A-level Economics/AQA/Markets and Market failure

"Markets and Market Failure" is the first of 3 units which must be completed in order to attain an AS level and the first of 6 for a full A-level accredited by AQA.

What is Economics?

Economics is the study of the social relations of production and distribution and how different societies cope with the basic economic problem of scarcity. It is also the study of human behavior as it makes rational decisions to satisfy its needs.

and also, "Economics is a social science that studies human behaviour as a relationship between ends and scarce means that have alternative uses" (Robbins)

Scarcity

Scarcity is based on the premise that human beings have unlimited wants and needs and that the resources which can be used to fulfill these wants and needs are limited (or finite). This means that choices have to be made about what, how and for whom to produce goods or services. Given the fundamental problem of resource scarcity in the face of infinite human wants, economic agents must make choices between competing alternatives. If resources were not scarce, there would be no need to choose between competing alternatives. Economics for this reason is also referred to as the science of constrained choice. Scarcity is why efficiency is so important to economists as inefficient use of resources reduces the amount of wants which can be satisfied.

Factors of Production

Economic resources can be divided into four different categories; LAND, LABOUR and CAPITAL and ENTERPRISE. These are referred to as the factors of production, each of which has a factor payment.

Factor payments are payments made to scarce resources, or generated by the factors of production, in return for productive services. The factors of production are also known as resource inputs to the productive process.

Land

• Land consists of all naturally occurring resources, i.e. agricultural land, mineral deposits. The resource land includes anything growing on land such as forestry or agricultural produce, or mineral subsoil assets lying beneath the surface. The factor land thus generates many different types of raw materials used in the production process.
• The factor payment for land is RENT.

Labour

• Labour is a measure of the work carried out by human beings
• Supply of labour is initially determined by the total population but then more directly by the labour force (those who are of working age and who participate in the Labour force).
• The skills and training of the labour force affects the overall PRODUCTIVITY.
• The factor payment for labour is WAGES

Capital

• Is the physical and non-human inputs used in production. This can can include factory buildings and other equipment such as vehicles, plant and machinery or tools used in the production process.
• The factor payment for capital is INTEREST. Interest is a simplification which embeds the assumption that typically many firms use a mixture of equity and debt to fund to acquisition of capital. Interest is payable on debt used for capital acquisition or expansion.

Enterprise

• Enterprise is the role of entrepreneur within the economy. The entrepreneurial ability of management organises the other three factors into a cohesive production process which results in the output of goods or services.Enterprise represents the skill of management.
• The entrepreneur is the risk taker who combines the other factors of production to create a good or service for which there is demand.
• There are several factors which can affect the level of entrepreneurship within an economy
• Start-up costs - high start-up costs will discourage entrepreneurship as it reduces the level of profit which can be attained. High start-up costs also discourage entrepreneurship because the total loss is great if the business fails.
• Level of profits - the higher the level of profit available the more incentive for the entrepreneur, this can be altered by wages levels and availability of labour, availability and cost of land, level of tax on profit
• Support - Financial support, such as loans. Knowledge support, advice on things such as marketing or accounts can encourage entrepreneurs.
• Factor payment for enterprise is PROFITS. Profit is also the return to the firm and its owners after all other factor payments have been made. Dividends represent a distribution of profits.

Markets

A market is anywhere where buyers and sellers meet for purpose of exchange, such as: eBay, a market etc. Within a market prices are determined by the market mechanism.

Supply and Demand

Demand

Demand is the amount of goods and services buyers are willing and able to purchase at a given price over a given period of time, Demand can be represented graphically in a demand curve or in a table known as a demand schedule. The main determinants of demand are; the price of the good, the price of substitute goods, the price of complimentary goods, levels of income. The price of a good and the quantity demanded usually have an inverse relationship; if one increase the other decreases.

Demand Schedule

Demand schedules are tables which show the price of a good and the quantity demanded.

An Example Demand Schedule
Price (£) Quantity Demanded ( 000's )
40 500
50 450
60 400
70 350
80 300

Demand Curve

A demand curve is the graphical representation of a demand schedule, in which quantity demanded is plotted on the X axis and price on the Y axis. The curve on a demand curve slopes downwards left to right, the only exception being status goods in which the demand curve slopes upwards from left to right.

Movement Along a Demand Curve

Movement along a demand curve occurs when the only variable to change is the price. For goods (except status goods) an increase in price causes a contraction of demand and a decrease causing an expansion of demand. In this example the original price of the good was at P1 and the quantity demanded was at Q1. An increase in price to a level of P2 has caused a contraction of demand to a level of Q2.

Shifts in Demand Curves

A shift in a demand curve occurs when a variable other than price changes. For instance a change of income, a change in fashions or trends, a change in the price of a complimentary or substitute good, a successful/unsuccessful advertising campaign.

Price Elasticities of Demand

The extent to which the quantity demanded responds to a change in price.

Price elasticity of Demand = ${\displaystyle {percent\ change\ in\ quantity\ demanded\ x \over percent\ change\ in\ price\ x}}$
Which can be worked out by; Price elasticity of Demand = ${\displaystyle {{change\ in\ quantity\ demanded\ of\ good\ x\ \over original\ quantity\ demanded\ of\ good\ x} \over {change\ in\ price\ of\ good\ x \over original\ price\ of\ good\ x}}}$

Types of Price Elasticity of Demand

Perfectly Inelastic Demand
P.E.D = 0 Any change in price will have no change in demand and whatever the price is the demand will remain equal. If this were to occur firms would set as high a price as possible to make maximum profit.
Inelastic Demand
0 < P.E.D < 1 This means that any change in price will have a less than proportional change in demand.
Unitary Demand
P.E.D = 1 Any change in price has an exactly proportional change in demand, i.e. 10% reduction in demand would cause a 10% reduction in price.
Elastic Demand
1 < P.E.D < ≈ Any change in price will cause a greater than proportional change in demand.
Perfectly Elastic Demand
P.E.D = ≈ Any change in price will have an absolute change in demand as buyers will only buy at one price and no other.

Supply

The quantity of goods and services a firm is willing and able to sell at a given price over a given period of time.

Supply Schedule

As with demand schedules supply schedules are tables which displays the amount of goods and services supplied at what price.

An Example Supply Schedule
Price (£) Quantity Supplied ( 000's )
40 500
50 550
60 600
70 650
80 700

Supply Curve

A supply curve is the graphical representation of a supply schedule, in which quantity supplied is plotted on the X axis and price on the Y axis. The curve of a supply curve slopes upwards right to left, the only exception being status goods in which the demand curve slopes downwards from right to left.

Equilibrium

Equilibrium is the point in a market at which supply and demand intersect, thus giving the equilibrium price and quantity. In the example below the equilibrium price is P1 and the equilibrium quantity is Q1. Were the price or the quantity supplied to change then the market would be in a state of disequilibrium. A price above P1 would mean there would be an excess of supplies, and a price below P1 would mean there is excess demand.

Elasticities

Elasticities measure the change on one variable in proportion to another.

Income elasticity of demand

Income elasticity of demand is a measure of the responsiveness of the demand for a good or service to a change in income. If an increase in income lead to an increase in demand, then the income elasticity of that good or service would be said to be positive. If a change in income lead to no change in demand then that good would be said to have an income elasticity of demand of zero. A rise in income leading to a decrease in demand would mean that the good or service is said to have a negative income elasticity of demand.

The following formula is used to calculate a good or service's income elasticity of demand: Income elasticity of Demand = ${\displaystyle percentage\ change\ in\ quantity\ demanded\ of\ good\ x \over percentage\ change\ in\ income}$

Cross elasticity of demand

Cross elasticity of demand measures the responsiveness of the demand of one good to a change in the price of another good. This allows, for instance, how a rise in the price of natural gas affects the demand of electricity. In addition to this, by calculating the cross elasticity of demand, it is possible to identify the relationship between two goods or services. If the cross elasticity of demand for two goods is positive, then it can be summarised that the two goods are substitute goods, as would be the case for the example of natural gas and electricity. If the cross elasticity of demand for two goods is negative, then the two goods are complimentary goods, such as fish and chips.
The following formula is used to calculate the cross elasticity of demand:
Cross elasticity of Demand = ${\displaystyle percentage\ change\ in\ quantity\ demanded\ of\ good\ x \over percentage\ change\ in\ price\ of\ good\ y}$

Price elasticity of supply

Price elasticity of supply is a measure of the responsiveness in quantity supplied to a change in price. The following formula is used to calculate price elasticity of supply:
Price elasticity of Supply = ${\displaystyle percentage\ change\ in\ quantity\ supplied\ of\ good\ x \over percentage\ change\ in\ price\ of\ good\ x}$

Factors Affecting Elasticity of Supply

1.Stock low stock-supply inelastic large stock-supply elastic

2.Time short period-inelastic long period-elastic

3.Availability of substitutes easily replicable capital and labour-elastic

4.Spare capacity less-inelastic more-elastic

Monopoly and The Allocation of Resources

An absolute monopoly is a market structure in which only one firm supplies a good or service. In addition to this there are, within the UK, legal monopolies, which are firms with a market share greater than 25%. In the long run, monopolies are created and prosper due to the erection of barriers to entry.

'Legal Barriers' The law can be used to create monopolies. This can be achieved in a number of ways. The use of copyrights or patents are examples of a legal barriers to entry. As one firm controls the production of goods for which they have a patent or copyright they can become monopolies. A further example would be the granting of a permit by the government to a firm, such as, the numerous train companies which are monopolies for their respective lines, allowing only them to run trains. Professional licensing is also promoted by existing firms in an effort to keep out additional firms. The licensing laws are often set up in ways that favor existing firms, but are difficult for new firms to meet.

'Resource Barriers' If a firm is able to control some or all of the resources necessary to produce a good, it can then become a monopoly. For instance, an oil company which controls all the oil fields has monopoly power over the production of oil. De Beers, the diamond company, controls over 95% of the Earth's diamond reserves, allowing only a certain number of diamonds to be mined a year, keeping the price high.

'Unfair Competition' Firms may undertake acts of unfair competition to maintain their monopoly status or to become monopolies. If a large firm is in competition with another then it could, as an example, lower its prices to a level which would drive a competitor out of business, safe in the knowledge that the loses associated can be sustained for a short amount of time due to the large reserves of the firm. Having driven the competing firm out of the market the monopoly is then free to revert back to the previous price charged.

'Natural Cost Advantages' Due to economies of scale (in which a larger firm can make a product at a lower per-unit cost than smaller firms due to the larger scale of its production capacities) and economies of scope (in which a single large firm can use the same input resource in multiple production processes, resulting in the production of multiple goods for lower per-unit costs than two smaller firms would experience), it is possible that a market with a single large firm is the most cost-efficient means of producing a good or service.