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Topic pack - Microeconomics - introduction

Welcome to this Triple A Learning topic pack for Microeconomics. The pack has a wide range of materials including notes, questions, activities and simulations.

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Terms and definitions

One of the key things you need to be sure to know are the definitions of all key microeconomics terms. In this section we give you explanations and definitions as well as some flash cards, crosswords and word searches to help you practice them.





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Microeconomics - key terms

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In this section are various key terms for microeconomics. We have split them into a number of different pages. Follow the link below for the section you want to look at:

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Games and activities

In this section are some games and activities to help you get to grip with terms and definitions in economics. You could try some crosswords, or perhaps a game of tic-tac-toe or, if you are revising, you might like to try going through the flashcards for each section.





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Tic Tac Toe

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Flash cards - microeconomics

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We have split the flash cards for microeconomics into a number of different pages. Follow the link below for the section you want to look at:

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Quizzes

Why not have a go at the quizzes below to see how well you know your economics terms and definitions?

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Crosswords & wordsearches

Why not try some economics crosswords to see how well you know your terms and definitions? Follow the links below to access interactive versions of the crosswords.

These links should open in a new web window and you should be able to complete the crosswords on-screen.

If you prefer, you could alternatively download pdf versions of the crosswords and print them out to complete them. Follow the links below to download the equivalent pdf files.

Section 2.1 Markets - notes

Introduction

Resources are allocated in competitive (free) markets through the workings of the price mechanism. Price changes give signals to suppliers who are able to respond to the demands of consumers. If the price of houses rise, for instance, more builders will want to build (supply) houses. Also, if more people want to buy houses (demand) in an area, say as a result of a government department relocating there, prices will rise.

Two key terms have been mentioned, supply and demand. Write down now, before you go any further, what you think these terms mean. Put your descriptions to one side. We will return to them later.

The free market price mechanism, operating under certain specific conditions (more of this later) is also the base against which the workings of real markets and economies are measured by economists.

This unit examines the concepts of demand and supply in detail, then goes on to examine the operation of a competitive market. It is an extremely important unit, not only in its own right, but also because it links in with other units, such as units 4 and 5.

In this section we consider the following topics in detail:





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Markets

So what is a market?

A market is any effective arrangement for bringing buyers and sellers together, not necessarily face to face.

The forces of supply and demand meet and react in a market. Prices are established and buyers and sellers alike give signals. Markets can involve face-to-face dealings between buyers and sellers, or may be postal or even electronic.

The market mechanism brings together two different forces, the power of the consumer and the interests of the supplier. Both want 'the best' from the market, but their 'bests' are different.

Objectives of consumers

Rational consumers want to get the most from their money and a RATIONAL CONSUMER wants the highest quality at the lowest price.

Objectives of producers

Firms want to get the maximum from the resources that they use. In financial terms they want to maximise profit. This means that they may want to sell as low a quality product as they can for as high a price as possible.

The general assumption of economics is that the main objective of private businesses is profit maximisation.

Types of markets

There are several different types of market. Markets may be local, national or international. Here are some examples:

Consumer markets

There are two main types of these:

1. Markets for consumer goods

Consumer goods are goods bought by individuals rather than businesses. Consumer goods are often divided into durable goods and non-durable goods. These are often traded on a national basis.

2. Markets for consumer services

The provision of a service involves the seller 'doing something' for the buyers in return for money. This includes financial services, travel and tourism, all types of leisure services etc. Services are part of the tertiary sector of an economy, and it is this sector which tends to grow most rapidly when living standards rise.

Commodity markets

A commodity can be defined as a raw material or a semi-raw material, e.g. rubber, coffee, copper orgold. Such markets are often characterised by large fluctuations in price, mainly because of the instability of supply due to seasonal factors, the weather natural disasters etc.

Major commodity markets exist in large cities such as London, Tokyo and Chicago.

Capital goods markets

The capital goods markets is where items bought by industries and business are traded, e.g. machinery and equipment. Capital goods are also known as producer goods as they are used in the production process to make other goods and services.

Stock markets

These are markets where the stocks and shares of public limited companies are traded, as well as other financial securities.

Market structure

In a competitive market, firms are expected to compete. We have assumed so far in our market model that firms compete on price only. This is not the case in the real world. Firms may compete on the basis of:

as well as on price.

The world of competition is dynamic. Firms try to improve, to produce better products, to increase their market share etc. They want to increase their profit. They will look at their production processes and try to reduce costs and to increase revenues.

They will only do this if they can get something from it, and that something is profit. Unless there is a financial return they will not invest in any improvements. Why should they?

Spectrum of competition

However, the way in which competition manifests itself in a market depends on what is called the market structure. The market structure is the degree of competition in the market and the way in which the market is organised. As consumers, we would all like markets to be as competitive as possible to ensure a wide variety of goods and low prices, but firms would rather have less competition to make the market more profitable and to minimise the costs associated with competition for them.

Economists argue that competition is beneficial for a variety of reasons. They therefore set up what they consider to be the ideal form of competition - known as perfect competition. This is a market structure at one end of the spectrum. At the other end is obviously little or no competition - this is called monopoly. In between is a range of market structures and we look at each of these below.

Market structures - monopoly to perfect competition

Perfect competition

This type of market has many competitors, who produce the same product and the market sets the price. So, firms in this type of market are price takers (they have little market power) and have to be aware of all possible efficiencies, the lack of opportunities to use modern marketing techniques, the ease with which new entrants can join the market and the probability of low profit margins. In fact, perfect competition should be considered as an ideal or a benchmark. It does not exist in practice, although some markets may approximate it. The key assumptions of perfect competition can be summarised as:

Monopoly

This comprises of just one producer in a particular market, although a firm is often considered as a potential monopolist if it has 25% or more of the market share of a particular market. The producer has the power to 'make' the price and profits will normally be high. To maintain the high profits the producer will build as many barriers to entry as possible and try to keep the monopoly status by not allowing others to enter the market.

Monopolistic competition

This type of market is a cross between perfect competition and monopoly, having characteristics of both. Firms have many competitors, but this time producing a different (or differentiated) product. They have some influence on prices within the market, but again have to concentrate on cost efficiencies and accept low profit margins. However, they can use marketing to promote their product but need to be aware that others can easily enter the market.

Oligopoly

This type of market has just a few competitors, and there is interdependence between the firms that comprise the market. The market relies a lot on non-price competition, e.g. after-sales service or guarantees, and normally spends large sums on advertising and promotion. If successful in this type of market, the firm can earn large profits. To protect their market share they use marketing techniques to build brand loyalty via such features as unique selling points. These are designed to build barriers to entry, so reducing potential competition. Some participants collude, or join together to make it even more difficult for new entrants to gain a place in their market.

You may also like to see a table summarising each of these key market structures with examples.

Summary of market types

The importance of price as a signal

This section requires knowledge of the way in which demand and supply interact. You may therefore wish to return to it after you have studied demand and supply analysis. Click on the relevant link in the table of contents on the left to switch to demand and supply (or click the 'home' icon at the top or bottom of the page.

The process of resource allocation

As we have seen in Unit 1, the central problem of economics is one of scarcity of productive resources relative to the unlimited potential demand which could be made upon them. It therefore follows that every society, be it centrally planned or based upon markets, has to have some mechanism by which its resources, that is its land, labour and capital , are allocated amongst all the numerous uses to which they could be put. So, by what process are resources deployed so as to ensure that consumers obtain exactly the right amounts of frying pans, ice-creams, jeans etc. that they require? Well, under a system of central planning the answer is not too difficult to ascertain - the state planning authority decides upon its priorities and directs resources to those lines of production which are deemed to be most important; but, in the absence of a central planning authority, how do consumers magically obtain those goods that they want in just the right quantities? Here the answer is slightly less obvious - essentially, it is through the interaction of demand and supply. But, how exactly does this interaction perform the allocative function?

The short answer to the above question is that it is through movements in prices which act as a link between demand and supply. These changes in price indicate and motivate - the so-called signalling function. Changes in price indicate the relative strength of consumer demand and signal to producers changing consumer tastes; they also indicate changes in supply which enable producers to signal to consumers what is available on the market and on what terms. Rising prices of goods, which in turn increase profitability, motivate producers to respond to increases in demand by increasing supply; producers will decrease supply when demand, prices and thus profits all fall. Likewise, labour will be motivated to supply more factor services as its price, that is the wage rate, rises, and vice versa. This process can be illustrated in the diagram below:

The process of resource allocation

In the diagram, consumers, who are assumed to be rational, knowledgeable and sovereign, decide, perhaps because of more inclement weather, to switch part of their demand from sandals to wellington boots. The increased desire for wellington boots means that consumers would be willing to pay more for them at each and every price, and the demand curve would therefore shift out to the right. This would cause the equilibrium price of boots to rise and boot producers, spurred on by the prospect of greater revenues and greater profits, to increase their output of boots, indicated by a movement along the supply curve from point X to Y. The fall in demand for sandals has the exact opposite effect, with the demand curve shifting to the left, the equilibrium price falling and producers receiving this as a signal to cut back their output of sandals in the light of less potential revenue and profit. At the same time the derived demand for labour would mean that the wages of workers in the wellington boot industry would rise and those of workers in the sandals industry would fall.

Through this mechanism, prices act as a link between consumers and scarce resources. Those sectors of the economy in which demand, prices and profits are rising will be able to commandeer resources away from declining sectors of the economy by paying more for labour, land and capital. The resources of the economy, which are assumed to be perfectly mobile, are therefore allocated to those sectors where consumers want them to be employed, in our example, to the wellington boots industry. Here, the consumer is said to have 'called the tune', to be 'king' or 'sovereign' - despite having no direct command over resources, consumers have determined how they should be used and have ensured their optimal allocation: hence the case for feely operating markets and the argument that government intervention, beyond a minimal level, is both unnecessary and undesirable.

Demand

A detailed understanding of demand theory is essential for success in economics.

Demand is defined as 'that quantity of a good or service that would be bought at each and every price over a period of time'. This means that demand combines:

This definition is important. You have to pass all three tests for it to be demand.

Look at these questions:

In other words to count as demand, the demand for something has to be what is known as effective demand. This means that the demand has to be backed by a willingness AND ability to pay (tests 2 and 3 above).

The law of demand

This assumes that consumers act in a rational manner, so that, other things being equal, the lower the price of a good, the greater the quantity demanded and the higher the price, the less the quantity demanded. Thus, in the diagram below (Figure 1), as the price falls from OP1 to OP2, the quantity demanded increases from OQ1 to OQ2. If price were to rise from OP2 to OP1, the quantity demanded would fall from OQ2 to OQ1.

Figure 1 Demand curve

It is quite important to distinguish between individual and market demand. The difference is hopefully clear. Individual demand is demand from an individual - like you or me! This will be affected by all the factors we identified in section 2.1. However, a whole market is made up of hundreds, thousands and sometimes millions of individuals and so to get market demand we need to add together all the individual demand curves. This will give us market demand.

To add the demand curves, we need to add the individual demand curves at each price. We can see this in Figure 2 below, where we assume that the market is made up of just two individuals - Posh and Becks.

Figure 2 Individual and market demand

Determinants of demand

The demand curve shows that demand depends on price. However, price is only one of the factors which influence demand, or is one of the determinants of demand, as economists call them. The full list of the determinants, including price, is:

If you understand how all these factors influence price, fine. If not, try to explain them yourself, then click as usual.

Shifts of the demand curve and movements along the demand curve

A change in price will produce a movement along an existing demand curve, but a change in one or more of the 'ceteris paribus' factors will shift the demand curve to a new position.

N.B. The demand curve is drawn on the assumption that only price has changed and everything else has remained the same. This is an important assumption to note. In reality many factors are changing at the same time, but if we are to analyse the factors causing a change in the market, we first need to isolate each of the factors. This assumption, known as 'ceteris paribus' or 'other things being equal' enables us to do this. See Unit 1 for more detail on this assumption.

Movements along the demand curve

When the price of the good, and only the price, changes there is a movement along the demand curve. A movement up a demand curve, to the left, is known as a contraction of demand. The price rises and quantity demanded falls. A movement down the demand curve is known as an expansion of demand. Both of these are shown in the diagrams below:

Figure 3 Expansion of demand

Figure 4 Contraction of demand

Shifts of the demand curve

These will occur as a result of any factor, apart from price, changing. A shift of a demand curve to the right will mean that more will be demanded at each and every price. A shift to the left will reduce the quantity demanded at each and every price. These possibilities are shown below.

Figure 5 Increase in demand

A shift to the right, an increase in demand at each and every price, will come from one or more of the following;

Can you think of any more? Jot them down, then click SHIFT 1.

Figure 6 Decrease in demand

Think about what might cause this type of shift, then click SHIFT 2.

Summary

Having completed this session you should know and understand that:

1. Effective demand is the quantity of a good that would be bought at each and every price over a period of time.
2. It combines the desire for the good with an ability and willingness to pay for it.
3. Demand has several determinants, e.g. own price, price of other goods, real income, changes in tastes and fashion, season and population.
4. A change in price results in a movement along an existing demand curve.
5. A change in any other factor apart from price will cause the demand curve to shift.

Example - shifts and movements along a demand curve

You must be absolutely certain about what causes shifts and movements along a demand curve. Work carefully through the following example.

Example 1 - Movements along and shifts of demand curve

The diagram below, Figure 1, represents the demand for a product at a point in time. The price then was P*.

Figure 1 Demand curve

Copy this onto another piece of paper, then sketch on this new diagram the effect of the following changes. Treat each change as a separate change - in other words start each time from Figure 1. Once you have had a go at each one then follow the link below to check you got the change right.

(a) The firm launches a new, effective advertising campaign.

Answer - change (a)

(b) The market price of the product rises to P2.

Answer - change (b)

(c) The price of a substitute good is reduced.

Answer - part (c)

(d) As result of a glut in the supply of the product price falls to P4.

Answer - part (d)

(e) The real incomes of the buyers of this desirable product increase significantly.

Answer - part (e)

(f) There is an increase in the population size and the size of the potential market.

Answer - part (f)

These should not be difficult if you keep calm. Ask yourself three questions:

Exceptions to the normal law of demand

We have assumed so far that demand curves slope downwards from left to right, and most of the time this is true. However, there are a few circumstances where it is possible for the demand curve to slope upwards to the right. This may be for the whole curve or, more likely, it may be over a certain price range, as shown in Figure 1. This is often termed a perverse or upward sloping demand curve.

Figure 1 Perverse demand curve

There are two particular types of goods where this may occur and they are called Giffen goods and Veblen goods. Let's look at the definitions of these.

Giffen good

A Giffen good is a good for which an increase in price results in an increase in demand for the good. It is an extreme inferior good and will have a perverse (i.e. upward sloping) demand curve.

Veblen good

A Veblen good (named after an American economist - Thorstein Bunde Veblen) is a good that has an upward-sloping demand curve. People buy more of the good because it is more expensive and therefore demand is higher when the price is higher.

Giffen goods

In some poor countries, the people often live on a basic diet of rice which is very cheap plus a few more expensive vegetables or some much more expensive meat. In such societies, if the price of rice rises then the people may well decide to buy more in order to substitute it for the more expensive vegetables and meat. There has been an increase in demand in response to an increase in price. Sir Robert Giffen fist noticed this phenomenon. In the 19th century, he saw that the demand for potatoes increased in response to the rises in the price of potatoes caused by the great potato famines in Ireland. Hence products of this kind are known as Giffen goods. Examples of Giffen goods are difficult to find in richer countries.

Veblen goods

Products such as perfumes, expensive cars and designer clothes maybe regarded as Veblen goods.With these products, a rise in price is often interpreted by the consumer as an increase in quality and so they may decide to buy more, thinking that they are buying a superior product. There may be psychological factors at work. The economist Veblen carried out research into this and concluded that the price of a product conveyed more than just value information for the consumer; it also represented status and exclusivity. These products which appear to experience rising demand with rising price are known as Veblen goods.

Price expectations

It is also possible for goods where price expectations are critical to have perverse demand curves. This is because if people expect prices to increase further, then they may buy more now. In this case it appears that an increase in price has increased demand, but in reality this has come about because people expect prices to rise even further in the future.

Supply

Supply

That quantity of goods and services that will be supplied to the market at various prices over a given period of time.

The law of supply

Other things being equal, the higher the price, the greater will be the quantity supplied and the lower the price, the less will be the quantity supplied. The supply function slopes upwards from left to right. As the price increases, the more firms will be willing to supply. Higher prices mean higher profits for those already producing. Those who were at the margin can now make a profit, and some less efficient firms will now be able to supply and remain profitable. Look at the illustration in Figure 1.

Figure 1 The supply curve

The diagram illustrates the law of supply - at a price of OP, OQ will be supplied. As price increases to OP1, the quantity supplied increases to OQ1. More is supplied at higher prices.

Determinants of supply

Like demand, there is a set of determinants of supply. These include the following:

If you understand how all these factors influence price, fine. If not, try to explain them yourself, then click as usual.

A change in price will produce a movement along an existing supply curve, whilst a change in one or more of the 'ceteris paribus' factors will result in a shift of the supply curve.

Summary

Having completed this session you should know and understand that:

  1. Supply is the quantity of a good that would be provided for a market at each and every price over a given time period.
  2. Supply has various determinants, e.g. own price, price of other goods that could be made, taxes and subsidy levels, technology and weather.
  3. A change in price results in a movement along an existing supply curve.
  4. A change in any other factor will cause the supply curve to shift.

Example - shifts and moves of supply curve

You must be absolutely certain about what causes shifts along or movements of a supply curve. Work carefully through the following example.

Example 1

The diagram below, Figure 1, represents the supply of a product (X) at a point in time. The price then was P* and the quantity supplied Q*.

Figure 1 The supply of Product X

Copy this onto another piece of paper, then sketch on this new diagram the effect of the following changes. Treat each change as a separate change - in other words start each time from Figure 1. Once you have had a go at each one then follow the link below to check you got the change right.

(a) Market price of the product falls to P1.

Answer - part (a)

(b) The government passes new minimum wage legislation, which will have the effect of increasing the cost of labour to the firm.

Answer - part (b)

(c) The government places a tax on the sale of the product.

Answer - part (c)

(d) The Research and Development department of the firm invent a new, highly efficient production process for the product. It is well protected by patents, and will give the company a significant cost advantage.

Answer - part (d)

(e) The firm makes another product in the same factory, and can switch production easily and quickly from one to another. The market for this other product collapses and its price falls significantly.

Answer - part (e)

This should not be too difficult if you keep calm. Ask yourself three questions:

Interaction of demand and supply

We have studied demand and supply separately. Now we put them together to get the whole market. The operation of demand and supply in a market is known as the market mechanism.

We are familiar with the upward sloping supply curve and the downward sloping demand curve. Combine the two on one diagram and we have a model of a market (Figure 1).

Figure 1 The demand and supply model of a market

The market will be in equilibrium at price P, when quantity Q will be bought and sold. In figure 1 OP* is the equilibrium or market clearing price at which the amount demanded exactly matches the amount supplied.

Changes in demand and supply

We can now see how shifts of supply and demand curves cause changes in prices and quantities bought and sold. In the next two sections, there are two example markets with a series of changes to each. Try working through each one and check that you understand how the curves shift. Click on the right arrow at the top or bottom of the page to look at the first example.

Summary

Having worked through this unit you should be able to:

1. Define a market
2. Show how it responds to changes in supply and demand
3. Demonstrate that movements along a demand curve come as a result of a shift in the supply curve, and movements along a supply curve from a shift of the demand curve.

Example 1 - the market for DVD players

Try copying out Figure 1 below, but label it as the market for DVD players.

Figure 1 The demand and supply model of a market

Now work through the following changes, and adjust the diagram as you go. After you have had a go at each change, follow the answer link below and see if you made the right changes. Treat each change as a separate change - in other words start with Figure 1 each time.

Change 1. The development of a new microchip enables manufacturers to reduce the price of their products.

Change 1 - answer

Change 2. The firm mounts a major successful advertising campaign for DVD's.

Change 2 - answer

Change 3. The government applies VAT to all home entertainment equipment.

Change 3 - answer

Example 2 - the market for fish

Let's look at another example, and make sure that you understand how the shifts and movements occur and interact. Now work through the following changes, and adjust the diagram as you go. After you have had a go at each change, follow the answer link below and see if you made the right changes.

Figure 1 represents the market for fish at the start of a week. Assume that all demand and supply changes occur without delay, i.e. they react instantly. The changes given are all sequential. In other words use the diagram you end up with as the starting point for the next change.

Figure 1 The Market for fish

Change 1. There are very rough seas, and small boats cannot fish.

Change 1 - answer

Change 2. It is Thursday, a day where the demand for fish is very high. Seas become even rougher.

Change 2 - answer

Change 3. It is Friday, when demand for fish is even higher. Storms weaken, though, and fishing becomes easier.

Change 3 - answer

In this example, we have seen price rises accompanied by an increase in sales. This does not mean that the rules of price and demand are wrong, just that in such cases there will have been changes in supply and demand. Be careful to separate shifts from movements. Notice that movements along a demand schedule come as the result of movements of supply

The impact of taxation

We looked briefly under supply at the impact of a tax and you should be clear now that a tax will shift the supply curve to the left. In fact, it shifts the supply curve vertically upwards by the amount of the tax.

However, we need to look at this in a little more detail as there are different types of taxes. So, first some definitions.

Specific (or per unit) tax

A specific tax is a fixed amount of tax charged on each unit. A specific tax will shift the supply curve vertically upwards by the amount of the tax. Examples include cigarette, petrol and alcohol taxes.

Ad-valorem tax

A tax that is levied as a percentage of the selling price. An example of an ad valorem tax would be VAT.

These two taxes will have different effects on the supply curve. First the specific tax. We know that this is a fixed amount (which is why Chancellors / Treasury Ministers tend to increase these each year - if they did not they would be losing out). Since it is a fixed amount whatever the price of the good, it will shift the supply curve parallel upwards as shown in Figure 1.

Figure 1 Specific (or unit) tax

However, the ad-valorem tax is a percentage of the selling price. This means that at low prices the tax will be relatively little (10% of $1 is just 10c), but at higher prices the tax levied will be higher (10% of $10 is $1). This means that the supply curve shifts to the left and outwards as price increases. This is shown in Figure 2.

Figure 2 Ad-valorem tax

Tax revenue

We can also use supply and demand diagrams to show the amount of tax revenue that the government will receive when they tax a good. We know from above that the tax per unit is the gap between the supply curves. So to calculate the full tax revenue we simply take the tax per unit and multiply by the number of units being bought and sold in the market. See if you can draw this and then click on TAX REVENUE.

Tax revenue

The impact of subsidies

A subsidy is a payment made to firms or consumers designed to encourage an increase in output. A subsidy will shift the supply curve to the right and therefore lower the equilibrium price in a market.

The aim of the subsidy is to encourage production of the good and it has the effect of shifting the supply curve to the right (shifting it vertically downwards by the amount of the subsidy). This is shown in Figure 1 below.

Figure 1 Impact of a subsidy

The amount of the subsidy is shown by the gap between the supply curves. This subsidy will cost the government money and we can use the diagram to show the amount they have to spend. Total subsidy expenditure will be the subsidy per unit (the vertical gap between the supply curves) multiplied by the number of units that are traded on the market. This gives the area shown in Figure 2 below.

Figure 2 Subsidy expenditure

As with a tax (see the previous section - click on the left arrow at the top or bottom of the page), some of the subsidy will benefit the consumer (the amount of the price decrease) and some will benefit the firm. This effect can be seen in Figure 3 below.

Figure 3 Subsidy shares - producer and consumer

Price controls

Price controls are controls that governments (or other authorities) put in place to try to influence the outcome of a market. For example, a government may feel that a price is too high and so set a maximum price for the good or service. An example of this may be rent controls - limits on the maximum rent that a landlord can charge for the use of a property. We look at this in the next section maximum prices - click on the right arrow at the top or bottom of the page to look at this.

Alternatively, a government may feel that the market results in a price that is too low and set a minimum price. An example of this occurs with labour markets where equilibrium wages can be very low and governments set a minimum wage. We look at this case in the section - minimum prices.

Markets can also be very unstable and this may persuade governments to try to intervene to stabilise the markets. This is particularly true with agricultural markets and we look at this situation in the section - intervention in agricultural markets.

Maximum - prices-set below the equilibrium

A maximum price may be set where the government feels that the price is too high. For example, rent controls in the rented housing market could be used to prevent rents from rising to the equilibrium market level. Maximum prices are designed to benefit consumers. The effect of a maximum price is shown in Figure 1 below.

Figure 1 Maximum price

The maximum price means that demand now exceeds supply (excess demand) and this means a shortage. This is shown in Figure 1 as the distance QsQd. For this reason, a maximum price will mean that some form of rationing will have to be applied as too little is being supplied. It is also likely that a black market (illegal market) may develop in the good or service.

N.B. There would be little point in the government setting a maximum that was above the equilibrium as the price is below that anyway!

Minimum prices - above the equilibrium

We saw in the previous section that governments may sometimes think that the equilibrium price is too high and set a maximum. Alternatively, if the government feel that the equilibrium price of a good or service is too low then they may choose to set a minimum price. A minimum price is designed to benefit producers. This is shown in Figure 1 below.

Figure 1 Minimum price

The impact of this policy is the opposite to a maximum price. This time the minimum price will create a surplus in the market (QsQd in Figure 1). Normally the price would fall as a result, but it is not allowed to fall below the minimum and so the surplus remains. Something therefore has to be done to store or destroy this surplus. An example of minimum prices at work is the Common Agricultural Policy (CAP) of the European Union and we look at this in a little more detail in the next couple of sections (click on the right arrow at the top or bottom of the page to access this).

Minimum wage

Many countries have now set a minimum wage. For example, a minimum wage was established in the UK in April 1999. It is a form of minimum price that sets a floor for wages which employers cannot pay below. From October 2003, the minimum wage in the UK was set at 4.50 per hour. The effect of a minimum wage will be very similar to that of a minimum price.

Assuming that the minimum wage is above the equilibrium level, wages will rise to the minimum wage level, but the number of employees will fall (to Qd in Figure 2), at least in the short run.

Figure 2 Impact of a minimum wage

However, the extent of the unemployment will depend on the elasticity of demand for labour and the elasticity of supply. If both are very inelastic then there may be very little unemployment.

If the substitutability of labour is very low (in other words employers cannot substitute capital (machines) for labour), then this should help minimise the impact on unemployment.

Task

Use the web to find out if there is a minimum wage in your country. If there is, try to answer the following questions.

  1. What is the level of the minimum wage?
  2. What age does it start at?
  3. Are there any exceptions where employers are allowed to pay below the minimum wage?
  4. How much has it increased in real terms (compared to inflation) in the last five years?

Intervention in agricultural markets

One area where national governments and the EU intervene extensively is in agricultural markets. The aim of this intervention is normally to guarantee farmers a stable and secure income as agricultural markets can fluctuate significantly. One of the largest intervention schemes is the Common Agricultural Policy (CAP) run by the European Union (EU).

Commodity agreements

These may take the form of attempts to stabilise prices, through the operation of a buffer stock scheme or attempts to raise prices by forming a producers' cartel and restricting supply through the use of quotas.

Buffer stock schemes

Firstly, we will consider the operation of buffer stock schemes which have existed on and off since the 1920s for a range of commodities including wheat, tin, rubber, coffee, sugar and cocoa. All of these have eventually failed for one reason or another, so there are no prominent examples to consider.

So what is a buffer stock scheme?

Buffer stock schemes are operated by a central authority and aim to stabilise prices and protect producers from sudden shifts in demand and supply (often supply in the case of agriculture). This is done by 'leaning into the wind', i.e. if there is too much supply, forcing the price down, the buffer stock agency will increase demand by buying up stocks. If there is a shortage of supply, forcing the price up, the agency will release stocks onto the market forcing the price down.

A buffer stock makes use of a price band. Figure 1 below shows the effect of setting up a buffer stock scheme for coffee. If the market is within the two boundaries set by the agency, no action is taken. However, if the market price moves outside the boundaries, the buffer stock operators will intervene.

Figure 1 Buffer stock for coffee

If there is a very good harvest of coffee, the supply curve will shift to the right and the price would fall below the boundary. The buffer stock operators would then step in to increase demand to keep the price within the boundary. This is shown in Figure 2 below.

Figure 2 Buffer stock - good harvest

The bumper harvest causes the supply curve to shift to S1. This would initially cause the price to fall below the lower boundary to OP1. By buying up stocks, the agency shifts the demand curve to D1 and brings price back within the upper and lower boundaries to OP2.

If there is a poor harvest of coffee, the supply curve will shift to the left and the price would increase above the upper boundary. The buffer stock operators would then step in to increase supply by selling stocks and this would push price down below the upper boundary. This is shown in Figure 3 below:

Figure 3 Buffer stock - poor harvest

Problems of a buffer stock scheme

There are a number of possible problems related to buffer stock schemes and these may include:

Cartel arrangements

Such schemes have been attempted in the case of rubber, tin, coffee and sugar, and involve the formation of a single selling organisation, i.e. a cartel, to restrict output of individual members through the issuing of quotas. Thus, when prices need to be increased, members would be ordered to reduce their output in accordance with their quota allocation. This is illustrated in Figure 3 below.

Figure 3 Cartel - use of quotas to restrict output

The supply of primary commodities tends to be perfectly inelastic in the short run, so the cartel requiring a reduction in output would shift the supply curve to the left from S to S1 and raise the price from OP to OP1.

Such schemes have suffered from some of the same problems that have beset buffer stock schemes, i.e. problems of maintaining the cartel and the switch towards substitute goods if prices are kept too high.

Common Agricultural Policy

The Common Agricultural Policy swallows almost half of the entire EU budget (though at one stage it was nearly three-quarters). The total subsidy budget of nearly 45bn euros amounts to nearly $140 per head of the EU population. With the enlargement of the EU and 10 new countries joining in 2004, reform of the system was vital and was partly agreed in June 2003.

The Common Agricultural Policy relies a lot on offering minimum prices and guaranteed prices to farmers to try to maintain consistent and reasonable levels of income for farmers. However, this policy means considerable surpluses being accumulated and the EU has, at various times, had a wheat mountain, a beef mountain, a butter mountain and a wine lake. All this conjures up a range of interesting visions!

The CAP has been criticised for a number of reasons, including:

A range of reforms have been proposed to the CAP to try to address some of these concerns, and the aim is to shift the emphasis from encouraging production by paying farmers to produce, to paying farmers to protect the land that they use. For further details on the changes proposed in June 2003, why not have a look at the BBC article 'EU farm reform'. There is also a useful short summary of the CAP in the BBC A-Z of Europe.

Section 2.1 Markets - questions

In this section are a series of questions on the topic - Markets.





Click on the right arrow at the top or bottom of the page to move on to the next page.

Market structures - self-test questions

1

Market structures

Match the following descriptions with the appropriate market structure?

a)
b)
c)
d)
Yes, that's correct. Well done.No, that's not quite right. Try again.Your answer has been saved.
Check your answer

2

Market structures

Which of the following is the most competitive market structure?

a)
b)
c)
d)
Please select an answerYes, well done.No, this is fairly competitive but not the most competitive.No, this is where a few firms only dominate the market.No, this is the least competitive.
Check your answer

3

Market structures

Which of the following is the least competitive market structure?

a)
b)
c)
d)
Please select an answerNo, this is the most competitive.No, this is fairly competitive.No, this is where a few firms only dominate the market.Yes, well done.
Check your answer

4

Market structures

Which of the following is NOT a feature of monopolistic competition?

a)
b)
c)
d)
Please select an answerNo, this is a feature. Although the firms are competing against each other, in monopolistic competition there is sufficient differentiation so as to view each firm as almost a monopoly for their own product.No, this is a feature. Although the firms are competing against each other, in monopolistic competition there is sufficient differentiation so as to view each firm as almost a monopoly for their own product.No, this is a feature. Although the firms are competing against each other, in monopolistic competition there is sufficient differentiation so as to view each firm as almost a monopoly for their own product.Yes, this is not a feature - products are assumed to be differentiated. Although the firms are competing against each other, in monopolistic competition there is sufficient differentiation so as to view each firm as almost a monopoly for their own product.
Check your answer

5

Market structures

In which form of market structure would price be the key factor when competing?

a)
b)
c)
d)
Please select an answerNo, there will be NO competition for the firm here.No, the few firms in this industry can also compete in non-price competition.No, firms will also compete through product differentiation. Yes, all products appear the same which means price becomes a crucial factor in competition. In perfect competition, there are many firms selling homogenous products. Prices are driven down to the same level.
Check your answer

Market structure - short answer

Question 1

Discuss three different ways that firms can compete.

Question 2

Why do firms do research?

Question 3

Distinguish between short run and long run advantages to a firm of competition.

Question 4

Distinguish between short run and long run advantages to a consumer of competition.

Question 5

What is the driving force behind the research done by firms?

Markets - essay

Question 1

(a) Explain the role of prices in allocating scarce resources in a market economy.

(b) Discuss the view that that the use of maximum and minimum price controls only serve to distort markets and bring about a misallocation of resources.

Price as a signal - short answer

The importance of price as a signal

Question 1

Explain how the price mechanism assists in the allocation of resources

Question 2

Discuss the case for and against doctors charging patients for their services

Demand - self-test questions

1

Demand

Which of the following would be likely to decrease the demand for a product?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is likely to increase the demand. No, that's not right. This is likely to increase the demand.Yes, that's correct. This would normally lead to a reduction in demand. No, this is likely to increase the demand (so long as the good is a normal good).
Check your answer

2

Shift in demand curve

Which of the following may lead to a shift in the demand curve?

a)
b)
c)
d)
e)
f)
a) Yes, that's correct. An increase in cost will shift the supply curve and not the demand curve.a) No, that's not right. An increase in cost will shift the supply curve and not the demand curve.b) Yes, that's correct. An increase in income will shift the demand curve to the right.b) No, that's not right. An increase in income will shift the demand curve to the right.c) Yes, that's correct. A decrease in income will shift the demand curve to the left.c) No, that's not right. A decrease in income will shift the demand curve to the left.d) Yes, that's correct. An increase in price will lead to a move along the demand curve and not a shift.d) No, that's not right. An increase in price will lead to a move along the demand curve and not a shift.e) Yes, that's correct. An increase in the price of a substitute good will mean a shift in the demand curve to the right as people demand more of this good instead.e) No, that's not right. An increase in the price of a substitute good will mean a shift in the demand curve to the right as people demand more of this good instead.f) Yes, that's correct. A change in productivity will shift the supply curve and not the demand curve.f) No, that's not right. A change in productivity will shift the supply curve and not the demand curve.
Check your answer

3

Demand

Which of the following would be likely to shift the supply curve for Mars Bars to the left?

a)
b)
c)
d)
Please select an answerYes, that's correct. Cocoa is a raw material for Mars Bars and an increase in prices will therefore shift the supply curve to the left.No, that's not right. Cocoa is a raw material for Mars Bars and a change in prices will therefore shift the supply curve, but prices have increased and this will shift the supply curve to the left.No, that's not right. Changes in productivity will shift the supply curve, but as productivity has increased this will shift the supply curve to the right. No, that's not right. Changes in price will lead to a move along the supply curve.
Check your answer

4

Demand

Which of the following would be likely to lead to an extension in demand for iPods?

a)
b)
c)
d)
Please select an answer No, that's not right. The Sony player will be a substitute and will therefore lead to a shift in the demand curve to the left (if at all).No, that's not right. An increase in income will mean people have more purchasing power and will therefore lead to a shift in the demand curve to the right, not an extension.Yes, that's correct. Changes in productivity will shift the supply curve, and as productivity has increased this will shift the supply curve to the right. This will lead to a move along the demand curve to the right - an extension in demand.No, that's not right. Changes in costs will shift the supply curve, but as costs have increased this will shift the supply curve to the left. This will lead to a movement along the demand curve to the left - a contraction in demand.
Check your answer

Demand - short answer

Question 1

What is individual demand? What is the difference between individual demand and market demand?

Question 2

The table below represents the market for DVD's. For each of the changes given, tick the relevant column to show whether the demand curve has shifted either left or right or whether there has been an extension or contraction of demand (a movement along the demand curve).

Change Shift right Shift left Extension in demand Contraction in demand
There is an increase in real incomes
Raw material costs increase
New capital equipment enables DVD producers to increase productivity
A new super CD-ROM is developed that is cheaper than DVD's but has same functionality
A major pay per view cable provider goes into liquidation
There is a serious recession
Prices of DVD players fall


Question 3

Demand curve shifting right

If the above demand curve is the demand curve for fax machines, which of the following events may have caused the shift shown?

(a) A fall in price of a substitute for fax machines
(b) An increase in the use of email to attach documents rather than faxing them
(c) A fall in the price of phone lines needed for fax machines
(d) A fall in the price of raw materials required for manufacture
(e) The development of a new compression method that enables fax transmission to be twice the speed
(f) A decrease in real incomes (assume that fax machines are an inferior good)
(g) An increase in real incomes (assume that fax machines are a normal good)
(h) A major advertising campaign showing the benefits of fax machines

Question 4

Which of the following would you regard as substitutes for a laptop computer and which may be complements? In each case consider whether they are 'close' complements or substitutes.

(a) The Apple iPod music player
(b) Desktop computers
(c) PDA's
(d) Web site development software
(e) Mobile phones
(f) Handheld computers
(g) Docking stations

Supply - short answer

Question 1

The table below represents the market for computers. For each of the changes given, tick the relevant column to show whether the supply curve has shifted either left or right or whether there has been an extension or contraction of supply (a move along the supply curve).

Change Shift right Shift left Extension in supply Contraction in supply
There is an increase in real incomes
A surplus of memory on world markets leads to a significant price fall for memory chips
New capital equipment enables computer producers to build machines cheaper
Labour costs for manufacture increase
There is agreement by G8 countries to put a tax on computers
Rapid growth in the developing world means increased demand for computers
The development of TV-based interactive internet services


Question 2

Supply curve shifting left

If the above supply curve is the supply curve for fax machines, which of the following events may have caused the shift shown?

(a) A fall in price of a substitute for fax machines
(b) A tax on fax machines
(c) Increased labour costs for production
(d) A fall in the price of raw materials required for manufacture
(e) Anticipating a fall in demand, major manufacturers stop updating their capital equipment for manufacture of fax machines
(f) A decrease in real incomes

Question 3

Which of the following is a reasonable explanation of the direct relationship between price and supply (the supply curve)? N.B. A number of them could be right.

(a) Improvements in technology help manufacturers to supply more at a lower price.
(b) As price of a good or service falls, firms will shift to producing other goods which become more profitable.
(c) At higher prices it is still profitable to use more expensive factors of production switched from other areas.
(d) At higher prices it is worthwhile producing more despite higher costs of production as the profit margin stays the same.
(e) Labour costs tend to increase each year.

Demand and supply - short answer

Interaction of demand and supply

Question 1

The data in the table below shows the demand and supply for digital cameras at various prices.

Price () Quantity demanded (millions per year) Quantity supplied (millions per year)
16 140 20
32 120 60
48 100 100
64 80 140
80 60 180


(a) Plot the demand and supply curves on a diagram.
(b) What would be the excess demand or supply if the price was set at 32?
(c) What would be the excess demand or supply if the price was set at 80?
(d) What is the equilibrium price and quantity?
(e) If income rises and demand, as a result, rises by 20 million units at each level, what will be the new equilibrium price?

Question 2

In the table below tick the appropriate column to show the impact of the change given on the market for cinema tickets.

Change Demand shift right Demand shift left Supply shift right Supply shift left
There is an increase in real incomes
Stelios Haji-Ioannou rolls out the EasyCinema low price model nationwide
The commission paid to film distributors by the cinemas falls
Planning law changes to restrict the development of out-of-town entertainment complexes
Pay-per-view cable, satellite and internet film services are developed and grow in popularity
Spiralling film production costs mean fewer new releases
Cinema operators develop new premium services


Markets and prices - self-test questions

1

Market changes

The diagram below shows the market for 3G mobile phones. Which of the following events might have caused the shift in the demand curve?

a)
b)
c)
d)
Please select an answerNo, that's not right. The economies of scale would reduce costs and therefore shift the supply curve to the right.Yes, that's correct. An increase in advertising may shift the demand curve to the right.No, that's not right. An increase in interest rates will reduce disposable income and therefore shift the demand curve to the left.No, that's not right. This will have the effect of shifting the supply curve to the right.
Check your answer

2

Market changes

The diagram below shows the market for coffee. Which of the following events might have caused the shift in the supply curve?

a)
b)
c)
d)
Please select an answerNo, that's not right. This would increase the demand for coffee. No, that's not right. This would decrease the demand for coffee.No, that's not right. An increase in income would shift the demand curve to the right.Yes, that's correct. This would shift the supply curve for coffee to the right and encourage more production of coffee.
Check your answer

3

Market changes

The diagram below shows the market for olive oil. Which of the following events might have caused the shift in the supply curve?

a)
b)
c)
d)
Please select an answerNo, that's not right. This would shift the supply curve for olive oil to the right as there would be further supply of olives available. No, that's not right. This would shift the demand curve not the supply curve.No, that's not right. An increase in income would shift the demand curve to the right.Yes, that's correct. This would shift the supply curve for olive oil to the left as Spain is a major producer of olives and with a drought the harvest will be much lower.
Check your answer

4

Market changes

The diagram below shows the market for hard disk music players. Which of the following events might have caused the shift in the demand curve?

a)
b)
c)
d)
Please select an answerNo, that's not right. This would shift the supply curve for hard drive players to the right and not the demand curve. No, that's not right. This would shift the supply curve to the right as costs of production would be lower. The demand curve would not shift.No, that's not right. An increase in income would shift the demand curve to the right not to the left.Yes, that's correct. These new phones would be a substitute product and this would lead to a reduction in demand for hard drive players. This would shift the demand curve to the left.
Check your answer

5

Shifts in demand and supply curves

Consider the market for Mars Bars. Match the changes below with the shifts in supply and demand that they are likely to lead to.

a)
b)
c)
d)
Yes, that's correct. Well done. The supply curve will be affected by changes in costs and productivity, while the demand curve will be affected by health scares and changes in the price of substitutes.No, that's not quite right. Try again. The supply curve will be affected by changes in costs and productivity, while the demand curve will be affected by health scares and changes in the price of substitutes.Your answer has been saved.
Check your answer

6

Subsidy payments

Farmers are paid subsidies for the production of wheat. On a separate sheet of paper, draw a supply and demand diagram to show the impact of a subsidy and type an explanation of the diagram in the box below.

The impact of a subsidy is to shift the supply curve for the product to the right as shown in the diagram below. This is because the farmers become more willing to supply the good at each and every price. The supply curve shifts vertically downwards by the amount of the subsidy.

Check your answer

7

Shifts in demand

Choose appropriate phrases from the drop down boxes below to complete the explanation of shifts of a demand curve and movements along demand curves.

When the price of a good changes there will a the demand curve. If the price increases, there will be a movement upwards and to the left on the demand curve and this is called a in demand or a in quantity demanded. If there is a decrease in price, then there will be a movement downwards to the right and this is called an in demand or an in quantity demanded. However, if one of the determinants other than price changes then the whole demand curve will shift, either to the right or to the left. For example, if income increases, then the demand curve will shift to the . If, however, the price of a substitute falls, then the demand curve will shift to the .

Your answer has been saved.Check your answer

Demand and supply - data response

Interaction of demand and supply

Question 1

Describe the change in the price of steel over the period shown in the chart below.

There is also a static version of the chart available.

Question 2

Compare the changes in the price and production of steel in the chart in question 1 and the chart below over the period shown.

There is also a static version of this chart available.

Question 3

Refer to the graph in question 1 and the quote below:

"In the last 6 months of 2000, world steel supply raced ahead of demand in response to industries' requirements for steel."

Use a supply and demand diagram to explain the change in the price of steel which occurred in the last 6 months of 2000.

Question 4

"Steel is a vital requirement for manufacturing industry worldwide and world steel consumption is 7 times greater than plastic consumption and 40 times greater than aluminium consumption. Nonetheless, one may sometimes be used instead of the other, so decreases in the price of plastics and aluminium may affect the market for steel."

Use a supply and demand diagram to help you explain how decreases in the price of plastics and aluminium may affect the market for steel.

Question 5

"Rising real incomes, low real interest rates and a stubbornly inflexible supply of houses would seem to indicate that house prices will continue to rise in the foreseeable future".

Use a demand and supply diagram to help you explain this rise in house prices.

Question 6

"Most metals used as industrial raw materials suffered a steep fall in demand in 2001, and the demand for copper was no exception. However, the change in price of copper was not as great as it might have been, as the closing down by many mining companies of production lines acted as a counter-balancing influence".

Use a demand and supply diagram to explain the changes that occurred in the price of copper in 2001.

Question 7

"Rising output of cocoa beans has caused prices to tumble, but it is hoped that the introduction of the Ivory Coast buffer stock stabilisation scheme will halt this process"

Use a demand and supply diagram to explain how this buffer stock scheme might stabilise the price of cocoa beans.

Price controls - short answer

Question 1

The table below gives the levels of demand and supply for a good.

Price () Demand ('000 per month) Supply ('000 per month)
11 - 200
10 30 180
9 60 160
8 90 140
7 120 120
6 150 100
5 180 80
4 210 60
3 240 40
2 270 20
1 300 -


(a) Draw the demand and supply curves on a graph.
(b) What is the equilibrium price and quantity?
(c) If the government supports a minimum price of 10, by how much does supply exceed demand?
(d) If the government controls the price at a maximum of 3, by how much does demand exceed supply?
(e) If the government placed a subsidy of 5 per unit on this good, what would be the new equilibrium price and quantity?
(f) How much would this subsidy cost the government per month?

Question 2

The diagram below represents the market for olives.

The market for olives

The Italian government decides to protect the production of olives and they agree to set a minimum price. Any olives that are left unsold at the minimum price, the government will buy.

(a) What is the equilibrium price in the absence of any intervention?
(b) If the government set a minimum price of P3, what would be the equilibrium market price?
(c) What would be the level of demand at this price?
(d) If the government set a minimum price of P1, what would be the market price?
(e) What would be the level of olives demanded at this price?
(f) What would be the level of olives supplied at this price?
(g) How many olives would the government have to buy if the minimum price was P1?
(h) Copy the diagram and shade the area that represents the total spending by consumers on olives at a price of P1.
(i) On the same diagram, show the level of government spending on excess olive production.

Agricultural markets - essay

Intervention in agricultural markets

Question 1

(a) Agricultural prices tend to fluctuate much more than the price of manufactured goods. Explain how a buffer stick scheme can help overcome this problem.

(b) "Intervention in agricultural markets is always for the good". Do you agree? Justify your answer.

Section 2.1 Markets - in the news

In this section are a series of questions on the topical news items in relation to the topic - Markets.





Click on the right arrow at the top or bottom of the page to move on to the next page.

Oil - the rise and rise

Read the article Oil jumps to near $120 a barrel and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also want to read:

Question 1

Using diagrams as appropriate, explain the changes that have taken place in the oil market.

Question 2

Analyse the extent to which the rise in oil prices has been as a result of policies pursued by OPEC - the oil cartel.

Question 3

Analyse the extent to which the increase in oil prices will impact on countries in the developed world

Question 4

Discuss the likelihood of the oil price rising further.

Cheap petrol

Read the article Cheap and cheerful: Venezuelans cling to right for petrol at 42p a tank and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using diagrams as appropriate, show how the fuel subsidy in Venezuela affects the market for petrol.

Question 2

Analyse the impact on economic efficiency of the Venezuelan fuel subsidy.

Question 3

Discuss the environmental impact of the Venezuelan fuel subsidy.

Feed the world

Read the article Feed the world? We are fighting a losing battle, UN admits and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also want to have a look at/listen to the following articles which consider the growth in world food prices:

Question 1

Using diagrams as appropriate, explain why world food prices have been rising significantly.

Question 2

Examine the likely impact of the increase in food prices on the levels of (a) relative poverty and (b) absolute poverty in the developed and developing world.

Question 3

Analyse the impact of rising food prices on the rate of economic development in the developing world.

Question 4

Discuss two policies that could be adopted by governments and the international community to alleviate the impact of rising food prices.

Cry for me Argentina

Read the article Cry for me, Argentina (and Russia and China) and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using diagrams as appropriate, illustrate the impact of the imposition of a price control on a market.

Question 2

Using diagrams as appropriate, illustrate the way in which price controls have been used to control energy price rises in Argentina.

Question 3

Analyse the impact on consumers of the imposition of price controls on energy markets in Argentina.

Question 4

Discuss the role likely effectiveness of price controls as a tool to reduce the level of inflation.

Bolivian fuel shortages

Read the article Fuelling Bolivia's crisis? and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using diagrams as appropriate, explain the reasons for fuel shortages in Bolivia.

Question 2

Using diagrams as appropriate, illustrate the impact of Bolivia's fuel subsidies on the market for diesel.

Question 3

Discuss the role of nationalisation in the fuel shortages faced by Bolivia.

Cheddar hits 2000 a tonne

Read the article Cheddar hits 2,000 a tonne as global milk demand soars and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Identify the key determinants of demand for cheddar cheese.

Question 2

Using diagrams as appropriate, explain the changes that have taken place in the market for cheddar cheese.

Question 3

Analyse the likely impact of the increase in the price of milk on

  1. yoghurt and
  2. soya milk and other milk substitutes.

Question 4

Discuss the extent to which cheese producers will be able to pass on the increased costs to consumers in the form of higher prices.

The big freeze

Read the article Big freeze sours US orange crops and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using supply and demand diagrams as appropriate, explain the impact of the freezing weather in California on the world price of oranges.

Question 2

Using supply and demand diagrams as appropriate, compare and contrast (a) the change in the price of oranges and orange juice and (b) the change in the price of oranges in the USA and the rest of the world.

Question 3

Analyse the likely impact of the cold weather in California on prices of other foods.

The aftermath of hurricanes

Read the article Hurricanes squeeze juice prices and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using supply and demand diagrams as appropriate, show why "the cost of juices could surge by up to 25%".

Question 2

Identify the principal determinants of (a) supply of and (b) demand for fruit juice.

Question 3

What substitute products are available for fruit juice? Using supply and demand diagrams as appropriate , analyse the impact of the hurricanes on the markets for these products.

How much is a 2p worth? Actually 3p

Read the article How much is a 2p worth? Actually 3p and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also like to read the article Mint warns against melting coins.

Question 1

Examine the principal factors that have caused the rise in copper prices on world markets.

Question 2

Describe the principal factors affecting the demand for copper and other metals.

Question 3

What is meant by the terms "goldilocks economy" and "super-cycle"? (See Guardian article.)

Japanese rice subsidies

Read the article Japan fights to protect rice farming and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using diagrams, as appropriate, show the methods used by the Japanese government to protect Japanese rice farmers.

Question 2

Analyse the advantages and disadvantages of these subsidies for (a) consumers, (b) Japanese rice farmers and (c) overseas farmers.

Question 3

Evaluate one other strategy that the Japanese government could use to protect the income levels of their rice farmers.

Coffee shortages in Venezuela

Read the article Venezuelan shoppers face food shortages and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using supply and demand diagrams, as appropriate, show why there have been coffee shortages in Venezuela.

Question 2

Discuss the effectiveness of price controls as a policy to reduce inflation.

Question 3

Analyse the impact of the price controls on Venezuela's major economic targets.

Labour mobility

Read the article 'Old EU' eases labour barriers and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Explain the reasons why some EU countries have maintained restrictions on workers entering their countries.

Question 2

Analyse the advantages and disadvantages of increasing labour mobility in Europe.

Question 3

Using diagrams as appropriate, evaluate the impact on greater labour mobility on the labour market of one of the 'Old EU' countries.

Section 2.1 Markets - simulations and activities

In this section are a series of simulations and activities on the topic - Markets.





Click on the right arrow at the top or bottom of the page to move on to the next page.

PlotIT - Build a demand curve

Consider the (imaginary) data in the following table. This shows the annual demand for tennis shoes in three sections of the market. Calculate the total (annual) market demand. Jot this down on a piece of paper. You may like to check your answer.

Price () Tennis club members ('000s) Players, but not club members ('000s) Non-tennis players ('000s) Total market ('000s)
100 6 1 0
80 7 3 0
60 8 6 2
40 9 10 8
20 10 18 20


From the table, plot each of the figures for total market demand on the following diagram. To do this, click your mouse on the graph axes for the position of each of the plots. When you have done this, the demand curve will automatically be drawn.

You may like to check your answer to see if it matches the correct curve.

1

Expansion/contraction of demand

If the price of tennis shoes falls, there will be an extension in demand.

a)
b)
Yes, that's correct. The statement is true. A fall in price leads to an extension in demand.No, that's not right. The statement is true. A fall in price leads to an extension in demand.Your answer has been saved.
Check your answer

2

Demand for tennis shoes

A higher rate of economic growth will lead to an expansion in demand.

a)
b)
Yes, that's correct. The statement is false. An increase in economic growth will lead to a shift in the demand curve. An extension in demand is a move along the demand curve.No, that's not right. The statement is false. An increase in economic growth will lead to a shift in the demand curve. An extension in demand is a move along the demand curve.Your answer has been saved.
Check your answer

AnimateIT - Markets and prices

In this section we look at animated versions of the supply and demand diagrams. It is worth going through these to see how the changes in supply and demand build up.

Demand curve - shift left

Demand curve - shift right

Supply curve - shift left

Supply curve - shift right

PlotIT - Build a demand and supply diagram

The demand and supply schedules for organically grown wheat are shown in the following table. From it we can see that at a price of 200, farmers will produce (or plan to plant and produce) 220 tonnes per annum (p.a.); likewise consumers will buy 220 tonnes p.a. at this price. However, the price of non-organic wheat falls dramatically and is considerably cheaper than organic wheat. As a result the demand for organically grown wheat changes by 80 tonnes at all prices. Calculate the new level of demand at each price level. Jot this down on a piece of paper. You may like to check your answer.

Price per tonne () 50 100 150 200 250 300 350
Tonnes supplied p.a. 100 140 180 220 260 300 340
Tonnes demanded p.a. 400 320 260 220 180 140 120
New tonnes demanded p.a 8 6 2


In the diagram below plot the original supply and demand curves and the new demand curve given this change in the price of non-organic wheat.

You may like to check your answer to see if it matches the correct demand and supply curves.

1

Market for organic wheat

What will be the shortage/surplus at the original price of 200 per tonne?

a)
b)
c)
d)
Please select an answerYes, that's correct (i.e. 220 tonnes supplied minus 140 tonnes demanded).No, that's not right. 220 tonnes will be supplied and 140 tonnes will be demanded. This gives a surplus of 80 tonnes, not a shortage.No, that's not right. 220 tonnes will be supplied and 140 tonnes will be demanded. This gives a surplus of 80 tonnes.No, that's not right. 220 tonnes will be supplied and 140 tonnes will be demanded. This gives a surplus of 80 tonnes.
Check your answer

2

Equilibrium

What will be the new equilibrium price and quantity?

The new equilibrium price will be 150 per tonne and the quantity demand and supplied will be 180 tonnes p.a. (where the supply curve and the new demand curve intersect).Check your answer

DragIT - Demand and supply

The following diagram shows the demand and supply of good X. For each of the following, click on either the demand or supply curve (or first one and then the other) and drag the curve(s) to a position that illustrates the question to help you match the events to the particular change.

1

Shifts in demand and supply

Match the following changes to the shifts that will take place.

a)
b)
c)
d)
Yes, that's correct. Well done.No, that's not right. Have another go. Try shifting the curve in the diagram to see the effect on price and quantity.Your answer has been saved.
Check your answer

Diagram toolkit

In the diagram toolkit you get given a panel showing possible curves and labels and you then drag these curves onto targets on the diagram to try to build an appropriate diagram.

There are a number of sections. Follow the links below to access the different sections or use the table of contents on the left.

Why not try the one below as some practice? Drag curves and labels onto the targets on the diagram to build a demand and supply diagram showing a market in equilibrium. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Click on the right arrow to start trying out the diagram toolkit.

Air travel (1)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Number 4

Click on the right arrow try some further examples.

Air travel (2)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Click on the right arrow try some further examples.

Air travel (3)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Click on the right arrow try some further examples.

iPods (1)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Number 4

Click on the right arrow try some further examples.

iPods (2)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Click on the right arrow try some further examples.

iPods (3)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

DragIT - Tax revenue

The following interaction illustrates the effects of a change in tax rates on the revenue received by the government. Remember that the effect of a tax is to shift the supply curve upwards by the amount of the tax per unit.

Click on the "S2" label and drag the supply curve S2 to the left and back to see the impact of a change in the level of taxation on the tax revenue.

1

Tax revenue

As the tax per unit rises the equilibrium quantity will fall.

a)
b)
Yes, that's correct. The statement is true. A higher rate of tax will reduce the equilibrium quantity traded in the market.No, that's not right. The statement is true. A higher rate of tax will reduce the equilibrium quantity traded in the market.Your answer has been saved.
Check your answer

DragIT Maximum prices

Government may set a ceiling for prices below the market equilibrium in order to benefit consumers. This is referred to as a 'maximum' price because suppliers are not allowed to charge a higher price. In the UK, the price of a standard loaf of bread was set by the government right up to the early 1970s. Low maximum prices are often used in developing countries as a means of helping the large numbers of urban poor.

Assume that the domestic market price for wheat is 5 (which is also the world price of wheat). In the diagram below drag the 'low maximum price' line to a level that reduces this country's market price of wheat by 20 per cent.

1

Maximum prices

In the above situation which of the following will be true?

a)
b)
c)
d)
e)
a) Yes, that's correct. There will be a shortage, but it will be 10,000 tonnes.a) No, that's not right. There will be a shortage, but it will be 10,000 tonnes.b) Yes, that's correct. Original income was 125,000 (5 25,000). New income is 80,000 (4 20,000).b) No, that's not right. Original income was 125,000 (5 25,000). New income is 80,000 (4 20,000).c) Yes, that's correct. Although demand has increased by 20 per cent (from 25,000 to 30,000 tonnes per annum), consumption will fall to 20,000 tonnes as that is all that is being produced (assuming none in store).c) No, that's not right. Although demand has increased by 20 per cent (from 25,000 to 30,000 tonnes per annum), consumption will fall to 20,000 tonnes as that is all that is being produced (assuming none in store).d) Yes, that's correct. Supply would fall from 25,000 to 20,000 tonnes per annum.d) No, that's not right. Supply would fall from 25,000 to 20,000 tonnes per annum.e) Yes, that's correct.e) No, that's not right. The statement is correct.
Check your answer

2

Maximum prices

In the above situation, which of the following will be true?

a)
b)
c)
d)
e)
a) Yes, that's correct. The statement is true.a) No, that's not right. The statement is true.b) Yes, that's correct. The statement is true.b) No, that's not right. The statement is true.c) Yes, that's correct. The statement is true.c) No, that's not right. The statement is true.d) Yes, that's correct. The statement is true.d) No, that's not right. The statement is true.e) Yes, that's correct. The statement is true.e) No, that's not right. The statement is true.
Check your answer

DragIT - Intervention in agricultural markets

Added to the problems of price fluctuations and relative declining income that they have faced, most European farmers have also suffered from growing competition from other food-exporting nations around the world (e.g. USA, Canada, Australia and parts of Africa). One solution to this specific problem would be to set a tariff on all imported products that compete directly with domestic producers.

The following diagram shows the domestic demand and supply for wheat in a given country. The world price of wheat is 3 per tonne (shown by the horizontal red line).

1

Import tariff

What will be the level of domestic production at a world price of 3 per tonne?

a)
b)
c)
d)
Yes, that's correct. Domestic production occurs where the domestic supply curve meets the world price. This is at a quantity of 15,000 tonnes.No, that's not right. Domestic production occurs where the domestic supply curve meets the world price. This is at a quantity of 15,000 tonnes.Your answer has been saved.
Check your answer

2

Import tariff

What will be the level of imports at a world price of 3 per tonne?

a)
b)
c)
d)
Yes, that's correct. It is 35,000 demanded - 15,000 supplied domestically.No, that's not right. It is 35,000 demanded - 15,000 supplied domestically.Your answer has been saved.
Check your answer

3

Import tariff

What will be the level of imports at a world price of 4 per tonne?

a)
b)
c)
d)
Yes, that's correct. It is 30,000 demanded - 20,000 supplied domestically.No, that's not right. It is 30,000 demanded - 20,000 supplied domestically.Your answer has been saved.
Check your answer

DragIT - Intervention in agricultural markets (2)

The Common Agricultural Policy (CAP) has traditionally used high minimum prices as the means of supporting the European farming community.

The following diagram is the same as the one we had before. It shows the demand and supply for wheat in a given country. The world price of wheat is 3 per tonne (shown by the horizontal red line). Given this low price for wheat, domestic production is 15,000 tonnes per annum, yet demand is 35,000 tonnes per annum. As a result this country imports 20,000 tonnes of wheat per annum.

Drag the horizontal red line upwards to represent the setting of a high minimum price that would result in the country now having a surplus of 10,000 tonnes of wheat per annum (a surplus that is then exported).

1

Import tariff

What will be the revenue of domestic wheat farmers before the policy change?

a)
b)
c)
d)
Yes, that's correct. Domestic production occurs where the domestic supply curve meets the world price. This is at a quantity of 15,000 tonnes. This 15,000 tonnes is sold at 3 per tonne making a total revenue of 45,000.No, that's not right. Domestic production occurs where the domestic supply curve meets the world price. This is at a quantity of 15,000 tonnes. This 15,000 tonnes is sold at 3 per tonne making a total revenue of 45,000.Your answer has been saved.
Check your answer

2

Import tariff

What will be the price charged after the policy change?

a)
b)
c)
d)
Yes, that's correct. The new price will be 6. This is the new world price and at this price there will be a surplus of 10,000 tonnes.No, that's not right. The new price will be 6. This is the new world price and at this price there will be a surplus of 10,000 tonnes.Your answer has been saved.
Check your answer

3

Import tariff

What will be the revenue of domestic wheat farmers after the policy change?

a)
b)
c)
d)
Yes, that's correct. Domestic production occurs where the domestic supply curve meets the world price. This is at a quantity of 30,000 tonnes. This 30,000 tonnes is sold at 6 per tonne making a total revenue of 180,000.No, that's not right. Domestic production occurs where the domestic supply curve meets the world price. This is at a quantity of 30,000 tonnes. This 30,000 tonnes is sold at 6 per tonne making a total revenue of 180,000.Your answer has been saved.
Check your answer

4

Import tariff

How much has consumer expenditure on wheat risen by?

a)
b)
c)
d)
Yes, that's correct. Before the policy change consumers were buying 35,000 tonnes at a price of 3. This meant they were spending 105,000. After the policy change demand falls to 20,000 tonnes, but consumers have to pay the higher price of 6. This means they are now spending 120,000. This gives an increase of 15,000.No, that's not right. Before the policy change consumers were buying 35,000 tonnes at a price of 3. This meant they were spending 105,000. After the policy change demand falls to 20,000 tonnes, but consumers have to pay the higher price of 6. This means they are now spending 120,000. This gives an increase of 15,000.Your answer has been saved.
Check your answer

5

Import tariff

Assume that as a result of the policy, the world price of wheat has fallen to 2 per tonne, and that the government buys any surplus and then exports it at the world price. What will be the taxpayers contribution to this policy?

a)
b)
c)
d)

Yes, that's correct. To buy the surplus: 6 10,000 = 60,000.

Minus export revenues of: 2 10,000 = 20,000

equals a net cost of 40,000 (not including any other costs of transporting and storing etc.).

No, that's not right. To buy the surplus: 6 10,000 = 60,000.

Minus export revenues of: 2 10,000 = 20,000

equals a net cost of 40,000 (not including any other costs of transporting and storing etc.).

Your answer has been saved.
Check your answer

Section 2.2 Elasticities - notes

This unit, with its numbers, will scare some students. Be positive, the maths is easy; the key is to understand what the words mean. It is language, not numbers, that is usually the problem.

In the last unit we saw what demand is, and what its determinants are. We know that demand is sensitive to changes into these determinants; it is important to know how sensitive. Economists do this by measuring elasticity. In particular, they study price, income and cross price elasticity of demand. This is new language, so some definitions are needed.

Elasticity is simply the economist's word for responsiveness. For example, price elasticity shows how responsive demand is to changes in price. In this section we consider the following topics in detail:





To start looking at these topics, click on the right arrow at the top or bottom of the page. To get back to the table of contents at any stage, simply click on the 'home' icon at the top or bottom of the page.

Price elasticity of demand

Price elasticity of demand (PED)

A measure of the resposniveness of the demand for a product to changes in its own price.

PED - formula

Price elasticity of demand is calculated and defined as:

Price elasticity of demand = % change in Qd / % change in P

Where Qd = Quantity demanded
and P = Price

Some students find it difficult to remember which way up this equation is. The following 'aide memoire' may be of use. You usually put your dinner (demand) on your plate (price). Demand is over price, D over P!

Price elasticity is negative because price and quantity demanded usually vary inversely with each other. This is so common that the sign is ignored. Do not forget, when price increases, demand falls and vice versa.

Elasticity values

Elasticity ranges from zero to infinity and the value is given different names over different numerical ranges as summarised in the table below.

Value Description Explanation
O PERFECTLY INELASTIC Price has no effect on demand at all
Under 1 INELASTIC Price has a small effect on demand. The % change in price is larger than the % change in demand
Exactly 1 UNITARY % Change in price and % change in demand are the same. Remember, though, the signs are different.
Over 1 ELASTIC Demand is very sensitive to price. The % change in price is less than the % change in demand.
Infinity PERFECTLY ELASTIC An infinite amount is demanded at one price but nothing at all at a slightly higher price.


Elasticity along a straight line demand curve

Because of the way that it is calculated, price elasticity will vary along a straight - line demand curve. Examine Figure 1 carefully.

Figure 1 Elasticity along a straight-line demand curve

It is usual to represent the degree of elasticity graphically. The common shapes for demand curves and their elasticity values are given in the diagrams below.

Figure 2 Perfectly inelastic demand curve

Figure 3 Inelastic demand curve

Figure 4 Elastic demand curve

Figure 5 Perfectly elastic demand curve

The special shape that represents a price elasticity of 1 is known as a rectangular hyperbola! This is shown below.

Figure 6 Unit elastic demand curve

Determinants of price elasticity

Price elasticity of a good or service depends on a range of factors:

For more detail on any of these factors, follow the links above.

You will be expected to calculate and use elasticity, and to interpret given data. This may happen in any of the papers that are taken. Some examples follow (click on the example links) and there are a series of practice questions which are accessible from the questions section (click on questions - module 2 in the left-hand menu bar).

Example 1 - price elasticity of demand

Example 2 - price elasticity of demand

Elasticity and revenue

Remember that if demand for a good or service is price inelastic then an increase in price will decrease sales but increase sales revenue. However, a price cut will increase both sales but decrease sales revenue.

Firms like the demand for their product if possible to be inelastic. This means that any increase in price that they put in place will have proportionately less of an effect on demand and their total revenue will rise.

If price elasticity is 1, then revenue is the same all the time, even if prices are increased or decreased.

The changes in revenue for different elasticity values are summarised in the table below.

Price elasticity value Price change Impact on firm's revenue Explanation
Elastic Increase Fall Elastic demand will mean that when price increases, demand will fall by a greater percentage than the price increased. This means a fall in revenue.
Elastic Decrease Increase Elastic demand will mean that when price falls, demand will increase by a greater percentage than the price decreased. This means an increase in revenue.
Inelastic Increase Increase Inelastic demand will mean that when price increases, demand will fall by a smaller percentage than the price increased. This means an increase in revenue.
Inelastic Decrease Fall Inelastic demand will mean that when price falls, demand will increase by a smaller percentage than the price decreased. This means a fall in revenue.


Cross elasticity of demand

Cross elasticity of demand

The cross elasticity is a measure of the responsiveness of the demand for one product to changes in the price of another product.

Cross elasticity - formula

Cross elasticity is calculated and defined as:

Cross elasticity of demand = % change in Qdx / % change in Py

Where Qdx = Quantity demanded of Good X
and Py = Price of Good Y

Cross price elasticity varies from 0 to infinity. As before, the now familiar descriptions are used:

Value Description
0 Perfectly inelastic
Under 1 Inelastic
1 Unitary
Over 1 Elastic
Infinity Perfectly elastic


Significance of XED sign

The sign is as important as the numerical value, however.

Some products tend to be bought together, others are purchased in competition to each other. Products bought together are called complementary goods. Products which are in competition with each other are called substitute goods.

Examples of complements are strawberries and cream, fish and chips, cars and petrol, and televisions and TV licences. Complementary goods have negative cross price elasticities. Perfect complements will have a cross price elasticity of - infinity.

Example - complements

Examples of substitutes are beef and lamb, gas and heating oil, petrol and diesel fuel. (Note that the substitution may not be possible at once). Substitutes have positive cross price elasticities.

Example - substitutes

Cross price elasticity can change with time, therefore.

Again, here are some examples of calculations.

Example 1 - cross price elasticity

Example 2 - cross price elasticity

Income elasticity of demand

Income elasticity of demand (YED)

The income elasticity of demand is a measure of the responsiveness of the quantity demanded to changes in real income.

YED - formula

Income elasticity of demand is calculated and defined as:

Income elasticity of demand = % change in Qd / % change in Y

Where Y = real income
and Qd is the quantity demanded

Normal and inferior goods

Elasticity can be calculated and a range of values found. What do they show? What do they tell an economist?

Income elasticity may be positive or negative. If income elasticity is negative, demand falls as real income rises. Goods or services with such elasticity are called inferior goods. Write down some examples of inferior goods.

If the income elasticity is positive, demand increases with real income. These goods are known as normal goods. Write down some examples of normal goods.

The sign reveals whether the good is inferior or normal.

Elasticity is given different names over different numerical ranges. Learn these, and the related diagrams.

Some examples of calculations:

Example 1 - income elasticity of demand

Example 2 - income elasticity of demand

Price elasticity of supply

Price elasticity of supply (PES)

The responsiveness of the quantity of a good supplied to changes in its price.

PES - formula

The value for price elasticity of supply is calculated and defined as:

Price elasticity of supply = % change in quantity supplied / % change in price

Possible PES values

The familiar descriptors are applied to the value that you get from this formula (known as the coefficients), namely:

Value Description Diagram
0 Perfectly inelastic
Between 0 and 1 Inelastic
1 Unitary
Between 1 and infinity Elastic
Infinity Perfectly elastic


Follow the links below to see some sample calculations if you are not sure about how to calculate the value of price elasticity of supply.

Example 1 - price elasticity of supply

Example 2 - price elasticity of supply

Price elasticity of supply measures the ability of a firm to increase or decrease its output in response to a change in price. This sensitivity changes with time, or rather with economic time and the degree of substitutability between factors of production.

Unitary elasticity of supply

Any straight-line supply function that passes through the origin has a coefficient of 1. Look at Figure 1. All the supply functions have an elasticity of 1.

Figure 1 Supply schedules with unitary elasticity

Determinants of PES

Supply elasticity depends on a number of factors:

Effect of time on supply elasticity

Firms use factors of production to manufacture their goods. Consider a farmer growing wheat. There is the farm and its equipment, silos and the farm workers. The owner farmer makes all the decisions.

Very short run - no changes possible other than the use of stocks

This is the position after the planting season. The yield is fixed. Excess grain may go into stock, or stocks may be sold to satisfy a shortage. Supply elasticity is very low, and may even be perfectly inelastic.

Short run - at least one factor fixed

The farmer may be able to increase or decrease the area used for wheat. The potential here will depend on the efficiency of the farm, the choices open to it, and its production possibility frontier. Look at Figure 2.

Figure 2 PPF between wheat (good A) and barley (good B)

If the farm was at point Y it can only increase wheat production at the cost of barley. On the other hand, if it is at X it has much more flexibility.

Supply will have become more elastic. The farmer will be able to respond to the signals that the market is sending out.

Long run - all factors are now variable

The farmer could buy more land, invest more capital and significantly increase production.

Supply will now be very responsive to demand; it will have become elastic.

Very long run

This is where technology comes in. A new process or procedure, such as genetic modification, can revolutionise an industry and radically change its potential. Such changes are few and come after much research and other investment.

Effect of substitutability on supply elasticity

The easier it is to increase or substitute factors of production the quicker that a firm will be able to respond and produce more. Consider a number of factors:

Capacity factors

Firms working below their maximum capacity can respond quicker to changes in demand than those working flat out. The greater the spare capacity, the greater the elasticity of supply.

Stocks

The availability of stocks can increase the ability of a firm to respond quickly so will increase the supply elasticity, at least for a short time.

Summary

Having completed this session you should know and understand that:

1. The responsiveness of supply to changes in price is known as supply elasticity.
2. Elasticity of supply is normally positive.
3. Supply is perfectly inelastic if its coefficient is 0, inelastic if it is between 0 and 1, unitary if it is exactly 1, elastic if it is between 1 and infinity and perfectly elastic if it is infinity.
4. Price elasticity of supply of a product varies with time, economic time (i.e. very short run, short run, long run, very long run). It also depends on the substitutability of the factors of production used in its manufacture.

Applications of demand and supply

Markets rarely react fast, so it takes time for the market to regain equilibrium after it has experienced a change or a shock. Examine Figure 1, which shows the effect of an increase in demand on the market for new houses in an area. Assume that a major, large government department has just announced that it is to relocate to this area.

Figure 1 The market for new houses

The initial market was defined by demand curve D and supply curve S. The market was in equilibrium at price P1 when Q1 new houses were bought and sold. The entry of the government department will increase demand and shift the demand curve to D1. Supply will take time to react so price will rise initially to P2, then fall back slowly to P3 as the supply of houses increases. It will move from one equilibrium position, P1Q1, to another, P3Q2, over a period of time. It will pass through P2Q1 on the way.

A further example, the market for drugs or alcohol. Suppose the police were to really crack down on drug dealing, with considerable but not perfect effect. What would happen?

The US Government once tried to ban the sale, and hence consumption of alcohol in America, but with only partial success. What happened here? Look at Figure 2.

Figure 2 The drug or alcohol market

In both cases the measures had no effect on demand, but reduced supply. So price would go up but the quantity available would fall.

For the drugs, the street price would be an indication of the success of the police. The greater the rise, the greater the degree of success.

The real supply curve?

The supply curve is usually drawn as an upwards (left to right) sloping curve. This implies that as price rises, so will the supply. This further supposes that the response time for the supplier is zero. In many cases this is far from the case. (If it was, then supermarket shelves would never be out of stock of the item you want!) Consider the market for houses in a region illustrated in Figure 1 below.

Figure 1 Supply of houses

Builders are constructing and selling 'Q' houses per month at present at price 'P'. Suddenly demand increases significantly, as a government department is moving a London office there. What can be done? Not much, at least in the next few months.

Supply is essentially fixed at Q1, regardless of demand. The supply curve is a vertical line. Prices will be put up by the developers if they think it worthwhile - in our diagram prices have risen to P1.

Supply will take time to react to the new situation. They need land and planning permission and this can take months or years to organise. It will then take anything from 6 months to a year to build the house itself.

Once adjusted, the builders will actually be operating on another vertical supply curve. They will now be building Q2 houses per month and the pressure on prices is eased (though the exact impact will depend on national effects as well). Let's hope the government does not change its mind!

Figure 2 Increase in supply

Now think about the supply of things like CIVIL AIRCRAFT, AGRICULTURAL PRODUCTS and FOREIGN HOLIDAYS.

SUPPLY CHANGES SLOWLY, MUCH SLOWER THAN DEMAND.

Applications of concepts of elasticity

Measuring elasticity

Price elasticity is based on the demand curve. In fact, the elasticity is the gradient of the demand curve at a particular point. (Mathematicians will note that it is the differential of the demand function, in fact.) This means it is a static measure, since it is based on static, or equilibrium data.

In the real world elasticity, is very difficult to measure. There are far too many variables, and these change all the time. Quantitative data is rare, but qualitative data can be useful.

It is useful to remember that essentials tend to be price inelastic, as are addictive products. This is one of the reasons behind the taxing of alcohol and tobacco. More on this later in the course.

PED and taxation

The imposition of a tax will mean that the price goes up (as supply shifts to the left). However, the amount of the price increase will depend on the elasticity of demand. Compare Figures 1 and 2 to see the difference.

Figure 1 Tax imposed on a good with elastic demand

Figure 2 Tax imposed on a good with inelastic demand

1

Tax revenue

If you aimed as a government solely to reduce the consumption of the good, which type of good would you be taxing?

a)
b)
Yes - if the sole intention was to reduce demand then this would be most effective if the good is elastic in demand. The tax would increase the price and reduce demand by proportionately more.No - if the sole intention was to reduce demand of the good then this will be less effective if the good was inelastic in demand. However, if the good has damaging external costs, then the government may nevertheless want to tax the good.Your answer has been saved.
Check your answer

2

Tax revenue (2)

If you aimed as a government to tax goods simply to raise tax revenue, which type of good would you tax?

a)
b)
Yes - if demand is inelastic, then firms are able to increase the price without demand falling very much. This will mean that the revenue raised will be relatively greater than for a good with elastic demand.No, that's not right. If the demand is elastic, then little revenue will be raised. The tax will put the price up, but this will lead to a proportionately greater decrease in demand and the revenue raised from the tax will be lower.Your answer has been saved.
Check your answer

So we can see that if we tax a good with elastic demand, then the price will rise very little and the tax will fall mainly on the producer (as they are not able to pass on the tax as a price increase). If, however, the good is inelastic in demand the producer will be able to increase the price more and therefore pass on more of the tax as a price increase. In this situation the burden of the tax falls mainly on the consumer. You can see this in Figure 3 below - the price increase is borne by consumers and the rest of the tax (the gap between the supply curves) is borne by the producer.

Figure 3 Tax burden - consumer and producer

The burden of the tax depends overall on the elasticity of the demand curve. The more inelastic the demand curve, the more of the tax will be borne by the consumer.

Other applications of elasticity

PED values are important to firms for a number of reasons and in this section, we look at the relevance of the price, cross and income elasticities for business decision making.

Click on the right arrow at the top or bottom of the page to start with a look at the relevance of the price elasticity of demand.

PED and business decisions

PED and business decisions - the effect of price changes on revenue

PED is important for business decision making as it determines the effect of price changes on total revenue. When a business is considering increasing or decreasing price, it is important to know what will be the resulting impact on its sales revenue.

Consider the following demand curves:

Unit elastic demand

Figure 1 Unit elasticity of demand

Here the curve is a rectangular hyperbola. Thus all rectangles under the curve are equal in area and each rectangle equals total revenue (for example, the blue and red rectangles are equal). Thus, total revenue remains unchanged as price changes.

In this case it might not be worthwhile for a business to lower price as the extra demand would not bring forth any extra revenue (MR = 0), but it is highly likely that extra costs would be incurred in producing the additional output.

Elastic demand

Figure 2 Elastic demand (PED greater than 1 but less than infinity)

Here a decision to reduce price would lead to an increase in total revenue. As price falls from OP1 to OP2, there is a more than proportionate rise in the quantity demanded from OQ1 to OQ2 and total revenue rises from OP1 x OQ1 to OP2 x OQ2. The fall in revenue from the lower price (the red area) is more than compensated by the rise in revenue from the extra sales (the blue area). The decision to lower price may well be sound in this case as total revenue will rise which may lead to higher profits, depending on the relationship between costs and revenue.

Conversely, a decision to raise price would lead to a fall in total revenue. A rise in price from OP2 to OP1 would cause a more than proportionate fall in demand and so reduce total revenue.

Where demand is elastic:

as price increases, total revenue falls

as price decreases, total revenue rises

Inelastic demand

Figure 3 Inelastic demand (PED greater than 0, but less than one)

Here a decision to lower price would lead to a decrease in sales revenue. As price decreases from OP1 to OP2, there is a less than proportionate increase in demand from OQ1 to OQ2 and total revenue falls. We can see from figure 3 that the loss in revenue from the lower price (the red area) is less than the gain in revenue from the higher sales (the blue area) and so total revenue will fall.

Conversely, a decision to raise price from OP2 to OP1 would lead to a less than proportionate fall in demand from OQ2 to OQ1 and sales revenue would rise.

Where demand is inelastic:

as price increases, total revenue increases

as price decreases, total revenue decreases

Thus knowledge of the PED facing a firm's product or service enables rational pricing decisions to be made.

XED and business decisions

Cross elasticity of demand: relevance for firms

Cross elasticity of demand (CED) is the responsiveness of demand for one good (good X) to a change in the price of another (good Y). Can you write down the FORMULA? Follow the link to check your answer.

The numerical value of the XED will depend on the relationship between the goods in question. If the goods are substitutes or complements, the numerical value of the XED will be much larger than if the two goods bear little relation to each other; i.e. a change in the price of one good will have a significant impact on the demand for the other good. This will be important for business decision making.

For example, consider two manufacturers of different brands of beer (perhaps your teachers will take you on a field trip to test this?) Brand X and Brand Y, which are close substitutes for each other. The decision by the manufacturer of Brand X to lower price will, other things being equal, lead to an increase in the consumption of Brand X beer. If the manufacturer of Brand Y beer leaves the price unchanged, he is likely to experience a decrease in demand as Brand X will become relatively, and possibly absolutely, more expensive than Brand Y. The manufacturer of Brand X is faced with an important pricing decision in order to compete effectively with the rival.

Conversely, consider the case of two goods which are complements, strawberries and cream. A good harvest will increase the supply of strawberries and lower their price. There will be a movement along the demand curve for strawberries, an extension of demand. Given that people like to pour cream on their strawberries to give extra taste, manufacturers of cream will have to make important output decisions if they are to meet the potential increase in demand for cream arising from higher consumption of strawberries.

YED and business decisions

Significance of YED for sectoral change (primary - secondary - tertiary) as economy grows

Income elasticity of demand (YED) is the responsiveness of demand to changes in income. Can you write down the FORMULA? Follow the link to check your answer.

Economic growth is the increase in productive capacity of the economy and is best measured by the increase in real GDP (output) over a period of time.

Typically, as economic growth occurs and real incomes and living standards rise over time, the primary sector tends to become relatively less important, while the secondary and tertiary sectors tend to become relatively more important. Fundamentally, this is because of the importance if YED.

In general, the products of the primary sector e.g. fruit, vegetables, raw materials and so on tend to have a low YED i.e. as real incomes rise, there tends to be a less than proportionate rise in demand for these products. No matter how rich you are, there is a limit to how much fruit and vegetables you can eat, so an increase in income may not stimulate a large increase in consumption of these goods. Consequently, the primary sector is likely to grow only slowly as living standards rise.

The demand for manufactured goods and the services of the tertiary sector, however, tend to have a very high YED. As we become better off, there tends to be a more than proportionate increase in demand for electrical equipment, furniture, banking, travel and tourism etc. Hence the secondary and tertiary sectors grow much more rapidly than the primary sector as living standards rise.

In the more developed countries, the tendency is for the tertiary sector to grow the most rapidly in response to rising real incomes. This is not because people in rich countries fail to buy more manufactured goods as they become better off. Rather, it is often the case that these goods are imported from other countries, often newly industrialised countries, which may be able to produce the manufactured goods with a comparative advantage, i.e. relatively more cheaply.

Thus YED has an important effect on resource allocation within an economy and the speed and nature of sectoral change as countries develop.

Section 2.2 Elasticities - questions

In this section are a series of questions on the topic - Elasticities.





Click on the right arrow at the top or bottom of the page to move on to the next page.

PED - short-answer

Question 1

'The demand for luxury cars is elastic, but the coefficient for Jaguar cars is higher than that for the luxury part of the car market as a whole'.

Why is this the case?

Question 2

'The price elasticity of demand for commuter rail travel is inelastic but that for vacation rail travel is elastic'. Comment on this fact.

Question 3

An exclusive pen manufacturer sells 4,000 pens per month at a price of 40 each. When the price is reduced to 30 sales increase to 6,000 pens per month.

(a) Calculate the price elasticity of demand for the pens over this price range.
(b) Is demand elastic, unit elastic or inelastic?
(c) Calculate the change in revenue due to the change in price.

Question 4

The table below shows the demand schedule for a good. Complete the following table with the total expenditure and indicate in the elasticity column whether the good is elastic or inelastic over that price range.

Price () Demand (per week) Total expenditure Elasticity - elastic / inelastic?
1 50 ****
2 40
3 30
4 25
5 20
6 16
7 13
8 10
9 8
10 5


Price, income and cross elasticity - self-test questions

1

Price elasticity

A cut in price from $1.50 to $1.20 sees demand for a product rise by 10%. What would the price elasticity of demand be for this product?

a)
b)
c)
d)
Please select an answerNo, have you got the formula upside down?No, this would mean the percentage changes were the same and they're not!Yes, well done.No. Have you calculated the correct percentage change in price?
Check your answer

2

Price elasticity

A firm increases its price from $8 to $12 and sees demand for the product fall by 20%. What would the price elasticity of demand be for this product?

a)
b)
c)
d)
Please select an answerYes, well done.No, this would mean the percentage changes were the same and they're not!No, have you got the formula upside down?No. Have you calculated the correct percentage change in price?
Check your answer

3

Income elasticity

What type of good would you expected to have a negative income elasticity of demand?

a)
b)
c)
d)
Please select an answerNo, this type of good would have a positive income elasticity because the demand for them rises as income rises.Yes, the demand for these goods falls as incomes rise and so the income elasticity is negative.No, these normally have a strong positive income elasticity.No, this is a good where demand rises as the price rises. It is therefore related to price and not income.
Check your answer

4

Income elasticity

If disposable incomes rise by 5% and the income elasticity of demand is known to be 0.5, what change in demand would we expect to see?

a)
b)
c)
d)
Please select an answerNo, this would only be the case if the income elasticity was 2. If income elasticity is positive, then, if income increases, there will always be an increase in demand.No, this would only be the case if the income elasticity was 1. If income elasticity is positive, then, if income increases, there will always be an increase in demand.No, this would only occur if the income elasticity was negative. If income elasticity is positive, then, if income increases, there will always be an increase in demand.Yes, well done. If income elasticity is positive, then, if income increases, there will always be an increase in demand.
Check your answer

5

Price elasticity

If a price cut does not lead to an increase in revenue, we might infer that the demand for this product is?

a)
b)
c)
d)
Please select an answerYes, well done. If a good is price inelastic, then a cut in price will lead to a smaller proportionate change in demand. This will mean that revenue earned from the good will fall.No, this refers to the effect of changes in income. You need to look at the price elasticity.No, a price cut would boost revenue if it were price elastic.No, this refers to the effect of changes in income. You need to look at the price elasticity.
Check your answer

6

Price elasticity

If the price elasticity of demand for a product is known to be (-) 2.5 and the firm cuts the price of this product by 5%, what change would we expect to see in the demand for this product?

a)
b)
c)
d)
Please select an answerNo, have you got the formula upside down?Yes, well done. From the price elasticity we know that the change in demand will be two and a half times the change in price. A cut in price will lead to an increase in demand and the increase will therefore be 12.5%.No, have you used the formula correctly?No, have you put the correct data into the formula?
Check your answer

7

Price elasticity

If the price elasticity of demand for a product is known to be (-) 0.5 and the firm increases the price of this product by 10%, what change would we expect to see in the demand for this product?

a)
b)
c)
d)
Please select an answerNo, have you got the formula upside down?No, have you taken into account the minus sign?No, have you used the formula correctly?Yes, well done. From the price elasticity we know that the change in demand will be half the change in price. An increase in price will lead to an decrease in demand and the decrease will therefore be 5%.
Check your answer

8

Price elasticity

If the price elasticity of demand for a product is known to be (-) 2.5 and the firm increases the price of this product by 5%, what change would we expect to see in the demand for this product?

a)
b)
c)
d)
Please select an answerNo, have you used the formula correctly?No, have you taken into account the minus sign?No, have you got the formula upside down?Yes, well done. From the price elasticity we know that the change in demand will be two and a half times the change in price. An increase in price will lead to an decrease in demand and the decrease will therefore be 12.5%.
Check your answer

9

Sales in a recession

In a recession, which sort of good would we expect to see a rise in sales for?

a)
b)
c)
d)
Please select an answerNo, not at all!No, why would we need more of a necessity in a recession?Yes, well done. Inferior goods are ones where demand falls as income rises. As income falls in a recession, we would therefore expect to see a rise in sales.No, normal goods are ones where demand rises as income rises. As income falls in a recession, we would therefore expect to see a fall in sales.
Check your answer

10

Price elasticity

A cut in price from $75 to $60 sees demand for a product rise by from 1,200 units to 1,500 units. What would the price elasticity of demand be for this product?

a)
b)
c)
d)
Please select an answerNo, have you got the formula upside down?No, this would mean the percentage changes were the same - and they're not!Yes, well done. Price has fallen by 20% and demand has risen by 25%. If we divide the change in demand by the change in price we get 1.25.No. Have you calculated the correct percentage change in price?
Check your answer

11

Income elasticity

If disposable incomes rise by 2% and the income elasticity of demand is known to be 1.5, what change in demand would we expected to see?

a)
b)
c)
d)
Please select an answerYes, well done. We know from the income elasticity that the change in demand will be one and a half times the change in income. As income has increased by 2%, demand will therefore increase by 3%.No, have you used the formula correctly?No, have you used the formula correctly?No, this would only occur if the income elasticity was negative. The number is right but the sign is wrong.
Check your answer

12

Price elasticity

The image below shows a medium size yacht. What would you expect the value of the price elasticity of demand for yachts to be?

a)
b)
c)
d)
Please select an answerYes, well done. Yachts would generally be considered a luxury good and because of the high proportion of income being spent on them, we would expect the price elasticity to be relatively elastic.No, unit elasticity means that demand and price change by the same amount. This is unlikely to be the case for yachts.No, we would generally expect the demand for necessities to be price inelastic. Yachts would generally be considered a luxury good and because of the high proportion of income being spent on them, we would expect the price elasticity to be relatively elastic.No, zero price elasticity means that there is no change in demand as price changes and this is very unlikely for yachts as they are generally considered a luxury.
Check your answer

13

Price elasticity

The image below shows cigarettes. What would you expect the value of the price elasticity of demand for cigarettes to be?

a)
b)
c)
d)
Please select an answerNo, that's not right. Cigarettes are addictive and so people tend to be less responsive to changes in price. This means that we would expect the price elasticity to be relatively inelastic.No, unit elasticity means that demand and price change by the same amount. This is unlikely to be the case for cigarettes.Yes, that's correct. Cigarettes are addictive and so people tend to be less responsive to changes in price. This means that we would expect the price elasticity to be relatively inelastic.No, zero price elasticity means that there is no change in demand as price changes and this is very unlikely for cigarettes as they are generally considered addictive.
Check your answer

14

Price elasticity

The image below shows wheat being harvested. What would you expect the value of the price elasticity of demand for wheat to be?

a)
b)
c)
d)
Please select an answerNo, that's not right. Wheat is a necessity (as a raw material for bread and so on) and so people tend to be less responsive to changes in price. This means that we would expect the price elasticity to be relatively inelastic.No, unit elasticity means that demand and price change by the same amount. This is unlikely to be the case for wheat.Yes, that's correct. Wheat is a necessity (as a raw material for bread and so on) and so people tend to be less responsive to changes in price. This means that we would expect the price elasticity to be relatively inelastic.No, zero price elasticity means that there is no change in demand as price changes and this is very unlikely for wheat as it is generally considered a necessity.
Check your answer

PES - short answer

Question 1

How would you expect the price elasticity of supply for houses to change over time? Explain your answer. (5 marks)

Question 2

Rank the following products according to the value of their price elasticity of supply, starting with the most elastic. Give reasons for your answers.

(a) Computers
(b) Houses
(c) Strawberries
(d) Olives
(e) Ice cream

Elasticities - in the news

In this section are a series of questions on topical news items in relation to the topic - Elasticities.





Click on the right arrow at the top or bottom of the page to move on to the next page.

Rice - the staple food

Read the article Farmers fall prey to rice rustlers as price of staple crop rockets and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also want to read:

Question 1

Explain how the factors affecting demand are likely to differ between developed and developing countries.

Question 2

Explain possible values for the price elasticity of demand for rice in (a) developed countries and (b) developing countries.

Question 3

Examine the principal factors that have led to the rapid rise in the price of rice on world markets.

Question 4

Evaluate the likely success of the Indian rice export ban at reducing the price of rice.

Elastic iPods

Read the article In time of need, Apple's new icon, a nation turns its lonely eyes to you and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Define the term income elasticity of demand.

Question 2

Examine the likely value of the income elasticity of demand for iPods.

Question 3

Analyse

  1. two goods (other than iPods) that are likely to face an increase in demand and
  2. two goods that are likely to face a decrease in demand

as a result of the US fiscal stimulus.

Question 4

Discuss the likely effectiveness of the fiscal stimulus in boosting economic growth in the US.

The rising cost of giving thanks

Read the article Thanksgiving dinner cost 'up 11%' and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using diagrams as appropriate, explain the changes, identified in the article, that have taken place in the price of turkeys.

Question 2

Examine the extent to which the demand for turkeys for Thanksgiving dinner is likely to fall as a result of the price rise.

Question 3

Analyse two possible causes of the rise in the price of turkeys.

Question 4

Discuss the likely value of the cross elasticity of demand for cranberry sauce with respect to the price of turkeys.

Charley and Wilma blamed for spiking orange juice

Read the article Charley and Wilma blamed for spiking orange juice and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using supply and demand analysis, illustrate the price changes identified in the article.

Question 2

Identify the principal factors that have led to the price changes for orange juice identified in the article.

Question 3

Discuss the likely change in demand for orange juice as a result of the price rise.

Question 4

Analyse the likely approximate value of the cross elasticity of demand for orange juice with respect to other fruit juices.

Mayday, mayday

Read the article Mayday, mayday and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Define the term 'cross price elasticity of demand'.

Question 2

Identify the principal determinants of the demand for powerboats.

Question 3

Analyse the main factors that determine the cross price elasticity of demand for powerboats with respect to the price of fuel.

Question 4

Discuss the likely difference between the values of the cross price elasticity of demand for cars with respect to the price of fuel and the cross price elasticity of demand for powerboats with respect to fuel.

Coffee prices hit seven year high

Read the article Coffee prices hit seven year high and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

What are the main factors that have led to the increase in coffee prices?

Question 2

Using diagrams as appropriate, illustrate the likely impact of the rise in the price of coffee beans on the market for instant coffee.

Question 3

Comment on the likely value of the price elasticity of demand for instant coffee.

Question 4

Discuss the extent to which coffee producers will be able to pass on the increase in the price of coffee beans to consumers.

SUV's - cross elastic?

Read the article Is this really the end of the SUV? and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Describe the main factors that have led to a fall in demand for SUVs.

Question 2

What is likely to be the value of the cross elasticity of demand for SUVs with respect to the petrol price? How has this value changed in the last year?

Question 3

What strategies could the car manufacturers adopt to try to reduce the cross elasticity of demand for SUVs with respect to the petrol price?

Question 4

Explain the external costs that arise from higher sales of SUVs.

I'm dreaming of a lardy Christmas - the market for lard

Lard is an important ingredient of Christmas puddings, but December 2004 saw a crisis looming as a shortage of lard was threatened! Read the article Lard lovers face national crisis. You can read this in the window below, or follow the previous link to read the article in a separate window. You might then like to have a go at the questions below.

Question 1

Use supply and demand analysis to illustrate the reasons for the shortage of lard. N.B. Consider both the market for pork and the market for lard.

Question 2

The article suggests that 'Lard is Lord' - particularly for the over 50s. How would you expect the value for the cross elasticity of demand between lard and butter (an alternative fat) to differ for young people and the over 50s?

Question 3

What are the main factors that determine the value of the cross elasticity of demand for butter with respect to the price of lard?

Question 4

How will you ensure a sufficient supply of lard for Christmas?

Price elasticity of private school

Read the article High fees force parent to abandon private schools and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

What did the Chairman mean when he said "I do not believe that price elasticity will forever be on our side"?

Question 2

What value would you expect for the price elasticity of demand for private school places? How has this value changed in recent years?

Question 3

Analyse the main factors that determine the value of the price elasticity of demand for private schools.

Question 4

Assess policies that the private schools could try to adopt to reduce the value of the price elasticity of demand.

A premier rip-off? - Football ticket prices

Read the article Probe urged into 'turnstile con'. You can read this in the window below, or follow the previous link to read the article in a separate window. You might then like to have a go at the questions below.

Question 1

Draw supply and demand diagrams to show the equilibrium price for an average premiership football match (where the ground is fixed capacity and likely to be over-subscribed) and for an average lower division match where the ground is still fixed capacity, but is unlikely to fill to capacity.

Question 2

What are the main determinants of demand for a premiership football match?

Question 3

Assess how the values of the price elasticity of demand for tickets for a premiership and lower division football match are likely to differ. Explain your reasons fully.

Question 4

Can the price differences identified in the article be explained simply by differences in supply and demand? If not, what other factors may be determining ticket prices?

Question 5

What areas is the OFT likely to investigate if it chooses to investigate football ticket pricing?

Question 6

What possible reasons might there be for ticket prices elsewhere in Europe being cheaper than in the UK?

Tracking supply and demand through seafood menus

Read the article When lobster was fertiliser and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using supply and demand analysis, illustrate the price changes identified in the article.

Question 2

Assess the factors that have led to the price changes for seafood identified in the article from the research.

Question 3

How has the demand for lobster changed over the period of the research? What factors have led to this change?

Question 4

Discuss how the price elasticity of lobster is likely to have changed over the period of the research.

Oil prices - price of oil tops $67 a barrel

The first six months of 2005 saw the oil price rising fast and by August 2005 it had topped $67 per barrel, though it then dropped slightly. To find out more about the price rise, read the article Oil tops $67 a barrel as US demand soars. You can read this in the window below, or follow the previous link to read the article in a separate window. You might then like to have a go at the questions below.

Further research

You may also like to read some of the following articles to give you more background information on the oil price rise and to help you answer the questions below.

Question 1

What are the main factors that have been causing the increase in oil prices during July and August 2005?

Question 2

What other factors are likely to affect the oil price in the medium to long-term?

Question 3

Draw demand and supply diagrams to show the effect of:

  1. Rising US demand for oil
  2. OPEC relaxing quotas on oil to try to prevent the oil price rising further
  3. Fires break out at two US refineries and a North Sea oil rig (see article Market jitters drive oil price over $62).

Question 4

What would you expect the value of the price elasticity of demand for oil to be? Why?

Question 5

Analyse the impact that the higher oil price is likely to have on:

  1. the UK economy
  2. the world economy

Question 6

Draw an aggregate demand and aggregate supply diagram to show national income equilibrium and show the impact that the higher oil price is likely to have on this equilibrium.

Smoking becoming more elastic?

Read the article Smokers buying fewer cigarettes and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Fewer cigarettes purchased, but more money spent! What can we conclude from this about the value of the price elasticity of demand for cigarettes?

Question 2

Using diagrams as appropriate, illustrate the changes that have taken place in the market for cigarettes.

Question 3

Assess the effectiveness of indirect taxation as a tool to improve public health by reducing smoking.

Is a price always what it seems?

The news

The arrival of broadband technology is now visible on our TV screens. Wanadoo and others are trying to get us to swap to this 'more advanced' form of communication. Some of the providers are using discounts in their offer price as a way of attracting new customers, whilst others are promoting the technical developments, such as quicker access to the Internet as their main selling point.

For those who are using price we have to ask why? Broadband is currently more expensive than conventional systems but with a discount for installation and an introductory offer for service agreements the difference in price packages is not that large. A further issue relates to the definition of broadband. Have a look at the articles below to see some of the debate taking place:

The theory

Early in our course of Economics we confront both demand and how a change in price might affect it. We call this elasticity and its is very important to many economic decisions. We also need to think how a price is calculated. In economics we know that costs are incurred in making anything and then a company has to make a certain level of profit. Some of you may have already started to work on normal and supernormal profits but for many of you costs are currently known to you as total, fixed, variable, average and marginal. We all should know that if we do not cover our costs with the sales revenue we make from selling to our customers then the business will not survive for very long.

For more detail on elasticity, follow the links below.

Elasticity

Factors affecting the price elasticity of demand

Applications of price elasticity

Questions

1 Calculate the following and say if the response is elastic or inelastic:

  1. The price of salt increases by 50% but its demand falls by 5%.
  2. The cost of mortgages goes up by 5% and the quantity demanded falls by 15%.
  3. Sports shoes rise in price by 10% and the quantity demanded falls by 5%.
  4. Reeboks increase in price by 10% and demand falls by 15%.

2. Why might some broadband providers have decided to use price as their main selling tactic?

3. Which factors affect the price elasticity of demand of a product?

4. Explain why a government taxes alcohol, cigarettes and petrol.

Suggested answers

Income elasticity of demand

The news

Market watchers are keeping a close eye on US consumer confidence, for it might be about to fall. If it does then corporate liquidity will be squeezed and profits might slip. It's an interesting dilemma to look at for 'young economists'. Until recently employment was high in the States and incomes were growing but now some of this confidence is starting to evaporate and what we know as a 'double dipper' might be just a round the corner. Consumers will therefore feel less secure and will cut expenditure. They might also begin to fear that their incomes would fall. If this is the case then serious problems could arise. Will the average US consumer cut their demand for certain products and if so what?

That is why the stock markets continue to have the jitters - oh and, of course the elections and Iraq also increase the feeling of uncertainty about jobs and incomes.

The theory

This news item moves us into another form of elasticity and this is time it's income elasticity. We are looking at the change in demand that results from a change in income. You need to think about whether your firm is selling a necessity or a luxury and to which members of the community. It is quite likely that Tesco see little change if consumers lose confidence and spend less, whilst a company producing luxury yachts might begin to really suffer. Like much of what we refer to as micro economic theory it's often best to think of it's in a 'real-life' situation. What would your household cut if it feared a fall in its income or at best a levelling-off in its ability to spend? Which companies do you think would be less concerned by falls in consumer incomes and why? And, of course which industries would gain if real incomes rose?

Income elasticity of demand

Income elasticity is the responsiveness of demand for a commodity to a change in income. Its formula is: the percentage change in the quantity demanded over the percentage change in income.

We normally consider a good to be income elastic if the change in demand is greater than the change in income (a value for the IED of greater than 1), whilst an income inelastic good has a value between 1 and 0. Goods with a positive income elasticity are considered normal goods. If a good has a negative income elasticity it is termed an inferior good (demand for the good falls as income rises) and the IED value will be negative.

The factors which affect income elasticity of demand are:

Applications of income elasticity of demand

Income elasticity is an important concept to firms when considering the size of the market for their products, in response to changes in national income over the long-term and the short-term fluctuations in the economy.

Questions

  1. Describe the difference between (a) gross and (b) real when discussing income levels.
  2. What are the main influences on the income elasticity of demand?
  3. What applications might an economist use income elasticity calculations for?
  4. Using the concept of income elasticity, compare the impact of a fall in the level of real disposable income on (a) a supermarket chain (b) a DIV shop and (c) a holiday firm.

Suggested answers

Winners take all in rockonomics

Read the article Winners take all in rockonomics and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Using supply and demand diagrams as appropriate, show why tickets for Madonna concerts can be priced at between 80 and 160.

Question 2

Suggest reasons why over the period 1982 - 2003 the cost of US concert tickets has been outpacing the country's inflation rate.

Question 3

What values (high or low) would you expect for (a) the income elasticity of demand and (b) the price elasticity of demand for tickets for a Madonna concert? Justify your answer.

Section 2.2 Elasticities - simulations and activities

In this section are a series of simulations and activities on the topic - Elasticities.





Click on the right arrow at the top or bottom of the page to move on to the next page.

DragIT - Calculating elasticity

In the diagram below, shift the demand curve to the right by 15 units. Do this by clicking on the 'D1' label and, keeping the mouse pressed, drag it to the right. Note that the slope remains the same (i.e. -5). Once you have done this, try the questions below.

1

Price elasticity

What is the value of the price elasticity on demand curve D1 when the price rises from 5 to 7?

The price has risen from 5 to 7 - this is a 40% change in price. When the price rises, the quantity demanded falls from 25 to 15. This is a 40% change in quantity. The percentage change in demand divided by the percentage change in price (40%/40%) is therefore 1.Check your answer

2

Price elasticity

What is the value of the price elasticity on demand curve D2 (once dragged to its new position) when the price rises from 5 to 7?

The price has risen from 5 to 7 - this is a 40% change in price. When the price rises, the quantity demanded falls from 40 to 30. This is a 25% change in quantity. The percentage change in demand divided by the percentage change in price (25%/40%) is therefore 0.625.Check your answer

DragIT - Elasticity

In this section you can check that you know all the elasticity formulae. In the exercises below, you need to drag the blue buttons on the right onto the orange target areas to build the relevant elasticity formula. Have a go at each in turn. Try to get them right straight away, rather than by trial and error!

Price elasticity of supply

Price elasticity of demand

N.B. A way of remembering this formula is to think of 'dinner (D) on your plate (P)'. In other words demand divided by price.

Income elasticity of demand

Cross elasticity of demand

Price elasticity of demand for exports

Income elasticity of demand for exports

DragIT - Incidence of tax

In this interaction, drag the end of the demand curve up and down to see the impact of a change in the elasticity of demand on the tax revenue received by the government and the incidence of the tax on the firm and on the consumer. The tax revenue is the sum of the two areas - consumer share and firm share.

In this next interaction, drag the end of the supply curve up and down to see the impact of a change in the elasticity of supply on the tax revenue received by the government and the incidence of the tax on the firm and on the consumer. Again, the tax revenue is the sum of the two areas - firm and consumer.

1

Incidence of tax

The more elastic the demand curve the lower the consumers share of the tax will be.

a)
b)
Yes, that's correct. The statement is true. The more elastic the demand curve, the lower the proportion of the tax is paid by the consumer as the firms are unable to pass the tax on.No, that's not right. The statement is true. The more elastic the demand curve, the lower the proportion of the tax is paid by the consumer as the firms are unable to pass the tax on.Your answer has been saved.
Check your answer

2

Incidence of tax

The more inelastic the supply curve the lower the producer share of the tax will be.

a)
b)
Yes, that's correct. The statement is false. The more inelastic the supply curve, the higher the proportion of the tax that is paid by the producer.No, that's not right. The statement is false. The more inelastic the supply curve, the higher the proportion of the tax that is paid by the producer.Your answer has been saved.
Check your answer

3

Incidence of tax

The more inelastic the demand curve the higher the producer share of the tax will be.

a)
b)
Yes, that's correct. The statement is false. The more inelastic the demand curve, the lower the proportion of the tax that is paid by the producer as the firms are able to pass the tax on.No, that's not right. The statement is false. The more inelastic the demand curve, the lower the proportion of the tax that is paid by the producer as the firms are able to pass the tax on.Your answer has been saved.
Check your answer

Section 2.3 Theory of the firm - notes (HL only)

In this section of the module, we start to look at the basis of supply. We know that consumers create demand and that firms create supply, but we need to look at the behaviour of firms in more detail if we are to understand supply fully.

The first stage of this is to look at the costs of production. This may seem an odd place to start, but costs are fundamental to supply. Firms exist to make a profit - that is their key objective. If their costs rise, then they will be more reluctant to supply and so we need to understand the costs they face.

In this section we consider the following topics in detail:

To start looking at these topics, click on the right arrow at the top or bottom of the page. To get back to the table of contents at any stage, simply click on the 'home' icon at the top or bottom of the page.

Cost theory

You need to be able to define and explain the following terms:

Fixed and variable costs

Total, average and marginal cost

These costs all relate to operations at a point in time, but they can all vary with time.

Fixed costs

These costs are those that remain unchanged as the output level of the firm changes. It does not matter what level of output the firm produces (even zero output makes no difference), any cost which is a fixed cost will remain the same. Common examples of fixed costs are as follows:

Examples of fixed costs

Fixed costs can be represented graphically and this would appear as follows:

Figure 1 Total fixed costs

Variable costs

Any cost which varies directly with the level of output would be classified as a variable cost. Varying directly means that the total variable cost will be dependent on the level of output. Common examples of variable costs are as follows:

Example of variable costs

Variable costs can be represented on a graph and this would appear as follows:

Figure 2 Total variable cost

We could also classify costs as semi-variable costs. Have a think about what these might be and then follow the link below.

Semi-variable costs

Calculating costs

You also need to be able to calculate a firm's costs from given data, be able to draw cost curves and then interpret what they mean. We come to that skill later.

You will also need to identify and explain short-run and long-run cost curves. Look carefully at the following examples.

Figure 3 Short-run average cost curve

Figure 4 Long-run average cost curve

In the short-run, at least one factor input is fixed. In the long-run all inputs are variable. This means that short-run curves are models of what is happening. Long-run curves are planning data. A firm cannot operate with all inputs variable. Having decided what it wants from an examination of the long-run curves, the firm makes a decision to fix a factor, usually capital, and this gives rise to a new short-run situation.

Now, the calculations and the drawing!

You could be presented with data in the form of a table, like the one below

Output (units 0 1 2 3 4 5 6 7 8 9 10
Total cost ($k) 100 110 125 145 170 200 235 275 320 370 425


Plot this with output on the horizontal axis and total cost on the vertical axis and look at it.

There is also a static version of this graph available.

What do you know now?

Now, some more sums. Work out the average cost (TC / output), the total variable cost (TC - FC), the variable cost (TVC / output), the average fixed cost (FC / Output) and the marginal cost (TC (Qx) - TC (Qx-1)).

Once you have had a go at calculating all these, follow the answer link below to compare how you got on.

Answer - cost calculations

Now plot this data on two separate graphs as follows, and see what it shows.

Graph 1 - Total cost, total variable costs and total fixed costs
Graph 2 - Marginal cost, average cost, average fixed cost and average variable cost

You should get the following:

Graph 1 Total cost, total variable costs and total fixed costs

There is also a static version of this graph available.

Graph 2 - Marginal cost, average cost, average fixed cost and average variable cost

There is also a static version of this graph available.

See Figure 6 below for the standard representation of these curves.

Why do average and marginal cost cross at the minimum point of average cost?

Well think of this in terms of cricket scores. Your last innings is your 'marginal' innings, whereas your batting average is your 'average'. Say your average is 50 and in your next innings you get 20 runs. What happens to your average? It will fall. However, if in your next innings you get 80 runs. In this case your average will rise.

So, if the marginal is below the average, the average will fall and if the marginal is above the average, the average will rise.

There are many questions for you to work on in the questions section (click on the questions - module 2 link in the left hand navigation bar). It may also be worth having a look at the Diggin' diagrams sections (accessible from the course homepage) to check how well you understand your diagrams.

Interactive spreadsheet

To see how changes in cost affect the cost curves, why not have a look at our interactive spreadsheet. On this, you can make changes in the values of costs and instantly see the effect on the diagram of cost curves. Follow the link below to view the spreadsheet.

Total cost curves - interactive spreadsheets

Summary

Remember, a standard marginal and average cost curve diagram should look like this:

Figure 5 Marginal and average cost

Add in the average fixed and average variable cost curves and it should look like this:

Figure 6 Marginal cost, average cost, average fixed cost and average variable cost

Short-run

It is important to know the difference between the short run and the long run. The law of diminishing returns is a short run law. Economies and diseconomies of scale occur in the long run.

Short run

The short run is the period of time in which at least one factor of production is fixed. Over this time period the firm can only expand production by using more of the variable factor.

Long run

The long run is the period of time when all factor inputs, including capital, can be changed.

You need to remember these as the time period makes a big difference to how the firm can react to changes in circumstances. In the short-run their capacity is fixed and so all they can do is employ more variable factors. They cannot expand the scale or size of the firm. In the long-run though they can. We put the word scale in bold just now because it is important - economies of scale will only arise in the long-run. In the short-run we get diminishing returns to a factor (because the firm can only change the variable factor).

In theory, in the short-run, the average costs of a firm should decrease as the output of the firm increases. Fixed costs are constant, so become spread over more and more product. In reality, however, average costs may fall initially, but at a decreasing rate. A minimum will be reached, and average costs will then start to rise. This is the background to the law of diminishing returns.

Figure 1 Illustration of law of diminishing returns

Initially, in region 0 - A, there are increasing returns. In the zone A - B there are decreasing returns, and beyond B there are negative returns.

This theory supports the shape of the marginal and average cost curves. Both of these curves will be u-shaped as eventually diminishing returns will lead to costs increasing. Initially increasing returns mean that both AC and MC will fall, but once diminishing returns set in both curves start to rise again. The MC and AC curves are shown in Figures 2 and 3, although we will return to these in more detail in the next section.

Figure 2 Marginal cost curve

Figure 3 Average cost curve

The marginal cost curve will intersect the average cost curve at its minimum point.

The actual position of the AC curve will vary with a number of factors.

Productivity is measured in a number of ways:

The choice of factor inputs will be driven by their costs, productivity and effect on product cost. An efficient firm will make its choices so as to minimise its average cost at the production rate being worked. Look at the following example.

Example

Student Computers make DVD drives. Its average cost curve is shown in figure 4 below.

Figure 4 Average cost curve for Student Computers on 1st May 2002

The following then takes place:

Business rates increase (fixed costs (FC))
Insurance premiums rise (FC)
Wage rates (variable costs (VC)?) and salaries (FC) increase

This will change the cost curves. The curve will move upwards due to the increase in fixed costs. The average cost of production at the present output will rise from C1 to C2. Unless something is done about it, the profits will fall.

Figure 5 Average cost curves for Student Computers on 1st July 2002

In response to these changes the research and development department introduces new materials that are cheaper to buy than the old ones. They also introduce new working practices and procedures that increase productivity considerably. The savings are shared between the firm and its employees. This all reduces variable costs and the AC curve falls again. Now the production average cost, at C3, is lower than before.

Figure 6 Average cost curves for Student Computers on 1st November 2002

The firm has responded to rises in certain costs by taking steps to reduce others.

Long-run

First let's remind ourselves of the definitions and what type of economies of scale there are. It is important to remember that economies/diseconomies of scale occur in the long run, with all factors variable.

Economies of scale

Economies of scale are the advantages that an organisation gains due to an increase in size. These will lead to a decrease in the average costs of production.

Diseconomies of scale

Diseconomies of scale are the disadvantages that an organisation experiences due to an increase in size. They will increase the average costs per unit.

Both economies and diseconomies of scale apply at all levels of output, but economies predominate at low outputs and diseconomies at high outputs. This is summed up, diagrammatically, in Figure 1 below.

Figure 1 Economies and diseconomies of scale

This behaviour can explain the movement towards monopoly in some industries. The lower costs can be passed on, at least in part, to the customer in lower prices, and demand will rise. Market share will grow, and the firm will gain monopoly power.

So what actually causes AC to fall or rise?

Both economies and diseconomies of scale can be internal or external. External factors relate to the industry itself, and are open to all firms within the industry. Typical examples are the availability of suppliers and specialist labour in a region, and the establishment of a better local infrastructure. However, as the concentration of an industry in a region grows, there will be excessive pressures on these facilities, so an advantage may change into a disadvantage.

Internal factors relate to the firm itself, and are particular to it.

Economies of scale

Typical examples of internal economies are:

Diseconomies of scale

These are mainly people related. They can be summarised as:

All of these can combine and interact to cause a fall in morale and motivation of the staff operating the business.

The point at which diseconomies of scale become dominant depends on the effectiveness of steps taken to suppress them. The more that firms trust their staff, delegate authority and reduce paper work, the longer that the diseconomies can be held at bay.

Long run cost curves

The long run cost curve of a firm is sometimes called an 'envelope' curve as it envelopes all the short run average cost curves. Consider the different ways that capital intensive and labour intensive industries develop. First, some definitions:

Capital-intensive activities have long, deep long-run average cost curves. Small firms cannot compete against large ones; the difference in average cost is too great. A few large firms, with perhaps a few small but very specialist businesses, will dominate industries. Look at Figure 2.

Figure 2 Long-run AC curve for capital-intensive business

Labour intensive activities have short and relatively flat long-run average cost curves. There is little advantage in being large, so the industry develops with many small firms. Look at Figure 3.

Figure 3 Long-run AC curve for labour intensive business

This means that it is very expensive to try to enter a capital-intensive industry. The minimum scale of operation will be high and will require a large investment of capital. The risk will be high, and the capital will be hard to raise. The cost becomes a real barrier to entry. The potential reward, however, will be large.

On the other hand, it is much easier to enter a labour intensive industry. The minimum scale of operation will be low, as will be the initial capital investment. The risk will be low, and not much capital will need to be raised. Cost will not be a barrier to entry, but the potential rewards are also smaller.

1

Economies of scale

Match the following examples of economies of scale with their classification.

a)
b)
c)
d)
e)
Yes, that's correct. Well done.No, that's not right. Try again.Your answer has been saved.
Check your answer

2

Capital and labour intensive

Which of the following industries would you expect to be capital intensive?

a)
b)
c)
d)
e)
Yes, that correct. Well done. Fruit growing and computer game development both require significant levels of labour and so would generally be described as labour intensive. No, that's not right. Fruit growing and computer game development both require significant levels of labour and so would generally be described as labour intensive. Your answer has been saved.
Check your answer

The very long run

So far we have looked at the short-run and the long-run. We now meet the very long run.

Very long run

Where changes in technology make major changes in costs possible.

Invention, innovation and technological change gives some firms a huge cost advantage in some industries, and brings into existence new industries in their own right.

A new invention, protected by patent, obviously gives its inventor a huge advantage. This is the way that the pharmaceutical industry works.

Patent

A document granting monopoly powers to the inventor of something for a period of time (up to 20 years) to allow it to recover its investment and make a reasonable return on it.

Within existing industries a smallish firm making a technological breakthrough can gain a cost advantage and become dominant. Look at the diagram below.

Figure 1 Effect of technical breakthrough on competitive position of a firm

Innovation and invention has to be paid for, and research and development is an expensive exercise with no guarantee of success. Investing firms aim to protect and exploit their inventions, whilst others aim to obtain and use this research.

Major breakthroughs are few and far between, but yield big gains. They are costly.

Revenues

Revenue is the income a firm obtains from the sales of its goods or services. Three terms must be understood:

Revenue curves vary depending on whether price is constant at all levels of output (as in the case of a firm which is a price-taker), or falls as output increases (as in the case of a firm who is a price-setter). Look at Figures 1 and 2 below to see the difference this makes to the shape of the average / marginal revenue and total revenue curves:

Figure 1 Revenue curves - constant price (price-taker)

Figure 2 Revenue curves - falling price (price-setter)

You have to be able to calculate revenue, in any form, from data, then draw and interpret curves. Time for an example, and for you to do some work again!

Output (units) 0 1 2 3 4 5 6 7 8 9 10
Total revenue ($ 000) 0 100 180 240 280 300 300 280 240 180 100


Plot this with output on the horizontal axis and revenue on the vertical axis. Look at it and then we will do some more calculations.

There is also a static version of this graph available.

Total revenue rose at first, reached a maximum, and then declined.

From the total revenue curve data above, now calculate the figures for marginal revenue and average revenue. Once you have had a go, click on the answer link below to check your calculations.

Answer - revenue calculations

Now, plot the marginal and average revenue curves from this data as well. Examine it. What does it tell you?

There is also a static version of this graph available.

Observation of the graph shows:

Profit

Within economics you will meet:

The definitions of supernormal and normal profit mean that profit on a diagram drawn by an economist shows supernormal profit only. Normal profit is included as an element of the ATC curve and arises where ATC = AR. Examine the following diagrams (we'll look at how to build these diagrams in more detail later on):

Figure 3 Firm in perfect competition - supernormal profit

Figure 4 Monopoly - supernormal profit

This has to be compared with the accountant's definition of profit.

Accounting profit

The difference between revenue from sales and the costs incurred in making these sales, regardless of any credits given or taken.

Accountants deal in facts. They do not get involved with concepts such as normal profit. Governments tax accounting profit, not normal profit.

Why do firms try to make a profit?

Profit has many uses:

Profit is a driving force within business. It is an incentive to invest for investors. It lies behind all cost reduction exercises, as the aim of cost reduction is profit maximisation.

Profit maximisation

Combining revenue and cost curves

Now, some diagrammatical work. Let's combine the two examples developed in this section and the figures from the previous notes on costs. This gives us the data below.

Output (units) 0 1 2 3 4 5 6 7 8 9 10
Total cost ($ 000) 100 110 125 145 170 200 235 275 320 370 425
Total revenue ($ 000) 0 100 180 240 280 300 300 280 240 180 100
Profit ($ 000) -100 -10 55 90 110 100 65 15 -80 -190 -325
Marginal revenue ($ 000) 100 80 60 40 20 0 -20 -40 -60 -80
Marginal cost ($ 000) 10 15 20 25 30 35 40 45 50 55


Now let's plot yet another graph. From the table above plot the marginal cost, marginal revenue and profit figures. You should get a graph looking like the figure below.

There is also a static version of the graph available.

See clearly that the profit is maximised when MC = MR. You can see this from the graph, but can confirm from the data that this is the case as well.

Profit maximisation

The traditional model of the firm assumes that the objective of all firms is profit maximisation. This is particularly applied to private firms. Publicly owned firms are treated differently.

As we have seen above, profit maximisation occurs where marginal cost is equal to marginal revenue. So, the first condition that you need to commit to memory is:

Profit maximisation occurs when MC = MR (Marginal cost = marginal revenue)

Below in figures 1 and 2 are the usual diagrams that show firms maximising profits:

Figure 1 Small firm in perfect competition (price taker)

Figure 2 Large firm in imperfect market (price setter)

We'll come back to these diagrams and look at them in more detail later on in this module, but the key difference between the two diagrams is in the shape of the revenue curves. The firm in perfect competition is a 'price-taker' - they are too small to influence price and so they simply charge the price given by the market. The firm in imperfect competition on the other hand has a degree of market power. This makes them a 'price setter'. They can set their price (subject to the constraints of the demand curve) and find the profit maximising level of output.

Why does profit maximisation occur where MC = MR?

  1. Profit = revenue - cost
  2. As you sell more, profit will grow as long as the extra revenue obtained is greater than the extra cost incurred (extra revenue = MR, extra cost = MC).
  3. MR is constant or falls, and MC may fall initially but quickly rises.
  4. This means that they will soon cross if plotted on the same graph.
  5. Before they cross MR is greater than MC and each extra unit will increase total revenue. However, once they have crossed MC is greater than MR and then each unit will reduce total profit (as more is being added to cost than revenue).
  6. Therefore maximum profit is where MR and MC cross.

Therefore if MR is greater than MC, increasing output is worthwhile as it will add more to revenue than to cost. If the MC is greater than MR, however, increasing output will not be worthwhile as more will be added to cost than to revenue. Thus the best place to produce is where MC =MR.

Other objectives

Profit maximisation is not the only objective of private firms. Other objectives include:

Objectives may be short-term as well as long-term. Short-term objectives, which are more tactical than strategic, might include:

State owned companies are often thought to be good because they are not profit maximisers. It is argued that they act 'in the public interest', avoid externalities, and minimise wasteful activities. However, this may not always be seen on examination of real nationalised corporations.

Perfect competition

Assumptions of the model

Perfect competition is considered as the ideal or the standard against which everything is judged. Perfect competition is characterised as having:

Equilibrium under perfect competition

In perfect competition, the market is the sum of all of the individual firms. The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the cost model (standard average and marginal cost curves). The firm as a price taker simply 'takes' and charges the market price (P* in Figure 1 below). This price represents their average and marginal revenue curve. Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.

Figure 1 Equilibrium of the firm and industry in perfect competition

Firms in equilibrium in perfect competition will make just normal profit. This level of profit is just enough to keep them in the industry and since profits are adequate they have no incentive to leave.

Normal profits

Normal profit is the level of profit that is required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits.

Any profit above normal profit is a 'bonus' for the firms, as it is more than they need to keep them in the industry. We call this supernormal (or abnormal) profit. However, this supernormal profit will be a signal to other firms and will attract more firms into the industry. If firms are making consistently below normal profits then they will choose to leave the industry.

What does this mean for prices and competition? Consider the following case.

A firm enters a perfectly competitive market with a product. It sells Q1 units of its product at price P1. It is able to make supernormal profits at this stage. It sells at P1 but has a cost of only C. It makes SNP's of P1 to C per unit sold. This is shown below.

Figure 2 Firm in perfect competition making supernormal profit

Competition is perfect. New firms enter the market. Supply increases (the supply curve shifts to the right - S2 in Figure 3 below) and prices fall. The original firm has to lower its price or it will sell nothing. It charges P2 (the same as the market price) and so now sells Q2. The market size expands from Q1 to Q2. Look at the modified diagram below.

Figure 3 The impact on a market of supernormal profit

The presence of SNP's has attracted more firms to the market and this has led to the price falling. The supernormal profits were competed away and equilibrium was reached where only normal profit was earned. Each of the firms will now be in long run equilibrium earning only normal profit. The long run equilibrium is where MC = MR = AC = AR. This can be seen in Figure 4 below.

Figure 4 Long run equilibrium in perfect competition

The falling prices put pressure on the less efficient firms. They may be forced to close and transfer their assets elsewhere.

Short-run losses

A firm with high costs may face a short-term loss-making situation. It is not at risk in the short-run provided price at least covers its variable cost, i.e. its day-to-day running costs, so that a contribution is made towards the fixed costs. This is shown below. The price, P*, covers variable costs and some fixed costs. A loss of C - P* is made.

Figure 5 Short-run losses

The firm will have to become more efficient. If it does not, it will be forced to leave the industry. As a number of firms leave the industry, the market supply curve will shift to the left, and price will rise until losses are eliminated and normal profits are again being made. The long run equilibrium will occur where no firms are making losses and no firms are making SNP's. It will be in equilibrium, as shown earlier. Look at the diagram again. You must know it and be able to explain its development.

Figure 6 Long-run equilibrium of firm and industry in perfect competition

So, perfect competition is a model of an efficient form of competition. Efficient firms face well informed consumers. Only normal profits are made, so prices are not excessive. Resources are used effectively and efficiently. Sounds too good to be true.

Shut down price, break-even price

The break-even price in perfect competition is where normal profits are made and AR = P = ATC = MC = MR. This is shown in Figure 7 below.

Figure 7 Perfect competition - break-even price

Shut down price

A firm may make a loss in the short run, providing AVC is being covered and some contribution is being made to the fixed costs. If a firm is unable to cover its AVC's, i.e. its day-to-day running costs, it will shut down immediately. This is illustrated in figure 8 below.

Figure 8 Shut down point

Here output is OQ*, where MC = MR. A loss of PBCE is being made, as ATC is greater than AR. The fixed costs are given by the area ABCD.

Thus if the firm receives a price of OP it will not cover all its costs but will contribute the area APED towards its fixed costs which have to be met even if output is zero. It will therefore be worth remaining in the business at least in the short run.

However, if the price were to fall to OP1 (the lowest point on the AVC curve, where AVC = MC), the firm would shut down immediately as it would be covering neither its fixed nor its variable costs.

Do perfectly competitively industries exist?

No 'perfect' perfectly competitive industries exist. Ironically, one of the closest today is probably the market for shares. However, as we mentioned before, it is still an important model as it provides a benchmark against which other markets can be judged. It can help in formulating appropriate policies to improve uncompetitive markets.

Efficient allocation of resources

Economists are concerned about the efficiency of markets, and ensuring that resources are allocated efficiently.

Perfect competition is considered to be efficient because:

The major assumption behind this analysis and evaluation is that firms cannot produce products cheaper if they were bigger. It assumes that there are no economies of scale available in the market.

Allocative efficiency

Allocative efficiency occurs when the value consumers put on the good or service equals the cost of producing the product or service. In other words, when price = marginal cost.

Productive efficiency

Productive efficiency occurs when output is achieved at the minimum average cost.

We can see from Figure 1 below that when it is in long-run equilibrium, perfect competition achieves allocative and productive efficiency as MC = MR = AC = AR. This means that they are maximising profits (MC = MR) but only making normal profit (AC = AR).

Figure 1 Long-run equilibrium - perfect competition

So, perfect competition looks good, but is it always so? Problems with perfect competition are:

Look at economies of scale. Some are always likely to exist. Financial economies apply - the better your reputation the cheaper the loans, bulk-buying economies are there as well. Economies of scale are there, like gravity. It is up to the firm to take advantage of them. Competition encourages their application and exploitation.

Perfect competition may well operate efficiently, as far as economists are concerned. The consumer, however, may get an ordinary product or service at a high price. Is it worth it?

1

Productive efficiency

At what point will the firm be productively efficient?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is the condition for profit maximisation.No, that's not right. This would mean that the firm is making normal profit.Yes, that's correct. If MC=AC then the firm is producing at the minimum point of the average cost curve and is therefore productively efficient.No, that's not right. This would mean that the firm is allocatively efficient.
Check your answer

2

Allocative efficiency

At what point will the firm be allocatively efficient?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is the condition for profit maximisation.No, that's not right. This would mean that the firm is making normal profit. No, that's not right. If MC=AC then the firm is producing at the minimum point of the average cost curve and is therefore productively efficient. Yes, that's correct. This would mean that the firm is allocatively efficient.
Check your answer

Monopoly and oligopoly - introduction

Concentrated markets, ones where there are only a limited number of suppliers, behave differently to competitive markets. You are required to know about monopoly and oligopoly.

Monopoly

One or occasionally a few firms dominate the market. The others have to accept the market as established by the others. A perfect monopoly is when there is a single supplier. However, a firm gets monopoly powers as its market share edges above 25%. Some industries are natural monopolies, such as water supply and basic power generation.

Oligopoly

Oligopoly is when a few suppliers who provide the same product dominate a market. Petrol companies and the soap and detergent industry are good examples. Each firm has to be concerned about what the others in the industry will do.

Governments are concerned about both of these types of competition. Economic theory suggests that as markets become more concentrated (the number of firms in the industry falls) they become controlled by the suppliers at the expense of the consumer. As we shall see, this is not always the case. They try to regulate, or control these industries.

As was seen earlier, the very size of the firms makes it difficult for others to enter the industry (the size of the firms acts as a barrier to entry). Sunk costs are high so potential losses are high. There is no great encouragement to enter the market however good a product the firm has.

Why do some markets become concentrated and others do not?

The simple answer is growth and economies of scale. Some firms are more efficient than others, and in some industries there are much greater economies of scale than others. This has led to the formation of a number of highly concentrated industries. Examples are the oil and petrochemical industry, the aircraft manufacturing industry, airlines, soft drinks and banking to name just a few. Follow the links below to see how each industry fits the characteristics of monopoly and oligopoly.

Oil and petrochemicals

Aircraft manufacture

Airlines

Soft drinks

Banking

All the above are examples of oligopoly. Examples of monopoly are few and far between. Many natural monopolies, often state owned, have been broken up (privatised) and artificial competition (usually with regulators to control the market) introduced. Examples are electrical power, gas and the telephone service.

More examples - web links

It is worth being aware of recent examples of monopoly and oligopoly and government policy towards them. The best bet is probably to do a search in the Biz/ed In the News archive. You can do this in the window below:

Try searching on terms like:

N.B. When you are searching on more than one word, it is best to check the 'match exact phrase' box.

Growth and power

Why do firms want to grow?

As they get larger they get stronger. They start to eliminate competition, and start to gain control of the market. They move from being a 'price taker' in a situation of perfect competition towards being a 'price setter' (or price maker) in a monopoly situation.

Price taker

A price taker is a firm which cannot influence the price of the product on the market. If it puts its price above the one ruling in the market it sells little or none. Firms in perfect competition are price takers.

Price setter

A price setter (or price maker) is a firm that can determine or fix the price of the product on the market. It sets the price, but the quantity sold is determined by the demand curve.

Firms start to develop monopoly power as they grow and increase their market share.

Monopoly power

The power, or ability to influence a market, influence the survival of others, and establish the price. It enables it to increase profits.

Sources of monopoly power

One of the features of monopoly is that, unlike perfect competition, supernormal profits may be made in the long run. If there were free entry to the market this could not of course happen as the arrival of new firms would have the effect of shifting the market supply curve to the right and lowering the market price until the supernormal profits were eliminated. The existence of long run supernormal profits therefore implies the presence of barriers which prevent the entry of new firms into the industry. Indeed the basis of monopoly power is the ability to prevent entry of new firms. So what are the barriers to entry that exist? They may include:

For more detail on any of these, follow the links.

Examples - web links

It is worth being aware of recent examples of monopoly and oligopoly and government policy towards them. The best bet is probably to do a search in the Biz/ed In the News archive. You can do this in the window below:

Try searching on terms like:

N.B. When you are searching on more than one word, it is best to check the 'match exact phrase' box.

The model of monopoly

Monopoly, as a market form, is at the opposite end of the spectrum to perfect competition. In the literal sense, a monopoly exists when one single firm or a small group of firms acting together controls the entire market supply of a good or service for which there are no close substitutes. This is a situation of pure monopoly, which like the case of perfect competition, is rarely easy to identify in reality. Moreover, whether an industry can be classed as a monopoly will depend on how narrowly the industry is defined; for example, a city underground often has a monopoly on the supply of underground travel within the city, but does not have a monopoly on all forms of public transport within the city: people can also travel by bus or overground trains.

Thus in practice, less stringent definitions than 'single producer' tend to be used and economists focus instead on the degree of monopoly power which exists rather than absolute monopoly power. A firm may be regarded as being a monopolist if it controls 25 per cent or more of the total market supply of a particular good or service.

A market concentration ratio is used to measure the degree of concentration within a particular industry or group of industries. A commonly used ratio is the five firm concentration ratio which indicates the proportion of the industry's output produced by the five largest firms.

Theory of monopoly

The monopolist's demand curve

In our analysis of perfect competition, we showed how there is a distinction between the demand curve of the individual firm and that of the market as a whole - the existence of many firms each competing against each other means that each one has no influence over price, and has to take the price that is determined in the market through the intersection of the demand and supply curves. The demand curve for each firm is therefore horizontal: an infinite amount is demanded at one price, with nothing at all being demanded at a higher price and with the charging of a lower price being inconsistent with the goal of profit maximisation.

However, under monopoly there is only one firm in the industry; thus there is no difference between the demand curve for the industryand the demand curve for the firm. As the monopolist is subject to the normal law of demand, the monopolist's demand curve will be downward sloping so that to sell more, price would have to be lowered (see figure 1). In comparison to other types of market, the monopolist's demand curve is likely to be relatively inelastic as close substitutes may not be available if price is raised. Indeed, the availability or non-availability of close substitutes is one of the key factors determining the monopolist's power in the market.

Figure 1 Monopolist's demand curve

The demand curve shown in Figure 1 presents the monopolist with a choice. The monopolist can either choose to make the price or the quantity, but cannot do both; for example, if the monopolist chooses to set a price of OP1, the market dictates that only a quantity of OQ1 could be sold; however, if the monopolist chooses to set a quantity of OQ2 to be sold, clearly the demand curve tells us that this could only be achieved at a price of OP2.

Marginal revenue and average revenue under monopoly

The table below assumes that the monopolist faces a normal demand schedule, and from this the revenue curves are derived. Try calculating the figures for total, average and marginal revenue and once you have had a go, follow the link to check your answers.

Output Price Total revenue Marginal revenue Average revenue
1 20
2 18
3 16
4 14


Total, average and marginal revenue answers

From the table two points can be seen:

a) As price has to be lowered to increase sales, marginal revenue is not equal to price as in perfect competition: the additional revenue gained from each extra sale is always less than price or average revenue, and thus the MR curve will always be below the AR curve in monopoly.

b) As price is identical to average revenue, the demand curve is also the curve relating average revenue to the quantity produced.

The information in this table can now be shown in diagrammatic form to show the relationship between the average and marginal revenue curves (figure 2).

Figure 2 Marginal and average revenue curves

Monopoly equilibrium

Like the firm in perfect competition, the monopolist will maximise profits where marginal cost = marginal revenue (MC=MR). This indicates the best or profit maximising level of output.

When the average cost and average revenue curves are related to each other, they indicate the level of profit.

Figure 3 Equating MC with MR in monopoly

Figure 3 shows that there is no level of output better than OQ for the monopolist; for example, if the monopolist decides to stop producing at OQ1, then MR would be greater than MC by the distance AB, and output could be expanded with more being added to revenue than to cost; if the monopolist decides to produce beyond OQ, say to OQ2, then MC would be greater than MR by the distance CD, with more being added to cost than to revenue, and clearly this would not be worthwhile. The best output would therefore be where MC=MR.

In Figure 4, we add the average cost and average revenue curves to the previous diagram to show the monopolist's best output and level of profit at that output.

Figure 4 Monopoly equilibrium

As in figure 3, the best level of output is at OQ where MC=MR. To find the price or average revenue, a vertical line is taken from OQ to the demand curve (the monopolist 'charges what the market will bear'), and a horizontal line is drawn across to the revenue/cost axis. The price is therefore OP or QR. The level of profit is indicated by the amount by which AR exceeds AC: AR=QR; AC=QS; so RS is the profit per unit of output, and the total supernormal profit is given by the area CPRS.

Under perfect competition, supernormal profits can only exist in the short run, as in the long run new firms are attracted into the industry and the abnormal profits are competed away as the market supply curve shifts to the right and the market price falls. However, under monopoly new firms are unable to enter the market as there are various barriers to entry which are the very source of monopoly power. Thus a single firm may remain the only supplier, and supernormal profits may persist in both the short and long run; in monopoly, there is therefore no distinction between short and long run equilibrium.

Although the existence of such long run abnormal profits implies a considerable degree of market power, the fact that the monopolist cannot control both the supply of the good and its demand means that complete control does not exist. Corporations devote an enormous amount of time, money and effort trying to mould our demand to fit in with their long term corporate plans: a situation which might be described as producer sovereignty; however, providing the demand curve is not completely inelastic, some element of consumer sovereignty will still remain.

You should note that a monopolist will always produce at a point where demand is elastic, and will achieve this by restricting output to keep price in the upper price ranges (the elasticity of demand on a straight line demand curve varies from infinity at the top left section of the curve to nought at its bottom right section).Figure 4 shows that the marginal revenue curve falls continuously as price falls, eventually becoming negative. It can be seen, however, that although the marginal cost curve falls and rises, it is always positive as there will always be some cost involved in producing any economic good. It would therefore follow that where MC=MR and the firm is in profit maximising equilibrium, MR will be positive, and where this occurs demand is always elastic.

Monopoly v. perfect competition

Monopoly compared with perfect competition

In the discussion that follows, we shall draw extensively upon several concepts that have been introduced earlier; that is, the perfect competition model and the various types of economic efficiency, static, dynamic, productive and allocative. If you are unsure about the meaning of any of these concepts, it would be advisable at this stage to refer to the relevant sections before proceeding.

Consumer and producer sovereignty

Because of the conditions of perfect competition - many buyers and sellers, perfect knowledge and freedom of entry - firms would be forced to produce those goods and services which consumers most wanted. Any firm or even group of firms not behaving in this way would be unable to survive for very long as the competitive pressures from those firms who were responding to consumers' wishes would soon drive them into extinction. From this point of view it could be argued that consumers are sovereign in as much that it is they who 'call all the shots'. However, as described previously, monopoly producers may well decide on which types of goods they are going to supply and at what prices, and then set about manipulating and moulding consumers' tastes, via their marketing activities, to match their pre-determined output plans - a situation in which the producer and not the consumer is sovereign.

Under monopoly price is likely to be higher and output lower as compared with perfect competition.

Figure 1 can be used to predict the effect of a monopoly taking over a perfectly competitive industry, making the assumption that costs would be unchanged in the process of monopolisation.

Figure 1 Perfect competition compared with monopoly

Arm(Dp) is the monopolist's demand curve and the market demand curve under perfect competition. MC is the combined marginal cost curve of all the firms in the perfectly competitive industry. As the competitive firm's marginal cost curve is also its supply curve, this combined marginal cost curve must also represent the industry's supply curve. Equilibrium occurs where demand equals supply, and therefore in perfect competition OPc would be the equilibrium price and OQc the equilibrium output of the industry. If the industry is monopolised and costs are unchanged the monopolist would produce where MC=MR, giving an equilibrium price of OPm, higher than OPc, and an equilibrium quantity of OQm, lower than OQc.

However, if monopolisation of a perfectly competitive industry leads to the reaping of economies of scale, as may well be the case when several small producers are replaced by one large producer, then lower prices and a greater output might result - the opposite of what we originally predicted. In this case, it is possible to predict a social gain from monopolisation. In Figure 1, the gaining of economies of scale is indicated by a downward shift of the marginal cost curve from MC to MC1, and where MC1 intersects with the marginal revenue curve a new and greater equilibrium output is obtained at OQ1, with a price of OP1, which is lower than the perfectly competitive price of OPc. However, the monopolist has still not achieved full allocative efficiency as price is still above marginal cost; neither has it achieved full productive efficiency as it will not be operating on the bottom point of its new average cost curve.

1

Output levels - Monopoly

At which output level in the diagram below will the monopolist produce to ensure productive efficiency?

a)
b)
c)
d)
e)
Please select an answerNo, that's not right. Profits are maximised where MC=MR.Yes, that's correct. This is the point where the firm will be productively efficient (minimum of average cost).No, that's not right. This is the point where the firm will be allocatively efficient (MC=price).No, that's not right. This is where total revenue will be maximised (MR=zero).No, that's not right. This is where the firm will make normal profits (AC=AR).
Check your answer

2

Output levels - Monopoly

At which output level in the diagram below will the firm produce to ensure allocative efficiency?

a)
b)
c)
d)
e)
Please select an answerNo, that's not right. Profits are maximised where MC=MR.No, that's not right. This is the point where the firm will be productively efficient (minimum of average cost).Yes, that's correct. This is the point where the firm will be allocatively efficient (MC=price).No, that's not right. This is where total revenue will be maximised (MR=zero).No, that's not right. This is where the firm will make normal profits (AC=AR).
Check your answer

3

Monopolist - productive and allocative efficiency

A monopolist will be productively and allocatively efficient in long run equilibrium.

a)
b)
Yes, that's correct. The statement is false. A monopolist can be either productively OR allocatively efficient, but not both. If they choose to maximise profits, they will be neither.No, that's not right. The statement is false. A monopolist can be either productively OR allocatively efficient, but not both. If they choose to maximise profits, they will be neither.Your answer has been saved.
Check your answer

4

Perfect competition - productive and allocative efficiency

A firm in perfect competition will be both productively and allocatively efficient in long-run equilibrium.

a)
b)
Yes, that's correct. The statement is true. In long-run equilibrium in perfect competition MC=MR=AC=AR and this will ensure both productive and allocative efficiency.No, that's not right. The statement is true. In long-run equilibrium in perfect competition MC=MR=AC=AR and this will ensure both productive and allocative efficiency.Your answer has been saved.
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Economic efficiency in perfect competition and monopoly

Productive efficiency

Productive efficiency refers to a situation in which output is being produced at the lowest possible cost, i.e. where the firm is producing on the bottom point of its average total cost curve. Since the marginal cost curve always passes through the lowest point of the average cost curve, it follows that productive efficiency is achieved where MC= AC.

Figure 1 Equilibrium in perfect competition and monopoly

The diagrams in Figure 1 show the long run equilibrium positions of the firm in perfect competition and the monopolist. We can clearly see that for the perfectly competitive firm, productive efficiency automatically arises as in long run equilibrium MC=AC at point X. However, in the case of monopoly, the firm is not operating on the lowest point of its AC curve (point X ) but is instead operating on some higher point (point S). We can therefore conclude that in contrast to perfect competition, and assuming an absence of economies of scale, the monopolist will be productively inefficient.

Allocative efficiency

Allocative efficiency occurs where price equals marginal cost in all parts of the economy.

Again, with reference to Figure 1, it can be seen that in perfect competition, MR = MC, and MR = price. MC therefore equals price (at point Y), and allocative efficiency occurs. However, the monopolist produces where MC = MR, but price does not equal MR. It can be seen that at the equilibrium output of OQ, price is greater than MC by the distance RZ, and the monopolist could thus be said to be allocatively inefficient.

Dynamic efficiency

Both productive and allocative efficiency are examples of static efficiency in that they are concerned with how well resources are being used at a particular point in time. However, it is also important to consider how efficiently resources are being allocated over a period of time, when, for example, there may be technological advances, and this is the concern of dynamic efficiency.

Monopoly has been justified on the grounds that it may lead to dynamic efficiency. This is because the supernormal profits made will not only enable the monopolist to finance expensive research and development programmes but may also provide the necessary inducement to undertake such programmes in the first place. In contrast to this, firms operating in a perfectly competitive environment may lack the incentive to finance expensive research and development programmes, as open access to the market would mean that their competitors would immediately be able to share in the fruits of any success. The greater certainty of being able to earn supernormal profits in the long run also explains why levels of investment in capital projects may be greater in more monopolistic markets.

So can you now summarise the advantages and disadvantages of monopoly? Have a think about them, jot them down and then follow the link to compare your notes with ours.

Efficiency and market structure

We are concerned here with concentrated (monopoly and oligopoly) and competitive markets.

Competitive markets are considered to be statically efficient - both allocatively and productively. Dynamic efficiency is another matter. Because firms are all small, no one firm can afford R&D; it would have to be done on a collective or industrial basis. This has been done, but a number of problems arise over funding levies and charges.

Concentrated markets, on the other hand, are considered to be inefficient in the short-run. They are statically inefficient, even though their AC may be significantly lower than their smaller 'perfectly competitive' equivalent. The profit motive makes them strive to be more efficient, so they may invest in R&D and may be dynamically efficient

1

Monopoly vs perfect competition

In the diagram below, which area represents the level of consumer surplus under perfect competition?

a)
b)
c)
d)
e)
Please select an answerNo, that's not right. This is the consumer surplus once the monopolist has taken over the industry.No, that's not right. This is a part of the deadweight welfare loss when a monopolist takes over.Yes, that's correct. The consumer surplus is the triangle above the price line and under perfect competition, the price will be set where MC=AR.No, that's not right. This is the producer surplus under perfect competition.No, that's not right. This area does not represent either producer or consumer surplus.
Check your answer

2

Monopoly vs perfect competition

In the diagram below, which area represents the level of consumer surplus under monopoly?

a)
b)
c)
d)
e)
Please select an answerYes, that's correct. This is the consumer surplus once the monopolist has taken over the industry.No, that's not right. This is a part of the deadweight welfare loss when a monopolist takes over.No, that's not right. The consumer surplus is the triangle above the price line and under perfect competition, the price will be set where MC=AR.No, that's not right. This is the producer surplus under perfect competition.No, that's not right. This area does not represent either producer or consumer surplus.
Check your answer

3

Monopoly vs perfect competition

In the diagram below, which area represents the welfare loss if a monopolist takes over a perfectly competitive industry?

a)
b)
c)
d)
e)
Please select an answerNo, that's not right. This is the consumer surplus once the monopolist has taken over the industry.No, that's not right. This is part of the deadweight welfare loss when a monopolist takes over, but you also need to include area 5 as well.No, that's not right. The consumer surplus is the triangle above the price line and under perfect competition, the price will be set where MC=AR.No, that's not right. This is the producer surplus after the monopolist has taken over.Yes, that's correct. This area is the deadweight welfare loss if a monopolist takes over. The areas were previously part of consumer or producer surplus, but are lost once the monopolist takes over and limits output.
Check your answer

Monopolistic competition

Monopolistic competition

An industry in monopolistic competition is one made up of a large number of small firms who produce goods which are only slightly different from that of all other sellers. It is similar to perfect competition with freedom of entry and exit for firms and any supernormal profits earned in the short-run will be competed away in the long-run as new firms enter the industry and compete away the profits.

Assumptions of monopolistic competition

In monopolistic competition, as with perfect competition, we make a number of assumptions. However, do not get muddled by the word monopolistic in the title. As a form of competition, this is closest to perfect competition and nowhere near the monopoly end of the scale. The reason for the name is that in monopolistic competition we drop the assumption from perfect competition of homogeneity of products and so each firm can develop their own 'brand' of product. This means that each firm has a 'monopoly' over their brand, but there is still a large number of firms.

The main assumptions are:

Examples of monopolistic competition

Petrol stations, restaurants, hairdressers and builders are all examples of monopolistic competition. Monopolistic competition is a common form of competition in many areas. A typical feature is that there is only one firm in a particular location. There may be many chip shops in town but only one in a particular street. People may be prepared to pay higher prices than go elsewhere, or they may simply prefer this 'brand' of fish and chips.

Monopolistic competition in the short-run

As with other market structures, profits are maximized in monopolistic competition where MC = MR. The AR and MR curves are more elastic than for a monopolist as there are more substitutes available. The profits depend on the strength of demand, the position and elasticity of the demand curve. In the short run therefore firms may be able to make supernormal profits. This situation is shown in the diagram below.

Figure 1 Equilibrium in monopolistic competition in the short-run

Monopolistic competition in the long run

In the long run firms will enter the industry attracted by the supernormal profits. This will mean that demand for the product of each firm will fall and the AR (demand curve) will shift to the left. Long run equilibrium occurs where only normal profits are being made as new firms will keep entering as long as there are supernormal profits to be made. In equilibrium, the demand curve (AR) will be tangential to the firm's long run average cost curve as shown in the diagram below.

Figure 2 Equilibrium in monopolistic competition in the long run

We can see this change between the short-run and long run clearly if we combine Figures 1 and 2 together. Figure 3 shows the changes taking place as new firms enter the market.

Figure 3 Changes in equilibrium in monopolistic competition short-run to long run

Limitations of model

The monopolistic competition model has various limitations and these include:

Efficiency in monopolistic competition

Oligopoly

The nature of oligopoly / assumptions of the model

Oligopoly is a market form in which there are only a few firms in the industry with many buyers; so market supply will be concentrated in the hands of relatively few producers, although an industry might still be said to be oligopolistic where several smaller firms existed alongside the few large firms that dominate; the wholesale petrol market provides a suitable example of the latter. The markets for cigarettes, records, confectionery, motor vehicles, fizzy drinks, high street banks, airline carriers, domestic appliances, soap powders and supermarket chains all provide good examples of oligopoly in the UK and elsewhere.

Where the few firms produce an identical product, this is known as perfect oligopoly, and where, more commonly, the products are differentiated, this is referred to as imperfect oligopoly. The case of duopoly, where there are only two firms in the industry, is a special case of oligopoly.

However, the absolute number of firms in the market is less significant than the way in which they behave and the relationship between the firms that comprise the industry. In the case of the monopolist, for example, independent price and output decisions can be made, with the only consideration being the customer's reaction to the change in price. However, in oligopoly, where there is competition amongst the relatively few, each firm has to also try to assess the reaction of its rivals to a change in price, as each firm will occupy a sufficiently important position within the industry for its particular price and output decisions to have a significant impact on its competitors. Thus if an oligopolist is thinking of raising the price of its product, it has to assess whether its rivals will do likewise or keep price down in order to gain more custom. Oligopoly is therefore characterised by interdependence between the firms that comprise the industry, and by reactive market behaviour.

Oligopoly has emerged as the most prevalent market form in the industrialised world. This can partly be explained by the existence of economies of scale, especially in manufacturing, encouraging the growth of large scale production; inevitably, as firms grow in size, the number of firms supplying the market falls, and hence the tendency towards oligopoly power. Moreover, once established, this power may be sustained by various barriers to entry, similar to those that exist under monopoly.

The importance of non-price competition

As we shall see from our forthcoming discussion of oligopoly, an important feature of oligopolistic markets, i.e. ones dominated by a few large firms, is the tendency towards relative price stability. Lack of price movement will occur most obviously where firms collude with each other to collectively fix their prices, but it may also occur in a situation of, what is known as, non-collusive oligopoly, where no such price agreements exist; inderdependent firms may well come to the conclusion that there is no point in 'cutting each others throats' by engaging in price warfare in the longer term as this could be disastrous for all the combatants, although there may be a tendency towards occasional short bursts of price cutting. However, this absence of price competition does not necessarily mean an absence of competition: oligopolistic firms are likely to compete in a variety of non-price forms.

Non- price competition occurs where firms attempt to win a competitive advantage over their rivals by strategies other than reducing prices. Non-price competition inevitably involves product differentiation. Here, oligopolistic competitors try to carve out separate markets in which they can command consumer loyalty through the creation of actual or imagined differences in the goods or services they offer, which are essentially the same as their rivals. This is in contrast to perfect competition where the good on offer, perhaps an agricultural one, is homogeneous, and product differentiation is difficult e.g. one carrot is pretty much the same as another.

Product differentiation is extremely widespread amongst the whole variety of consumer goods and services that we buy e.g. washing machines, television sets, home computers, motor cars, washing powders, soft drinks, packaged holidays and financial services, to name but a few. These are all differentiated one from another in a variety of ways, including shape, size, quality and image.

Non-price competition may take a variety of forms, including:

We shall examine the first three of the above i.e. advertising, branding and product innovation in greater detail.

Advertising

Advertisements are usually classified according to whether they are informative or persuasive.

Informative advertising

As the name implies, this type of advertising is concerned with the dissemination of information about products or services, e.g. as regards availability, price or performance, and such information would be of a factual type. For instance, an advertisement for a car could focus on such things as its fuel consumption, its safety features, the time it takes to reach certain speeds, its price, the names and addresses of main dealers etc.

Persuasive advertising

The main feature of persuasive advertising is that it provides consumers with little, if any, meaningful information about the products being advertised; rather it seeks to persuade consumers to buy one particular brand of a product rather than another through a combination of 'catchy' jingles and appealing images.

If the advertising is successful, the images and jingles register into our consciousness and create strong brand loyalty, e.g. the lines, 'A Mars a day helps you work, rest and play', and 'Coke, the real thing' are extremely widely known, but provide consumers with absolutely no information on the sugar, fat and chemical contents of the products in question.

Often the images are sexual and are intended to lead consumers to believe that their relative attractiveness to the opposite sex will be enhanced by the consumption of the good. Many advertisements for such things as cigarettes, alcohol, cosmetics, sports cars and even ice-cream fall into this category.

Task

The next time you watch commercial television, make a note and brief summary of the advertisements which appear during your first hour of viewing.

Classify these advertisements into informative and persuasive. Which type of advertising predominates?

The following table provides a summary of the potential advantages and disadvantages of advertising to consumers, firms and the economy as a whole, although its overall impact on such factors as prices, costs, competition and resource allocation is, as with many aspects of economics, very much a matter of judgement.

Advantages Disadvantages
For consumers Acts as a medium of communication between buyers and sellers, provides information on product availability and facilitates wider choice Persuasive advertising may render consumer choice irrational and destroy consumer sovereignty
May lead to lower prices if (a) larger sales and production levels result in economies of scale and lower unit costs and (b) the advertising is based on price competition Through its portrayal of a fantasy, largely affluent world, it creates unnecessary wants by generating feelings of inadequacy and greed
May lead to higher prices because (a) there may be higher costs, particularly if economies of scale are not achieved and (b) advertising may act as a barrier to entry of new firms and thus increase monopoly power, particularly where established firms engage in saturation advertising which cannot be matched by smaller firms
For firms If successful, advertising will (a) shift the demand curve to the right and (b) make the demand curve more inelastic. Lower profits if costs of production are increased without raising sufficient extra revenue, or without shifting the demand curve making demand more inelastic
It may enable firms to maintain their monopoly power through the creation of brand loyalty and barriers to entry
Greater profits may be earned if higher sales and output levels lead to economies of scale and lower costs
For the economy as a whole A greater level of employment if the level of sales and production increase Advertising may lead to a misallocation of society's scarce resources as the pattern of production may reflect the skill of the advertisers in manipulating consumers' tastes, rather than what consumers actually want / need.
Certain sectors of the economy only survive because of the revenue which advertising earns, e.g. commercial radio, newspapers and magazines The generation of negative externalities through tasteless or unsightly advertising


Task

As a group task, in a formal debate, discuss the following motion:

"This house believes that goods which have to be advertised ought not to be produced at all."

Select two main speakers to support the motion and two speakers to oppose it. Other class members should prepare points either for or against the motion so that they can contribute to the proceedings when the discussion is thrown open to the 'floor of the house'.

Branding

The creation of consumer loyalty to particular brands is mainly achieved through advertising, and it is in oligopolistic markets where branding, backed by extensive product promotion, is most prevalent. The markets for soap-powders, cereals, cars, confectionery and cosmetics provide a few notable examples.

The main aim of branding is to make particular goods, produced by particular firms, appear as if they have unique features which the products of competing firms do not possess. On occasions these features may be real, e.g. the distinctive quality of a BMW car or a Sony camcorder. However, often the 'uniqueness' may only exist in consumers' minds, but a difference, real or imagined, in how consumers perceive branded products, may be sufficient to allow goods to be sold at very different prices e.g. well known brands of soft drinks, sports-wear, bars of soap and shaving creams are all sold at higher prices than their 'own brand', or lesser-known, equivalents.

Thus, if successful, branding will reduce the degree of substitutability for the good, make its demand more inelastic, allow for higher prices and profits to be earned and enable the brand to become unassailable.

Moreover, the practice of multiple branding serves as a very effective barrier to entry of new firms e.g. go to any supermarket and you will see several brands of soap powders on the shelves, but these are mainly produced by just two firms, Unilever and Procter and Gamble - the costs of breaking into such a market would be formidable as any new entrant would have to compete against numerous brands of soap powder, requiring an enormous outlay on advertising; obviously if Unilever and Procter and Gamble only produced one brand each, the task of contesting the market would be made considerably easier.

Product innovation

Non-price competition in oligopoly may also take the form of product innovation whereby rival firms attempt to gain a larger slice of the market by constantly seeking to improve the quality and/or style of their existing products, or by developing entirely new products. This innovation usually has to be backed by extensive research and development (R&D), and has the effect of causing rapid obsolescence of consumer durable goods, a renewable source of demand and certain decline for those firms unwilling or unable to engage in such innovation. Most car manufacturers, for example, are constantly in the process of changing the design and other features of particular models so as to generate new demand, and the few large firms that dominate the pharmaceuticals industry are locked into a perpetual struggle to develop new and better drugs.

This process fits well with the writings of Joseph Schumpeter (1883-1950) who took a long-run, dynamic view of monopoly to argue that over time it would be far more efficient than perfect competition. He argued that the static method i.e. taking a point in time approach, of comparing perfect competition with monopoly, overlooked the likelihood of technical advances which may lower costs and prices as output expands. Although Schumpeter's analysis relates specifically to monopoly, it is appropriate to apply it to contemporary oligopolistic markets.

Schumpeter identified two main reasons why monopolies would be more innovative than competitive industries: firstly, because of the earning of long term supernormal profits, the monopolist would have greater access to the funds necessary to finance inevitably expensive research and development programmes which are the basis of most innovation; and secondly, the monopolist would have a far greater inducement to undertake R&D in the first place - in highly competitive markets, any technical advantage gained by one firm would only permit the earning of high profits to be made for a relatively short period of time, as new entrants and existing firms copy the innovation and bid any abnormal profits away; the monopolist however would be the sole beneficiary of technical advance and would thus be able to reap the benefits of lower costs and higher profits indefinitely.

However, empirical evidence on the subject suggests that whilst smaller firms, i.e. those not possessing substantial monopoly power, tend to undertake little R&D, no clear, positive relationship between the amount of R&D spending and company size exists beyond a certain minimum size of enterprise.

Theories of oligopoly

A central aim of market theory is to formulate predictions about firms' price and output decisions in different situations, and, under such market forms as perfect competition and monopoly, economists can be fairly certain about likely outcomes: in the case of the former, price is set in the market through the free interaction of demand and supply, and individual firms passively take this price and equate marginal cost with marginal revenue to determine the best output; in the case of the latter, the firm will still equate MC with MR, but can restrict output and raise price in so doing.

However, under oligopoly no such certainty exists - where the number of firms in the industry is small and much interdependence exists between these firms, there will be a whole variety of ways in which individual oligopolists may respond to rivals' price and output decisions. Consequently, several different models of oligopoly have been developed, underpinned by different analytical approaches and assumptions about the nature of oligopolistic, reactive market behaviour.

Unfortunately, therefore, for students of economics, there is no single, general and all-embracing theory of oligopoly to explain the nature of the business world around us! Particular theories of price and output determination under oligopoly should therefore be seen as illustrative of what might happen under certain sets of assumptions about the reactions of rival oligopolists.

The various models of oligopoly can be classified under two main headings: non-collusive or competitive oligopoly and collusive oligopoly. We shall consider each in turn:

Non-collusive or competitive oligopoly

In this case, each firm will embark upon a particular strategy without colluding with its rivals, although there will of course still exist a state of interdependence, as possible reactions of rivals will have to be considered.

There are three broad approaches that might be adopted by firms in a situation of competitive oligopoly:

This is the basis of game theory in which competition under oligopoly is seen as being similar to a game of chess in which every potential move must be regarded as a strategy, and possible reactive moves by opponents and subsequent counter-moves must all be carefully considered. The application of the theory of games to economics was first introduced in 1944 by J. von Neuman and O. Morgenstern. Games theory involves the study of optimal strategies to maximise payoffs, taking into account the risks involved in estimating reactions of opponents, and also the conditions under which there is a unique solution, such that an optimum strategy for two opponents is feasible and not inconsistent. A zero-sum game is one in which one player's gain is another's loss, and a non-zero-sum game is one in which a decision adopted by one player may be to the benefit of all.

In this discussion of non-collusive oligopoly, we shall focus our attention on the second of the three broad approaches identified above.

The kinked demand curve theory

This theory of oligopoly was first developed in 1939 by Paul Sweezy in the U.S.A, and by R. Hall and C. Hitch in the U.K, to explain why oligopolistic markets would be characterised by relatively rigid prices, even when costs increase.

As mentioned previously, the kinked demand curve model makes the assumption of an asymmetrical reaction to a change in price by one firm: a decrease in price by one firm will cause a similar reduction of price by other firms eager to protect their market share, whilst a price increase by one firm will not be matched and its market share will be eroded. This is shown in Figure 1 below.

Figure 1 Kinked demand curve

Price is initially set at OP1, at the kink of the demand curve, and the oligopolist sells an output of OQ1. If the firm tries to reduce price to OP2 in order to sell more, other firms would match this reduction so that sales would increase only slightly, or more technically, by a less than proportionate amount, to OQ2. The demand curve would be inelastic and the reduction in price would not represent a sound strategy as total sales revenue, and probably profit levels, would both fall; clearly the area OP1 x OQ1, representing initial revenue, is greater than OP2 x OQ2, the producer's revenue after the reduction in price. The alternative ploy of raising price to OP3 would also be unsound as none of the other oligopolists would follow suit, and a large or more than proportionate fall in demand would follow.

Here, the demand curve would be elastic and the change in price would again cause total revenue to fall - OP3 x OQ3 is smaller than OP x OQ. The logical conclusion from this analysis would therefore be that oligopolists would benefit from keeping prices stable so long as all could enjoy reasonable profits at the established price.

The kinked demand curve theory also has other implications. A normal demand curve becomes less elastic as price falls, but the oligopolist's demand curve becomes less elastic suddenly at the kink. Mathematically, this causes the MR curve to suddenly change to a different position, as can be seen in Figure 2, so that a discontinuity exists along the vertical line YZ above output OQ1.

Figure 2 The oligopolist's absorption of a rise in costs

This implies that the MC curve can increase or decrease between this discontiuity, without necessitating a change in the profit maximising output OQ1 or price OP1 - the oligopolist will absorb the higher costs. According to normal demand and supply analysis, an increase in costs would cause a fall in output and an increase in price. An example of cost absorption in practice is when the price of crude oil rises and petrol companies wish to increase price, but do not as no company wants to be the first to do so.

Criticisms of the kinked demand curve theory

Cut-price competition (predatory pricing)

Although oligopolistic markets tend to be characterised by relative price stability in the longer term, occasionally short bursts of price warfare break out. This typically occurs when the dominant players attempt to defend and/or raise their market shares because the total level of demand in the market is insufficient to enable all to achieve their intended level of sales, and overcapacity results. The price cutting has the effect of reducing the profits of all the combatants in the short run, with consumers gaining the temporary benefit of lower prices.

However, the likely outcome is that the weakest firms, i.e. those with the highest costs, will be driven into bankruptcy, with a new era of relative price stability eventually emerging. If too many casualties are caused, consumers are likely to face greater monopoly power and possibly higher prices. There have been numerous examples of price wars in recent years with the most notable battles occurring on the petrol forecourts and in the retail grocery and travel businesses.

Collusive oligopoly

A central feature of competitive or non-collusive oligopoly is the existence of uncertainty amongst the interdependent firms. Although these firms may utilise informed guesswork and calculation to cope with such uncertainty, they can never be entirely sure as to how their competitors will react to any given marketing strategy. Thus instead of living with uncertainty, firms may adopt a policy of reducing, or even eliminating, it by some form of central co-ordination, co-operation or collusion. Such collusion may occur where firms attempt to maximise their joint profits, by reaching agreement on their price, output and other policies, or where firms seek to prevent the entry of new firms into the industry so as to protect their longer run profits.

In the next section we consider the forms that such collusion may take. Click on the right arrow at the top or bottom of the page to have a look at this section.

Forms of collusion

Formal collusion

The most common type of formal collusion is through the cartel; where a small number of rival firms, selling a similar product, come to the conclusion that it is in their joint interests to formally collude rather than compete, they may establish a cartel arrangement in which they agree to set an industry price and output which enables them to achieve a common objective. This is likely to involve the setting of agreed output quotas for each member in order to maintain the agreed price.

A successful cartel arrangement, from the point of view of the participating firms, would be one in which the cartel acts like a single monopolist to maximise profits of individual members. This is illustrated in figure 1 below.

Figure 1 Profit maximisation for the cartel

This is the familiar monopoly diagram, with each curve representing the aggregated situation for all the firms in the cartel. In order to maximise profits, MC is equated with MR and a price of OP is set, with an output of OQ, which represents the potential level of sales. The allocation of this market quota between members could be decided by such criteria as geography, productive capacity or pre-cartel market share, or cartel members, having set a price of OP, could engage in non-price competition to each gain as large a slice of OQ as they can.

In practice, cartels may tend to be rather fragile and may not last for very long. This is because individual members may have an incentive to renege on the agreement by secretly undercutting the cartel price. The almost inevitable necessity to limit output to keep price high will tend to leave individual firms with spare productive capacity, and provide the temptation to increase profits by expanding output. Such an expansion would not only generate profit on the additional sales, but would also increase the profits on existing sales, as average fixed costs would fall as output expanded.

As the end result of successful collusion will be to create a situation similar to monopoly, with its consequent drawbacks and loss of economic efficiency, cartels are illegal in many countries, including the UK and the USA. Various cartels do, however, operate internationally, the most famous of which is OPEC. Another example of an international cartel is IATA (The International Air Transport Association) which has sought to set prices for international airline routes. However, the experience of both these cartels has been one of price cutting amongst its members, particularly during periods of declining product demand and competition from non-members.

Informal or tacit collusion

The most usual method of tacit collusion is priceleadership which occurs where one firm sets a price which is subsequently accepted as the market price by the other producers. There need be no formal or written agreement for this to happen; it is sufficient that firms believe this to be the best way of maintaining or increasing their profits. Price leadership may take various forms:

Dominant firm price leadership

This type of price leadership occurs where a firm, probably by virtue of its size comes to dominate an industry in terms of its power to influence market supply. The dominant firm sets a price to suit its own needs and the smaller firms then adjust their planned output in line with the market price that has been set for them. An example of such price leadership is provided by Ford Motor Company, who have often been the first to raise prices in the car industry.

Barometric price leadership

A barometric price leader need not necessarily be the dominant firm in the industry; rather it will be a firm, possibly small in size, which is acknowledged by others in the industry as having an informed insight into current market conditions, perhaps because it employs the best team of accountants and market analysts. The firm's reputation will therefore enable it to act as a 'barometer' to others in the industry, and its price movements will be closely followed.

Collusive price leadership

This involves a form of tacit group collusion in which prices within an industry change almost simultaneously and is linked to price parallelism where there are identical prices and price movements in a given market. In practice collusive price leadership might be difficult to distinguish from dominant firm leadership, especially in circumstances where the price leader is quickly followed.

Tacit collusion may also occur where firms in the industry follow a set of 'rules of thumb' instead of a price leader. Such rules may be designed to prevent destructive competition and thus maintain longer term profitability, although some short run profitability may be sacrificed as the rules do not require MC and MR to be equated. One such rule of thumb is cost-plus pricing.

Cost-plus pricing

This is also known as average cost pricing, mark-up pricing and full-cost pricing, and empirical evidence suggests that it is the most common pricing procedure adopted by firms. It involves firms setting price by adding a standard percentage profit margin to average costs, so that:

Price = AFC+ AVC + profit margin

Cost-plus pricing is consistent with the idea of relatively stable oligopoly prices as, providing costs are stable, prices will also remain stable in the short run, even though demand might be changing. Conversely, if costs rise on average by 5%, then prices in the industry will also be rising by a similar percentage.

Coursework task

Choose a particular market to study, e.g. the market for soap powders, chocolate bars, computers or any other of your choice.

Investigate the degree and nature of competition in your chosen market and the implications of this for producers and consumers.

Contestable markets

This theory was first developed by the American economist W.J.Baumol in the early 1980s. The theory argues that what really matters in determining an industry's price and output is not, in reality, whether the industry is perfectly competitive or a monopoly, but the potential of new firms to enter or leave the market. The theory is based on the idea that a firm may enjoy a monopoly position within a market, but if there existed the real threat of competition from other firms, this would force the firm to behave as if it actually faced competition; that is, the firm would not pursue a policy of charging exorbitant prices to make excessive profits.

What is a contestable market?

The term 'contestability' has nothing to do with the number of firms currently in the industry, but refers instead to the ease with which firms are able to enter or leave a market; a perfectly contestable market is one in which there are no barriers or costs to entry or exit: the greater these are, the less contestable is the market, and thus the greater is the monopoly power of existing firms; so for a market to be contestable, a barrier to entry, such as a patent protecting technical knowledge, must be absent.

We previously discussed the various restrictions to entry, the idea of barriers to exit needs further explanation. A firm will incur substantial costs of leaving an industry of its capital equipment cannot be transferred to other uses. In this case these costs are known as sunk costs or irrecoverable costs, and are costs which cannot be recovered in the event of exit from the market. For example, the air travel industry is often cited as an example of a contestable market as an established airline operating on a particular route would easily be able to gain entry to another route, and, just as importantly, would be able to withdraw from that route if it so desired. Should operations on the new route prove unprofitable, the airline could transfer its operations without incurring high sunk costs because aircraft can easily be switched from one particular route which is loss making to another which is more profitable. Thus, so long as a firm is able to redeploy its capital or sell it when it wishes to leave a market, then the sunk costs would be low and relatively costless exit would be ensured.

One feature of markets which are contestable, that is where entry and exit costs are low, is that it may encourage hit-and-run competition - because entry to the industry is easy, firms may enter that industry to share in the fruits of temporarily high profits, and then withdraw as soon as the abnormal profits have been whittled away. However, the threat of such competition may be sufficient to force firms to price as competitively as possible.

Implications of the theory

The theory implies that, given easy entry to and exit from an industry, monopoly or oligopoly firms will behave as if they actually existed in perfect competition; that is they will:

It would appear from the theory that the 'best of both worlds' can be enjoyed; that is, so long as there exists the threat of entry into an industry, consumers will be protected from the worst abuses of monopoly power, whilst at the same time firms will be able to reap the advantages of large scale production in the form of greater economies of scale, and will operate in accordance with the criteria for economic efficiency.

The theory has been 'taken to heart' by right-wing politicians and economists who argue the case for non-intervention by the government and a policy of deregulation. The theory, it is argued, implies that providing there is sufficient potential for competition, there is no need for the government to interfere with the pricing and output policies of firms, but should instead confine itself to ensuring contestability through the use of deregulatory policies designed to remove barriers to entry and exit. Such policies have had a major influence on government's monopoly policies in recent years.

It has been argued that the theory represents an improvement on the simple perfect competition and monopoly models:

Like perfect competition, the perfectly contestable market may exist only rarely in practice and could be said to represent a model or abstraction of the real world rather than the real world itself. However, advocates of the theory of contestable markets argue that it is a more useful model than that of perfect competition as it provides a more effective means of making predictions about firms' price and output behaviour than does the number of sellers in a market.

The theory of monopoly only considers the markets in terms of the number of firms operating in it or in terms of concentration ratios, but does not make any allowance for the impact that potential competition might have.

Criticisms of the theory

The extent to which the theory of contestable markets may be applied in practice is limited. Two pre-requisites may not be met:

  1. Firstly, firms' sunk costs must be low so that they can easily leave the market. However, in reality sunk costs may be extremely high, even when capital is transferable. For example, if the Ford Motor Company decided to switch its operations from Dagenham (UK) to Delhi (India), it could not do so without substantial costs, despite the possibility of taking much fixed capital to India with it.
  2. Secondly, the specific technical knowledge necessary to operate in the industry must be freely available. However, sole possession of technical knowledge, often protected by patent, is a common and powerful barrier to entry to monopolistic markets where production is of a highly sophisticated nature, and is underpinned by extensive R&D - for example, the case of the drugs industry.

The theory ignores the possible aggressive actions of existing firms to potential entrants. In a market where cost barriers to entry and exit are low, existing firms may behave like monopolists by charging high prices and making supernormal profits, but might frighten off potential entrants by making it quite clear that any firm attempting to enter their 'patch' would face 'big trouble' in the form of all-out, to-the-death competition.

Those on the political right view the theory in terms of a justification of free markets and non-government intervention as both consumers and producers appear to benefit. However, this standpoint may be criticised on the grounds that even if perfect contestability exists, which is in itself by no means common in practice, government intervention in the free market may be warranted for a whole variety of other reasons.

Price discrimination

Price discrimination

Price discrimination is the practice of charging different prices for the same or similar product/service to different consumers where the price differences do not reflect the differences in cost of supply.

Reasons for price discrimination

Price discrimination is carried out primarily to increase the profits of the discriminating firms. It occurs where different consumers are charged different prices in different markets for the same product or service, or where the same consumer is charged different prices for the same product, where the different prices are not due to differences in supply costs.

Necessary conditions for price discrimination

Condition 1

There must be some imperfection of the market. If there were perfect competition, price discrimination would be impossible since the individual producer could have no influence on price. At least some degree of monopoly power is therefore necessary so that producers have some ability to make rather than take the market price.

Condition 2

The discriminating supplier must be able to split the market into separate sections and keep them separate, such that it is difficult to transfer the seller's product from one sector to another i.e. there must be no 'seepage' between markets in the sense that goods can be bought in the cheaper market and re-sold in the dearer.

Barriers between markets may be:

The two conditions discussed so far would make price discrimination possible, but for it to also be profitable a third condition must also be satisfied:

Condition 3

Price elasticity of demand in each market must be different; if this were the case , the discriminating supplier would increase price in the market with an inelastic demand curve, and reduce price where demand is elastic in order to increase total revenue and profits. If the elasticity of demand in each market was the same at each and every price, a common price would be charged in both markets as this price would represent the profit maximising price in each market where MC = MR. You might wish to refer back at this stage to where we discussed the relationship between price elasticity of demand and total revenue.

Equilibrium of the discriminating monopolist

Figure 1 Equilibrium of the discriminating monopolist

The profit gain from price discrimination is (x + y) - z

In figure 1 there are two distinct markets, Market A and Market B. A third market, Market C, which is the combined market, is obtained by the horizontal summation of the individual AR and MR curves from A and B. Market A has an inelastic demand curve, whilst Market B has a more elastic demand curve. The gradient of the combined market demand curve will lie between that of A and B.

In the combined market, MC is equated with MR to give a single profit maximising price of OPc with an output of OQc, and a total profit equal to the shaded area z is earned. With a single price, this is the maximum profit that could be earned as the charging of a higher price would reduce demand and the area of profit, z.

However, total profits can be increased through price discrimination, with the total output OQc being sold at different prices in markets A and B. Price will always be higher in the market with a more inelastic demand as consumers will be less responsive to price changes.

As price discrimination only occurs where the differences in price are not associated with any cost differences, the combined market MC curve will also apply to markets A and B, and the output of each sub-market is therefore determined by equating MR in each market with the marginal cost of producing OQc units of output. Thus in figure 1, it can be seen that the marginal cost of production, OM, is projected back from the combined market as a horizontal line to enable the monopolist to find the equilibrium points Ea and Eb where MC = MR in each of the individual markets, A and B. Similarly the average cost of production, OC, is projected back from the combined market to determine the area of profit in markets A and B. As the level of profit is denoted by the amount by which AR exceeds AC, the areas x and y will represent the total profit for A and B respectively.

From the producer's standpoint, price discrimination will be a success if total profits increase as a result. In the diagram, it can be seen that Area x + Area y is greater than Area z, so the producer has succeeded.

Advantages and disadvantages of price discrimination

Disadvantages

The main disadvantage will be experienced by consumers, particularly those having to pay the higher prices who may object to the discrimination against them e.g. users of peak time public transport. It could be argued that price discrimination represents a transfer of welfare from consumers to producers and is a way in which producers gain at the expense of consumers through the extraction of consumer surplus. In the extreme case of perfect or first degree price discrimination, no consumer receives any consumer surplus at all.

In more general terms, the higher profits earned through price discrimination could be viewed as an unjustifiable redistribution of income in favour of profit takers with higher prices reducing consumers' real incomes.

Advantages

Figure 2 Profits and losses (a) without and (b) with discrimination

In figure 2, the producer's best output, where MC = MR is at OQe, but the price of OPe does not cover the average cost of OC, and a loss, equivalent to the rectangular area x, is made. However, a loss can be transformed into a profit by charging those consumers who are prepared to pay, a higher price of OPe1. The shaded area y shows the additional revenue that accrues to the firm from charging a two-part tariff. As area y exceeds that of x, the loss making firm is now able to make a profit at the current output level.

In the absence of price discrimination, this good would probably not be supplied in the long run, which would particularly represent a loss to society if it were one which generated positive externalities e.g. a doctor in a remote area charging wealthier patients more than the less affluent ones.

Alternative aims of firms

Although the traditional theory of the firm assumes that all firms aim to maximise their profits, in reality firms may have a range of objectives. These alternative aims particularly arise in the case of public limited companies where there is a divorce (separation) between ownership and control; i.e. one set of people own these companies (the shareholders) and another set of people control them (the salaried managers and directors). Often there will be a difference between what the owners want (usually the maximum profit which maximises dividend payments) and what the controllers are trying to achieve (sometimes just a quiet life!).

There are thus many different aims that firms could pursue, but we shall just concentrate on the 3 specifically mentioned in the IB specification (sales revenue maximisation, sales volume maximisation and environmental aims) plus the aim of satisficing.

Figure 1 below usefully enables a comparison between profit maximisation, sales revenue maximisation and sales volume maximisation.

Figure 1

Profit maximisation.

Firms maximise their profits where MR = MC, indicated by the point Q in Figure 1. Firms will also be maximising their profits where total revenue most exceeds total cost.

Sales revenue maximisation.

In Figure 1, sales revenue is maximised at Q1 where MR = 0. This will correspond to the point where the (total revenue) is at a maximum. This is shown in Figure 2 below.

Figure 2

So long as MR is positive, even if it is falling, TR must be rising, as more is being added to TR. When MR becomes negative, TR must fall, as less is being added to TR. Thus when MR = 0, TR must be at its highest point.

It should also be noted from Figure 1 that the sales revenue maximising output is greater than the profit maximising level of output (i.e. OQ1 rather than OQ).

Managers may wish to maximise sales revenue rather than profits because

Sales volume maximisation

In Figure 1, sales volume is maximised at OQ2, subject to a profit constraint, where AR = AC. The firm might be able to sell more than this, but the diagram shows that on all units of output beyond OQ2, AC is greater than AR and, therefore, a loss would be incurred. So, OQ2 maximise sales volume without a loss being incurred.

Managers may wish to maximise sales volume rather than profit because

Environmental aims

With increasing concern nationally and globally for the environment, firms may wish to be regarded as responsible members of the community by adopting environmentally friendly policies. Firms may enhance their 'green' image by sponsoring worthwhile events, donating funds to environmentally based charities / organisations or adopting practices which show a high level of concern for the environment. For example, supermarkets may sell fairtrade products, usually at a higher price than normal products, to show support for producers in developing countries.

Satisficing

In contrast to maximising behaviour,e.g. of profits or sales revenue. Satisficing theory suggests that the people in charge of business may decide to achieve a satisfactory performance across a range of indicators and not to maximise any one of them. This approach is more likely to keep all the firms stakeholders happy and is what is known as 'satisficing'. For example a firm hell - bent on making the maximum possible level of profit may have to reduce the quality of its products, hold down the wages of its workers and pollute the environment, thus falling foul of three of its important stakeholders, i.e. its customers, its employees and the local community respectively.

Thus, if the managers can make a satisfactory profit, rather than a maximum profit, the owners of the firm and the stakeholders will be happy and the managers will keep their jobs.

Section 2.3 Theory of the firm - questions (HL only)

In this section are a series of questions on the topic - Theory of the firm.





Click on the right arrow at the top or bottom of the page to move on to the next page.

Short-run - numerical

Question 1

A firm uses two variable factors of production in the manufacture of its product, labour and capital. It combines these with a fixed factor, land, to produce different quantities of output.

a) Is this firm operating in the short or long run?

The following data is available

Units of labour 1 2 3 4 5 6 7
Output 10 25 30 25 20 15 10


b) When does the law of diminishing returns click in?

Question 2

A firm is planning to expand production by 300 units per hour. To do this it will have to either employ more labour, or bring in more special equipment. It has the following data available. Using this data only, advise the firm what it should do.

Cost of labour - 30 per hour
Productivity - 60 units per hour

Cost of equipment (hire charge) - 100 per hour
Productivity - 350 units per hour.

Question 3

You have asked the question, and the firm has supplied you with the following information:

Number of extra workers 1 2 3 4 5 6 7
Expected total output 60 150 300 420 500 480 420


If more than 5 workers are employed, cost per worker will have to rise to 35 per worker. How does this information influence your case?

Question 4

The following information has been provided by the firm.

Anticipated cumulative increase in production requirements for next 6 periods

Period 1 2 3 4 5 6
Extra sales expected 300 400 550 700 1000 2000


How does this affect your advice?

Short-run - short-answer

Question 1

What is productivity and how is it affected by changes in the prices of factors of production?

Question 2

Explain the law of diminishing returns.

Question 3

All other things being equal, how would a firm decide what factors of production to use in its factory?

Question 4

Explain the term 'short-run'.

Question 5

Distinguish between diseconomies of scale and the law of diminishing returns.

Long-run - short answer

Question 1

Explain why all the firms in an industry within a single economy are not all the same size.

Question 2

Explain why firms are bigger in some industries than others.

Question 3

Explain how full exploitation of the benefits of economies of scale and the division of labour can result in a firm having to become international/multinational.

Question 4

An industry has 12 firms that operate within it. The market shares of the top 6 firms in 2002 are given below.

Firm A B C D E F
Market share (%) 24 21 16 12 8 6


Calculate the 3, 5 and 6 firm concentration ratios (the percentage market share accounted for by the top 3, top 5 and top 6 firms) for this industry.

Question 5

An industry has 24 firms that operate within it. The sales value of the top 6 firms in 2002 is given below.

Firm A B C D E F
Sales value ($m per year) 12.5 2.5 2.3 1.7 0.9 0.8


The industry is worth $24 million per year

Calculate the 3, 5 and 6 firm concentration ratios for this industry.

Question 6

Explain three economies and three diseconomies of scale that may affect a firm.

Question 7

Explain the term 'capital intensive' firm.

Question 8

Why do capital-intensive firms tend to be large in relation to the size of the market they are in?

Question 9

Explain the term 'minimum efficient scale of production'.

Cost theory - numerical

Question 1

Given the following table of costs:

Output 0 1 2 3 4 5
Total cost 50 80 100 150 250 750


Calculate the following:

(i) Fixed cost
(ii) Average cost of production
(iii) Variable cost per unit
(iv) Marginal cost

Plot all the cost curves on a single graph, and determine where diminishing returns sets in.

Question 2

A firm manufactures cars at its plant in Swindon. At a capacity of 100 cars per week it knows that it has an assembly cost of 5,000 per car. It needs to expand production and does a series of design and cost exercises. The results are summarised below.

Output (cars per week) 200 400 600 800 1,000 1,200 1,400 1,600
Assembly cost ( per car) 3,000 2,500 2,300 2,200 2,000 2,400 2,800 4,000


(i) Plot the cost curve for the possible factory extensions.
(ii) Is this a short run or long run cost curve?
(iii) Explain why this curve is U shaped.

Cost theory - short-answer

Question 1

Why can fixed costs be considered as an entry fee?

Question 2

Distinguish between the very short-run, the short-run, the long run and the very long run.

Question 3

Explain the term marginal cost.

Question 4

How would you decide, looking at a firm's average cost curve, if it was capital or labour intensive?

Question 5

How and why do cost curves change with time?

Question 6

Explain how a firm's short run average total cost curve and marginal cost curve are related.

Question 7

Use diagrams to distinguish between the law of diminishing returns and economies of scale.

Interactive questions

The following table of data describes the operation of a firm over a limited output range, and is used for the next 5 questions.

Output 0 1 2 3 4 5 6 7 8 9 10
Total cost 100 120 140 160 220 300 450 600 1,000 2,500 5,000


1

Fixed costs

The fixed costs for the firm are:

a)
b)
c)
d)
Yes, well done. FC is the costs of 'output zero'. It is the entry cost to production in the short-run.No. Look again, but think first.Your answer has been saved.
Check your answer

2

Average cost

The average cost of production when 5 items were made is:

a)
b)
c)
d)
Yes. Spot on. Answer. AC = TC/output. In this case, for 5 units, 300/5 = 60.No. Look again, but think first.Your answer has been saved.
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3

Marginal cost

The marginal cost of the 7th unit is:

a)
b)
c)
d)
Yes. Spot on. It helps to know your definitions. Answer. Marginal cost of 7th = TC of 6th - TC of 7th = 600 - 450 = 150No. Look again, but think first.Your answer has been saved.
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4

Diminishing returns

The firm exhibits diminishing returns to the variable factor from the:

a)
b)
c)
d)
Yes. Spot on. Diminishing returns = rising AVC. AVC is: at output 1=20, 2=20, 3=20, 4=30, 5=40, 6=58, 7=71. Constant returns up until 3 units and then diminishing.No. Look again, but think first.Your answer has been saved.
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5

Variable cost per unit

The variable cost per unit when 4 units are made is:

a)
b)
c)
d)

Yes. Spot on. VC per unit = TVC / Output.

From table AVC is at output 3=20, 4=30, 5=40, 6=58. Now read off the answer. It is 30.

No. Look again, but think first.Your answer has been saved.
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Costs and cost curves - self-test questions

1

Cost calculation

A firm produces 200 units and the total cost of production is $4000. When they increase output to 220, the cost rises to $4200. What is the marginal cost?

a)
b)
c)
d)
Please select an answerNo, that's not right. When output rises to 220, cost goes up by $200, but the marginal cost is the cost of one more unit.No, that's not right. The marginal cost is the cost of one more unit. This is the cost of two more units.Yes, that's correct. The marginal cost is the cost of one more unit (increase in cost of $200, from an increase in output of 20 equals $10 per unit).No, that's not right. Have you divided the increase in cost by the increase in output correctly?
Check your answer

2

Cost calculation

A firm produces 200 units and the total cost of production is $4000. When they increase output to 220, the cost rises to $4200. What is the average cost of producing 220 units?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is the total cost, you need to divide by the level of output to get average cost.No, that's not right. This is the average cost of 200 units. No, that's not right. Have you divided by 200 units rather than 220 units?Yes, that's correct. Total cost of 220 units is $4200. Divide the total cost by the level of output and we get $19.10.
Check your answer

3

Cost calculation

A firm producing in the short run produces 200 units and the total cost of production is $4000. When they increase output to 220, the cost rises to $4200. When output rises to 240, the cost rises to $4100. The firm is experiencing:

a)
b)
c)
d)
Please select an answerNo, that's not right. The firm is facing diminishing returns as the marginal cost is falling.No, that's not right. The firm is producing in the short run and so is not facing returns to scale.No, that's not right. The firm is producing in the short run and so is not facing returns to scale.Yes, that's correct. The marginal cost is falling and so the firm is facing diminishing returns to the variable factor.
Check your answer

4

Cost calculation

A firm produces 200 units and the total cost of production is $4000. When they increase output to 220, the cost rises to $4200. When the firm produces zero output, the cost is $1000. What is the fixed cost per unit when they produce 200 units?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is the total fixed cost.No, that's not right. You seem to have done the calculation slightly wrong and are out by a multiple of 10.No, that's not right. This is the variable cost per unit.Yes, that's correct. Total fixed costs are $1000 and output is 200 and so fixed cost per unit is $5.
Check your answer

5

Cost calculation

A firm produces 200 units and the total cost of production is $4000. When they increase output to 220, the cost rises to $4200. When the firm produces zero output, the cost is $1000. What is the variable cost per unit when they produce 200 units?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is the total variable cost.No, that's not right. You seem to have done the calculation slightly wrong and have perhaps divided by 220 rather than an output of 200.Yes, that's correct. This is the variable cost per unit. Total variable costs are $3200 and output is 200 and so variable cost per unit is $16.No, that's not right. This is the fixed cost per unit.
Check your answer

6

Types of costs

Match the following cost definitions to their type.

a)
b)
c)
d)
e)
Yes, that's correct. Well done.No, that's not quite right. Have another go.Your answer has been saved.
Check your answer

Revenues - numerical

Question 1

The following table of data represents a business in operation.

Output/sales 0 1 2 3 4 5 6 7 8
Total revenue 0 100 180 240 280 300 300 280 240
Total costs 20 60 110 170 240 320 410 510 620


Determine:

(i) Average revenue
(ii) Marginal revenue
(iii) Profit
(iv) Marginal cost
(v) Average cost

Plot all the data on one graph and determine the profit maximising output. Confirm that at this output, MC = MR.

Question 2

A firm is selling 5 units of its product, and has the following cost and revenue figures.

Output/sales 0 1 2 3 4 5
Total revenue 0 200 350 450 500 500
Total costs 50 100 140 200 250 310


(a) Determine:

(i) the firm's average revenue and price
(ii) the firm's profit level.

b) Is the firm operating below or above its profit maximising output?

c) Determine the new total revenue and profit at the new level of output and sales.

Question 3

The following table shows the sales and revenue data for a firm selling its product.

Sales (units) 0 1 2 3 4 5 6 7 8
Price () 200 180 160 140 120 100 80 60 40


Determine the firms TR, MR and AR over this range of output. Plot the firm's Revenue curves and show where the firm maximises its sales revenue.

Question 4

Distinguish between normal and supernormal profits.

Question 5

Who decides what level of profit is normal?

Question 6

Explain the difference between profit and money.

Question 7

What is a windfall profit?

Question 8

What is the difference between the average revenue of a product and its price?

Question 9

Why do businesses aim to make a profit?

Interactive questions

The following table of data represents a business in operation and is used for the following series of multiple-choice questions

Output/sales 0 1 2 3 4 5 6 7 8
Total revenue 0 50 90 120 140 150 150 140 120
Total costs 10 30 55 85 120 160 205 255 310


1

Average revenue

What is the average revenue for the firm at an output of 6 units?

a)
b)
c)
d)
Please select an answerNo. This is the average cost.No, this is nothing to do with 6 units.No. This is the total revenue, not the average.Yes, spot on. Answer is: Average revenue = price, so this is a simple one to start with. TR = 150 Sales = 6 AR = 150/6 = $25
Check your answer

2

Marginal revenue

What is the marginal revenue obtained from selling the 4th unit?

a)
b)
c)
d)
Please select an answerNo. This is the price for 3 units.No. This is the price for 4 units.Yes, spot on. Answer: Definition - marginal revenue - the extra revenue from selling one more. Look at the calculations and the graph. You will see that the answer is $20.No. This is the TR when 4 are sold.
Check your answer

3

Profit maximising output

The firms profit maximising output is:

a)
b)
c)
d)
Please select an answerNo. That is the maximum profit.No. One unit too few.Yes, spot on. Answer: equation MC = MR or look at the graph. Profit is maximised when the third unit is sold.No. That is the revenue maximising output.
Check your answer

4

Marginal revenue

What is the marginal revenue obtained from selling the 7th unit?

a)
b)
c)
d)
Please select an answerNo. This is for the 6th.Yes, spot on. Answer: do the sums first and this type of question is easy. Guess, or try and do in your head, and you are in trouble, usually. Answer is a reduction of $10.No. This is for the 8th.No. This is the marginal cost of the 7th unit.
Check your answer

5

Revenue maximisation

The firm will maximise its revenue if it sells:

a)
b)
c)
d)
Yes, spot on. Answer: equation - revenue maximization when MR = zero. From the chart or the diagram - when it sells the 6th unit.No. Look again at the table, carefully.Your answer has been saved.
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Profit maximisation - short answer

Question 1

Why is profit maximised when MC = MR?

Question 2

What is the basic assumption that economists make about the objectives of private firms?

Question 3

Explain two other objectives a private firm might have.

Question 4

Why is it assumed that private firms ignore external costs?

Question 5

Explain the term 'satisficing'.

Question 6

Why is there more likely to be a divorce between ownership and control in a plc than a sole trader business?

Question 7

Why is a divorce between the ownership and control of a firm a cause for concern?

Revenue and profit - self-test questions

1

Revenue definitions

Match the following definitions to the appropriate type of revenue.

a)
b)
c)
Yes, that's correct. Well done.No, that's not right. Have another go.Your answer has been saved.
Check your answer

2

Revenue calculation

A firm is selling 100 units at a price of $25. However, to sell 110 units they need to cut the price to $24. What is the level of marginal revenue at this higher level of sales?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is the extra revenue from selling the 10 extra units. The marginal cost is the cost of just one of these.No, that's not right. This is the total revenue of selling 110 units.Yes, that's correct. The marginal revenue is the difference between total revenue at 100 units ($2500) and total revenue at 110 ($2640) divided by ten to get the extra cost per unit.No, that's not right. This is the change in price, not the marginal revenue.
Check your answer

3

Revenue calculation

A firm is selling 100 units at a price of $25. However, to sell 110 units they need to cut the price to $24. What is the average revenue at 110 units?

a)
b)
c)
d)
Please select an answerNo, that's not right. This is the average revenue at 100 units.No, that's not right. This is the total revenue of selling 110 units.No, that's not right. This is the marginal revenue, not the average revenue.Yes, that's correct. This is the average revenue of 110 units.
Check your answer

Perfect competition - numerical

Question 1

Examine the diagram that is given below, which represents a firm in a perfectly competitive market.

What price would the firm require to:

(i) stay in the market in the long run
(ii) stay in the market in the short run
(iii) leave the market at once

Question 2

It is known that a firm is operating in a perfectly competitive market. Its situation is summarised in the table of data that follows.

Sales/production 0 1 2 3 4 5 6 7
Total revenue 0 30 60 90 120 150 180 210
Total cost 10 40 60 70 80 100 130 160


What price would the firm require to:

(i) stay in the market in the long run?
(ii) stay in the market in the short run?
(iii) leave the market at once?

Is the firm in long or short run equilibrium?

Perfect competition - short answer

Question 1

Explain why a market for shares may be considered to approximate perfect competition.

Question 2

Is it possible for a firm in perfect competition to make supernormal profits?

Question 3

A firm in a perfectly competitive industry finds that it is trying to sell its product at a price above the prevailing market price. What can it do about the situation?

Question 4

What does the term 'freedom of entry and exit' to the market mean?

Question 5

Draw and explain the models for a firm and an industry in a perfectly competitive market in the long run.

Question 6

Will you find advertising in a perfectly competitive industry?

Question 7

It is an assumption of perfect competition that, in the long run, no firm makes supernormal profits, only normal profit. Does that mean that all firms in perfect competition make the same level of profit?

Question 8

Examine the data below, which is for 4 different firms.

Revenue data (k) for four firms

Sales 0 1 2 3 4 5
A 0 10 20 30 40 50
B 0 30 60 90 120 150
C 0 50 95 135 170 155
D 0 40 80 120 160 200


All of the firms are in perfectly competitive industries except?

Question 9

Discuss the main problems with perfect competition.

Question 10

Why is the existence of perfect competition unlikely in the real world?

Perfect competition - self-test questions

1

Assumptions of perfect competition

Which of the following are assumptions we make about perfect competition?

a)
b)
c)
d)
e)
f)
Yes, that's correct. Well done. A large number of industries is not a condition of perfect competition as we are looking at just one industry. A lack of government intervention is not a condition and perfect competition requires perfect knowledge, not just reasonable access to information.No, that's not right. Have another go. A large number of industries is not a condition of perfect competition as we are looking at just one industry. A lack of government intervention is not a condition and perfect competition requires perfect knowledge, not just reasonable access to information.Your answer has been saved.
Check your answer

2

Long-run equilibrium - perfect competition

Which of the following will be true when a firm is in long-run equilibrium in perfect competition?

a)
b)
c)
d)
e)
f)
a) Yes, that's correct. MC=MR means that the firm will be maximising profits. This is true in long-run equilibrium.a) No, that's not right. MC=MR means that the firm will be maximising profits. This is true in long-run equilibrium.b) Yes, that's correct. AC=AR means that the firm will be making normal profits. This is true in long-run equilibrium.b) No, that's not right. AC=AR means that the firm will be making normal profits. This is true in long-run equilibrium.c) Yes, that's correct. In long-run equilibrium the firm will make just normal profits.c) No, that's not right. In long-run equilibrium the firm will make just normal profits.d) Yes, that's correct. In long-run equilibrium MC=MR=AC=AR, and so MC=AR.d) No, that's not right. In long-run equilibrium MC=MR=AC=AR, and so MC=AR.e) Yes, that's correct. The average cost curve will just touch the average revenue curve and so is tangential.e) No, that's not right. The average cost curve will just touch the average revenue curve and so is tangential.f) Yes, that's correct. The MC curve will be upward sloping, not horizontal. It is the MR curve that is horizontal.f) No, that's not right. The MC curve will be upward sloping, not horizontal. It is the MR curve that is horizontal.
Check your answer

3

Long-run equilibrium - perfect competition

Which of the following will be true when a firm is in short-run equilibrium in perfect competition?

a)
b)
c)
d)
e)
f)
a) Yes, that's correct. MC=MR means that the firm will be maximising profits. This is true in short-run equilibrium.a) No, that's not right. MC=MR means that the firm will be maximising profits. This is true in short-run equilibrium.b) Yes, that's correct. AC=AR means that the firm will be making normal profits. This is NOT true in short-run equilibrium as the firm can be making supernormal profits in the short-run.b) No, that's not right. AC=AR means that the firm will be making normal profits. This is NOT true in short-run equilibrium as the firm can be making supernormal profits in the short-run.c) Yes, that's correct. In short-run equilibrium the firm can make supernormal profits.c) No, that's not right. In short-run equilibrium the firm can make supernormal profits.d) Yes, that's correct. In short-run equilibrium the firm can be making supernormal profits and so MC does not need to be equal to AR. This will only be true in long-run equilibrium.d) No, that's not right. In long-run equilibrium MC=MR=AC=AR, and so MC=AR.e) Yes, that's correct. In short-run equilibrium the firm can be making supernormal profits and so the AC curve can be below the MR (AR) curve. This will only be true in long-run equilibrium.e) No, that's not right. In short-run equilibrium the firm can be making supernormal profits and so the AC curve can be below the MR (AR) curve. This will only be true in long-run equilibrium.f) Yes, that's correct. The MC curve will be upward sloping, not horizontal. It is the MR curve that is horizontal.f) No, that's not right. The MC curve will be upward sloping, not horizontal. It is the MR curve that is horizontal.
Check your answer

4

Shut down price

Select appropriate options in the paragraph below to make up a suitable description of the shut-down price.

A firm may make a in the short run, providing is being covered and some contribution is being made to the fixed cost. If a firm is at least unable to cover its in the i.e. its day-to-day running costs, it will shut down immediately. In the the firm will need to at least break-even or make a if it is to survive.

Yes, that's correct. Well done.No, that's not right. Have another go.Your answer has been saved.Check your answer

Monopoly and oligopoly - short answer

Monopoly and oligopoly - introduction

Question 1

Explain the difference between a monopoly industry and an oligopoly.

Question 2

Examine the factors which might give a firm a degree of monopoly power in a market consisting of several suppliers.

Question 3

What are barriers to entry, and why do monopoly suppliers spend so much time in establishing and maintaining them?

Question 4

Evaluate the following proposition:

'All monopolies are bad for the consumer and the economy, so should be strictly controlled'

Question 5

A car is a car, so how do car companies compete effectively?

Question 6

Why do some industries, like the manufacture of aircraft engines, become highly concentrated, but the market for meals (restaurants) remains highly fragmented?

Question 7

Explain the differences between internal and external growth.

Question 8

Why do firms try to expand and grow?

Question 9

Explain the differences between a price taker and a price setter (maker).

Question 10

What factors affect the ability of a firm to expand?

Question 11

From where does a firm derive monopoly power?

Question 12

Many firms exist in the business world that operate in two sectors of the market, but very few operate in all three (primary, secondary and tertiary). Suggest why this is so.

Question 13

Describe the various ways in which firms compete to increase their market share

Question 14

Is such competition (see question 13) always in the interest of the consumers?

Monopoly - short answer

The model of monopoly

Question 1

Explain the meaning of the phrase 'the monopolist is constrained by the demand curve for the product'.

Question 2

Discuss the statement 'monopoly is always bad'.

Question 3

Discuss the statement 'monopoly is always inefficient'.

Question 4

Explain why, if a monopolist takes over a perfectly competitive industry and takes advantage of no economies of scale, then the monopolist will reduce the quantity available for sale and at the same time raise the price.

Question 5

Look at the data below, which gives the total revenue schedules for firms. Which company, A, B, C or D, is a monopolist?

Sales 1 2 3 4 5
Firm A 10 20 30 40 50
Firm B 100 190 270 340 400
Firm C 200 400 600 800 1000
Firm D 100 200 300 400 500


Question 6

Look at the data below, which gives the market shares for 4 different firms. Which company, A, B, C or D, is unlikely to have any monopoly power?

Company A B C D
Market share 65% 45% 25% 12%


The model of monopoly - self-test questions

1

Monopoly

Choose appropriate options below to make up an appropriate paragraph describing the characteristics of monopoly.

Under , can only exist in the , as in the new firms are attracted into the industry and the abnormal profits are competed away as the market supply curve shifts to the right and the market price falls. However, under new firms are unable to enter the market as there are various which are the very source of monopoly power. Thus a single firm may remain the only supplier, and supernormal profits may persist in both the short and long run; in monopoly, there is therefore no distinction between short and long run equilibrium.

Yes, that's correct. Well done.No, that's not quite right. Have another go.Your answer has been saved.Check your answer

2

Monopoly

Which of the following are true in monopoly?

a)
b)
c)
d)
e)
f)
a) Yes, that's correct. The monopolist can set EITHER price OR output but not both.a) No, that's not right. The monopolist can set EITHER price OR output but not both.b) Yes, that's correct. The monopolist can make supernormal profits in both the short run and long run thanks to barriers to entry.b) No, that's not right. The monopolist can make supernormal profits in both the short run and long run thanks to barriers to entry.c) Yes, that's correct. The monopolist faces the market demand curve.c) No, that's not right. The monopolist faces the market demand curve.d) Yes, that's correct. Though a monopolist CAN make supernormal profits, these are not guaranteed.d) No, that's not right. Though a monopolist CAN make supernormal profits, these are not guaranteed.e) Yes, that's correct. Barriers to entry enable the firm to protect their supernormal profits in the long run.e) No, that's not right. Barriers to entry enable the firm to protect their supernormal profits in the long run.f) Yes, that's correct. The monopolist will always produce on the section of the demand curve that is elastic.f) No, that's not right. The monopolist will always produce on the section of the demand curve that is elastic.
Check your answer

3

Output levels - Monopoly

At which output level in the diagram below will the monopolist produce to maximise profits?

a)
b)
c)
d)
e)
Please select an answerYes, that's correct. Profits are maximised where MC=MR.No, that's not right. This is the point where the firm will be productively efficient (minimum of average cost).No, that's not right. This is the point where the firm will be allocatively efficient (MC=price).No, that's not right. This is where total revenue will be maximised (MR=zero).No, that's not right. This is where the firm will make normal profits (AC=AR).
Check your answer

4

Output levels - Monopoly

At which output level in the diagram below will the monopolist produce to maximise revenue?

a)
b)
c)
d)
e)
Please select an answerNo, that's not right. Profits are maximised where MC=MR.No, that's not right. This is the point where the firm will be productively efficient (minimum of average cost).No, that's not right. This is the point where the firm will be allocatively efficient (MC=price).Yes, that's correct. This is where total revenue will be maximised (MR=zero).No, that's not right. This is where the firm will make normal profits (AC=AR).
Check your answer

Economic efficiency - short answer

Economic efficiency in pc and monopoly

Question 1

Explain the differences between allocative and productive efficiency.

Question 2

Why does perfect competition give efficient allocation of resources?

Question 3

What cannot be available in a perfectly competitive industry?

Question 4

Why, in spite of an efficient allocation of resources, may perfect competition not be a good thing for the consumer?

Question 5

Explain the differences between static and dynamic efficiency.

Question 6

Explain the differences between competitive and concentrated markets.

Question 7

What is meant by economic efficiency?

Question 8

Can monopolies ever be efficient?

Oligopoly - short answer

Question 1

Explain why price competition is rare in oligopoly.

Question 2

Explain the phenomenon of sticky prices in an oligopolistic market.

Question 3

Explain two models of an oligopolistic market.

Question 4

Why is it often considered that firms in oligopoly will collude over prices and form cartels and other forms of price fixing?

Question 5

Why is it difficult to break into an oligopolistic market?

Question 6

Discuss the various factors which a firm in an oligopolistic market is likely to take into account when deciding upon the price to charge for its product.

Contestable markets - short answer

Question 1

Discuss how some barriers to entry can be considered as legitimate, or earned.

Question 2

Discuss the theory and practice of contestable markets.

Question 3

Discuss the desirability of hit-and-run competition.

Question 4

What are sunk costs?

Question 5

If a monopoly market became contestable, what changes might you expect to see in its performance and behaviour?

Price discrimination - short answer

Question 1

Explain how a motorcar manufacturer may practice price discrimination.

Question 2

What does a monopolist have to ensure does not happen if it wants the process of price discrimination to work?

Question 3

For price discrimination to work successfully the supplier will have to divide the market into at least two sections or segments. What characteristics do these segments have to have for the procedure to work?

Question 4

Who gains from price discrimination?

Question 5

Discuss how price discriminating monopolists stop products or services leaking from one market to another.

Theory of firm - essay

Question 1

(a) Explain why only normal profit may be earned in the long run in perfect competition

(b) Evaluate the view that the main goal of firms will always be that of profit maximisation.

Section 2.3 Theory of the firm - in the news (HL Only)

In this section are a series of questions on topical issues in relation to the topic - Theory of the firm.





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The big giveaway

Read the article The big giveaway and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Explain what is meant by the term 'freeconomics'.

Question 2

How can firms afford to make goods and services available for free?

Question 3

"Anderson's idea is that the internet, by reducing marginal costs, encourages businesses to make their money by offering free goods or services to an extent we have not witnessed before". Discuss the extent to which doing business over the internet reduces marginal costs.

Fixing it transparently

Read the articles Glassmakers fined record 1.4bn euros for price-fixing by European regulators and Europe fines glassmakers record 1.4bn euros then consider answers to the questions below. You can either read the articles in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Explain what is meant by a cartel and how it is able to increase the profits of its members.

Question 2

What market conditions are most likely to lead to the formation of a cartel?

Question 3

Evaluate two policies that can be used by governments to prevent price-fixing.

Section 2.3 Theory of the firm - simulations and activities (HL only)

In this section are a series of simulations and activities on the topic - Theory of the firm.





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AnimateIT - Short-run total cost curve

In this section we look at an animated version of the short-run total cost curves. It is worth going through this to see how the diagram is built up.

Total cost curves

DragIT - Revenue curves (1)

The demand curve for product Z is drawn below. Drag the orange dot, (located at the origin) to where you think is the correct price and quantity combination that would return maximum total revenue (TR) (as you do this the corresponding marginal revenue curve will appear).

1

Revenue curves

What is the price charged by the firm to generate maximum revenue?

The maximum revenue will be at a price of 14. The marginal revenue curve should be twice the slope of the demand curve. The demand curve crosses the axis at 14 units and so the MR curve should cross the axis at 7 units of output. This is the point where total revenue is at a maximum (any increase in output will mean negative marginal revenue and therefore a reduction in total revenue). At this level of output, the demand curve shows that the firm is charging a price of 14.Check your answer

2

Revenue curves

What will be the value of the total revenue received by the firm if they choose to maximise revenue?

Yes, that's correct. Well done. To maximise revenue the firm will sell 7 units at a price of 14 each. This will give them a total revenue of 98.No, that's not right. To maximise revenue the firm will sell 7 units at a price of 14 each. This will give them a total revenue of 98.Your answer has been saved.Check your answer

DragIT - Revenue curves (2)

A change in the firm's output represents a movement along the demand curve (AR) and a movement along the TR curve. A shift in the demand curve would cause the total revenue curve to shift too.

The diagram below shows the current demand curve and marginal revenue curve (AR1and MR1 respectively) for product Z. Demand for this product falls by two units at all prices.

(a) Click on the points where the demand curve crosses the two axes in order to construct the new demand curve.

(b) Now click on the two points where the MR curve crosses the two axes in order to construct the new MR curve.

You may like to check your answer.

1

Revenue curves

What is the new price charged by the firm to generate maximum revenue? (For the AR2 and MR2 curves)

The maximum revenue will, following the shift of the AR and MR curves, be at a price of 12. The marginal revenue curve should be twice the slope of the demand curve. The demand curve now crosses the axis at 12 units and so the new MR curve should cross the axis at 6 units of output. This is the point where total revenue is at a maximum (any increase in output will mean negative marginal revenue and therefore a reduction in total revenue). At this level of output, the demand curve shows that the firm is charging a price of 12.Check your answer

2

Revenue curves

What will be the value of the total revenue received by the firm following the shift of the demand curve to AR2 if they choose to maximise revenue?

Yes, that's correct. Well done. To maximise revenue the firm will sell 7 units at a price of 12 each. This will give them a total revenue of 72.No, that's not right. To maximise revenue the firm will sell 6 units at a price of 12 each. This will give them a total revenue of 72.Your answer has been saved.Check your answer

PlotIT - Profit maximisation

As we saw earlier, profit maximisation will occur for a firm where MC=MR. The following diagram shows the costs and revenues for a product Y over a range of output from zero to 80 units per week. Product Y is one of many products produced by the firm. The fixed costs associated with producing Y are 120 per week, 60 of which is normal profit.

What happens when the demand for a firm's product changes? How will this affect the profit maximising price and output? The following diagram is the same as the one above. It shows the cost and revenue curves for firm X in the production of good Y.

Now assume that a close competitor of product Y has dropped the price of its product. As a result demand for product Y changes by 15 units per week.

In the diagram below, click on the two points in turn where the new AR curve strikes the axes. Then do the same for the MR curve.

You may like to check your answer.

1

Shift in demand

Given the drop in demand faced by the firm, what is the new equilibrium profit maximising output and price? How much profit is the firm making at this equilibrium?

The new equilibrium output will be at 25 units (where MR = MC - profit maximising).The equilibrium price will be 12.00.

At this equilibrium, the firm will be making just normal profit, since AR = AC. In other words, supernormal profit is zero.

Check your answer

DragIT - Perfect competition

It should now be clear that the amount of profit or loss that the firm makes will depend on the market price.

In the diagram below drag the price up and down to see the impact of these price changes. Note that the vertical dotted line represents the profit-maximising or loss-minimising output, where MC = MR.

1

Perfect competition - equilibrium

When the firm in perfect competition is making supernormal profits, they are in long-run equilibrium.

a)
b)
Yes, that's correct. The statement is false. If supernormal profits are being made in perfect competition, this will attract new firms into the industry until the supernormal profits are competed away. In long-run equilibrium in perfect competition, there will therefore be just normal profits.No, that's not right. The statement is false. If supernormal profits are being made in perfect competition, this will attract new firms into the industry until the supernormal profits are competed away. In long-run equilibrium in perfect competition, there will therefore be just normal profits.Your answer has been saved.
Check your answer

2

Perfect competition - shut-down point

If the price falls below the level of AVC the firm in perfect competition will cease production.

a)
b)
Yes, that's correct. The statement is true. A firm in perfect competition will cease production when price falls below average variable cost as they will make less of a loss if they cease production and pay just their fixed costs.No, that's not right. The statement is true. A firm in perfect competition will cease production when price falls below average variable cost as they will make less of a loss if they cease production and pay just their fixed costs.Your answer has been saved.
Check your answer

AnimateIT - Perfect competition

In this section we look at animated versions of the perfect competition diagrams. It is worth going through this to see how the diagrams are built up.

Perfect competition - short run supernormal profits

Perfect competition - short run losses

Perfect competition - firm and industry

DragIT - Monopoly (1)

The amount of profit that the firm under monopoly makes depends on (a) demand, and hence the position of the AR and MR curves; (b) costs, and hence the position of the AC and MC curves.

In the diagram below, drag the average and marginal cost curves to see the impact that changes in cost will have on the firm's profitability.

1

Monopoly equilibrium

If AC is greater than AR where MC=MR, then the monopolist will be making a loss.

a)
b)
Yes, that's correct. The statement is true. If the monopoly is maximising profits (MC=MR) and the average cost is great than the price (average revenue), then the firm will be making a loss. Try it on the above diagram.No, that's not right. The statement is true. If the monopoly is maximising profits (MC=MR) and the average cost is great than the price (average revenue), then the firm will be making a loss. Try it on the above diagram.Your answer has been saved.
Check your answer

2

Monopoly - equilibrium

Where the AC is tangential to the AR curve the monopolist will be making supernormal profit.

a)
b)
Yes, that's correct. The statement is false. If the AC is tangential to the AR (just touching it), then the monopolist is making just normal profit.No, that's not right. The statement is false. If the AC is tangential to the AR (just touching it), then the monopolist is making just normal profit.Your answer has been saved.
Check your answer

DragIT - Monopoly (2)

The diagram below shows the profit-maximising price and output of a firm facing a downward-sloping demand curve. Show the effect on price and output of a rise in demand by dragging the AR and MR curves. Do this by clicking on the 'MR1' label and dragging it vertically up and down.

Now click on the top of the MC curve and, by making it steeper or flatter, show the effect on Q and P after the AR curve has been dragged to the right.

Download the Flash player

AnimateIT - Monopoly

In this section we look at animated version of the monopoly diagram. It is worth going through this to see how the diagram is built up.

Monopoly equilibrium

DragIT - Welfare loss under monopoly

Deadweight welfare loss depends on the degree of monopoly power, which in turn depends on the price elasticity of demand for the monopoly's product.

To see how the deadweight welfare loss changes as the price elasticity of demand changes, drag the handle at the end of the AR curve (i.e. the demand curve) in the diagram below. The deadweight welfare loss is represented by the shaded area. As demand becomes more elastic, so the deadweight welfare loss decreases.

AnimateIT - Monopolistic competition

In this section we look at animated versions of the monopolistic competition diagrams. It is worth going through these to see how the diagrams are built up.

Monopolistic competition - short run supernormal profits

Monopolistic competition - short run to long run

Section 2.4 Market failure - notes

Market failure is a situation in which the free market leads to a misallocation of society's scarce resources in the sense that either overproduction or underproduction of a particular good occurs, leading to a less than optimal outcome.

Reasons for market failure

The reasons for market failure include:

In this section we consider the following topics in detail:





To start looking at these topics, click on the right arrow at the top or bottom of the page. To get back to the table of contents at any stage, simply click on the 'home' icon at the top or bottom of the page.

Positive and negative externalities

What are externalities?

Externalities are costs (negative externalities) or benefits (positive externalities), which are not reflected in free market prices. Externalities are sometimes referred to as 'by-products', 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the generator of the externality, either producers or consumers, or both, impose costs or benefits on others who are not responsible for initiating the effect. The key feature of an externality is that it is initiated and experienced, not through the operation of the price system, but outside the market.

Proponents of laissez-faire would argue that externalities particularly arise because of the absence of markets - as no markets exist for such things as clean air and seas, beautiful views or tranquillity, economic agents are not obliged to take them into account when formulating their production and consumption decisions, which are based on private costs and benefits i.e. those which are internal to themselves. Another way of putting this is to say individuals have no private property rights over such resources as the air sea and rivers, and thus ignore them in making their production and consumption decisions.

Property rights refer to those laws and rules which establish rights relating to:

Thus a firm may feel free to dump effluent into a river as the spoiling of the environment and the killing of fish is not a cost which it would directly have to bear. Those on the political left would be more likely to argue that such an externality would arise because of the market system which is based upon the private ownership of resources, with individuals acting in their own self interest and therefore not having to consider what is in the public interest i.e. the problem is due to an absence of communal property rights and of a system of planned production.

The above example of an externality is one which is commonly cited, but it is important to establish at this stage that there are various types of externalities and that they can be classified in different ways: they can arise from acts of consumption or production, and can thus be production, consumption or mixed externalities, and, as previously mentioned they can be experienced as external costs (negative externalities) or as external benefits (positive externalities).

Figure 1 below summarises the different possibilities and provides some examples. It can be seen from this table that there are in fact four different varieties of externality:

A) a production externality: initiated in production and received in production;
B) a mixed externality: initiated in production, but received in consumption;
C) a consumption externality: initiated in consumption and received in consumption;
D) a mixed externality: initiated in consumption, but received in production.

Each of these are sub-divided into two, according to whether they are experienced as an external cost or as an external benefit, giving a total of eight varieties.

Figure 1 The various kinds of externality

In practice, the most important externalities are those which affect the environment, and it is these which have received widespread adverse publicity in recent years, and which have prompted the rise of 'green' pressure groups and political parties. Indeed, so great has been the impact of environmental pollution, that in addition to the externalities identified in figure 1, we can also, in a global context, identify externalities which are transmitted from one country to another, and which may be mutually damaging; for example, the Chernobyl nuclear disaster in 1986 in Russia, not only contaminated the local area, but also polluted other parts of Europe; emissions of acid rain from West European nations not only harm the environment in the initiating countries, but also wreak havoc on the forests, lakes and rivers of the Scandinavian countries.

Task 1

Try adding a further example of your own to each of the eight types of externality given in figure 1.

Task 2

Try matching the following examples of externalities to each type of externality in figure 1. (Hint - there is one example of each). Once you have had a go, have a look at our answer to see how you got on.

  1. A person smoking a pipe at a football match causes the person sitting behind to passively smoke.
  2. A large retail organisation attracts numerous extra customers to its store, some of whom spend money in other shops in the vicinity.
  3. Children are taken to school by car instead of walking or using public transport. This worsens congestion and raises the production costs of firms.
  4. Owner occupiers in a particular area take measures to increase the value of their properties. Estate agents benefits from the extra commission earned when the houses are sold.
  5. Juggernauts (large trucks) travel through inner city areas, causing traffic congestion for other commercial road users which raises their production costs.
  6. A power station belches black fumes into the air which discolours the paintwork of nearby houses.
  7. Farmers provide pathways in the countryside which benefit walkers.
  8. A private gardener plants an assortment of beautiful plants in her front garden and enhances the environment for her neighbours and passers-by.

Task 2 - suggested answers

How do externalities affect allocative efficiency?

Given the existence of perfect competition, allocative efficiency would automatically occur where price equals marginal cost in all markets, assuming that neither negative nor positive externalities are present.

So, how do externalities affect our condition for efficiency? We will consider the oft quoted case of a firm which discharges its waste products into a river. Such a firm would be treating the environment as a free resource, and would be imposing a cost on society as a whole, rather than just on the consumers of the good. The price charged to consumers would not therefore, in this instance, reflect the true cost of the product; if the firm were compelled to install equipment which could treat its effluent and render it harmless to the environment, its production costs and prices would rise and consumers would, as a consequence, reduce their demand for the product in question. Resources would then be reallocated to other lines of production.

In this case there is a divergence between private and social cost.

Similarly, if the firm's production decisions were to generate positive externalities, such as the beneficial effects arising from the provision of employment, then there would be a divergence between private and social benefit.

Social cost

Social cost is the private, internal cost plus the value of negative externalities.

Social benefit

Social benefit is the private, internal benefits plus the value of positive externalities.

Now, the significance of this analysis is that allocative inefficiency will occur if private cost or benefit diverges from social cost or benefit. Where externalities exist the condition for allocative efficiency is that price = social marginal cost = social marginal benefit i.e. the price must equal the true marginal cost of production to society as a whole, rather than just the private marginal cost.

We will now illustrate the above in relation to the firm discharging waste into the river. Have a look at Figure 1 below.

Figure 1 Negative externalities causing market failure

The firm's demand curve indicates the value that consumers place on each additional unit of the good and it is thus the private marginal benefit curve. If no positive externalities are present, it would also be the same as the social marginal benefit curve.

The marginal private cost curve indicates the cost of producing an additional unit of output.

If no negative externalities were present, output would settle at OQ, and allocative efficiency would be achieved. However, the dumping of waste into a river imposes an external cost on society as a whole, for which the firm would not have to pay. Clearly, if the firm had to pay the full social cost of its production activities, the additional cost would shift the supply curve, or private marginal cost curve, to the left. Thus S1 represents the social marginal cost, the vertical distance between the two supply curves indicating the value of the negative externality, or the marginal external cost. The intersection of S1 and D would indicate a reduced level of output at OQ1. However, if the firm did not pay for the external cost caused, MSC would be greater than price, and over-production, over-consumption and a misallocation of society's scarce resources would occur.

Conversely, if the production of a good conferred net positive externalities on society, then there would be under-production and under-consumption at the free market price and again a misallocation of resources. This is illustrated in Figure 2 below.

Figure 2 Positive externalities causing market failure

In Figure 2, S is the private marginal cost curve, and as it is assumed that there are no negative externalities, it is also the social marginal cost curve. If positive production externalities are generated, for which producers receive no payment e.g. the beneficial 'knock-on' effects of higher employment, the social marginal benefit would exceed the private marginal benefit. The curve D (private marginal benefit) would shift to D1 (social marginal benefit), the vertical distance between the two curves representing the value of the positive externality, or marginal external benefit at each level of output. The socially optimum level of production would be at OQ2 where MSB=MSC. However, if the firm were to ignore the external benefit, which it is likely to do on account of receiving no payment for it, an output of OQ1 is likely to arise which is less than socially desirable.

Hence externalities cause market failure:

The economic theory of traffic congestion

Figure 1 below shows how the analysis of externalities that we looked at in the previous section can be applied to the problems of traffic congestion.

Figure 1 Road transport, congestion and economic theory

Economic theory can be used to analyse the issues involved in traffic congestion as shown here. Figure 1 indicates the relationship between the cost of travel and the flow of traffic along a particular route. The essence of this theory is based on the fact that, when making a journey by car, a motorist only considers the marginal private cost (MPC). This is the cost directly attributable to him/herself, such as time, fuel and the maintenance of the vehicle, rather than the full cost of the journey, which may include costs imposed on society such as pollution, noise and time lost due to congestion. When added to the private costs, these are termed the marginal social costs (MSC), the difference between the two representing the externality imposed by the motorist.

In outlining the theory, it is assumed that, when making a journey, congestion is the only externality. The graph represents the demand for travel along a particular stretch of road over a period of time. Up to a flow of traffic F0, there is no congestion, thus there is no divergence between MPC and MSC, although in reality, such a situation only applies to extremely low volumes of traffic.

As the flow of traffic increases above F0, congestion is apparent and there is a divergence between MSC and MPC. Note that the MSC is equal to the MPC, plus the social cost of congestion.

If the demand for travel on this particular route is of the normal shape (represented by D on the graph) and is a measure of the marginal benefit, then the flow of traffic will be determined by the intersection of the demand curve and the MPC curve at F1 and the private cost to the motorist will be b. At a flow of F1, the external cost, not taken into account by the motorist, is ab (the difference between the MPC and MSC). This means that resources are not being allocated efficiently and that individuals are making more journeys than they would if they were aware of the full social costs.

To get some up to date examples on traffic congestion, try searching the Biz/ed In the News archive. You can do this in the window below.

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Possible government responses to externalities

The outstanding characteristic of a market economy is that production does not occur as a result of some grand, master plan; rather, it is the result of the pulls and pushes of supply and demand, of the numerous uncoordinated decisions of individuals and firms. As individuals are assumed to seek to maximise their own satisfaction, and firms their own profits, decisions made are likely to be strictly on the basis of private costs and benefits, and, as previously explained, herein lies the problem: unless the full social costs and benefits of production and consumption decisions are taken into account, so that MSC is equated to MSB, social inefficiency and a misallocation of society's scarce resources will result.

So, what measures can a government take to rectify such inefficiency, and how successful is it likely to be? As is the case with most important questions in economics, a range of answers are possible, depending largely on the political perspective of the respondent. At one end of the spectrum, governments could 'leave well alone', essentially not interfering with markets but trying to gently persuade firms and individuals to modify their behaviour. At the other extreme, the market could be completely replaced by direct government provision, and in between various policy options are possible. We now turn to an examination of some of these options.

In practice it is the problem of production externalities, particularly environmental ones, which most occupy the attention of governments, and our discussion will mainly, but not exclusively, focus on these.

The main measures that governments can take will be considered in the next few sections and include:

Click on the right arrow at the top or bottom of the page to start looking at each of these approaches in more detail.

Direct government provision

Direct provision of goods and services by the government

The existence of externalities provides an important argument for the common ownership, or nationalisation of a number of key industries.

The argument is that privately owned firms, in order to survive in a competitive world, necessarily have to put their own interests before those of society at large, for to do otherwise might be inconsistent with the goal of long run profit maximisation, or even survival. This harsh reality of the market is likely to manifest itself in the generation of negative externalities such as pollution, as the control of these externalities would involve higher costs and an adverse impact on profits; conversely, production activity which conferred net positive externalities on society might not be undertaken in sufficient quantities if the criterion of private profitability could not be met.

Nationalised industries, on the other hand, which, on account of being commonly owned, could be operated according to broad social criteria, rather than the narrow commercial one of private profitability, and this allows for the possibility of externalities to be fully incorporated into production decisions. Thus, for example, questions of workers' safety standards and atmospheric pollution could be accorded priority status, rather than being ignored on the grounds that to do otherwise would adversely affect profits and competitiveness; and activities such as the keeping open of 'uneconomic' pits and the provision of postal and transport services to remote outlying areas, could all be maintained on the grounds that they provide substantial positive externalities to society at large, although not necessarily being profitable in the sense that the private revenues from such activities exceed the private costs.

Similarly, an important argument for merit goods such as education and health being directly provided by the government rather than through the market, is that they not only confer private benefits on individuals but also significant positive externalities on society as a whole which individuals would tend to ignore when making their consumption decisions. As a result, left to the market, under-provision is likely to occur; for example, individuals would be prepared to buy education through the market if they had to, as substantial private benefits, such as higher life-time earnings, are likely to result; however, a case for a higher level of government provision can be made on the grounds that not all the benefits accrue solely to the individual - society gains from a more efficient and adaptable labour force and perhaps a more tolerant and more aware population. The issue of merit goods is considered in the rest of this unit.

The above arguments for direct government provision would of course be strongly contested by free market economists who would argue the case for privatisation, the desirability of using markets to provide merit goods and the extremely poor record of pollution control of the formerly centrally planned economies of Eastern Europe.

Extension of property rights

Property rights concern the legal entitlement to property and the right to use or sell the property, as well as the rights that other people have, or do not have, over the property. It is argued that negative externalities in particular arise because of the existence of incomplete property rights over natural resources such as air, land, rivers and seas i.e. as property rights are not fully allocated to these areas as nobody really owns them, individuals and firms are free to impose external costs from their production and consumption activities without having to pay any compensation. The dumping of toxic wastes into the sea and the riding of a noisy motorbike provide two examples.

Thus by extending property rights individuals would be able to stop others imposing costs on them or to claim compensation if they did so. A person purchasing a house, for example, could also acquire a set of 'amenity' rights which would entitle the owner to peace and quiet in the vicinity of the property as well as a supply of water and air of a reasonable quality. Any infringement of such rights e.g. by neighbours playing heavy metal music unduly loudly, or juggernauts emitting excessive exhaust fumes into the air, would give the owner of the amenity rights entitlement to compensation. In this case the externality would be internalised as the initiators of the external costs would be forced to pay for them, and adjust their production/consumption decisions to more socially efficient levels.

However, there may be a number of problems with this solution in practice:

Taxes and subsidies

The use of taxes and subsidies to tackle the problem of externalities is a market-based method of control as it works through the price system, i.e. through the impact of changes in prices.

If negative externalities exist, and there is allocative inefficiency at the free market price because SMC is greater than price and overproduction is occurring, then the appropriate solution would be to tax the good; if, on the other hand, the market is under-producing because positive externalities are not being taken into account, it would be appropriate for the government to grant a subsidy. We shall consider each in turn:

Taxes

There are two types of tax which may be applied to address the problem of negative externalities: a tax set equal to each firm's marginal external costs and an environmental or 'green' tax.

The policy of taxing firms according to the marginal external costs that they impose on society can be illustrated using figure 1 below. In this example we assumed that a firm was dumping waste products into a river. The government would have to assess the cost to society of such an action, and impose a tax on the offending firm equal to the value of the marginal external cost (or negative externality); in this case the tax would internalise the externality by making the polluter pay. The levying of such a tax would shift the supply curve from S to S1,which would increase the market price to OP1, and cause the level of output to fall to OQ1, where P = SMC and allocative efficiency is achieved.

Figure 1 Negative externalities - dumping of waste

An environmental tax could be imposed either on a product responsible for creating pollution, or on the inputs to an industry which have caused environmental damage e.g. carbon producing fuels, which are believed to play the major role in the process of global warming. The aim of a carbon tax on each unit of carbon in fossil fuels would be to: raise the price of those sources of power with high carbon contents, thus encouraging a switching to power sources causing lower CO2 emissions; encourage greater conservation of energy in general; and stimulate the search for more environmentally-friendly technologies.

Subsidies

Whilst a tax may be imposed on generators of negative externalities, a subsidy may be granted to generators of positive externalities to ensure a higher level of consumption and production than would arise through the completely free interaction of market forces. This is illustrated in figure 2 below. In this case the government would have to assess the value of the marginal external benefit (i.e. the positive externality) to society and give a subsidy equivalent to this amount. If the good in question were loft insulation which confers benefits on society in terms of energy conservation, households prepared to lag their lofts could be given a grant, and this would shift the demand curve D=PMB to the right to D1=SMB. Allocative efficiency is achieved as SMB = SMC at OQ1. A similar result could be achieved by subsidising the output of loft insulation which would cause the supply curve to shift to the right until the socially optimum level of production is reached.

Figure 2 Positive externalities - loft insulation

Issues arising from the tax/subsidy approach

Advocates of this approach would argue that it permits the forces of demand and supply to operate. At the same time generators of negative externalities are induced to 'clean-up their act' because the less pollution they create, the less their tax liability; and conversely, grants and subsidies encourage greater output and consumption of those goods involving net social benefits.

In practice various difficulties are likely to arise:

Tradeable pollution rights

Like the use of taxes and subsidies, tradeable pollution rights (otherwise known as tradeable emission allowances or permits), represent another market-based solution to the problem of negative externalities, in particular pollution. They were first introduced in the USA in 1990 under the Clean Air Act in which the Environmental Protection Agency set a target rate of reduction for power stations' emissions of sulphur dioxide. Initially, power stations were issued with emission permits in proportion to their current pollution levels and were allowed to discharge pollution into the air up to a specified limit. Thereafter, those power stations for whom the cost of reducing pollution was low, could sell their spare pollution permits to generators for whom the cost of pollution abatement, through the installation of appropriate equipment, would be very high. Thus, a market in tradeable pollution rights is created, stimulating pollution reduction through the possibility of making money out of selling surplus permits.

Tradeable pollution rights

Tradeable pollution rights are emission allowances or permits which can be traded between organisations whose operations generate pollution.

The main argument in favour of such a scheme is that it operates through the market via the price system: firms are given a profit incentive, i.e. through the right to sell spare permits, to find cheap ways of reducing their pollution levels; and such a system should be administratively cheap and simple to implement , as the regulatory agency need have no information regarding firms' costs - it simply has to issue the permits and arrange for their sale; in addition, consumers may benefit if the extra profits made by low pollution power stations, arising from the sale of their spare permits to other companies, are passed on in the form of lower prices.

The main argument against the use of tradeable emission permits is that they do not actually stop firms from polluting the environment; they only provide an incentive to so - where a degree of monopoly power and relatively inelastic demand exist, the extra cost of purchasing additional permits so as to further pollute the atmosphere, could easily be offset by the possibility of charging consumers higher prices; moreover, the system of allocating permits in accordance to existing emission levels could be seen as a reward for the greatest polluters!

To get some up to date examples on tradeable permits, try searching the Biz/ed In the News archive. You can do this in the window below.

Regulation, legislation and direct controls

In practice the use of direct controls represents the most common approach to pollution abatement. Such controls can be applied both to individuals and firms and can take a number of forms; for example, restrictions can be imposed on smoke emissions from private homes and firms; restrictions may be placed on all forms of building in designated green-belt areas; minimum environmental standards may be stipulated for air and water quality; laws may be passed to prevent drinking and driving and the sale of alcohol and tobacco to people under a certain age.

Apart from restriction, direct controls can also be used more severely: activities generating negative externalities could be banned completely; for instance, the dumping of waste into rivers or the sea; or an activity which conferred net positive externalities on society could be made compulsory; for example, all children under the age of 16 in the UK must by law receive some form of education, whether it be in a state school, a private school or at home and this is true in many other countries as well.

The main advantage of regulation is that it is the most direct way of tackling the problem of externalities; for example, market-based solutions such as taxes and tradeable emission permits provide incentives to firms to reduce their pollution levels but do not compel them to do so; as such problems as global warming and the depletion of the ozone layer are thought by many to threaten the very survival of our planet, it is argued that we cannot afford to trust our futures with policies which allow for the possibility of non-compliance. Providing legal restrictions are backed by inspections which are sufficiently regular and rigorous, they should be effective.

Against this, it is argued that in reality the policing of regulations can present great difficulties as the less environmentally conscious firms may attempt to circumvent the controls e.g. through the generation of pollution during the night. Thus an extremely large number of inspectors might have to be employed to ensure compliance.

It is also claimed that regulation can be a rather blunt, indiscriminate instrument of control; for example the setting of maximum emission limits does not take into account the fact that the cost of reducing pollution would vary considerably as between different firms, some facing high costs with others facing low costs. Thus a uniform limit applied to all firms would be an inefficient way of reducing pollution, implying as it would a high resource cost. Also it may be the case that once emission targets have been achieved, there would be no further incentive to continue to reduce pollution, as would be the case with a pollution tax.

Regulation may also give rise to the problem of regulatory capture - those being regulated may be successful in manipulating the regulatory body to act in accordance with the private interests of the firms concerned, rather than in the interests of society as a whole.

Public goods

What are public goods?

Pure public goods are ones that when consumed by one person can be consumed in equal amounts by the remainder of society, and where the possibility of excluding others from consumption is impossible.

Examples of public goods are:

It is likely that the market, left to itself, will seriously under-produce such goods, or possibly not produce them at all. This is because the market will only provide goods for which a profit can be made, and pure public goods possess two important properties that together make their production on the basis of private profitability extremely difficult. These features are:

Firstly, consider the characteristic of non-rivalry: this means that one person's use of the public good does not deprive any other person of such use or does not diminish the amount available to others; for example, if one person enjoys the benefits of being protected by the police-force, a flood control dam or the national defence system, it does not prevent everyone else doing the same; similarly, if one person benefits from walking along a street at night-time which is paved, free of pot-holes, and well-lit, the benefits and the availability to others would not be diminished.

Secondly, consider the characteristic of non-excludability: this means that when the public good is provided to one person, it is not possible to prevent others from enjoying its consumption - sometimes summarised as: provision at all means provision for all; thus, if a police force, a flood- control dam or a national defence system is successful in offering protection to citizens of a country, once it has been provided it is impossible to exclude anyone within the country from consuming and benefiting from such goods; similarly, for a paved and well-lit public street - nobody can be prevented from enjoying its benefits.

The concept of a 'public good' can perhaps best be understood by comparing it with its opposite, a private good.

A private good possesses two features, excludability and rivalry, and when consumed by one person, it is not available to others; thus, a person buying a new washing machine can exercise private property rights over it and exclude others from enjoying its cleaning abilities, whilst, at the same time, diminishing the total stock of washing machines available for sale to others.

Thus, in the case of public goods,the market fails because the private sector would be unwilling to supply them - their non-excludabilty makes them non-marketable, because non-payers cannot be prevented from enjoying the benefits of consumption, and therefore prices cannot be attributed to particular consumers. This involves the free-rider problem, which arises when it is impossible to provide a good or service to some without it automatically and freely being available to others who do not contribute to its cost. For example, imagine a situation in which you shared an island with five other inhabitants; if you paid privately for an army to defend the island against violent invaders, your five co-inhabitants could 'free-ride' off you by enjoying the benefits of the defence, without having to pay anything towards it; there would probably come a point when you would withdraw your payments and, like the others, leave it to someone else to foot the bill; eventually, the army would not be provided at all.

Free riders

Free riders are those who enjoy the benefits of a public good without having to pay, because it is impossible to exclude them.

Hence, in a free market, a whole range of pure public goods may not be provided, and the only answer is for the state to provide them, financed out of general taxation. Moreover, the non-rivalry aspect of public goods means that the cost of supplying one more user i.e. the marginal cost, is zero; for example, once paving stones have been laid, it makes no difference how many people walk along them as there is no additional cost involved. As the condition for the achievement of allocative efficiency is that price should be set equal to marginal cost, it would therefore follow that to achieve an optimum level of output and consumption of public goods the state should provide them at zero prices.

Non-pure public goods (quasi-public goods)

In practice, various ways may be devised for excluding free riders from the consumption of public goods, as the characteristics of non-excludabilty and non-rivalry may not be completely present. In such cases, the goods would be referred to as non-pure or quasi-public goods; for example, in the case of a motorway, various methods could be used, such as electronic tagging or toll-gates, to make users pay ( an impossibility with a pure public good), so excludabilty would be possible; and, if the motorway were to become sufficiently congested, non-rivalry would not be present i.e. as the road reaches its full vehicle capacity, as often happens in the rush-hour periods on urban motorways, each extra road user does reduce the availability of the motorway to other motorists and raises the marginal supply cost above zero. (The marginal cost would of course be zero, or near to zero, on an entirely uncongested motorway.)

Thus a non-pure public good is an example of a mixed good, which is one which has both a public and a private good content. A motorway provides an example of a public good with a private good component, and conversely it is possible to identify private goods, with a public good component e.g. driving a car is an act of private consumption, but when public transport is not available, perhaps because transport workers are on strike, car owners may offer lifts to stranded travellers creating some publicness. Hence, in practice, many public and private goods contain some mix of both.

Merit goods

What are merit goods?

Merit goods are the opposite of demerit goods - they are goods which are deemed to be socially desirable, and which are likely to be under-produced and under-consumed through the market mechanism. Examples of merit goods include education, health care, welfare services, housing, fire protection, refuse collection and public parks.

In contrast to pure public goods, merit goods could be, and indeed are, provided through the market, but not necessarily in sufficient quantities to maximise social welfare. Thus goods such as education and health care are provided by the state, but there is also a parallel, thriving private sector provision. Indeed, there is considerable disagreement between economists on the right and left of the political spectrum over the extent to which such goods should be provided by the state or the private sector. We consider these arguments later in this section.

Before we proceed with our discussion of merit goods, and in particular the question of why merit goods tend to be underprovided by the market, it would be useful at this stage to summarise the main differences between public goods, private goods and merit goods. Have a go at filling in the blank table below (we have put in a few entries to help you along). Once you have had a go, follow the link under the table to compare your answers with ours.

Main features Public goods Merit goods Private goods
Diminishability (non-rivalry) Non-diminishable (non-rivalry)
Excludability Excludable
Benefits Individual and communal (strong positive externalities)
Provider Usually private enterprise
Financed by Usually taxation
Examples


Main features of public, merit and private goods - full table

Why might merit goods be underprovided by the market?

Merit goods will tend to be underprovided by the market because:

We shall examine each of these factors in more detail in turn below:

Merit goods generate substantial positive externalities

Merit goods confer benefits on society in excess of the benefits conferred on individual consumers; in other words, there is a divergence between private and social costs and benefits, as the social benefits accruing to society as a whole from the consumption of such goods tend to be greater than the private benefits to the individual. This divergence means that the private market cannot be relied upon to ensure an efficient allocation of society's scarce resources. The problem is that individual consumers and producers make their decisions on the basis of their own, internal costs and benefits, but, from the standpoint of the welfare of society at large, externalities must be considered. This point can be illustrated in relation to health care and education:

Health care generates a number of positive externalities; for example, if all people receive adequate levels of healthcare, the nation's workforce is likely to be fitter and healthier, less working days would be lost through sickness, and this would have beneficial effects on the level of output and economic growth; vaccinations and preventative health care which prevent the spread of contagious diseases such as small-pox and whooping cough, clearly not only benefit the individuals receiving the treatment, but also the rest of society at large. Indeed, a major reason for the relatively weak economic performance of many of the poorer countries of the world is the widespread incidence of ill-health and disease amongst their populations.

Similarly, in the case of education, there are a number of positive externalities from which society at large may benefit, which may not directly accrue to the individual pupil/student. Individuals clearly derive private benefits from higher levels of education as, for example, earning capacity is to a considerable extent a function of educational attainment. However, society at large receives the benefits of a more highly skilled, adaptable and thus more efficient workforce, which is one of the key ingredients of economic success - the West German post-war 'economic miracle' has, in part, been attributed to its highly educated and trained workforce. Society also benefits in less tangible ways as it could be argued that educated people are less prone to crime and racial intolerance, although this argument is obviously not foolproof!

The important point then is that if people had to pay privately through the market for such merit goods as health and education they would consider only their private benefits and their private costs and would thus consume too little from the point of view of the best interests of society as a whole. This problem of under-consumption is illustrated in Figure 1 below.

Figure 1 Under-consumption of a merit good.

In the diagram, OQ is the free market level of consumption, as, at this point, individuals equate their private marginal benefit with their private marginal cost. The existence of positive externalities means that the social marginal benefit curve lies above the private marginal benefit curve as the social benefits of consumption exceed the private benefits. Allocative efficiency would require a level of consumption of OQ1 at which SMB = SMC.

There is an unequal distribution of income

Perhaps a more basic reason for the market tending to under-provide merit goods is that, given the highly unequal distribution of income, and the widespread poverty such as exists in most economies today, many people would be unable to afford adequate education, health care and housing in the absence of state provision or subsidy. A market system only takes effective demand into account; that is, demand backed by the ability to pay the asking price. It does not respond to human demand as indicated by peoples' needs, so quite simply the poor may have to go without. Thus, on the grounds of equity, it may be decided that such merit goods as health and education should be provided free on the basis of need rather than according to ability to pay. Underpinning this approach would be the view that all have a fundamental human right to the various merit goods, which should not be determined by the market criteria of prices and profits.

Consumers may lack perfect information

At one level, market provision of health care and education may not provide a socially optimum outcome because consumers may not be aware of all the benefits of such goods, and may behave in a foolish manner - they may choose to spend their money on demerit goods such as cigarettes, alcohol and pornography, rather than making adequate provision for their own and their children's medical and educational needs. In this case, government provision may be justified on the paternalistic grounds of protecting us against our own folly.

At another level, consumers of such goods as health care and education may have every intention of behaving wisely, but because of the particular characteristics of these goods, may not be able to do so. A basic assumption of economic theory is that consumers are aware of their own best interests better than anybody else, and providing they possess full information, will act in such a way as to maximise their satisfaction. Thus, consumers of fresh fruit will not usually experience too much difficulty in establishing the best prices available in the market, and most would be able to make fairly accurate assessments of quality merely by sight and feel; and, if an incorrect decision is made, for instance by purchasing sour satsumas which were perceived to be sweet, the consequences of such a mistaken decision are unlikely to be too catastrophic, as the amounts spent are likely to be relatively small, and the sour satsumas could simply be thrown away.

However, health care and education are considered to be different from other goods, and the sovereignty of the consumer is likely to be considerably less than in the case of fresh fruit, for instance.

A major problem of providing health care through the market is that there is likely, in the overwhelming majority of cases, to be an imbalance between the information possessed by the suppliers i.e. the doctors, and the consumers i.e. the patients: medical treatment is usually technically complex, and consumers will rarely possess sufficient information to make rational choices between the alternatives available - most would have to rely on the suppliers of medical care for their information; and it is somewhat doubtful as to whether a profit maximising supplier could always be relied upon to provide completely impartial information. Also, as many medical problems only occur once, any information acquired may be of no future use; and finally, in contrast to buying a sour instead of a sweet satsuma, any mistaken choices in the case of health care are likely to involve a far greater cost and to be considerably more difficult to reverse; for example, the consumption of poor quality facial plastic surgery.

Similarly, in the case of education , consumers, usually parents, intending to act wisely, may not be able to do so and the consequences of mistaken decisions may be extremely great; education is a multi-faceted, complex process about which there is considerable disagreement, even amongst the 'experts', and obtaining the necessary information on such variables as teachers' qualifications, examination performance, intake according to social class, the incidence of bullying and racial harassment, may be extremely time-consuming and difficult to acquire ; moreover, in the case of higher education, it is usually far more difficult for those who have not experienced it to appreciate its benefits and make wise decisions, as compared with those who have. As it is generally accepted that education is a prime determinant of life chances, future earning potential and quality of life, mistaken decisions because of imperfect information can have particularly severe consequences.

Consumers may be uncertain as to their future needs

Not only is a lack of information likely to cause market failure, but so too can uncertainty of information - particularly in the case of health care. A situation in which consumers are uncertain about future market information can lead to allocative inefficiency, with too little health care being consumed if state provision is not available. Few people are able to predict with any degree of certainty the level and type of health treatment that they will require at some point in the future, as the incidence of serious accidents or ill-health are essentially unknown variables, even for the smartest of medical practitioners. As paying through the market for an operation, hospitalisation or long-term disability would almost certainly involve exceedingly large sums of money, it would be very difficult for individuals to plan their savings and consumption so as to ensure that all future medical requirements could be met; the market in this situation is unlikely to provide the optimal quantity of health care because at the particular point in time when consumers actually need it, they may lack the wherewithal to pay the market price. Direct government provision of health care, free at the point of contact, overcomes this problem.

A possible market-based solution to this problem would be that of private medical insurance; in the same way that it is obligatory for all motorists to take out some form of car insurance, everybody could be required to purchase a minimum level of health insurance to guard against unforeseen contingencies. However, such a scheme is likely to present a number of problems:

Monopoly power may arise

Previously we demonstrated how under monopoly, price will tend to be higher and output lower compared to the case of perfect competition; and as price will be set at a level above marginal cost, and the firm is unlikely to operate on the lowest point of its average cost curve, neither allocative nor productive efficiency will occur. Thus, where monopoly occurs, the market could not be relied upon to produce an efficient allocation of resources.

If education were provided solely through the market, it is likely that spatial monopolies would arise, as various geographical areas would not be adequately populated to support more than one school, college or university i.e. monopolistic educational providers would be protected from competition by virtue of distance and such provision may lead to sub-optimality in the market.

Spatial monopoly

Spatial monopoly is monopoly power obtained by a business organisation through locating at a distance from its competitors.

Similarly, in the case of health care, market provision would be likely to generate substantial monopoly power, and therefore market failure: as the consumers of medical services lack perfect or even adequate information about the products they consume, scouring the market place for the best deals is not possible, and in this situation the suppliers i.e. the doctors and hospitals, would be able to act like monopolists and raise their prices with relative impunity; and, not only might consumers face monopoly pricing, but may also, on account of their relative ignorance, end up purchasing more health care than they might actually need: the 'sound of cash-tills' might induce the less scrupulous practitioners to be over-zealous as the regards the amount and type of treatment they recommend; for example, in the USA where a direct charge for childbirth delivery is usually made, many more caesarean deliveries on average are carried out as compared to the UK, where most childbirth is provided free through the NHS.

Government responses - merit goods

Possible government responses to the under-provision of merit goods

One solution would be for the government to play no role whatsoever and to allow the provision of merit goods to be decided completely through the free interaction of market forces. However, for all the reasons previously mentioned, this would lead to extreme under-provision of these goods and a misallocation of resources from the standpoint of society as a whole. Thus, in practice, governments play a substantial role in the provision of merit goods such as health and education, even where they are ideologically committed, as the present Conservative government is, to the market system. However, the exact form that such government involvement should take is a subject of much dispute, and we shall consider each of the following in turn:

Direct government provision

Traditionally in Western Europe the overwhelming majority of health care and education is still paid for out of general taxation and provided free at the point of contact by the government - for most people, when they visit their doctor, go to hospital, school or college, no direct charge is levied upon them; the private sector still only accounts for a relatively small proportion of all health and education provision. Apart from generating substantial positive externalities and overcoming the problems arising from unequal income distribution, lack of current and future information and potential private monopoly power, direct government provision may also give rise to large economies of scale, and may thus be productively efficient; for example, when a service such as health care is provided to the population as a whole, greater scale economies are likely to arise in terms of capital and labour costs than could be expected to accrue to the private health care sector, whose scale of operations is necessarily much smaller than that of the NHS.

However, the idea of universal provision for all on the basis of need, with prices and profits playing no role, is one which sits very uneasily with the philosophy of market economics, and has thus in recent years come under fierce attack from right-wing, market-oriented economists. They have argued that government provision of health and education has led to an undesirable situation of state monopoly power in these areas and that to increase consumer choice, lower costs and raise the level of efficiency, greater competition is required.

Regulation

The government may also use a range of regulatory devices both to increase the consumption of merit goods and to ensure their quality. In the case of education, it may be compulsory that all children between the ages of 5-16 receive some form of schooling, be it in the private or public sector, and quality is controlled in such ways as school teachers being required to have stipulated qualifications before they are allowed to teach. In the case of health care, vaccinations against various contagious diseases could be made compulsory and medical practitioners such as doctors, dentists, opticians and nurses could be required to obtain certain qualifications before they can practice. The government could also use regulation to enforce the consumption of a good provided by the private sector which is deemed to be a merit good by virtue of the positive externalities that it generates: the compulsory consumption of seat-belts by motorists provides one such example.

In the case of housing, the use of rent controls on private sector rented accommodation are a means by which the market can be regulated so as to protect tenants from having to pay high rents.

Rent controls represent a form of price fixing. More specifically, they represent an attempt to fix a maximum price below the equilibrium i.e. a maximum rent that a private landlord may charge for rented accommodation; and, to be effective, rent controls may also have to be accompanied by further regulation preventing the landlord from ousting the tenant once the rent has been fixed. Figure 1 below illustrates the fixing of such a maximum, and the possible longer term problems

Figure 1 The use of rent controls

The diagram shows that, with a relatively inelastic supply of rented accommodation, the free market rent would be established at a price of OP, with the quantity demanded and supplied equal at OQ. However, if the government impose a ceiling of OP1 on the price that landlords can charge, an initial shortage of Q1Q2 develops as the short term profitability of renting-out accommodation declines. In the longer term , if landlords' rate of return falls below what they could receive from alternative investments, such as government bonds, then existing landlords could be expected to leave the housing market with little new rented accommodation coming onto it. As a consequence, the supply of rented accommodation would shift from S to S1, and the shortage would increase to Q3Q2. Thus, unless the government could shift the supply curve to the right, for example by building more publicly owned council houses, the long term shortage would worsen, with the existing rent-controlled stock descending into an ever greater state of disrepair, as a result of landlords seeking to reduce their costs by postponing or cancelling repair and maintenance work.

Subsidies

Subsidies may be used to increase the output of merit goods, provided both by the private and public sectors, to the socially optimum level.

For example, the theatre is usually provided by the private sector , and is often regarded as a merit good on account of the educative and civilising benefits that it confers on society. The government might take the view that without state assistance to the arts, there would be an unacceptably small number of theatres able to survive. Figure 2 illustrates how the subsidy would operate.

Figure 2 The effect of subsidising a merit good

In the diagram, the free market price of theatre tickets is established by the intersection of the curves D and S at OP, with the equilibrium quantity at OQ. A government subsidy, equivalent to the vertical distance XY, would have the effect of shifting the supply curve to the right, causing the market price to fall to OP1 and the quantity of theatre tickets demanded and supplied to increase to OQ1. Consumers' expenditure on the theatre increases from OPZQ to OP1YQ1 and the area P1RXY represents the total amount that the government spends on the subsidy.

In the case of health care in several West European countries, the majority of it is provided free to the user out of general taxation, although charges may be levied for prescriptions and optical and dental treatment. In these cases the prices charged have been made cheaper than they would otherwise be, with patients only paying part of the cost of treatment and the government making up the difference through the payment of subsidies to suppliers. In the case of housing, owner occupiers receive a subsidy through the receipt of tax relief on mortgage interest repayments, which is not available to those people who rent their accommodation. State education like health care, may be provided without direct charges being made, although education vouchers represent an alternative form of market-based, subsidised provision which has been proposed.

Demerit goods

What are demerit goods?

Demerit goods are goods which are deemed to be socially undesirable, and which are likely to be over-produced and over-consumed through the market mechanism. Examples of demerit goods are cigarettes, alcohol and all other addictive drugs such as heroine and cocaine.

The problem arises from the fact that so long as an effective demand is present, such goods are, in all probability, going to be extremely profitable to produce, and this is all that a price system takes into account - the market neither possesses a 'heart' to enable it to help those in need, nor is it inherently able to make value judgements about which commodities are good or bad for society as a whole: it is prices and profits which act as the 'guiding light' to resource allocation.

However, the consumption of demerit goods imposes considerable negative externalities on society as a whole, such that the private costs incurred by the individual consumer are less than the social costs experienced by society in general; for example, cigarette smokers not only damage their own health, but also impose a cost on society in terms of those who involuntarily passively smoke and the additional cost to the National Health Service in dealing with smoking-related diseases. Thus, the price that consumers pay for a packet of cigarettes is not related to the social costs to which they give rise i.e. the marginal social cost will exceed the market price and overproduction and over-consumption will occur, causing a misallocation of society's scarce resources. This is illustrated in figure 1 below.

Figure 1 Over-consumption of a demerit good

The diagram illustrates how the market fails in the case of demerit goods. At a market price of OP, OQ quantity of the demerit good is consumed, where demand (private marginal benefit) equals supply (private marginal cost). However, at OQ the social marginal cost exceeds the price by the vertical distance XY, the value of the marginal external cost. Social optimality would require a smaller level of consumption at OQ1, where price = social marginal cost = social marginal benefit.

Government responses - demerit goods

Possible government responses to correct market failure arising from demerit goods

Less severe regulatory controls might take the form of spatial restrictions e.g. people may be disbarred from smoking in their place of work, on public transport and in cinemas and restaurants; there may be time restrictions in that it may be illegal to sell alcohol during certain periods of the day, or there may be age restrictions in terms of a minimum age being stipulated at which young people are permitted to buy cigarettes and alcohol.

Abuse of monopoly power

A most important assumption of the ideal free market economy is that markets within it are competitive, so that a large number of competing firms passively take the price that is set in the market as a whole and either increase or decrease their output in response to shifts in consumer demand.

However, as we saw in the section on monopoly, markets may be dominated by a single producer of the good or service, in which case a situation of monopoly exists, or by a few producers, in which case an oligopoly exists. In either situation, producers may not be content to take a price set in the market. Having significant control over supply, firms in pursuit of maximum profits may attempt to make the market price higher than it would otherwise have been by restricting output. The outcome for consumers may therefore be that they are paying a higher price for a smaller output. This would represent market failure and a misallocation of society's scarce resources, as the economy would be deprived of some of the output which would be valued more highly than that currently being consumed.

Also, in a situation of monopoly or oligopoly, profits may not perform the function that they are supposed to in the 'ideal' free market situation. Here, the making of profit is deemed to be a sign of efficiency; that is, the goods that are being produced are precisely those that consumers want and of a suitably high quality, and because firms cannot influence price, the profit has been achieved by operating efficiently, with costs being kept below the ruling price. However, given the power of firms in monopoly and oligopoly to restrict output to keep price artificially high, the making of profits may reflect market power and dominance rather than efficiency. Monopoly may involve both allocative and technical inefficiency. Refer back to the section on monopoly and re-read the course notes if you are not sure about this.

Inequality

Advocates of a freely operating price system often liken it to a political democracy where all voters can cast their votes for the candidates of their choice, with everyone who is eligible having an equal say: the price system, according to this line of reasoning, is a consumers', economic democracy; every time we go out and buy a particular good, we are affecting the demand for that good, and hence also its profitability and supply. Hence, the simple act of buying a good is akin to casting a 'vote' in favour of the production of that good, and is the way in which consumers determine how scarce resources should be allocated.

Unlike the political democracy however, in which each person has equal voting rights, the consumer democracy described above, given the unequal distribution of income that exists in most capitalist economies, is unlikely to be one in which all have an equal say _ clearly voting power is directly related to income so that the rich would have many more votes, and thus a much greater pull on resources, than the poor. Consequently, the resulting pattern of resource allocation may overlook the pressing, often life and death needs of the poor, and reflect instead the more trivial wants of the rich. In the economics of the market place, human wants are those that are supported by effective demand i.e. demand backed by the ability and willingness to pay the market price. Human needs, however, if unaccompanied by the wherewithal to pay, are simply ignored. This is the overriding reason for the existence of mal-nutrition and starvation in the world today: it is not that there is an overall shortage of food - there is more than enough in total terms to feed everyone; the problem, quite simply, is that those who need the food lack the money to pay for it.

Hence the 'free' market, given the degree of inequality which typically exists, is likely to be one in which many people are severely disadvantaged in terms of their market power. 'Electoral successes' will be the fast cars, exquisite jewellery and luxury hotels etc. for those who can pay, with basic health care, education, safe drinking water and nutritious food for the poor almost certainly 'losing their deposits'. Clearly, some consumers are a lot more 'sovereign' than others!

Section 2.4 Market failure - questions

In this section are a series of questions on the topic - Theory of the firm.





Click on the right arrow at the top or bottom of the page to move on to the next page.

Market failure - short answer

Market failure - introduction

Question 1

Explain the term market failure.

Question 2

What is short-termism, and what is its role in market failure?

Question 3

(a) Explain why environmental pollution is regarded as a source of market failure.

(b) Evaluate two different policies which a government might implement to reduce pollution.

Question 4

Assess the argument for and against subsidising public transport.

Question 5

Friedman

"The existence of a free market does not of course eliminate the need for government. On the contrary, government is essential both as a forum for determining the rules of the game and as an umpire to enforce the rules decided on.

What the market does is to reduce greatly the range of issues that must be decided through political means, and thereby to minimise the extent to which government need participate directly in the game. The characteristic feature of action through political channels is that it tends to require or enforce substantial conformity. The great advantage of the market, on the other hand, is that it permits wide diversity. It is, in political terms, a system of proportional representation. Each man can vote, as it were, for the colour of tie he wants and get it: he does not have to see what colour the majority wants and then, if he is in the minority, submit."

Source: Milton Friedman, Capitalism and Freedom (Chicago University Press, 1962)

Thatcher

"Freedom is indivisible. Once the state controls the means or production, distribution and exchange, all of us would become dependent on it." (1986)

Gray

"Hayek's insight is that against a background of stable laws, human individuals, left to their own devices, will produce an order spontaneously which is more complex and more stable than any which could be designed by the human mind. It's also an order ... which embodies their purposes and their goals. The moral defence of the market is that it protects freedom and voluntary exchange: whereas the moral hazard of economic planning is that it subordinates the purposes of some to those of the rulers."

John Gray (Oxford University, 1989)

Part (a)

All three quotes equate "freedom" with a market system. Explain the reasons that the authors would be likely to give for this.

Part (b)

In what ways might a market system not lead to greater "freedom" for all?

Externalities - short answer

Positive and negative externalities

Question 1

Distinguish between private costs and social costs using examples to illustrate your answers.

Question 2

Explain the difference between (i) a social cost and a negative externality and (ii) a social benefit and a positive externality.

Question 3

Re-write and fill in the gaps in the text below:

The existence of negative externalities will lead to a misallocation of resources and over-production at the free market price. The existence of positive externalities will cause a misallocation of resources at the free market price as there will be .........................................................................

Negative externalities cause a divergence between private and social cost.

The private cost is the internal money cost of production incurred by the firm i.e. costs such as ................................................................... Which must be paid to carry out production, and which would appear in the firm's accounts.

The social cost, on the other hand, is the real cost to society; it is the private internal costs plus ....................................

Similarly, if the firm's production decisions were to generate positive externalities, such as the beneficial effects arising from the provision of employment, then there would be a divergence between private and social benefit.

The private benefit is the money value of the benefits accruing internally to the firm from production activity e.g. in the form of sales revenues.

The social benefit, on the other hand, is the private benefit plus ..............................

So, social cost = ...................... + ...................... and social benefit = ...................... + ......................

The difference between the private and social cost is therefore the value of the ...................... and the difference between the private and social benefit is therefore the value of ......................

Externalities & allocative efficiency - short answer

Question 1

Explain in your own words how traffic congestion leads to allocative inefficiency.

Externalities - self-test questions

1

Externalities

What type of externality is evident from the picture below?

a)
b)
c)
d)
Please select an answerNo, that's not right. This pollution is a production externality. No, that's not right. This pollution is a production externality.Yes, that's correct. This pollution is an external cost as the cost is borne by people other than the factory polluting. This means that pollution is a negative production externality.No, that's not right. A positive production externality would be something that has an external benefit. Pollution is an external cost and so is a negative externality.
Check your answer

2

Externalities

What type of externality is evident from the picture below?

a)
b)
c)
d)
Please select an answerNo, that's not right. A negative consumption externality would be one that led to external costs. This attractive sculpture in someone's garden will have external benefits as other can also enjoy it. Yes, that's correct. This attractive sculpture in someone's garden will have external benefits as other can also enjoy it.No, that's not right. Someone has bought this sculpture and hung it in their garden which allows others to enjoy it. It therefore offers external benefits arising from consumption.No, that's not right. Someone has bought this sculpture and hung it in their garden which allows others to enjoy it. It therefore offers external benefits arising from consumption.
Check your answer

3

Externalities

What type of externality is evident from the picture below?

a)
b)
c)
d)
Please select an answerYes, that's correct. A negative consumption externality is one that leads to external costs. Smoking is a consumption activity and results in costs being imposed on those other than just the people smoking (health costs etc). It is therefore a negative consumption externality.No, that's not right. A positive consumption externality is one that leads to external benefits. Smoking is a consumption activity that results in external costs (health costs etc).No, that's not right. Smoking is a consumption activity and so is a consumption externality.No, that's not right. Smoking is a consumption activity and so is a consumption externality.
Check your answer

4

Externalities

What type of externality is evident from the picture below?

a)
b)
c)
d)
Please select an answer No, that's not right. A negative consumption externality is one that leads to external costs. The external costs here are arising from a production activity (production and storage of gas).No, that's not right. A positive consumption externality is one that leads to external benefits. This image shows external costs arising from a production activity (production and storage of gas).Yes, that's correct. The gasholder leads to an external cost for this house (and people passing by) and arises from a production activity.No, that's not right. The gasholder leads to an external cost for this house (and people passing by) and arises from a production activity.
Check your answer

5

Externalities

What type of externality is evident from the picture below?

a)
b)
c)
d)
Please select an answerYes, that's correct. A negative consumption externality is one that leads to external costs. The external costs here are arising from the consumption activity of buying and using cars for transport.No, that's not right. This is a consumption externality, but a positive consumption externality is one that leads to external benefits. This image shows external costs arising from the dumping of a car.No, that's not right. Though there may have negative consumption externalities arising from the production of the car in the first place, these external costs have arisen from the consumption and dumping of a car.No, that's not right. The image shows external costs arising from consumption of a car and the car subsequently being dumped.
Check your answer

6

Externalities

The image below shows syringes used for vaccination. What type of externality is evident from this?

a)
b)
c)
d)
Please select an answer No, that's not right. A negative consumption externality is one that leads to external costs. Vaccination will lead to external benefits rather than costs. Yes, that's correct. Vaccination will lead to external benefits as it will protect other from catching diseases.No, that's not right. Vaccination is a consumption activity and so any externalities resulting from it will be consumption externalities.No, that's not right. Vaccination is a consumption activity and so any externalities resulting from it will be consumption externalities.
Check your answer

Public goods - short answer

Question 1

Explain, with the aid of examples, the main characteristics of public goods.

Question 2

To what extent is it desirable that the government should provide public goods?

Question 3

Identify goods which are non-pure public goods, and explain in each case why some excludability and diminishability are possible.

Question 4

Why are health and education not pure public goods?

Question 5

Classify the following goods as either public (P), merit (M) or demerit goods.

Good Public (P), merit (M) or demerit (D)?
Dentistry
Museums
Birth control
Radio transmissions
Marijuana
Sea defences
Seat belts
Public parks
Nursery education (pre-school)
Loft insulation
Theatres
Lighthouses
Motorways
Cocaine
Vaccinations
Milk
Cigarettes
Alcohol


Merit goods - short answer

Question 1

Explain, with the aid of examples, the main characteristics of merit goods.

Question 2

To what extent is it desirable that the government should provide merit goods?

Question 3

Discuss the case for and against doctors charging patients for their services

Question 4

Why might housing be described as a merit good?

Question 5

Discuss the arguments for and against the state reducing its role in the direct provision of housing.

Question 6

Classify the following goods as either public (P), merit (M) or demerit goods.

Good Public (P), merit (M) or demerit (D)?
Dentistry
Museums
Birth control
Radio transmissions
Marijuana
Sea defences
Seat belts
Public parks
Nursery education (pre-school)
Loft insulation
Theatres
Lighthouses
Motorways
Cocaine
Vaccinations
Milk
Cigarettes
Alcohol


Question 7

The effect of subsidising theatre tickets will, to a large extent, depend on the elasticity of demand for theatre tickets. Draw two diagrams, one with a relatively inelastic demand curve and one with a relatively elastic demand curve. Explain the different effects on price and quantity.

Question 8

Organise a class debate on the following motion:

"This house believes that education, health care and housing are best provided through the market."

Demerit goods - short answer

Question 1

Discuss the possible economic arguments for and against the legalisation of cannabis in a country where it is currently illegal.

Question 2

Classify the following goods as either public (P), merit (M) or demerit goods.

Good Public (P), merit (M) or demerit (D)?
Dentistry
Museums
Birth control
Radio transmissions
Marijuana
Sea defences
Seat belts
Public parks
Nursery education (pre-school)
Loft insulation
Theatres
Lighthouses
Motorways
Cocaine
Vaccinations
Milk
Cigarettes
Alcohol


Types of goods - self-test questions

1

Types of goods

How would you classify the type of good shown in the image below?

a)
b)
c)
d)
Please select an answer Yes, that's correct. Well done. Defence is considered to be non-rival and non-excludable and is therefore a public good.No, that's not right. Merit goods are goods which are deemed to be socially desirable, and which are likely to be under-produced and under-consumed through the market mechanism. Defence would not be provided at all through the market mechanism and is therefore a public good. No, that's not right. A demerit good is a good which is deemed to be socially undesirable, and which are likely to be over-produced and over-consumed through the market mechanism.No, that's not right. Free goods are goods which we can consume in infinite quantities without any cost. They take no resources to produce and can be obtained without having to give up the opportunity to produce another good.
Check your answer

2

Types of goods

How would you classify the type of good shown in the image below?

a)
b)
c)
d)
Please select an answerNo, that's not right. Smoking is not non-rival and non-excludable in consumption and is therefore not a public good.No, that's not right. Merit goods are goods which are deemed to be socially desirable, and which are likely to be under-produced and under-consumed through the market mechanism. Smoking would be over-provided through the market mechanism and is therefore a demerit good.Yes, that's correct. Well done. A demerit good is a good which is deemed to be socially undesirable, and which are likely to be over-produced and over-consumed through the market mechanism. Smoking is a good of this nature.No, that's not right. Free goods are goods which we can consume in infinite quantities without any cost. They take no resources to produce and can be obtained without having to give up the opportunity to produce another good.
Check your answer

3

Types of goods

How would you classify the type of good shown in the image below?

a)
b)
c)
d)
Please select an answerNo, that's not right. Health care is not entirely non-rival and non-excludable in consumption and is therefore not a public good. It has social benefits when provided and is therefore usually categorised as a merit good. Yes, that's correct. Well done. Merit goods are goods which are deemed to be socially desirable, and which are likely to be under-produced and under-consumed through the market mechanism. This is the case with healthcare and it is therefore usually categorised as a merit good. No, that's not right. A demerit good is a good which is deemed to be socially undesirable, and which are likely to be over-produced and over-consumed through the market mechanism. Healthcare is the opposite of this and is therefore a merit good.No, that's not right. Free goods are goods which we can consume in infinite quantities without any cost. They take no resources to produce and can be obtained without having to give up the opportunity to produce another good. Healthcare takes significant resources to provide.
Check your answer

4

Types of goods

How would you classify the type of good shown in the image below?

a)
b)
c)
d)
Please select an answer Yes, that's correct. Well done. A lighthouse is considered to be non-rival and non-excludable and is therefore a public good.No, that's not right. Merit goods are goods which are deemed to be socially desirable, and which are likely to be under-produced and under-consumed through the market mechanism. Lighthouses would not be provided at all through the market mechanism (too difficult to 'exclude' people who haven't paid) and are therefore a public good. No, that's not right. A demerit good is a good which is deemed to be socially undesirable, and which are likely to be over-produced and over-consumed through the market mechanism.No, that's not right. Free goods are goods which we can consume in infinite quantities without any cost. They take no resources to produce and can be obtained without having to give up the opportunity to produce another good.
Check your answer

Government responses - short answer

Question 1

Explain the functions that prices perform in a market economy

Question 2

Assess the case for and against using the price mechanism to relieve the problem of traffic congestion.

Question 3

Discuss the importance of the distinction between private costs and social costs for a government considering whether or not to help finance the construction of a new railway line.

Question 4

What remedies could the government take to remedy the allocative inefficiency arising from traffic congestion?

Section 2.4 Market failure - in the news

In this section are a series of questions on topical issues in relation to the topic - Market failure.





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Plastic bags - carrying the weight of the environment?

Read the article Plastic bag bans around the world and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Once you have read this article then listen to the following podcast:

Question 1

Identify the external costs and external benefits that result from the use of single-use plastic bags.

Question 2

Using diagrams as appropriate, show how the use of single-use plastic bags results in the socially optimal equilibrium differing from the market equilibrium.

Question 3

Analyse the effectiveness of banning the use of plastic bags as a policy to reduce the environmental impact of carrying goods from shops.

Question 4

Evaluate two policies, other than bans, that governments could use to reduce the environmental impact of the use of plastic bags.

Bio-fuels - friend or foe?

Read the article An agricultural crime against humanity and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Identify the external costs and external benefits that result from the use of bio-fuels as a partial source of fuel for drivers in the developed world.

Question 2

Analyse the impact on the market for petrol of the increased use of bio-fuels.

Question 3

With reference to the article, discuss whether the growing and use of bio-fuels increases or reduces the external costs of driving in the developed world.

Question 4

Discuss the extent to which governments in the developed world need to adopt policies to reduce demand for driving as opposed to introducing bio-fuels to reduce the overall environmental impact.

Cement - the hidden polluter?

Read the article The unheralded polluter: cement industry comes clean on its impact and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Define the terms:

  1. External costs
  2. Social costs.

Question 2

With reference to the article, identify the main external costs resulting from the production of cement.

Question 3

Analyse the extent to which there is a "trade-off between development and sustainability" as identified by Dimitri Paplexopoulos, managing director of Titan Cement.

Question 4

Discuss policies that governments could adopt to try to move the market for cement to a more socially optimal equilibrium.

Pig fat into bio-diesel

Read the article Pig fat to be turned into Diesel and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Define the terms 'external costs' and 'external benefits'.

Question 2

Using diagrams as appropriate, compare and contrast the environmental impact of conventional diesel and the new pig fat bio-diesel.

Question 3

Discuss the extent to which the new pig fat diesel will be better for the environment than conventional diesel.

Question 4

Evaluate two policies that the government could implement to encourage the use of alternative fuels like the new pig fat bio-diesel.

African roses - red or green

Read the article Buy African flowers - UK minister and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also like to read the following article relating to African flowers:

Question 1

Define the terms 'external costs' and 'external benefits'.

Question 2

Draw a diagram to show the social optimum in the market for red roses.

Question 3

Compare and contrast the social costs and social benefits (including both private and external costs) of buying red roses produced in Europe and those produced in Africa.

Question 4

Assess which are the most environmentally beneficial presents to give on Valentine's Day. Give reasons to justify your answer.

Question 5

Evaluate two policy options available to the government to reduce the environmental impact of Valentine's Day.

Congestion charging

Read the article Leafy Kensington shows its anger and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also like to read the following articles relating to the congestion charge:

Question 1

Using diagrams as appropriate, show the impact of the extended congestion zone on traffic levels in London.

Question 2

Identify two external costs resulting from traffic congestion in London.

Question 3

Discuss whether the implementation of a larger congestion zone will help move closer to a socially optimal position in this market.

Question 4

Choose one other measure that the Mayor of London could introduce to meet emissions targets for the city and evaluate its likely success.

Putting a price on carbon

Read the article Putting a price on carbon: the key to securing global stability and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also like to read the following articles relating to carbon trading schemes:

Question 1

Define the terms 'tradable permit' and 'carbon trading scheme'.

Question 2

Explain how the European Emissions Trading Scheme (ETS) is intended to reduce emissions of CO2.

Question 3

Evaluate the extent to which the European ETS has succeeded in meeting its objectives.

Question 4

Discuss the viability of using personal domestic carbon quotas as a policy to help meeting emissions targets.

Question 5

According to the Stern Review ".... the second ingredient necessary to tackle climate change [i]s a range of policies to support the development of low-carbon and high-efficiency technologies." Identify two policies that would help achieve this and evaluate their likely success.

Climate costs: the next generation

Read the article Climate costs: the next generation and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also like to read the following articles relating to Sir Nicholas Stern's report on climate change:

Question 1

Identify two external costs likely to result from climate change.

Question 2

Summarise the main conclusions of the Stern Review on climate change.

Question 3

What policies does Sir Nicholas suggest for minimising the impact of climate change? Choose one of these policies and evaluate its likely success if implemented.

Question 4

"... action now will cost a mere 1% of global GDP by 2050, whereas business as usual could cost up to 20%." Explain, in terms of private and external costs, what Sir Nicholas Stern means by this assertion.

Cost of saving the planet: a year's growth

Read the article Cost of saving the planet: a year's growth and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Examine the economic costs that are likely to result from climate change.

Question 2

Analyse the likely success of the "green-growth strategy" proposed in the Price Waterhouse Coopers report.

Question 3

Choose one policy that a government could adopt to reduce climate change and evaluate its likely success.

The rush to find Jade

Read the article Jade rush 'damages Chinese river' and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Identify two external costs and two external benefits that may result from the 'jade rush' taking place on the Yurungkax river.

Question 2

Using diagrams as appropriate, show the socially optimal level of jade output and price.

Question 3

Discuss possible policies that the Chinese authorities could adopt to minimise the external impact of prospecting for jade on the Yurungkax river.

Chopsticks tax

Read the article China introduces chopsticks tax and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Identify and explain the external costs and external benefits resulting from the use of disposable wooden chopsticks in China.

Question 2

Discuss the likely effectiveness of the 5% chopsticks tax on reducing the demand for chopsticks. (You should consider the likely value of the price elasticity of demand in your answer.)

Question 3

With the use of appropriate diagrams, assess the likely impact of the chopsticks tax on the equilibrium level of price and output in the market for disposable chopsticks.

Domestic tradeable quotas

Read the article That'll be 17 and 10 carbon points. You can read this in the window below, or follow the previous link to read the article in a separate window. You might then like to have a go at the questions below.

Question 1

Write a brief summary of how a domestic tradable quotas scheme would work.

Question 2

Explain how a scheme of this nature would help to reduce the market failure of externalities.

Question 3

Assess the advantages and disadvantages of domestic tradable quotas compared to the use of taxes and subsidies to correct market failure.

Question 4

Summarise alternative policy solutions to the problem of climate change.

Taxing light bulbs - there's an idea

Read the article Bright idea and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Explain, with reference to external costs and external benefits, why some campaigners are arguing for a tax on incandescent light bulbs.

Question 2

Using diagrams, as appropriate, show the impact of a tax on incandescent light bulbs on (a) the market for incandescent light bulbs and (b) the market for energy efficient bulbs.

Question 3

Evaluate two further policies that governments could adopt to reduce carbon emissions resulting from energy use.

4x4 by far - four wheel market failure

Ken Livingstone has branded them 'Chelsea tractors' and environmental groups have been campaigning against them in urban area. The French have even started to tax them more than other vehicles. Just what is it about 4x4's that makes them a market failure?

Read the article French wrath over four-wheel drives. You can read this in the window below, or follow the previous link to read the article in a separate window. You might then like to have a go at the questions below.

You may also like to read the article Driving into the abyss by George Monbiot from the Guardian.

Question 1

What negative externalities are caused by the growth in the use of 4x4 vehicles?

Question 2

Discuss the equity of the French proposal to tax 4x4 vehicles and use the proceeds to subsidise smaller more fuel-efficient vehicles.

Question 3

Evaluate whether higher fuel tax would be an appropriate policy to reduce the number of four-wheel drive vehicles and reduce greenhouse gas emissions.

Question 4

Assess other policies that a government could use to reduce the emissions from 4x4 vehicles. What package of policies would you propose?

Teaching 'white van man' how to drive

Read the article Teaching 'white van man' how to drive and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Explain the private costs and external costs that result from the use of 'white vans'?

Question 2

Identify the private and external benefits that the government hopes will arise from the free driving lessons being offered to van drivers.

Question 3

Discuss whether the growth in van deliveries to homes resulting from the growth in online shopping will have a net positive or negative environmental impact.

Trading pig excrement - a particularly shitty form of market failure

Pigs emit methane from their nether regions and these are a contributory factor to global warming. Under new tighter EU rules for emissions, this will raise farmer's costs. So what's the solution? Well a Florida firm has proposed fitting a plastic membrane over farmer's pig waste tanks to capture the methane and then use it as a bio-fuel rather than allowing it to be emitted into the atmosphere. Farmer's will then be able to claim carbon credits under the new EU emissions trading market.

No, this really isn't an April Fool! Read the article Where there's muck, there's brass. You can read this in the window below, or follow the previous link to read the article in a separate window. You might then like to have a go at the questions below.

Question 1

Explain why methane emissions are considered a form of market failure.

Question 2

Using diagrams as appropriate, show how methane emissions from pig waste may result in a misallocation of resources.

Question 3

Using the diagrams from question 1, show the impact of using XL Techgroup's technology to collect the methane and sell it.

Question 4

Explain how the new EU carbon emissions trading system will help to reduce emissions of greenhouse gases.

Question 5

Assess the other policies available to governments to lower emissions of greenhouse gases.

The chemistry of a cartel

Read the article Brussels hits chemical cartel companies with 400m euro fines and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Explain what is meant by a cartel.

Question 2

Describe the market conditions most likely to lead to the emergence of a cartel.

Question 3

Discuss the effectiveness of using the threat of fines as a tool to try to reduce cartels.

Question 4

Evaluate one further strategy that governments can use to deal with cartels.

Road charging

Read the article Road charge 'won't deter drivers' and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Describe possible methods that could be used to charge drivers for the use of roads.

Question 2

In the light of the report quoted in the article, discuss the likely success of road charging as a policy to reduce congestion on the roads.

Question 3

Evaluate two further policies that a government could use to reduce the level of traffic congestion.

Sugary taxes

Read the article Norway gets soft drinks eco-tax and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

Question 1

Explain why Norway has put a tax on soft drinks.

Question 2

Discuss the likely effectiveness of this tax in increasing the level of recycling of drink containers.

Question 3

Suggest two further strategies for the government to adopt to increase the level of recycling and evaluate the likely success of one of them.

The carbon trade

Read the article Q&A: The carbon trade and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.

You may also like to read the articles:

Question 1

Explain how the EU carbon trading (European Trading Scheme - ETS) scheme works.

Question 2

Analyse the reasons why the EU carbon trading scheme has had problems in its first year of trading.

Question 3

Suggest two further strategies for the government to adopt to reduce carbon emissions and evaluate the likely success of one of them.

Section 2.4 Market failure - simulations and activities

In this section are a series of simulations and activities on the topic - Market failure.





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AnimateIT - Externalities

In this section we look at animated versions of the externalities diagrams. It is worth going through these to see how the different externalities affect the market.

Negative consumption externalities

Positive consumption externalities

Negative production externalities

Positive production externalities