Markets and Market Failure Flashcards
What are assumptions in economics?
Assumptions are initial conditions made before a micro or macroeconomic analysis is built.
Sometimes assumptions are used for simplification
Assumptions can be used to isolate the effects of a change in one variable on another.
Many assumptions are criticised for being unrealistic
What is the ceteris paribus assumption?
To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus -i.e. all other influencing factors are held constant.
What is a positive statement?
Positive statement are objective statements that can be tested, amended or rejected by referring to the evidence.
(Objective and testable theories)
What is an example of a positive statement?
The falling price of crude oil on world markets will lead to a fall in demand for fuel efficient cars.
What is a normative statement?
Normative statements are subjective statements -i.e. they carry one or more value judgments about what ought to be.
(Value judgement and opinions)
What is an example of a normative statement?
A sugar tax is the best policy to cut obesity
What is positive economics?
Positive economics deals with objective explanation and the testing and rejection of theories.
What are the four economic resources?
Land
Labour
Capital
Enterprise
What is land as a economic resource?
The stock of natural (environmental) factor resources available for production.
What is enterprise as a economic resource?
Entrepreneurs organise the factors of production and also take risks
What is labour as a economic resource?
The quantity and quality of the human input into the production process.
What does capital refer to as a economic resource?
Man-made goods used to supply other products, e.g. technology, factories, machinery and software.
What are capital goods?
Goods that are used to make consumer goods and services.
What are examples of capital goods?
Factories Offices Machines Printing press Combine harvester Assembly line
What are Free Goods?
A free good has zero opportunity cost in its supply.
What are non-renewable resources?
Non-renewable resources are finite in supply.
Examples are crude oil, coal, natural gas and other fossil fuels, no mechanisms exist at present to replenish them.
The rate of extraction of finite resources depends in part on the current market price
What are renewable resources?
Renewables resources are resources that are replaceable if the rate of extraction is less than the natural rate at which a resource renews.
Examples of renewable resources are solar energy, tidal power, oxygen, biomass, fish stocks and forestry.
What is opportunity cost?
Opportunity cost measures the cost of a choice expressed in terms of the next best alternative foregone or sacrificed.
What are examples of opportunity costs? (READ)
Work leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost wages given up.
The opportunity cost of the government spending an extra £10 billion on investment in the NHS might be that £10 billion less is available for spending on education or defence equipment.
Why would you ration scarce resources?
Rationing is one way of allocating scarce goods and services when market demand exceeds available supply.
What are examples of rationing?
Health rationing occurs when demand for health care services outstrips the available resources leading to waiting lists and delay for health treatments.
Cash rationing in Indian banks when the government in 2016 took larger denominations of bank notes out of circulation in a bid to reduce corruption.
Ticket rationing by clubs when demand for tickets for a big match exceeds capacity of a stadium.
What are different ways to ration scarce resources?
By market price
By consumer income
By assessment of people’s need
By household postcode
By education level
By age
By gender
By nationality.
Why has Food bank use grown rapidly in recent years?
Higher food prices have made food less affordable for low income households
High long term unemployment have hit family budgets
Declining real incomes for many people on lower wages
Welfare reforms including a a maximum welfare cap for families and tighter rules for claiming benefits.
More food banks have been set- i.e. supply is responding to growing demand and need among many families.
What is a PPF?
A PPF shows the maximum potential output combinations of two goods an economy can achieve when all its resources are fully and efficiently employed.
Points inside the PPF are what?
Is an inefficient allocation of resources since it is possible to produce more of one good without sacrificing any of the other.
What are points on the PPF?
Any point on the PPF is an efficient allocation of resources.
What are points outside the PPF?
An output combination that is not yet attainable.
For an economy to be productively efficient it must be where on its PPF?
It must be on the PPF curve.
If there is a linear PPF (straight line PPF) what is the marginal opportunity cost between consumer and capital goods?
The marginal opportunity cost of switching resources between consumer and capital goods is constant.
What is a straight line PPF an indication of?
Perfect substitutability of resources such as labour or capital.
Combinations of consumer and capital goods lying inside the PPF happen when?
There are unemployed resources or resources are used inefficiently. We could increase output by moving towards the PPF.
If a country produces more with the same resources what is this an improvement in?
Economic welfare through a gain in allocative efficiency.
What are causes of an outward shift in the PPF?
Higher productivity/ efficiency of factor inputs
Better management of factor inputs
Increase in the stock of capital and labour supply
Innovation and invention of new products and resources
Discovery / extraction of new products and resources
How does an increase in productivity cause an outward shift in PPF?
This increases the output per unit of an input used in production
How does better management of factor inputs cause an outward shift in PPF?
Improved management reduces waste and also improves quality.
How does an increase in the stock of capital and labour supply cause an outward shift in PPF?
Increased capital investment and inward labour migration
How does an increase in innovation and invention of new products and resources cause an outward shift in PPF?
Improved production processes can help to lift efficiency shifting PPF outwards.
How does the discovery / extraction of new natural resources shift PPF outwards?
Discovery of commercial viable land inputs drives extraction.
What causes an inward shift in PPF?
Damaging effects of natural disasterss
Destruction / loss of factor inputs caused by civil war or other forms of conflict
Large scale net outward labour migration
A trend decline in the productivity of inputs perhaps caused by recession which causes net investment to be negative.
What is resource depletion?
This is a decline in the stock of resources available, for example arising in the long run from the effects of de-population, climate change and low rates of investment in new capital inputs.
What are examples of resource depletion?
Human capital flight
Capital scrapping
Natural disasters
Deforestation
What is resource depreciation?
When the productivity / efficiency of resources diminishes with age and also with repeated use.
What are examples of resource depreciation?
Machinery
Skills Atrophy
Buildings
Basic infrastructure.
What are index numbers?
Index numbers are a useful way of showing data more easily and comparing and contrasting information.
The base value always has an index of 100.
How do you calculate percentage change?
New Figure - Old Figure / Old Figure * 100
What are the key assumptions of rational behaviour?
Agents choose independently of one another
An agent has fixed and stable tastes and preferences
An agent gathers complete information on all alternatives
Always make an optimal choice when given preference.
People make choices in order to maximise the satisfaction they get from spending a limited budget.
What is utility?
Utility measures the satisfaction we get from purchasing and consuming a product.
What is total utility?
The total satisfaction from a given level of consumption
What is Marginal utility?
The change in satisfaction from consuming an extra unit.
How does diminishing returns affect marginal utility?
The marginal utility of extra units decline as more is consumed.
If marginal utility is falling then what may consumers want?
Consumers may be only willing to purchase at a lower price.
What does marginal mean in economics?
Marginal in economics means having a little more or a little less of something.
It refers to the effects of consuming and or producing one extra unit of a good or service.
What is marginal benefit?
Marginal benefit is the change in total benefit from one extra unit.
What is marginal cost?
Marginal cost is the change in total cost from one extra unit.
Are ration consumers and producers assumed to calculate the marginal cost and benefit of each decision?
Yes.
What are information gaps?
Information gaps exist when either the buyer or seller does not have access to the information needed for them to make a fully-informed decision.
For example, risks from using tanning salons, the complexity of pension schemes, uncertain quality of second hand products and knowledge of the nutritional content of foods and drinks.
What is Asymmetric information?
Is when there is an imbalance in information between buyer and seller which can distort choices
What are examples of Asymmetric information?
A used car seller knows more about vehicle quality than a buyer
Mortgages a borrower knows more about their ability to repay a loan than the lender, insufficient checks might be made.
What is adverse selection?
Adverse selection occurs when buyers have better information than sellers, and this can distort the usual market process. It can lead to missing markets as firms do not find it profitable to sell a good.
Adverse selection example explained?
Health insurance
Those most likely to purchase health insurance are those who are most likely to use it, i.e. smokers/drinkers those with chronic health conditions.
The health insurance company knows this and so raises the average price of insurance cover.
This may price some healthy lower-risk consumers out of the market, meaning that mainly higher risk individuals gain this insurance- this causes a market failure.
What is Moral hazard?
Moral Hazard is the concept that individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others
Any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly
What is an example of a moral hazard?
Bail-outs of the banking system after the 2007 crash.
How was the bail out of the banking system after the 2007 crash a moral hazard by banks.
Banks take excess risks leads to bank losses
This forces the government to bailout banks as the government can’t allow banks to go bust.
The government bail-outs encourage increased risk taking by banks, as the banks know the increased risk could result in losses but know they won’t bear the cost if things go badly.
What is an economic agent?
An economic decision maker who can recognise that different factors influence and motivate different economic groups.
Economics agents do not always act rationally- they sometimes:
Have a limited capacity to calculate all costs
Are influenced by their own social networks
Often act reciprocally rather than in pure self interest
Lack self control and seek immediate satisfaction
They are loss averse
They make different choices in cold and emotional states
Often fall back on simple rules of thumb when choosing
Satisfice rather than maximise utility/ private benefit.
Have a strong default to maintain the status quo.
What is bounded rationality?
This is the theory that there is only so much information that humans can be aware of. Therefore, when making decisions, we base them on a limited choice. They are rational given the limited choice and awareness of alternatives, but they rarely maximise total utility because people don’t want to take the time to fully consider all options.
What is anchoring?
Value is often set by anchors or imprints in our minds which we then use as mental reference points when making decisions.
Some anchors establish in our mind a low price, others establish a high price that we may pay on a regular basis.
What are examples of anchoring?
Refereeing decisions anchored by the size of home crowd.
Recommended tips used by taxi companies / restaurants
Behavioral scientists describe this as a cognitive bias.
What is habitual behaviour?
Most people carry on behaving as they have always done.
Repeat choices / purchases often become automatic because default choices don’t involve any mental effort.
To get people to change their behaviour may require compelling incentives or introducing a form of mandated choice.
What are examples of habitual behaviour?
Your choice of daily breakfast cereal / razor / sandwich
Many consumers of energy, broadband stay with the same provider.
What are social norms?
Decisions where social norms outweigh personal decisions of utility, e.g. voting because it is considered social duty – even if we know voting makes no difference anyway.
What are examples of social norms?
Changing the social stigma of drink-driving and speeding
Observing white lines in car parks and on roads
Queuing behaviour in shops or at sports events
Observing smoking bans in public places
What is altruism?
The phenomenon in behavioural science for humans to behave with more kindness and fairness than would be the case if they behaved rationally.
Altruism is often linked to the concept of inequity aversion, whilst this is usually seen as positive it can also result in a negative outcome.
E.g. a person being willing to forego a gain if it means that someone else won’t gain an even better reward.
What is loss aversion?
In behavioural economics, loss aversion refers to people’s preferences to avoid losing compared to gaining the equivalent amount.
What are the reasons for loss aversion?
Attachment to objects/decision. If we own something, we can develop an attachment/relationship. If a family member gave us a statue worth £100, we might feel bad about selling – even if someone offered us £200. However, if we saw the exact same statue in the shop, we may not want to pay even £10.
It feels careless/bad luck. We don’t like losing because it feels like bad luck, carelessness.
Image/reputational costs. If we lose, it may appear we are weak and it has a reputational cost. For example, if we invest in a project, but then give up because marginal cost is greater than marginal benefit – we may not be given another project. Therefore, it may be in our rational interest to persevere and put a gloss on the new project, rather than admit we were wrong.
What are behavioural nudges?
A nudge is a technique used by choice architects to change someone’s behaviour in an easy and low-cost way, without reducing the number of choices available.
We often see it described as non enforced compliance.
What are examples of behavioural nudges?
Specific messages. To reduce missed hospital appointments, most hospitals send SMS text reminders on the day. Studies suggest that changing the words of the SMS can influence how successful these text messages are. For example, if text messages mention the direct costs to the NHS for missing an appointment (£160) – it helped reduce missed appointments from 11.1% to 8.5%. (Behavioural insights Blog)
Encouraging certain behaviours. A study found that if students are sent motivating text messages, attendance rates improved.
What is choice architecture?
Choice architecture described how decisions are affected by design / sequencing / range of choices available.
For example getting students to eat more healthy might involve altering the layout of the restaurant.
Smart building designs might make it more attractive / easier to take the stairs rather than use a lift.
When is choice architecture generally most effective?
Choice architecture is often effective when it encourages simplicity in the decisions that people must make in which the benefits and costs are made clear.
What is mandated choice?
A situation when people must decide in advance with respect to whether they wish to participate in a particular action they are required by law to make that choice.
These decisions are usually public policy decisions e.g. deciding whether to donate your organs when you die, choosing whether to make a ‘‘living will’’ etc.
What conventional interventions are there to tackle obesity?
Increased indirect taxes on high fat / sugar / salt foods
NHS Provision of weight-loss drugs
Tougher regulations on product content for food / drink manufacturers
Education programmes
Compulsory nutritional information.
What behavioural interventions are there to tackle obesity?
Appeal to loss aversion e.g. the impact on family of heart attacks / premature death
Changing choice architecture in restaurants / vending machines / hospitals
Pre-commitment devices e.g. parents choosing healthy school meals in advance.
What conventional interventions are there on preventing / persuading against gambling?
Regulation of betting laws
Stronger advertising code
Better financial education on risks from betting
Maximum bets e.g. £2 instead of £100 on fixed odd terminals
Tougher local authority planning laws on new betting shops
Treating free bets offered by betting companies as taxable.
What behavioural interventions could be used to tackle gambling addictions?
Anchoring (maximum bet on a single bet)
Self commitment devices e.g. self-exclusion schemes from shops for 6 months
Friction cost- people wanting to stake over £50 on a fixed odds terminal must load cash via staff
Framing the savings from quitting in attractive terms.
Evaluate the effectiveness of behavioural nudges in achieving their aims?
Nudge theory may help minor behaviours but less so in addressing deeper social problems.
Samples used in laboratory testing for psychological biases might be flawed e.g. not diverse testing group.
Interventions such as taxes, subsidies and regulations are often as effective as behavioral nudges.
The impacts of nudges are contextual- i.e. what works in one country might not be as effective in another nation at different stages of economic development.
What is demand?
Demand for a product is the quantity that purchasers are willing and able to buy at a given price in a given time period
What is effective demand?
Only if demand for a product is backed up by a willingness and ability to pay the market price does demand become effective or realized or actual.
What is Latent demand?
Demand that is not yet expressed in the market place.
How does a fall in price of goods affect consumers income if ceteris paribus?
A fall in price increased the real purchasing power of consumers
This allows people to buy more with a given budget
For normal goods demand rises with an increase in real income.
What causes shift in the demand curve (LIST AT LEAST 5)?
Changing prices of substitutes in competitive demand
Changing price of a complement in joint demand
Changes in the real disposable incomes of consumers
Inequality in wages
Effects of advertising and marketing changing people’s tastes
Interest rates
Seasonal factors
Changes in size and age structure of a population
Social and emotional factors
What is derived demand?
Derived demand occurs when there is a demand for a good or factor of production resulting from demand for an intermediate good or service.
Give an example of derived demand?
The rise in demand for mobile phones and other mobile devices has led to a strong rise in demand for lithium. Lithium is used in the batteries.
What is joint demand?
Joint demand is when demand for one product is positively related to market demand for a related good or service.
Are Two complements in joint demand and what is their cross price elasticity of demand?
Two complements are said to be in joint demand and their cross price elasticity of demand is negative.x
Give examples of goods in joint demand?
Fish and chips, iron ore and steel, apps for smartphones.
What is composite demand?
Composite demand is where goods have more than one use.
An increase in the demand for one product leads to a fall in supply of the other.
What are examples of composite demand?
An example is milk which can be used for cheese, yoghurts, cream, butter and other products.
What is supply?
Supply is defined as the quantity of a good or service that producers are willing and able to supply at a given price in a given time period.
What is the law of supply?
Is that as the price of a product rises, so businesses expand supply. Higher prices provide a profit incentive for firms to expand production.
What does a supply curve show?
A supply curve shows a relationship between market price and how much a firm is willing and able to sell.
What are causes of shifts in market supply? (Name 5)
Changes in the unit costs of production
A fall in the exchange rate causes an increase in price of imported components and raw materials
Advances in production technologies
The entry of new producers into the market
Favourable weather conditions
Taxes, subsidies and government regulations
What is joint supply?
Joint supply is where an increase or decrease in the supply of one good leads to an increase or decrease in supply of a by-product.
What are examples of joint supply?
An expansion in beef production will lead to a rising market of beef hides
A contraction in the market supply of lamb will reduce the supply of wool.
What happens at the equilibrium market price?
At the equilibrium price that is a state of balance between market demand and supply, the equilibrium price is the price at which the market for the product clears.
What are prices where demand are supply are out of balance called?
Points of disequilibrium.
What is excess demand?
Excess demand is when quantity demanded exceeds available supply.
How does Excess demand occur?
Excess demand happens when the current market price is set below the equilibrium price.
What is the result of excess demand?
This will result in queuing and upward pressure on price.
Higher prices then ration demand to those consumers with effective demand.
And higher prices in theory stimulate an expansion of supply as producers respond to the chance of higher profits.
What is excess supply?
Excess supply is a state of disequilibrium in the market.
When supply is greater than the demand and there are unsold goods in the market, then there is excess supply.
What is the result of excess supply in the market?
Surpluses put downward pressure on the market price.
As prices fall, there is an extension of demand which helps to lower the surplus and take the market towards equilibrium.
What is consumer surplus?
Consumer surplus is the difference between the price consumers are willing and able to pay for a good or service.
Where is Consumer surplus on a demand curve?
Consumer surplus is shown by the area under the demand curve and above the market price.
What is producer surplus?
Producer surplus is the difference between the price producers are willing and able to supply a product for and the price they get in the market.
Where is consumer surplus on a supply curve?
Producer surplus is shown by the area above the supply curve and below the price.
What is PED?
Price elasticity of demand measures the responsiveness of demand after a change in the good’s own price.
How do you calculate PED?
% Change in quantity demanded
% Change in price
What is PED of a normal good with a downward sloping demand curves?
All normal goods with a downward sloping demand curves will have a negative coefficient of PED.
Does it matter about the negative symbol when calculating PED?
Since changes in price and quantity usually move in opposite directions, usually we do not bother to put in the minus sign.
We are more concerned with the co-efficient of elasticity.
If PED = 0 demand is?
Perfectly inelastic
What does Perfectly inelastic demand mean?
Demand does not change when the price changes, the demand curve is vertical.
If PED is between 0-1 what is demand?
Inelastic
What does inelastic demand mean?
The change in demand is smaller than the percentage change in price.
If PED = 1 what is demand?
Demand is unit elastic?
