Notes

Economic Problem

Economics – The study of how to allocate scarce resources in the most effective way
Economic Problem – How to allocate scarce resources among alternative uses
Household – A group of people whose spending decisions are connected
Microeconomics – The study of how households and firms make decisions in markets
Macroeconomics – The study of issues that affect economies as a whole

The fact that resources are scarce compared to the unlimited wants > Choices having to be
made

Goods – Tangible products, i.e. products that can be seen and touched, such as cars,
food and washing machines
Services – Intangible Products, i.e. products that cannot be seen or touched, such as
banking, beauty therapy and insurance




Factors of Production

Factors of Production – The resource inputs that are available in an economy for the
production of goods and services

The Four Factors:
Land – This is a natural resource. Things such as oil, coal, rivers and the land itself.
Labour – This is the human resource that is available in any economy / The quantity and quality
of human resources
Some economies (generally poor countries) have large populations but lack a skilled workforce
and for other countries like Germany with declining populations, they depend on immigrant
workers to do both skilled and unskilled jobs. Quality of labour is essential for economic
progress.
Capital - Man-made aids for production / Goods used to make other goods
It is combined with Land and Labour
MERC - Machines, Equipment, Robots and Computers
Entrepreneurship - The willingness of an entrepreneur to take risks and organise production.
Entrepreneur Definition - Someone who bears the risks of businesses and who organises
production.

Some Extra Definitions

The world’s poorest countries tend to have few or poor Factor Endowments (vice versa).
Factor Endowments - The stock of factors of production
Production -The output of goods and services
Want - Anything you would like, irrespective of whether you have the resources to
purchase it
Scarcity - A situation where there are insufficient resources to meet all wants
Choice - The selection of appropriate alternatives
Opportunity Cost - The cost of the (next) best alternative, which is forgone when a
choice is made / The next best alternative forgone
Specialisation - The concentration by a worker or workers, firm, region or whole
economy on a narrow range of goods and services
Exchange - The process by which goods and services are traded



International Specialisation

The Advantages of International Specialisation (ORE):
 An increase in the output of goods and services - In comparison to what they could
achieve on their own
 A widening of the range of goods that are available in an economy
 Increased exchange between developed and developing economies

The Disadvantages of International Specialisation (WIFT):
 Bad weather – It can wipe out a whole years crops
 De-industrialisation – Due to cheap imported goods displacing workers
 Finite Resources – If they run out trouble will ensue, unless the income gained from it
has been wisely invested in the future
 Tastes or needs of consumers may change – Hardship among those producing goods
that are no longer wanted / needed is inevitable

Productivity – Output, or production of a good or service, per worker per period of
time



Production Possibility Curve (PPC)

Production Possibility Curve (Firm) – This shows the maximum quantities of different
combinations of output of two products, given current resources and the state of technology
Production Possibility Curve (Country) – This shows the maximum quantities of different
combinations of output of capital and consumer goods, given current resources and the state of
technology
Developed Economy – An economy with a high level income per head
Developing Economy - An economy with a relatively low level of income per head
Productive Efficiency – Any point on the line
Allocative Efficiency – Choosing between two points Eg. E > A
Unemployed Resources - Any point inside the curve Eg. X
Unobtainable – Any point outside the curve Eg. Y
Bliss Points – Where the curve starts or ends Eg. 6 Computers or 21 Bicycles
Economic Growth – Change in the productive potential of an economy
Productive Potential – The maximum output that an economy is capable of producing

PPC Shifters (Right):
1. Changes in the quantity of resources
o The quantity of labour may increase as a result of net immigration of people of
working age, a higher proportion of women entering the labour force or a rise in the
retirement age.
o The purchase of extra capital goods, referred to as net investment, increases the
quantity of capital goods causing the PPC to increase (shift to the right).
o The quantity of enterprise may be increased by a reduction in rules and regulations
placed on firms, privatisations and government incentives to start up new
businesses
2. Changes in the quality of resources
o Improvements in education and training will improve the quality of labour and raise
productivity causing the PPC to increase (shift to the right)
o The quality of capital goods is raised by advances in technology causing the PPC to
shift right.
o The quality of enterprise may be raised by management training and improved
education

PPC Shifters (Left):
- Natural Disaster (Less resources > Less of each product can be produced)

PPC Stretches:
- More resources / Capital (More of one product can be produced) Eg. Wine
- Advances in technology (More of one product can be produced) Eg. Wine



Economics Systems and The Role Of The Market

Economic System – The way in which production is organised in a country or group of countries
An economic system - The term used to describe the means by which a country’s people,
organisations and government make decisions with respect to(WHW):
 What goods and services are to be produced
 How these goods and services are produced
 Who should receive these goods and services

Market Economy – An economic system whereby resources are allocated through the market
forces of demand and supply
Price System – A method of allocating resources by the free movement of prices
Command Economy – An economic system in which most resources are state owned and also
allocated centrally
Mixed Economy – An economic system in which resources are allocated through a mixture of
the market and direct public sector involvement

The advantages of a free market economy / The disadvantages of command economies(CIGE):
 Choice – Firms will produce whatever consumers are prepared to buy and there is no
restriction on what they produce in the FM. Planners are more concerned that there
are enough essentials goods to go around rather than allocating resources efficiently
between all goods
 Innovation – Firms will look to produce something new in order to be competitive.
Because of property rights(intellectual property rights through patents) there are
incentives for innovation and producing better quality products. Planners do not have
this incentive, they are happy just producing essentials.
 Higher Economic Growth Rates – Countries with economic systems closer to the free
market tend to have higher economic growth.
 Efficiency – Free markets are very competitive. Most of their industries are assumed to
be perfectly competitive and so allocative and productive efficiency occur. This is
because decisions about what to produce are made by the consumers rather than by
planners

The advantages of command economy / The disadvantages of free market economies(PmdIE):
 Public, Merit and Demerit Goods - Public goods cannot be provided in the private
sector. Merit goods are likely to be under consumed in the free market and demerit
goods over consumed. In a command economy demerit goods are likely to be banned
or heavily taxed and public goods and merit goods will be provided at high levels.
 Unequal Distribution of Income – Benefits will be low and health service and school
unaffordable for a lot. Those who are poor are likely to fall to destitution. A command
economy may not allow the successful to make millions but it will at least try to make
sure the poor are not left to destitution so the economy is fairer
 Environment – Free market economies are likely to produce more pollution. Command
economies will attempt to make sure that the level of output is the socially optimal
level of output through things such as taxes and pollution permits although pollution
does tend to still be high



Specialisation / Division of Labour

Division of Labour Definition – The specialisation of labour where the production process is
broken down into separate tasks

The Advantages of Specialisation / Division of Labour to Firm (From Mark Scheme):
 Increased output
o With improvement in efficiency and use of machinery output is increased
 More innovation
 Improved quality
 Increased productivity
o Specialised machinery can be used which further increases the productivity.
 Developing and maintaining a brand image
 Economies of scale

The Disadvantages of Specialisation / Division of Labour to Firm (From Mark Scheme):
 Reliance on a narrow range of products
 Specialist factor inputs are more expensive per unit
 Limited market size
 Reliance on one specialist resources / suppliers or factor immobility
 Reduced flexibility
 Boredom of workers / demotivation

The Advantages of Specialisation / Division of Labour – TO THE FIRM:
 Specialist workers become quicker at producing goods
o Production becomes cheaper per good because of this
o Production levels are increased
 Each worker can concentrate on what they are good at and build up their expertise
The Advantages of Specialisation / Division of Labour – TO THE WORKER:
 Increased productivity
 Higher pay for specialised work
o Improved skills at that job

The Disadvantages of Specialisation / Division of Labour – TO THE FIRM:
 Greater cost of training workers
 Quality of products may suffer if workers become bored by the lack of variety in their
jobs

The Disadvantages of Specialisation / Division of Labour – TO THE WORKER:
 Boredom as they do the same job
 Their quality and skills may suffer
 May eventually be replaced by machinery

Competitive Markets and How They Work

Market – Where or when buyers and sellers meet to trade or exchange products
Sub-Market – A recognised or distinguishable part of a market> Also known as a market segment
Ceteris Paribus – Assuming other variables remain unchanged
Disposable Income – Income after taxes on income have been deducted and state benefits have
been added
Real Disposable Income – Income after taxes on income have been deducted and state benefits
have been added and the result has been adjusted to take into account changes
Normal Goods – Goods for which an increase income leads to an increase in demand
Inferior Goods – Goods for which an increase in income leads to a fall in demand
Substitutes – Competing Goods
Complements – Goods for which there is joint demand
Efficiency - Where the best use of resources is made for the benefit of consumers
Consumer Surplus – The extra amount that a consumer is willing to pay for a product above the
price that is actually paid
Producer Surplus – The difference between the price a producer is willing to accept and
what is actually paid

How a Consumer / Producer Surplus Changes (Mark Scheme) (4 Marks):
 Correctly labelled, Downward sloping demand curve / Upward sloping supply curve
 Original Consumer / Producer surplus identified
 Consumer / Producer surplus will Increase / Decrease
 Area of Consumer / Producer surplus Increase / Decrease indicated by letters or
labels

Comment on size of change of Consumer / Producer surplus:
 Change in price
 Elasticity of Curve



Demand

Demand – The quantity of a product that consumers are able and willing to purchase at various
prices over a period of time
Notional Demand – The desire for a product
Effective Demand – The willingness and ability to buy a product
Demand Curve - This shows the relationship between the quantity demanded and the price of a
product
Demand Schedule – The data that is used to draw the demand curve for a product
Movement Along The Demand Curve – This is in response to a change in the price of a product
Change In Demand – This is where a change in a non-price leads to an increase or decrease in
demand for a product

ILAPTIMERS(Demand shifters / Determinants):
I – Income – Increase in Income > Increase in D
L – Legislation – Eg. Motorcycle Helmet Law Introduced > Increase in D for Motorcycle Helmets
A – Advertising – Increase in Advertising stimulates demand > Increase in D
P – Population – Increase in Population > Increase in D
T – Tastes – Consumer Taste changes to 3D TVs > Increase In D for TVs
I – Interest Rates – Decrease Interest Rates > Increase in D
M – Market Size – Increase in Market Size > Increase in D (Not 100% sure about this one)
E – Expectations of Future Prices – Price expected to increase > D increases now
R – Related Goods – Increase in price of Substitutes > Increase in D for original product
S – Seasons – Christmas is coming > Increase in D for Santa Costumes

Income Substitution Effect For A Price Increase – Why The Demand Curve Is Downwards Sloping:
- If the price of a good increases, then there will be two effects:
1. Substitution Effect
o The good is relatively more expensive than alternative goods and people can
switch to other goods.
2. Income Effect
o The increase in price decreases one’s purchasing power and so one’s real disposable
income decreases. This lower income is likely to reduce demand for normal goods
but increase demand for inferior ones.



Supply

Supply – The quantity of a product that produces are willing and able to provide at different market
prices over a period of time
Profit – The difference between the total revenue (sales revenue) of a producer and total cost
Supply Curve – This shows the relationship between the quantity supplied and the price of a product
Supply Schedule – The data used to draw the supply curve of a product
Change In Supply – Occurs when a change in a non-price influence leads to an increase or decrease
in the willingness of a producer to supply a product
PRATNESTS(Supply shifters / Determinants):
P – Productivity – Increase in productivity > Increased S
R – Resource Cost – Decrease in Resource Cost > Increase in S
A – Alternative Output – Alternative product selling for higher price > Increase S of alternative
T – Technology – Better / More Technology > Increased productivity > Increase in S
N – Number Of Suppliers – Increased Number Of Suppliers > Increase in S
E – Expectations of Future Prices – Price expected to rise > Increase in S later
S – Subsidies – Increase in amount of Subsidy > Decrease in Cost of Production > Increase in S
T – Taxes – Taxes Increased > Increase in Cost of Production > D increases now
S – Seasons – Winter is coming > Decrease in S of crops

Price – The amount of money that is paid for a given amount of a particular good or service
Equilibrium Price – The price where demand and supply are equal
Clearing Price – Same as equilibrium price
Disequilibrium – Any position in the market where demand and supply are not equal
Surplus – An excess of supply over demand
Shortage – An excess of demand over supply

Comment on how overall impact of shift in D or S depends on (Generally worth 2 marks):
 Size of Shift/s (1 mark) + elaborated with reference to effect on price or quantity (1 mark)
 Elasticity of curve not shifting or elasticity of both curves (1 mark) + elaborated with
reference to effect on price or quantity (1 mark)
 There are other factors that affect demand and/ or supply (up to 2 marks)




Elasticity

Elasticity:
 Is a numerical estimate
 Measures the response to a change in price or to a change in any other factors that
determine the demand or supply of a product
Elasticity Definition – The extent to which buyers and sellers respond to a change in market
conditions




Price Elasticity (PED)

Price Elastic Definition – Where the percentage change in the quantity demanded is sensitive to
a change in price of the product {Greater than 1 or Less than -1} / Further away from 0
Price Inelastic Definition – Where the percentage change in the quantity demanded is
insensitive to a change in price of the product {Less than 1 or Greater than -1} / Closer to 0
Price Unit Elastic Definition - Where the percentage change in the quantity demanded is equal
to a change in price of the product {Equal to 1}
Price Elasticity Of Demand (PED) Definition – The responsiveness of the quantity demanded to
a change in the price of the product

Price Elasticity Of Demand (PED) Formulae:

ELASTICITY= %Δ Q D / %Δ P = (( NEW Q - OLD Q)/ OLD Q X 100) / ((NEW P - OLD P)/ OLD P X 100)

Determinants Of The Price Elasticity Of Demand (SHITBND):
 The availability and closeness of substitutes – the more substitutes, the more price
elastic demand is
 Habit Forming – Habit forming goods tend to have very price inelastic demands
 The relative expense of the product with respect to income – Increased price elasticity
with relatively expensive goods
 Time (Short Term / Long Term) – Consumers are less likely to change spending habits in
the short term but in the long term will become more aware of substitutes increasing
price elasticity. Also products that don’t warrant instant consumption and take up a
large proportion of income (cars, bathrooms etc…) are usually more price elastic.
 Brand Loyalty – Products with strong brands tend to have more price inelastic demands
 Necessities – Necessities tend have very price inelastic demands
 Durability – Goods that are expected to last a long time tend to be more price elastic as
the purchase can be delayed whereas milk will run out quickly and need to be
repurchased even if its price rises



Income Elasticity Of Demand (YED)

Income Elasticity Of Demand Definition - The responsiveness of demand to a change in income
Income Elastic Definition – Goods for which a change in income produces a greater
proportionate change in demand
Income Inelastic Definition – Goods for which a change in income produces a less than
proportionate change in demand
Normal Good Definition – Goods for which an increase in income leads to an increase in
demand / Goods with a positive income elasticity of demand YED > 0

Normal Necessity – YED = 0.1 - 0.4
Pure Normal – YED = 0.6 - 0.9

Superior Good Definition – Goods for which an increase in income leads to a relatively large
increase in demand / Goods with a relatively large positive income elasticity of demand YED > 1
Inferior Good Definition – Goods for which an increase in income leads to a fall in demand /
Goods with a negative income elasticity of demand YED < 0
Giffen Good – YED < -2

Income Elasticity Of Demand (YED) Formulae:
YED= %Δ Q D /%Δ INCOME

Comment on Income Elasticity of Demand:
1. YED Coefficient – What type of good is it? + Its Elasticity
2. 10% Example – YED = 1.5 Income goes up 10% Demand goes up 15%
3. Does the YED correspond with economic theory? e.g. A TV can’t be an inferior good
4. These are estimates + They may also be unreliable
5. These estimates can change over time
6. Assumes ceteris paribus which may not apply (Usually accepted)


Cross Elasticity Of Demand (XED)
Cross Elasticity Of Demand (XED) Definition – The responsiveness of demand for one product in
relation to a change in the price of another product
A positive XED indicates two substitutes Positive Substitute
A negative XED indicates two complements Complement Negative Number
A zero XED indicates that the two products have no real relation in terms of Price affecting D
(Zero XED would be a vertical line)

Cross Elasticity Of Demand (XED) Formulae

XED= %Δ Q D OF GOOD X /%Δ P OF GOOD Y

Comment on Cross Elasticity of Demand:
1. XED Coefficient – Substitute or Complement + Its Elasticity
2. 10% Example – XED = 1.5 Product X goes up 10% Product Y goes up 15%
3. Does the XED correspond with economic theory? PS and Xbox aren’t complements
4. These are estimates + They may also be unreliable
5. These estimates can change over time
6. Assumes ceteris paribus which may not apply (Usually accepted)



Price Elasticity Of Supply (PES)

Price Elasticity Of Supply (PES) Definition – The responsiveness of the quantity supplied to a
change in the price of the product

Price Elasticity Of Supply (PES) Formulae
PES= %Δ Q SUPPLIED / %Δ PRICE

Determinants Of The Price Elasticity Of Supply (FTSCN):
 Factor Mobility – When labour is the most important factor of production, supply is
elastic as labour is generally easy to obtain. When capital is the most important factor of
production, supply is inelastic as new machinery must be installed (additionally market
conditions may change before the new machinery is installed so resources may be
wasted)
 Time Period – In the short-term supply is more inelastic. In the long-term supply is
more elastic.
 The Availability Of Stocks Of The Product – For stock that can be stored (Store items)
the supply is elastic. For stock that cannot be stored (Hotel rooms and Cinema Seats)
the supply is inelastic as the product must be consumed on a particular day or within a
certain time period
 Existence of Spare Capacity – Supply is more elastic, the greater the spare capacity, as
it is easier to raise output if the price rises
 Number Of Producers - Supply will be more price elastic as the more producers there
are the easier the market can respond to a change in price

Comment on Price Elasticity of Demand/Supply:
1. PED / PES Coefficient – Elastic or Inelastic
2. 10% Example – PES = 1.5 Price goes up 10% Supply goes up 15%
3. Does the PED / PES correspond with economic theory? e.g. PES can’t be negative
4. These are estimates + They may also be unreliable
5. These estimates can change over time
7. Other factors can affect Supply / Demand
8. Assumes ceteris paribus which may not apply (Usually accepted)

How information on elasticity can be collected:
 Sample surveys
 Past records from within a company
 Competitor analysis



Market Structure
There is a range of market structures. The market structure is concerned with how
the market is organised.

Perfect Competition , Monopolistic Competition, Oligopoly, Monopoly
Lower Barrier Of Entry and More Constables from left to right
More Market Power and Less Efficiency from right to left

Objective of Firms:
Profit: Profit is an important objective of most firms. Models that consider the traditional
theory of the firm are based upon the assumption that firms aim to maximise profits.
However, firms can have other objectives which affect how they behave.
Profit is the difference between total revenue and total cost. It is the reward that
entrepreneurs yield when they take risks.

Survival: Some firms, particularly new firms entering competitive markets, might aim
to simply survive in the market. This is a short term view. During periods of economic
decline such as the 2008 financial crisis, when consumer spending plummets, firms
might have survival as their objective, until there is economic growth again. Firms
might aim to sell as much as possible to keep their market position, even if it is at a
loss in the short run.

Growth: Some firms might aim to increase the size of their firm. This could be to
take advantage of economies of scale, such as risk-bearing or technological. This
would lower their average costs in the long run, and make them more profitable.
Firms might grow by expanding their product range or by merging or taking over
existing firms. Large firms are also more able to participate in research and
development, which might make them more competitive and efficient in the long
run.

Perfect competition
A perfectly competitive market has the following characteristics:
o Many buyers and sellers
o Sellers are price takers
o Free entry to and exit from the market
o Perfect knowledge
o Homogeneous goods
o Firms are short run profit maximisers
o Factors of production are perfectly mobile

Advantages
In the long run, there is a lower price.
P =MC, so there is allocative
efficiency.
Since firms produce at the bottom of
the AC curve, there is productive
efficiency.


Disadvantages
In the long run, dynamic efficiency
might be limited due to the lack of
supernormal profits.
Since firms are small, there are few or
no economies of scale
.The assumptions of the model rarely
apply in real life. In reality, branding,
product differentiation, adverts and
positive and negative externalities,
mean that competition is imperfect.

Oligopoly
Characteristics of an oligopoly:
High barriers to entry and exit
There are high barriers of entry to and exit from an oligopoly. High barriers to entry
make the market less competitive.
High concentration ratio
In an oligopoly, only a few firms supply the majority of the market. For example, in
the UK the supermarket industry is an oligopoly. The high concentration ratio makes
the market less competitive.
Interdependence of firms
Firms are interdependent in an oligopoly. This means that the actions of one firm
affect another firm’s behaviour.
Product differentiation
Firms differentiate their products from other firms using branding. The degree of
product differentiation can change how far the market is an oligopoly.

For example Supermarkerts are an example of and Oligopolistic market.

Advantages
Oligopolies can earn significant
supernormal profits, so they might invest
more in research and development. This
can yield positive externalities, and make
the monopoly more dynamically efficient
in the long run. There could be more
invention and innovation as a result.
Moreover, firms are more likely to
innovate if they can protect their ideas.
This is more likely to happen in a market
where there are high barriers to entry.

Since oligopolies are large, they can
exploit economies of scale, so they have
lower average costs of production. T

Higher profits could be a source of
government revenue.

Industry standards could improve. This is
especially true in the pharmaceutical
industry and for car safety technology.
This is because firms can collaborate on
technology and improve it. It saves on
duplicate research and development.

Disadvantages
The basic model of oligopoly suggests
that higher prices and profits and
inefficiency may result in a misallocation
of resources compared to the outcome
in a competitive market.

If firms collude, there is a loss of
consumer welfare, since prices are raised
and output is reduced.

Collusion could reinforce the monopoly
power of existing firms and makes it
hard for new firms to enter. The absence
of competition means efficiency falls.
This increases the average cost of
production.

Monopoly and monopoly power
Monopolies can be characterised by:
o Profit maximisation. A monopolist earns supernormal profits in both the
short run and the long run.
o Sole seller in a market (a pure monopoly)
o High barriers to entry
o Price maker
o Price discrimination

In the UK, when one firm dominates the market with more than 25% market share,
the firm has monopoly power. For example, Google.

Monopoly power is influenced by factors such as:
o Barriers to entry: The higher the barriers to entry, the easier it is for firms to
maintain monopoly power. Examples of barriers to entry which can maintain
monopoly power are:
 Economies of scale: As firms grow larger, the average cost of
production falls because of economies of scale. This means existing
large firms have a cost advantage over new entrants to the market,
which maintains their monopoly power. It deters new firms from
entering the market, because they are not able to compete with
existing firms.
 Limit pricing: This involves the existing firm setting the price of their
good below the production costs of new entrants, to make sure new
firms cannot enter profitably.
www.pmt.education
 Owning a resource: Early entrants to a market can establish their
monopoly power by gaining control of a resource. For example, BT
owns the network of cables so new firms would find it very difficult to
enter the market.
 Sunk costs: If unrecoverable costs, such as advertising, are high in an
industry, then new firms will be deterred from entering the market,
because if they are unable to compete, they do not get the value of
the costs back.
 Brand loyalty: If consumers are very loyal to a brand, which can be
increased with advertising, it is difficult for new firms to gain market
share.
 Set-up costs: If it is expensive to establish the firm, then new firms
will be unlikely to enter the market.
o The number of competitors: The fewer the number of firms, the lower the
barriers to entry, and the harder it is to gain a large market share.
o Advertising: Advertising can increase consumer loyalty, making demand price
inelastic, and creating a barrier to entry.
o The degree of product differentiation: The more the product can be
differentiated, through quality, pricing and branding, the easier it is to gain
market share. This is because the more unique the product seems, the fewer
competitors the firm faces.







Market Failure and Government Intervention

Market Failure – When the free market fails to achieve allocative efficiency
Allocative Efficiency – When resources are used to produce the goods and services that
consumers want and in such a way that consumer welfare is maximised
Productive Efficiency – Where production takes place using the least amount of scarce
resources
Economic Efficiency – Where both allocative and productive efficiency are achieved
Inefficiency – Any situation where economic efficiency is not achieved
Free Market Mechanism – The system by which the market forces of demand and supply
determine prices and the decisions made by consumers and firms
Regulations – Consists of laws/ restrictions imposed by the government

Government Failure – Government failure is a situation where government intervention in the
economy to correct a market failure creates inefficiency and leads to a misallocation of scarce
resources

Causes of government failure:
Distortion of price signals
Government subsidies could distort price signals by distorting the free market
mechanism. A free market economist would argue that this could lead to
government failure. There could be an inefficient allocation of resources because the
market mechanism is not able to act freely.
For example, the government might end up subsidising an industry which is failing or
has few prospects.

Unintended consequences
This is when the actions of producers and consumers have unexpected, or
unintended, consequences.
With government policies, consumers react in unexpected ways. A policy could be
undermined, which could make government policies expensive to implement, since
it is harder to achieve their original goals.

Information gaps
Some policies might be decided without perfect information. This might require a full
cost-benefit analysis, and it could be time-consuming and expensive.
For example, government housing policies are long term, and have failed several
times in the past.
However, it is impractical for governments to gain every bit of information they
need, so assumptions are made.

Market failure occurs whenever a market leads to a misallocation of resources.
A misallocation of resources is when resources are not allocated to the best interests
of society. There could be more output in the form of goods and services if the
resources were used in a different way.
Economic and social welfare is not maximised where there is market failure.

Types of market failure:
o Externalities
An externality is the cost or benefit a third party receives from an economic
transaction outside of the market mechanism. In other words, it is the spillover effect of the production or consumption of a good or service. Negative
externalities are caused by the consumption of demerit goods, such as
cigarettes, and positive externalities are caused by the consumption of merit
goods, such as recycling schemes.
o The under-provision of public goods
Public goods are non-excludable and non-rival, and they are underprovided in
a free market because of the free-rider problem.
o Information gaps
It is assumed that consumers and producers have perfect information when
making economic decisions. However, this is rarely the case, and this
imperfect information leads to a misallocation of resources.
o Monopolies
Since the consumer has very little choice where to buy the goods and services
offered by a monopoly, they are often overcharged. This leads to the underconsumption of the good or service, and therefore there is a misallocation of
resources, since consumer needs and wants are not fully met.
o Inequalities in the distribution of income and wealth
There is an unequitable distribution in income and wealth. Income refers to a
flow of money, whilst wealth refers to a stock of assets. This can lead to
negative externalities, such as social unrest.

Complete and partial market failure:
Complete market failure occurs when there is a missing market. The market does not
supply the products at all.
Partial market failure occurs when the market produces a good, but it is the wrong
quantity or the wrong price. Resources are misallocated where there is partial
market failure.

Information Failure
Information Failure – A lack of information resulting in consumers and producers making
decisions that do not maximise welfare
Asymmetric Information – Information not equally shared between two parties
Examples of Information Failure:
 When consumers are not aware of the benefits or the harmful effects of consuming a
particular product
 When advertising over stimulates demand  Overconsumption
 Inaccurate or misleading claims on product packaging

Examples of Asymmetric Failure Information Failure:
 Health Care – You are forced to rely on the doctor’s experience and competence. They
have more knowledge than you
 Environment – We know less about our negative effects on the environment than
environmental experts.
 Consumer Purchases – Eg. Mobile phones – The seller is likely on commission and has
more knowledge than the buyer leading them to make a bad choice potentially.
 Insurance – You know more about your circumstances than the company selling you a
policy. They are relying on your honesty and integrity.



Government Intervention
Government intervention to target market failure:
Governments intervene in the market to correct market failure. For example, they
might provide healthcare and education, which the free market would underprovide.

Indirect taxes:
Indirect taxes are taxes on expenditure. They increase production costs for
producers, so producers supply less. This increases market price and demand
contracts. They could be used to discourage the production or consumption of a
demerit good or service. For example, the government could impose a £1 tax per
packet of cigarettes.

Subsidies:
A subsidy is a payment from the government to a producer to lower their costs of
production and encourage them to produce more.
Subsidies encourage the consumption of merit goods. This includes the full social
benefit in the market price of the good. Therefore, the external benefit is
internalised. For example, the government might subsidise recycling schemes so it is cheaper for
consumers to recycle waste, which will yield positive externalities for the
environment.

Provision of information:
By providing information, governments can ensure there is no information failure, so
consumers and firms can make informed economic decisions.
For example, governments might make it illegal for second-hand car dealers not to
reveal the entire history of a car, so consumers know exactly what they are buying.
This could be expensive to police.

Regulation:
The government could use laws to ban consumers from consuming a good. They
could also make it illegal not to do something. For example, the minimum school
leaving age means young people have to be in school until the age of 16, and
education or training until they turn 18.
This has positive externalities in the form of a higher skilled workforce.
If there was a compulsory recycling scheme, it would be difficult to police and there
could be high administrative costs. Bans could be enforced for harmful goods,
although they can still be consumed on the black market.
Firms which fail to follow regulations could face heavy fines, which acts as a
disincentive to break the rule.
It could raise costs of firms, who might pass on the higher costs to consumers.


Externalities, Social Costs and Benefits
Externality – A cost imposed or benefit felt by a third party (a party not involved in the economic
decision)
Private Costs – The costs incurred by those taking a particular action
Private Benefits – The benefits accruing to those taking a particular action
External Costs – The costs that are the consequence of externalities to third parties
External Benefits – The benefits that accrue as a consequence of externalities to third parties
Social Costs – Private Costs + External Costs
Social Benefits – Private Benefits + External Benefits

Positive Externalities:
Positive externalities are caused by merit goods. These are associated with
information failure too, because consumers do not realise the long run
benefits to consuming the good. They are underprovided in a free market.
For example, education and healthcare are merit goods. The positive
externality to third parties of education is a higher skilled workforce.

Negative Externalities:
Negative externalities are caused by demerit goods. These are associated
with information failure, since consumers are not aware of the long run
implications of consuming the good, and they are usually overprovided. For
example, cigarettes and alcohol are demerit goods. The negative externality
to third parties of consuming cigarettes is second-hand smoke or passive
smoking.


Merit Good – These have more private benefits than their consumers actually realise
Demerit Goods – Their consumption is more harmful than is actually realised



Public Goods
Public Goods – Goods that are collectively consumed and have the characteristics of nonexcludability and non-rivalry
Non-Excludability – Situation existing where individual consumers cannot be excluded from
consumption
Non-Rejectable – Situation existing where individual consumers cannot reject consumption
Non-Rivalry – Situation existing where consumption by one person does not affect the
consumption of all others
Free Riders – Someone who directly benefits from the consumption of a public good but who
does not contribute towards its provision
Quasi-Public Goods – Goods having some but not all of the characteristics of a public good
Direct Tax – One that taxes the income of people and firms and that cannot be avoided
Indirect Tax – A tax levied on goods and services
Polluter Pays Principle – Any measure, such as a green tax, whereby the polluter pays explicitly for
the pollution caused
Polluter Pays Principle Problems:
 Amount of Tax – Virtually impossible to estimate the cost of the negative externality
 Producers not paying full amount of tax - Some of it often gets pushed onto the consumer
 PED is often Inelastic –Consumption not reduced by as much as intended so production is
higher than intended
 Better quality information for consumers – May lead to consumption being decreased too
much
Subsidy – A payment, usually from a governing body, to encourage production or consumption
Tradable Pollution Permits – A permit that allows the owner to emit a certain amount of
pollution and that, if unused or only partially used, can be sold to another polluter