped into rivers. from the use of copper in integrated circuits to its value as a corrosive resistant material in shipbuilding and as a component of coins.tutor2u. copper mining production has fallen short of expectations. June 2008) Thieves risking lives for copper (BBC news. copper has a huge array of possible industrial uses. From copper wire to copper plumbing. June 2008) Peru's 'copper mountain' in Chinese hands (BBC news. Price theory would predict an increase in demand for scrapped copper and a substitution effect away from copper towards aluminium." There has also been speculative demand for copper as investment funds around the world have started to track commodity prices as an asset class in its own right.6kg of copper.net . And hybrid cars which incorporate electric motors in conjunction with combustion engines could lead to further rises in copper demand. cutlery and to colour glass. In the automobile industry. But if prices remain high then we can expect to see some shifts occurring. In recent years.

net .91 - Zambia targets copper fortune (BBC news.tutor2u. July 2008) © Tutor2u Limited www..

with the bulk of revenues from the coffee trade retained by developed countries. ―The importance of coffee to Ethiopia is difficult to overstate.35. When buyers have significant power and influence over the market price we call this a © Tutor2u Limited www. A coffee „boom‟ in consuming countries with rising sales and profits for coffee retailers. A recent Oxfam research report showed that Ugandan coffee farmers only get about 2.5 percent of the final retail price of their coffee in the UK market.‖ Source: Adapted from the Independent. 95 depend on exports of commodities for at least 50 percent of their total export earnings. The trade generates some 54 per cent of Ethiopia's gross domestic product. October 2006 Experts on the world coffee market often make reference to the ―coffee paradox‖. Coffee is a good example of ―commodity-dependency‖ representing. Coffee farmers in producing countries only obtain a fraction of the final retail price of coffee. notably the coffee roasting companies who buy the raw coffee beans and then process them into coffee-based products. Coffee accounts for no less than 90 per cent of Ethiopia's exports. A widening gap between producer and consumer prices only partly offset by the growing influence of Fair Trade in the coffee industry. declining producer incomes and profits affecting millions of people in some of the world‘s poorest countries. The global market for coffee is characterised by volatile prices and production levels which impacts directly on the incomes and survival of producers. Globally. the place where coffee originated remains one of the poorest on Earth. cappuccino and latte drinkers are bringing huge profits to some of the world's biggest multinationals. The Coffee Paradox ―While espresso. A coffee worker in Ethiopia earns less than half of that in a day.92 - Markets in Action: The Market for Coffee Each day nearly 2. Around the world more than 2 billion cups of the stuff are consumed each day.. Coffee production and developing countries The World Bank estimates that out of the total 141 developing countries. Because the supply-side of the world coffee market is very fragmented – will millions of small-scale producers – much of the power in the market lies with the major buyers.biggest in the world. The country is the largest coffee producer in Africa and the sixth. In Starbucks in south London the cheapest shot of espresso costs £1.tutor2u. for example. It is the 5th most widely traded commodity in the world and millions of people depend directly or indirectly on the production and sale of coffee for their livelihoods. A coffee crisis in producing countries with a trend towards lower real prices. 75% of the total exports of Burundi and 54% in Uganda.net . About 20 to 25 million families produce and sell coffee for their livelihood and most of them are small-scale farmers with limited financial resources and scope to diversify out of coffee production. and about 22% in the case of Honduras. coffee sales each year exceed $70 billion. half of which go to EU countries.5 billion cups of coffee are consumed. but coffee producing countries only capture $5 billion of this value.

08 million bags in 2006 and 118.tutor2u.US cents per lb 110 100 90 80 70 60 50 40 30 Source: Reuters EcoWin Consumption of coffee and price elasticity of demand Coffee consumption worldwide in 2007 was estimated at around 122.. Since then prices have been determined by the market forces of supply and demand.40 in 2002. when the buffer-stock system run by the International Coffee Agreement broke down.30 per lb in 1998 to less than $0. In the last four or five years there has been a recovery in prices – but they remain below the levels seen in the mid 1990s. World Coffee Prices US cents per lb. Demand has been stagnating in many of the richer advanced nations of the world but consumption growth has been stronger in emerging market countries and especially in some of the former eastern Bloc countries most of whom have recently joined the European Union.net . And the danger is that this buying power can force down the price that farmers receive for their products – creating problems of poverty and damaging the chances of sustainable economic development for regions dependent on coffee production.7 million bags . © Tutor2u Limited www. daily closing price 150 140 130 120 150 140 130 120 110 100 90 80 70 60 50 40 30 98 99 00 01 02 03 04 05 06 07 08 Price of Coffee . As the chart below confirms.1 million bags in 2005.93 - monopsony.up from 121. Coffee prices There have been no price controls in the global coffee trade since 1989. over the last ten years coffee prices have been volatile – collapsing from $1.

dominated by four firms: Nestlé. Procter & Gamble and Sara Lee. According to the International Coffee Organisation ―25 million small coffee farmers and their families who produce 90% of the world‘s coffee are particularly affected by fluctuations in market prices and imbalances in supply and demand. Brazil is effectively the ―swing producer‖ for the global coffee markets.94 - The main buyers of raw coffee beans are the largest multinational buyers. suggesting that coffee has a very low price elasticity of demand. Coffee farmers dependent on selling raw coffee beans to buyers at rock-bottom prices were afflicted by deep poverty by falling prices and many opted to maintain their livelihoods by increasing production of cheaper varieties of coffee at the expense of the environment.2004 seemed to have little impact on world demand. changes in Brazil's supplies of coffee account for a large portion of the change in the world total supplies of coffee which then directly affects the prevailing international price. Changes in eating habits and increased demand for alternative drinks to coffee are largely behind this relatively slow growth of global market demand. The International Coffee Organisation (ICO) The International Coffee Organization (ICO) is the main organization for coffee. Coffee consumption has been growing at a steady rate of between 1 and 1. an increase in consumption favouring a gradual rise in world prices would be a positive factor for economic growth and increased per capita incomes in these countries. in other words.. bringing together producing and consuming countries to tackle the challenges facing the world coffee sector through cooperation.‖ The economic and social costs of the coffee price collapse 2000-2004 The slump in global coffee prices in the early years of this decade was caused by overproduction in countries such as Vietnam and Indonesia and the sharp fall in prices had a devastating impact on some of the world's poorest communities and on the environment. © Tutor2u Limited www.tutor2u. In Brazil alone more than a million jobs are generated by the coffee industry.5 % per year. Kraft. a growth rate is well below that for food products as a whole which is closer to 4% per annum. Employment in coffee producing countries Coffee production employs a labour force estimated at around 25 million families by the ICO and accounts for more than 50% of export earnings in many countries. since Brazil is the largest coffee producer. Even the sharp fall in coffee prices during 2000 . Brazil is the world leader in coffee production and consumption. Other coffee growers abandoned their farms to other crops including the drug Chat or to livestock grazing or they chose to chop down forests to grow a cheaper variety of coffee called Robusta that is less environmentally friendly. The sustainability of the industry in many countries was thrown into real doubt.net .

July 2008) Is the domination of Starbucks on the wane? (Independent. Background reading on the coffee market Black Gold – the movie Black Gold film highlights coffee industry (BBC news. October 2006) Tracking the true cost of coffee (BBC worldwide.tutor2u. May 2007 The real price of coffee (Independent. June 2008) The hidden cost of your £2 latte – The Guardian..the currency used to value trade in coffee. March 2007) UK leads Fairtrade shopping revolution as sales hit £560m (Independent.net millions 250 250 . $ million (bottom pane) and world price (top pane) 140 120 USc/Pound 140 120 ICO Coffee Price 100 80 60 40 400 350 300 100 80 60 40 400 350 300 USD (millions) 200 Brazilian coffee export revenues 200 150 100 50 00 01 02 03 04 05 06 07 08 150 100 50 Source: Reuters EcoWin As we can see there is a relationship between the current world price and the value of exports of coffee from nations such as Brazil. July 2008) Starbucks closes over 500 shops (BBC news. the recovery in prices since 2004 has been important in boosting for their export incomes although plateau in the value of coffee exports in 2007-08 is largely due to the fall in the value of the US dollar. June 2007) Fair Trade campaign on coffee prices Film highlights coffee industry – BBC news online. May 2008) © Tutor2u Limited www. Factors such as changes in the exchange rate can influence the income that coffee exporting countries will generate from their overseas sales. June 2007 In search of the perfect cash crop (BBC news.95 - Coffee Prices and value of Exports of Brazilian Coffee Monthly value of exports. But for Brazil.

Real Incomes: As living standards rise. They have the luxury of a wider choice of housing and they should be able to negotiate a price lower than the published price.net . Sellers may require a quick sale and this puts extra bargaining power into the hands of buyers. A rise in mortgage rates increases the cost of financing the loan on the purchase of a property. 5. Mortgage Interest Rates: Since most homes are purchased with a mortgage. incomes will be lower and this limits the number of people who are able to afford properties. 3. so the demand for housing expands. The determination of price levels in local housing markets are great examples of microeconomics in action! Each day there are hundreds and thousands of separate negotiations between buyers and sellers with prices being offered and agreed before a final transaction is made. area or region is high and when there is a shortage of properties then the balance of power in the market shifts towards the seller. Consumer confidence: Consumer confidence is vital for if expectations for the future performance of the economy deteriorate and people become less optimistic about their own financial circumstances.96 - Markets in Action: The UK Housing Market This chapter applies supply and demand concepts to the housing market. Indeed early potential buyers may come straight in with an offer in excess of the asking price in order to avoid the possibility of losing the property that they want. A Sellers Market When demand for properties in a locality. the balance of power switches to buyers. Some of the conditions of demand in the market are as follows: 1.. Economic Growth: When the economy is enjoying sustained growth and rising prosperity. including demand for more expensive properties as people move ―up market.‖ 2. 4. A Buyers Market When there is a glut of properties available on the market (excess supply). they may be tempted to delay entry into the market for property. © Tutor2u Limited www. Unemployment: In areas or regions when unemployment is above the national average. The actual price that the buyer is willing and able to pay. changes in interest rates affect demand for housing. Housing Demand The demand for housing is the quantity of properties that homebuyers are willing and able to buy at a given price in a given time period. The price that is established with each housing transaction in the market depends on The price that the seller is willing to agree for their property. improved confidence raises the number of homebuyers.tutor2u. They can wait for offers on their property to reach (or exceed) their minimum selling price.

5 3. the main alternative is to rent – so a higher cost of renting could lead to an increased demand for owneroccupied homes. Should housing to be regarded as a consumer durable that provides a flow of services to the owner over a long period? Or should we think of a house purchase.0 6.tutor2u. In recent years the boom in house prices in the UK has caused a major affordability problem for millions of people wanting to enter the market for the first time.net .97 - 6. property values are falling sharply in the UK and are forecast to dip by more than 20 percent over the next year or so.UK house price/earnings ratio Monthly data. At the time of writing. Effective demand for housing – property affordability Demand in a market is only effective when potential buyers have the ability to pay.. Consider this question. The decline in effective demand has been an important factor bringing about an end to the boom as first-time-buyers have gradually disappeared from the market.0 5.5 4. Nowhere is this truer than in the property market.5 Ratio of house prices to average earnings 5.0 4. source: Halifax house price index 6.0 Source: Reuters EcoWin Expectations of future price movements and housing demand Expectations of changing prices can have a considerable bearing on the demand for all types of property.5 3. as one of major investments that we expect will provide us with substantial capital gains? The answer is probably a mix of the two! Price elasticity of demand for housing © Tutor2u Limited www. The Price of Substitutes: For people wanting to buy their own home.0 3. Housing Affordability .0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 3.5 5.0 5.0 4. This will help to improve the affordability problem. The ratio of average prices to incomes has climbed higher and made it much more expensive to take out a mortgage.5 4.

98 - Price elasticity of demand (Ped) measures the responsiveness of demand for a product to a change in its own price. If you have set your heart on a particular property. © Tutor2u Limited www. we expect demand to be inelastic. When housing is regarded as a necessity and when there are few close substitutes available.. Price An elastic demand for housing Supply Supply Price An inelastic demand for housing P2 P1 D1 D2 Q1 Quantity Q2 Quantity The price elasticity of demand for a property depends on the availability of close substitutes – for example the supply of rented housing.net . then you will be far less sensitive to the market price and demand will become price inelastic.tutor2u. This may well force up the eventual market price when a transaction is agreed. or are convinced that you need to live in a specific area. perhaps to live within a school catchment area or because you want to be close to friends and family.

Costs of purchasing building components and raw materials. c. Elasticity of Housing Supply © Tutor2u Limited www. average. Government taxation and subsidy of new housing developments (e.g. the conditions of supply include the following: 1. 2. 3. b. Costs of production for construction companies a. The number of construction companies in the market and their business objectives. overtime payments and employer national insurance contributions etc). Costs of purchasing land for housing development. £s 190000 180000 170000 160000 190000 180000 170000 160000 150000 140000 130000 120000 110000 100000 90000 80000 70000 00 01 02 03 04 05 06 07 08 Average property prices £s 150000 140000 130000 120000 110000 100000 90000 80000 70000 Source: Reuters EcoWin Housing Supply The housing supply is the total flow of properties available at a given price in a given time period. The supply will be a mix of newly-built housing and older properties.. Costs associated with achieving planning consent from local authorities. 4.99 - UK House Prices (Nationwide Index) All properties. grant aid and other forms of state funding for housing developers building properties for key workers and financial support for other forms of social housing).tutor2u. Employment costs (including wages.net . d. The extent to which the construction industry is able to achieve economies of scale in house building and reduce their constructions costs by implementing innovation in building projects. For new housing.

tutor2u. 2." Source: Adapted from the House Builders’ Federation web site © Tutor2u Limited www. we have a serious problem. So for example a 15 per cent rise in price may lead to only a 3% increase in new housing supply in the first year. One reason is the existence of planning regulations and other constraints on new housing developments. Construction companies cannot suddenly plan and then build thousands of new homes in areas when there is an increase in demand. Elasticity of supply in this case is +0. When the price elasticity of supply of new homes is low. then the quantity of housing available for purchase is not responsive to short term changes in price.000 being built.2 (a low figure). With only 160.000 new homes annually to keep pace with the growth in households. A spokesman for the HBF said: "The country needs 200. Supply is also restricted by the limited availability of skilled labour such as bricklayers and electricians and other factor inputs needed in the construction process. The Need for More Housing Supply Increases in UK house prices are due in part to supply shortages in the market according to the House Builders' Federation (HBF) which revealed that new home building is failing to keep pace with demand.. unemployment and interest rates. This low supply elasticity suggests that rising demand can quickly feed through into higher prices in the market. Several reasons have been put forward for the low price elasticity of supply of housing: 1.net .100 - The supply of new housing tends to be inelastic in the short run which means that house prices are determined almost exclusively by demand factors such as income.

whilst millions of individuals offer their labour services in different jobs. But we start with the most obvious – the wage rate or salary. For example: A rise in the level of consumer demand for a product which means that a business needs to take on more workers (see below on the concept of derived demand) An increase in the productivity of labour which makes using labour more cost efficient than using capital equipment A government employment subsidy which allows a business to employ more workers © Tutor2u Limited www. The curve shifts when there is a change in the conditions of demand in the jobs market.. Wage Rate W3 Contraction of demand W1 Expansion of demand W2 Labour Demand (1) E3 E1 Employment of Labour (E) E2 Shifts in the Demand for Labour The number of people employed at each wage level can change and in the diagram below we see an outward shift of the labour demand curve.101 - Markets in Action: The Labour Market The labour market is a factor market – it provides a means by which employers find the labour they need. labour becomes relatively cheaper than for example using capital inputs. it is more costly to hire extra employees. The Demand for Labour Many factors influence how many people a business is willing and able to take on. When wages are lower. There is usually an inverse relationship between the demand for labour and the wage rate that a business needs to pay as they take on more workers. If the wage rate is high.tutor2u. A fall in the wage rate might thus create a substitution effect and lead to an expansion in labour demand.net .

net . is shedding jobs from the assembly plant to the boardroom as it struggles to respond to falling demand for its vehicles. Many Americans are switching to smaller. plant shut-downs and short term redundancies lead to a reduction in the derived demand for labour.e.have already cut more than 100.tutor2u.000 jobs since 2006. is a derived demand i. Soaring petrol prices and fears of recession have put motorists off buying its pick-up trucks and gas-guzzling 4x4s. Wage Rate W1 Labour Demand (2) Labour Demand (1) E1 E2 Employment of Labour (E) Labour as a Derived Demand The demand for all factor inputs. including labour. more fuel-efficient cars. business profits are falling and many employers cannot afford to keep on their payrolls as many workers. which tend to be a speciality of Asian motor manufacturers. we expect to see a rise in the aggregate demand for labour providing that the rise in output is greater than the increase in labour productivity. © Tutor2u Limited www. In a recession. The result is often labour redundancies and an overall decline in the demand for labour at each wage rate.102 - The labour demand curve would shift inwards during an economic slowdown / recession when sales of goods and services are in decline. General Motors has announced a two-year pay freeze and a programme of voluntary redundancies as it looks to reduce labour costs. General Motors.. during a recession or a slowdown. the demand depends on the demand for the products they produce. When the economy is expanding. the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production. Here is a good example of the derived demand in the jobs market: Car-maker cuts jobs as sales fall The biggest car-maker in the United States. GM and its rivals Ford and Chrysler . In contrast. business failures.

June 2008 The construction industry is another example of the derived demand for labour. © Tutor2u Limited www. output and employment. But the turnaround in the housing market is likely to lead to thousands of job losses during 2008 and 2009 as the market demand for workers in housing construction has shifted inwards. a firm that sells a product where final demand is inelastic will be better placed to pass on higher costs to consumers. The demand for labour may therefore be more elastic as a consequence. In many service jobs such as customer service centres or gas boiler repairs.. The elasticity of demand for labour depends on these factors: 1.103 - Source: adapted from news reports. then the demand for labour will be more inelastic with respect to the wage rate.tutor2u. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs. Labour costs as a % of total costs: When labour expenses are a high proportion of total costs. labour costs are a high proportion of the total costs of a business.net . In contrast. For example it might be fairly easy and cheap to replace security guards with cameras but a hotel would find it almost impossible to replace hotel cleaning staff with machinery! 3. Elasticity of Demand for Labour Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the ruling market wage rate. When specialised labour or capital is needed. then labour demand is more elastic than a business where fixed costs of capital are the dominant business expense. they may have little market power to pass on higher wage costs to consumers through a higher price. 2. The price elasticity of demand for the final output produced by a business: If a firm is operating in a highly competitive market where final demand for the product is price elastic. The decade long property boom in the UK has led to rising prices.

net . such as housewives or the unemployed.. as wages rise.g. This is because. The labour supply curve for any industry or occupation will be upward sloping.tutor2u. a 10% fall in the wage rate might only lead to a 4% expansion of labour demand W1 W2 Labour Demand (2) Labour Demand (1) E1 E2 E3 Employment of Labour (E) Labour Supply The labour supply refers to the total number of hours that labour is willing and able to supply at a given wage rate. -0.4 i. © Tutor2u Limited www. They may have moved from other industries or they may not have previously held a job.e.104 - Wage Rate Labour demand (2) is more elastic – perhaps because the employer can easily switch to capital inputs as a means of producing an output if wage rates were to increase Labour demand (1) is relatively inelastic – e. other workers enter this industry attracted by the incentive of higher rewards. The extent to which a rise in the prevailing wage or salary in an occupation leads to an expansion in the supply of labour depends on the elasticity of labour supply. It can also be defined as the number of workers willing and able to work in a particular job or industry for a given wage.

employer-provided in-work training.tutor2u.net . through the introduction of minimum entry requirements or other legal barriers to entry) can restrict labour supply and force average pay and salary levels higher – this is particularly the case in professions such as legal services and medicine where there are strict ―entry criteria‖ to the professions. 5. Improvements in the occupational mobility of labour: For example if more people are trained with the necessary skills required to work in a particular occupation. Non-monetary characteristics of specific jobs – include factors such as the level of risk associated with different jobs. 4. opportunities for promotion and the chance to live and work overseas. Overtime: Opportunities to boost earnings come through overtime payments. productivityrelated pay schemes. So for example an increase in the relative earnings available to trained plumbers and electricians may cause some people to switch their jobs.g. 6. 3. The real wage rate on offer in the industry itself – higher wages raise the prospect of increased factor rewards and should boost the number of people willing and able to work 2. and share option schemes. the requirement to work anti-social hours or the nonpecuniary benefits that certain jobs provide including job security.105 - The Labour Supply Curve The supply curve for labour shows the number of workers willing and able to enter an industry or occupation different wage levels Wage Rate Labour Supply Wage Rate Shifts in the Labour Supply Curve LS1 LS2 W2 W1 W3 D2 D1 W1 E3 E1 E2 Employment E1 E2 Employment Key factors affecting labour supply The supply of labour to a particular occupation is influenced by a range of factors: 1. Substitute occupations: The real wage rate on offer in competing jobs is another factor because this affects the wage and earnings differential that exists between two or more occupations. © Tutor2u Limited www. Barriers to entry: Artificial limits to an industry‘s labour supply (e..

Equilibrium wages The equilibrium price of labour (market wage rate) in a given market is determined by the interaction of the supply and demand for labour.in a competitive labour market equilibrium. 7. Employees are hired up to the point where the extra cost of hiring an employee (their wage) is equal to the addition to sales revenue from hiring them. 2. Real Wage Rate Real Wage Rate Labour Supply Labour Supply W3 W1 W2 W1 D3 D1 D2 D1 E1 Employment E2 E1 E3 Employment Wage differentials in the economy There is a wide gulf in pay and earnings rates between different occupations in the UK labour market. or to meet the seasonal demand for workers in agriculture and the construction industry. Some of the relevant factors are listed below 1. working in poor conditions and having to work unsocial hours. A rising flow of people seeking work in the UK is making labour migration an important factor in determining the supply of labour available to many industries – be it to relieve shortages of skilled labour in the NHS or education.higher pay can often be some reward for risk-taking in certain jobs.. No one factor explains the gulf in pay that exists and persists between occupations and within each sector of the economy. Net migration of labour – the UK is a member of the European Union single market that enshrines free movement of labour as one of its guiding principles. wage differentials compensate workers for (opportunity and direct) costs of human capital © Tutor2u Limited www. their MRP.net .106 - employer-provided or subsidised health and leisure facilities and other in-work benefits including occupational pension schemes.tutor2u. Compensating wage differentials . Equalising difference and human capital .

protect workers against unfair dismissal and provide a range of other work-related services including support for people claiming compensation for injuries sustained in a job.tutor2u. Employer discrimination is a factor that cannot be ignored despite over twenty years of equal pay legislation in place Real Wage Rate Real Wage Rate W2 Ls Ls W1 Ld Ld E1 Employment E2 Employment Trade Unions Trade unions are organisations of workers that seek through collective bargaining with employers to protect and improve the real incomes of their members. This pushes up pay levels. One reason is that the market demand for skilled labour grows more quickly than the demand for semi-skilled workers. Examples include Amicus.107 - acquisition. Different skill levels . 5.net . provide job security.measured by the current earnings foregone by staying in full or part-time education.unions might exercise their bargaining power to offset the power of an employer in a particular occupation and in doing so achieve a mark-up on wages compared to those on offer to non-union members 6. the Rail and Maritime Union and the National Union of Teachers. Trade unions and their collective bargaining power . There is an opportunity cost in acquiring qualifications . City economists and analysts are often highly paid not least because they can claim annual bonuses based on performance. © Tutor2u Limited www. Highly skilled workers are often in inelastic supply and rising demand forces up the "going wage rate" in an industry.the gap between poorly skilled and highly skilled workers gets wider each year. Top sports stars can command top wages because of their potential to generate extra revenue from ticket sales and merchandising. Unison.workers whose efficiency is highest and ability to generate revenue for a firm should be rewarded with higher pay. 3. Most trade unions in the UK belong to the Trades Union Congress (TUC). Differences in labour productivity and revenue creation .. 4.

In the past this was possible if a union operated a closed shop agreement with an employer – i.tutor2u. a union may simply bid through bi-lateral negotiations with employers to achieve an increase in wages ahead of the rate of inflation so that real wages rise.net . Labour Supply (union controlled) Wage Rate W2 W1 W1 Labour Supply to the Economy Labour Demand Labour Demand E2 E1 Employment E2 E1 Employment Unions might seek to exercise their collective bargaining power with employers to achieve a mark-up on wages compared to those on offer to non-union members. More frequently. where the employer and union agreed that all workers would be a member of a particular union.e.39 million employees in the UK were members of a trade union. a union must have some control over the total labour supply available to an industry. © Tutor2u Limited www. accumulation of human capital Protection of pension rights for union members A counter-balance to possible power of employers in the labour market Trade Union membership There has been a large decline in union membership over the last twenty-five years In 2006 an estimated 6. and other improvements to working hours and conditions. workload & health and safety issues Workplace training and education. For this to happen.. the closed shop is now history. Elastic labour demand – union control of labour supply forces wages higher – but employment contracts Labour Supply (union controlled) W3 Inelastic labour demand – unions may be more effective in negotiating higher pay levels and increasing total wage income. However in most sectors.108 - Main roles of trade unions Protecting and improving the real living standards of their members Protecting workers against unfair dismissal (employment rights) Promoting improvements in working conditions.less than half the figure when union membership peaked in 1979.

The effect of net inward migration on the labour supply is shown in the diagram below. or shortages of teachers in certain subjects. Reforms to the system of direct taxation: In the 1980s. Reforms to the benefits system: The emphasis here has changed away from the rather crude idea of cutting the real and relative value of welfare benefits towards encourage people into searching for work. 3. More recently. 4. Increased investment in education and training: This is designed to boost the human capital of the labour force and improve the occupational mobility of the labour force to meet the changing demands of employers across different industries. there is the prospect of an outward shift in a country‘s long run aggregate supply W1 W2 Labour Demand E1 E2 Employment © Tutor2u Limited www. successive governments have tended to focus more on reductions in the lower rates of income tax and tax allowances for lower-paid workers.tutor2u. that lower direct taxes increase the post-tax reward to working and act as an incentive for more people to join the labour supply. A more relaxed approach to labour immigration: Particularly where there are shortages of workers with skills such as consultants and fully trained nurses in the NHS.109 - Government economic policies and the labour supply The main policies designed to increase the supply of labour available to the economy are as follows: 1. The aim is to reduce the disincentive problems created by the unemployment and poverty trap. towards a reliance on tax credits (for example the Working Families Tax Credit) to give parents with children a greater financial incentives to work. Real Wage Rate Labour Supply Labour Supply with migration Strong inflows of labour into the economy can have the effect of increasing the labour supply This puts downward pressure on real wages (for a given level of labour demand) e. through helping to relieve labour shortages in particular industries and occupations If migration provides a boost to the labour supply and to labour productivity.net . 2. The theoretical idea remains broadly the same..g. In 2007 the government announced that the 10% starting rate of income tax would be withdrawn in 2008 and that the basic rate of tax would be cut from 22% to 20%. Thatcherite economics focused on cutting income tax rates particularly at the top end and switching away from direct towards indirect taxation.

110 - UK Employment All aged 16 and over. Joanne Brady.5 29. is unable to work because she loses more in means-tested child tax credits than she gains in income. is among the 28 per cent of parents with children under 18 and an income of less than £15.0 28. You still have to pay your housing.5 27. But for many workers there are disincentives to supply their labour – and these problems often affect people in lowly paid jobs. The Poverty Trap worsens in Scotland The soaring cost of child care is worsening the poverty trap according to a new report commissioned for the save the Children Fund in Scotland. Most of us rely on income from our work to pay for the things we need and higher pay and better conditions should be an incentive perhaps to work some extra hours or search for work in the first place. July 2008 Suggestions for further reading on labour demand and labour supply © Tutor2u Limited www.0 26.5 27.0 25. a single mother of two children from Glasgow.0 26. More than one quarter of Scots parents on low incomes cannot work full time because of the cost of registered childcare which has risen by more than 10 per cent this year across most of the country.5 25.0 25.tutor2u. This is known as the problem of the poverty trap and there is a good example in the mini case study below.5 28. Source: The Times.0 29.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Source: Reuters EcoWin The importance of incentives Incentives are important in affecting the labour supply.0 29.5 Person (millions) 30..5 29.0 27.0 28.0 27. source: Labour Force Survey 30.‖ Ms Brady. 27.5 25.000. ―They take 20 per cent off for each child when you go to work.net millions .0 28.5 26.5 26. seasonally adjusted. travel and lunches and it's just not adequate.

July 2008) Claimants to work for benefits (BBC news. May 2008) Carers need help to get to work (BBC news. December 2007) © Tutor2u Limited www.tutor2u. May 2008) Government Policies toward Work Incentives Back to Beveridge (The Times. July 2008) Rising oil price creating new dive jobs (BBC news. June 2008) Hard Rock wages below the minimum (BBC news. July 2008) Record Premier League wage bill (BBC news. July 2008) New biomass power station will create 500 jobs (BBC news.net . June 2008) UK growth boosted by immigration (BBC news.80 a week (BBC news. July 2008) Wages and Wage Differentials Migrant worker paid £8. July 2008) Farmers fear strawberry shortage (BBC news. July 2008) US bosses shed thousands of jobs (BBC news.500 jobs (BBC news. July 2008) Labour Supply The factors pulling migrant workers home (BBC news.. July 2008) Migrant workers leave the UK (BBC Politics Show. Labour Demand Airline Qantas to cut 1.111 - Each of these articles has been selected because it is relevant to the ideas discussed in this chapter on the demand for and supply of labour in different labour markets and how this can affect wages and employment.

do we achieve productive efficiency?) or could improvements be made in the efficiency with which health services are provided for millions of people? (2) Equity Are people‘s health needs met by health treatments on the basis mainly of clinical need or alternatively based on an ability to pay for health services? Are health outcomes in the UK reasonably equal across localities.To some extent.112 - Markets in Action: Economics of Health Care Who should pay for health care? In 2008 the British National Health Service celebrated its 60th birthday but the future of the NHS as it exists at present always seems to be under question and in the headlines. Doctors are usually self employed or in private practice.net . such as hernias and varicose veins. health care is provided by the mixed economy. In Germany and France the system is funded largely from compulsory contributions made by employers and workers and from voluntary private insurance. Ration care . 2.e. Co-payments . In Canada. Social insurance . the government accounts for nearly three-quarters of health care expenditure. ethnic groups. the government is now committed to giving hospitals much greater autonomy in running their own affairs and in contracting out some health care to the private sector through its foundation hospital system Four of the possible funding options for health care are 1.tutor2u.. regions. 3.A specific tax could be levied to help pay for treatment 4. The lowest share is in the United States where state funding represents less than fifty per cent of total health spending. In most countries. The government sector is most heavily involved in operating hospitals. How much longer can most NHS treatments and other services be provided free at the point of treatment and based on clinical need rather than ability to pay? On average across the leading rich developed countries. age groups and by gender? Or are there © Tutor2u Limited www.Public could be asked to pay into an insurance scheme Equity and Efficiency in Health Care (1) Economic Efficiency Consider first the two main types of efficiency – allocative and productive: Does the health care provided in Britain meet people‘s changing needs and wants (i. the health service is funded mainly through general taxation.e. Although in Britain.Ask patients to contribute towards the cost of non-emergency surgery. do we achieve allocative efficiency?) Is health care provided at the lowest possible cost per treatment (i. this is already done by the National Institute for Clinical Excellence watchdog. NHS tax . Britain and Sweden.

Imperfect information among health care providers and consumers . Externalities arising from health care provision: Health services are normally assumed to be merit goods providing a private benefit for people who consume them and additional external benefits for society as a whole.net . Millions of people are wholly dependent on the NHS for health care– they have no hope of being able to fund private health insurance.tutor2u.113 - unacceptable inequalities in the provision of health care across different sections of the population? The issue of equitable provision of health is an important ongoing issue. But this does not stop many millions of Americans being unable to afford their own health care insurance – this has become a huge political issue in the United States. The NHS will always face the problem of resource scarcity because our ever-growing demand for different types of health care exceeds the available supply. High-risk individuals may find it impossible or extremely expensive to get appropriate medical insurance if the market was the only provider of health care. 4.. it is likely that in the long run. If people were required to pay for more treatments they would often be unable to afford them 5. which remains the world‘s largest spender on health care. The fundamental policy question regarding health care in the UK is this: Should it remain essentially funded by the tax system and provided mainly free at the point of need? In the United States. state provided and state-financed health care goes mainly to the old and families on low incomes. Market Failure in Health Care What might cause market failure in the provision of health services? 1. In rich developed countries. The Labour government is committed to significant increases in real spending on health + share of health in total GDP. Sudden illness or injury may require extensive and expensive medical care for which most people are unlikely to have adequate health care insurance. Inequalities in access to basic health care: There are regional and local differences in the quality and quantity of health care available (media stories are fond of discussing socalled ―postcode prescribing‖). Fundamental Principles of the National Health Service The Fundamental building blocks of the NHS are as follows: Providing a national universal (comprehensive) service © Tutor2u Limited www. The ‗failure‘ of health insurance companies to provide cover for high risk groups is an example of „missing markets‟ – another cause of market failure 3. health care spending on average takes up nearly ten per cent of national income (GDP) and the projections for the years ahead see that figure continuing to rise. There are also huge worries among US companies about the soaring cost of employer-funded health benefit schemes. Indeed the private health insurance market will not provide cover for all groups of people. Most American workers are insured privately through the health insurance schemes run by their employers. 2.Consumers may under-value the longer term private benefits of consuming health care – due to information failure (or ‗patient ignorance‘). several dominant health care providers would emerge raising concerns about increasing market concentration and the opportunities for these firms to exploit their monopoly power. Health providers such as doctors and consultants have more specialised information than consumers – an example here of asymmetric information. Monopoly power among health care suppliers: if there was a wholly free market in providing health care. Lack of adequate health insurance: A second cause of information failure is that it is virtually impossible for people to predict their future health needs.

15 per cent of tax and National Insurance Contributions go to pay for the health service.e. Around 2 per cent of working days each year are lost due to short-term sickness.3 million people employed in the NHS in England alone. while more than 7 per cent of the working age population is unable to work due to long-term sickness or disability costing over £12 billion a year in welfare benefits. Higher GDP/Economic Growth and Standard of Living: If average life expectancy could be increased by five years (i.114 - Health care free at the point of use Medical care is not based on ability to pay but rather on the basis of clinical need Who should pay for the drugs dispensed by the National Health Service? The Economic and Social Importance of Health Care Quality of Life and Poverty: Health and well-being in childhood affect educational attainment with consequences for people throughout their lives. Productivity: Ill health imposes a restriction on the productive potential of the economy. The NHS faces many challenges – these are four of the main ones: (1) Persistent resource crises: Resource problems are the inevitable consequence of underfunding and under-investment in the health service over many years – affecting the quality and quantity of the capital stock available to health providers (2) Hospital waiting lists: There are persistent delays in people receiving appointments to see consultants and delays in receiving emergency treatment (3) Problems in recruiting sufficient well qualified staff which leads to long hours for NHS staff and contributes to wide disparities in the quality of care and range of care from region to region and between local health authorities. (4) Meeting the growing demand for health care: There are growing doubts as to whether the NHS is meeting changing consumer preferences and growing health needs © Tutor2u Limited www. After social security payments. Fundamental Problems Facing the NHS Rarely a day goes by without a health story featuring in the newspapers. Ill health in adulthood is associated with poverty and long periods out of work. There is now solid evidence that improvements in medical care pay off in the long term in terms of healthier and longer lives.. to Japanese levels) then UK real GDP could be between £3 billion and £5 billion a year higher. health is the biggest single component of government expenditure. Employment: The NHS is the largest employer in UK with over 1.net .tutor2u.

this is a consequence of asymmetric information in the market where consumers know more than insurers about their intended future actions Health Care Rationing – An Inevitable Process Health rationing occurs because demand for health care always outweighs supply. even if the government invests higher levels of money into the NHS system permitting an outward shift in the PPF for health care services. there is still an issue of scarcity to resolve even though the total ―output‖ of the NHS can rise as a result. In a free market. for doctors to prescribe more expensive treatment than is necessary in order to increase their profits.net . this. markets match supply and demand by altering price. where they take more risks and therefore require more treatment because they are insured. But opportunity cost is still relevant and scarcity still exists Quantity of Heart Operations The NHS currently rations health resources in a variety of ways (1) Government rationing: Ministers and Parliament decide on the overall size of the NHS budget thus dictating the type and volume of care the NHS can provide © Tutor2u Limited www. In the diagram below. Again. however. Many consumers in the healthcare market take out insurance to help pay for treatment..no amount of resources from the Government funded by taxation could possibly meet all of our demands for health care when the NHS system remains based on the fundamental principle of most health services being free at the point of need. therefore. This is an inefficient use of resources. This form of rationing relies on the simply fact that post-tax incomes are unequal and that those households on relatively low incomes will be the first to be priced out of the market.115 - Asymmetric information in the health care market In the private healthcare market. leads to a problem of moral hazard. There is an incentive. Quantity of all Other Operations C A B An increase in resources available for the NHS or an increase in health service productivity increases the potential to provide health services.tutor2u. Rationing in the NHS is inevitable . doctors know more than patients about healthcare and treatments (asymmetric information).

On average. (3) The increased costs of staffing in the NHS -the NHS is a highly labour intensive industry.net . The costs of pay and other employment costs can take up to sixty per cent of the operating expenses of a hospital. new treatments and new products (e. magnetic-resonance imaging scanners) (2) New drugs including drugs that reduce the ―risk‖ of disease rather than the symptoms of illness – e. Chancellor Brown announced huge increases in real spending on health financed in part by a rise in National Insurance Contributions from 10% to 11% (effectively an increase in direct taxation). cancer and coronary heart disease.tutor2u. The Case for Maintaining a Tax Funded Health Care System The Government is committed to maintaining a National Health Service funded mainly through general taxation. around a quarter of all the health care someone consumes in their lifetime is consumed in the last year of their life.116 - (2) The National Institute for Clinical Excellence (NICE) contributes to rationing decisions by advising the NHS on clinical and economic benefits and costs of certain health care interventions (3) Health authorities and primary care groups allocate money to particular disease/treatment areas. statins to lower cholesterol or anti-hypertensives to reduce the likelihood of strokes. Treatment decisions for individuals are made at the clinical level by health care professionals Key Factors Putting Increased Financial Pressures on the NHS (1) Developments in medical technology and new treatments: The fruits of research and development in health sciences has brought us many new medical procedures (such as transplants)..The cost of health care rises dramatically for older patients and the UK population along with that of many other countries is becoming older as average life expectancy continues to grow (6) Increasing expectations of patients and their families – in part the result of politicians promising to achieve improved health outcomes from extra funding Demographic Change and the NHS The UK population is ageing. Over the next 20 years. (4) Growing health problems including increased incidence of diseases associated with affluence and the health issues following an increase in relative poverty – for example the costs of treating smoking related diseases and the costs of treating illness associated with rising levels of obesity (5) Long term change in age structure of the population . Spending on health varies significantly with age.g. In the March 2002 Budget. The beginning and end of life are the most expensive. the UK population is projected to increase by around 5 million. Just over a third of all spending on hospital and community health services is for people who are over the age of 65. Justifications for having a state funded National health Service The NHS can exploit huge economies of scale and therefore provide health services for millions of people at an efficient cost – these scale economies include the benefits of specialization and significant buying power in the purchasing of drugs from pharmaceutical companies © Tutor2u Limited www.g.g. The medical conditions that account for the majority of the burden of disease in the UK are primarily related to old age – e.

rising prices and the fear of acquiring infections such as MRSA during a stay in hospital. Source: Adapted from news reports. According to polls. In most cases. eye examinations and prescriptions – the principle of user charges could be extended without challenging the fundamental principles upon which the NHS is based Mini Case Study: The Rise of Health Tourism Fed up with lengthy waiting lists. The European Commission is considering plans to open its borders to medical tourists..000 people travelled abroad for treatment in 2007 to places as far as South Africa and South East Asia up from 70. the expansion of choice will focus attention on the performance of the NHS against other health systems on the Continent. Higher income taxpayers are therefore paying more towards the general provision of health care – the NHS is a means towards greater equality of opportunity within society Basing health care treatments on being able to pay might discourage people from seeking important treatments Case for using the market mechanism / charging for some forms of health care What are the arguments for extending the market mechanism to providing health care in the UK? With user charges. the danger of experiencing health care of a lower quality than that available at home has not materialised . households would freely choose their own pattern of consumption and the supply of health care would then adjust to the pattern of preferences and level of demand for different treatments Some economists believe that the price mechanism is a better way of rationing health care than the current arbitrary system of queuing / waiting lists The demand for health treatments would be linked to the private benefit to the patient – so a wider system of charging / private sector provision would lead to a lower demand for non-essential treatments and free up resources for more urgent treatments Some user charges already exist within the NHS such as those for dental treatment. If the proposals are approved. record numbers of British patients are travelling abroad for medical and dental treatment and often taking in a package holiday at the same time! An estimated 100.satisfying the principle of vertical equity. The EU claims that this move will encourage countries to specialise in certain health treatments and benefit from economies of scale. Member nations of the EU spend in total €1. 4 per cent of Europeans had treatment in another country last year .117 - Revenue to fund the NHS is drawn from a millions of taxpayers who pay mainly through a progressive system of direct taxation.000 in 2006.net . allowing citizens of any of the 27 states to seek treatment in a neighbouring country with their home country. Hungary is the most popular destination for dental treatment and Cyprus is popular for cosmetic surgery whilst India is a favoured location for general surgery and scans. March-July 2008 Suggestions for further reading on the economics of health care © Tutor2u Limited www. picking up the bill.000bn (£796bn) annually on healthcare. and at present just 1 per cent is ―across border‖.although health professionals in the UK warn that patients must also consider the costs of after-care and possible complications. The British Government says it will not finance 'health tourism' and will instead prioritize in providing high quality treatments for NHS patients close to home. in certain circumstances.most of whom were people on their holidays.tutor2u.

net . July 2008) A 4 way split on the NHS (BBC news.tutor2u.118 - Does the NHS have a future? (BBC news. July 2008) The National Health Service at 60 (BBC news special) © Tutor2u Limited www..

119 - Background to Supply: Production and Costs In this chapter we consider the background to the theory of supply by considering the concepts of production and productivity and how they relate to the costs that all businesses must face. how long would it take a newly created business delivering sandwiches around a local town to move from the short to the long run? Let us assume that the business starts off with leased premises to make the sandwiches. the output of a business expands when more variable factors of production (e. For example.tutor2u. labour. buy in some more capital equipment and also lease some extra delivery vans – by the time it has done this. In the short run. they can increase production by using more raw materials and by bringing in extra staff as required. But if demand grows. it wont take the business long to perhaps lease another larger building. Production creates the supply that allows our changing needs and wants to be satisfied. In the short run. Production Production refers to the output of goods and services produced by businesses. raw materials and components) are brought into use. The long run for a retail business such as Pret a Manger will be different from the long run for the power generation industry. The long run is when all factors of production are variable – there are no fixed factors! The length of time between the short and the long run will vary from industry to industry. Long run production In the long run. 1. This is usually capital such as machinery and technology.g. it has already moved into the long run! © Tutor2u Limited www.net . 2.. economists create a number of time periods for analysis. two leased vehicles for deliveries and five full-time and parttime staff. To simplify the idea of the production function. Short run production The short run is a period of time when there is at least one fixed factor input. all of the factors of production can change allowing a business to increase the scale of its operations.

Explaining the law of diminishing returns The law of diminishing returns occurs because factors of production such as labour and capital inputs are not perfect substitutes for each other. But productivity is also about other inputs. The government‘s objective is to improve labour and capital productivity in order to improve the supply-side potential of the country. the labour input is assumed to be the only variable factor by a firm. The marginal product is maximized when the 4th worker is employed. a company could increase productivity by investing in new machinery which embodies the latest technological progress. for example. Notice that once marginal product falls below average product we have reached the point where average product is maximized – i. So. Units of Labour Employed 0 1 2 3 4 5 6 7 Total Physical Product (tonnes of wheat) 0 3 10 24 36 40 42 42 Marginal Product (tonnes of wheat) Average Product (tonnes of wheat) 3 5 8 9 8 7 6 3 7 14 12 4 2 0 Diminishing returns occurs when the marginal product of labour starts to fall. then the long run can be a sizeable period of time. a business hires extra units of labour to produce a higher quantity of wheat. This means that resources used in producing one type of product are not as efficient when switched to the production of another good.net . For © Tutor2u Limited www. Thereafter the output from new workers is falling although output continues to rise until the seventh worker is employed.tutor2u.e. Other factor inputs such as capital are assumed to be fixed in supply. Measuring Productivity When economists and government ministers talk about productivity they are referring to how productive labour is. The ―returns‖ to adding more labour to the production process are measured in two ways: Marginal product (MP) Average product (AP) = = Change in total output from adding one extra unit of labour Total output divided by the total units of labour employed In the example below. we have reached the point of productive efficiency. The table below tracks the output that results from each level of employment. extra labour is added to a fixed supply of land when a farming business is harvesting wheat.120 - The point is that for some businesses the long run can be a matter of weeks! Whereas for industries that requires expensive capital equipment which may take months or perhaps years to become available. Productivity and the law of diminishing returns In the example of productivity given below.. In the example above.

(2) Variable Costs Variable costs vary directly with output. Costs of production Costs are expenses faced by a business when producing a good or service. workers employed in producing glass for use in the construction industry may not be as efficient if they have to be re-employed in producing cement or kitchen units. According to the Milk Development Council. Examples of variable costs for a business include the costs of raw materials. for people employed on permanent contracts. We say that factors of production such as labour and capital can be ―occupationally immobile” i.g.tutor2u. In the short run a firm will have fixed and variable costs of production. but with a loss of productivity. A Cheesy Example Cheese makers in the UK are struggling to keep prices down as a shortage of milk affects the dairy industry. Source: Adapted from BBC news online.121 - example. mild cheddar increased by £350 per tonne compared to June last year. The depreciation in the value of capital equipment due to age. Marketing and advertising costs. The costs of staff salaries e. It follows that if a business can achieve higher levels of efficiency. the unit costs will be higher. there may well be a benefit from lower costs and higher profits. Every business faces costs and these must be recouped if a business is to make a profit. July 2007 © Tutor2u Limited www. labour costs and other components used directly in the production process. unsalted butter prices were up £600 per tonne and bulk cream prices rose £390 per tonne.net . Farmers are warning the cost of milk could go up as food prices generally are affected by the bad weather. When productivity is low. they can be switched from one use to another.e. There is normally an inverse relationship between the productivity of the factors of production and the unit costs of production for a business. Interest charges on borrowed money. The costs of purchasing new capital equipment. Many diary farmers are converting their milk to powder and selling it overseas which is also driving up prices. Examples of fixed costs include: Rent paid on buildings and business rates charged by local authorities.. Insurance charges. (1) Fixed Costs These costs do not vary directly with the level of output.

7 1.7 0. the lower will be the fixed cost per unit as the fixed costs are spread over a higher number of units.0 4. ATC = TC divided by output Marginal cost (MC) is the change in total costs from the production of one extra unit of output.0 Average Total Cost (ATC) is the cost per unit of output produced.3 0.6 5.tutor2u.9 2.5 0. The table below gives an example of the short run costs of a firm Output Total Fixed Cost Total Variable Cost Total Cost Average Total Cost Marginal Cost Units TFC (£s) TVC (£s) TC (£s) ATC (£ per unit) MC (£) 0 20 40 60 80 100 120 140 160 180 200 100 100 100 100 100 100 100 100 100 100 100 0 40 60 74 84 90 104 138 188 260 360 100 140 160 174 184 190 204 238 288 360 460 7..5 6 5 4.8 2. if average cost rises as the firm expands.122 - The greater the total volume of units produced.5 3.0 2. Long run costs of production The long run is a period of time in which all factor inputs can be changed. In our example below. a business is assumed to have fixed costs of £30. This is one reason why mass-production can bring down significantly the unit costs for consumers – because the fixed costs are being reduced continuously as output expands.7 1. The firm can therefore alter the scale of production.3 2.7 1.000 per month regardless of the level of output produced. diseconomies of scale are happening.9 1. Output (000s) 0 1 2 3 4 5 6 7 Total Fixed Costs (£000s) 30 30 30 30 30 30 30 30 30 15 10 7.3 Average Fixed Cost (AFC) When we add variable costs into the equation we can see the total costs of a business.0 0. Conversely. The table shows total fixed costs and average fixed costs (calculated by dividing total fixed costs by output).7 2. © Tutor2u Limited www. it is experiencing economies of scale.0 1.net . If the firm experiences a fall in long run average total cost.0 2.3 1.

.123 - Suggestions for further reading on productivity and cost London cabbies seek fair deal on fares (BBC news.net . July 2008) © Tutor2u Limited www.tutor2u.

some are more important than others.9 4. The effect is to reduce the long run average (unit) costs of production.6 4. What are economies of scale? Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. Internal economies of scale (IEoS) Internal economies of scale arise from the growth of the business itself.000 36. These lower costs are an improvement in productive efficiency and can benefit consumers in the form of lower prices.000 100.000 20..000 120.net .000 2.000 50.000 490.5 7.300.500 15.000 65.000 10.0 5.000 280. the effect of economies of scale on unit costs and the effects of economies of scale on prices and competition in markets.5 6.000 2.000 500.tutor2u. Technical economies of scale: © Tutor2u Limited www. Examples include: 1.2 6.124 - Economies and Diseconomies of Scale This chapter focuses on long run costs.000 Total Costs (£s) 8. But they can also give a business a competitive advantage too! Long Run Output (units per month) 1.000 Long Run Average Cost (£s per unit) 8.5 7. Why can you now buy high-performance personal computers for just a few hundred pounds when a similar computer might have cost you over £2000 just a few years ago? Why is it that the average price of digital cameras is falling all the time? The answer is that scale economies have brought down the unit costs of production and feeding through to lower prices for consumers.000 5.6 There are many different types of economy of scale and depending on the particular characteristics of an industry.

Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‗credit worthy‘ and have access to credit facilities. That is. b. 4. Some networks and services have huge potential for economies of scale. Network economies of scale: This is a demand-side economy of scale. trade with all of the existing members or parts of the network. a supermarket chain such as Tesco or Sainsbury can invest in technology that improves stock control. 5.net . extra financial capital) more cheaply through the issue of equities. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets. We can identify networks economies in areas such as online auctions. It might not. 3. Large-scale manufacturers employ specialists to supervise production systems and oversee human resources. Each short run average cost curve assumes a given quantity of © Tutor2u Limited www. Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market. but the resulting benefits may be huge because each new user to the network can then interact. Network economies are best explained by saying that the marginal cost of adding one more user to the network is close to zero. In contrast. The division of labour in mass production of motor vehicles and in manufacturing electronic products is an example. be viable or cost-efficient for a small corner shop to buy this technology.125 - a. The law of increased dimensions. The expansion of ecommerce is a great example of network economies of scale – how many of you are devotees of the EBay web site or Facebook? Illustrating economies of scale – the long run average cost curve The diagram below shows what might happen to the average costs as a business expands from one scale of production to another. Specialization of the workforce: Larger businesses split complex production processes into separate tasks to boost productivity. This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – this is an important scale economy in distribution and transport industries and also in travel and leisure sectors. For example. air transport networks. The major food retailers also have monopsony power when purchasing supplies from farmers and wine growers. The classic examples are the expansion of a common language and a common currency. with favourable rates of borrowing. smaller firms often face higher rates of interest on overdrafts and loans..e. however. 2. as they are more widely used they become more valuable to the business that provides them. Managerial economies of scale: This is a form of division of labour. Businesses quoted on the stock market can normally raise fresh money (i. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. Large-scale businesses can afford to invest in expensive and specialist capital machinery.tutor2u. c.

One such business is TNT logistics. TNT Express Services was established in the UK in 1978. Attention is now focusing on some of the likely rivals to the Royal Mail in the newly competitive market.in excess of 50 million items per year.. Source: TNT investor relations web site © Tutor2u Limited www.600 people in the UK & Ireland and operates more than 3. the market for postal services was opened up to competition thus ending the monopoly of the Royal Mail in the delivery of letters to households and businesses. Economies of scale are the advantages of large scale production that result in lower unit (average) costs (cost per unit) Costs SRAC1 SRAC2 AC1 SRAC3 LRAC AC2 AC3 Q1 Q2 Q3 Output (Q) Exploiting economies of scale – TNT In January 2006. TNT employs 10.net . the scale of production is increasing.126 - capital inputs.tutor2u. The long run average cost curve (drawn as the dotted line below) is derived from the path of these short run average cost curves. As we move from SRAC1 to SRAC2 to SRAC3.500 vehicles from over 70 locations. with an annual turnover in excess of £750 million. TNT Express Services delivers hundreds of thousands of consignments every week . the company has developed its dominant position in the time-sensitive express delivery market through organic growth and.

Likewise..net .workers in large firms may feel a sense of alienation and subsequent loss of morale. Lack of market demand: Market demand may be insufficient for economies of scale to be fully exploited leaving businesses with a lot of spare capacity.127 - Why are economies of scale important for a business such as TNT? What types of economies of scale might the business be able to exploit in the long run? External economies of scale External economies of scale occur within an industry.    Standardization of products: Mass production might lead to a standardization of products – limiting the amount of consumer choice. © Tutor2u Limited www.tutor2u. Diseconomies of scale A firm may eventually experience a rise in average costs caused by diseconomies of scale. Diseconomies of scale a firm may experience relate to: 1. their productivity may fall leading to wastage of factor inputs and higher costs Do economies of scale always improve the welfare of consumers? There are some disadvantages and limitations of economies of scale. Co-operation . a reduction in consumer welfare and a loss of allocative efficiency. Developing monopoly power: Businesses may use economies of scale to build up monopoly power and this might lead to higher prices. Examples of external economies of scale include the development of research and development facilities in local universities that several businesses in an area can benefit from and spending by a local authority on improving the transport network for a local town or city. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly – this links to the concept of the principal-agent problem – how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation? 2. the relocation of component suppliers and other support businesses close to the main centre of manufacturing are also an external cost saving. If they do not consider themselves to be an integral part of the business.

tutor2u. July 2008) How world's biggest ship is delivering our Christmas .128 -  Protecting monopoly power: Economies of scale might be used as a barrier to entry – whereby existing firms can drive prices down if there is a threat of the entry of new suppliers Suggestions for further reading on economies of scale Consoles look to hit their stride (BBC news. July 2008) Salad production on a massive scale (BBC news. March 2008) GM installs world's biggest rooftop solar panels (Guardian. December 2007) Economies of scale in printing (Tutor2u economics blog..net .all the way from China (Guardian) Mobile web reaches critical mass (BBC news. June 2008) © Tutor2u Limited www. July 2008) Cost headache for games developers (BBC news.

No one factor on its own is sufficient to explain the differences in efficiency. productivity isn't everything. © Tutor2u Limited www. together with fewer workers with higher skills (at degree level or above) compared to the United States and fewer workers with intermediate and vocational skills compared to Germany and Japan. encouraging higher demand. by relating the quantity of inputs to output.e. (1) Relatively low rates of capital investment – i. 18% below the US level and 20% below France. research from the London School of Economics has found that output per hour worked in the UK is still about 13% lower than Germany‘s. Britain has one of the highest rates of functional illiteracy among adults. (4) Over-regulation of industry and commerce and a lack of competition – the 1999 McKinsey Report highlighted a lack of competitive pressures in some industries (notably retailing) as a source of inefficiency and low productivity growth. Higher productivity can lead to: (1) Lower average costs: These cost savings might be passed onto consumers in lower prices. This is known as the productivity gap. As the adage goes. (3) Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested to support the long term growth of the business. (5) Economic growth: If the British economy can raise the rate of growth of productivity then the trend growth of national output can pick up.129 - Productivity Productivity is a measure of the efficiency of the labour force measured by output per worker or output per worker hour. (4) Higher wages: Businesses are better able to afford higher wages when their labour force is more efficient. The advantages of higher productivity Productivity is the main determinant of national living standards – it quantifies how an economy uses the resources it has available. the failure of the economy to invest and thereby to raise the stock of physical capital available to the workforce (2) Low rates of spending on research and development – The UK now devotes much less of GDP to research spending than other nations and this impacts on the pace of innovation and the speed with which new technology is incorporated into production (3) Skills of the labour force – there are long-standing concerns about the educational skills of the UK labour force including basic literacy and the quality of job specific training. Some progress has been made in closing the gap but there is still much work to do. but in the long run it‘s almost everything. The productivity gap The level of GDP per worker and GDP per hour worked in the UK is well below that of the United States. France and Germany.tutor2u.. (2) Improved competitiveness and trade performance: Productivity growth and lower unit costs are key determinants of the competitiveness of British firms in global markets. Despite these recent improvements.net . more output and an increase in employment.

greater benefits for the needy or lower taxes.net . during a recession or a slowdown in demand. we could award ourselves 20% higher wages or take a day off and still earn the same. as well as making the best of modern working practices such as lean manufacturing and high performance working. Suggestions for further reading on productivity © Tutor2u Limited www. Part of the problem for manufacturers has been a lack of profits to invest.tutor2u. Productivity growth is highest in industries with greater product market competition . When demand is high and production plants are running close to full capacity. Capital investment plays an important role in productivity growth. full-integrated production plants and good industrial relations are also at the heart of achieving year on year improvements in output per person employed.uk ‗Productivity in Britain continues to lag behind that of our main European competitors.‘ Adapted from research published by House of Lords Economic Affairs Committee. low productivity and low pay.where less productive firms contract and close while new more productive ones open and grow. and the prospect of a poor quality job. The EEF argues that UK firms need to invest in capital equipment and skills and innovation. In contrast. consequently. But the UK has less physical capital per worker than the United States and considerably less than France and Germany. Young people with low skills on the UK labour market are faced with restricted employment opportunities. The strength of demand also affects productivity. Adapted from research published by the Engineering Employers Federation www. The availability of large-scale green-field. Those industries with the most up-to-date capital machinery. then output per worker employed is likely to be rising because factor resources including labour and capital are being used to their full extent. July 2007 Report into low UK productivity by economists at the London School of Economics The persistent productivity gap between the UK and the two big continental European economies can mainly be 'explained' by the fact that they have more capital invested per worker and their workers are more skilled. If the UK could reach French productivity levels. Productivity growth often slows down in a recession. the utilisation of labour and capital falls.org.130 - Skills gap and low profits contribute to poor productivity A recent study from the Engineering Employers Federation finds that fewer firms in Britain take on apprentices. together with advanced managerial skills and highly qualified and well-trained workforces tend to achieve much higher levels of productivity.. One important reason is the large number of workers in Britain who have low skills and. Or we could spend the extra resources on schools and hospitals. Many young people still fail to acquire any adequate level of skill. Many explanations have been offered for these shortfalls. including macroeconomic instability and business uncertainty. and where competitive pressures force existing firms to improve.eef. investment projects are often ditched by managers and skilled workers are in short supply.

June 2007) Closing the UK's productivity gap (Management Issues.131 - Britain clocks up a dismal record on productivity (David Smith. June 2007) © Tutor2u Limited www..tutor2u. Economics UK. July 2007) The Office for National Statistics Guide to Productivity UK productivity during the Blair era (LSE.net . July 2006) Our ill-trained youth will kick Britain out of the economic elite (Liam Halligan. Telegraph. 2004) Britain narrows productivity gap (Guardian.

Thus P2 is not an allocative efficient allocation of resources for this market whereas P1. suppliers were able to restrict output to Q2 and hike the market price up to P2. but there also would be an even greater loss of consumer surplus. Normally the market mechanism is good at allocating these inputs. In the diagram above. the total area of consumer and producer surplus is maximised. We will return to this when we study market failure in more detail.net . If for example. © Tutor2u Limited www. Allocative efficiency Allocative efficiency is concerned with whether the resources we have available are actually used to produce the goods and services that we want and which we place the greatest value on. there are several meanings of the term economic efficiency but they generally relate to how well a market allocates our scarce resources to satisfy consumers.tutor2u. Costs Revenues Consumer Surplus (CS) Supply P2 P1 Producer Surplus (PS) Consumer Surplus (CS) Demand Producer Surplus (PS) Q2 Q1 Output (Q) Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production. the market equilibrium price is deemed to be allocative efficient..132 - Economic Efficiency Efficiency is really about a society making the best or optimal use of our scarce resources to satisfy most wants & needs. Have a look at the next diagram. Confusingly. sellers would gain extra producer surplus by widening their profit margins. but there are occasions when the market can fail. At this point. The condition required for allocative efficiency is that price = marginal cost. Allocative efficiency is reached when no one can be made better off without making someone else worse off. the market is in equilibrium at price P1 and output Q1.

Output of Capital Goods B C2 A C1 X X2 X1 Output of Consumer Goods © Tutor2u Limited www. Have you ever felt ripped off buying sandwiches from a motorway service station? The producer has become better off but someone else (aka the consumer) has become worse off.net .. This has an effect on allocative efficiency for if a monopoly supplier can select a price well above the costs of supply.133 - We will see when we study the economics of monopoly that when businesses have plenty of ‗pricing power‘ in their own markets. In the diagram below. they may opt to increase their profit margins to squeeze some extra profit from consumers (they are turning consumer surplus into producer surplus). the combination of output shown by Point A is allocatively efficient as is the combination shown at point B – but at the output combination X we can increase production of both goods by making fuller use of existing resources or increasing efficiency. consumers will suffer a reduction in their welfare.tutor2u.” This can be illustrated using a production possibility frontier – all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available. Using the production possibility frontier to show allocative efficiency Pareto defined allocative efficiency as a position “where no one could be made better off without making someone else at least as worth off.

the resulting equilibrium throughout the economy will be Pareto-efficient.134 - Innovation as a source of dynamic efficiency Dynamic efficiency is improved when businesses bring to the market goods and services that are innovative and high quality and which offer consumers greater choice. It is achieved when the output is produced at minimum average total cost (ATC) i. The existence of negative and positive externalities means that the private optimum level of consumption or production often differs from the social optimum leading to some form of market failure and a loss of social welfare. A private producer who opts to ignore the negative production externalities might choose to maximise their own profits at point A. Social Efficiency The socially efficient level of output and or consumption occurs when marginal social benefit = marginal social cost. © Tutor2u Limited www.e. when a firm is exploiting the available economies of scale.. Productive efficiency also exists when producers minimise the wastage of resources in their production processes. This divergence between private and social costs of production can lead to market failure. Productive Efficiency Productive efficiency refers to a firm's costs of production.net .e. In the diagram below the socially optimum level of output occurs where the social cost of production (i. If every market in the economy is a competitive free market.tutor2u. At this point we maximise social welfare. the private cost of the producer plus the external costs arising from externality effects) equals demand (a reflection of private benefit from consumption. Dynamic Efficiency Dynamic efficiency occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available.

tutor2u.135 - Costs Revenues Marginal Social Cost Private Marginal Cost (Supply) P2 P1 External Cost Demand = Private Marginal Benefit = Social Marginal Benefit Q2 Q1 Output (Q) © Tutor2u Limited www..net .

g. when the market does actually function but it produces either the wrong quantity of a product or at the wrong price.136 - Introduction to Causes of Market Failure Public and Merit Goods (Missing Markets) Immobility of Factors of Production Lack of competition Root causes of market failure Poverty and Inequality in an economy Information Failure Externalities in production & consumption Market failure occurs whenever markets fail to deliver an efficient allocation of resources and the result is a loss of welfare.net . Markets can generate an ‗unacceptable‘ distribution of income and consequent social exclusion which the government may choose to change © Tutor2u Limited www. Markets can fail for lots of reasons and the main causes of market failure are summarized below: (1) Negative externalities (e.e. we see ―missing markets‖).g.tutor2u.. and partial market failure. Complete and partial market failure One useful distinction is between complete market failure when the market simply does not supply products at all (i. Market failure exists when the competitive outcome of markets is not satisfactory from the point of view of society. the effects of environmental pollution) causing the social cost of production to exceed the private cost (2) Positive externalities (e. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit (3) Imperfect information means merit goods are under-produced while demerit goods are over-produced or over-consumed (4) The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet people‘s needs and wants (5) Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition (6) Factor immobility causes unemployment hence productive inefficiency (7) Equity (fairness) issues.

tutor2u. There are 26 million domestic electricity and 21. supplied mainly by six suppliers. 1.g. The market share of the largest firms. industrial and household consumers. Supplier British Gas PowerGen SSE Npower Scottish Power EDF Energy 22 22 13 16 10 15 Market Shares in Electricity Dec 2002 March 2007 21 19 18 16 12 14 63 12 6 9 5 5 Market Shares in Gas Dec 2002 March 2007 46 13 13 12 9 7 Source: OFGEM The UK energy market is split into three elements.5 million domestic gas customers in Great Britain. The number and the power of buyers of the industry‘s main products.net . © Tutor2u Limited www. Some of the main aspects of market structure are listed below: The number of firms in the market and extent of overseas competition. The nature of production costs in the short and long run e. Suppliers –who sell electricity and gas to commercial. The turnover of customers . by building and maintaining the infrastructure of pipes and cables in the road and in installing meters. Distributors . 2. have you changed your bank account or your mobile phone service provider in the last year? What might stop you doing this? The market for gas and electricity supplies – an oligopoly The market for gas supply in the UK was privatised in 1986 with the market for electricity generation and distribution also transferred to the private sector of the economy a few years later. to what extent do the businesses try to make their products different from those of competing firms? The price and cross price elasticity of demand for different products..137 - Competition and Monopoly in Markets A market structure describes the characteristics of a market which can affect the behaviour of businesses and also influence the outcome in terms of efficiency and the welfare of consumers.this is a measure of the number of consumers who switch suppliers each year and it is affected by the strength of brand loyalty and the effects of marketing.g.responsible for getting energy to users e. For example. Generators .responsible for generating the energy used in homes. offices and factories. the ability of businesses to exploit economies of scale.e. Since then there have been changes in the market share of the leading electricity distribution companies and domestic gas suppliers with the former state monopolies losing much of their dominance over this time. 3. The extent of product differentiation i.

9 11. A working monopoly: A working monopoly is any firm with greater than 25% of the industries' total sales. © Tutor2u Limited www.4 8.8 15. The Royal Mail used to have a statutory monopoly on delivering household mail. In actual fact many people do not switch their suppliers even when they might be able to make savings on their bills. A pure monopolist in an industry is a single seller.9 2.2 92. An oligopolistic industry is characterised by the existence of a few dominant firms. The market share of new entrants into the industry since privatisation is now above 40 per cent for both gas and electricity.3 1.tutor2u. each has market power and which seeks to protect and improves its position over time. The gas and electricity supply industry is an oligopoly since the lion‘s share of the market is taken by the six leading businesses. The industry regulator OFGEM believes that the opening up of the market to competition has worked well over the last fifteen years.1 3.9 75.9 2.3 83. 2.5 94.7 . Gillette has approximately 70% of the global shaving market. But this is now changing fast as the industry has been opened up to fresh competition. 4.3 90. 3.2 31. One reason is that people do not find it easy to get accurate information about what the differences are between these competing suppliers.0 63.138 - The retail market for energy is competitive because all customers are now able to change their gas or electricity supplier. there are many markets where businesses enjoy some degree of monopoly power even if they do not have a twenty-five per cent market share.. It is quite rare for a firm to have a pure monopoly – except when the industry is state-owned and has a legally protected monopoly. In a duopoly. the majority of sales are taken by two dominant firms.net Cumulative market share (%) 31.2 16. But the market is competitive because consumers have a real choice about who will sell them their energy. The UK food retail sector is an oligopoly – shown by these market share figures for June 2008. A good example of this is the market for razors in the UK – one dominated by Gillette and also is Schick (the manufacturers of the Wilkinson Sword brand).2 48. In practice. Market Share (%) Tesco Asda (Wal-Mart) Sainsburys Morrisons (Safeways) Co-operative (Somerfield) Waitrose Aldi Lidl Iceland What is a monopoly? There are several meanings of the term monopoly: 1. How monopolies can develop Monopoly power can come from the successful organic (internal) growth of a business or through mergers and acquisitions (also known as the integration of firms).4 87.

or processes. Vertical Integration This is where a firm integrates with different stages of production e. For example two car manufacturers may decide to merge. Another example came in July 2004 with the merger between Travel Inn and Premier Lodges to form Premier Travel Inn. Advertising and marketing: Developing consumer loyalty by establishing branded products can make successful entry into the market by new firms much more expensive and less successful. inventions. Forward vertical integration occurs when a business merges with another business further forward in the supply chain Backward vertical integration occurs when a firm merges with another business at a previous stage of the supply chain The Internal Expansion of a Business Firms can generate higher sales and increased market share and exploiting possible economies of scale. A good example is the oil industry where many of the leading companies are explorers. German sports goods firm Adidas announced an agreement to buy US rival Reebok for £2. The owners of patents can sell licences to other businesses to produce versions of their patented product – this can often prove to be lucrative. They are generally valid for 17-20 years and give the owner an exclusive right to prevent others from using patented products.. This is internal rather than external growth and therefore tends to be a slower means of expansion contrasted to mergers and acquisitions.tutor2u. or a leading bank successfully takes-over another bank.1bn. Monopolies can then enjoy higher profits in the long run. This is common in markets such as detergents. Barriers to Entry Barriers to entry are the means by which potential competitors are blocked. producers and refiners of crude oil and have their own retail networks for the sale of petrol and diesel and other products. by buying its suppliers or controlling the main retail outlets. confectionery and household goods – it is non-price competition.   Monopoly. market failure and government intervention Should the government intervene to break up or control the monopoly power of firms in market? © Tutor2u Limited www.net . Advertising can also cause an outward shift of the demand curve and also make demand less sensitive to price Brand proliferation: In many industries multi-product firms engaging in brand proliferation can give a false appearance of competition. There are several different types of entry barrier – these are summarised below:  Patents: Patents are legal property rights to prevent the entry of rivals.139 - Horizontal Integration This is where two firms join at the same stage of production in one industry. In August 2005.g. A good recent example in the UK is the merger between the Co-Op and Somerfield to create the 5th biggest food retailer.

consumer sovereignty has been partially replaced by producer sovereignty. Relatively Inelastic Demand Price Price Relatively Elastic Demand P2 Higher profit margin Lower profit margin P2 P1 Demand AC AC P1 Demand Q2 Q1 Q2 Q1 In the diagrams above we contrast a market where demand is price inelastic (i. And higher prices mean that consumers‘ needs and wants are not being satisfied. the level of consumer surplus is high. When demand is inelastic.net .e. raising the possibility that the monopolist can reduce output and raise price above cost thereby operating with a higher profit margin (measured as the difference between price and average cost per unit).140 - The main case against a monopoly is that it can earn higher profits at the expense of allocative efficiency. Ped>1).. © Tutor2u Limited www.e. as the product is being under-consumed. Ped <1) with one where demand is more sensitive to price changes (i. The monopolist will seek to extract a price from consumers that is above the cost of resources used in making the product. The former is associated with a monopoly where consumers have few close substitutes to choose from. Under conditions of monopoly.tutor2u.

.net . 1. Research and Development Spending: Huge corporations enjoying big profits are well placed to fund capital investment and research and development projects. businesses must keep firm control of their costs because otherwise. they may achieve economies of scale – leading to a fall in average costs. there is a loss of allocative efficiency. These inefficiencies can lead to a waste of scarce resources. This results in a transfer of consumer surplus into extra producer surplus. they may be less inclined to spend money on research and improved management. This can lead to gains in dynamic efficiency and social benefits.tutor2u. The positive spill-over effects of research can be seen in more innovation.141 - Price Consumer Surplus (CS) P2 Supply P1 Producer Surplus (PS) Demand Loss of economic welfare from price P2 raised above the market equilibrium price Q2 Q1 Output (Q) If a monopoly reduces output from the equilibrium at Q1 to Q2 then it can sell this at a price P2. Potential Benefits of Monopoly The possible economic benefits of monopoly power suggest that the government and the competition authorities should be careful about intervening directly in markets and try to break up a monopoly. if they believe that they have a protected market. But because price is now about the cost of supplying extra units. This is shown in the diagram by the shaded area which is not transferred to the producer. Exploitation of Economies of Scale: Because monopoly producers often supply on a large scale. Market power can bring advantages both to the firms themselves and also to consumers and these should be included in any evaluation of a particular market or industry. This is particularly the case in industries such as telecommunications and pharmaceuticals. merely lost completely because output is lower than it would otherwise be in a competitive market. When competition is tough. © Tutor2u Limited www. 2. Some economists go further and say that monopolists may be even less efficient because. Higher costs – loss of productive efficiency: Another possible cost of monopoly power is that businesses may allow the lack of real competition to cause a rise in production costs and a loss of productive efficiency. they risk losing market share.

jsp www.142 - 3. Suggestions for further reading on competition and monopoly There are many examples that you can follow in this area – this selection of web links provides a window on some of them and is categorized into a number of areas linked to topics in this chapter: Barriers to entry in markets Barriers to entry – Playboy and the Bunnies (BBC news. The European Competition Authority examines anti-competitive behaviour.ofwat. Another key role for the regulators is to monitor the quality of service provision and improve standards for consumers. September 2006) © Tutor2u Limited www. The Office of Fair Trading reports on allegations of anti-competitive practices including claims of collusive ―price-fixing‖ behaviour. but still face competition in overseas markets. The regulators have used the power to introduce and review price capping and they have also have sought to bring fresh competition into markets. we should be careful not simply to assume that monopoly power is bad and competition is good. Government intervention in markets – an introduction to UK competition policy Competition policy involves the regulation of markets to protect and improve consumer welfare: The Competition Commission – its main concern is to investigate mergers and takeovers to examine if these mergers will have a negative effect on competition.uk/ www.g.uk/ Many markets have firms with monopoly power but they seem to work perfectly well from the point of view of the consumer. A firm may enjoy domestic monopoly power. Competition was introduced into the telecommunications in 1984. Deliberate government policies to open up markets and give new businesses the right to compete e. in Gas from 1996-98 and in Electricity from 1998. A good example was the recent report into the UK supermarket industry. Technological change 2.uk/ofgem/index. mergers and takeovers between European businesses and investigates state aid to struggling businesses to make sure that subsidies do not reduce or distort competition. There are persuasive arguments on both sides.tutor2u.gov.ofgem.gov..org. Although there is a consensus among many economists that competition is a force for good in the long-run. Globalisation – low-cost competition from emerging market economies 3. It also engages in in-depth investigations of markets where there are competition worries. Monopolies and International Competitiveness: The British economy needs multinational companies operating on a scale large enough to compete in global markets. In recent years many markets have become more competitive with the entry of new suppliers and much greater choice for consumers. in the markets for postal services. car retailing and telecommunications – this is called deregulation or liberalisation. Examples include the following: OFGEM: OFWAT: OFCOM: www. Many factors have contributed to this including: 1.net .ofcom. Utility regulators monitor the industries that were privatised during the 1980s and 1990s. October 2006) Murdoch versus the Evening Standard – competition in free newspapers (BBC.

July 2007) Dutch brewers fined over cartel (BBC news. February 2008) Europe burns rubber cartel with £350m fine (Guardian. July 2007) Power companies are ripping off consumers (Times. May 2008) Product sabotage helps consumers (BBC online.tutor2u. Tim Harford.143 - The chewing gum war (BBC Money Programme. February 2007) Gaviscon maker cheated the NHS (Newsnight. March 2008) Have supermarkets become too powerful? (Independent. February 2008) © Tutor2u Limited www. May 2007) China‘s big investment in Peru (BBC news. December 2007) Law broken on pricing by tobacco firms (Guardian. April 2007) EU fines Microsoft record $1. March 2008) Plane weird – the aircraft duopoly (Guardian. June 2008) Price fixing – collusive behaviour BA fined for price fixing (BBC news. April 2008) Monopoly and consumer welfare Airlines fined $504m in US air-cargo price fixing probe (BBC news.. August 2007) Open skies deal comes into effect (BBC news. September 2007) MEP demands city parking inquiry (BBC news. Slate. August 2007) Transatlantic Price War (Money Programme.4bn (BBC news.net . November 2006) Rubber firms fined over condoms (BBC news. June 2008) Economics of hotel mini bars (Tim Harford.

e. the communist government passed a law that protects the property rights of private sector businesses.. And these externalities can be positive and negative.tutor2u. Put another way. © Tutor2u Limited www. Externalities and the importance of property rights Who owns the air we breathe? Who has ownership of the air waves that carry radio signals or wireless networks that allow us to surf the internet? When we study the issue of externalities it doesn‘t take long before we must consider the question of property rights. they affect people not directly involved in the production and/or consumption of a good or service. A really important point to emphasise is that externalities occur outside of the market i. Many types of activity give rise to externalities. For markets to operate efficiently. Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid. if an asset is un-owned.net . Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid. They are also known as spill-over effects. Property rights confer legal control or ownership of a good. undoubtedly a landmark day for the Chinese economy! Failure to protect property rights may lead to what is known as the Tragedy of the Commons examples include the over use of common land and the long-term decline of fish stocks caused by over-fishing which leads to long term permanent damage to the stock of natural resources.144 - Negative Externalities Externalities are common everywhere in everyday life but will the market – left to its own devices take these externalities into account? If not. then market failure can occur and there is a justification for some form of government intervention. no one has an economic incentive to protect it from abuse. property rights must be clearly defined and protected – perhaps through government legislation and regulation. The right to own property is an essential building block of a market-based system and in China in March 2007.

according to a study from experts at York University. This leads to an over-production of the product if producers do not take into account the externalities. A hard core of problem drug abusers is running up a bill of £600 a week each in crime. © Tutor2u Limited www. External costs from consumption Consumption externalities are generated and received in consumption . social costs exceed private cost. accident and emergency admissions and treatment linked to drug abuse.000 problematic drug users in England.. Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit.145 - Smokers ignore the harmful impact of toxic ‗passive smoking‘ on non-smokers Air pollution from road use and traffic congestion and the impact of road fumes on lungs External costs of scraping the seabed for supplies of gravel The external cost of food waste The external costs of cleaning up from litter and the dropping of chewing gum The external costs of the miles that food travels from producer to the final consumer The externalities linked to the oil sands project in the Canadian wilderness Private Costs and Social Costs The existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption.tutor2u.examples include pollution from driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas. External costs from production Production externalities are generated and received in supplying goods and services .net .examples include noise and atmospheric pollution from factories. Social Cost = Private Cost + External Cost = Private Benefit + External Benefit Social Benefit When negative production externalities exist. Last year. Heroin and crack cocaine addicts are costing the country up to £19 billion a year. police and court time. the NHS spent about £235 million on GP services. health care and unemployment benefits. The External Costs of Drug Dependency The latest estimate is that there are more than 327.

© Tutor2u Limited www. Externalities from Alcohol Use and Misuse For most adults drinking alcohol is part of a pleasurable social experience. The rise has been especially sharp in men and women aged fewer than 45. Deaths from liver cirrhosis are rising faster in Britain than anywhere else in Europe. Sources: Adapted from government reports and newspaper reports. In the absence of externalities. their family and friends and to the community as a whole. says the study. we must add the external costs to the firm‘s supply curve to find the social marginal cost curve. But if there are negative externalities.5 million recreational and regular users of Class A drugs.7 billion a year. where death rates now exceed the European average.net . which causes no harm to themselves or others. For some people though. The average cost to society of all Class A drug users is £2.8 billion. Britons are paying the penalty for the soaring rate of alcohol consumption. There are at least 1. July 2008 Illustrating the market failure from negative externalities Costs Revenues Social Marginal Cost Private Marginal Cost (Supply) P2 P1 Negative externalities cause the social cost curve to lie above the private cost curve Demand = Private Marginal Benefit = Social Marginal Benefit External Cost We assume in this example that there are no externalities arising from consumption Q2 Q1 Output (Q) The diagram above shows the effects of negative externalities arising from production on the private and social costs and benefits to producers and consumers. the private marginal costs of the supplier are the same as the costs for society. Ten million adults in England regularly consume more than the government guidelines and the cost to the NHS of alcohol misuse is put at £2.146 - When social costs are added.9 billion and £18. alcohol misuse is causing serious damage to themselves.tutor2u. The key is to understand the difference between private and social costs. the bill rises to between £10.030 each a year..

plastic and metal foil are produced for use in the UK but less than ten per cent are recycled. According to the Department of the Environment. Belgium introduced a similar tax in June 2007. Every year over four billion cartons made of layers of cardboard. or the revenue from higher taxes on cigarettes might be used to fund better health care programmes. ―Taxes send a signal to polluters that our environment is valuable and is worth protecting. The vast majority of these cartons end up in landfill sites as part of a 300 million ton rubbish mountain..net . We have not eliminated the pollution (we cannot do this) – but at least the market has recognised them and priced them into the price of the product. 3. Examples of Environmental Taxes 1. A report from the Institute for Public Policy Research (IPPR) argues for a new tax on these cartons as a way of improving incentives for manufacturers to create less waste and cut the tonnage of waste finding its way into landfill sites. It is designed to cut traffic congestion in inner-London by charging motorists £8 per day to enter the central charging zone. Only two per cent of disposable batteries are recycled – the © Tutor2u Limited www. for example through recycling or composting and to use environmentally friendly methods of waste disposal. Vehicle excise duty (VED): Also known as ‗road tax‘ – VED starts from a theoretical 'nil' rate and accelerating up depending on the carbon emissions of the vehicle Report calls for a tax on waste disposal Britain is the dustbin of Europe. Plastic Bag Tax: In Ireland a pioneering new 15 cent levy on plastic shopping bags was launched in 2002. Introducing a tax increases the private cost of consumption or production and ought to reduce demand and output for the good that is creating the externality. The Landfill Tax . This is sometimes known as “making the polluter pay”. From a social welfare viewpoint. The Congestion Charge: -this is a high profile environmental charge introduced in February 2003.‖ Some economists argue that the revenue from pollution taxes should be ‗ring-fenced‟ and allocated to projects that protect or enhance our environment. Proceeds from the tax go to the Environment Fund and are used to fund various waste management and other environmental initiatives. A socially-efficient output would be Q2 with a higher price P2. 2. we want less output from activities that create an ―economic-bad‖ such as pollution and other types of environmental damage. For example.this tax aims to encourage producers to produce less waste and to recover more value from waste. the money raised from a congestion charge on vehicles entering busy urban roads.147 - If the market fails to include these external costs. 4.tutor2u. Negative externalities and government intervention To many economists interested in environmental problems the key is to internalise some or all of the external costs and benefits to ensure that the businesses and consumers who create the externalities include them when making decisions. Pollution Taxes One common approach to adjust for externalities is to tax those who create negative externalities. At this price level. might be allocated towards improving mass transport services. then the private equilibrium output will be Q1 and the price P1 where private marginal cost = private marginal benefit. The tax rose to 22 cents per bag in July 2007. the external costs have been taken into account.

The onus is now on producers to provide facilities for consumers to bring back their unwanted products. Cigarette smoking can be banned in public places – such as the ban on smoking in workplaces and bars and restaurants introduced in Ireland in 2004. Problems with Environmental Taxes Many economists argue that pollution taxes can create problems which lead to government failure. For example..as a result. and this might have an adverse effect on consumer welfare. Producers may pass on the tax to the consumers if the demand for the good is inelastic and.tutor2u. the long-term effects if resource depletion and the value of human life. batteries. unruly neighbours and can pass by-laws preventing the public consumption of alcohol. Assigning the right level of taxation: There are problems in setting tax so that private cost will exactly equate with the social cost. Employment and investment consequences: If pollution taxes are raised in one country. This will not reduce global pollution. Consumer welfare effects: Taxes reduce output and raise prices. 80 per cent of all disposable cameras are now recycled or reused. The European Union has introduced directives on how consumer durables such as cars. In 1996 Belgium introduced a £5 on disposable cameras that were not recycled or reused .net . the tax may only have a small effect in reducing demand. The IPPR claims that similar taxes introduced in Sweden. the government may choose to intervene directly in a market through the use of regulations and laws. as result. Would a tax on aviation fuel be an effective and appropriate way to reduce carbon emissions from the airline industry? 2. 3. fridges freezers and other products should be disposed of. and may create problems such as structural unemployment and a loss of international competitiveness. The main problems are as follows: 1. disposable razors and nonrechargeable batteries. the Health and Safety at Work Act covers all public and private sector businesses.148 - rest end up in landfill sites. producers may shift to countries with lower taxes. The government cannot accurately put a monetary value on externalities such as the cost to natural habitat. Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on lowerincome consumers and leader to a widening of inequalities in the distribution of income. Denmark and Belgium have all reduced consumption of disposable products. Carbon Emissions Trading © Tutor2u Limited www. The British government introduced a ban on smoking in public places from 1 July 2007. Externalities and Regulation Instead of trying to change market prices and therefore affect the behaviour of consumers and producers. The report recommends that a new tax would be the right approach to the external costs created by the waste from throw-away cameras. Local Councils can take action against noisy.

and scarcity brings economic value. June 2007) Clean Development Mechanism is working (BBC news. May 2007) California passes emissions law (BBC news. May 2008) Carbon trade scheme 'is failing' (BBC Radio 4 File on 4. For example the Government may subsidise state health care. limiting emissions makes polluting a scarce resource. April 2008) Pollution 'alters brain function' (BBC news. carbon trading is designed to reduce the cost of achieving cuts in greenhouse gas emissions and secondly to extend property rights as a means of meeting environmental objectives. In short.tutor2u. Quite simply.. March 2008) Examples of government intervention and externalities At-a-glance: The Stern Review (BBC news. As long as the total bank (or stock) of permits is reduced year by year by the government or an agency. distributed among firms that pollute. Emissions‘ trading is a central feature of the Kyoto Protocol and the European Carbon Emissions Trading Scheme started in full in January 2005. and allows them to be traded in a secondary market. in exchange for revenues from selling surplus pollution rights.net . public transport or investment in new technology for schools and colleges to help spread knowledge and understanding. September 2006) Carbon market's value hits $64bn (BBC news. March 2008) Pollution 'ups blood clot risk' (BBC news. April 2008) China 'now top carbon polluter' (BBC news. May 2008) Do smoke and drink tax rises work? (BBC news. October 2006) © Tutor2u Limited www. March 2008) Hit the young with alco-pop tax – minister (Guardian. The intent is to encourage lowest-cost pollution reduction measures to be utilized. October 2006) Bin charges 'to boost recycling' (BBC news. This reduces the costs of production for suppliers and encourages a higher output. There is also a case for subsidies to encourage higher levels of training as a means to raise labour productivity and improve our international competitiveness. July 2008) Life in Peru‘s most polluted town (BBC news. November 2007) Pneumonia 'linked' to pollution (BBC news. cuts in total pollution can be achieved most efficiently. Suggestions for further reading on negative externalities Recent articles on external costs Britain's seaside rubbish woes (BBC news. May 2008) Warning on plastic's toxic threat (BBC news. Companies that are efficient at cutting pollution will have spare permits that they can then sell to other businesses. This new approach involves the creation of a limited volume of pollution rights.149 - Some countries have moved toward market-based incentives to achieve pollution reduction. Subsidising positive externalities An alternative to taxing activities that create negative externalities is to subsidise activities that lead to positive externalities. March 2008) Gag guzzlers to face £950 tax (BBC news. April 2008) Cost of crime '£275 per person' (BBC news.

. June 2008) UK‘s first emissions zone begins (BBC news.150 - MPs back personal carbon credits (BBC news. November 2006) Scrutinising climate economics (BBC. June 2007) Petrol taxes .tutor2u. February 2008) US city to start charging polluting firms (BBC news. January 2007) Taxing time to stabilise the climate (BBC news. May 2008) Paying for environmental damage (BBC news.Pigou or NoPigou? (Economist. May 2008) © Tutor2u Limited www.net .

Examples of positive externalities External benefits from development of renewable energy sources such as wind power External benefits from other new production technologies External benefits from vaccination / immunisation programmes Social benefits from providing milk to young schoolchildren Social benefits from the maintenance of a post-office network Positive externalities and market failure Where positive externalities exist. Costs Benefits A With positive externalities. the normal market equilibrium is at P1 and Q1 – but if there are external benefits. To maximise welfare we need to encourage increased provision and consumption Supply = Private Marginal Cost External Benefit B Private Demand Qp Qs Demand + External Benefits = Social Marginal Benefit Quantity of the Good There is a case for some form of government intervention in the market designed to increase consumption towards output level Q2 so as to increase economic welfare. the Q1 is an output below the level that maximises social welfare.net . the good or service may be under consumed or under provided since the free market may fail to value them correctly or take them into account when pricing the product. In the diagram above. © Tutor2u Limited www..151 - Positive Externalities There are many occasions when the production and/or consumption of a good or a service creates external benefits which boost social welfare. the social benefit of consumption is greater than the private benefit.tutor2u.

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The economics of vaccination What good is a vaccination? Obviously there are benefits for the person receiving the vaccine, they are less susceptible to disease and children in particular are more likely to attend school and earn more income over their lifetime. A study from the World Bank finds that comprehensive vaccination programmes have a positive effect on savings and wealth and encourage families to have fewer children which lead to less demographic pressures on scarce resources. More subtly, it can be good for an entire population since, if enough of its members are vaccinated, even those who are not will receive a measure of protection. That is because, with only a few susceptible individuals, the transmission of the infection cannot be maintained and the disease spread. The dispassionate economic case for vaccination, therefore, looks at least as strong as the compassionate medical one. Spending on vaccination programmes appears to be a sound social investment for the future. Source: Adapted from the Economist, October 2005 Suggestions for further reading on positive externalities These articles have been selected for being relevant to the concepts of positive externalities and the associated social benefits. When reading through them try to identify some of the external benefits and how they might be measured and valued. It is worth remembering that in nearly all cases we have to make a judgement on both benefits and costs to evaluate whether social welfare will improve as a result. Brussels offers NHS patients Europe-wide treatment (The Times, July 2008) Cross-Rail splits fans and foes (BBC news, October 2007) Economy needs trains not planes (BBC news, June 2008) EU urged to cut 'green' goods tax (BBC news, March 2008) Lakes restoration plan for Broads (BBC news, July 2008) No jab no school says Labour MP (BBC news, May 2008) Pupils to get free toothbrushes (BBC news, March 2008) Super bug vaccines 'within decade' (BBC news, July 2008)

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Public Goods and Private Goods
Public goods provide an example of market failure resulting from missing markets. To understand this, it is helpful first to discuss what is meant by a private good or service. Private Goods A private good or service has three main characteristics: 1. Excludability: A ticket to the theatre or a meal in a restaurant or pay-per-view sporting events are private goods are both examples of private goods because buyers can be excluded from enjoying the product if they are not willing and able to pay for it. Excludability gives the service provider (the seller) the chance to make a profit. When goods are excludable, the owners can exercise property rights. 2. Rivalry: If you order and then enjoy a pizza from Pizza Hut, that pizza is no longer available to someone else. Likewise driving your car on a road uses up road space that is no longer available at that time to another motorist. With a private good, one person's consumption of a product reduces the amount left for others to consume and benefit from because scarce resources are used up in producing and supplying the good or service. 3. Rejectable: If you don't like the soup on the school menu, you can use your money to buy something else! You can choose not to travel on Virgin Rail on a journey to the North West and go instead by coach, or you can choose not to buy a season ticket for your local soccer club and instead use the money to finance a subscription to a local fitness club. All private goods and services can be rejected by the final consumer if their tastes and preferences of if their budget changes.

Private and Public Goods – a question of exclusion Le Shuttle is a private good – the service is excludable, rival in consumption and rejectable. But not all providers of public goods make a profit.

Characteristics of Public Goods As one might expect, the characteristics of pure public goods are the opposite of private goods: 1. Non-excludability: The benefits derived from pure public goods cannot be confined solely to those who have paid for it. Indeed non-payers can enjoy the benefits of consumption at

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no financial cost – economists call this the „free-rider‟ problem - and it means that people have a temptation to consume without paying! 2. Non-rival consumption: Consumption of a public good by one person does not reduce the availability of a good to everyone else – the marginal cost of supplying a public good to an extra person is basically zero. Examples of Public Goods There are relatively few examples of pure public goods. Examples include flood control systems, some of the broadcasting services provided by the BBC, public water supplies, street lighting for roads and motorways, lighthouse protection for ships and also national defence services. Policing – a public good? Is policing an example of a public good? The general protection that the police services provide in deterring crime and investigating criminal acts serves as a public good. But resources used up in providing policing means that fewer resources are available elsewhere. Private protection services such as private security guards, privately bought security systems and detectives are private goods because the service is excludable and rival in consumption and people and businesses are often prepared to pay a high price.

Public goods and market failure Pure public goods are not normally provided at all by the private sector because they would be unable to supply them for a profit. Thus the free market may fail totally to provide public goods and under-provide quasi public goods (see below). It is up to the Government to decide what output of public goods is appropriate for society. To do this, it must estimate the social benefits from making public goods available. Putting a monetary value on the benefit derived from street lighting and defence systems is problematic partly because elections are rarely won and lost purely on the grounds of government spending plans and the turnout at elections continues to fall. Quasi-Public Goods A quasi-public good is a near-public good i.e. it has many but not all the characteristics of a public good. Quasi public goods are: 1. Semi-non-rival: up to a point, extra consumers using a park, beach or road do not reduce the space available for others. Eventually beaches become crowded as do parks and other leisure facilities. 2. Semi-non-excludable: it is possible but often difficult or expensive to exclude nonpaying consumers. E.g. fencing a park or beach and charging an entrance fee; building toll booths to charge for road usage on congested routes The air waves – a public good or quasi public good?

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The airwaves used by mobile phone companies, radio stations and television companies are essentially owned by the government. Do they count as a pure public good? One person‘s use of the airwaves rarely limits how other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and access to the networks can become slow. The government also controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised £22 billion in doing so. The government was using the auction to ration the airwaves through a licence system. Although the government has monopoly control in the sense that it controls the issue of licences, it did not set the market price. This was determined by the auction, and the fact that at the end of a bidding war, the major mobile phone companies were prepared to pay such a high price for a licence is evidence of the private benefit (i.e. the anticipated future profit) that the companies expected to make from selling 3rd generation contracts to customers. Typology of public goods
Public Goods, Quasi Public Goods and Private Goods Totally non-rival in consumption Encrypted digital broadcasting Fire Service Analogue broadcasting National defence Street lighting

Forth Road Bridge

Education and Health Totally rival in consumption Totally excludable

Mass MMR vaccination

Totally nonexcludable

The case for government intervention in the case of public goods The non-rival nature of consumption provides a strong case for the government rather than the market to provide and pay for public goods. Many public goods are provided more or less free at the point of use and then paid for out of general taxation or another general form of charge such as a licence fee.

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State provision may help to prevent the under-provision and under-consumption of public goods so that social welfare is improved. Public Bads A public bad is the opposite of a public good – it provides disutility or dis-satisfaction to people when consumed and therefore reduces our economic welfare. A good example to look at would be the disposal of household and commercial waste. People are normally prepared to pay a price for their household waste to be collected and disposed of in a safe and non-polluting way. But if waste was changed for according to how much had been generated, then some people would find an incentive to dump their waste on other people‘s property and thereby avoid direct charges. Suggestions for further reading on public and private goods Overhaul of flood defences urged (BBC news, July 2007) Companies win contracts for new aircraft carriers (BBC news, July 2008)

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Merit Goods
Merit goods are those goods and services that the government feels that people will underconsume, and which ought to be subsidised or perhaps provided free at the point of use so that consumption does not depend primarily on the ability to pay for the good or service. Who provides merit goods? Both the state and private sector provide merit goods & services. We have an independent education system and people can buy private health care insurance. Externality issues: Consumption of merit goods is believed to generate positive externalities- where the social benefit from consumption exceeds the private benefit. A merit good is a product that society values and judges that people should have regardless of their ability to pay. In this sense, the government is acting paternally in providing these merit goods and services. They believe that individuals may not act in their own best interest in part because of imperfect information. Good examples of merit goods include health services, education, work training programmes, public libraries, Citizen's Advice Bureaux and inoculations for children and students.

Costs Benefits A

Welfare loss because merit goods tend to be underconsumed by the free market

External Benefit B

C

Supply = Private Marginal Cost

Social Marginal Benefit Private Marginal Benefit Qp Qs Output (Q)

Education as a merit good

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The argument concerning imperfect information is an important one here. Parents may be unaware of the longer-term benefits that their children might derive from education. Children themselves will tend to underestimate the long term gains from a proper education. Education is a long-term investment decision. The private costs must be paid now but the private benefits (including higher earnings potential over one‘s working life) take time to emerge. Education should provide a number of external benefits including rising incomes and productivity for current and future generations; an increase in the occupational mobility of the labour force which should help to reduce unemployment. Increased spending on education should also provide a stimulus for higher-level research which can add to the long run trend rate of growth. Other external benefits might include the encouragement of a more enlightened and cultured society. Providing that the education system provides a sufficiently good education across all regions and sections of society, increased education and training spending should also open up more equality of opportunity. School milk – should it be subsidised? Economists at London Economics have written a paper arguing that the Government should consider ending the current milk subsidy scheme for 1.2 million primary school children in England as they cost too much to administer and do little to improve health. But Milk for Schools, a campaign funded by the dairy industry, says the subsidy should be extended, not dropped. A spokesman said that "School milk schemes are essential to ensure access to nutrition for all and that the scheme was important as a way of alleviating child poverty." Source: Tutor2u Blog and Dairy UK, Milk for Schools The debate over free entry into museums Campaigners have hailed the success of free access to museums which have attracted an extra 30 million people to the nation's great artistic and cultural collections since admission charges were scrapped six years ago. Entrance fees to national museums across the country were scrapped on 1 December 2001. A report last year by the LSE found that before free admissions the total number of museum visits per year was approximately 27 million. By 2005 that had increased to 42 million, more than the number of people who visited Premiership matches that year and 50 per cent more than West End and Broadway theatre shows combined. Those museums that abandoned entry charges saw their annual attendance figures did particularly well, recording, on average, an 83 per cent increase in visits since 2001. But despite the government grants that have enabled museums to cut their entry fees many national museums are still finding it hard to make ends meet, particularly as their income has not been rising as fast as staff costs and inflation. The LSE's report found that national museums show a falling total of capital expenditure and an increased reliance on government support. Victoria and Albert Museum, London: 2001 1.1 million; 2006 2.5 million Science Museum, London: 2001 1.3 million; 2006 2.4 million National Museums, Liverpool: 2001 0.7 million; 2006 1.7 million National Maritime Museum, London: 2001 0.9 million; 2006 1.6 million Natural History Museum, London: 2001 1.7 million; 2006 3.5 million Source: Department for Culture, Media and Sport Adapted from news reports, June 2007

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Notice here that we are talking about the sorts of goods and services that society judges to be in our best welfare. Judgements involve subjective opinions – and we cannot escape from making value judgements when we are discussing merit goods. Do you believe that most National Health Services and dental services should be made available free at the point of need? Should the state continue to provide free and compulsory education up to the age of 16? Should people be forced to make compulsory savings for their retirement? How much should the government spend on subsidising school meals? So why does the government provide merit goods and services? To encourage consumption so that positive externalities of merit goods can be achieved To overcome the information failures linked to merit goods On grounds of equity – because the government believes that consumption should not be based solely on the grounds of ability to pay for a good or service Suggestions for further reading on merit goods These articles have been selected because they are relevant to the issue of merit goods and services and the question of who should provide merit goods – the private sector or the government. In many cases both private and public sector provision occurs – which is more efficient and equitable? NHS dental work put out to tender (BBC news, April 2008)

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.160 - Demerit goods Obesity – is it a case of market failure? Healthcare costs related to obesity-linked illnesses such as diabetes. Higher taxes cause prices to rise and should lead to a fall in demand. Banning consumption through regulation may reduce demand. Should the government intervene in the market in order to combat the growing costs of obesity? The City of Detroit in the USA has considered a fast-food tax to combat some of the external costs of obesity De-merit goods are thought to be ‗bad‘ for you. But many economists argue that taxation is an ineffective and inequitable way of curbing the consumption of drugs and gambling particularly for those affected by addiction. but risks creating secondary (illegal) or underground markets in the product. The consumption of de-merit goods can lead to negative externalities. The government may decide to intervene in the market for de-merit goods and impose taxes on producers or consumers. Consumers may be unaware of the negative externalities that these goods create – they have imperfect information about long-term damage to their own health. heart disease and high cholesterol are soaring.tutor2u. © Tutor2u Limited www. cigarettes and drugs together with the social effects of addiction to gambling.net . Examples include the costs arising from consumption of alcohol.

The case for a complete ban © Tutor2u Limited www.net . Consumers too may experience imperfect information about the long term costs to themselves of consuming products deemed to be de-merit goods Obesity – a time bomb There is a huge debate at the moment about the root causes of obesity and the social costs that arise from increasing levels of obesity.161 - Costs Benefits Social Marginal Cost External costs (negative externalities) Private Marginal Cost Demand (Limited Information) Demand (Full Information) Q3 Q2 Q1 Quantity The social optimal level of consumption would be Q3 – an output that takes into account the information failure of consumers and also the negative externalities. Obesity is also an international problem.tutor2u.. Another approach would be to divert resources away from regulation towards giving better information to drug users about the longer term health implications of their consumption decisions. What of harder drugs? Should hard drugs be prohibited at all costs by the government in a bid to control demand by restricting supply? Regulation has been the route chosen by most governments in developed countries over recent years – but economists are once again divided on the issue. Market failure with demerit goods The free market may fail to take into account the negative externalities of consumption (because the social cost > private cost). A report published in June 2007 said that obesity could be a factor that bankrupted the National Health Service in the years to come. arguing that regulation is both ineffective and also costly. Some believe that legalisation and taxation of harder class drugs is a more appropriate policy to pursue.

the Grand National. Food additives – a de-merit good? The use of food additives has long been a subject of controversy. political..tutor2u. In the diagram above there is no output where the social benefit equals the social cost and welfare would be best protected by trying to enforce a total ban on the product.net . Research published in 2007 by the Food Standards Agency (FSA) claimed a link between food additives and hyperactive behaviour in children leading to losses of concentration and a worsening in classroom behaviour ands they want a number of food colourings to be banned. Examples include the preservatives used in products from soft drinks to barbecue sauce – designed mainly to lengthen the shelf life of products available for sale in supermarkets. There is also a fiscal dividend from this booming industry with a predicted £3bn per year of extra tax revenues flowing into the Treasury's coffers. we seem to have an almost insatiable desire for gambling on the outcomes of virtually every sporting. Inevitably the rapid expansion of this industry raises important questions about the external costs and benefits of gambling. Gambling – economic and social effects From betting on the results of general elections. © Tutor2u Limited www.162 - Costs Benefits Social Marginal Cost External costs (negative externalities) Private Marginal Cost Social Marginal Benefit Q1 Quantity The case for a complete ban on de-merit goods such as class A narcotics could be justified on the ground that the social marginal cost of consumption is always higher than the social marginal benefit. the number of corners that England win in one of their World Cup matches or the temperature in London on Christmas Day. meteorological event. Some researchers point to the employment and tourism benefits that flow from the growth in demand for gambling services especially if businesses are established in some of the UK's poorest towns and cities.

Suggestions for further reading on de-merit goods and market failure These articles have been selected because they are relevant to the ideas in this chapter on demerit goods and – in some cases – the related question of government intervention to influence behaviour. The usual approach to de-merit goods is to tax consumption.163 - But gambling also creates external costs.000 people in the UK are thought to be addicted to betting and their problem gambling can contribute to crises including personal debt or bankruptcy. Over 350. January 2007) Bid to remove food additives (BBC news. August 2007) Minimum age for buying cigarettes to be raised to 18 (BBC news. April 2008) Call for better NHS gambling help (BBC news. September 2006) Doctors attack gambling policies (BBC news. April 2007) Estonia to raise tax on alcohol (BBC news. The dangers of addiction are greatest for the young and the vulnerable susceptible to advertising and marketing strategies. July 2008) Australia in thrall of gambling mania (BBC news. July 2007) Smokers kick habit after ban (BBC news. January 2008) Surge in alcohol related hospital admissions (Telegraph. Alcohol sales under scrutiny (BBC news. so that the private cost of consumption is increased and demand contracts.tutor2u.net . July 2008) © Tutor2u Limited www. January 2007) 'Casino social costs outweigh benefits' (BBC news. But the government has actually got rid of betting & gaming duty (it was abolished in 2001) to be replaced with a tax on the profits of gaming companies. loss of employment and the breakdown of families. The Gambling Act of 2005 deregulates the industry and allows the creation of more casinos in the UK..

000 teenagers.tutor2u. Occupational Immobility Occupational immobility occurs when there are barriers to the mobility of factors of production between different sectors of the economy which leads to these factors remaining unemployed. There are good reasons why geographical immobility might exist:  Family and social ties. This problem is called structural unemployment. meanwhile. employment or training and their job prospects are getting worse by the year. occupational and geographical immobility. Clearly this leads to a waste of scarce resources and represents market failure. or being used in ways that are not efficient. There are two main types of factor immobility. Some capital inputs are occupationally mobile – a computer can be put to use in many different industries. And commercial buildings such as shops and offices can be altered to provide a base for many businesses.not in education. Geographical Immobility Geographical immobility refers to barriers people moving from one area to another to find work. workers made redundant in the sheet metal industry or in heavy engineering may find it difficult to find a new job. An estimated 206. However some units of capital are specific to the industry they have been designed for – a printing press or a nuclear power station for example! People often experience occupational immobility. © Tutor2u Limited www. are languishing as so-called Neets .. For example.net . They may have specific skills that are not necessarily needed in growing industries which causes a mismatch between the skills on offer from the unemployed and those required by employers looking for workers.164 - Factor Immobility Immobility of labour – a cause of unemployment and market failure One of the main causes of unemployment is that workers lack the skills required by expanding industries in the economy. There is a major problem of youth unemployment in the UK. One cause of market failure is the immobility of factors of production.

6 0.tutor2u.3 0.2 0.7 .9 0.net millions 0.0 Source: Reuters EcoWin Policies to Improve the Mobility of Labour To reduce occupational immobility:   Invest in training schemes for the unemployed to boost their human capital to equip them with new skills and skills that can be transferred from one occupation to another.8 0.9 Persons (millions) 1.2 1.7 0.4 0. Huge regional variations in house prices.0 0. Differences in the general cost of living between regions and also between countries.1 1.4 0.8 0.5 0. July 2008) © Tutor2u Limited www.6 0. seasonally adjusted. using Labour Force Survey data 1.3 1.1 0.1 1.5 0.2 0. UK Unemployment.0 0. By Duration Millions.1 0..3 0. Suggestions for further reading on immobility of factors of production Job shortage for unskilled youths (BBC news.2 Unemployed for up to six months 1. Encourage part-ownership / part-rented housing Specific subsidies for people moving into areas where there are shortages of labour – for example teachers and workers in the National Health Services.165 -    The financial costs involved in moving home including the costs of selling a house.3 1. Subsidise the provision of vocational training by private sector firms to raise the skills level To reduce geographical immobility:    Reforms to the housing market designed to improve the supply and reduce the cost of rented properties and to increase the supply of affordable properties.0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Unemployed for over 24 months Unemployed for over 12 months 0. removal expenses and other associated expenditure.

June 2008) © Tutor2u Limited www.tutor2u..net .166 - Record numbers of young people in education or work (The Guardian.

and provide more nutritional information. choosing between makes of computers requires specialist knowledge of hardware. The issue is whether the information failure is trivial or whether it has a huge effect on individuals.167 - Imperfect Information A question of missing information Information failure occurs when people have inaccurate. all of us suffer from one or more information failures. Do I buy an Apple or PC computer? The problems of choosing a quality second hand car or when deciding whether or not to buy a property. Source: Adapted from news reports. persuasive advertising may ‗oversell‘ the benefits of a product leading to a higher demand and consumption than is optimal. should younger workers be buying into pension schemes when we can only guess at economic conditions in 40 years time? Complex information e.. Spam mail can be a cause of misinformation for consumers. salts and sugars. from investing in the stock market to ignorance about the consequences of borrowing and debt. They also said they would provide better nutritional information on beverages.g. their families and the community as a whole. The classic case of this is the demand for health or education services– where consumers may well underestimate the long term private benefits from investing time and money into extra education or buying a specific form of health treatment. uncertain or misunderstood data and so make potentially ‗wrong‘ choices.net . incomplete. The decision comes as food companies come under in-creasing pressure to provide more information about the nutritional value of their products amid concern about rising levels of obesity.g. the social costs and benefits of different classes of drugs and the private and social benefits from higher education when there are so many universities and courses to choose from. Inaccurate or misleading information e. Food companies have argued that consumer education is not their job but soft drink producers have agreed to a voluntary ban on advertising to children in Europe.g. From pensions to computer games consoles. drug addicts may be unable to stop consumption of harmful substances     Health warnings for snacks in bid to improve consumer information The food industry has made its first move towards issuing health warnings for snack foods.tutor2u. Food and drink manufacturers have already made efforts to cut down on fats. There may well be a case for the government to intervene in the market in some way if information failures become serious. Uncertainty about costs and benefits e. February 2006 Asymmetric Information © Tutor2u Limited www.g. It marks a shift in the food industry‘s attitude towards consumers.g. Read this Tim Harford article on spam! Addiction e. Examples of information failure Imperfect information can be caused by  Misunderstanding the true costs or benefits of a product: E.

Slate. If buyers had full information they could strike fair trades with the sellers. there will be only one market for all used cars. careful-driver old lady with the well-maintained estate won't part with hers for less than $17. This can make it difficult for the two people to do business together Examples include the following:  Warranties: The miss-selling of extended warranties by high street retailers on domestic electrical goods such as televisions and dishwashers Sub-prime mortgages: A lender does not know how likely a borrower is to repay their loan. Is there sufficient justification for the government to intervene in these examples? Britain‘s favourite fakes (Money Programme.tutor2u. often resemble a used-car sale more closely than a McDonald's restaurant.  A used-car seller knows more about the quality of the car being sold than do buyers. labour and insurance. February 2008) Confusion Pricing . October 2007) Drinkers ignorant about alcohol (BBC news.000.000 to part with their old banger. consumers and producers have the same level of knowledge about the products. October 2001 Suggestions for wider reading on information failure These articles have been selected because they are relevant to the ideas on possible information failures and the impact such imperfect knowledge might have on consumer choices and outcomes. March 2007) © Tutor2u Limited www.Why cell-phone plans are so hard to understand (Tim Harford. April 2007) Consumers in danger of being misled by price comparison sites (Independent. while the one-owner. If buyers cannot spot the quality difference. there needs to be symmetric information i. including those for shares. though. Suppose further that used-car shoppers would be prepared to pay $20.168 - For markets to work. The mini case study below covers this example! The Market for Lemons Assume that used cars come in two types: those that are in good repair.000 that good-car owners require. and duds (or ―lemons‖ as Americans call them). lemon-owners require $8. so they will exit the market. This result. This is below the $17. July 2008) Government information campaign on the dangers of passive smoking (BBC news. As for the sellers. and they know everything there is to know about them. May 2008) EBay hit with £30m fine for sales of fake luxuries (Guardian. A car insurance company cannot tell the risks associated with each single driver    A motorist approaching a toll-road may not know how busy it is compared to substitute roads that do not charge a motorist for use..000 for a lemon. and buyers will be ready to pay only the average price of a good car and a lemon. the old lady getting a high price and the lemon-owner rather less. A great many markets. Source: Adapted from the Economist. when bad quality pushes good quality from the market because of an information gap. leaving only bad cars. or $15.000. Asymmetric information occurs when somebody knows more than somebody else in the market. is known as ―adverse selection‖.000 for a good one and $10.e.net .

January 2008) Sun bed use puts lives at risk (BBC news. April 2008) The big cost of avoiding little risk – Tim Harford (BBC online.net ..169 - Morning coffee is meal in a cup (BBC news.tutor2u. August 2006) © Tutor2u Limited www.

good housing and social activities. The Poverty Trap The poverty trap affects people living in households on low incomes. © Tutor2u Limited www.net . Source: BBC news and Institute for Fiscal Studies The most commonly used threshold of low income in Britain is 60% of median household income after deducting housing costs. Poverty is not simply about being on a low income and going without – it is also to do with being denied hood health. It creates a disincentive to look for work or work longer hours because of the effects of the income tax and welfare benefits system. Absolute poverty Absolute poverty measures the number of people living below a certain income threshold or the number of households unable to afford certain basic goods and services. we cannot escape making value judgements. When we are discussing inequality and poverty. as well as basic self-esteem‖ Source: Child Poverty Action Group In a market economy an individual‘s ability to consume goods & services depends upon his/her income. Relative poverty Relative poverty measures the extent to which a household‘s financial resources falls below an average income level. such as unemployment and changing family structures. Poorer families have a lower life expectancy People from poorer backgrounds are unhealthier and die earlier than the rich. education. What we choose to include in a basic acceptable standard of living is naturally open to discussion. according to a report from the Institute of Fiscal Studies (IFS). Although living standards and real incomes have grown because of higher employment and sustained economic growth. The poor often have to stop work early due to ill health.. according a study measuring the link between health and wealth. Poorer people in their fifties were 10 times more likely to die earlier than those who are richer. there is little doubt that Britain has become a more unequal society over the last 20-25 years. the group added and this increases the risk of these groups suffering income poverty during their retirement years. The free-market system will not necessarily respond to the needs and wants of those with insufficient economic votes to have any impact on market demand because what matters in a market based system is your effective demand for goods and services. An unequal distribution of income and wealth may result in an unsatisfactory allocation of resources and can also lead to alienation and encourage crime with negative consequences for all.tutor2u.170 - Poverty and Inequality in Resource Allocation Going without ―In the UK people can become poor as a result of social and economic processes.

The individual may also lose some income-related welfare benefits and the combined effects of this might be to take away over 70% of a rise in income.171 - For example. then the disincentive to work may be quite strong. Special employment measures (including New Deal): Government employment schemes seek to raise employment levels and improve the employment prospects of the long-term unemployed. When one adds in the possible extra costs of more expensive transport charges and the costs of arranging child care. increases in higher rates of income tax would make the British tax system more progressive and reduce the post-tax incomes of people at the top of the income scale. November 2007) © Tutor2u Limited www. It is a statutory pay floor . The National Minimum Wage: The National Minimum Wage (NMW) was introduced in April 1999. Their pension would rise in line with the growth of average earnings each year 4.. This would help the welfare system to target help for those households on the lowest incomes. Increased spending on education and training: Unemployment is a cause of poverty and structural unemployment makes the problem worse. A means-test involves a check on the financial circumstances of the benefit claimant before paying any benefit out. 2. Financial Times. Changes to the tax and benefits system: For example.employers cannot legally undercut the NMW. the beneficial impact of the minimum wage has been concentrated on the lowest paid workers in service sector jobs where there is little or no trade union protection. 5. a sensible way to measure poverty (Tim Harford. a worker might be given the opportunity to earn an extra £60 a week by working ten additional hours. Linking the state retirement pension to average earnings rather than prices: This policy would help to relieve relative poverty among low-income pensioner households.net . Since 1999. July 2008) Breadline Britain (BBC) How the super rich just got richer (Money Programme. A switch towards greater means-tested benefits: Means testing allows welfare benefits to go to those people and families in greatest need. Government Policies to Reduce Poverty Policies to reduce relative poverty normally focus on (a) changes to the tax and benefits system and (b) policies designed to increase employment and reduce unemployment. When evaluating different policies to reduce poverty consider some of these related issues: Cost Effectiveness Impact on others in the economy 1. leaving little in the way of extra net or disposable income. 3. The risk is that higher rates of taxation may act as a disincentive for people to earn extra income and might damage enterprise and productivity. This boost to his/her gross income is reduced by an increase in income tax and national insurance contributions. Further background reading on poverty and inequality in the UK At last. 6. There are millions of households in the UK where no one in the family is in any kind of work and this increases the risk of poverty.tutor2u. However means tested benefits are often unpopular with the recipients.

tutor2u..000 poor children. It's London (The Times. January 2008) The changing face of poverty (BBC) © Tutor2u Limited www.172 - It's a rich city but it has 650. April 2008) Mind the Gap (Guardian.net .

. Free market economists criticise the scale of regulation in the economy arguing that it creates an unnecessary burden of costs for businesses – with a huge amount of ―red tape‖ damaging the competitiveness of businesses. © Tutor2u Limited www. All governments intervene in the economy to influence the allocation of scarce resources among competing uses What are the main reasons for government intervention? The main reasons for policy intervention are: (1) (2) (3) To correct for market failure To achieve a more equitable distribution of income and wealth To improve the performance of the economy Options for government intervention in markets There are many ways in which intervention can take place – some examples are given below Government Legislation and Regulation Examples include: Laws on minimum ages for buying cigarettes and alcohol The Competition Act which penalizes businesses found guilty of price fixing cartels Statutory national minimum wage A new law in Scotland banning under-18s from using sun-beds Equal Pay Act and acts preventing other forms of discrimination Changes in the law on cannabis Maximum CO2 emissions for new vehicles. gas and rail transport. uphold the rule of law and maintain the value of the currency. governments take the view that markets are best suited to allocating scarce resources and allow the forces of supply and demand to set prices. the water industry The economy operates with a huge and growing amount of regulation. telecommunications. Competitive markets often do deliver improvements in allocative. electricity.g. The role of the government in a laissez faire system is to protect property rights.173 - Government Intervention in the Market Laissez faire economics In a free market economic system.tutor2u. laws which restrict flight times at night Government appointed utility regulators who may impose price controls on privatised monopolists e. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications. productive and dynamic efficiency – but there are occasions when they fail – providing a rationale for intervention of different forms. Intervention in the market Government intervention in the price mechanism is usually justified largely on the grounds of wanting to achieve an improvement in economic and social welfare.net .

net . The main state-owned businesses in the UK are the Royal Mail and Network Rail. Government action can have a role in improving information to help consumers and producers value the ‗true‘ cost and/or benefit of a good or service. but they seek to influence ―demand‖ and therefore output and consumption in the long run.174 - Regulation may be used to introduce fresh competition into a market – for example breaking up the existing monopoly power of a service provider.g.. Fiscal Policy Intervention Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy. A good example of this is the attempt to introduce more competition for British Telecom. State funding can also be used to provide merit goods and services and public goods directly to the population e. Or a reduction in corporation tax (a tax on company profits) designed to promote new capital investment and extra employment (d) Changes to taxation and welfare payments can be used to influence the overall distribution of income and wealth – for example higher direct tax rates on rich households or an increase in the value of welfare benefits for the poor to make the tax and benefit system more progressive Intervention designed to close the information gap Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. © Tutor2u Limited www. Increasingly adverts are becoming more hard-hitting in a bid to have an effect on consumers. This is known as market liberalisation.tutor2u. the state-owned sector of the economy is much smaller than it was twenty years ago. They are designed to boost consumption and output of products with positive externalities – remember that a subsidy causes an increase in market supply and leads to a lower equilibrium price (c) Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development. (a) Indirect taxes can be used to raise the price of de-merit goods and products with negative externalities designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level (b) Subsidies to consumers will lower the price of merit goods. They don‘t have any direct effect on market prices. the government pays private sector firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network. Direct State Provision of Goods and Services Because of privatization. Examples might include: (1) Compulsory labelling on cigarette packages with health warnings to reduce smoking (2) Improved nutritional information on foods to counter the risks of growing obesity (3) Anti-speeding television advertising to reduce road accidents and advertising campaigns to raise awareness of the risks of drink-driving (4) Information campaigns on the dangers of addiction and binge-drinking (5) Home Information Packs for home-buyers These programmes are really designed to change the “perceived” costs and benefits of consumption for the consumer.

Competitors within a market Topical issues where the stakeholder concept might be considered important Stakeholders affected by all kinds of issues including the following: 1. World Bank. many businesses are taking into account the effects of their actions not just on the value that such decisions create for shareholders – but also to a broader range of stakeholder groups. Examples of stakeholders you might think of bringing into a discussion 1.175 - Intervention and Stakeholders As an economist. Communities where a business is located or affected directly by a decision 3. The building and opening of Heathrow Terminal 5 4. Professional associations 9. The decisions of government.g. Local communities 13. Increasing the national minimum wage 2. whenever you are required to discuss the costs and benefits of an example of government intervention it is worth asking yourself ―who are the major stakeholders in this issue?‖ A stakeholder is any person or organization that has a legitimate interest in a specific project or policy decision. businesses and other non-governmental organisations inevitably affect different groups within society. Prospective customers 12. Government (and through them – taxpayers) 7. Changes to rules on mortgage lending as a result of the credit crunch © Tutor2u Limited www. Employees of a business / organisation (who may / may not be members of a union) 2. Prospective employees 11.. Government investment in wind farm technology 5. International community 15. NGOs and other advocacy groups (i.g. Creditors (people owed money) 6.tutor2u. back down the supply chain) 4.e. Shareholders and other investors / financiers 5. Possible introduction of a tax on aviation fuel for flights inside the EU 7. Key decisions on developing new towns to help meet the demand for housing 8. India increasing the tax on exported rice) 9. Rise in the London Congestion charge and expansion of the congestion charge zone 3. Reforms to the EU‘s common agricultural policy 6. Suppliers to a particular business (e. Trade unions (and the workers they represent) 8. IMF. Increasingly. Food export bans and export taxes (e. Pressure Groups) 10.net . National communities 14. Typically stakeholder issues come into play on major infrastructural projects where a cost benefit analysis might be undertaken to assess the likely social costs and benefits – it is important to bring as many stakeholders into the picture as possible – many people might be affected. Decisions to lower import tariffs on goods and services coming into the UK 10.

1.. more properties per square acre). Build more social housing: Allowing each local authority (council) greater freedom to borrow money to fund the construction and supply of social housing may help to reverse the collapse in the building of council properties over the last ten to twenty years. 6.400 housing associations responsible for building and maintaining nearly 3 million homes in the UK is also an option. Using tariffs to change the relative prices of imports in a domestic economy c) Social science: Economics is a social science and the effects of intervention cannot be calibrated / forecast with great accuracy – people‘s behaviour is subject to change – remember the ‗law of unintended consequences‘! d) Combinations of policies: One single intervention is unlikely to produce a solution to deep-rooted economic and social problems – try to build a variety of policy options into your discussion e. 4. Tax breaks for investors willing to make rented properties available at affordable rents. 5.176 - 11.e.net . Reducing the number of empty homes – There are several options for this including compulsory purchase orders if owners of properties allow their properties to remain empty and unused for 6 months or more – these properties could then be made available to people on housing waiting lists at sub-market rents. raising the price of fuel to curb consumption b. Encouraging self-build schemes: Self-build homes work out cheaper in the long run and they give people the satisfaction of building a home to their own specification and design.tutor2u. There is no shortage of land in the UK. previously developed land). Evaluation on the effects of government intervention a) Value judgements: Be aware of the use of ‗value judgements‘ in discussions about government intervention – many people want a particular intervention because of their own vested interests. 3. Offering a subsidy to bio-fuel producers c. Removing the 10% starting rate of income tax 12. merely a shortage of land on which it is possible to build new homes. b) Changing prices to change incentives and behaviour: Many interventions work though the price mechanism by changing the relative prices / relative costs of day-to-day decisions a. Increased funding for the 1.g. Building homes on brown-field sites: Financial incentives for construction companies to build on brown-field sites (e. Increased innovation and productivity in house-building industry: Encouraging more innovation in the building industry – for example innovations that make it possible to build new homes attractively at higher densities (i. A loosening of planning restrictions: Relaxation of planning constraints for new housing – including relaxation of the greenbelt restrictions. 2. policies that work on market demand and market supply © Tutor2u Limited www. 7. E.g. Higher tuition fees for UK students at English universities Intervention in Action – The UK Housing Shortage Government Intervention to reduce the shortage of housing The elasticity of housing supply in the UK is low – one of the lowest in Europe – current policy is focused on improving the elasticity of supply so that house building is more responsive to changes in market demand.g.

e.net . Part of the fascination of studying Economics is that the ―law of unintended consequences‖ often comes into play – events can affect a particular policy. As with any form of government intervention in the market. Effectiveness of a policy: i.tutor2u.g. productive and dynamic efficiency? For example . Winners and losers from intervention – the ban on smoking in public places On July 1st 2007 a ban on smoking in public places was introduced into England following similar decisions for Scotland and Wales.e.. Losers from the decision Dry-cleaners (smoke-free pubs mean less need for people to launder suits and other clothes) Winners from the decision Packaging companies – the demand for beer cans has increased as more people drink at © Tutor2u Limited www.177 - e) The power of markets: Is government intervention always necessary? Market forces can be really powerful in finding profitable solutions to problems – don‘t underestimate the importance of innovation and invention – government‘s rarely have all of the answers and the new economics of mass collaboration offers powerful insights into the impact that collusive behaviour can have e.would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity? 2. is a policy thought of as fair or does one group in society gain more than another? For example. would it be equitable for the government to increase the top rate of income tax to 50 per cent in to make the distribution of income more equal? 4.e.e. Efficiency of a policy: i. and consumers and businesses rarely behave precisely in the way in which the government might want! Judging the effects of intervention – a useful check list To help your evaluation of government intervention – it may be helpful to consider these questions: 1. The intervention was justified on the grounds of supporting the long term aim of reducing cigarette consumption and improving the nation‘s health. some businesses have gained whilst others have lost out. in fast-tracking ideas linked to reducing carbon emissions f) Costs and benefits: You cannot go far wrong in an evaluation question by trying to identify and then discuss the costs and benefits of government intervention – some of which only become apparent over long time periods g) The „law of unintended consequences‟: Government intervention does not always work in the way in which it was intended or the way in which economic theory predicts it should. does a particular intervention lead to a better use of scarce resources? E. which policy is most likely to meet a specific economic or social objective? For example which policies are likely to be effective in reducing road congestion? 3. does it improve allocative. Sustainability of a policy: i. Equity effects of intervention: i. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we rely on in future years.g.

July 2008) Law bans under-18s in Scotland from using sun-beds (BBC news. May 2008) Carbon emissions trading – special reports (Guardian) Cigarette sales overhaul plan (BBC news. Each of the articles below has been selected because it is relevant to some of the concepts and issues covered in this chapter. June 2008) School-gate fast food ban urged (BBC news. June 2008) UK airport ownership review (BBC news. In each case consider whether you feel that government intervention in the market is justified? And what alternative policies might be considered at the same time? Australia proposes a carbon trading scheme (BBC news. May 2008) Road pricing 'should be assessed' (BBC news. April 2008) © Tutor2u Limited www. awnings and decking Cigarette companies – domestic demand for cigarettes has fallen but they have offset this by growing sales to Eastern Europe – helped by the falling exchange rate Do you agree with the smoking ban? If the government wants to reduce demand for cigarettes what are the other options available to it beyond a ban on smoking in public places? Suggestions for further reading on government intervention As we have seen in this chapter there are many ways and many reasons why the government and its appointed agencies may choose to intervene in markets. June 2008) MPs back personal carbon credits (BBC news. March 2008) Smoking ban saves lives (BBC news. April 2008) Drinks industry facing tough laws (BBC news.net .tutor2u. July 2008) Government may intervene on pre-payment meters (BBC news.178 - home Specialised tobacconists Bingo halls Pubs – pub closures in the UK have run at a net rate of 27 per week during 2008 Pizza delivery companies – more people ordering take-away instead of pub meals Manufacturers of outdoor patio heaters. July 2008) Binge-drinking adverts launched (BBC news. May 2008) Divided Britain needs new ladder of opportunity (The Times. June 2008) Cannabis laws to be strengthened (BBC news..

the supplier may be able to pass on some or all of this tax onto the consumer through a higher price. A tax increases the costs of a business causing an inward shift in the supply curve. When demand is elastic. A Tax When Demand is Price Elastic Price S + Tax Price A Tax when Demand is Price Inelastic S1 S + Tax S1 P2 P1 P2 D1 P1 D1 Q2 Q1 Quantity Q2 Q1 Quantity In the left hand diagram. demand is elastic so the producer must absorb most of the tax and accept a lower profit margin on each unit sold.. With an indirect tax. This is known as shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of demand and supply. Output has fallen from Q to Q1. In the right hand diagram demand for the product is inelastic and therefore the producer is able to pass on most of the tax to the consumer by raising price without losing much in the way of sales. the effect of a tax is to raise the price – but we see a bigger fall in quantity.net . The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit.tutor2u. The table below shows the demand and supply schedules for a good Price (£) 10 9 8 7 6 5 4 Quantity Demanded 20 60 150 260 400 600 900 Quantity Supplied (Pre-tax) 1280 1000 850 600 400 150 50 Quantity supplied (Post-tax) 600 400 150 50 © Tutor2u Limited www.179 - Indirect Taxation An indirect tax is imposed on producers (suppliers) by the government. Examples include duties on cigarettes. alcohol and fuel and also VAT.

The new supply schedule is shown in the right hand column of the table – less is now supplied at each and every market price Find the new equilibrium price after the tax has been imposed Calculate the total tax revenue going to the government How have consumers been affected by this tax? There has been a fall in quantity traded and a rise in the price paid by consumers – this leads to a fall in economic welfare as measured by consumer surplus New price =£8 Tax revenue = £450 Who pays the tax? The burden of taxation When demand is inelastic. the producer cannot pass on much of the tax to the consumer.tutor2u. the producer is able to pass on most or perhaps all of an indirect tax to the consumer by raising the market price. © Tutor2u Limited www.. An example of this is the high level of duty on cigarettes and petrol. they must absorb the majority of the tax themselves A Tax When Demand is Price Elastic Price S + Tax Price A Tax when Demand is Price Inelastic S + Tax S1 S1 P2 P1 P2 P3 D1 P1 P3 D1 Q2 Q1 Quantity Q2 Q1 Quantity The burden of an indirect tax paid by the consumer The burden of an indirect tax paid by the producer The Government would rather place indirect taxes on commodities where demand is inelastic because the tax causes only a small fall in the quantity consumed and as a result the total revenue from taxes will be greater. Conversely when demand is price elastic.net .180 - 1 2 3 4 5 What is the initial equilibrium price and quantity? Price = £6 Quantity = 400 The government imposes a tax of £3 per unit.

Another example is air passenger duty Ad valorem taxes Where the tax is a percentage of the cost of supply – e. Price An ad valorem tax causes a pivotal shift in the producer’s supply curve Supply + Ad valorem tax S1 P1 P2 Demand Q1 Q2 Quantity Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve. July 2008) EU plans cut in VAT for local businesses (BBC news. value added tax currently levied at the standard rate of 17.net .5%. March 2008) Potatoes are not potato crisps in VAT ruling (BBC news. an ad valorem tax has been imposed on producers. The equilibrium price rises from P1 to P2 whilst quantity traded falls from Q1 to Q2. March 2008) © Tutor2u Limited www. May 2008) Call for review of motoring taxes (BBC news. July 2008) EU urged to cut 'green' goods tax (BBC news.181 - Specific taxes A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint of beer or the tax per packet of twenty cigarettes. July 2008) The toxic issue of green taxes (BBC news. Tobacco tax is an example of a product on which both specific and ad valorem taxes are applied. March 2007) Call for cut in indirect taxes on garden plants (BBC news.tutor2u. The absolute amount of the tax will go up as the market price increases.. In the diagram below. So a good that could be supplied for a cost of £50 will now cost £58. Suggestions for further reading on indirect taxes Brown cuts VAT on contraceptives (BBC news.g. This is because the tax is a percentage of the unit cost of supplying the product.75 when VAT of 17.5% is applied whereas a different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied.

182 - Producer Subsidies A subsidy is a payment by the government to suppliers that reduce their costs of production and encourages them to increase output. © Tutor2u Limited www. Indeed when demand is perfectly inelastic the consumer gains most of the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price. a guaranteed minimum price offered to farmers such as under the old Common Agricultural Policy (CAP). (4) Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e. Occasionally the government can offer a direct subsidy to the consumer – which has the effect of boosting demand in a market Different Types of Producer Subsidy (1) A guaranteed payment on the factor cost of a product – e.g..g. When demand is relatively elastic.g. (2) An input subsidy which subsidises the cost of inputs used in production – e. The subsidy causes the firm's supply curve to shift to the right.g. as part of a regional policy designed to boost employment. the main effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a much lower market price. a grant given to cover losses in the railway industry or a loss-making airline. The effect of a subsidy is to increase supply and (ceteris paribus) reduce the market equilibrium price. an employment subsidy for taking on more workers. (3) Government grants to cover losses made by a business – e. The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output.tutor2u. Price S pre subsidy P1 S post subsidy P2 Demand Q1 Q2 Quantity To what extent will a subsidy feed through to lower prices for consumers? This depends on the price elasticity of demand for the product.net . The more inelastic the demand curve the greater the consumer's gain from a subsidy.

a subsidy will have more of an effect on quantity traded Price S pre subsidy S pre subsidy S post subsidy P1 S post P2 subsidy P1 D2 P2 Demand Q1 Quantity Q1 Quantity Economic and Social Justifications for Subsidies Why might the government be justified in providing financial assistance to producers in certain markets and industries? How valid are the arguments for government subsidies? (1) To keep prices down and control inflation – in the last couple of years several countries have been offering fuel subsidies to consumers and businesses in the wake of the steep increase in world crude oil prices. Free market economists argue that subsidies distort the working of the free market mechanism and can lead to government failure where intervention leads to a worse distribution of resources.tutor2u. (i) Distortion of the Market: Subsidies distort market prices – for example. (2) To encourage consumption of merit goods and services which are said to generate positive externalities (increased social benefits).net . (3) Increase the revenues of producers during times of special difficulties in markets. (5) Subsidies to slow-down the process of long term decline in an industry Economic Arguments against Subsidies The economic and social case for a subsidy should be judged carefully on the grounds of efficiency and fairness.. (4) Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply.183 - Price The effect of a subsidy on the market price is greatest when demand is inelastic When demand is price elastic. Might the money used up in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an opportunity cost and in the long run there might be better ways of providing financial support to producers and workers in specific industries. export subsidies distort the trade in goods and services and can curtail the ability of ELDCs to compete in the markets of rich nations. © Tutor2u Limited www.

July 2008) The rise. June 2006) Should the British pub get a government subsidy? (BBC news. July 2007) Reforming wine subsidies in the EU (BBC news online.tutor2u. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments. July 2007) Dearing calls for tuition fee cap to be lifted (Guardian. January 2006) Trade war brewing over US bio-fuel subsidies (Guardian. July 2008) What price a post office? (BBC news online. June 2007) From subsidy drunk to subsidy comatose (The Times. Suggestions for further reading on subsidies Subsidies often create controversy – the best recent example is probably the subsidy offered to producers of bio fuels – each of these articles has been selected because it is relevant to some of the arguments relating to the costs and benefits of subsidies mentioned in this chapter. it delays much needed reforms.net . Corn Dog: The ethanol subsidy is worse than you can imagine (Slate Magazine. April 2008) USA and EU urged to cut bio-fuels (BBC news. fall and rise of Brazil's bio-fuel (BBC news online.184 - (ii) (iii) (iv) (v) (vi) (vii) Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary Financial Cost: Subsidies can become expensive – note the opportunity cost! Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or tax-payers) who themselves may have derived no benefit from the subsidy.e.. Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i. June 2007) EU extends state help for movies (BBC news online. April 2007) © Tutor2u Limited www. There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects.

it must be set below the normal market-clearing price. The normal equilibrium price is shown at Pe – but the government imposes a maximum price of Pmax.tutor2u. At the original equilibrium price consumer surplus = triangle ABPe and producer surplus equals the triangle PeBC. An example of a maximum price is shown in the next diagram.185 - Maximum Prices The Government can set a maximum price in an attempt to prevent the market price from rising above a certain level. To be effective a maximum price has to be set below the free market price. This is shown in the next diagram. Because of the maximum price ceiling. This price ceiling creates excess demand equal to quantity Q2-Q2 because the price has been held below the equilibrium.net . A maximum price seeks to control the price – but also involves a normative judgement on behalf of the government about what that price should be. Consumers gain from the price being set artificially lower than the equilibrium. Maximum prices and consumer and producer welfare How does the introduction of a price ceiling affect consumer and producer surplus. At P max the new level of consumer © Tutor2u Limited www. One example of a maximum price might be when shortage of foodstuffs threatens large rises in the free market price. but there is a loss of consumer welfare because of the reduction in the quantity traded. Rent £s Supply Free Market Equilibrium Pe P max Excess Demand Price (Rent) Ceiling Demand Q2 Q1 Quantity of Rented Property It is worth noting that a price ceiling set above the free market equilibrium price would have no effect whatsoever on the market – because for a price floor to be effective. Other examples include rent controls on properties – for example the system of rent controls still in place in Manhattan in the United States. the quantity supplied contracts to output Q2..

Rationing when there is a market shortage Rationing when there is a maximum price might also be achieved by allocating the good on a „first come.186 - surplus = the trapezium ADEPmax. When there is a shortage. first served‟ basis – e. Both of these ways of rationing goods might be © Tutor2u Limited www. There is also evidence of black markets in the illegal distribution and sale of computer software products where pirated copies can often dwarf sales of legally produced software. There has been a net reduction in economic welfare shown by the triangle DBE. Some consumers are prepared to pay higher prices in black markets in order to get the goods or services they want. this year the market will top £250m. rock concerts and black markets for children‘s toys and designer products that are in scarce supply. Producer surplus is reduced to a lower level Pmax EC. higher prices act as a rationing device. Suppliers might also allocate the scarce goods by distributing only to preferred customers. Price A D Supply Consumer surplus at the equilibrium market price B Pe Producer surplus at the equilibrium market price P max E Price Ceiling C Demand Q2 Q1 Quantity Black Markets Ticket touting is nothing new. Good examples of black markets include tickets for major sporting events. Source: econoMax. Last year Britons purchased £100m worth of resold tickets..g. queues of consumers.net . January 2008 A black market (or shadow market) is an illegal market in which the market price is higher than a legally imposed price ceiling. but the rise of online ticket-exchanges has expanded the market by making it much easier for sellers and buyers to find each other.tutor2u. Black markets develop where there is excess demand for a commodity.

Rent £s Free Market Equilibrium Supply (short run) Supply (long run) Pe P max Excess Demand (short run) Excess Demand (long run) Price (Rent) Ceiling Demand Q3 Q2 Q1 Quantity of Rented Property If landlords decide that they cannot make a satisfactory rate of return by selling rented properties in the market because of the maximum price.net . Suggestions for further reading on maximum prices Cup Final tickets sell for £2.. This is illustrated in the next diagram which looks at the effect of a maximum price for rented properties. they might decide to withdraw some properties from the market. The end result would be a loss of allocative efficiency because there are fewer properties on the market and the quality is getting worse – fewer people‘s needs and wants are being met at the prevailing market price. May 2007) © Tutor2u Limited www. Another problem arising from the maintenance of a maximum price is that in the long run. Although maximum prices such as rent controls are still in place in many countries. over the last fifteen years the government has actively sought to encourage an expansion in the total supply of rented properties provided by both private sector landlords and also registered social landlords such as housing associations. The rapid growth in the buy-to-let property market has also contributed to a huge increase in the supply of properties available for letting in the majority of towns and cities in the UK.187 - considered as inequitable (unfair) – because it is likely that eventually those who might have the greatest need for a commodity are unlikely to have their needs met. The quality of rented properties might deteriorate over time because landlords decide to cut spending on maintenance and improvements. suppliers might respond to a maximum price by reducing their supply – the supply curve becomes more elastic in the long term. rent controls were essentially abolished in the late 1980s. At the maximum rent.000 (BBC news online. in the UK.tutor2u. And. the long run supply curve shows a smaller quantity of rented properties available for tenants – which with a given level of market demand cause the excess demand (shortage) in the market to increase.

188 - Mexican president announces fixed food prices for six months (Guardian.tutor2u.. June 2008) Should ticket touting be illegal? (BBC news online. April 2007) © Tutor2u Limited www.net . April 2007) Ticket touts face the music (BBC news online.

85 £5.189 - Minimum Prices A minimum price is a legally imposed price floor below which the market price cannot fall.10 £4..50 £4.net .20 £4. © Tutor2u Limited www.35 £5. Labour supply and demand curve analysis can be used to show the effects.52 £5. This applies both to full-time and part-time workers.73 How does a minimum wage work? The minimum wage is a price floor – employers cannot legally undercut the current minimum wage rate per hour. If the minimum wage is set at Wmin. The market equilibrium wage for this particular labour market is at W1 (where demand = supply).05 £5. Perhaps the best example of a minimum price is the minimum wage which was introduced into the UK in 1999. A diagram showing the possible effects of a minimum wage is shown below.70 £4. there will be an excess supply of labour equal to E3 – E2 because the supply of labour will expand (more workers will be willing and able to offer themselves for work at the higher wage than before) but there is a risk that the demand for workers from employers (businesses) will contract if the minimum wage is introduced. Adult Rate (for workers aged 22+) 1 Apr 1999 1 Oct 2000 1 Oct 2001 1 Oct 2002 1 Oct 2003 1 Oct 2004 1 Oct 2005 1 Oct 2006 1 Oct 2007 1 Oct 2008 £3. To be effective the minimum price has to be set above the equilibrium price.tutor2u.60 £3.

Effect on relative poverty: Is the minimum wage the most effective policy to reduce relative poverty? There is evidence that it tends to boost the incomes of middle-income households where more than one household member is already in work whereas the greatest risk of relative poverty is among the unemployed. The equity justification: That every job should offer a fair rate of pay commensurate with the skills and experience of an employee. Can a minimum wage actually increase employment? © Tutor2u Limited www. 3. Labour market discrimination: The NMW is a tool designed to offset some of the effects of persistent discrimination of many low-paid female workers and younger employees. 2. Possible disadvantages of a minimum wage Although all political parties are now committed to keeping the minimum wage. Labour market incentives: The NMW is designed to improve incentives for people to start looking for work – thereby boosting the economy‘s labour supply. there are still plenty of economists who believe that setting a pay floor represents a distortion to the way the labour market works because it reduces the flexibility of the labour market 1. 2. elderly and single parent families where the parent is not employed. Competitiveness and Jobs: Firstly a minimum wage may cost jobs because a rise in labour costs makes it more expensive to employ people and higher labour costs..190 - Wage Rate (W) W min Labour Supply Minimum Wage (Wage Floor) W1 Free-market equilibrium wage Demand for Labour E3 E2 E1 Employment of Labour (E) Number of people employed The main aims of the minimum wage 1.tutor2u.net .

In addition to the psychological benefits of being paid more. There are two main explanations for the possibility of higher employment 1. Inflation: In many sectors firms find it hard to pass on higher wage costs to final consumers – limiting the inflationary effect of the minimum wage © Tutor2u Limited www. If labour demand is inelastic then the contraction in employment is likely to be less severe than if employers‘ demand for labour is elastic with respect to changes in the wage level. businesses may take steps to improve production processes. The efficiency wage argument that raising pay levels for low-paid employees may have a positive effect on their productivity. Thus they will increase their spending and this will feed through the circular flow of income and spending 2. Employment: Since the minimum wage was introduced. Wage Rate (W) W min Minimum Wage (Wage Floor) Labour Supply W1 Demand for Labour Q3 Q2 Q1 Employment of Labour (E) Evidence on the minimum wage – has it worked? 1.191 - The answer is yes – depending on the circumstances in the labour market when a pay floor is introduced and also on what happens to the productivity of labour when a high (statutory) rate of pay is introduced.net . workplace training etc if they know that they must pay at least the statutory pay floor. The importance of elasticity of demand and supply of labour The impact of a minimum wage on employment levels depends in part on the elasticity of demand and elasticity of supply of labour in different industries.. The Keynesian argument that higher wage rates will increase the disposable incomes of lower-paid workers many of whom have a high propensity to consume.tutor2u. 2. unemployment in Britain has fallen and the level of employment in the British economy is now at a record high although the economy has avoided a recession throughout this period. The excess supply created is much higher than in the previous diagram. In the next diagram we see the possible effects of a minimum wage when both labour demand and labour supply are elastic in response to a change in the market wage rate.

the Federation of Small Businesses and the Low Pay Commission. February 2007) © Tutor2u Limited www. the demand for labour tends to be inelastic with respect to changes in wages 4.net . the Confederation of British Industry. Suggestions for further reading on minimum prices You can find out more about the minimum wage in Britain by visiting the Department for Trade and Industry. 2006) Minimum wage rise of 3. Productivity: It is hard to identify any strong positive effect on labour productivity . Discrimination: The minimum wage has had an impact on the earnings of part-time female workers. April 2007) Hard Rock wages below the minimum (BBC news.tutor2u.. July 2008) Japan sets up minimum wage raise (BBC news. July 2008) Deluge of complaints on minimum wage abuse (Times. 5.8% stokes union anger (The Times. a trend which started before the minimum wage was introduced.192 - 3. March 2008) UK gets a minimum wage (BBC news audio-visual. Butcher guilty of low staff wages (BBC news. In the short term. Wage costs: The minimum wage affects only a small proportion of workers and the effects on the wage bills of most businesses is not a significant factor in their employment decisions. The Trades Union Congress. April 1999) USA minimum wage rises for the first time in a decade (BBC news online.but efficiency gains have been made in most low-paying industries. April 2007) Living on the minimum wage (BBC news audio-visual.

. The price floor is set above the normal free market equilibrium price. Notice that the price elasticity of supply for wheat in the short term is very low because of the length of time it takes for producers to supply new quantities of wheat to the market. (Indeed in the momentary period. One way to smooth out the fluctuations in prices is for the government to operate price support schemes through the use of buffer stocks. we would draw the supply curve as vertical indicating a fixed supply). Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low.net . The government offers a guaranteed minimum price (P min) to farmers of wheat.193 - Buffer Stock Schemes World Cocoa Price London/NY market. The diagram below illustrates the operation of a buffer stock scheme. This is largely due to the volatility in the market supply of agricultural products coupled with the fact that demand and supply are price inelastic.tutor2u. tea and coffee tend to fluctuate more than the prices of manufactured products and services. But many of them have had a chequered history. Average. © Tutor2u Limited www. US dollars per ton 3250 3000 2750 2500 2250 USD/Ton 3250 3000 2750 2500 2250 2000 1750 1500 1250 1000 750 2000 1750 1500 1250 1000 750 00 01 02 03 04 05 06 07 08 Source: Reuters EcoWin The prices of agricultural products such as wheat.

194 - Supply Price S2 P min Price Floor (Guaranteed) Pe Demand Q3 Q1 Q4 Quantity If the government is to maintain the guaranteed price at P min. This estimate is the scheme‘s target price and obviously determines the maximum and minimum price boundaries. The price of the product will then crash as the excess stocks built up by the organization are dumped onto the market.. But if the target price is significantly above the correct average price then the organization will find itself buying more produce than it is selling and it will eventually run out of money. the market supply of wheat will shift out (see the diagram on the next page) – putting downward pressure on the free market equilibrium price. the government will have to intervene once more in the market and buy up the surplus stock of wheat to prevent the price from falling. then it must buy up the excess supply (Q3-Q1) and put these purchases into intervention storage. Setting up a buffer stock scheme also requires a significant amount of start up capital. Should there be a large rise in supply due to better than expected yields of wheat at harvest time. perishable items cannot be stored for long periods of time and can therefore be immediately ruled out of buffer stock schemes. In this situation. There are also high administrative and storage costs to be considered. It is easy to see how if the market supply rises faster than demand then the amount of wheat bought into storage will grow.tutor2u. The problems with buffer stock schemes In theory buffer stock schemes should be profit making. since they buy up stocks of the product when the price is low and sell them onto the market when the price is high. since money is needed to buy up the product when prices are low. it will end up selling more than it is buying and will eventually run out of stocks © Tutor2u Limited www. Conversely if the target price is too low then the organization will often find the price rising above the boundary.net . However. Clearly. The success of a buffer stock scheme however ultimately depends on the ability of those managing a scheme to correctly estimate the average price of the product over a period of time. they do not often work well in practice.

But what if intervention leads to further inefficiencies? What if government policies prove to be costly to implement but ineffective in achieving their desired outcomes? What happens if intervention distorts markets still further leading to a further loss of allocative efficiency? What is Government Failure? Even with good intentions governments seldom get their policy application correct. by-passes. control and regulate but the eventual outcome may be a deepening of the market failure or even worse a new failure may arise. Government failure occurred when the central planners produced products that were not wanted by consumers – a loss of allocative efficiency. Ten countries became new members of the European Union in May 2004. inequitable and misplaced. Government failure may range from the trivial. (a) Political self-interest The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation of resources. The essence of a command economy was that the state planning mechanism would decide what to produce and how to produce it and for whom to produce. Another fundamental failing of the pure command economy was that there was little incentive for workers to raise productivity. Countries such as Hungary.195 - Government Failure A failure of the free market and the price mechanism to deliver an allocatively efficient allocation of scarce resources is normally regarded as justification for some form of government intervention in the economy. © Tutor2u Limited www. Causes of Government Failure Government intervention can prove to be ineffective. but where harm is restricted to the cost of resources used up and wasted by the intervention. schools and hospitals may be decided with at least one eye to the political consequences. some of them former state-run economies in the Eastern Block. when intervention is merely ineffective. This intervention is designed to correct for instances of market failure and achieve an improvement in economic and social welfare. to cases where intervention produces new and more serious problems that did not exist before.. and little innovation by firms as no profit motive existed. All of these economies are now moving towards the western mixed economy. poor quality control. They can tax. For example decisions about where to build new roads.tutor2u. The consequences of this can take many years to reverse. since there was no price mechanism to signal changes in consumer preferences and demand. Government failure in a non-market economy The collapse of the Soviet Union in the late 1980s marked the failure of command or state-run economies as a means of allocating resources among competing uses. Command economies also suffered massive environmental de-gradation because they did not posses structures for valuing the environment and giving consumers and producers the right incentives to protect their environmental heritage.net . though at varying speeds and with varying success. the Czech Republic and Poland are all moving towards a market based system for the allocation of resources through privatisation and market liberalisation.

(b) Policy myopia Critics of government intervention in the economy argue that politicians have a tendency to look for short term solutions or “quick fixes” to difficult economic problems rather than making considered analysis of long term considerations.g. the environment and developing countries who claim that they are being unfairly treated in world markets by the effects of import tariffs on food and export subsidies to loss-making European farmers? (d) Government intervention and disincentive effects © Tutor2u Limited www. . This is when the industries under the control of a regulatory body (i. (c) Regulatory capture.tutor2u. Critics of government subsidies to particular industries also claim that they distort the proper functioning of markets and lead to inefficiencies in the economy. Critics of current government policy towards tobacco taxation and advertising.net . The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural economic problems. telecommunications. They clearly believe that government failure is endemic in our transport industry – although we should remember that their view is normative.e. For example. based on value judgements! Secondly criticisms of the huge increases in state spending on the National Health Service. We might find examples of this in agriculture. Some economists argue that regulators can prevent the ability of the market to operate freely. to what extent has the system of agricultural support known as the Common Agricultural Policy operated too much in the interests of farmers and the farming industry in general? And as a result. For example short term financial support to coal producers to keep open loss-making coal pits might prove to be a waste of scarce resources if the industry concerned has little realistic prospect of achieving a viable rate of return in the long run given the strength of global competition. the main household utilities and in transport regulation. boosting welfare spending in the run up to an election. a decision to build more roads and by-passes might simply add to the problems of traffic congestion in the long run encouraging an increase in the total number of cars on the roads. Government critics argue that much of the extra spending is being ―lost‖ in higher pay and administration rather than finding its way into improving front-line health services. or bringing forward major items of capital spending on infrastructural projects without the projects being subjected to a full and proper cost-benefit analysis to determine the likely social costs and benefits. has the CAP worked against the long-term interest of consumers. a government agency) appear to operate in favour of the vested interest of producers rather can consumers. and the controversial issue of genetically modified foods argue that government departments are too sensitive to political lobbying from the major corporations. The Commission for Integrated Transport has criticised the Government for a failure to develop a properly integrated transport policy.e.196 - The pressures of a looming election or the influence exerted by special interest groups can foster an environment in which inappropriate spending and tax decisions are made.. For example.

The law of unintended consequences is often used to criticise the effects of government legislation. How does the government know how many extra houses need to be built in the UK over the next twenty years? Is building thousands of extra homes in an already congested South-east the right option? Are there better solutions? There have been plenty of instances of government housing policy having failed in previous decades! (g) The Law of Unintended Consequences The law of unintended consequences is that actions of consumer and producers — and especially of government—always have effects that are unanticipated or "unintended. (e) Government intervention and evasion A decision by the government to raise taxes on de-merit goods such as cigarettes might lead to an increase in attempted tax avoidance.tutor2u.197 - Free market economists who fear government failure at every turn argue that attempts to reduce income and wealth inequalities can worsen incentives and productivity. tax evasion. The result can be misguided policies and damaging long-term consequences. in the long-run.. there is general disinterest in the political process. people rarely vote purely out of their own self-interest or on the basis of a well informed and rational assessment of the costs and benefits of different government policies. Equally a decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of drugs and a substantial loss of social welfare arising from over consumption. national. Often a government will choose to go ahead with a project or policy without having the full amount of information required for a proper cost-benefit analysis. people act in unexpected ways because or ignorance and / or error. shadow markets develop to undermine an official policy. (f) Policy decisions based on imperfect information How does the government establish what citizens want it to do in their name? Can the government ever really know the true revealed preferences of so many people? Our current electoral system is not an ideal way to discover this! Turnout in every type of election." Particularly when people do not always act in the way that the economics textbooks would predict – this is of course the essence of a social. People find ways to circumvent laws. behaviour science – we do not live our lives in sanitised laboratories where all of the conditions can be controlled.net . They would argue against the National Minimum Wage because they believe that it artificially raises wages above their true free-market level and can lead to real-wage unemployment. taxation and regulation. (local. They would argue against raising the higher rates of income tax because it is deemed to have a negative effect on the incentives of wealth-creators in the economy and generally acts as a disincentive to work longer hours or take a better paid job. Furthermore. the best way of finding out (a) What consumer preferences are and (b) Aggregating these preferences based on the number of people that are willing and able to pay for particular goods and services. Proponents of government failure argue that the free market mechanism is. © Tutor2u Limited www. smuggling and the development of grey markets where trade takes place between consumers and suppliers without paying tax. European etc) is falling.

tutor2u. The estimated social benefits of a particular policy might be largely swamped by the administrative costs of introducing it. companies and businesses may have been deliberately given more allowances than they needed. DEFRA. The market thus provides little incentive for businesses to invest money in reducing their emissions. The original caps set by the EU are now seen as being set way too high and some people believe that this was not an accident. Carbon trading and government failure Coal production is on the increase in the UK and around Europe. Source: Tutor2u Blog. and the power stations have to buy extra emissions credits. The surplus of C02 emission allowances has meant that scarcity in the market has disappeared leading to a collapse in the price of carbon . Carbon Trade Watch believe that the EU has been captured by strong corporate lobbying who themselves knowingly over-estimated their "business as usual" C02 emissions when they submitted them to national governments ahead of the launch of the carbon trading scheme. creating surplus permits that could be profitably sold onto to other businesses. Why are the power stations turning back to coal? Because the price of carbon emissions is low and coal has become price competitive against oil and gas. so C02 emissions are rising.198 - Unintended consequences can add hugely to the financial costs of some government programmes so that they make them extremely expensive when set against their original goals and objectives. Emissions from coal fired power stations in the UK in 2006 alone increased by 8%! Consumers are paying the price of higher energy bills but they are not getting the environmental pay off in terms of reducing carbon production as a contribution to controlling climate change. the UK environment agency has estimated that the windfall profits for the electricity generators in the UK might have been as high as £1. effectively the price of polluting is close to zero. but the price of credits is low so the consequences for the power generators are not significant. (h) Costs of administration and enforcement Government intervention can prove costly to administer and enforce. The carbon trading scheme started in January 2005 with carbon allowances being bought and sold.the aim is to progressively reduce this cap over time and therefore mitigate climate change. For firms with plenty of surplus C02 emissions (given away free of charge in the first place!) there has been a huge windfall gain. One criticism of the EU carbon trading scheme is that the EU allocated initial allowances free rather than using a market-based auction system. "Polluter pays" seems to have been replaced with "polluter earns"! The major power generators have been given a free block of pollution rights which they can then sell onto the market and make a profit. June 2007 Key points about government failure © Tutor2u Limited www. As coal production expands. But this is the sort of thing that isn't supposed to be happening! Even with the potential for clean coal technology.. it is widely regarded as a dirty source of energy and a major contributor to C02 emissions.prices now are 20-30 Euro cents. The cap places a limit on the total pot of emissions that can be released by industry .net . The largest C02 emitters were brought into the cap and trade system.5bn.

June 2008) © Tutor2u Limited www.199 - 1. Limited information . Free market economists are naturally distrustful of government intervention in the economy.net . July 2008) Canadians ponder the cost of the rush for dirty oil (Guardian. That is the nature of politics. London 2012 9. Costs and benefits of the introduction of competition into a market e.g.g. the result can be a deepening of an existing market failure. Costs and benefits of indirect taxes e. Costs and benefits of a decision to relax planning controls on new house-building Suggestions for further reading on government failure All of the following web links have been chosen because they link to to the topic of government failure.. Costs and benefits of different policies designed to reduce unemployment e. the national minimum wage or a rise in the top rate of income tax 6. objective judgements. Costs and benefits of different strategies designed to reduce income and wealth inequality e. Often we can accuse the government of policy failure only with the benefit of hindsight 4. 5. Failure happens when policies do not work as intended – as you read through the articles that take your interest. Costs and benefits of major infrastructural projects such as new motorways. The cost-benefit principle says that you should take an action if. They believe that the signalling. free entry to museums and galleries 5.tutor2u. postal market liberalisation 4. consider where (if at all) the government failure may lie in these examples. incentive and rationing functions of the price mechanism should be given more freedom to operate 2. July 2008) Inside one of Britain‘s cannabis factories (BBC news. comparing the effectiveness of investment in training with an employment subsidy for the long term unemployed 8. Government failure is most likely to occur when decisions are made in the vested interest of special interest groups. environmental taxes or taxes designed to curb demand for / consumption of de-merit goods 3. The result is a further loss of allocative and productive efficiency because of the waste of scarce resources – leading to a reduction in consumer and producer welfare 3.g.no government has the resources and information available to it to make fully-informed. Appetite for bio fuel starves the poor (Guardian.g. at the expense of other groups (the result is a loss of equity) Using the cost-benefit principle in AS micro economics The cost-benefit principle is one of those core ideas that can be brought into so many discussions both in micro and macroeconomics – you should be using it in your papers tomorrow. the bio-fuel debate or subsidies for industries affected by globalisation 2. the extra benefit from taking it is greater than the extra cost Here are some examples where the principle might be built into your analysis and evaluation 1.g. Costs and benefits of an increase in government spending on public goods and merit goods such as flood defence schemes. Costs and benefits of the introduction of carbon trading as a way of reducing CO2 emissions 7. When government failure exists. Costs and benefits of subsidies e. and only if.

200 - NHS dentistry reforms are failing (BBC news.tutor2u. May 2007) © Tutor2u Limited www.. March 2008) Watchdog admits failure over Northern Rock (BBC news. July 2008) Run on the Bank – Northern Crock (Money Programme. June 2008) The Great Green Fuel Gamble (Money Programme. July 2008) Regulatory failure over Equitable Life (BBC news. March 2008) Will the smoking ban kill bingo halls? (BBC news.net . November 2007) The great carbon bazaar (BBC news.

The skill of application requires you to select relevant information from the data source that is used in a question and then to use the selected information as a stimulus or as evidence in the answer Analysis: Level 3 tests your ability to use economic theories and concepts to analyse microeconomic and macroeconomic problems e.g. there are two main methods of measuring unemployment and different ways of measuring the rate of inflation using the Retail Price Index Application: Level 2 test your ability to apply your economics knowledge and understanding to particular problems and issues. We will say much more about evaluation further on in this revision guide! © Tutor2u Limited www. candidates answer one Each question will have four sub-questions. Explanation may require explaining the causes or the consequences of a problem or policy Evaluation: Level 4 tests your ability to evaluate problems and government policies and make informed judgements based on theory and evidence e. Analysis is an important skill both at AS level and even more so at A2 level. 8.tutor2u.. The command word explain usually requires that some analysis is provided in the answer – usually in the form of a specific problem or policy. 12 and 25 marks (50 marks in total) Assessment objectives for the exam The economics exam tests four types of assessment objectives. carrying 5. short term and long term implications.net . knowledge. analysis and evaluation: Knowledge: Level 1 tests your knowledge of the syllabus and your ability to express that knowledge e. and application of knowledge.g. Evaluation must be based on appropriate analysis for L4 marks to be awarded.g. use aggregate demand & aggregate supply to show rising unemployment caused by a negative output gap.201 - Exam Technique The AQA Unit 1 Exam Paper – Markets and Market Failure The exam consists of Written Paper: 1 hour 15 minutes – carrying 25% of total A Level marks = 75 raw marks (100UMS) Section A: 25 compulsory objective test (multiple choice) items (25 marks) Section B: Two optional data response questions are set.

g. come to a reasoned conclusion at the end Analyse Economic Problems and Issues Analyse Set out the main points Explain a theoretical relationship Diagrams are nearly always required for analysis Apply Use the data provided in a specific way Compare Give similarities and differences Consider Give your thoughts about Explain (why) Give clear reasons or make clear Explain (using the concept of) In this question you must use the concept in the question Justify/account Give reasons for for Summarise Give main points.tutor2u.but support it (them) with relevant evidence Discuss Give the arguments. making some attempt to weight your opinions To what extent Make a judgement.net .202 - Key Command Words in Questions The table below helps to give you an idea of the different command words that can be used in a question. for and against Evaluate Discuss the importance of. Knowledge & Application of Knowledge Calculate Work out using the information provided (calculators can and should be used in the exam e. Industries and economies) How (explain In what way or in what how) ways Identify Point out Illustrate Give examples/diagram Outline Describe without detail State Make clear Evaluate Economic Arguments and Evidence Assess Show how important something is Criticise Give an opinion or set of opinions . without detail Which Give a clear example/state what © Tutor2u Limited www. when manipulating the data provided in charts and tables) Define Give the exact and precise meaning Describe Give a description of Give (an As `describe' account of) Give (an Give a particular example example of) (drawn from real world markets..

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