Chains of Analysis-Full Paragraphs Flashcards
Specialisation and the division of labour
Specialisation is the reduction of scope of activity to improve productivity. In economics we see specialisation by countries in terms of markets (e.g. UK and financial services), firms in products (Audi and cars), and individuals by careers (e.g. teachers). Division of labour is a type of specialisation by individuals when a production task is split into it’s individual components and workers are allocated to a specific task. Through repetition the worker improves their skill at the task and as there are fewer workers doing each task it is more cost effective to provide these workers with specialist equipment. These both lead to improvements in productivity leading to an increase in output for the firm leading to higher revenues and greater profitability. The individual generates a higher marginal revenue product as a specialist and as such can command a higher wage. However, there is the chance that workers will get bored or alienated focusing on the same task and their productivity will fall. Also, specialists at any level are susceptible to changing market conditions. If taste and preferences change it could lead to specialists having advantages in areas which are no longer valuable e.g. coal mining firms in the UK in the late 20th century.
Defending the price mechanism
Consumers are considered rational utility maximisers. They have limited incomes and so must choose between alternative consumption options. To maximise utility, they will demand products which deliver the highest utility per pound spent. This demand creates a signal for profit maximising firms. Firms have limited factors of production available to them and must choose between alternative production options - including what to produce and how to produce it. Firms are motivated by the profit incentive to produce goods that are in high demand. This leads to the free market system allocating resources to where they produce high utility per pound meaning allocative efficiency. Firms also look to use the most efficient resources to cut costs in order to maximise profits, leading to improved productive efficiency.
Increase in demand
——— leads to an increase in the demand for ——— which is illustrated in my diagram below by a rightward shift in the demand curve from D1 to D2. At the current market price there will be excess demand Q1Q3 which leads to consumers competing against each other for limited stock. This leads to upwards pressure on the market prices as consumers bid against each other. The increase in price incentivises firms to increase quantity supplied and the rationing function rations the good or service to those willing and able to pay the higher price. A new equilibrium is formed at Q2P2 where the market clears. Overall there is an increase in price and quantity of ———.
Fall in demand
——— leads to a decrease in the demand for ——— which is illustrated in my diagram below by a leftward shift in the demand curve from D1 to D2. At the current market price there is excess supply Q1Q3. This leaves firms with excess stock which they will try to sell by cutting prices. This leads to downward pressure on the market price. The falling prices reduces the incentive for firms to produce due to falling profitability leading to a fall in quantity supplied. The rationing function of prices rations ——— to those willing and able to pay the new price. A new equilibrium is formed at Q2P2 where the market clears. Overall there is a fall in price and quantity of ———.
Increase in supply
——— leads to an increase in the supply of ——— which is illustrated in my diagram below by the rightward shift in the supply curve from S1 to S2. At the current market price there is excess supply Q1Q3. This leaves firms with excess stock which they will try to sell by cutting prices. This leads to downward pressure on the market price. The falling prices signals to consumers that ——— is more available with ——— rationed to those willing and able to pay the new price. There is an extension in demand and a new equilibrium is formed at Q2P2 where the market clears. Overall there is a fall in price and an increase in quantity of ———.
Fall in supply
——— Leads to a fall in supply of ——— which is illustrated in my diagram below by the leftward shift in the supply curve from S1 to S2. At the current market price there is excess demand Q1Q3. This leads to consumers competing against each other for limited stock, bidding up the price. This leads to upward pressure on the market price. The higher prices signal to consumers that ——— is more scarce with it being rationed to those willing and able to pay the new price. There is a contraction in demand and a new equilibrium is formed at Q2P2 where the market clears. Overall there is an increase in price and a fall in quantity.
Public good (free rider problem)
——— is a public good as it has the characteristics of being non rival and non excludable. Due to the non excludability of ——— it wont be produced in the free market as a result of the free rider problem. Once the good is created there is no way to stop the consumption or benefit of ——— being gained by any and all consumers and as such there is no incentive for the consumer to pay. Without paying customers firms are not able to make a profit and thus have no incentive to produce ——— which leads to a missing market for ——— as there would be a net welfare gain in society if it was produced but the price mechanism means none are.
Information - merit good under consumed e.g. healthcare
The market for ——— suffers from information failure as the actual benefits of it are unknown/under appreciated by consumers. This is because (give contextual reason here). If there was full understanding of the benefit of ——— then demand for it would be greater. This is illustrated in my diagram below by demand (actual) being to the right of demand (perceived). Without intervention the good is under consumed and under priced leading to too few resources being allocated to its production. Society experiences a net welfare loss as a result illustrated by the area abc.
Information - demerit good over consumed e.g. junk food
The market for ——— suffers from information failure as the actual benefits of it under appreciated/the negative consequences for consumption are unknown. [give contextual reason here]. If there was full understanding of the benefits of ——— then demand for it would be lower. This is illustrated in my diagram below by demand (actual) being to the left of demand (perceived). Without intervention the good is over consumer and over priced leading to too many resources being allocated to its production. Society experiences a net welfare loss as a result illustrated by the area abc.
Asymmetric information - 2nd hand cars (seller has info)
The market for 2nd hand cars suffers from asymmetric information. This is because the seller of the car knows the cars condition, and therefor its value, but the consumer does not. This leads to an outcome illustrated by the story of Akerlof’s Lemons. As consumers don’t know the value of the 2nd hand car presented to them they must base their offer on the average value of cars available. Based on this offer, all those with higher quality cars which would earn a higher price will be unwilling to sell leaving only lower quality cars. The consumer knows this and adjusts their offer accordingly. After enough iterations of this logic only the lowest quality of cars are traded at the fair price for low quality cars. As a result there is a missing market for high quality second hand cars as there are buyers and sellers willing to trade at a mutually agreeable price but can’t do so due to the asymmetric information.
Asymmetric information - Insurance (buyer has info)
The market for insurance sluggers from asymmetric information. This is because the buyer is aware of their risk profile but the sellers are not. As sellers of insurance don’t know the risk profile of the individual they have to set their premiums based on the average risk of potential buyers. Based on this premium, those customers with a lower risk profile than what is suitable for the insurance will not take up insurance leaving only the higher risk consumers in the market. The sellers know this and adjust premiums accordingly. After enough interactions of this logic only the highest risk consumers buy insurance at the premium offered. As a result there is a missing market for insuring lower risk consumers as there are buyers and sellers who would be willing to trade who don’t as a result of the asymmetric information.
Maximum price
The imposition of a maximum price creates a legal ceiling above which it is illegal to sell ———. To be effective, the price must be set below the current market price. A maximum price in a competitive market is illustrated below by the price Pmax. At the price Pmax, there is excess demand due to a breakdown in the price mechanism. The lower price leads to an extension in demand and a contraction in supply which fails to ration the good to all those willing and able to pay the price. Those who are able to acquire to good are better off due to the lower price however there will be potential customers who are unable to consumer the good. As a result you could see other forms of competition between competitive consumers such as queues and bribery, you may also see the formation of an informal market as there are still firms and consumers left in the market who would be willing to trade at a mutually agreeable price.
[some contextual comment about the market being unregulated so being potentially dangerous and not generating tax revenue for the government]
Minimum Price
The imposition of a minimum price creates a legal floor below which it is illegal to sell ———. To be effective, the price must be set about the current market price. A minimum price in a competitive market is illustrated below by the price Pmin. At the price Pmin, there is excess supply due to a breakdown in the price mechanism. The higher price leads to an extension in supply and a contraction in demand. The profit incentive of the higher price leads to firms increasing production which then leaves them with excess stock they are unable to sell. The firms who are able to sell their product are better off due to receiving a higher price however many firms will lose out by producing stock without a customer to purchase it. Customers are worse off as they face a higher price for the product.
Negative production externality
The production of ——— produces negative production externality which are [what are the externalities and why are they a problem]. As a result, the marginal social cost of production exceeds the marginal private cost of production as illustrated in the diagram below. Now, because private economic agents in the free market only consider private costs and benefits, the free market outcome will be an equilibrium where MPC=MPB and that would yield Qfm and Pfm. However, the socially optimal equilibrium is where MSC=MSB which would yield Qso and Pso. So leaving the production of ——— to the free market means the quantity is too high (over-production) and the price is too low by not accounting for the total cost of production to society. As a result, there is partial market failure - a misallocation of resources, a welfare loss to the economy and allocative inefficiency as too many resources are allocated to the production of this good/service. For all the output of the range of the welfare loss, MSC exceeds MSB so society would have been better off if that output had not been produced.
Positive production externality
The production of ——— produces positive production externalities such as [state the externality and why is it beneficial to society]. As a result, the marginal private cost of production exceeds the marginal social cost of production as illustrated in the diagram below. Now because private economic agents in the free market only consider private costs and benefits the free market outcome will be an equilibrium where MPC=MPB and that will yield Qfm and Pfm. However, the socially optimum equilibrium is where MSC = MSB which would yield Qso and Pso. So leaving the production of ——— to the free market nears the quantity is too low (under production) and the price is too high but not accounting for the lower overall cost to society of production. As a result, there is a partial market failure - a miss allocation of resources, a welfare loss to the economy and allocative inefficiency as too few resources are currently being allocated to the production of this good/service. For all the output over the range of the welfare loss, MSB exceeds MSC so society would have been better off if that output had been produced.
Positive consumption externality
Positive consumption externality
The consumption of — leads to positive consumption externalities such as [state the externality and why it is beneficial to society]. As a result, the marginal social benefit of consuming the good excess the marginal private benefit as illustrated in the diagram below. As private economic agents in the free market only consider their private costs and benefits, the free market outcome will be an equilibrium where the MPC=MPB and that yields Qfm and Pfm. However, the socially optimal equilibrium is where MSC=MSB which would yield Qso and Pso. So leaving the production of — to the free market means the quantity is too low (under-production) and the price is too low by not accounting for the total benefit to society. As a result, there is a partial market failure - a misallocation of resources, a welfare loss to the economy and allocative inefficiency as too few resources are allocated to the production of this good/service. For all the output of the range of the welfare loss, MSB exceeds MSC so society would be better off if that output was produced.
Negative consumption externality
The consumption of — leads to negative consumption externalities such as [state the externality and whit it is damaging to society]. As a result, the marginal social benefit of consuming the good is less the than marginal private benefit as illustrated in the diagram below. As private economic agents in the free market only consider their private costs and benefits, the free market outcome will be an equilibrium where the MPC=MPB and that yields Qfm and Pfm. However, the socially optimal equilibrium is where MSC=MSB which would yield Qso and Pso. So leaving the production of — to the free market means the quantity is too high (over production) and the price is too high by not accounting for the negative benefit to society. AS a result, there is a partial market failure - a misallocation of resources, a welfare loss to the economy and allocative inefficiency as too many resources are allocated to the production of this good/service. For all the output of the range of the walfare loss, MSC exceeds MSB so society would be better off if that output wasn’t produced.
Price elastic demand (either an addition to analysis or useful in evaluation)
The effect of —– depends on the price elasticity of demand. —– is considered price elastic in demand because of [insert determinant of elastic demand]. This means that the change in price leads to a more than proportional change in quantity demanded. [Add a contextual comment about why elasticity is relevant e.g. a tax on this sort of product is likely to cause a significant reduction in consumption which is good/bad because…]
Price inelastic demand (either an addition to analysis or useful in evaluation)
The effect of —- depends on the price elasticity of demand. — is considered price inelastic in demand because of [insert determent of inelastic demand]. This means that the change in price leads to a less than proportional change in quantity demanded. [Add a contextual comment about why elasticity is relevant e.g. a tax on this sort of product is likely to cause a small change in consumption which is good/bad because….].
Income elasticity
The change in demand as a result of the [increase/decrease] in income is determined by the income elasticity of demand. —- is considered an income [elastic/inelastic] good due to [insert determinant of income elasticity]. As a result the increase in income leads to a [large/small] change in demand. [Add contextual comment as to why this is relevant].
Cross price elasticity of demand.
—– and —- are [substitutes/complements] as they are in [competitive/joint] demand. As a result, when the price of —- increases the quantity demanded for that good falls. With less of that good being consumed [more/less] of [the other good] will experience an [increase/decrease] in demand. [either go into price mechanism analysis or give a contextual comment as to why this is relevant].
Privatisation
Privatisation is the transfer of assets from the public sector, that is it is controlled by the government for the national interest, to the private sector, controlled by private individuals in the interest of owners and shareholders. The major benefit of privatisation is that the firm is motivated to respond to free market incentives. Owners and shareholders want to maximise their return through greater profit. To make the greatest profit firms need to be productively efficient and produce goods and services which are demanded by consumers which leads to greater allocative efficiency. This compared to a nationalised firm where the managers try to achieve government controlled objectives. As the government is able to run its enterprises at a loss, there is less motivation for the firm to be efficient. Free market economists argue that consumers are best placed to determine what goods and services they would benefit from so production determined by the free market rather than the government should lead to greater welfare.
Property rights
Common resources are often used in a way which isn’t allocatively efficient. As no one has property rights over these resources they are overused or rapidly depleted. In the absence of property rights, there is no private cost attached to using common resources. As a result, firms and individuals will use the common resource without considering the damage they are doing. In fact, they will use the resource until the marginal benefit of using it is zero. Because the resource is commonly available, even if one economic agent chose to act responsibly and sustainably, others wouldn’t meaning the efforts and sacrifice of that agent is wasted. As a result, the common resource will be damaged and used up to the point where it can’t be used to benefit future generations. For example, common fish stocks. Fishing companies have a financial incentive to catch as many fish as possible to earn the biggest profit. They will catch fish until their marginal benefit is zero (e.g. they can’t store any more fish on the boat) and as a result fish stocks may be used up faster than they regenerate. Sustained overfishing can lead to partial extinction meaning no more fish left for the future. With property rights, the owner has a financial incentive to maintain fish stocks into the future, so the revenue stream is maintained. To do this, they will restrict fishing and charge firms to fish aiming to restrict fishing to at or less than the replacement rate of the fish stock so the stock is maintained into the future. Even if the property rights were given to a fishing company they are likely to fish more sustainably because they can restrict access to their stock by their competitors.
