AQA

AS Economics

Unit 1 Markets and

Market Failure

GEOFF RILEY 8th Edition – October 2010

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Table of Contents Scarcity and Choice ............................................................................................................................ 3 Economic Resources ............................................................................................................................ 7 Factor Rewards.................................................................................................................................. 9 The Production Possibility Frontier ....................................................................................................... 11 Specialisation and Trade .................................................................................................................. 14 Positive and Normative Statements ..................................................................................................... 19 Markets: Understanding Demand ....................................................................................................... 20 Markets: Understanding Supply ......................................................................................................... 27 Markets: Finding an Equilibrium Price .................................................................................................. 32 Price Elasticity of Demand ................................................................................................................. 38 Price Elasticity of Supply ................................................................................................................... 44 Income Elasticity of Demand .............................................................................................................. 48 Cross Price Elasticity of Demand ......................................................................................................... 52 Functions of the Price Mechanism ........................................................................................................ 55 Price Volatility in Markets ................................................................................................................. 58 Inter-relationships between Markets ................................................................................................... 65 Consumer Surplus ............................................................................................................................. 67 Producer Surplus .............................................................................................................................. 70 Markets in Action: The Market for Oil ................................................................................................. 73 Markets in Action: The Market for Copper ........................................................................................... 78 Markets in Action: The Market for Coffee ............................................................................................ 80 Markets in Action: The UK Housing Market ........................................................................................... 83 Markets in Action: The Labour Market ................................................................................................. 88 Markets in Action: Economics of Health Care ........................................................................................ 97 Background to Supply: Production and Costs ...................................................................................... 103 Economies and Diseconomies of Scale ............................................................................................... 107 Productivity ................................................................................................................................... 112 Economic Efficiency ......................................................................................................................... 114 Introduction to Causes of Market Failure ........................................................................................... 119 Competition and Monopoly in Markets .............................................................................................. 120 Negative Externalities .................................................................................................................... 129 Positive Externalities ....................................................................................................................... 136 Public Goods and Private Goods ..................................................................................................... 138 Merit Goods and Services ............................................................................................................... 141 Demerit goods ............................................................................................................................... 143 Factor Immobility ........................................................................................................................... 147 Imperfect Information ..................................................................................................................... 149 Poverty and Inequality in Resource Allocation .................................................................................... 151 Government Intervention in the Market .............................................................................................. 154 Indirect Taxation ............................................................................................................................ 160 Producer Subsidies ......................................................................................................................... 163 Maximum Prices ............................................................................................................................. 167 Minimum Prices .............................................................................................................................. 170 Buffer Stock Schemes ...................................................................................................................... 173 Government Failure ........................................................................................................................ 175 Glossary ....................................................................................................................................... 181

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Scarcity and Choice The Economist's Dictionary of Economics defines economics as "The study of the production, distribution and consumption of wealth in human society" Another definition of the subject comes from economist Lionel Robbins, who said in 1935 that

"Economics is a social science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. That is, economics is the study of the trade-offs involved when choosing between alternate sets of decisions."

The purpose of economic activity It is often said that the central purpose of economic activity is the production of goods and services to satisfy our changing needs and wants. The basic economic problem is about scarcity and choice. Every society has to decide:

(i) What goods and services to produce: Does the economy uses its resources to operate more hospitals or hotels? Do we make more iPhones and iPads or double-espressos? Does the National Health Service provide free IVF treatment for childless couples?

(ii) How best to produce goods and services: What is the best use of our scarce resources? Should school playing fields be sold off to provide more land for affordable housing? Should coal be produced in the UK or is it best imported from other countries?

(iii) Who is to receive goods and services: Who will get expensive hospital treatment - and who not? Should there be a minimum wage? If so, at what level should it be set?

Scarcity We are continually uncovering of new wants and needs - which producers attempt to supply by employing factors of production. For a perspective on the achievements of countries in meeting people’s basic needs, the Human Development Index produced by the United Nations is worth reading. The economist Amartya Sen (Winner of the 1998 Nobel Prize for Economics) has written extensively on this issue. Making choices Because of scarcity, choices have to be made by all consumers, businesses and governments. For example, over six million people travel into London each day and they make choices about when to travel, whether to use the bus, the tube, to walk or cycle – or whether to work from home. Millions of decisions are being taken, many of them are habitual – but somehow on most days, people get to work on time and they get home too! This is a remarkable achievement, and for it to happen, our economy must provide the resources and the options for it to happen.

Road space is becoming increasingly scarce as the demand for motor transport increases each year – what do you think are the best solutions to reducing the problem of congestion on our roads?

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Trade-offs when making choices Making a choice made normally involves a trade-off – this means that choosing more of one thing can only be achieved by giving up something in exchange.

1. Housing: Choices about whether to rent or buy a home – there are costs and benefits to renting a property or in choosing to buy a home with a mortgage. Both decisions involve risk. People have to weigh up the costs and benefits of the decision.

2. Working: Do you work full-time or part-time? Is it worth your while studying for a degree? How have these choices been affected by the introduction of university tuition fees?

3. Transport and travel: The choice between using Euro-Tunnel, a low-cost ferry or an airline when travelling to Western Europe.

The cost benefit principle In many of these decisions, people consider the costs and benefits of their actions – economists make use of the ‘marginal’ idea, for example what are the benefits of consuming a little extra of a product and what are the costs. Economic theory states that rational decision makers weigh the marginal benefit one receives from an option with its marginal cost, including the opportunity cost. This cost benefit principle well applied will get you a long way in Economics! Consumer welfare and rationality What makes people happy? Why despite several decades of rising living standards, surveys of happiness suggest that people are not noticeably happier than previous generations? Typically we tend to assume that, when making decisions people aim to maximise their welfare. They have a limited income and they seek to allocate their money in a way that improves their standard of living. Of course in reality consumers rarely behave in a well informed and rational way. Often decisions by people are based on imperfect or incomplete information which can lead to a loss of welfare not only for people themselves but which affect others and our society as a whole. As consumers we have all made poor choices about which products to buy. Behavioural economics is an exciting strand of the subject that looks at whether we are rational in our everyday decisions. One of the best people to read on behavioural economics is Dan Ariely.

Opportunity Cost There is a well known saying in economics that “there is no such thing as a free lunch!” Even if we are not asked to pay a price for something, scarce resources are used up in the production of it and there is an opportunity cost involved. Opportunity cost measures the cost of any choice in terms of the next best alternative foregone.

Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost wages foregone. If you are being paid £6 per hour to work at the local supermarket, if you take a day off from work you might lose £48 of income.

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Government spending priorities: The opportunity cost of the government spending nearly £10 billion on investment in National Health Service might be that £10 billion less is available for spending on education or the transport network.

Investing today for consumption tomorrow: The opportunity cost of an economy investing resources in capital goods is the production of consumer goods given up.

Making use of scarce farming land: The opportunity cost of using farmland to grow wheat for bio-fuel means that there is less wheat available for food production

Economic Systems

An economic system is a network of organisations used by a society to resolve the basic problem of what, how much, how and for whom to produce.

1. Traditional economy: Where decisions about what, how and for whom to produce are based on custom and tradition. Land is typically held in common i.e. private property is not well defined. This BBC news article looks at the traditional economy of Vanuatu.

2. Free market economy: Where households own resources and markets allocate resources through the workings of the price mechanism. An increase in demand raises price and encourages businesses to switch additional resources into the production of that good or service. The amount of products consumed by people depends on their income and household income depends on the market value of an individual’s work. In a free market economy there

is a limited role for the government. Indeed in a pure free market system, the government limits itself to protecting the property rights of people and businesses using the legal system and it also seeks to protect the value of money or the value of a currency.

3. Planned or command economy: In a planned or command system typically associated with a socialist or communist system, scarce resources are owned by the government. The state allocates resources, and sets production targets and growth rates according to its own view of people's wants. In such a system, market prices play little or no part in informing resource allocation decisions and queuing rations scarce goods.

4. Mixed economy: In a mixed economy, some resources are owned by the public sector (government) and some resources are owned by the private sector. The public (or state) sector typically supplies public, quasi-public and merit goods and intervenes in markets to correct perceived market failure.

Life inside North Korea Sue Lloyd-Roberts has produced some remarkable reports for television over the years. Few can be as impressive as the ones available on BBC Our World and BBC Newsnight tracking her time in North Korea. She tries to gain an insight into the daily existence of people in North Korea and, despite the constant presence of government minders and security officials; she discovers private markets which for many can be the difference between a meagre life and starvation. The North Korean authorities refuse to acknowledge the existence of these markets but they are the inevitable result of the complete failure of the state planning system. She meets some North Korean defectors who are still coming to terms with the ultimate culture shock. Here are some links to Sue Lloyd-Roberts’ reports Glimpses of real North Korean life behind the facade

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Sampling North Korea’s version of the internet North Korean defectors on the ultimate culture shock Sectors of Production Production of goods and services takes place in different sectors, when added together they give us a figure for a nation’s gross domestic product (GDP). These sectors are as follows:

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Economic Resources Finite resources and sustainability There are only a finite - or limited - number of workers, machines, acres of land and reserves of oil and other natural resources on the earth. Because most resources are finite, we cannot produce an unlimited number of different goods and services. Indeed by supplying more for an ever-growing and richer population we are in danger of destroying the natural resources of the planet.

Our ecological footprint will affect the long-term sustainability of economies and have huge implications for our future living standards. Environmental pressure groups such as Friends of the Earth and Greenpeace seek to highlight the permanent damage to the stock of natural resources and the dangers from rapid development and global warming. The Worldwide Fund for Nature has claimed that the natural world is being degraded "at a rate unprecedented in human history" and has warned that if demand continues at the current rate, two planets will be needed to meet global demand by 2050. Resources are being consumed faster than the planet can replace them

One issue is the threat posed by the shortage of water as the world’s demand for household and commercial use continues to grow each year. Experts predict that half the world's population will be affected by water shortages in just 20 years' time. During the 20th century the world population increased fourfold, but the amount of freshwater that it used increased nine times over. Already 2.8 billion people live in areas of high water stress. For more on this issue visit the World Heath Organisation’s special web site on water scarcity. At the heart of improving resource sustainability is the idea of de-coupling – a process of trying to increase the efficiency with which resources are used and breaking the link between increasing demand and resource depletion. Factors of Production Land: Land includes all of the natural physical resources – for example the ability to exploit fertile farm land, the benefits from a temperate climate or the harnessing of wind power and solar power and other forms of renewable energy. Some nations are richly endowed with natural resources and then specialise in the their extraction and production – for example – the development of the North Sea oil and gas in Britain and Norway or the high productivity of the vast expanse of farm land in Canada and the United States and the oil sands in Alberta, Canada. Other countries are reliant on importing these resources. Labour: Labour is the human input into production. An increase in the size and the quality of the labour force is vital if a country wants to achieve growth. In recent years the issue of the migration of labour has become important. Can migrant workers help to solve labour shortages? What are the long-term effects on the countries who suffer a drain or loss of workers through migration? Capital: Capital goods are used to produce other consumer goods and services in the future.

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• Fixed capital includes machinery, equipment, new technology, factories and other buildings.

• Working capital means stocks of finished and semi-finished goods (or components) that will be either consumed in the near future or will be made into consumer goods

New items of capital machinery, buildings or technology are used to enhance the productivity of labour. For example, improved technology in farming has vastly increased productivity and allowed millions of people to move from working on the land into more valuable jobs in other industries. Infrastructure - Examples of critical infrastructure include road & rail networks; airports & docks; telecommunications e.g. cables and satellites to enable web access. The World Bank regards infrastructure as an essential pillar for economic growth in developing countries. India is often cited as a country whose growth prospects are being limited by weaknesses in national infrastructure. Entrepreneurship An entrepreneur is an individual who supplies products to a market to make a profit. Entrepreneurs will usually invest their own financial capital in a business and take on the risks. Their main reward is the profit made from running the business. Renewable and Finite Resources

Renewable resources are commodities such as solar energy, oxygen, biomass, fish stocks or forestry that is inexhaustible or replaceable over time providing that the rate of extraction of the resource is less than the natural rate at which the resource renews itself. This is an important issue in environmental economics, for example the over-extraction of fish stocks, and the global risks of permanent water

shortages resulting Finite resources cannot be renewed. For example with plastics, crude oil, coal, natural gas and other items produced from fossil fuels, no mechanisms exist to replenish them. Suggestions for further reading on economic resources and sustainability BBC “Costing the Earth” podcasts (free to download)

BBC science and environment news

Environmental news from the Guardian

Inside the environment – news from the Independent

TED video talks on the environment

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Factor Rewards

Income The main sources of income for people are:

1. Wages and salaries from a job often boosted by overtime and productivity bonuses

2. Interest from savings

3. Dividends from share ownership

4. Rent income from the ownership of property The government can change people’s disposable income by taxing incomes and providing welfare benefits to households on lower wages or to those who are out of work. Wealth Wealth is defined as a stock of assets that, in turn, creates a flow of income.

o Financial wealth – e.g. stocks and shares, bonds, savings in bank and building society accounts and contributions to pension schemes.

o Marketable wealth – items that can be sold for a price e.g. rare antiques and fine wines.

o Social capital – social infrastructure such as transport systems, schools and hospitals. It is important to distinguish between income and wealth. For example, if you receive a higher wage or salary, this adds to your monthly income and if this is saved in a bank, or by making contributions to a pension fund then you are accumulating wealth. Being wealthy can generate income for if you own shares in companies you expect to receive dividend income perhaps once or twice a year. Money in savings accounts pays interest. Likewise, if you own properties you can rent it out to tenants. Inequality in income and wealth The distribution of income and wealth in the UK and in many other countries is highly unequal and there is a huge gap between the richest and poorest households. For example, the latest data

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shows that 94% of the total wealth in Britain is held by 50% of the population. Globally, the United Nations has reported that the World's richest 1% own 40% of all wealth. Millions of people rely on relatively low incomes with little opportunity to accumulate wealth. Is this fair? What are the consequences of a high level of inequality? Should the government intervene to change the distribution of income? These are important questions for economists.

• Labour and Wages: In industries and jobs where labour is not scarce, wages tend to be lower. Millions of workers in the UK are paid hourly wages well below the national average. The minimum wage seeks to address some of the problems associated with low pay. On the other hand, some people have skills that are rare, and these people will command high salaries in the labour market.

• Capital and Interest: Businesses often need to borrow money to fund investment. The

reward for investing money is interest. Interest rates can of course go up or down. If the interest rate is high, it becomes less worthwhile to borrow money because any project will have to make more money than before to be profitable since more interest is being paid.

• Enterprise and Profit: In return for having innovative business ideas and taking the risk in

putting funds into a business the entrepreneur takes any money that the business has left after the other factors of production have received their rewards. This is called gross profit. Taxes then have to be paid to the government, and the entrepreneur takes what is left. This after-tax profit is called net profit.

Business Objectives Economists often assume that one of the main objectives of a business is to achieve maximum profits. But this is not always the case! Some businesses are looking to achieve a rising market share and increasing market share might mean having to sacrifice some profits in the short run by cutting prices and under-cutting rival suppliers in the market. There is also a growing interest in the concept of social enterprises, ethical businesses, and corporate social responsibility where the assumption of firms driven solely by the profit motive is being challenged and where businesses are encouraged to take account of their economic, social and environmental impacts. The rise of consumer power in influencing the decisions of businesses is part of this trend. Social network sites such as Twitter and Facebook may be giving consumers increased influence in shaping the decisions of many different businesses. Suggestions for further reading on factor rewards

The rising gap in health inequality in the UK (BBC news, July 2010)

London living wage rises to £7.85 an hour (BBC news, May 2010)

Household wealth grows five-fold in past 50 years (BBC news, May 2010)

BBC news articles on business profits

Guardian news articles on social enterprises

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The Production Possibility Frontier A production possibility frontier (PPF) is a boundary which shows the combinations of two or more goods and services that can be produced whilst using all available factor resources efficiently. We normally draw a PPF on a diagram as concave to the origin i.e. as we move down the PPF, as more resources are allocated towards Good Y the extra output gets smaller – so more of Good X has to be given up in order to produce Good Y. This is the law of diminishing returns and it occurs because not all factor inputs are equally suited to producing items.

PPF and economic efficiency

• Combinations of the output of consumer and capital goods lying inside the PPF happen when there are unemployed resources or when resources are used inefficiently – e.g. point X. We could increase total output by moving towards the PPF and reaching any of points C, A or B.

• Point D is unattainable at the moment because it lies beyond the PPF. A country would require an increase in factor resources, an increase in the productivity or an improvement in technology to reach this combination of Good X and Good Y. As we shall see a little later, trade between countries allows nations to consume beyond their own PPF.

• Producing more of both goods would represent an improvement in welfare and an gain in what is called allocative efficiency

Opportunity cost and the PPF Reallocating scarce resources from one product to another involves an opportunity cost. If we increase our output of consumer goods (moving along the PPF from point A to point B) then fewer

Output of capital goods

Output of consumer

goods

A

B

C

X

D

A PPF shows the different combinations of goods and services that can be produced with a given amount of resources in their most efficient way Any point inside the curve – suggests resources are not being utilised efficiently Any point outside the curve – not attainable with the current level of resources

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resources are available to produce capital. if the law of diminishing returns holds true then the opportunity cost of expanding output of X measured in terms of lost units of Y is increasing.

If the opportunity cost for producing two products is constant, then we draw the PPF as a straight line. The gradient of that line is a way of measuring the opportunity cost between two goods.

Shifts in the Production Possibility Frontier The PPF will shift when:

Output of Capital Goods

Output of Consumer

Goods

C2

C1

X Y

A

B

Z 0

In this diagram, the opportunity cost of producing 0C1 units of consumer goods is the choice of to giving up YZ units of capital goods

Output of Good

Output of Good A

A straight line PPF shows a constant opportunity cost between two products Increasing output of good B from 60 to 90 units implies giving up 90 units of good A The marginal opportunity cost for each extra unit of good B is 30 units of Good A

A

B 200

160

60 90

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o There are improvements in productivity and efficiency perhaps because of the introduction of new technology or advances in the techniques of production

o More factors of production are exploited perhaps due to an increase in the size of the workforce or a rise in the amount of capital available for businesses

In the diagram below, there is an improvement in technology which shifts the PPF outwards.

Free Goods Free goods are not scarce and no cost is involved when consuming them. Is fresh air an example of a free good? Usually the answer is yes – yet we know that air can become contaminated by pollutants. And, in thousands of offices, shops and schools, air-conditioning systems cool the air before it is “consumed”. With air conditioning, scarce resources are used up in providing the “product” – for example the

capital machinery and technology that goes into manufacturing the air conditioning equipment; the labour involved in its design, production, distribution and maintenance and the energy used up in powering the system. Cool air might appear to be free – but in fact it is often an expensive product to supply! Air conditioning guzzles 15 per cent of total American energy consumption, higher than any other country, and uses the same amount of fossil fuel as the whole of Africa employs for all its energy needs.

Output of Capital Goods

Output of Consumer Goods

C2

C1

X2 X1

A

B

PPF1

PPF2

C

C3

X3

An outward shift in the PPF shows that there has been either an improvement in productivity or an increase in the total stock of resources available to produce different goods and services. The outward shift represents an improvement in efficiency and leads to economic growth.

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Specialisation and Trade Specialisation is when we concentrate on a product or task. Surplus products can then be exchanged and traded creating the potential for gains in welfare for all involved. Specialisation happens at all levels of an economy:

1. Within the family for example the specialization of tasks within extended families in many of the world’s poorest countries

2. Within businesses and organizations

3. In a particular country – for example Bangladesh is a major producer and exporter of textiles; Norway is a leading oil exporter. And Ghana is one of the biggest producers of cocoa in the world.

4. In a region of a country – for example for many years the West Midlands has been a centre for motor car assembly.

The gains from specialization By concentrating on what people and businesses do best rather than relying on self sufficiency:

• Higher output: The total level of production of goods and services is raised and quality can be improved.

• Variety; Consumers have access to a greater variety of higher quality products

• A bigger market: Specialisation and global trade increase the size of the market offering opportunities for economies of scale.

• Competition and lower prices: Increased competition acts as an incentive to minimise costs, keep prices down and therefore maintains low inflation

The Division of Labour The division of labour occurs where production is broken down into many separate tasks. Division of labour raises output per person as people become proficient through constant repetition of a task – “learning by doing”. This gain in productivity helps to lower cost per unit and ought to lead to lower prices for consumers.

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Limitations of division of labour

Unrewarding, repetitive work that requires little skill lowers motivation and hits productivity. Workers begin to take less pride in their work and quality suffers, the result may be a problem of diseconomies of scale. We often see dissatisfied workers becoming less punctual at work and the rate of absenteeism increases. Many people may choose to move to less boring jobs creating a problem of high worker turnover for businesses. According to figures for 2010, the overall employee turnover rate for the UK to be 13.5% per year. In other words, nearly one worker in seven changes jobs each year. The highest levels of labour turnover are found in retailing, hotels, catering and leisure, call centres and among other lower paid private sector services groups Some workers receive a little training and may not be able to find alternative jobs if they find themselves out of work (they may then suffer structural unemployment). Another disadvantage is that mass-produced standardized goods tend to lack variety for consumers Comparative advantage

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First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the supply of a product i.e. the cost of production is lower. Countries will usually specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed. So for example the Canadian economy which is rich in low cost land is able to exploit this by specializing in agricultural production. The dynamic Asian economies including China have focused their resources in exporting low-cost manufactured goods which take advantage of much lower labour costs. In highly developed countries, the comparative advantage is shifting towards specializing in producing and then exporting high-value and high-technology manufactured goods and high-knowledge services.

The PPF and Specialisation

Two countries are producing two products (X and Y). With a given amount of resources:

Output of X Output of Y

Country A 180 90

Country B 200 150 In this example, country B has an absolute advantage in both products. Absolute advantage occurs when a country or region can create more of a product with the same factor inputs. But Country A has a comparative advantage in the production of good X. It is 9/10ths as efficient at producing good X but it is only 3/5ths as efficient at producing good Y.

Output of Good Y

Output of Good X

PPF for Country A

360

90 180

400

300

PPF for Country B

200

150

180

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Comparative advantage exists when a country has lower opportunity cost, i.e., it gives up less of one product to obtain more of another product. In our example above, for country A, every extra unit of good Y produced involves an opportunity cost of 2 unit of good X. For country B, an additional unit of good Y involves a sacrifice of only 4.3 units of good X. There are gains to be had from country A specializing in the supply of good X and country B allocating more of their resources into the production of good Y. Another example of comparative advantage Consider two countries producing two products – digital cameras and vacuum cleaners.

Pre-specialisation Digital Cameras Vacuum Cleaners

UK 600 600

United States 2400 1000

Total 3000 1600 Were the UK to shift more resources into higher output of vacuum cleaners, the opportunity cost of each cleaner is one digital television. For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners. If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in producing digital cameras.

Digital Cameras Vacuum Cleaners

UK 0 (-600) 1200 (+600)

United States 3360 (+960) 600 (-400)

Total 3000

3360 1600

1800

o The UK specializes totally in producing vacuum cleaners – doubling its output to 1200.

o The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners.

o Output of both products has increased - representing a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. There are gains from trade between the two countries. If the two countries trade at a rate of exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be as follows:

o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras

o The USA exports 840 digital cameras and imports 420 vacuum cleaners

Digital Cameras Vacuum Cleaners

UK 840 780

United States 2520 1020

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Total 3360 1800 Compared with the pre-specialisation output levels, consumers in both countries now have an increased supply of both goods to choose from. We have seen in this chapter how specialisation and trade based on the idea of comparative advantage can lead to an improvement in welfare.

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Positive and Normative Statements Detecting bias in arguments Whenever you are reading articles on current affairs it is important to be able to distinguish between objective and subjective statements. Often, the person writing an article has a particular argument to make and will include subjective statements about what ought to be or what should be happening. Their articles carry value judgements where they are trying to persuade you of the particular merits or demerits of a policy decision. These articles may be lacking in objectivity. Positive Statements Positive statements are objective statements that can be tested or rejected by referring to the available evidence. Positive economics deals with objective explanation and the testing and rejection of theories. For example:

• A fall in incomes will lead to a rise in demand for own-label supermarket foods

• If the government raises the tax on beer, this will lead to a fall in profits of the brewers.

• The rising price of crude oil on world markets will lead to an increase in cycling to work

• A reduction in income tax will improve the incentives of the unemployed to find work.

• A rise in average temperatures will increase the demand for sun screen products.

• Higher interest rates will reduce house prices

• Cut-price alcohol has increased the demand for alcohol among teenagers

• A car scrappage scheme will lead to fall in the price of second hand cars Normative Statements Normative statements express an opinion about what ought to be. They are subjective statements rather than objective statements – i.e. they carry value judgments. For example:

• Pollution is the most serious of all economic problems

• The congestion charge for drivers of petrol-guzzling cars should increase to £25

• The government should increase the minimum wage to £6 per hour to reduce poverty.

• The government is right to introduce a ban on smoking in public places.

• The retirement age should be raised to 70 to combat the effects of our ageing population.

• Resources are best allocated by allowing the market mechanism to work freely

• The government should enforce minimum prices for beers and lagers sold in supermarkets and off-licences.

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Markets: Understanding Demand Demand Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming it. Effective demand Effective demand is when a desire to buy a product is backed up by an ability to pay. For example, what price are you willing to pay for a ticket for the opening ceremony of the London 2012 Olympics or for a flight to your summer holiday destination? There has been a huge growth in demand for live events such as pop festivals. Comedy festivals and other concerts – when people buy tickets for these they reveal their preferences for the types of goods and services they are willing and able to buy. Latent Demand Latent demand exists when there is willingness to buy among people for a good or service, but where consumers lack the purchasing power to be able to afford the product. Derived Demand The demand for a product X might be linked to the demand for a related product Y – giving rise to the idea of a derived demand. For example, the demand for steel is strongly linked to the demand for new vehicles and other manufactured products, so that when an economy goes into a recession, so we would expect the demand for steel to decline likewise. Steel is a cyclical industry which means that the total market demand for steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate. Recently the world price of steel has been surging to new heights as our chart indicates below. This is because of rising global demand for steel which itself is derived from the demand for new buildings and the rapid growth of manufacturing especially in far-east Asian emerging countries. As we shall see, the sharp rise in the price of steel will affect demand for substitutes to steel.

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US dollars per tonneWorld Prices for Different Types of Steel

Cold Rolled Coil Hot Rolled Coil Hot Rolled PlateSource: Reuters EcoWin

Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan06 07 08 09 10

400

500

600

700

800

900

1000

1100

1200

1300

1400

US

dol

lars

per

tonn

e

400

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800

900

1000

1100

1200

1300

1400

The demand for new bricks is derived from the demand for the final output of the construction industry- when there is a recovery in the British building industry, so the market demand for bricks will increase

The Law of Demand There is an inverse relationship between the price of a good and demand.

1. As prices fall, we see an expansion of demand. 2. If price rises, there will be a contraction of demand.

Ceteris paribus assumption Many factors affect demand. When drawing a demand curve, economists assume all factors are held constant except one – the price of the product itself.

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The Demand Curve A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. There are two reasons why more is demanded as price falls:

1. The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain the same consumption for less expenditure. Provided that the good is normal, some of the resulting increase in real income is used to buy more of this product.

2. The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and some consumers switch their spending from the alternative good or service.

Please note that many demand curves are drawn as straight lines – this is to make the diagrams easier to interpret. Many other factors can affect demand - when these change, the demand curve can shift. This is explained below. Changes in the Conditions of Demand – Shifts in Demand There are two possibilities: either the demand curve shifts to the right or it shifts to the left.

1. D1 – D3 would be an example of an outward shift of the demand curve (or an increase in demand). When this happens, more is demanded at each price.

2. A movement from D1 – D2 would be termed an inward shift of the demand curve (or decrease in demand). When this happens, less is demanded at each price.

Price

Quantity Demanded

Demand

P1

P2

P3

Q1 Q2 Q3

Rising price - contraction of demand

Falling price - expansion of demand

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The conditions of demand for a product in a market can be summarised as follows: Changing prices of a substitute good Substitutes are goods in competitive demand and act as replacements for another product. For example, a rise in the price of Esso petrol should cause a substitution effect away from Esso towards competing brands such as Shell. When it is easy and cheap to switch, then demand will be sensitive to price changes. Changing price of a complement Two complements are in joint demand – e.g. DVD players and DVDs, iron ore and steel.

• A rise in the price of a complement to Good X should cause a fall in demand for X. For example an increase in the cost of flights from London Heathrow to New York would cause a decrease in the demand for hotel rooms in New York and also a fall in the demand for taxi services both in London and New York.

• A fall in the price of a complement to Good Y should cause an increase in demand for Good Y. For example a reduction in the price of the new iPhone should lead to an expansion in demand for the iPhone and a complementary increase in demand for download applications.

Changes in the income of consumers Most of the things we buy are normal goods. When income goes up, our ability to purchase goods and services increases, and this causes an outward shift in the demand curve. But when incomes fall there will be a decrease in the demand, except for inferior goods The effects of advertising and marketing

Price

Quantity Demanded

D1

P1

Q1 Q2 Q3

D3 D2

D1 to D2 – an inward shift of demand

D1 to D3 – an outward shift of demand

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Heavy spending on advertising and marketing can help to bring about changes in consumer tastes and fashions. In 2009, online advertising spending in the UK overtook television expenditure for the first time. Online spending grew 4.6% to £1.752bn in the first half of 2009, while TV spending shrank 16.1% to £1.639bn. Discretionary income is disposable income less essential payments like electricity & gas and mortgage repayments. An increase in interest rates often means an increase in monthly mortgage payments reducing demand. In recent years we have seen a sharp rise in the cost of utility bills with a series of hikes in the prices of gas and electricity. This has eaten into the discretionary incomes of millions of households across the UK. The discretionary incomes of people suffering from fuel poverty have become a major current issue. Interest rates and demand Many products are bought on credit using borrowed money, thus the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the Bank of England decides to alter interest rates – the demand for many goods and services may change. Examples of “interest sensitive” products include household appliances, electronic goods, new furniture and motor vehicles. The demand for housing is affected by changes in mortgage interest rates. Market demand Market demand is the sum of the individual demand for a product from each consumer in the market. If more people enter the market and they have the ability to pay for items on sale, then demand at each price level will rise. Exceptions to the law of demand There are two possible reasons why more might be demanded even when the price of a good or service is increasing. We consider these briefly – ostentatious consumption and the effects of speculative demand. (a) Ostentatious consumption: Some goods are luxurious items where satisfaction comes from knowing the price of the good and being able to flaunt consumption to other people! The demand for the product is a direct function of its price. A higher price may be regarded as a reflection of product quality and some consumers are prepared to pay this for the “snob value effect”. Examples might include perfumes, designer clothes, and top of the range cars. Goods of ostentatious consumption are known as Veblen Goods and they have a high-income elasticity of demand. That is, demand rises more than proportionately to an increase in income or an increase in price. (b) Speculative Demand: When there is speculative demand buyers are interested not just in the satisfaction they may get from consuming the product, but also the potential rise in price leading to a capital gain or profit. The speculative demand for housing and for shares might come into this category and we have also seen, in the last few years, strong speculative demand for many of the world’s essential commodities. Speculation drives the prices of commodities to fresh highs World commodity prices have reached new highs this year helped by an increase in the rate of economic growth in the global economy. Among the metals that have achieved record price levels are copper, zinc, gold and platinum; prompting sceptics to question how much longer prices can continue rising. Many market experts believe that the demand for commodities has been spurred by heavy speculator activity. For example, pension funds and hedge funds have been investing in commodity mutual funds over recent years leading to increased demand for precious metals. Prices have risen quickly because commodity producers are unable to raise output sufficiently to meet unexpectedly strong demand.

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Source: Adapted from news reports, July 2006 Price points In many markets an assumption of a linear relationship between price and quantity demanded is not realistic. Many price-demand relationships are non-linear and an example of this is provided in the previous chart, used to illustrate the idea of price-points.

0

100

200

300

400

500

600

700

800

900

1000

0 100 200 300 400 500 600 700 800

Weekly sales of mountain bikes

Price of mountain bikes (£s)

Price points are points on the demand curve where a small change in price may cause a sizeable contraction in demand leading to a loss of total revenue for the producer. Consider price point A where raising the selling price of the mountain bike above £650 causes demand to decline quite quickly. From selling 250 bikes per week increasing the price to £700 leads to sales dipping to 175 per week. In technical terms we say that the price elasticity of demand is higher at a price just above the price point. Another price point might exist at B. Looking at this in a slightly different way, cutting the price below £400 leads to a large expansion of demand. Price points can be justified in a number of ways:

1. A price rise at the price point may make the product more expensive than a close substitute causing consumers to change their preferences.

2. Customers may have become used to paying a certain price for a type of product and if they see a further price rise, this may cause them to revalue how much satisfaction they get from buying and consuming something, leading to a decline in demand.

3. There may be psychological effects at work, supermarkets for example know the importance of avoiding price points - £2.99 somehow seems cheaper than £3.00 despite the tiny price difference.

A

B

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Markets: Understanding Supply Definition of Supply Supply is defined as the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period. The basic law of supply is that as the price of a product rises, so businesses expand supply to the market. A supply curve shows a relationship between the price and how much a firm is willing and able to sell.

A supply curve is drawn assuming ceteris paribus - if the price of the good varies, we move along a supply curve. In the diagram above, as the price rises from P1 to P2 there is an expansion of supply. If the market price falls from P1 to P3 there would be a contraction of supply in the market. Businesses are responding to market price signals when making their output decisions. Explaining the Law of Supply There are three main reasons why supply curves are drawn as sloping upwards from left to right giving a positive relationship between the market price and quantity supplied:

1. The profit motive: When the market price rises following an increase in demand, it becomes more profitable for businesses to increase output.

2. Production and costs: When output expands, a firm’s production costs tend to rise, therefore a higher price is needed to cover these extra costs of production. This may be due to the effects of diminishing returns as more factor inputs are added to production.

3. New entrants coming into the market: Higher prices may create an incentive for other businesses to enter the market leading to an increase in total supply.

Price

Quantity supplied

Supply

P1

P2

P3

Q1 Q3 Q2

Expansion of supply

Contraction of supply

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Shifts in the Supply Curve – Factors affecting supply The supply curve can shift position. If the supply curve shifts to the right (from S1 to S2) this is an increase in supply; more is provided for sale at each price. If the supply curve moves inwards from S1 to S3, there is a decrease in supply meaning that less will be supplied at each price

Changes in the costs of production

• Lower costs of production mean that a business can supply more at each price. For example a magazine publisher might see a reduction in the cost of its imported paper and inks. These cost savings can then be passed through the supply chain to wholesalers and retailers and may result in lower market prices for consumers.

• If the costs of production increase, for example following a rise in the price of raw materials or a firm having to pay higher wages to its workers, then businesses cannot supply as much at the same price and this will cause an inward shift of the supply curve.

A fall in the exchange rate causes an increase in the prices of imported components and raw materials and will lead to a decrease in supply. For example if the pounds falls 10% against the Euro, it becomes more expensive for British car manufacturers to import their rubber and glass from Western European suppliers, and higher prices for paints imported from Eastern Europe. Changes in technology

Price

Quantity

S1

P1

Q1 Q3 Q2

S2

S3

Increase in Supply

Decrease in Supply

Changes in any of the factors other than price cause a shift in the supply curve A shift in supply to the left – the amount that producers offer for sale at every price will be less A shift in supply to the right – the amount producers wish to sell at every price increases

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Production technologies can change quickly and in industries where change is rapid we see increases in supply and lower prices for the consumer. Government taxes and subsidies

Price

Quantity

Demand

Supply (post-tax)

P2

Q2

P1

Q1

Supply (pre-tax)

Size of the tax per unit

A tax increases the costs faced by producers. The amount of the tax is shown by the vertical distance between the two supply curves. Because of the tax, less can be supplied at each price level. The result is an increase in the market price and a contraction in demand to a new equilibrium output of Q2

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Changes in climate For commodities such as coffee, oranges and wheat, the effect of climatic conditions can exert a great influence on market supply. Favourable weather will produce a bumper harvest and will increase supply. Unfavourable weather conditions including the effects of drought will lead to a poorer harvest, lower yields and therefore a decrease in supply. Changes in climate can therefore have an effect on prices for agricultural goods such as coffee, tea and cocoa. Because these commodities are often used as ingredients in the production of other products, a change in the supply of one can affect the supply and price of another product. Higher coffee prices for example can lead to an increase in the price of coffee-flavoured cakes. Change in the prices of a substitute in production A substitute in production is a product that could have been supplied using the same resources. If cocoa prices rise for example this may cause some farmers to switch from other crops and invest money in establishing new cocoa plantations.

Price

Quantity

Demand

S1

P1

Q1

P2

Q2

Supply + Subsidy

P3

Subsidy per unit

A government subsidy encourages an increase in supply at each price level because the subsidy provides a reduction in a firm’s costs of production. The extent of the subsidy per unit is shown by the vertical distance between the two supply curves.

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US dollars per tonne, Daily priceWorld Cocoa Prices

Source: Reuters EcoWin

Jan06

Apr Jul Oct Jan07

Apr Jul Oct Jan08

Apr Jul Oct Jan09

Apr Jul Oct Jan10

Apr Jul

1250

1500

1750

2000

2250

2500

2750

3000

3250

3500

3750U

SD

/Ton

(met

ric)

1250

1500

1750

2000

2250

2500

2750

3000

3250

3500

3750

The number of producers in the market and their objectives The number of sellers in an industry affects market supply. When new businesses enter a market, supply increases causing downward pressure on price. If the existing businesses decide to move away from maximising their profits towards seeking a higher share of the market, then total supply available at each price will increase – the market supply curve will shift outwards. Competitive supply Goods and services in competitive supply are alternative products that a business could make with its factor resources of land, labour and capital. An example is the diversion of land used in supplying food to producing bio-fuels and the impact this has had on global food prices.

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Markets: Finding an Equilibrium Price The Concept of Market Equilibrium

Equilibrium means a state of equality or a state of balance between market demand and supply. Without a shift in demand and/or supply there will be no change in price. In the diagram above, the quantity demanded and supplied at price P1 are equal. At price P3, supply exceeds demand and at P2, demand exceeds supply.

• Prices where demand and supply are out of balance are termed points of disequilibrium.

• Changes in the conditions of demand or supply will cause changes in the equilibrium price and quantity in the market.

Demand and supply schedules can be represented in a table. The example below provides an illustration of the concept of equilibrium. The weekly demand and supply schedules for T-shirts (in thousands) in a city are shown in the next table:

Price

Quantity (Q)

Demand

Supply

P1

Q1

Equilibrium point – a “market clearing” point where supply = demand

P2

P3

Market price is set by the interaction of supply and demand. Equilibrium price is the price at which the quantity demanded by consumers and the quantity that firms are willing to supply of a good or service are the same.

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Price per unit (£) 8 7 6 5 4 3 2 1

Demand (000s) 6 8 10 12 14 16 18 20

Supply (000s) 18 16 14 12 10 8 6 4

New Demand (000s) 10 12 14 16 18 20 22 24

New Supply (000s) 26 24 22 20 18 16 14 12

1. The equilibrium price is £5 where demand and supply are equal at 12,000 units

2. If the current market price was £3 – there would be excess demand for 8,000 units

3. If the current market price was £8 – there would be excess supply of 12,000 units

4. A rise in income causes demand to rise by 4,000 at each price. The next row of the table shows the higher level of demand. Assuming that the supply schedule remains unchanged, the new equilibrium price is £6 per tee shirt with an equilibrium quantity of 14,000 units

5. The entry of new producers into the market causes a rise in supply of 8,000 T-shirts at each price. The new equilibrium price becomes £4 with 18,000 units bought and sold

Changes in Market Demand and Equilibrium Price

The outward shift in the demand curve causes an expansion along the supply curve and a rise in the equilibrium price and quantity. Firms in the market will sell more at a higher price and therefore receive more total revenue. The reverse effects will occur when there is an inward shift of demand. A shift in the demand curve does not cause a shift in the supply curve! Demand and supply factors are assumed to be independent of each other although some economists claim this assumption is no longer valid!

Price

Quantity

D1

Supply

P1

Q2

Price

Quantity

D1

Supply

P1

Q1

D3

Q3

P3

D2

Q1

P2

An Outward Shift (increase) in Demand An Inward Shift (fall) in Demand

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Changes in Market Supply and Equilibrium Price

Rising costs feed through to higher bread prices

Price

Quantity

S1

Q1

Price

Quantity

D1

S1

P1

Q1 Q3

P3

D2

Q2

P1

An Outward Shift (increase) in Supply An Inward Shift (fall) in Supply

S2

P2

S3

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Premier Foods has announced that the price of its Hovis and Mothers Pride branded breads will rise following the surge in world wheat prices. It is another example of how agri-flation is feeding through to the prices of processed foods. For Hovis, wheat is an important variable cost. Premier Foods buys about 1.3m to 1.4m tonnes of wheat a year. Premier needs to raise bread prices to recover further increases in raw material costs. In other words, it is banking on an ability to raise price to protect their profit margins. The effect on demand will depend on how other bread manufacturers respond and also the price elasticity of demand for bread in the market.

Source: Adapted from news reports, March 2008 Important note for the exams: A shift in the supply curve does not cause a shift in the demand curve. Instead we move along (up or down) the demand curve to the new equilibrium position. The equilibrium price and quantity in a market will change when there shifts in both market supply and demand. Two examples of this are shown in the next diagram:

In the left-hand diagram above, we see an inward shift of supply together with a fall in demand. Both factors lead to a fall in quantity traded, but the rise in costs forces up the market price. The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market from Q1 to Q3. Moving from one equilibrium to another

Price

Quantity

D1

S1

P1

Q1

Price

Quantity

D1

S1

P1

Q1

D3

Q3

P3

D2

Q2

P2

An Outward Shift in Demand and a Rise in Supply An Inward Shift in Demand and a fall in Supply

S2

S2

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Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand outlined in the diagrams in previous pages are reflective of changes in conditions in the market. So an outward shift of demand (depending upon supply conditions) leads to a short term rise in price and a fall in available stocks. The higher price is an incentive for suppliers to raise their output (termed as an expansion of supply) causing a movement up the short term supply curve towards the new equilibrium point. We tend to use these diagrams to illustrate movements in market prices and quantities – this is known as comparative static analysis. The reality in most markets and industries is more complex. For a start, many businesses have imperfect knowledge about their demand curves – they do not know precisely how consumer demand reacts to changes in price or the true level of demand at each and every price. Likewise, constructing accurate supply curves requires detailed information on production costs and these may not be readily available. Regulated prices Not all prices are set by the free market forces of supply and demand. In Britain, a number of prices are affected by the decisions of industry regulators – good examples are rail fares, the cost of postage stamps and water bills. In the rail market, some of the fares are unregulated allowing train operating companies to set their own prices. But around half of the fares charged for UK rail travellers are determined by the rail regulator which applies an Retail Price Index + 1% formula – this means that fares can rise by the rate of retail price inflation plus 1% each year. The extra 1% is designed to provide extra revenue for investment in improving rail infrastructure and new rolling stock.

You can see from the chart above that average rail fares in the UK have grown faster than the overall consumer price index. The result is that the real cost or price of travel has increased over recent years.

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Other examples of regulated prices are in telecoms and in the water industry. PostComm is the regulator which controls how much the Royal Mail can charge for postage stamps. OFWAT is the regulator for the water industry and every five years it announces a programme of planned price increases for water and sewerage bills.

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Price Elasticity of Demand

Ped measures the responsiveness of demand following a change in its own price. The formula for calculating the co-efficient of elasticity of demand is: Percentage change in quantity demanded divided by the percentage change in price Since changes in price and quantity usually move in opposite directions, usually we do not bother to put in the minus sign. We are more concerned with the co-efficient of elasticity of demand. Values for price elasticity of demand

1. If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes – the demand curve will be drawn as vertical.

2. If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is inelastic.

3. If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level.

4. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example a 10% increase in the price of a good might lead to a 30% drop in demand. The price elasticity of demand for this price change is –3

Demand for rail services At peak times, the demand for rail transport becomes inelastic – and higher prices are charged by rail companies who can then achieve higher revenues and profits

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Factors affecting price elasticity of demand

1. The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch.

2. The cost of switching between products – there may be significant costs involved in switching. In this case, demand tends to be relatively inelastic. For example, mobile phone service providers may insist on a12 month contract.

3. The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.

4. The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of income will tend to have a more elastic demand

5. The time period allowed following a price change – demand tends to be more price elastic, the longer that consumers have to respond to a price change. They may search for cheaper substitutes and switch their spending.

6. Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice).

7. Peak and off-peak demand - demand tends to be price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services.

8. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.

Demand curves with different price elasticity of demand

Price

Demand

P1

P2

P3

Q1 Q2 Q3

Price

Demand

P1 P2

P3

Q1 Q2 Q3

Relatively Inelastic Demand Relatively Elastic Demand

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Elasticity of demand and total revenue for a producer The relationship between elasticity of demand and a firm’s total revenue is an important one.

• When demand is inelastic – a rise in price leads to a rise in total revenue – for example

a 20% rise in price might cause demand to contract by only 5% (Ped = -0.25)

• When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in price might cause demand to expand by only 25% (Ped = +2.5)

The table below gives an example of the relationships between prices; quantity demanded and total revenue. As price falls, the total revenue initially increases, in our example the maximum revenue occurs at a price of £12 per unit when 520 units are sold giving total revenue of £6240.

Price Quantity Total Revenue Marginal Revenue

£ per unit Units £s £s

20 200 4000

18 280 5040 13

16 360 5760 9

14 440 6160 5

12 520 6240 1

10 600 6000 -3

8 680 5440 -7

6 760 4560 -11

Price

Demand

P1

P2

Q1 Q2

Price

Demand

P1

P2

Q1 Q2

Relatively Inelastic Demand Relatively Elastic Demand

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• Consider the elasticity of demand of a price change from £20 per unit to £18 per unit. The % change in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i.e. highly elastic).

• In this situation when demand is price elastic, a fall in price leads to higher total consumer spending / producer revenue

• Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit. The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of elasticity of – 0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a reduction in total revenue.

CHANGE IN THE MARKET WHAT HAPPENS TO TOTAL REVENUE?

Ped is inelastic and a firm raises its price. Total revenue increases

Ped is elastic and a firm lowers its price. Total revenue increases

Ped is elastic and a firm raises price. Total revenue decreases

Ped is -1.5 and the firm raises price by 4% Total revenue decreases

Ped is -0.4 and the firm raises price by 30% Total revenue increases

Ped is -0.2 and the firm lowers price by 20% Total revenue decreases

Ped is -4.0 and the firm lowers price by 15% Total revenue increases Elasticity of demand and indirect taxation Many products are subject to indirect taxes. Good examples include the excise duty on cigarettes (cigarette taxes in the UK are among the highest in Europe) alcohol and fuels. Here we consider the effects of indirect taxes on a producers costs and the importance of price elasticity of demand in determining the effects of a tax on market price and quantity.

A tax increases the costs of a business causing an inward shift in supply. The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the

Price

Quantity

S1

Q1

Price

Quantity

D1

S + Tax

P2

Q2 Q1

P1 D1

Q2

P1

A Tax when Demand is Price Inelastic Most of the tax is paid by the consumer

A Tax When Demand is Price Elastic Most of the tax is paid by producer

S + Tax

P2

S1

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supplier may be able to pass on some or all of this tax to the consumer by raising price. This is known as shifting the burden of the tax and this depends on the elasticity of demand and supply. Consider the two charts above. In the left hand diagram, the demand curve is drawn as price elastic. The producer must absorb the majority of the tax itself (i.e. accept a lower profit margin on each unit sold). When demand is elastic, the effect of a tax is still to raise the price – but we see a bigger fall in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand. In the right hand diagram, demand is drawn as price inelastic (i.e. Ped <1 over most of the range of this demand curve) and therefore the producer is able to pass on most of the tax to the consumer through a higher price without losing too much in the way of sales. The price rises from P1 to P2 – but a large rise in price leads only to a small contraction in demand from Q1 to Q2. The usefulness of price elasticity for producers Firms can use PED estimates to predict:

• The effect of a change in price on the total revenue & expenditure on a product.

• The likely price volatility in a market following changes in supply – this is important for commodity producers who may suffer big price movements.

• The effect of a change in an indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.

• Information on the PED can be used by a business as part of a policy of price discrimination. This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many of our domestic and international airlines.

Price elasticity of demand and changing market prices The price elasticity of demand will influence the effects of shifts in supply on price and quantity in a market. This is illustrated in the next two diagrams.

Price

Quantity

S2

Q2

D1

Q1

P2

An outward shift of supply when demand is price elastic (Ped > 1)

S1

P1

Price

Quantity

S2

Q2

D1

Q1

P2

S1

P1

An outward shift of supply when demand is price inelastic (Ped < 1)

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• In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward shift of supply – which leads to a large rise in equilibrium price and quantity and only a relatively small change in the market price.

• In the right hand diagram, a similar increase in supply is drawn together with an inelastic

demand curve. Here the effect is more on the price. There is a sharp fall in the price and only a relatively small expansion in the equilibrium quantity.

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Price Elasticity of Supply

Price elasticity of supply (Pes) measures the relationship between change in quantity supplied and a change in price.

• If supply is elastic, producers can increase output without a rise in cost or a time delay

• If supply is inelastic, firms find it hard to change production in a given time period. The formula for price elasticity of supply is: Percentage change in quantity supplied divided by the percentage change in price

1. When Pes > 1, then supply is price elastic

2. When Pes < 1, then supply is price inelastic

3. When Pes = 0, supply is perfectly inelastic

4. When Pes = infinity, supply is perfectly elastic following a change in demand What factors affect the elasticity of supply? (1) Spare production capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources. (2) Stocks of finished products and components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in the market. (3) The ease and cost of factor substitution: If both capital and labour resources are occupationally mobile then the elasticity of supply for a product is higher than if capital and

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labour cannot easily be switched. A good example might be a printing press which can switch easily between printing magazines and greetings cards. (4) Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield. In contrast the supply of milk is price elastic because of a short time span from cows producing milk and products reaching the market place.

An empty restaurant – plenty of spare capacity to meet any rise in demand!

When networks get congested at peak times, elasticity of supply becomes low

Businesses with plentiful stocks can supply quickly and easily onto the market when demand changes

For many agricultural products, time lags in the production process means that elasticity of supply is

low in the momentary time period

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The non-linear supply curve

Price

Quantity

Price

Quantity

Perfectly elastic supply An elastic supply curve

D2 D1

P1

D2 D1

S S

Q1 Q2 Q1 Q2

If Pes is inelastic: it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic – supply can react quickly to changes in price

Price

Quantity

Price

Quantity

Inelastic Supply Curve Perfectly inelastic supply

P1

P2

Q1 Q1 Q2

D1

D2 D1 D2

Perfectly inelastic supply: Pes = zero (supply cannot respond to a change in demand / price) – often associated with the momentary period with agricultural products

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A good recent example of price elasticity of supply in action is the strong demand for Apple’s new tablet device, the iPad. Over three million iPads were sold in the first few months of the product becoming available. But new supplies have been held up by a shortage of the flat panel LCD screens used in their manufacture from the Korean producers LG and Samsung.

Price

Quantity

P2

P3

P1

Q2 Q1 Q3

P4

P5

Supply

Q4 Q5

D1

D2

D3

D4

D5

Pes > 1

Pes < 1

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Income Elasticity of Demand

Income elasticity of demand measures the relationship between a change in quantity demanded for good X and a change in real income. The formula for calculating income elasticity is: % change in demand divided by the % change in income Normal Goods Normal goods have a positive income elasticity of demand so as consumers’ income rises more is demanded at each price i.e. there is an outward shift of the demand curve

1. Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4. Demand is rising less than proportionately to income.

2. Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise in the demand for new kitchens. The income elasticity of demand in this example is +1.25.

Inferior Goods Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises. Typically inferior goods or services exist where superior goods are available if the consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned properties. The income elasticity of demand is usually strongly positive for

• Fine wines and spirits, high quality chocolates and luxury holidays overseas.

• Sports cars

• Consumer durables - audio visual equipment, smart-phones

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• Sports and leisure facilities (including gym membership and exclusive sports clubs). In contrast, income elasticity of demand is lower for

• Staple food products such as bread, vegetables and frozen foods.

• Mass transport (bus and rail).

• Beer and takeaway pizza!

• Income elasticity of demand is negative (inferior) for cigarettes and urban bus services. Product ranges and longer term trends.

• Income elasticity of demand will vary within a product range. For example the Yed for own-label foods in supermarkets is less for the high-value “finest” food ranges.

• There is a general downward trend in the income elasticity of demand for many basic

products, particularly foodstuffs. One reason is that as a society becomes richer, there are changes in tastes and preferences. What might have been considered a luxury good several years ago might now be regarded as a necessity? How many of you regard a Sky sports subscription or an iPhone4, an iPad or a new Blackberry as a necessity?

How high is the income elasticity for fine wines?

Income elasticity for baked beans? Likely to be low but positive as beans are a staple food

Income elasticity for cigarettes? According to some estimates, cigarettes are inferior goods

What of the income elasticity of demand for private executive air travel?

The table below shows estimated price and income elasticity of demand for a selection of foods: PRODUCT SHARE OF BUDGET

(% OF HOUSEHOLD INCOME)

PRICE ELASTICITY OF DEMAND (PED)

INCOME ELASTICITY OF DEMAND (YED)

All Foods 15.1 n/a 0.2 Fruit juices 0.19 -0.55 0.45

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Tea 0.19 -0.37 -0.02 Instant coffee 0.17 -0.45 0.16

Source: DEFRA www.defra.gov.uk

The income elasticity of demand for most types of food is low – occasionally negative (e.g. for margarine) and likewise the own price elasticity of demand for most foodstuffs is also inelastic. Sales of organic food drop in the recession Sales of organic foods in the UK slumped by more than 12% in 2009 as cost-conscious consumers cut back on their purchases of premium-priced organic fruit, vegetables and meats. The recession seems to have had a big impact. Real incomes have been falling and organic food’s reputation for being expensive has caused many consumers to rein back on spending. The three biggest categories of organic food – dairy; fruit and vegetables; and fresh meat – saw supermarket sales fall by 6.5%, 14.8% and 22.7% respectively. Demand may also have been influenced by a recent Food Standards Agency report last year which found that there were “‘no important differences in nutritional content, or any additional health benefits, of organic food when compared with conventionally prepared food.”

Tutor2u Economics Blog, November 2009 How do businesses make use of estimates of income elasticity of demand? Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle on sales. Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the cycle. Income elasticity and the pattern of consumer demand As we become better off, we can afford to increase our spending on different goods and services. The income elasticity of demand will also affect the pattern of demand over time.

• For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the proportion of a consumer’s income spent on that product will go up.

• For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall

• For inferior goods as income rise, demand will decline and so too will the share of income spent on inferior products.

A good example of a product with a negative income elasticity of demand is tobacco products. Many factors affect demand for cigarettes and related products – not least the level of indirect tax placed on them by the government and also the effects of health campaigns and bans on smoking in public places. Even allowing for this, as the chart above shows, real spending on tobacco has fallen in nearly every year since 1980 and is now less than half the level at the start of the 1980s.

Annual spending £ billion at constant 2001 pricesUK Household Spending on Tobacco Products

Source: Reuters EcoWin

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

billio

ns

12.5

15.0

17.5

20.0

22.5

25.0

27.5

30.0

32.5

2003

GB

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12.5

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17.5

20.0

22.5

25.0

27.5

30.0

32.5

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Demand in a recession – counter-cyclical products

At first thought, most people assume that recession can only spell bad things for businesses. However, there are a good number of examples of industries that thrive when times are hard. Some produce inferior goods; some goods that are cheap substitutes for more luxury items; some equip households with the ability to repair rather than replace. Inferior goods are those for which demand rises when income falls. The typical examples discussed in class are usually things such as bus tickets and supermarket value ranges. Demand for inferior goods is, by its nature, counter-cyclical. A recent article in The Times analysed the effects of recession on the sale of McDonald’s’ “Extra Value Meals” (EMVs): “As the effects of recession continued to be felt...the lure of fast food at McDonald’s, as an alternative to more expensive eating out, proved irresistible to many consumers...in Britain, McDonald’s attracted 8% more customers in its third quarter”. Other fast-food companies that have seen similar rises in demand include KFC and Pizza Hut. In a similar vein, sales of caravans have soared in the UK, as people have chosen to ‘staycation’ rather than travel abroad. Demand for second hand caravans has been high, and surprisingly, many of the consumers are young, first-time caravan-buyers. The Camping and Caravanning Club saw a record 53,000 new members in 2008 with a 21% rise in bookings, and The Caravan Club (a competitor) saw its bookings rise by 17%. Demand for a number of other goods rises in recessions, yet these goods are not really ‘inferior’. Take lipstick sales, for example. Recent analysis suggests that sales of lipstick rise in times of recession or low consumer confidence, the reason being that women substitute more expensive purchases (clothes, handbags, shoes etc) for lipstick which is relatively cheaper yet can provide a morale boost. Condom sales are another example. An article in USA Today earlier in the year stated that sales of condoms rose by 5% in the last quarter of 2008 compared with the previous year, and nearly 3% in the first quarter of 2009 compared with the same time in 2008. The effect was even more pronounced in the UK, with one report suggesting that sales of Durex have so far risen by 22% over the course of the recession! Two reasons for the link with recession have been given; firstly, staying in is cheaper than going out, and secondly, households are more concerned with the potential cost of having children. As well as these more ‘active’ pursuits, many more people are staying in and enjoying a night on the sofa with takeaway pizza. Domino’s Pizza, the UK’s largest pizza delivery chain, has seen market growth of 8.3% over the past year according to their own figures. Their sales growth has been further boosted by increased advertising, since advertising fees have fallen dramatically as advertising companies have lowered prices to retain business. Demand has also risen for ‘DIY’ related goods. Households are choosing to repair broken items such as cars or household equipment rather than replace. Sales of fruit and vegetable seeds also increased in the early part of 2009 as more people took advantage of the growing season. A number of examples of ‘counter-cyclical’ sales have been given here. There are many more. Use of these examples is a great way of introducing evaluation into exam answers relating to the effects of recession.

Source: Ruth Tarrant, EconoMax, December 2009

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Cross Price Elasticity of Demand

Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the price of a related good Y. We are looking here at the effect that changes in relative prices within a market have on the pattern of demand. With cross elasticity we make a distinction between substitute and complementary products. Substitutes: With substitute goods such as brands of cereal, an increase in the price of one good will lead to an increase in demand for the rival product. The cross price elasticity for two substitutes will be positive. For example, the iPhone now provides genuine competition for the Blackberry in providing users with ‘push technology’ to send all emails through to a mobile device. But how many Blackberry users will switch? Many have become addicted to their machines! Another good example is the cross price elasticity of demand for music. Sales of digital music downloads have been soaring with the growth of broadband and falling prices for downloads. As a result, sales of traditional music CDs are declining at a steep rate.

Complements: Complements are in joint demand. The CPED for two complements is negative. The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand. For example with two close substitutes, the cross-price elasticity will be strongly positive. Likewise when there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative. Unrelated products have a zero cross elasticity. Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms use estimates of CPED to predict the effect on demand and total revenue of their own

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product. For example, two or more airlines competing with each other on a given route will have to consider how one airline might react to its competitor’s price change. Will many consumers switch? Will they have the capacity to meet an expected rise in demand? Will the other firm match a price rise? Will it follow a price fall? Pricing strategies for complementary goods: Popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements. Popcorn has a high mark up i.e. pop corn costs pennies to make but sells for more than a pound. If firms have a reliable estimate for CPed they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn. The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into the cinema. For some movie theatres, the revenue from concessions stalls selling popcorn; drinks and other refreshments can generate as much as 40 per cent of their annual turnover. Brand and cross price elasticity When consumers become habitual purchasers of a product, the cross price elasticity of demand against rival products will decrease. This reduces the size of the substitution effect following a price change and makes demand less sensitive to price. The result is that firms may be able to charge a higher price, increase their total revenue and achieve higher profits.

Party Season Nearly Christmas This mnemonic will help students remember quickly what the figure given by the cross price elasticity of demand formula means.

Positive Substitutes

Negative Complements

Price Of Good Y

Demand for Good X

P1

P2

Q1 Q2

Price of Good B

Demand for Good A

P2

P1

Q2 Q1

Relationship between two close complements

Relationship between two substitutes

An increase in the price of good Y leads to a decrease in demand for

good X

An increase in the price of good B leads to an increase in demand for

good A (a substitute)

Quantity Quantity

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Case study in income and cross price elasticity – sat nav systems and atlases

In recent years sales of satellite navigation systems (sat-navs) have grown at the expense of the traditional road atlas. They have obvious advantages over atlases, although they have had some bad publicity with people ending up down isolated farm tracks miles from their destination. Sat-navs are also easily stolen from cars.

Nonetheless they have clearly been seen by many as a superior substitute to atlases although whether they have a clear positive cross elasticity relationship is more debatable. Sat-navs retail at £100 plus and road atlases cost less than £10 for the most basic, and in addition both have been falling in price recently. However, many would feel that they are in competitive demand.

In the five years prior to the recent recession sat-nav sales in Europe doubled to almost 14 million units, whereas sales of road atlases through UK bookshops fell by 17%. This could indicate that sat-navs can be regarded as a normal good and road atlas inferior goods as the launch of the sat-nav occurred alongside rising GDP and real incomes in the economy.

However with the onset of recession the luxury and novelty of having a sat-nav has been tested. In 2009 one of the UK’s major retailers of sat-navs is said to have reported sales down by 30%. By contrast in the two months since the launch of the new editions of the Britain 2010 road atlases sales were reported to be up by nearly 10% over the same period last year.

The recession has seen people being much more careful with their spending on perceived luxuries, and having an up-to-date road atlas which is often very cheap via Amazon, book clubs or at petrol stations is now very attractive as a reliable necessity for drivers. It seems that these current sales trends continue to confirm that sat-navs are normal goods and road atlases inferior goods.

The A-Z Map Company has added postcodes against places of interest on their road atlases. This means people can study a road atlas first for routes to wherever they are going and can then use the postcode reference and put it into the sat-nav. Will the products become complements in the future to some extent? Will sales of free-standing sat-navs fall as a people increasingly buy cars with sat-navs as a standard feature? This market has clearly still some way to go.

Source: Bob Nutter, EconoMax, summer 2010

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Functions of the Price Mechanism The invisible hand – the workings of the price mechanism Adam Smith, one of the Founding Fathers of modern economics once described the “invisible hand of the price mechanism” in which the hidden hand of the market operating in a competitive market through the pursuit of self-interest allocated resources in society’s best interest. This remains a view held by free-market economists who believe in the virtues of an economy with minimal government intervention. The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses. The price mechanism plays three important functions in a market: 1/ the signalling function Prices perform a signalling function – they adjust to demonstrate where resources are required, and where they are not. Prices rise and fall to reflect scarcities and surpluses. So, for example, if prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand.

In the example on the right, an increase in market supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve

Price of Computer

Games

Quantity

S1

Price of Digital Cameras

Quantity

D1

D2

S1

P2

P1 P1

P2

Q1 Q2

D2

S2

Q1 Q2

Higher demand signals to producers to step up production – if they are driven by the profit motive. Total revenue is higher at price P2 and output Q2

In this diagram, an increase in supply leads to lower market prices – a signal to consumers that their real income has increased – they can afford to buy more

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Conversely, a rise in costs of production will induce suppliers to decrease supply, while consumers will react to the resulting higher price by reducing demand for the good or services. Scarcity and market prices “We are no longer living in an age of abundant resources. The high prices of scarce resources such as oil and gas are the market’s response to huge shifts in supply and demand. The market is saying that we must use more wisely resources that have now become more valuable. The market is right.”

Source: Adapted from Martin Wolf, Financial Times www.ft.com accessed May 14th 2008 2/ signalling Function – the transmission of preferences Through their choices consumers send information to producers about the changing nature of needs and wants. Higher prices act as an incentive to raise output because the supplier stands to make a better profit. When demand is weaker (for example during a recession) then market supply contract as producers cut back on output. One of the features of a market economy system is that decision-making is decentralised i.e. there is no single body responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic market system. 3/ Rationing function Prices serve to ration scarce resources when demand in a market outstrips supply. When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product. Be it the demand for tickets among England supporters for an Ashes cricket series or the demand for a rare antique, the market price acts a rationing device to equate demand with supply. The popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market. Most economies are mixed economies, comprising not only a market sector, but also a non-market sector, where the government (or state) uses planning to provide public goods and services such as police, roads and merit goods such as education, libraries and health. In a command economy, planning directs resources to where the state thinks there is greatest need. Following the collapse of communism in the late 1980s and early 1990s, the market-based economy is now the dominant system – even though we are increasingly aware of many imperfections in the operation of the market. Prices and incentives

• Incentives matter! For competitive markets to work efficiently all ‘economic agents’ (i.e. consumers and producers) must respond to appropriate price signals in the market.

• Market failure occurs when the signalling and incentive functions of the price mechanism

fail to operate optimally leading to a loss of economic and social welfare. For example, the market may fail to take into account the external costs and benefits arising from production and consumption. Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision to buy and consume a product.

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Secondary markets Secondary markets occur when buyers and sellers are prepared to use a second market to re-sell items that have already been purchased. Perhaps the best example is the secondary market in tickets for concerts and sporting-events. Government intervention in the market mechanism Often the incentives that consumers and producers have can be changed by government intervention in markets. For example a change in relative prices brought about by the introduction of government subsidies and taxation.

• Agents may not always respond to incentives in the manner in which textbook economics

suggests.

• The “law of unintended consequences” encapsulates the idea that government intervention can often be misguided of have unintended consequences!

Price

Quantity

S1

Q1

Price

Quantity

D1

Supply

P1

Q2 Q1

P2

D1

Q2

P1

S + Tax

P2

Indirect Taxes An indirect tax increases the relative price of a product and should cause a contraction of demand. The government is intervening in the market because it wants to changes the price signals and incentives of producers and consumers. In this case the justification may be a desire to correct for negative externalities.

Government Subsidies A subsidy to consumers to cover some of the costs of buying child care or employing nannies is designed to reduce the relative cost of this and therefore increase demand. The justification could be to encourage more young mothers to actively seek work, expand the labour supply and contribute to the country’s productive potential.

D2

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Price Volatility in Markets Price stability Not all markets experience volatile prices. They tend to be markets with products where the conditions of supply and demand are stable from year to year and where the price elasticity of demand and the elasticity of supply are both high. We can see this in the diagram below.

Stable prices The price of milk is pretty stable over time. Partly this is due to intense competition between the leading supermarkets but the conditions of market demand and supply are also relatively stable and predictable. The price elasticity of supply is high and mass production of milk leads to a predictable price in the supermarket. The recent increase in milk prices is the result of sharply rising costs of wholesale milk which itself has been due to increasing costs of production for milk farmers and the rising price of imported milk.

Price

Quantity

S1

Q1

Price

Quantity

D1

S

P1

Q2 Q1

P2

D1

Q2

P1

S2

P2

When demand is highly elastic, shifts in the supply curve have little effect on the market equilibrium price, although market quantities will change. In the example below, there is a fall in market supply with conditions of demand remaining unchanged.

When supply is highly elastic, shifts in demand again have little impact on the market equilibrium price. In the example below we see the effects of an outward shift in the market demand curve.

D2

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Price per pintAverage Price of Pasteurised Milk

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

27.5

30.0

32.5

35.0

37.5

40.0

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45.0pr

ice

per p

int

27.5

30.0

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35.0

37.5

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Price

Quantity

S1

Q1

D

Q2

P1

S2

P2

Inelastic demand and shifts in supply When the price elasticity of demand is low, volatile shifts in market supply causes large changes in the market equilibrium price, although the equilibrium quantity traded may not change that much.

Inelastic supply and demand We then consider shifts in demand when the price elasticity of demand is low. If Ped and Pes are both low then the scene is set for big changes in the market equilibrium price. E.g. a fall in supply from S1 to S2 and an increase in demand from D1 to d2 causes market price to jump from P1 to P4

S3

P3

Price

Quantity

S1

Q1

D1

Q2

P1

S2

P2

S3

P3

D2

P4

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Products with unstable conditions of supply and demand will experience price fluctuations. For example, for many products there are seasonal variations in demand which cause prices to rise sharply at peak times and then fall back during the off-peak periods. Seasonal demand is strong in the tourism and leisure industries. You will find that the prices of hotel rooms and the prices of package holidays are higher during the school holidays because hoteliers and travel businesses know that the demand is price inelastic and families will have to pay higher prices. Agricultural (farm) prices tend to be volatile because:

• Supply changes from one time period to the next because of weather conditions which affect the size of the harvest

o When supply falls short of planned output, for a given demand, price will rise

o When actual output is in excess of planned output, for a given level of demand, market price will fall

• The effects of changes in supply can be amplified by a price-inelastic demand, for raw materials and components where the buyer sees them as essential to their production processes they must buy at whatever the market price is.

• Price volatility can be magnified because of the activity of speculators who are betting on future price changes.

Many economists regard price volatility as a source of market failure. Problems arising from price volatility in markets can include the following:

1. Risk: Makes incomes and profits for producers unpredictable and may inhibit investment

spending because suppliers are concerned about their expected profits.

2. Poverty: Sharp falls in prices and incomes can cause hardship and poverty and also unemployment, especially in regions and countries dependent on cash from exporting.

3. Balance of Payments: Big swings in prices cause large changes in export revenues for major exporters of primary commodities - affecting their balance of payments and their ability to finance essential imports of food and technology.

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In recent years we have seen a lot of volatility in the prices of many internationally traded commodities such as oil, gas, iron ore, palm oil, rubber, copper and many foodstuffs. The chart above tracks the Economist Commodity Price Index and shows just how volatile have been the prices of foodstuffs and industrial metals. There are many factors at work here as this IMF report on rising global food prices makes clear: The food price surges since 2006 reflect a confluence of factors. Demand growth has generally outstripped supply growth for many food commodities over the past 10 years or so, particularly for edible oils and major grains—including corn, rice, soybeans, and wheat. Correspondingly, global stocks of these crops have declined to relatively low levels last seen in the mid-1970s over the past several years. The upward pressure on prices has been increased through the effects of unfavourable weather conditions in a number of countries which reduced crop production in 2006-07, particularly wheat. Second, the demand for corn increased sharply in 2006-07 as a result of the sharp increase in corn-based ethanol production. On top of this, the rising oil prices over the past year and a half have added substantial broad cost pressures. In a seller's market, such cost increases are passed on fully to producer prices. Finally, a growing number of countries have imposed export restrictions in response to rising food prices, which added to international price pressures. As usual, these developments not only pushed up the prices of the foods directly affected, but also those of close substitutes. In addition, rising food prices have led to cost pressures elsewhere along the food chain, notably poultry and meats Changes in commodity prices are often called “external shocks” and they have direct and indirect effects on consumers and producers across many different parts of the economy. The notes below trace some of the costs and benefits of higher commodity prices mainly from a UK perspective.

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Costs

1. Rise in input costs (variable costs) – leading to surge in producer price inflation – now showing through in a rise in consumer price inflation

2. Higher food price inflation (agflation) – perhaps brings an end to the era of cheap food. This may be damaging to lower income groups and especially those with little/no wage bargaining power.

3. Rising cost of essential foodstuffs and energy has caused a fall in real incomes and less income available to spend after ‘essentials’ such as food and utilities This in turn has negatively affected consumer confidence and risks causing an economic recession.

4. Higher input costs for businesses: Hits profits especially if manufacturers cannot pass on to final consumers. More expensive commodities may accelerate trend towards out-sourcing production to lower cost countries and it also makes it more costly to transport products around the world. There is possible damage to export businesses if rising costs worsen competitiveness and the risk of stagflation

5. Worsening trade deficit: The UK is a net importer of foodstuffs and also now a net importer of oil! A trade deficit is a leakage from the circular flow – causing a slowdown in aggregate demand.

Benefits

1. Higher food prices are good for the farming sector which has suffered from years of declining real prices and real incomes. (That said farming in Britain contributes less than 1 per cent of UK GDP!)

2. Stronger prices provide a boost for sectors such as renewable energy and if fuel prices remain high this may have important environmental benefits – e.g. encourage car manufacturers to invest more in improving fuel efficiency / change the pattern of demand towards smaller cars. Will rising food prices contribute to less obesity? Or have the reverse impact?

3. A stimulus to the North Sea oil and gas industry and related sectors Mini Case Study: Rice Prices Hit Curry Lovers Devotees of their local curry house should make a point of checking the menu next time they pop out for a hot one. The cost of the fragrant basmati rice - one of the most popular in the UK - has almost doubled leaving curry houses with little choice but to pass some of this onto their customers! Supply and demand-side factors help explain the steep increase in world prices. 95 per cent of the world's rice is consumed in the country in which it is produced, but the largest producers such as India, Thailand and China have deliberately reduced their exports, and Vietnam and Egypt have taken their exports off the market altogether. India and China are concerned that their fast-growing populations and rising incomes which have encouraged a switch in demand towards higher quality rice may leave them with insufficient rice to feed their own people.

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The supply-potential of the major rice growing nations has also been affected by a switch in the use of farming land away from food production towards bio-fuels. According to the International Rice Research Institute: 'China provides an example — rice area decreased by almost 3 million hectares between 1997 and 2006 because of this economic pressure.' Rice fields are also being given over to property developments in countries such as The Philippines and Vietnam. And floods and cyclones in Bangladesh have devastated large parts of their rice crop.

US $s per tonneWorld Price of Rice

Source: Reuters EcoWin

Jan07

Apr Jul Oct Jan08

Apr Jul Oct Jan09

Apr Jul Oct Jan10

Apr Jul

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Global demand for rice has been rising steadily in both advanced and emerging market countries. Demand for rice in Asia is expected to continue to rise in the future as its population expands even though per capita consumption might decline above a certain income level. Additional demand is likely to arise from Africa, where rice is becoming an increasingly important food crop. The rising cost of shipping rice around the world is another reason for the price increases. Britain is directly affected by big movements in world prices. We are the largest importer of rice in the European Union buying in around 200,000 tonnes of rice every year. We also have a sizeable Bangladeshi community whose staple diet is rice - there are fears about how big price hikes will hit this particular group. For people whose dependence on rice as part of their essential diet is high, the impact is serious.

Source: EconoMax, March 2008 Unintended consequences of market price volatility! The price of scrap metal has been soaring and this has led to a rise in criminal activity! Thieves seem prepared to steal lead from church roofs and railway yards have also been targeted, Thieves can currently get £120 a tonne for steel and between £500 and £600 a tonne for scrap aluminium. The UK collects around 15m tonnes of used metal each year and uses only 40% of it. The remaining 60% is exported around the world with increasing demand notable from Russia, Saudi Arabia, China, India and South America.

Source: Adapted from news reports, June 2008

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Case Study: Volatility in world sugar prices

Index of UK consumer prices 2005=100Prices for sugar, jam, honey, syrups and confectionery

Spot price of sugar, New York exchange, daily closing price Price index for sugar, jam, honey, syrups, chocolate and confectionery

Source: Reuters EcoWin

04 05 06 07 08 09 10

95

100

105

110

115

120

125

130

Inde

x

95

100

105

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115

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125

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Price index for sugar, jam, honey, syrups and confectionery

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ound

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World Sugar Price

The global price of raw sugar has increased to its highest level since March 1981 on the back of a widening imbalance between world supply and demand. The hike in sugar prices is a market response to a rise in the demand for sugar - especially in Brazil where a growing volume of sugar is being used as a (subsidised) source of ethanol - combined with supply shortages caused by low rainfall during the monsoon season in India and China and hail and drought affecting supplies from Russia. Sugar output in India has contracted by more than 45% over the last year and the country might move from being a net exporter to a net importer of sugar as measures are taken to limit existing exports to maintain sufficient supplies for the home economy. When demand exceeds supply, existing stocks fall and this is a key factor driving prices higher. Speculators can cause the price movements to be exaggerated as they trade in the forward markets to buy up available stocks in the expectation of further price increases. One reason for supply shortages in India may be the 40 per cent drop in prices in the middle of 2008. Some market analysts believe that many Indian farmers were quick to swap their sugar canes for bananas when sugar prices collapsed - and this rapid supply response is now showing through in lower than forecast production. Shortages of and rising prices for raw sugar will give a hit to food processing companies and then affect prices in the shops. A cluster of food manufacturers in the United States including well known brands such as Mars, Krispy Kreme Doughnuts, Hershey and Kraft Foods have created the Sugar Policy Alliance which is lobbying the Obama government to relax existing sugar import quotas. Without this they claim that sharply higher input costs will have a damaging effect on profits, production and jobs. Some countries have already moved into action. Egypt has temporarily abandoned import duties on raw and white sugar imports to businesses that use sugar as a key raw material. Governments in other countries will also come under pressure to purchase at super-high prices whatever sugar is available in the world markets to guarantee supplies for their own consumers. Here in the UK we are yet to see the full impact of the 28 year high in global sugar prices. But wait a few months and you will see the retail price of sugar-based jam and honey moving higher. If your demand for sugary foods is inelastic, you will be paying quite a bit more between now and the end of the year!

Source: Geoff Riley, EconoMax, September 2009

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Inter-relationships between Markets Supply and demand analysis can be used to explain and inter-relationships between different markets and industries.

In the first example we consider an increase in the supply of low-cost flights available from airports across the United Kingdom. The market supply of flights has shifted out to the right as lost cost airlines have entered the market and existing airlines have expanded their route network and fleet capacity. The result is a reduction in the real price of flights to short-haul destinations in Europe. A fall in the price of airline flights increases the market demand for overseas holidays (short city breaks, package holidays for example). Assuming that British tourists can choose to holiday at home or overseas and regard the two products as substitutes, then the effect is to reduce the demand for holidays in the UK – putting downward pressure on prices, profit margins and leading to the risk of excess capacity in the UK tourist industry.

Airline Ticket Prices

Quantity demanded (Million passenger km per year)

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Quantity demanded of holidays in the UK

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Consider how rising oil prices can feed through to related markets

Derived demand The demand for a product X might be strongly linked to the demand for a related product Y. For example, the demand for steel is strongly linked to the market demand for new cars, the construction of new buildings and many manufactured products. In factor markets, the demand for labour is derived from the demand for the goods and services that we employ labour to produce. Composite demand Composite demand exists where goods or services have more than one use so that an increase in the demand for one product leads to a fall in supply of the other. The most commonly quoted example is that of milk which can be used for cheese, yoghurts, cream, butter and other products. Another good example is land – land can be developed in many different ways – for commercial property, residential properties, leisure facilities, farming, common land and so forth. Joint supply Joint supply describes a situation where an increase or decrease in the supply of one good leads to an increase or decrease in supply of another. For example an expansion in the volume of beef production will lead to a rising market supply of beef hides. A contraction in supply of lamb will reduce the supply of wool.

Crude Oil Prices ($ per

barrel)

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Increasing demand for crude oil forces up the world market price (P1 – P2 – P3) Crude oil is used as a raw material in producing heating oil for central heating systems – the higher price of crude causes an increase in costs and reduction in the market supply of heating oil at each price level (shown in the right hand diagram)

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Consumer Surplus When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at. Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods. Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price). The level of consumer surplus is shown by the area under the demand curve and above the price as in the diagram below.

Consumer surplus and price elasticity of demand

1. When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches what they are willing to pay.

2. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does

not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such a low price elasticity of demand?

Price

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Consumer surplus is the difference between the price that a consumer is prepared to pay and the actual price paid

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3. The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the diagram below.

Changes in demand and consumer surplus

When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will alter. This is shown in the diagrams above. In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.

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Quantity Demanded Quantity Demanded

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Supply

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In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare shown by a rise in consumer surplus. Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge. Text calls and consumer welfare The EU Competition Commission is capping the cost of mobile phone text messages as complaints rise that consumers are being ripped off. Their research finds that texting across borders carries a big price tag in Europe - British holidaymakers in Spain can pay up to €0.63 for a message home. EU Telecoms commissioner Viviane Reding has decided that such charges are unjustified and should be capped at €0.11, down from an average price of €0.29 in the 27-member EU. “EU citizens should be free to text across borders without being ripped off,” Reding said. “Roaming charges have already drained the wallets of mobile customers too much.” 2.5 billion roaming messages sent every year by mobile users in the EU and they cost over 10 times more than the messages they send when at home.

Sources: Adapted from EU Commission press releases and newspaper reports Price discrimination and consumer surplus Producers often take advantage of consumer surplus when setting prices. If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products, then sellers use price discrimination – this is a way of turning consumer surplus into producer surplus, put simply to make higher revenues and profits. Airlines and train companies are expert at this, extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of demand for different types of passenger service. You will always get a better deal / price with airlines such as EasyJet and Ryan Air if you are prepared to book in advance. The airlines are happy to sell tickets more cheaply because they get the benefit of cash-flow together with the guarantee of a seat being filled. The nearer the time to take-off, the higher the price. If a businessman is desperate to fly from Newcastle to Paris in 24 hours time, his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher. One of the main arguments against firms with monopoly power is that they exploit their monopoly position by raising prices in markets where demand is inelastic, extracting consumer surplus from buyers and increasing profit margins at the same time. We shall consider the issue of monopoly in more detail when we come on to our study of market failure.

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Producer Surplus Producer surplus is a measure of producer welfare. It is measured as the difference between what producers are willing and able to supply a good for and the price they actually receive. The level of producer surplus is shown by the area above the supply curve and below the market price and is illustrated in the diagram above.

Producer surplus and changes in demand and supply We first consider the effects of a change in market supply – for example caused by an improvement in production technology or a fall in the cost of raw materials and components used in the production of a good or service

Price

Quantity

Demand

Supply

P1

Q1

Equilibrium Point

Producer Surplus

Producer surplus is the difference between the market price received by the seller and the price they would have been prepared to supply at

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We now consider the effects on producer surplus of a rise in market demand

Price Wars in the Budget Hotel Market

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Producer surplus at price P2 = area

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The UK budget hotel industry is dominated by two firms: Travelodge (582 hotels) and Premier Inn (377 hotels). This duopoly is currently in the midst of a profit-slashing price war. Premier Inn is selling rooms over the starting at £29 per night, prompted by falling occupancy rates due to the recession. Travelodge has responded in predictable fashion by offering a proportion of its rooms at just £19 per night for the same period. As prices come down on hotel rooms, not only will consumer surplus rise for those who had already intended to stay away, but customers who would otherwise have been priced out of the market can now participate. Thus, we can argue that total consumer welfare will rise as a result in the short term. This conclusion assumes that the quality of the rooms available does not alter as a result of the price war; there may be a chance that quality will suffer as costs must fall in order to remain profitable. Large companies such as Travelodge should be able to bear short-term losses. However, the much smaller companies that also make up this duopolistic market may be priced out of the market, and may not survive. In the longer-term, the reduction in competition and choice for consumers may lead to higher prices and lower quality, as supply falls. In addition, a fall in price will lead to a fall in revenue earned if demand is relatively price inelastic. Many consumers use budget hotel rooms out of necessity (e.g. breaking up long journeys). Demand for budget rooms is also closely linked to the price of car transport, which remains relatively high in the UK; a fall in price, therefore, is unlikely to lead to a more than proportionate rise in demand. Since we can also probably safely assume that costs have not fallen, then ultimately profits will fall. Exacerbating this outcome is the possibility of the price-anchoring effect taking hold, as consumers come to expect very low prices for budget hotel rooms, thus preventing the price from rising again in the future. Furthermore, once consumer confidence and income starts to noticeably rise again, it is likely that consumers will increase their demand for higher quality hotel rooms, rather than budget hotel rooms. Consumers are the winners in the short-term from price wars, whilst the benefits accruing to businesses are more dubious. In the longer term, however, it is difficult to see precisely how a price war generates benefits to either consumers or businesses. It will be interesting to see whether the pillow fight between Travelodge and Premier Inn ends in a room full of feathers.

Source: Ruth Tarrant, EconoMax, Easter 2010

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Markets in Action: The Market for Oil The effects of changes in the price of oil can be far-reaching, not just for Britain but for the global economy too. A basic study of the oil market is a useful application of the principles of supply and demand analysis and a way of understanding the interconnections between the microeconomics of the oil market and their macroeconomic consequences. What determines crude oil prices?

Light Crude Spot (WTI), Nymex, US dollars per barrelNymex crude oil

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Oil is one of the most heavily traded commodities in the world. Fluctuating prices have important effects for oil producers/exporters and the many countries that remain dependent on oil as a key input in their energy, manufacturing and service industries. Demand for Oil

1. Cyclical demand: When global economic growth is strong, the demand for crude oil increases. There is a positive relationship between world GDP and total demand for crude. Fast-growing emerging market countries have provided the bulk of the extra demand for crude in recent years although the world’s biggest economy – the United States – has also added to total demand. More recently the global economic recession has caused a fall in demand for crude oil – a key factor behind the drop in prices in the second half of 2008.

2. Rising living standards: Undoubtedly the sustained rise in living standards in many countries that accompanied a decade or more of globalisation has contributed to increasing demand for energy and other oil-related products. China overtook Japan as the world's second-largest consumer of oil five years ago and is closing in on the USA, with demand for oil growing by more than ten per cent a year. Transport provides an important clue to

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unparalleled demand for crude oil. In July 2008, OPEC forecast that demand for oil would grow by 50% between now and 2030 as people in developing countries drive more cars.

3. Prices of substitutes: Demand for crude oil is affected by the relative prices of and availability of economically viable oil substitutes such as bio fuel.

4. Changes in climate – e.g. affecting the demand for heating oil. It is often said that if the winter in North America is fierce, then the price of crude rises as the USA and Canadian economies raise their demand to fuel household heating systems and workplaces

5. Market speculation: There is always a speculative demand for oil. Indeed one of the features of the most recent spike in oil prices has been the high level of demand by hedge funds and other investors pouring into the international petroleum exchanges to buy up surplus oil futures contracts. They hope that by the time the contracts are ready to be fulfilled, they will have made a large profit. Speculation involves risk, prices can do down as well as up. The scale of speculative activity has been open to question – some of it has been encouraged by the depreciation in the value of the US dollar. This is because oil is priced in dollars – so overseas investors holding other currencies can buy more barrels of oil as the dollar declines.

Nearly two thirds of global crude oil production is consumed by leading industrialised nations – i.e. the nations that make up the Organisation of Economic Cooperation and Development (OECD). But a rising share of demand comes from emerging economies including China, Brazil, Russia and India. Derived demand for oil Crude oil is bought not for its own sake but for its uses including:

1. Gasoline: used in motor spirit/petrol

2. Middle Distillates e.g. diesel – used in vehicles and other motors/engines and jet fuel

3. Kerosene – cooking/heating

4. Heating Oil

5. Fuel Oil: boiler fuel for industry, power and shipping

6. Other: lubricants, bitumen etc The supply of oil Supply is a flow concept – what matters for the oil market is how many barrels of oil per day are being extracted from reserves and how much of that is able to be refined for different uses. In short, the short-run supply of crude oil is affected by a series of different factors

1. Profit motive: The production decisions of OPEC and Non-OPEC countries.

2. Spare capacity: The level of spare production capacity in the oil sector.

3. Stocks: The level of crude oil stocks available for immediate supply from the refineries

4. External shocks: The effects of production shocks e.g. loss of output from rig closures or disruption of oil supplies due to war and terrorist attacks.

Taking a longer-term perspective, the long run world oil supply is linked to

1. Reserves: Depletion of proven oil reserves – the faster that demand grows, the quicker the expected rate of depletion. Peak oil theory claims that the world has long since past the peak of new discoveries of oil and that most oil producing nations will see a long-term decline in crude oil output in the years ahead.

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2. Exploration: Investment spending on exploring, finding and exploiting new oil reserves. When oil prices are high and are expected to stay strong, it makes financial sense to invest in exploring for new reserves, even though these may not come on stream for some years.

3. Technology: Technological change in oil extraction which affects the costs of extraction and the profitability of extracting and then refining the oil.

The interaction between oil demand and supply in the short run Higher oil demand matched against an inelastic short run supply invariably drives prices higher – this is shown in the diagram below. An increase in demand causes a fall in stocks at refineries and pushes prices higher. This acts as a signal to suppliers to expand production. However there are time lags between a change in price and extra supplies coming on stream. The demand for oil is also price inelastic at least in the short term. This combination of an inelastic demand and supply helps to explain some of the volatility in world oil prices.

OPEC

• A producer cartel founded in 1960 – now has twelve member nations

• Controls around 40% of world crude oil output and just over half of world oil exports

• Has a larger share of world crude oil reserves

• Controls it’s own supply through a system of output quotas

• Many OPEC nations have accumulated huge currency reserves as the world price of oil has soared – contributing to the growing power of sovereign welfare funds

• The UK is a net importer of oil, and along with Norway and the USA, it is not part of OPEC

Oil Output Million barrels per day

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Oil Output Million barrels per day

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Oil Price $ Per barrel

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OPEC's mission is to coordinate the policies of Member Countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital to those investing in the petroleum industry. The producer cartel needs to tread a fine line – too low a price for oil and their balance of payments and fiscal balances suffer especially for those countries highly dependent on oil exports. But if world crude prices stay high for too long, demand will fall away because the economic incentives for finding oil substitutes become increasingly strong.

Microeconomic effects of higher oil prices

After a long period of low oil prices, in the last few years, the world economy has had to come to terms with the prospect that the era of cheap oil is now over. This affects many industries and has direct and indirect effects on consumers. For those industries that use oil as an input into their production process, then a rising price acts as a supply-side shock – leading to a rise in their variable costs of production. The increase in costs causes a profit maximising firm to increase price and reduce the equilibrium level of output. The extent to which a business is able to pass on an increase in costs depends on the price elasticity of demand for their products. If demand

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is price inelastic, then the supplier may choose to pass on some or all of any rise in variable costs to the consumer of the final product. For example, a controversial issue has been the decision by many (although not all) of the airlines to increase their fuel surcharges to customers. For consumers, higher oil prices led directly to more expensive fuel at the pumps, higher gas and electricity bills and a reduction in their real incomes. This contributed to the recession of 2008-09.

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Markets in Action: The Market for Copper Copper is a commodity that measures the pulse of the global economy. The world price nearly trebled between the start of 2005 and the summer of 2008 before the price collapsed to $3000 in the autumn of 2008. There has been a clear recovery in prices and copper prices are not too far below their 2007-08 levels. At their peak copper was so expensive on world markets that some copper coins were now worth more than their face value.

Source: London Metal ExchangeThe World Market for Copper

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World Price of Copper - US dollars per tonne

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Over recent years the demand for copper has been rising more quickly than market supply – putting upward pressure on international prices. New discoveries of copper have raised global reserves by less than 1 per cent a year since 1925 but usage has risen at 3 per cent per annum. And demand is growing on the back of sustained growth in China, India and other emerging market economies. When stocks are low prices rise and when stocks recover (for example in 2008-09) there is pressure on prices to fall. World supply of and demand for copper Most copper ore is mined or extracted as copper sulfides from open pit mines. Over 40 per cent of world supply comes from North and South America; 31 per cent from Asia and 21 per cent from Europe. Chile is far and away the world’s largest supplier of copper with around 35% of the total. Copper – an example of derived demand Because copper is malleable and ductile, there is a huge industrial demand for copper. Like most metals the demand for it is derived from the demand for products that use copper as a component or raw material – notably the construction and electrical sectors. From copper wire to copper plumbing, from the use of copper in integrated circuits to its value as a corrosive resistant material in shipbuilding and as a component of coins, cutlery and to colour glass, copper

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has a huge array of possible industrial uses. In the automobile industry, an average new car contains 27.6kg of copper. And hybrid cars which incorporate electric motors in conjunction with combustion engines could lead to further rises in copper demand. A typical electric hybrid car might use around 2 times the current usage of copper in extra cabling and windings for electric motors."

Low elasticity of supply The price elasticity of supply of copper is low. Supply is unresponsive to price movements in the short term because of the high fixed costs of developing new extraction plants which involve lengthy lead-times. If existing copper mining businesses are working close to their current capacity then a rise in world demand will simple lead to a reduction in available stocks.

The effects of rising copper prices The demand for copper will continue to remain strong provided that the global industrial sectors continue to expand production. Little surprise that emerging market countries such as China and India are spending billions of dollars from their trade surpluses to secure supply contracts for copper ore from producers such as Peru and Chile. But if prices remain high we may see more copper recycling although the costs of doing so are often high and there are fears concerning the negative externalities arising from the pollution created by trying to recycle used copper. These external costs include atmospheric emissions from recycling plants and waste products dumped into rivers. Economic theory would predict an increase in demand for scrapped copper and a substitution effect away from copper towards aluminium. And new technologies may cause a shift in demand away from copper based products. Plastics provide lower material and installation costs for businesses. The take off in wireless technology and fibre optics will also have an impact. And higher prices should stimulate an expansion of copper ore production. In recent years, copper mining production has fallen short of expectations. But as with any market, if the price is high enough suppliers will eventually respond!

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Markets in Action: The Market for Coffee Each day nearly 2.5 billion cups of coffee are consumed. It is the fifth most widely traded commodity in the world and millions of people depend directly or indirectly on the production and sale of coffee for their livelihoods. The global market for coffee is characterised by volatile prices and production levels which impacts directly on the incomes and survival of producers. The Coffee Paradox “While espresso, cappuccino and latte drinkers are bringing huge profits to some of the world's biggest multinationals, the place where coffee originated remains one of the poorest on Earth. Around the world more than 2 billion cups of the stuff are consumed each day. In Starbucks in south London the cheapest shot of espresso costs £1.35. A coffee worker in Ethiopia earns less than half of that in a day. “The importance of coffee to Ethiopia is difficult to overstate. The country is the largest coffee producer in Africa and the sixth- biggest in the world. Coffee accounts for no less than 90 per cent of Ethiopia's exports, half of which go to EU countries. The trade generates some 54 per cent of Ethiopia's gross domestic product.”

Source: Adapted from the Independent, October 2006 Experts on the world coffee market often make reference to the “coffee paradox”.

• A coffee crisis in producing countries with a trend towards lower prices, declining incomes and profits affecting millions of people in the world’s poorest countries.

• A coffee ‘boom’ in consuming countries with rising sales and profits for coffee retailers and roasters

• A widening gap between producer and consumer prices only partly offset by the growing influence of Fair Trade in the coffee industry.

The World Bank estimates that out of 140 developing countries, 95 depend on exports of commodities for at least 50 percent of their total export earnings. Coffee is an example of “commodity-dependency” representing, for example, 75% of the total exports of Burundi and 54% in Uganda. About 25 million families produce and sell coffee for their livelihood and most are small-scale farmers with limited financial resources and scope to diversify out of coffee. Globally, coffee sales each year exceed $70 billion, but coffee producing countries only capture $5 billion of this value, with the bulk of revenues retained by developed countries. A recent Oxfam research report showed that Ugandan coffee farmers only get about 2.5 percent of the final retail price of their coffee in the UK market. Because the supply-side of the world coffee market is fragmented – will millions of small-scale producers – much of the market power lies with the coffee roasting companies who buy raw coffee beans and process them into coffee-based products. When buyers have power over the market price, this is monopsony. And this buying power can force down the price that farmers receive for their products – creating poverty and damaging the chances of sustainable development for regions dependent on coffee production. There have been no price controls in the global coffee trade since 1989, when the buffer-stock system run by the International Coffee Agreement broke down. Since then prices have been determined by the market supply and demand. As the chart below confirms, over the last ten years coffee prices have been volatile – collapsing from $1.30 per lb in 1998 to less than $0.40 in 2002. In the last four or five years there has been a recovery in prices – but they remain below the levels seen in the mid 1990s.

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Monthly average composite price, US dollars per pound, ICO: International Coffee OrganisationWorld Coffee Prices

Source: International Coffee Organisation

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Coffee consumption worldwide in 2007 was estimated at around 122.7 million bags - up from 121.08 million bags in 2006 and 118.1 million bags in 2005. Demand has been stagnating in many of the richer nations of the world but consumption growth has been stronger in emerging market countries and especially in some of the former eastern Bloc countries most of whom have recently joined the European Union.

The main buyers of raw coffee beans are the largest multinational buyers, dominated by four firms: Nestlé, Kraft, Procter & Gamble and Sara Lee. Coffee consumption has been growing at a steady rate of between 1 and 1.5 % per year; a growth rate is well below that for food products as a whole which is closer to 4% per annum. Changes in eating habits and increased demand for alternative drinks to coffee are largely behind this relatively slow growth of global market demand. Even the sharp fall in coffee prices during 2000 - 2004 seemed to have little impact on world demand, suggesting that coffee has a low price elasticity of demand. Employment in coffee producing countries

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Coffee production employs a labour force estimated at around 25 million families by the ICO and accounts for more than 50% of export earnings in many countries, an increase in consumption favouring a gradual rise in world prices would be a positive factor for economic growth and increased per capita incomes in these countries. In Brazil alone more than a million jobs are generated by the coffee industry. According to the International Coffee Organisation “25 million small coffee farmers and their families who produce 90% of the world’s coffee are particularly affected by fluctuations in market prices and imbalances in supply and demand.”

Monthly value of exports, $ million (bottom pane) and world price (top pane)Coffee Prices and value of Exports of Brazilian Coffee

Source: Reuters EcoWin

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The International Coffee Organisation (ICO) The International Coffee Organization (ICO) brings together producing and consuming countries to tackle the challenges facing the world coffee sector through cooperation. Brazil is effectively the “swing producer” for the global coffee markets, in other words, since Brazil is the largest coffee producer, changes in Brazil's supplies of coffee account for a large portion of the change in the world total supplies of coffee which then directly affects the prevailing international price. There is a relationship between the current world price and the value of exports of coffee from nations such as Brazil. Factors such as changes in the exchange rate can influence the income that coffee exporting countries will generate from their overseas sales as coffee is traded in US dollars.

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Markets in Action: The UK Housing Market This chapter applies supply and demand concepts to the housing market. The determination of price levels in local housing markets are great examples of microeconomics in action! Each day there are hundreds and thousands of separate negotiations between buyers and sellers with prices being offered and agreed before a final transaction is made. The price that is established with each housing transaction in the market depends on

• The price that the seller is willing to agree for their property. • The actual price that the buyer is willing and able to pay.

A Sellers Market When demand for properties in a locality, area or region is high and when there is a shortage of properties then the balance of power in the market shifts towards the seller. They can wait for offers on their property to reach (or exceed) their minimum selling price. Indeed early potential buyers may come straight in with an offer in excess of the asking price in order to avoid the possibility of losing the property that they want. A Buyers Market When there is a glut of properties available on the market (excess supply), the balance of power switches to buyers. They have the luxury of a wider choice of housing and they should be able to negotiate a price lower than the published price. Sellers may require a quick sale and this puts extra bargaining power into the hands of buyers.

Housing Demand The demand for housing is the quantity of properties that homebuyers are willing and able to buy at a given price in a given time period. Some of the conditions of demand in the market are as follows:

1. Real Incomes: As living standards rise, so the demand for housing expands, including demand for more expensive properties as people move “up market.”

2. Mortgage Interest Rates: Since most homes are purchased with a mortgage, changes in interest rates affect demand for housing. A rise in mortgage rates increases the cost of financing the loan on the purchase of a property.

3. Consumer confidence: Consumer confidence is vital for if expectations for the future performance of the economy deteriorate and people become less optimistic about their own financial circumstances, they may be tempted to delay entry into the market for property.

4. Economic Growth: When the economy is enjoying sustained growth and rising prosperity, improved confidence raises the number of homebuyers. The reverse is true in a recession.

5. Unemployment: In areas or regions when unemployment is above the national average, incomes will be lower and this limits the number of people who are able to afford properties.

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6. The Price of Substitutes: For people wanting to buy their own home, the main alternative is to rent – so a higher cost of renting could lead to an increased demand for owner-occupied homes.

Effective demand for housing – property affordability Demand in a market is only effective when potential buyers have the ability to pay. Nowhere is this truer than in the property market. In recent years the boom in house prices in the UK caused a major affordability problem for millions of people wanting to enter the market for the first time. The ratio of average prices to incomes climbed higher and made it much more expensive to take out a mortgage. The decline in effective demand has been an important factor bringing about an end to the boom as first-time-buyers have gradually disappeared from the market. Since the summer of 2007 house prices have been falling and as a result, the ratio of prices to earnings has dropped indicating an improvement in this measure of housing affordability. However although properties look more affordable at first glance, the difficulties in getting a mortgage following the credit crunch means that demand in the property market has remained subdued. Expectations of future price movements and housing demand Expectations of changing prices can have a considerable bearing on the demand for all types of property. Consider this question. Should housing to be regarded as a consumer durable that provides a flow of services to the owner over a long period? Or should we think of a house purchase, as one of major investments that we expect will provide us with substantial capital gains? The answer is probably a mix of the two! Price elasticity of demand for housing Price elasticity of demand (Ped) measures the responsiveness of demand for a product to a change in its own price. When housing is regarded as a necessity and when there are few close substitutes available, we expect demand to be inelastic. This may well force up the eventual market price when a transaction is agreed.

Monthly data, source: Halifax house price indexUK house price/earnings ratio

Source: HBoS Housing Research

98 99 00 01 02 03 04 05 06 07 08 09 103.0

3.5

4.0

4.5

5.0

5.5

6.0

Rat

io o

f hou

se p

rices

to a

vera

ge e

arni

ngs

3.0

3.5

4.0

4.5

5.0

5.5

6.0

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The price elasticity of demand for a property depends on the availability of close substitutes – for example the supply of rented housing. If you have set your heart on a particular property, or are convinced that you need to live in a specific area, perhaps to live within a school catchment area or because you want to be close to friends and family, then you will be far less sensitive to the market price and demand will become price inelastic.

Average house prices £s, seasonally adjusted, source: Halifax house price dataA Selection of Regional House Price Averages

Source: Reuters EcoWin

99 00 01 02 03 04 05 06 07 08 09 100

50000

100000

150000

200000

250000

300000

350000

GB

P

0

50000

100000

150000

200000

250000

300000

350000

Greater London

South West

Wales

North of England

South East

Price

Quantity

D1

Supply

P1

Price

Quantity

D2

Supply

P2

Q2 Q1

An inelastic demand for housing An elastic demand for housing

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Housing Supply The housing supply is the total flow of properties available at a given price in a given time period. The supply will be a mix of newly-built housing and older properties. For new housing, the conditions of supply include the following:

1. Costs of production for construction companies

a. Employment costs (including wages, overtime payments and employment taxes).

b. Costs of purchasing land for housing development.

c. Costs of purchasing building components and raw materials.

d. Costs associated with achieving planning consent from local authorities.

2. The number of construction companies in the market and their business objectives.

3. The extent to which property builders can achieve economies of scale in house building and reduce their constructions costs by implementing innovation in building projects.

4. Government taxation and subsidy of new housing developments

Elasticity of Housing Supply The supply of new housing tends to be inelastic in the short run which means that house prices are determined almost exclusively by demand factors such as income, unemployment and interest rates. Several reasons have been put forward for the low price elasticity of supply of housing:

1. Construction companies cannot suddenly plan and then build thousands of new homes in areas when there is an increase in demand. One reason is the existence of planning regulations and other constraints on new housing developments.

2. Supply is also restricted by the limited availability of skilled labour such as bricklayers and electricians and other factor inputs needed in the construction process.

The Need for More Housing Supply Increases in UK house prices are due in part to supply shortages in the market according to the House Builders' Federation (HBF) which revealed that new home building is failing to keep pace with demand. A spokesman for the HBF said: "The country needs 200,000 new homes annually to keep pace with the growth in households. With only 160,000 being built, we have a serious problem."

Source: Adapted from the House Builders’ Federation web site Why housing matters

• Asset prices have grown in importance – 70% of homes in the UK are privately owned • The rented sector accounts for 30% of properties – around 12% are rented from private

landlords • Millions of jobs linked directly or indirectly to the property / construction sectors – this

emphasises the importance of inter-related markets and industries in the economy • Changes in household wealth can affect consumer spending on goods and services –

falling prices can lead to reduced consumer confidence and demand • Over 15% of aggregate demand (AD) is linked directly and indirectly to housing activity • Construction accounts for 7% of GDP and employs over two million people.

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Seasonally adjusted data, millions employedEmployment in the UK Construction Industry

Source: Reuters EcoWin

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

milli

ons

1.7

1.8

1.9

2.0

2.1

2.2

2.3

2.4

Per

son

(milli

ons)

1.7

1.8

1.9

2.0

2.1

2.2

2.3

2.4

The 2008-09 UK Housing Slump and the UK Recession

• The sub-prime mortgage crisis in the USA spread globally leading to the collapse of Northern Rock and Lehman Bros bankruptcy in September 2008.

• The supply of mortgage finance dried up as many mortgage lenders withdrew from the market. There has been a fall in loan to valuation ratios – higher deposits are needed to get a home loan. The ability to borrow money to buy a house is the life-blood of the market.

• We have seen a big change in market expectations among both buyers and sellers and construction companies – many building firms have cut back on the number of new properties (falling demand has led to a contraction of market supply).

• House prices have slumped with declines of >15% pa. It is estimated that nearly 1/3rd of homeowners will suffer negative equity where the market value of a house is worth less than the debt on it.

• During the housing slump there has been a large rise in demand for social housing putting pressure on local councils. The demand for private rented homes has also increased.

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Markets in Action: The Labour Market The labour market is a factor market – it provides a means by which employers find the labour they need, whilst millions of individuals offer their labour services in different jobs. The Demand for Labour Many factors influence how many people a business is willing and able to take on. But we start with the most obvious – the wage rate or salary. There is an inverse relationship between the demand for labour and the wage rate that a business needs to pay as they take on more workers. If the wage rate is high, it is more costly to hire extra employees. When wages are lower, labour becomes relatively cheaper than for example using capital inputs. A fall in the wage rate might thus create a substitution effect and lead to an expansion in labour demand.

Shifts in the Demand for Labour The number of people employed at each wage level can change and in the next diagram we see an outward shift of the labour demand curve. The curve shifts when there is a change in the conditions of demand in the jobs market. For example:

• A rise in the level of consumer demand for a product which means that a business needs to take on more workers (see below on the concept of derived demand)

• An increase in the productivity of labour which makes using labour more cost efficient than using capital equipment

• A government employment subsidy which allows a business to employ more workers

The labour demand curve would shift inwards during a recession when sales of goods and services are in decline, business profits are falling and many employers cannot afford to keep on

Wage Rate

Employment of Labour (E)

Labour Demand (1)

W1

W2

E1 E3

Expansion of demand

Contraction of demand W3

E2

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their payrolls as many workers. The result is often labour redundancies and an overall decline in the demand for labour at each wage rate.

Labour as a Derived Demand

The demand for all factor inputs, including labour, is a derived demand i.e. the demand depends on the demand for the products they produce. When the economy is expanding, we see a rise in the aggregate demand for labour providing that the rise in output is greater than the increase in labour productivity. In contrast, during a recession or a slowdown, the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production. In a recession, business failures, plant shut-downs and short term redundancies lead to a reduction in the derived demand for labour. This has been a feature of the recession in the British economy from 2008 onwards.

Car-maker cuts jobs as sales fall The biggest car-maker in the United States, General Motors, is shedding jobs from the assembly plant to the boardroom as it struggles to respond to falling demand for its vehicles. Soaring petrol prices and fears of recession have put motorists off buying its pick-up trucks and gas-guzzling 4x4s. Many Americans are switching to smaller, more fuel-efficient cars, which tend to be a speciality of Asian motor manufacturers. General Motors has announced a two-year pay freeze and a programme of voluntary redundancies as it looks to reduce labour costs. GM and its rivals - Ford and Chrysler - have already cut more than 100,000 jobs since 2006.

Source: Adapted from news reports, June 2008 The construction industry is another example of the derived demand for labour. The decade long property boom in the UK has led to rising prices, output and employment. But the turnaround in the

Wage Rate

Employment of Labour (E)

Labour Demand (1)

W1

E1

Labour Demand (2)

E2

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housing market has led to thousands of job losses during 2008 and 2009 as the market demand for workers in housing construction has shifted inwards. Elasticity of Demand for Labour Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the ruling market wage rate. The elasticity of demand for labour depends on these factors:

1. Labour costs as a % of total costs: When labour expenses are a high proportion of total costs, then labour demand is more elastic than a business where fixed costs of capital are the dominant business expense. In many service jobs such as customer service centres or gas boiler repairs, labour costs are a high proportion of the total costs of a business.

2. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs. When specialised labour or capital is needed, then the demand for labour will be more inelastic with respect to the wage rate. For example it might be fairly easy and cheap to replace security guards with cameras but a hotel would find it almost impossible to replace hotel cleaning staff with machinery!

3. The price elasticity of demand for the final output produced by a business: If a firm is operating in a highly competitive market where final demand for the product is price elastic, they may have little market power to pass on higher wage costs to consumers through a higher price. The demand for labour may therefore be more elastic as a consequence. In contrast, a firm that sells a product where final demand is inelastic will be better placed to pass on higher costs to consumers.

Wage Rate

Employment of Labour (E)

Labour Demand (1)

W1

W2

E2 E1

Labour Demand (2)

E3

Labour demand (2) is more elastic – perhaps because the employer can easily switch to capital inputs as a means of producing an output if wage rates were to increase Labour demand (1) is relatively inelastic – e.g. -0.4 i.e. a 10% fall in the wage rate might only lead to a 4% expansion of labour demand

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Labour Supply The labour supply refers to the total number of hours that labour is willing and able to supply at a given wage rate. It can also be defined as the number of workers willing and able to work in a particular job or industry for a given wage. The labour supply curve for any industry or occupation will be upward sloping. This is because, as wages rise, other workers enter this industry attracted by the incentive of higher rewards. They may have moved from other industries or they may not have previously held a job, such as housewives or the unemployed. The extent to which a rise in the prevailing wage or salary in an occupation leads to an expansion in the supply of labour depends on the elasticity of labour supply.

Key factors affecting labour supply The supply of labour to a particular occupation is influenced by a range of factors:

1. The real wage rate on offer in the industry itself – higher wages raise the prospect of increased factor rewards and should boost the number of people willing and able to work

2. Overtime: Opportunities to boost earnings come through overtime payments, productivity-related pay schemes, and share option schemes.

3. Substitute occupations: The real wage rate on offer in competing jobs is another factor because this affects the wage and earnings differential that exists between two or more occupations. So for example an increase in the relative earnings available to trained plumbers and electricians may cause some people to switch their jobs.

Wage Rate

Employment

Labour Supply

W1

D1

E1

W2

D2

E3

W3

Wage Rate

Employment E1 E2

The Labour Supply Curve The supply curve for labour shows the number of workers willing and able to enter an industry or occupation different wage levels

Shifts in the Labour Supply Curve

LS1

E2

W1

LS2

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4. Barriers to entry: Artificial limits to an industry’s labour supply (e.g. through the introduction of minimum entry requirements or other legal barriers to entry) can restrict labour supply and force average pay and salary levels higher – this is particularly the case in professions such as legal services and medicine where there are strict “entry criteria” to the professions.

5. Improvements in the occupational mobility of labour: For example if more people are trained with the necessary skills required to work in a particular occupation.

6. Non-monetary characteristics of specific jobs – include factors such as the level of risk associated with different jobs, the requirement to work anti-social hours or the non-pecuniary benefits that certain jobs provide including job security, opportunities for promotion and the chance to live and work overseas, employer-provided in-work training, employer-provided or subsidised health and leisure facilities and other in-work benefits including occupational pension schemes.

7. Net migration of labour – the UK is a member of the European Union single market that enshrines free movement of labour as one of its guiding principles. A rising flow of people seeking work in the UK is making labour migration an important factor in determining the supply of labour available to many industries – be it to relieve shortages of skilled labour in the NHS or education, or to meet the seasonal demand for workers in agriculture and the construction industry.

Equilibrium Wages

Real Wage Rate

Employment

W1

Real Wage Rate

Employment

D2

D1

E2 E1

The equilibrium price of labour (market wage rate) in a given market is determined by the interaction of the supply and demand for labour. Employees are hired up to the point where the extra cost of hiring an employee (their wage) is equal to the addition to sales revenue from hiring them, their MRP.

Labour Supply

D1

E1

Labour Supply

W1

W2

D3

W3

E3

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Wage Differentials There is a wide gulf in pay and earnings rates between different occupations in the UK labour market. No one factor explains the gulf in pay that exists and persists between occupations and within each sector of the economy. Some of the relevant factors are listed below

1. Compensating wage differentials - higher pay can often be some reward for risk-taking in certain jobs, working in poor conditions and having to work unsocial hours.

2. Equalising difference and human capital - in a competitive labour market equilibrium, wage differentials compensate workers for (opportunity and direct) costs of human capital acquisition. There is an opportunity cost in acquiring qualifications - measured by the current earnings foregone by staying in full or part-time education.

3. Different skill levels - the gap between poorly skilled and highly skilled workers gets wider each year. One reason is that the market demand for skilled labour grows more quickly than the demand for semi-skilled workers. This pushes up pay levels. Highly skilled workers are often in inelastic supply and rising demand forces up the "going wage rate" in an industry.

4. Differences in labour productivity and revenue creation - workers whose efficiency is highest and ability to generate revenue for a firm should be rewarded with higher pay. City economists and analysts are often highly paid not least because they can claim annual bonuses based on performance. Top sports stars can command top wages because of their potential to generate extra revenue from ticket sales and merchandising.

5. Trade unions and their collective bargaining power - unions might exercise their bargaining power to offset the power of an employer in a particular occupation and in doing so achieve a mark-up on wages compared to those on offer to non-union members

6. Employer discrimination is a factor that cannot be ignored despite over twenty years of equal pay legislation in place

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Trade Unions Trade unions are organisations of workers that seek through collective bargaining with employers to protect and improve the real incomes of their members, provide job security, protect workers against unfair dismissal and provide a range of other work-related services including support for people claiming compensation for injuries sustained in a job. Most trade unions in the UK belong to the Trades Union Congress (TUC). Examples include Amicus, Unison, the Rail and Maritime Union and the National Union of Teachers. Main roles of trade unions

• Protecting and improving the real living standards of their members • Protecting workers against unfair dismissal (employment rights) • Promoting improvements in working conditions, workload & health and safety issues • Workplace training and education, accumulation of human capital • Protection of pension rights for union members • A counter-balance to possible power of employers in the labour market

Trade Union membership There has been a large decline in union membership over the last twenty-five years In 2006 an estimated 6.39 million employees in the UK were members of a trade union- less than half the figure when union membership peaked in 1979.

Real Wage Rate

Employment

W1

Real Wage Rate

Employment

Ld

E1

Ls

W2

E2

Ls

Ld

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Unions might seek to exercise their collective bargaining power with employers to achieve a mark-up on wages compared to those on offer to non-union members. For this to happen, a union must have some control over the total labour supply available to an industry. In the past this was possible if a union operated a closed shop agreement with an employer – i.e. where the employer and union agreed that all workers would be a member of a particular union. However in most sectors, the closed shop is now history. More frequently, a union may simply bid through bi-lateral negotiations with employers to achieve an increase in wages ahead of the rate of inflation so that real wages rise, and other improvements to working hours and conditions. Government economic policies and the labour supply The main policies designed to increase the supply of labour available to the economy are as follows:

1. Reforms to the system of direct taxation: In the 1980s, Thatcher’s economic policies focused on cutting income tax rates particularly at the top end and switching away from direct towards indirect taxation. More recently, successive governments have tended to focus more on reductions in the lower rates of income tax and tax allowances for lower-paid workers. The theoretical idea remains broadly the same, that lower direct taxes increase the post-tax reward to working and act as an incentive for more people to join the labour supply. In 2007 the government announced that the 10% starting rate of income tax would be withdrawn in 2008 and that the basic rate of tax would be cut from 22% to 20%.

2. Reforms to the benefits system: The emphasis here has changed away from the rather crude idea of cutting the real and relative value of welfare benefits towards encourage people into searching for work, towards a reliance on tax credits (for example the Working

Wage Rate

Employment

Labour Supply (union controlled)

E1 E2

Labour Demand

W1

W2

Employment

Labour Supply (union controlled)

E1 E2

Labour Demand

Labour Supply to the Economy

W1

W3

Elastic labour demand – union control of labour supply forces wages higher – but employment contracts

Inelastic labour demand – unions may be more effective in negotiating higher pay levels and increasing total wage income.

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Families Tax Credit) to give parents with children a greater financial incentives to work. The aim is to reduce the disincentive problems created by the unemployment and poverty trap.

3. Increased investment in education and training: This is designed to boost the human capital of the labour force and improve the occupational mobility of the labour force to meet the changing demands of employers across different industries.

4. A more relaxed approach to labour immigration: Particularly where there are shortages of workers with skills such as consultants and fully trained nurses in the NHS, or shortages of teachers in certain subjects. The effect of net inward migration on the labour supply is shown in the diagram below.

The importance of incentives Incentives are important in affecting the labour supply. Most of us rely on income from our work to pay for the things we need and higher pay and better conditions should be an incentive perhaps to work some extra hours or search for work in the first place. But for many workers there are disincentives to supply their labour – and these problems often affect people in lowly paid jobs. This is known as the problem of the poverty trap. The Poverty Trap Worsens in Scotland The soaring cost of child care is worsening the poverty trap according to a new report commissioned for the save the Children Fund in Scotland. More than one quarter of Scots parents on low incomes cannot work full time because of the cost of registered childcare which has risen by more than 10 per cent this year across most of the country. Joanne Brady, a single mother of two children from Glasgow, is unable to work because she loses more in means-tested child tax credits than she gains in income. “They take 20 per cent off for each child when you go to work. You still have to pay your housing, travel and lunches and it's just not adequate.” Ms Brady, 27, is among the 28 per cent of parents with children under 18 and an income of less than £15,000. Source: The Times, July 2008

Real Wage Rate

Employment

Labour Supply

W2

E1

W1

Labour Demand

Labour Supply with migration

E2

Strong inflows of labour into the economy can have the effect of increasing the labour supply This puts downward pressure on real wages (for a given level of labour demand) e.g. through helping to relieve labour shortages in particular industries and occupations If migration provides a boost to the labour supply and to labour productivity, there is the prospect of an outward shift in a country’s long run aggregate supply

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Markets in Action: Economics of Health Care Who should pay for health care? In 2008 the British National Health Service celebrated its 60th birthday but the future of the NHS as it exists at present always seems to be under question. How much longer can most NHS treatments and other services be provided free at the point of treatment and based on clinical need rather than people’s ability to pay? In most advanced countries the state is the dominant provider and funder of health care. The lowest share is in the United States where state funding represents less than fifty per cent of total health spending. In Canada, Britain and Sweden, the health service is funded mainly through general taxation. In Germany and France the system is funded largely from compulsory contributions made by employers and workers and from voluntary private insurance. In most countries, health care is provided by the mixed economy. Doctors are usually self employed or in private practice. The government sector is most heavily involved in operating hospitals. Although in Britain, the government is giving hospitals greater autonomy in running their own affairs and in contracting out some health care to the private sector through its foundation hospital system Four of the possible funding options for health care are

1. Co-payments - Ask patients to contribute towards the cost of non-emergency surgery, such as hernias and varicose veins.

2. Ration care - To some extent, this is already done by the National Institute for Clinical Excellence watchdog,

3. NHS tax - A specific tax could be levied to help pay for treatment

4. Social insurance - Public could be asked to pay into an insurance scheme Equity and Efficiency in Health Care (1) Economic Efficiency Consider first the two main types of efficiency – allocative and productive:

Does the health care provided in Britain meet people’s changing needs and wants (i.e. do we achieve allocative efficiency?)

Is health care provided at the lowest possible cost per treatment (i.e. do we achieve productive efficiency?) or could improvements be made in the efficiency with which health services are provided for millions of people?

(2) Equity Are people’s health needs met by health treatments on the basis mainly of clinical need or alternatively based on an ability to pay for health services? Are health outcomes in the UK reasonably equal across localities, regions, ethnic groups, age groups and by gender? Or are there unacceptable inequalities in the provision of health care across different sections of the population? The issue of equitable provision of health is an important ongoing issue.

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Market Failure in Health Care What might cause market failure in the provision of health services?

1. Imperfect information among health care providers and consumers - Consumers may under-value the long-term private benefits of consuming health care – due to information failure (or ‘patient ignorance’). Health providers such as doctors and consultants have more specialised knowledge than consumers – an example here of asymmetric information.

2. Moral hazard: Many consumers in the healthcare market take out insurance to help pay for treatment; this, however, leads to a problem of moral hazard, where they take more risks and therefore require more treatment because they are insured. Again, this is a consequence of asymmetric information in the market where consumers know more than insurers about their intended future actions

3. Lack of adequate health insurance: It is virtually impossible for people to predict their future health needs. Sudden illness or injury may require extensive and expensive medical care for which most people are unlikely to have adequate health care insurance. Indeed the private health insurance market will not provide cover for all groups of people. High-risk individuals may find it impossible or expensive to get medical insurance if the market was the only provider of health care. The ‘failure’ of health insurance companies to provide cover for high risk groups is an example of ‘missing markets’ – another cause of market failure

4. Externalities arising from health care provision: Health services are normally assumed to be merit goods providing a private benefit for people who consume them and additional external benefits for society as a whole.

5. Inequalities in access to basic health care: There are regional and local differences in the quality and quantity of health care available (media stories are fond of discussing so-called “postcode prescribing”). Millions of people are wholly dependent on the NHS for health care– they have no hope of being able to fund private health insurance. If people were required to pay for more treatments they would often be unable to afford them

6. Monopoly power among health care suppliers: if there was a wholly free market in providing health care, it is likely that in the long run, several dominant health care providers would emerge raising concerns about increasing market concentration and the opportunities for these firms to exploit their monopoly power.

The fundamental policy question regarding health care in the UK is this: Should it remain essentially funded by the tax system and provided mainly free at the point of need? In the United States, which remains the world’s largest spender on health care, state provided and state-financed health care goes mainly to the old and families on low incomes. Most American workers are insured privately through the health insurance schemes run by their employers. But this does not stop many millions of Americans being unable to afford their own health care insurance – this has become a huge political issue in the United States. There are also huge worries among US companies about the soaring cost of employer-funded health benefit schemes. In rich developed countries, health care spending on average takes up nearly ten per cent of national income (GDP) and the projections for the years ahead see that figure continuing to rise. The NHS will always face the problem of resource scarcity because our ever-growing demand for different types of health care exceeds the available supply. The Labour government is committed to significant increases in real spending on health + share of health in total GDP.

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Fundamental Principles of the National Health Service The Fundamental building blocks of the NHS are as follows:

• Providing a national universal (comprehensive) service

• Health care free at the point of use

• Medical care is not based on ability to pay but rather on the basis of clinical need

Who should pay for the drugs dispensed by the National Health Service?

The Economic and Social Importance of Health Care

• Quality of Life and Poverty: Health and well-being in childhood affect educational attainment with consequences for people throughout their lives. Ill health in adulthood is associated with poverty and long periods out of work. There is now solid evidence that improvements in medical care pay off in the long term in terms of healthier and longer lives.

• Employment: The NHS is the largest employer in UK with over 1.3 million people employed in the NHS in England alone. After social security payments, health is the biggest single component of government expenditure.

• Productivity: Ill health imposes a restriction on the productive potential of the economy. Around 2 per cent of working days each year are lost due to short-term sickness, while more than 7 per cent of the working age population is unable to work due to long-term sickness or disability costing over £12 billion a year in welfare benefits.

• Higher Economic Growth and Standard of Living: If average life expectancy could be increased by five years, UK real GDP could be £5 billion a year higher.

Fundamental Problems Facing the NHS Rarely a day goes by without a health story featuring in the newspapers. The NHS faces many challenges – these are four of the main ones:

(1) Persistent resource crises: Resource problems are the consequence of under-funding and under-investment in the health service over many years – affecting the quality and quantity of the capital stock available to health providers

(2) Hospital waiting lists: There are persistent delays in people receiving appointments to see consultants and delays in receiving emergency treatment

(3) Problems in recruiting sufficient well qualified staff which leads to long hours for NHS staff and contributes to wide disparities in the quality of care and range of care from region to region and between local health authorities.

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(4) Meeting the growing demand for health care: There are growing doubts as to whether the NHS is meeting changing consumer preferences and growing health needs

Health Care Rationing – An Inevitable Process Health rationing occurs because demand for health care always outweighs supply. In a free market, markets match supply and demand by altering price. This form of rationing relies on the simply fact that post-tax incomes are unequal and that those households on relatively low incomes will be the first to be priced out of the market. Rationing in the NHS is inevitable - no amount of resources from the Government funded by taxation could possibly meet all of our demands for health care when the NHS system remains based on the fundamental principle of most health services being free at the point of need. In the diagram below, even if the government invests higher levels of money into the NHS system permitting an outward shift in the PPF for health care services, there is still an issue of scarcity to resolve even though the total “output” of the NHS can rise as a result.

The NHS currently rations health resources in a variety of ways

(1) Government rationing: Ministers and Parliament decide on the overall size of the NHS budget thus dictating the type and volume of care the NHS can provide

(2) The National Institute for Clinical Excellence (NICE) advises the NHS on clinical and economic benefits and costs of certain health care interventions

(3) Health authorities and primary care groups allocate money to particular disease/treatment areas. Treatment decisions for individuals are made at the clinical level by health care professionals

Quantity of Heart Operations

Quantity of all Other

Operations

An increase in resources available for the NHS or an increase in health service productivity increases the potential to provide health services. But opportunity cost is still relevant and scarcity still exists

A

B

C

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Key Factors Putting Increased Financial Pressures on the NHS

(1) Developments in medical technology and new treatments: The fruits of research and development in health sciences has brought us many new medical procedures (such as transplants); new treatments and new products (e.g. magnetic-resonance imaging scanners)

(2) New drugs including drugs that reduce the “risk” of disease rather than the symptoms of illness – e.g. statins to lower cholesterol

(3) The increased costs of staffing in the NHS -the NHS is a highly labour intensive industry. The costs of staff can take up to sixty per cent of the operating expenses of a hospital.

(4) Growing health problems including diseases associated with affluence and the health issues following an increase in relative poverty – for example the costs of treating smoking related diseases and the costs of treating illness associated with rising levels of obesity

(5) Long term change in age structure of the population - The cost of health care rises dramatically for older patients and the UK population along with that of many other countries is becoming older as average life expectancy continues to grow

(6) Increasing expectations of patients and their families – in part the result of politicians promising to achieve improved health outcomes from extra funding

Demographic Change and the NHS The UK population is ageing. The medical conditions that account for the majority of the burden of disease in the UK are primarily related to old age – e.g. cancer and coronary heart disease. Spending on health varies significantly with age. The beginning and end of life are the most expensive. On average, around a quarter of all the health care someone consumes in their lifetime is consumed in the last year of their life. Just over a third of all spending on hospital and community health services is for people who are over the age of 65. Case for Maintaining a Tax Funded Health Care System

1. The NHS can exploit economies of scale and provide health services for millions of people at an efficient cost – these scale economies include the benefits of specialization and significant buying power in the purchasing of drugs from pharmaceutical companies

2. Revenue to fund the NHS is drawn from a millions of taxpayers who pay mainly through a progressive system of direct taxation- satisfying the principle of vertical equity. Higher income taxpayers are therefore paying more towards the general provision of health care – the NHS is a means towards greater equality of opportunity within society

3. Basing health care treatments on being able to pay might discourage people from seeking important treatments

Case for using the Market Mechanism

1. With user charges, households would choose their own pattern of consumption and the supply of health care would then adjust to the pattern of preferences

2. The demand for health treatments would be linked to the private benefit to the patient – so a wider system of charging / private sector provision would lead to a lower demand for non-essential treatments and free up resources for more urgent treatments

3. Some user charges already exist within the NHS such as those for dental treatment, eye examinations and prescriptions – the principle of user charges could be extended without challenging the fundamental principles upon which the NHS is based

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The Rise of Health Tourism Fed up with lengthy waiting lists, rising prices and the fear of acquiring infections such as MRSA during a stay in hospital, record numbers of British patients are travelling abroad for medical and dental treatment and often taking in a package holiday at the same time! An estimated 100,000 people travelled abroad for treatment in 2007 to places as far as South Africa and South East Asia up from 70,000 in 2006. Hungary is the most popular destination for dental treatment and Cyprus is popular for cosmetic surgery whilst India is a favoured location for general surgery and scans. In most cases, the danger of experiencing health care of a lower quality than that available at home has not materialised - although health professionals in the UK warn that patients must also consider the costs of after-care and possible complications. The European Commission is considering plans to open its borders to medical tourists, allowing citizens of any of the 27 states to seek treatment in a neighbouring country with their home country, in certain circumstances, picking up the bill. The EU claims that this move will encourage countries to specialise in certain health treatments and benefit from economies of scale. Member nations of the EU spend in total €1,000bn (£796bn) annually on healthcare, and at present just 1 per cent is “across border”. According to polls, 4 per cent of Europeans had treatment in another country last year - most of whom were people on their holidays. If the proposals are approved, the expansion of choice will focus attention on the performance of the NHS against other health systems on the Continent. The British Government says it will not finance 'health tourism' and will instead prioritize in providing high quality treatments for NHS patients close to home.

Source: Adapted from news reports, March-July 2008 Rationing treatment in the NHS – the role of NICE The National Institute for Clinical Excellence (NICE) was created in 1999 and given the task of making decisions about which types of drugs ought to be made available through the National Health Service. One of their aims is to ensure a standardised level of medical care throughout the country and minimise the risk of postcode prescriptions - where healthcare seems to be determined by where someone lives rather than their clinical need. If a drug is recommended by NICE, the NHS in England and Wales has a legal obligation to fund it. NICE investigates the effectiveness and cost of new drugs and medical technologies and considers their impact on quality of life of patients. The system is different in Scotland. At the heart of their decision making is the requirement to achieve cost-efficient health care. When assessing a range of drugs the concepts of opportunity cost and cost benefit analysis come into play. First, NICE must determine (using evidence-based medicine) whether a new drug is better value than the next best alternative treatment already in use. Second, NICE will assess the costs of providing treatments - decisions are made using the existing market prices for each drug – and calculate the like benefits to patients using metrics such as symptom free days, life years or months gained and also the impact on the quality of life during and after a treatment. If NICE opts not to recommend a new drug or treatment, people have to find their own money to purchase it - and many choose to go overseas for medical care. There has been much coverage in the media in recent years about the expanding market for health tourism with Britons heading to Eastern European countries and further afield (including Africa) seeking treatments that meet their changing needs and preferences. Invariably many of NICE’s decisions have been highly unpopular. Recently NICE has been criticised for not recommending new treatments for Alzheimer’s, kidney cancer and in 2009 it advised against NHS funding for Tyverb, a treatment for an aggressive form of advanced breast cancer. In the autumn of 2009, NICE hit the headlines by announcing that “therapeutic” injections of steroids, such as cortisone, which are used to reduce inflammation, should no longer be offered to patients suffering from persistent lower back pain when the cause is not known. Instead NICE recommended to GPs that they offer patients remedies like acupuncture and osteopathy

Tutor2u Economics Blog, August 2010

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Background to Supply: Production and Costs

Production Production refers to the output of goods and services produced by businesses. To simplify the idea of the production function, economists create a number of time periods for analysis.

1. Short run production The short run is a time period when there is at least one fixed factor input. This is usually capital such as machinery and technology. In the short run, the output of a business expands when more variable factors such as raw materials and extra workers are brought into use

2. Long run production In the long run, all of the factors of production can change allowing a business to change the scale of its operations.

The long run for a retail business such as Pret a Manger will be different from the long run for the power generation

industry. The long run is when all factors of production are variable – there are no fixed factors! The length of time between the short and the long run will vary from industry to industry. For example, how long would it take a newly created business delivering sandwiches around a local

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town to move from the short to the long run? Let us assume that the business starts off with leased premises to make the sandwiches; two leased vehicles for deliveries and five full-time and part-time staff. In the short run, they can increase production by using more raw materials and by bringing in extra staff as required. But if demand grows, it wont take the business long to perhaps lease another larger building, buy in some more capital equipment and also lease some extra delivery vans – by the time it has done this, it has already moved into the long run! The point is that for some businesses the long run can be a matter of weeks! Whereas for industries that requires expensive capital equipment which may take months or perhaps years to become available, then the long run can be a sizeable period of time. Productivity and the law of diminishing returns Productivity is a measure of the efficiency of a factor input. The basic measure of productivity is output per person employed. There is a difference though between marginal and average productivity: Marginal product (MP) = Change in total output from adding one extra unit of labour Average product (AP) = Total output divided by the total units of labour employed In the example below, a business hires extra units of labour to produce a higher quantity of wheat. The table below tracks the output that results from each level of employment.

Units of Labour

Employed

Total Physical Product (tonnes of

wheat)

Marginal Product (tonnes of wheat)

Average Product (tonnes of wheat)

0 0 n/a n/a 1 3 3 3 2 10 7 5 3 24 14 8 4 36 12 9 5 40 4 8 6 42 2 7 7 42 0 6

Diminishing returns occurs when the marginal product of labour starts to fall. In the example above, extra labour is added to a fixed supply of land when a farming business is harvesting wheat. The marginal product is maximized when the 4th worker is employed. Thereafter the output from new workers is falling although output continues to rise until the seventh worker is employed. Explaining the law of diminishing returns The law of diminishing returns occurs because factors of production such as labour and capital inputs are not perfect substitutes for each other. This means that resources used in producing one type of product are not as efficient when switched to the production of another good. For example, workers employed in producing glass for use in the construction industry may not be as efficient if they have to be re-employed in producing cement or kitchen units. We say that factors of production such as labour and capital can be “occupationally immobile” i.e. they can be switched from one use to another, but with a loss of productivity. There is normally an inverse relationship between the productivity of the factors of production and the unit costs of production for a business. When productivity is low, the unit costs will be higher. It follows that if a business can achieve higher levels of efficiency, there may well be a benefit from lower costs and higher profits.

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Costs of production Costs are expenses faced by a business when producing a good or service. Every business faces costs and these must be recouped if a business is to make a profit. In the short run a firm will have fixed and variable costs of production. (1) Fixed Costs These costs do not vary directly with the level of output. Examples of fixed costs include:

1. Rent paid on buildings and business insurance premiums 2. The depreciation in the value of capital equipment due to age 3. The costs of staff salaries 4. Interest charges on borrowed money 5. The costs of purchasing new capital equipment

(2) Variable Costs Variable costs vary directly with output. Examples of variable costs for a business include the costs of raw materials, labour costs and other components used directly in the production process. The greater the total volume of units produced, the lower will be the fixed cost per unit as the fixed costs are spread over a higher number of units. This is one reason why mass-production can bring down significantly the unit costs for consumers – because the fixed costs are being reduced continuously as output expands. In our example below, a business is assumed to have fixed costs of £30,000 per month regardless of the level of output produced. The table shows total fixed costs and average fixed costs (calculated by dividing total fixed costs by output).

Output (000s) Total Fixed Costs (£000s) Average Fixed Cost (AFC) 0 30 1 30 30 2 30 15 3 30 10 4 30 7.5 5 30 6 6 30 5

When we add variable costs into the equation we can see the total costs of a business. The table below gives an example of the short run costs of a firm Output Units

Total Fixed Cost TFC (£s)

Total Variable Cost TVC (£s)

Total Cost TC (£s)

Average Total Cost ATC (£ per unit)

Marginal Cost MC (£)

0 100 0 100 20 100 40 140 7.0 2.0 40 100 60 160 4.0 1.0 60 100 74 174 2.9 0.7 80 100 84 184 2.3 0.5

100 100 90 190 1.9 0.3 120 100 104 204 1.7 0.7 140 100 138 238 1.7 1.7 160 100 188 288 1.8 2.5

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180 100 260 360 2.0 3.6 Average Total Cost (ATC) is the cost per unit of output produced. ATC = TC divided by output Marginal cost (MC) is the change in total costs from the production of one extra unit of output.

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Economies and Diseconomies of Scale

This chapter focuses on long run costs, the effect of economies of scale on unit costs and the effects of economies of scale on prices and competition in markets. What are economies of scale? Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. The effect is to reduce the long run average (unit) costs of production. These lower costs are an improvement in productive efficiency and can benefit consumers in the form of lower prices. But they can also give a business a competitive advantage too! Long Run Output (units per month) Total Costs (£s) Long Run Average Cost (£s per unit)

1,000 8,500 8.5 2,000 15,000 7.5 5,000 36,000 7.2

10,000 65,000 6.5 20,000 120,000 6.0 50,000 280,000 5.6 100,000 490,000 4.9 500,000 2,300,000 4.6

There are many different types of economy of scale and depending on the particular characteristics of an industry, some are more important than others.

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The answer is that scale economies have brought down the unit costs of production and feeding through to lower prices for consumers. Internal economies of scale Internal economies of scale arise from the growth of the business itself. Examples include:

1. Technical economies of scale:

a. Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a supermarket chain such as Tesco or Sainsbury can invest in technology that improves stock control. It might not, however, be viable or cost-efficient for a small corner shop to buy this technology.

b. Specialization of the workforce: Larger businesses split complex production processes into separate tasks to boost productivity. The division of labour in mass production of motor vehicles and in manufacturing electronic products is an example.

c. The law of increased dimensions. This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – this is an important scale economy in distribution and transport industries and also in travel and leisure sectors.

2. Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The major food retailers also have monopsony power when purchasing supplies from farmers and wine growers.

3. Managerial economies of scale: This is a form of division of labour. Large-scale manufacturers employ specialists to supervise production systems and oversee human resources.

4. Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of equities. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.

5. Network economies of scale: This is a demand-side economy of scale. Some networks and services have huge potential for economies of scale. That is, as they are more widely used they become more valuable to the business that provides them. The classic examples are the expansion of a common language and a common currency. We can identify networks economies in areas such as online auctions, air transport networks. Network economies are best explained by saying that the marginal cost of adding one more user to the network is close to zero, but the resulting benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The expansion of e-commerce is a great example of network economies of scale – how many of you are devotees of the EBay web site or Facebook?

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Illustrating economies of scale – the long run average cost curve The diagram below shows what might happen to the average costs as a business expands from one scale of production to another. Each short run average cost curve assumes a given quantity of capital inputs. As we move from SRAC1 to SRAC2 to SRAC3, the scale of production is increasing. The long run average cost curve (drawn as the dotted line below) is derived from the path of these short run average cost curves.

Exploiting economies of scale – TNT In January 2006, the market for postal services was opened up to competition thus ending the monopoly of the Royal Mail in the delivery of letters to households and businesses. Attention is now focusing on some of the likely rivals to the Royal Mail in the newly competitive market. One such business is TNT logistics. TNT Express Services was established in the UK in 1978, the company has developed its dominant position in the time-sensitive express delivery market through organic growth and, with an annual turnover in excess of £750 million. TNT employs 10,600 people in the UK & Ireland and operates more than 3,500 vehicles from over 70 locations. TNT Express Services delivers hundreds of thousands of consignments every week - in excess of 50 million items per year.

Source: TNT investor relations web site

Costs

Output (Q)

SRAC1

SRAC2 SRAC3

Q1 Q2 Q3

AC1

AC2

AC3

LRAC

Economies of scale are the advantages of large scale production that result in lower unit (average) costs (cost per unit)

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Why are economies of scale important for a business such as TNT? What types of economies of scale might the business be able to exploit in the long run?

External economies of scale External economies of scale occur within an industry. Examples include the development of research and development facilities in local universities that several businesses in an area can benefit from and spending by a local authority on improving the transport network for a local town or city. Likewise, the relocation of component suppliers and other support businesses close to the main centre of manufacturing are also an external cost saving. Diseconomies of scale A firm may eventually experience a rise in average costs caused by diseconomies of scale. Diseconomies of scale a firm might be caused by:

1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly.

2. Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs. A fall in productivity means that workers may be less productively efficient in larger firms.

3. Loss of control over costs – big businesses may lose control over fixed costs such as expensive head offices, management expenses and marketing costs. There is also a risk that very expensive capital projects involving new technology may prove ineffective and leave the business with too much under-utilized capital.

Do economies of scale always improve the welfare of consumers?

Standardization of products: Mass production might lead to a standardization of products – limiting the amount of consumer choice.

Lack of market demand: Market demand may be insufficient for economies of scale to be fully exploited leaving businesses with a lot of spare capacity.

Developing monopoly power: Businesses may use economies of scale to build up monopoly power and this might lead to higher prices, a reduction in consumer welfare and a loss of allocative efficiency.

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Protecting monopoly power: Economies of scale might be used as a barrier to entry – whereby existing firms can drive prices down if there is a threat of the entry of new suppliers

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Productivity

Productivity is a measure of the efficiency of the labour force measured by output per worker or output per worker hour. The advantages of higher productivity Productivity is the main determinant of living standards – it quantifies how an economy uses the resources it has available, by relating the quantity of inputs to output. As the adage goes, productivity isn't everything, but in the long run it’s almost everything. Higher productivity can lead to:

(1) Lower average costs: These cost savings might be passed onto consumers in lower prices, encouraging higher demand, more output and an increase in employment.

(2) Improved competitiveness and trade performance: Productivity growth and lower unit costs are key determinants of the competitiveness of British firms in global markets.

(3) Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested to support the long term growth of the business.

(4) Higher wages: Businesses can afford higher wages when their workers are more efficient.

(5) Economic growth: If the British economy can raise the rate of growth of productivity then the trend growth of national output can pick up.

The productivity gap The level of GDP per worker and GDP per hour worked in the UK is well below that of the United States, France and Germany. This is known as the productivity gap. Some progress has been made in closing the gap but there is still much work to do. No one factor on its own is sufficient to explain the differences in efficiency.

(1) Relatively low rates of capital investment – i.e. the failure of the economy to invest and thereby to raise the stock of physical capital available to the workforce

(2) Low rates of spending on research and development – The UK now devotes much less of GDP to research spending than other nations and this impacts on the pace of innovation and the speed with which new technology is incorporated into production

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(3) Skills of the labour force – there are long-standing concerns about the educational skills of the UK labour force including basic literacy and the quality of job specific training. Britain has one of the highest rates of functional illiteracy among adults, together with fewer workers with higher skills (at degree level or above) compared to the United States and fewer workers with intermediate and vocational skills compared to Germany and Japan.

(4) Over-regulation of industry and commerce and a lack of competition – the 1999 McKinsey Report highlighted a lack of competitive pressures in some industries (notably retailing) as a source of inefficiency and low productivity growth.

Skills gap and low profits contribute to poor productivity A recent study from the Engineering Employers Federation finds that fewer firms in Britain take on apprentices, investment projects are often ditched by managers and skilled workers are in short supply. The EEF argues that UK firms need to invest in capital equipment and skills and innovation, as well as making the best of modern working practices such as lean manufacturing and high performance working. Part of the problem for manufacturers has been a lack of profits to invest.

Adapted from research published by the Engineering Employers Federation www.eef.org.uk

‘Productivity in Britain continues to lag behind that of our main European competitors. One important reason is the large number of workers in Britain who have low skills and, consequently, low productivity and low pay. Many young people still fail to acquire any adequate level of skill. Young people with low skills on the UK labour market are faced with restricted employment opportunities, and the prospect of a poor quality job.’

Adapted from research published by House of Lords Economic Affairs Committee

Report into low UK productivity by economists at the London School of Economics The persistent productivity gap between the UK and the two big continental European economies can mainly be 'explained' by the fact that they have more capital invested per worker and their workers are more skilled. Productivity growth is highest in industries with greater product market competition - where less productive firms contract and close while new more productive ones open and grow; and where competitive pressures force existing firms to improve. If the UK could reach French productivity levels, we could award ourselves 20% higher wages or take a day off and still earn the same. Or we could spend the extra resources on schools and hospitals, greater benefits for the needy or lower taxes. Capital investment plays an important role in productivity growth. But the UK has less physical capital per worker than the United States and considerably less than France and Germany. Many explanations have been offered for these shortfalls, including macroeconomic instability and business uncertainty.

Those industries with the most up-to-date capital machinery, together with advanced managerial skills and highly qualified and well-trained workforces tend to achieve much higher levels of productivity. The availability of large-scale green-field, full-integrated production plants and good industrial relations are also at the heart of achieving year on year improvements in output per person employed. The strength of demand also affects productivity. When demand is high and production plants are running close to full capacity, then output per worker employed is likely to be rising because factor resources including labour and capital are being used to their full extent. In contrast, during a recession or a slowdown in demand, the utilisation of labour and capital falls. Productivity growth often slows down in a recession.

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Economic Efficiency

Efficiency is about a society making optimal use of scarce resources to satisfy wants & needs. There are several meanings of efficiency but they all link to how well a market allocates our scarce resources to satisfy consumers. Normally the market mechanism is good at allocating these inputs, but there are occasions when the market can fail. Allocative efficiency Allocative efficiency is concerned with whether factor inputs are used to produce the goods and services that match our changing needs and preferences and which we place the greatest value on. Allocative efficiency is reached when no one can be made better off without making someone else worse off. This is also known as Pareto efficiency.

Costs Revenues

Output (Q)

Demand

Supply

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

Consumer Surplus (CS)

Producer Surplus (PS)

Q2

P2

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Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production. The condition required for allocative efficiency is that price = marginal cost of supply. In the diagram above, the market is in equilibrium at price P1 and output Q1. At this point, the total area of consumer and producer surplus is maximised. If for example, suppliers were able to restrict output to Q2 and hike the market price up to P2, sellers would gain extra producer surplus by widening their profit margins, but there also would be an even greater loss of consumer surplus. Thus P2 is not an allocative efficient allocation of resources for this market whereas P1, the market equilibrium price is deemed to be allocative efficient. We will see when we study the economics of monopoly that when businesses have ‘pricing power’ in their own markets, they may increase their profit margins to squeeze extra profit from consumers (they are turning consumer surplus into producer surplus). This has an effect on allocative efficiency for if a monopoly supplier can select a price well above the costs of supply, consumers will suffer a reduction in their welfare. Have you ever felt ripped off buying sandwiches from a motorway service station? The producer has become better off but someone else has become worse off. Using the production possibility frontier to show allocative efficiency Pareto defined allocative efficiency as a position “where no one could be made better off without making someone else at least as worth off.” This can be illustrated using a production possibility frontier – all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available. In the diagram below, the combination of output shown by Point A is allocatively efficient as is the combination shown at point B – but at the output combination C we can increase production of both goods by making fuller use of existing resources or increasing efficiency. C represents a loss of economic efficiency.

If an economy is operating within the PPF there will be an under-utilisation of resources causing output of goods and services to be lower than is feasible. In this sense unemployment is a waste of scare resources; indeed the hours lost through jobless workers can never be recovered – unemployment can be very costly from both an economic and social viewpoint. If every market in

Output of Consumer Goods

Output of Capital Goods

C2

C1

X2 X1

A

B

C

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the economy is a competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient. Productive Efficiency Productive efficiency is achieved when the output is produced at minimum average total cost (ATC) i.e. when a firm is exploiting economies of scale. Productive efficiency also exists when producers minimise the wastage of resources in their production processes. Dynamic Efficiency Dynamic efficiency occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available. Social Efficiency The socially efficient level of output and or consumption occurs when marginal social benefit = marginal social cost. At this point we maximized social welfare. The existence of negative and positive externalities means that the private optimum level of consumption or production often differs from the social optimum leading to some form of market failure and a loss of social welfare. In the diagram below the socially optimum level of output occurs where the social cost of production (i.e. the private cost of the producer plus the external costs arising from externality effects) equals demand (a reflection of private benefit from consumption. A private producer who opts to ignore the negative production externalities might choose to maximise their own profits at point A. This divergence between private and social costs of production can lead to market failure.

Innovation as a source of dynamic efficiency

Dynamic efficiency is improved when businesses bring to the market goods and services that are innovative and high quality and which offer consumers greater choice.

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Efficiency and productivity at the Royal Mail

If a firm is producing the maximum output it can from the resources (inputs) it employs, such as labour and capital, and is also using the best technology available, it is said to be X-efficient. It is doubtful that the Royal Mail can be said to be X-efficient in view of the issues facing it in recent years. The postal workers strikes in October 2009 were the latest in a series industrial relations problems faced by the organisation which go back several years. These problems are a consequence of the Royal Mail facing severe competitive pressures, which 25 years ago, when it was a monopoly, were simply not there. Most recently the Royal Mail has had try to modernise working practices and introduce new sorting technology as competitive pressures have reduced demand for its mail services (down 10% last year and losing it £170m in revenue).

Quantity

Demand = Private Marginal Benefit = Social Marginal Benefit

Marginal Private Cost (Supply)

Q1

Price Marginal Social Cost

Q2

External Cost P1

P2

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Arguably Royal Mail has been carrying a significant degree of X-inefficiency for many years and has now had to tackle it. What is X-inefficiency? It was Harvey Liebenstein in a 1966 article in the American Economic Review, who first introduced this concept. Liebenstein argued that, due to organisational slack resulting from the absence of competitive pressures, monopolies are likely to be technically and productively inefficient. This means that at all levels of output a firm would always operate above its long run average cost curve in terms of cost per unit. Over the last 25 years the Royal Mail’s postal service has been hit first by fax, and then by e mail and texting. In addition since 2006 the market has been fully open to new entrants such as TNT and UK Mail. These firms have successfully bid for lucrative bulk mail contracts from banks, and insurance and credit card companies who send out thousands of items per day. Firms such as TNT collect the mail from these bulk mail customers, deliver them to Royal Mail sorting offices and then postal workers deliver the letters to people’s homes. The Royal Mail has lost a lot of profitable business to these firms, hence the need to be able to compete effectively in a rapidly changing market where new technology and powerful competitors are a threat. Over the last few years the Royal Mail has tried to address the efficiency issues with 55,000 jobs going since 2002. However, a reform of working practices and significant investment in new sorting machinery is needed if its market share is not to fall further. For many years the lack of competitive pressures gave the Royal Mail the opportunity to carry organisational slack, but now rapid modernisation, with possibly part or full privatisation, are the only options, as X-inefficiency from the past has come back to bite the company. Improvements in efficiency helped Royal Mail's letter delivery unit make profits totalling £58m in 2008, compared with a loss of £3m for the year before. For the first time in 20 years all four parts of Royal Mail group were profitable making profits totalling £321m, but much still needs to be done after years of neglect when the company was a pure monopoly.

Source: Bob Nutter, EconoMax, autumn 2009

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Introduction to Causes of Market Failure

• Market failure occurs whenever markets fail to deliver an efficient allocation of resources and the result is a loss of economic and social welfare.

• Market failure exists when the competitive outcome of markets is not satisfactory from the

point of view of society. What is satisfactory nearly always involves value judgments. Complete and partial market failure One useful distinction is between complete market failure when the market simply does not supply products at all (i.e. we see “missing markets”), and partial market failure, when the market does actually function but it produces either the wrong quantity of a product or at the wrong price. Markets can fail for lots of reasons:

(1) Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost

(2) Positive externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit

(3) Imperfect information or information failure means that merit goods are under-produced while demerit goods are over-produced or over-consumed

(4) The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet people’s needs and wants

(5) Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition, causing consumer welfare to be damaged

(6) Factor immobility causes unemployment and a loss of productive efficiency

(7) Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and consequent social exclusion which the government may choose to change

In subsequent chapters we will explore each of these different types of market failure and then move on to consider examples of government intervention.

Root causes of market failure

Lack of competition /

monopoly power

Externalities in production & consumption

Information Failures in the

market

Immobility of Factors of Production

Public and Merit Goods (Missing

Markets)

Poverty and Inequality in

society

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Competition and Monopoly in Markets

A market structure describes the characteristics of a market which can affect the behaviour of businesses and also affect the welfare of consumers. Some of the main aspects of market structure are listed below:

• The number of firms in the market

• The market share of the largest firms

• The nature of production costs in the short and long run e.g. the ability of businesses to exploit economies of scale

• The extent of product differentiation i.e. to what extent do the businesses try to make their products different from those of competing firms?

• The price and cross price elasticity of demand for different products

• The number and the power of buyers of the industry’s main products

• The turnover of customers - this is a measure of the number of consumers who switch suppliers each year and it is affected by the strength of brand loyalty and the effects of marketing. For example, have you changed your bank account or your mobile phone service provider in the last year? What might stop you doing this?

The market for gas and electricity supplies – an oligopoly The market for gas supply in the UK was privatised in 1986 with the market for electricity generation and distribution also transferred to the private sector of the economy a few years later. Since then there have been changes in the market share of the leading electricity distribution companies and domestic gas suppliers with the former state monopolies losing much of their dominance over this time. There are 26 million domestic electricity and 21.5 million domestic gas customers in Great Britain, supplied mainly by six suppliers.

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Supplier Market Shares in Electricity Market Shares in Gas December 2002 March 2007 December 2002 March 2007 British Gas 22 21 63 46 PowerGen 22 19 12 13 SSE 13 18 6 13 Npower 16 16 9 12 Scottish Power 10 12 5 9 EDF Energy 15 14 5 7

Source: OFGEM The UK energy market is split into three elements.

1. Suppliers –who sell electricity and gas to commercial, industrial and household consumers

2. Distributors - responsible for getting energy to users e.g. by building and maintaining the infrastructure of pipes and cables in the road and in installing meters.

3. Generators - responsible for generating the energy used in homes, offices and factories. The retail market for energy is competitive because all customers are now able to change their gas or electricity supplier. In actual fact many people do not switch their suppliers even when they might be able to make savings on their bills. One reason is that people do not find it easy to get accurate information about what the differences are between these competing suppliers. The gas and electricity supply industry is an oligopoly since the lion’s share of the market is taken by the six leading businesses. But the market is competitive because consumers have a real choice about who will sell them their energy. The market share of new entrants into the industry since privatisation is now above 40 per cent for both gas and electricity. The UK food retail sector is an oligopoly – shown by these market share figures for June 2008. Market Share

(%) Cumulative market share (%)

Tesco 31.2 31.2 Asda (Wal-Mart) 16.8 48.0 Sainsburys 15.9 63.9 Morrisons (Safeways) 11.4 75.3 Co-operative (Somerfield) 8.1 83.4 Waitrose 3.9 87.3 Aldi 2.9 90.2 Lidl 2.3 92.5 What is a monopoly?

1. A pure monopolist in an industry is a single seller. It is rare for a firm to have a pure monopoly – except when the industry is state-owned and has a legally protected monopoly.

2. A working monopoly: A working monopoly is any firm with greater than 25% of the industries' total sales. In practice, there are many markets where businesses enjoy some degree of monopoly power even if they do not have a twenty-five per cent market share.

3. An oligopolistic industry is characterised by the existence of a few dominant firms, each has market power and which seeks to protect and improves its position over time.

4. In a duopoly, the majority of sales are taken by two dominant firms. A good example of this is the market for razors in the UK – one dominated by Gillette and also is Schick (the

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manufacturers of the Wilkinson Sword brand). Gillette has approximately 70% of the global shaving market.

How monopolies can develop Monopoly power can come from the successful organic (internal) growth of a business or through mergers and acquisitions (also known as the integration of firms). Horizontal Integration This is where two firms join at the same stage of production in one industry. For example two car manufacturers may decide to merge, or a leading bank successfully takes-over another bank. Vertical Integration This is where a firm integrates with different stages of production e.g. by buying its suppliers or controlling the main retail outlets. A good example is the oil industry where many of the leading companies are explorers, producers and refiners of crude oil and have their own retail networks for the sale of petrol and diesel and other products.

• Forward vertical integration occurs when a business merges with another business further forward in the supply chain

• Backward vertical integration occurs when a firm merges with another business at a previous stage of the supply chain

The Internal Expansion of a Business Firms can generate higher sales and increased market share and exploiting possible economies of scale. This is internal rather than external growth and therefore tends to be a slower means of expansion contrasted to mergers and acquisitions. Barriers to Entry Barriers to entry are the means by which potential competitors are blocked. Monopolies can then enjoy higher profits in the long run. There are several different types of entry barrier – these are summarised below: Patents: Patents are legal property rights to prevent the entry of rivals. They are

generally valid for 17-20 years and give the owner an exclusive right to prevent others from using patented products, inventions, or processes. Owners can sell licences to other businesses to produce versions of their patented product.

Advertising and marketing: Developing consumer loyalty by establishing branded

products can make successful entry into the market by new firms much more expensive. Advertising can also cause an outward shift of the demand curve and make demand less sensitive to price

Brand proliferation: In many industries multi-product firms engaging in brand proliferation can give a false appearance of competition. This is common in markets such as detergents, confectionery and household goods – it is non-price competition.

Monopoly, market failure and government intervention Should the government intervene to break up or control the monopoly power of firms in market?

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The main case against a monopoly is that it can earn higher profits at the expense of allocative efficiency. The monopolist will seek to extract a price from consumers that is above the cost of resources used in making the product. And higher prices mean that consumers’ needs and wants are not being satisfied, as the product is being under-consumed. Under conditions of monopoly, consumer sovereignty has been partially replaced by producer sovereignty.

Price

In the two diagrams above we contrast a market where demand is price inelastic (i.e. Ped <1) with one where demand is more sensitive to price changes (i.e. Ped>1). The former is associated with a monopoly where consumers have few close substitutes to choose from. When demand is inelastic, the level of consumer surplus is high, raising the possibility that the monopolist can reduce output and raise price above cost thereby operating with a higher profit margin (measured as the difference between price and average cost per unit).

Price

Demand

P2

P1

Q2 Q1

Demand

P2

P1

Q2 Q1

Relatively Inelastic Demand Relatively Elastic Demand

Average cost

Higher profit margin

Lower profit margin

Price

Quantity Quantity

Average cost

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If a monopoly reduces output from the equilibrium at Q1 to Q2 then it can sell this at a price P2. This results in a transfer of consumer surplus into extra producer surplus. But because price is now about the cost of supplying extra units, there is a loss of allocative efficiency. This is shown in the diagram by the shaded area which is not transferred to the producer, merely lost completely because output is lower than it would otherwise be in a competitive market. Higher costs – loss of productive efficiency: Another possible cost of monopoly power is that businesses may allow the lack of real competition to cause a rise in costs and a loss of productive efficiency. When competition is tough, businesses must keep firm control of their costs because otherwise, they risk losing market share. Some economists go further and say that monopolists may be even less efficient because, if they believe that they have a protected market, they may be less inclined to spend money on research and improved management. These inefficiencies can lead to a waste of scarce resources. Potential Benefits of Monopoly The possible economic benefits of monopoly power suggest that the government and the competition authorities should be careful about intervening directly in markets and try to break up a monopoly. Market power can bring advantages both to the firms themselves and also to consumers and these should be included in any evaluation of a particular market or industry.

1. Research and development spending: Huge corporations enjoying big profits are well placed to fund capital investment and research and development projects. The positive spill-over effects of research can be seen in more innovation. This is particularly the case in industries such as telecommunications and pharmaceuticals. This can lead to gains in dynamic efficiency and social benefits.

2. Exploitation of economies of scale: Because monopoly producers often supply on a large scale, they may achieve economies of scale – leading to a fall in average costs.

3. Monopolies and international competitiveness: The British economy needs multinational companies operating on a scale large enough to compete in global markets. A firm may enjoy domestic monopoly power, but still face competition in overseas markets.

Price

Quantity

Demand

Supply

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

P2

Q2

Loss of economic welfare from price P2 raised above the market equilibrium price

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SPEW Here is a good way to remember some of the issues we have covered regarding monopoly, efficiency and economic welfare Service - does the lack of competition affect the quality of service to consumers? Prices - how high are prices compared to competitive / contestable market Efficiency - productive, allocative and dynamic Welfare - what are the overall welfare outcomes? Is there a net loss of welfare in markets dominated by businesses with monopoly power?

Acknowledged source: Ruth Tarrant

Case Study: The Cadbury-Kraft Takeover In January 2010, Cadbury agreed to be taken over by its American rival, Kraft, in a £11.6 billion deal. A combined Kraft/Cadbury would rank alongside Mars, which in 2008 acquired Wrigley, as one of the world’s biggest confectionery companies. The new entity’s CEO, Irene Rosenfeld, stressed that the combination was all about growth stating that the deal represented “a strong and complementary strategic fit, creating a global confectionery leader with a portfolio of more than 40 confectionery brands each with annual sales in excess of $100 million” with a leading position in developing markets such as Brazil, Russia, India, China and Mexico. On paper, whilst it is clear why Kraft would want Cadbury’s, it is unclear what Kraft brings to the party. The proposed deal brings together two very different organisations, with cultures and histories that appear to have more differences than similarities. A lot of management time will now be taken up trying to integrate the Cadbury business into the Kraft empire (from selling 31 different types of cheese in 1914, it has grown rapidly via inorganic growth, most recently acquiring Danone for $7.2 billion in 2007, to become the largest American confectionary, food, and beverage corporation and the second in the world only to Nestle, marketing many brands in more than 155 countries). Comparing the two, in the last 12 months, Kraft’s revenues reached $40.3 billion while Cadbury achieved $9.5 billion. There is no doubting that size matters in the food business, where economies of scale can be significant in a number of ways. Particularly it can help a company gain monopsony power and negotiate with even bigger retailers and suppliers.

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However, the fact remains that the majority of big M&A deals ultimately fail to create value for shareholders. Alleged over ambitious synergies never quite materialise and the disruption, and integration costs render many deals in negative territory. Cadbury today is the product of a 1969 merger between Cadbury and Schweppes that was supposed to deliver superior synergies. But more than sixty acquisitions over the ensuing four decades created a sluggish conglomerate that ranked low on both profitability and competitiveness. Kraft could learn an important lesson from this, because in May 2008, Cadbury Schweppes split its business into two separate entities: one focusing on its main confectionery market; the other on its US drinks business stating that diversification did not guarantee a sustainable advantage. Arguably, it was this refocusing of operations that helped Cadbury’s rise to the top; and perhaps the Kraft-Cadbury conglomerate again falls foul of this.

Source: Mo Tanweer, EconoMax, Easter 2010

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Case Study: Local monopoly in action – the motorway service station network Driving on the UK’s motorways is rarely a pleasant experience as large sections of the network seem to be permanently congested. There is, at least, the opportunity to take a break at one of more than 100 service stations. The first service station was opened on the M1 in 1959 at Watford Gap. The number of service stations has almost doubled since 1990 from 55 to 102 but has that meant the much criticised standards have risen over the years? There have often been accusations of high prices and poor quality of service. Many feel that the service stations have a captive market and exploit this at the expense of consumers. The UK’s motorways are served for the most part by only three providers, Moto, Roadchef and Welcome Break – an oligopoly. These three names account for 85% of the market, the largest being Moto with 42 service stations and a turnover of £843m last year. Like many household names, although they operate as profit centres, they are part of much larger, often overseas owned, property companies. There are smaller operators such as First which owns two service stations, one on the M4 and another on the M61. The Tebay Services on the northbound M6 close to the Lake District are independently owned by Westmorland Ltd. Is there evidence of real competition between the big three players in the market? Customer inertia may prevail. Many motorists see all service stations as much the same although there are online opportunities for motorists to find out the good and the bad from online user sites. Therefore they may be able to fill any information gap via the internet. The evidence is that service station operators engage in non price competition as seen by the ‘tie-ups’ that all now have with other retail and food outlets. Moto has on its sites Marks and Spencer’s ‘Simply Food’ and Costa Coffee. Welcome Break has Waitrose and Starbucks while Roadchef has WH Smith and Costa Coffee. Indeed the service stations have become mini shopping malls. New sites continue to emerge, taking advantage of the long forgotten gaps in the existing coverage of the 2,200 mile motorway network. In addition rising traffic levels mean a bigger customer base. The scope for new stations is limited by the government as they must be at least 15 miles apart which perhaps explains the decision by Welcome Break to start providing service stations on A roads. There has also been a new entrant to the market, Extra MSA Services Ltd, which is part of the property group Swayfields Ltd. This group has McDonalds on its sites which include, Beaconsfield on the M40, Blackburn (M65) and Cullompton (M5). Their entry to the market indirectly resulted from the Competition Commission investigation into the merger of Granada and Welcome Break in 1995. Following that investigation the government deregulated the market making it easier for new firms to set up service stations. This attempt to increase contestability has had limited effect on increasing competition as Swayfields went into administration in March 2010. The new Cobham services on the M25 due to open in 2012 were being built by Extra but they may well have new owners soon. Will the incumbent firms in the market be allowed by the competition authorities to buy Extra as it will further increase market concentration? Set against the criticism of motorway services we have to remember they provide free parking and free toilets. The set-up costs are high and the asset is specific to the service provided–arguably there are high sunk costs. In any case if motorists dislike service stations so much in the last resort they can bring their own sandwiches!

Source: Bob Nutter, EconoMax, June 2010 Government intervention in markets – an introduction to UK competition policy Competition policy involves the regulation of markets to protect and improve consumer welfare:

The Competition Commission – its main concern is to investigate mergers and takeovers to examine if these mergers will have a negative effect on competition. It also engages in

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in-depth investigations of markets where there are competition worries. A good example was the recent report into the UK supermarket industry.

The Office of Fair Trading reports on allegations of anti-competitive practices including claims of collusive “price-fixing” behaviour.

The European Competition Authority examines anti-competitive behaviour, mergers and takeovers between European businesses and investigates state aid to struggling businesses to make sure that subsidies do not reduce or distort competition.

Utility regulators such as OFGEM, OFCOM and OFWAT monitor the industries that were privatised during the 1980s and 1990s. The regulators have used the power to introduce and review price capping and they have also have sought to bring fresh competition into markets. Competition was introduced into the telecommunications in 1984; in Gas from 1996-98 and in Electricity from 1998.

Many markets have firms with monopoly power but they seem to work perfectly well from the point of view of the consumer. Although there is a consensus among many economists that competition is a force for good in the long-run, we should be careful not simply to assume that monopoly power is bad and competition is good. There are persuasive arguments on both sides.

Competition Policy Snapshots In the Frame

The European Commission has launched two competition inquiries to study whether IBM has abused its dominant position in mainframe computers. The study will examine whether IBM has put obstacles in place that prevent competitors from operating freely. The other inquiry, launched by the Commission itself, will look at IBM’s relations with maintenance suppliers. (August 2010)

Bathroom cartel

Seventeen bathroom equipment makers have been fined a total of 622m Euros by the European Commission for price-fixing. Given the relatively homogenous nature of the products offering in this industry, and the high concentration ratio, it is ripe for collusion and cartel-like behaviour. (June 2010)

Capping mobile charges

The Telecoms regulator OFCOM has ordered UK mobile phone companies to cut the cost of termination charges - levied when people phone different networks from 4.5p to 0.5p by 2015. Mobile termination rates are the wholesale charges that operators make to connect calls to each others’ networks. (April 2010)

Heavy fines for tobacco cartel

The Office of Fair Trading (OFT) has given out the largest ever total fine in a case under the UK Competition Act 1998. A huge fine has been imposed on two tobacco manufacturers and ten retailers engaged in illegal price fixing for tobacco products in the UK. This is a good example of the financial risks that companies face when found guilty of anti-competitive behaviour. The tobacco manufacturers involved are Imperial Tobacco and Gallaher, and the retailers are Asda, The Co-operative Group, First Quench, Morrisons, One Stop Stores (formerly T&S Stores), Safeway, Sainsbury’s, Shell, Somerfield and TM Retail.

Imperial Tobacco was fined £112m and Co-op and Asda were penalized by £14m each (April 2010)

Source: Tutor2u Economics Blog

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Negative Externalities Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid.

Many types of activity give rise to externalities. And these externalities can be positive and negative. Externalities occur outside of the market i.e. they affect people not directly involved in the production and/or consumption of a good or service. They are also known as spill-over effects. The importance of property rights Property rights confer legal control or ownership of a good. For markets to operate efficiently, property rights must be protected – perhaps through regulation. Put another way, if an asset is un-owned, no one has an incentive to protect it from abuse. The right to own property is an essential building block of a market-based system and in China in March 2007, the communist government passed a law that protects the property rights of private sector businesses, undoubtedly a landmark day for the Chinese economy! Failure to protect property rights may lead to what is known as the Tragedy of the Commons - examples include the over use of common land and the long-term decline of fish stocks caused by over-fishing which leads to long term permanent damage to the stock of natural resources. Negative externalities Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid.

• Smokers ignore the harmful impact of toxic ‘passive smoking’ on non-smokers

• Air pollution from road use and traffic congestion and the impact of road fumes on lungs

• External costs of scraping the seabed for supplies of gravel

• The external cost of food waste

• The external costs of cleaning up from litter and the dropping of chewing gum

• The external costs of the miles that food travels from producer to the final consumer

• The externalities linked to the oil sands project in the Canadian wilderness

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Private Costs and Social Costs The existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption.

Social Cost = Private Cost + External Cost Social Benefit = Private Benefit + External Benefit

When negative production externalities exist, social costs exceed private cost. This leads to over-production if producers do not take into account the externalities. External costs from production Production externalities are generated and received in supplying goods and services - examples include noise and atmospheric pollution from factories. External costs from consumption

Consumption externalities are generated and received in consumption - examples include pollution from driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas. Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit.

The External Costs of Drug Dependency There are more than 327,000 problematic drug users in England. Heroin and crack cocaine addicts are costing the country up to £19 billion a year, according to a study from experts at York University. A hard core of problem drug abusers is running up a bill of £600 a week each in crime, police and court time, health care and unemployment benefits. Last year, the NHS spent about £235 million on GP services, accident and emergency admissions and treatment linked to drug abuse. When social costs are added, the bill rises to between £10.9 billion and £18.8 billion. There are at least 1.5 million recreational and regular users of Class A drugs. The average cost to society of all Class A drug users is £2,030 each a year, says the study. Externalities from Alcohol Use and Misuse For most adults drinking alcohol is part of a pleasurable social experience, which causes no harm to themselves or others. For some people though, alcohol misuse is causing serious damage to themselves, their family and friends and to the community as a whole. Britons are paying the penalty for the soaring rate of alcohol consumption. Ten million adults in England regularly consume more than the government guidelines and the cost to the NHS of alcohol misuse is put at £2.7 billion a year. Deaths from liver cirrhosis are rising faster in Britain than anywhere else in Europe. The rise has been especially sharp in men and women aged fewer than 45, where death rates now exceed the European average.

Sources: Adapted from government reports and newspaper reports, July 2008

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Illustrating market failure from negative externalities

In the absence of externalities, the private marginal costs of the supplier are the same as the costs for society. But if there are negative externalities, we must add the external costs to the firm’s supply curve to find the social marginal cost curve. If the market fails to include these external costs, then the private equilibrium output will be Q1 and the price P1 where private marginal cost = private marginal benefit. From a social welfare viewpoint, we want less output from activities that create an “economic-bad” such as pollution. A socially-efficient output would be Q2 with a higher price P2. At this price level, the external costs have been taken into account. We have not eliminated the pollution – but at least the market has recognised them and priced them into the price of the product. E-Waste and Negative Externalities The United Nations Environment Programme (UNEP) has estimated that worldwide, between 20 and 50 million tonnes of electrical and electronic goods which had come to the end of their lives is being thrown away every year. The latest UNEP report now estimates the annual total at 40 billion tonnes, with America in the lead, producing 3m tonnes domestically every year, followed by China with 2.3m tonnes. (February 2010)

Quantity

Demand = Private Marginal Benefit = Social Marginal Benefit

Private Marginal Cost (Supply)

Q1

Price Social Marginal Cost

Q2

External Cost

P1

P2 Negative externalities cause the social cost curve to lie above the private cost curve

We assume in this example that there are no externalities arising from consumption

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Case Study: Externalities in the prison service

The UK prison population continues to rise without an accompanying rise in prison capacity. This imbalance between demand and supply is generating a number of negative externalities. In August of this year, the UK prison population hit a new high of over 84,000 prisoners, with some 65% of prisoners serving sentences under-12 months, and around half serving only 6 months. These record figures have been reached despite 2500 prisoners being released early from their sentences each month. Amongst men aged 18-21, the re-offending rate is around 75%; within 2 years of release, many prisoners are re-convicted and return to prison. The private cost of prisons Estimates from 2008 suggest that the average cost of prison per year per inmate stands at £23,585, with the total annual running costs of prisons currently amounting to £1,936m. The government is planning to increase the number of prisons in the UK, which will in turn incur more expenditure; initial plans to build so-called Titan prisons, costing around £350m each, to house 2,500 inmates each have been sidelined for the moment, but if the government is to retain its commitment to increasing capacity, there will inevitably be some capital expenditure in the near future. When we consider that the cost of building a new school, for example, is around £25m, there are some difficult economic choices to be made and large opportunity costs to be incurred. The external costs of prisons Following riots in April 2009 at HMP Ashwell, the Prisoner Officers’ Association (POA) stated that people living in the vicinity of low category prisons (those prisons designed for ‘less dangerous’ criminals) were not safe; a spokesperson for this union claimed that “very dangerous prisoners.. Are being sent to open and semi-open prisons far too early in their sentence”, presumably to reduce pressure on capacity in the high-category prisons. Many offenders who are locked up with short sentences have committed crimes to feed drug/alcohol addictions or have severe mental health problems (less than 5% of the general population have 2 or more mental health disorders compared with around 70% of the prison population). Many argue that prison currently does very little to treat the causes of such crimes and so, on release, these prisoners continue to re-offend, causing social disruption and contributing yet further to the demand on the taxpayer. Cost-benefit analysis could be used to help develop alternatives to short-sentencing for much of the prison population. Some research already carried out suggests that treating prisoners with drug habits whilst in prison will cost an additional £5300 per year per offender, but that the subsequent savings to the taxpayer and victims could amount to around £200,000. Similarly, pursuing a ‘surveillance’ programme following a prisoner’s release from prison is likely to cut re-offending rates by over 30%, saving the taxpayer over £130,000 in the longer term (although the cost per offender per year is around £5000). So, even though these ‘enhanced’ prison programmes cost more than prison alone to deliver, there is a belief that ultimately, they will prove to be better value for money for the UK taxpayer. However, if the prison population continues to rise, then these interventions will be more difficult to achieve. There is a fine balance to be struck.

Source: EconoMax, Ruth Tarrant, spring 2010

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Economic and Social Welfare Private economic welfare requires us to consider only the private (or internal) costs and benefits of production and consumption of goods and services. But if we wish to look at the economic welfare of the whole community (i.e. the social welfare) then we need to calculate the positive and negative externalities and add them to private benefits and costs. Here is a simple numerical example: A government is considering four possible capital investment projects. It has the resources to finance and implement only one of these projects. The table below shows the estimated value of the private and external costs and benefits that each project is expected to yield: New city by-pass

(£ million) New schools

(£ million)

Improvement to an existing airport

(£ million)

New hospitals (£ million)

Private benefits 50 135 130 80

Private costs 120 80 100 65

Positive externalities 90 55 35 120

Negative externalities 60 20 60 45

Net private benefit -70 +55 +30 +15

Net social benefit -40 +80 +5 +90

Net social benefit may be taken into account by a government when deciding which project offers the best potential return for society as a whole Negative externalities and government intervention To many economists interested in environmental problems the key is to internalise external costs and benefits to ensure that those who create the externalities include them when making decisions. Pollution Taxes One common approach to adjust for externalities is to tax those who create negative externalities. This is sometimes known as “making the polluter pay”. Introducing a tax increases the private cost of consumption or production and ought to reduce demand and output for the good that is creating the externality. Some economists argue that the revenue from pollution taxes should be ‘ring-fenced’ and allocated to projects that protect or enhance our environment. For example, the money raised from a congestion charge on vehicles entering busy urban roads, might be allocated towards improving mass transport services; or the revenue from higher taxes on cigarettes might be used to fund better health care programmes. Examples of Environmental Taxes include some of the following

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1. The Landfill Tax - this tax aims to encourage producers to produce less waste and to recover more value from waste, for example through recycling or composting and to use environmentally friendly methods of waste disposal.

2. The Congestion Charge: -this is a high profile environmental charge introduced in February 2003. It is designed to cut traffic congestion in inner-London by charging motorists £8 per day to enter the central charging zone.

3. Plastic Bag Tax: In Ireland a pioneering new 15 cent levy on plastic shopping bags was launched in 2002. Belgium introduced a similar tax in June 2007. Proceeds from the tax go to the Environment Fund and are used to fund various waste management and other environmental initiatives. The tax rose to 22 cents per bag in July 2007.

4. Vehicle excise duty (VED): Also known as ‘road tax’ – VED starts from a theoretical 'nil' rate and accelerating up depending on the carbon emissions of the vehicle

Problems with Environmental Taxes Many economists argue that pollution taxes can create problems which lead to government failure.

1. Assigning the right level of taxation: There are problems in setting tax so that private cost will exactly equate with the social cost.

2. Consumer welfare effects: Producers may pass on the tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a small effect in reducing demand. Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on lower-income consumers and leader to a widening of inequalities in the distribution of income.

3. Employment and investment consequences: If pollution taxes are raised in one country, producers may shift to countries with lower taxes. This will not reduce global pollution, and may create problems such as structural unemployment and a loss of international competitiveness.

Externalities and Regulation The government may choose to intervene through the use of regulations and laws. For example, the Health and Safety at Work Act covers all public and private sector businesses. Local Councils can take action against noisy, unruly neighbours and can pass by-laws preventing the public consumption of alcohol. The British government introduced a ban on smoking in public places from July 1st 2007. The European Union has introduced directives on how consumer durables such as cars, batteries, fridges freezers and other products should be disposed of. The onus is now on producers to provide facilities for consumers to bring back their unwanted products. Carbon Emissions Trading Some countries have moved toward market-based incentives to achieve pollution reduction. This new approach involves the creation of a limited volume of pollution rights, distributed among firms that pollute, and allows them to be traded in a secondary market. The intent is to encourage lowest-cost pollution reduction measures to be utilized, in exchange for revenues from selling

Would a tax on aviation fuel be an effective and appropriate way to reduce carbon emissions from the airline industry?

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surplus pollution rights. Companies that are efficient at cutting pollution will have spare permits that they can then sell to other businesses. As long as the total bank (or stock) of permits is reduced year by year by the government or an agency, cuts in total pollution can be achieved most efficiently. Quite simply, limiting emissions makes polluting a scarce resource, and scarcity brings economic value. Emissions’ trading is a central feature of the Kyoto Protocol and the European Carbon Emissions Trading Scheme started in full in January 2005. Subsidising positive externalities An alternative to taxing activities that create negative externalities is to subsidise activities that lead to positive externalities. This reduces the costs of production for suppliers and encourages a higher output. For example the Government may subsidise state health care; public transport or investment in new technology for schools and colleges to help spread knowledge and understanding. There is also a case for subsidies to encourage higher levels of training as a means to raise labour productivity and improve our international competitiveness.

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Positive Externalities There are many occasions when the production and/or consumption of a good or a service creates external benefits which boost social welfare. Examples of positive externalities

• External benefits from development of renewable energy sources such as wind power • External benefits from other new production technologies • External benefits from vaccination / immunisation programmes • Social benefits from providing milk to young schoolchildren • Social benefits from the maintenance of a post-office network

Positive externalities and market failure Where positive externalities exist, the good or service may be under consumed or under provided since the free market may fail to value them correctly or take them into account when pricing the product. In the diagram above, the normal market equilibrium is at P1 and Q1 – but if there are external benefits, the Q1 is an output below the level that maximises social welfare.

There is a case for government intervention in the market designed to increase consumption towards output level Q2 so as to increase economic welfare. The economics of vaccination What good is a vaccination? Obviously there are benefits for the person receiving the vaccine, they are less susceptible to disease and children in particular are more likely to attend school and earn more income over their lifetime. A study from the World Bank finds that comprehensive vaccination programmes have a positive effect on savings and wealth and encourage families to have fewer children which lead to less demographic

Costs Benefits

Quantity of the Good

Private Demand

Supply = Private

Marginal Cost

Demand + External

Benefits = Social

Marginal Benefit

Qp Qs

External Benefit

A

B

With positive externalities, the social benefit of consumption is greater than the private benefit. To maximise welfare we need to encourage increased provision and consumption

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pressures on scarce resources. More subtly, it can be good for an entire population since, if enough of its members are vaccinated, even those who are not will receive a measure of protection. That is because, with only a few susceptible individuals, the transmission of the infection cannot be maintained and the disease spread. The dispassionate economic case for vaccination, therefore, looks at least as strong as the compassionate medical one. Spending on vaccination programmes appears to be a sound social investment for the future.

Source: Adapted from the Economist, October 2005

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Public Goods and Private Goods Public goods provide an example of market failure resulting from missing markets. To understand this, it is helpful first to discuss what is meant by a private good or service. Private Goods A private good or service has three main characteristics:

1. Excludable: A ticket to the theatre or a meal in a restaurant or pay-per-view sporting events are private goods because buyers can be excluded from enjoying the product if they are not willing and able to pay for it. Excludability gives the seller the chance to make a profit. When goods are excludable, the owners can exercise property rights.

2. Rival in consumption: If you order and enjoy a pizza from Dominos, that pizza is no longer available to someone else. Likewise driving your car on a road uses up road space that is no longer available at that time to another motorist. With a private good, one person's consumption of a product reduces the amount left for others to consume and benefit from - because scarce resources are used up in supplying the good or service.

3. Rejectable: If you don't like the soup on the school menu, you can use your money to buy something else! You can choose not to travel on Virgin Rail and go instead by coach, or you can choose not to buy a season ticket for your local soccer club and instead use the money to finance a subscription to a health club. All private goods and services can be rejected by the consumer if their needs and preferences or their budget changes.

Characteristics of Public Goods The characteristics of pure public goods are the opposite of private goods:

1. Non-excludability: The benefits derived from pure public goods cannot be confined solely to those who have paid for it. Indeed non-payers can enjoy the benefits of consumption at no financial cost – economists call this the ‘free-rider’ problem - and it means that people have a strong temptation to consume without paying!

2. Non-rival consumption: Consumption of a public good by one person does not reduce the availability of a good to everyone else – in other words, the marginal cost of supplying a public good to an extra person is zero. If it is supplied to one person, it is available to all.

3. Non-rejectable: The collective supply of a public good for all means that it cannot be rejected by people, a good example is a nuclear defence system or flood defence projects.

There are relatively few examples of pure public goods. Examples include flood control systems, some of the broadcasting services provided by the BBC, public water supplies, street lighting for roads and motorways, lighthouse protection for ships and also national defence services.

Private and Public Goods – a question of exclusion Le Shuttle is a private good – the service is excludable, rival in consumption and rejectable. But not all providers of public goods make a profit.

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Policing – a public good? Is policing an example of a public good? The general protection that the police services provide in deterring crime and investigating criminal acts serves as a public good. But resources used up in providing policing means that fewer resources are available elsewhere. Private protection services such as private security guards, privately bought security systems and detectives are private goods because the service is excludable and rival in consumption and people and businesses are often prepared to pay a high price. Public goods and market failure Pure public goods are not normally provided by the private sector because they would be unable to supply them for a profit. It is up to the government to decide what output of public goods is appropriate for society. To do this, it must estimate the social benefits from making public goods available. Quasi-Public Goods A quasi-public good is a near-public good i.e. it has many but not all the characteristics of a public good. Quasi public goods are:

1. Semi-non-rival: up to a point, extra consumers using a park, beach or road do not reduce the space available for others. Eventually beaches become crowded as do parks and other leisure facilities.

2. Semi-non-excludable: it is possible but often difficult or expensive to exclude non-paying consumers. E.g. fencing a park or beach and charging an entrance fee; building toll booths to charge for road usage on congested routes

The air waves – a public good or quasi public good?

The airwaves used by mobile phone companies, radio stations and television companies are essentially owned by the government. Do they count as a pure public good? One person’s use of the airwaves rarely limits how other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and access to the networks can become slow.

The government also controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised £22 billion in doing so. The government was using the auction to ration the airwaves through a licence system. Although the government has monopoly control in the sense that it controls the issue of licences, it did not set the market price. This was determined by the auction, and the fact that at the end of a bidding war, the major mobile phone companies were prepared to pay such a high price for a licence is evidence of the private benefit (i.e. the anticipated future profit) that the companies expected to make from selling 3rd generation contracts to customers.

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Typology of public goods

The case for government intervention in the case of public goods

• The non-rival nature of consumption provides a strong case for the government rather than the market to provide and pay for public goods.

• Many public goods are provided more or less free at the point of use and then paid for out of general taxation or another general form of charge such as a licence fee.

• State provision may help to prevent the under-provision and under-consumption of public goods so that social welfare is improved.

• If the government provides public goods they may be able to do so more efficiently because of economies of scale.

Public Bads A public bad is the opposite of a public good – it provides disutility or dis-satisfaction to people when consumed and therefore reduces our economic welfare. A good example to look at would be the disposal of household and commercial waste. People are normally prepared to pay a price for their household waste to be collected and disposed of in a safe and non-polluting way. But if waste was changed for according to how much had been generated, then some people would find an incentive to dump their waste on other people’s property and thereby avoid direct charges.

Totally non-rival in consumption

Totally non-excludable

National defence

Street lighting

Analogue broadcasting

Mass MMR vaccination

Encrypted digital broadcasting

Forth Road Bridge

Education and Health

Fire Service

Public Goods, Quasi Public Goods and Private Goods

Totally rival in consumption

Totally excludable

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Merit Goods and Services Merit goods are those goods and services that the government feels that people will under-consume, and which ought to be subsidised or provided free at the point of use so that consumption does not depend primarily on the ability to pay for the good or service.

• Both the state and private sector provide merit goods & services. We have an independent education system and people can buy private health care insurance.

• Consumption of merit goods is believed often to generate positive externalities- where the social benefit from consumption exceeds the private benefit.

• A merit good is a product that society values and judges that people should have regardless of their ability to pay. In this sense, the government is acting paternally in providing these merit goods and services. They believe that individuals may not act in their own best interest in part because of imperfect information.

• Good examples of merit goods include health services, education, work training programmes, public libraries, Citizen's Advice Bureaux and inoculations for children

Education as a merit good The argument concerning imperfect information is an important one here. Parents may be unaware of the longer-term benefits that their children might derive from education. Children themselves will tend to underestimate the long term gains from a proper education. Education is a long-term investment decision. The private costs must be paid now but the private benefits (including higher earnings potential over one’s working life) take time to emerge. Education should provide a number of external benefits including rising incomes and

Price

Quantity

Private Marginal Benefit

Supply

Qp Qs

External Benefit

Welfare loss because merit goods tend to be under-

consumed by the free market A

B

C

Social Marginal Benefit

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productivity for current and future generations; an increase in the occupational mobility of the labour force which should help to reduce unemployment. Increased spending on education should also provide a stimulus for higher-level research which can add to the long run trend rate of growth. Other external benefits might include the encouragement of a more enlightened and cultured society. Providing that the education system provides a sufficiently good education across all regions and sections of society, increased education and training spending should also open up more equality of opportunity. The debate over free entry into museums Campaigners have hailed the success of free access to museums which have attracted an extra 30 million people to the nation's great artistic and cultural collections since admission charges were scrapped six years ago. Entrance fees to national museums across the country were scrapped on 1 December 2001. A report last year by the LSE found that before free admissions the total number of museum visits per year was approximately 27 million. By 2005 that had increased to 42 million, more than the number of people who visited Premiership matches that year and 50 per cent more than West End and Broadway theatre shows combined. Those museums that abandoned entry charges saw their annual attendance figures did particularly well, recording, on average, an 83 per cent increase in visits since 2001. But despite the government grants that have enabled museums to cut their entry fees many national museums are still finding it hard to make ends meet, particularly as their income has not been rising as fast as staff costs and inflation. The LSE's report found that national museums show a falling total of capital expenditure and an increased reliance on government support.

Adapted from news reports, June 2007 Notice here that we are talking about the sorts of goods and services that society judges to be in our best welfare. Judgements involve subjective opinions – and we cannot escape from making value judgements when we are discussing merit goods. Why does the government provide merit goods and services?

• To encourage consumption so that positive externalities of merit goods can be achieved

• To overcome the information failures linked to merit goods

• On grounds of equity – because the government believes that consumption should not be based solely on the grounds of ability to pay for a good or service

Comparing and contrast merit goods with pure public goods

Merit Goods Pure Public Goods

Provided by both the public and private sector Normally funded & provided by the government

Positive marginal cost to supply to extra users Marginal cost of supply close to zero – if provided to one, it is provided to all

Limited in supply – may be a high opportunity cost Largely unconstrained in supply

Rival – consumption reduces availability for other Non-rival – one person’s consumption does not reduce availability for others

Excludable Non-excludable giving rise to the free rider

Rejectable by those unwilling to pay Non rejectable - usually funded by general taxes

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Demerit goods De-merit goods are thought to be ‘bad’ for you. Examples include the costs arising from consumption of alcohol, cigarettes and drugs together with the social effects of addiction to gambling. The consumption of de-merit goods can lead to negative externalities. Consumers may be unaware of the negative externalities that these goods create – they have imperfect information about long-term damage to their own health. The government may decide to intervene in the market for de-merit goods and impose taxes on producers or consumers. But many economists argue that taxation is an ineffective and inequitable way of curbing the consumption of drugs and gambling particularly for those affected by addiction. Banning or limiting consumption through regulation may reduce demand, but risks creating secondary (illegal) or underground markets in the product.

Obesity – is it a case of market failure? Healthcare costs related to obesity-linked illnesses such as diabetes, heart disease and high cholesterol are soaring. Should the government intervene in the market in order to combat the growing costs of obesity?

The City of Detroit in the USA has considered a fast-food tax to combat some of the external costs of obesity

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Market failure with demerit goods The free market may fail to take into account the negative externalities of consumption because the social cost exceeds the private cost. Consumers too may experience imperfect information about the long term costs to themselves of consuming products deemed to be de-merit goods Obesity – a time bomb There is a huge debate at the moment about the root causes of obesity and the social costs that arise from increasing levels of obesity. A report published in June 2007 said that obesity could be a factor that bankrupted the National Health Service in the years to come. Obesity is also an international problem. What of harder drugs? Should hard drugs be prohibited at all costs by the government in a bid to control demand by restricting supply? Regulation has been the route chosen by most governments in developed countries – but economists are divided on the issue. Some believe that legalisation and taxation of harder class drugs is a better policy to pursue, arguing that regulation is ineffective and costly. Another approach would be to divert resources away from regulation towards giving better information to drug users about the longer term health implications of their consumption decisions. The case for a complete ban

Costs and benefits

Output

Demand (Limited Information)

Marginal private cost

Q1

Marginal social cost

Q2 Q3

Demand (Full Information)

External costs (negative externalities)

The social optimal level of consumption would be Q3 – an output that takes into account the information failure of consumers and also the negative externalities.

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The case for a complete ban on de-merit goods such as class A narcotics could be justified on the ground that the social marginal cost of consumption is always higher than the social marginal benefit. In the diagram above there is no output where the social benefit equals the social cost and welfare would be best protected by trying to enforce a total ban on the product. Food additives – a de-merit good? The use of food additives has long been a subject of controversy. Examples include the preservatives used in products from soft drinks to barbecue sauce – designed to lengthen the shelf life of products available for sale in supermarkets. Research published in 2007 by the Food Standards Agency claimed a link between food additives and hyperactive behaviour in children leading to losses of concentration and a worsening in behaviour ands they want a number of food colourings to be banned. Gambling – economic and social effects From betting on the results of general elections, the Grand National, the number of corners that England win in one of their World Cup matches or the temperature in London on Christmas Day, we seem to have an almost insatiable desire for gambling on the outcomes of virtually every sporting, political, meteorological event. Inevitably the rapid expansion of this industry raises important questions about the external costs and benefits of gambling. Some researchers point to the employment and tourism benefits that flow from the growth in demand for gambling services especially if businesses are established in some of the UK's poorest towns and cities. There is also a fiscal dividend from this booming industry with a predicted £3bn per year of extra tax revenues flowing into the Treasury's coffers.

Costs and Benefits

Output

Marginal private cost

Marginal social cost

Q1

Marginal private and social benefits

External costs (negative externalities)

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But gambling also creates external costs. Over 350,000 people in the UK are thought to be addicted to betting and their problem gambling can contribute to crises including personal debt or bankruptcy, loss of employment and the breakdown of families. The dangers of addiction are greatest for the young and the vulnerable susceptible to advertising and marketing strategies. The usual approach to de-merit goods is to tax consumption, so that the private cost of consumption is increased and demand contracts. But the government has actually got rid of betting & gaming duty (it was abolished in 2001) to be replaced with a tax on the profits of gaming companies. The Gambling Act of 2005 deregulates the industry and allows the creation of more casinos in the UK. Mephedrone ban – intervening to regulate a demerit good The UK government has announced a ban on mephedrone. Behind the reason to classify this drug as a demerit good includes the informational failures that exist - “It is being taken by young people who have never taken drugs before in their lives because they think it is legal and it is safe. It is neither legal nor safe.” David Nutt, ex-head of Advisory Council on the Misuse of Drugs, discusses in this article in the Guardian why regulation rather than an outright ban should be implemented instead. (March 2010) Credit card cheques as a demerit good The government has announced a move to ban credit card cheques addressing the issue of the soaring value of UK consumer debt. The move is part of a broader range of measures that attempts to partly bridge the informational failures (and resultant market failure) that lead to consumers inadvertently taking on debt that is beyond their means; and this recent measure highlights the government’s view on it as a demerit good. (July 2009)

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Factor Immobility One cause of market failure is the immobility of factors of production. There are two main types of factor immobility, occupational and geographical immobility.

Occupational Immobility Occupational immobility occurs when there are barriers to the mobility of factors of production between different sectors of the economy which leads to these factors remaining unemployed, or being used in ways that are not efficient. Some capital inputs are occupationally mobile – a computer can be put to use in many different industries. And commercial buildings such as shops and offices can be altered to provide a base for many businesses. However some units of capital are specific to the industry they have been designed for – a printing press or a nuclear power station for example! People often experience occupational immobility. For example, workers made redundant in the steel industry

or in heavy engineering may find it difficult to find a new job. They may have specific skills that are not necessarily needed in growing industries which causes a mismatch between the skills on offer from the unemployed and those required by employers looking for workers. This problem is called structural unemployment. Clearly this leads to a waste of scarce resources and represents market failure. Geographical Immobility Geographical immobility refers to barriers people moving from one area to another to find work. There are good reasons why geographical immobility might exist:

Family and social ties.

The financial costs involved in moving home including the costs of selling a house and removal expenses.

Huge regional variations in house prices.

Differences in the general cost of living between regions and also between countries.

Immobility of labour – a cause of unemployment and market failure

One of the main causes of unemployment is that workers lack the skills required by expanding industries in the economy.

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Millions, seasonally adjusted, using Labour Force Survey dataUK Unemployment, By Duration

Source: Reuters EcoWin

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

milli

ons

0.00

0.25

0.50

0.75

1.00

1.25

1.50

Per

sons

(milli

ons)

0.00

0.25

0.50

0.75

1.00

1.25

1.50

Unemployed for up to six months

Unemployed for over 12 months

Unemployed for over 24 months

Policies to Improve the Mobility of Labour The economic benefits of apprenticeships Recent studies have shown that investing in an apprentice is often cheaper than recruiting qualified workers from rivals and then having to retrain them in the procedures of their new employer. British Telecom has “calculated a net financial benefit of over £1,300 ($1,910) per apprentice a year when compared with non-apprentice recruitment. A more recent study by Warwick University for the taskforce’s successor, the Apprenticeship Ambassadors Network, found that it cost £28,762 to train an engineering apprentice but the employer’s investment was, on average, paid back in less than three years.

Source: Tutor2u Economics Blog, December 2008 To reduce occupational immobility:

Invest in training schemes for the unemployed to boost their human capital to equip them with new skills and skills that can be transferred from one occupation to another.

Subsidise the provision of vocational training by private sector firms to raise the skills level To reduce geographical immobility: Reforms to the housing market designed to improve the supply and reduce the cost of

rented properties and to increase the supply of affordable properties.

Encourage part-ownership / part-rented housing

Specific subsidies for people moving into areas where there are shortages of labour – for example teachers and workers in the National Health Services.

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Imperfect Information Information failure occurs when people have inaccurate, incomplete, uncertain or misunderstood data and so make potentially ‘wrong’ choices. From pensions to computer games consoles, from investing in the stock market to ignorance about the consequences of borrowing and debt, all of us suffer from one or more information failures. The issue is whether the information failure is trivial or whether it has a huge effect on individuals, their families and society as a whole. There may well be a case for the government to intervene in the market in some way if information failures become serious. Examples of information failure Imperfect information can be caused by

Misunderstanding the true costs or benefits of a product: E.g. the social costs and benefits of different classes of drugs and the private and social benefits from higher education when there are so many universities and courses to choose from.

Uncertainty about costs and benefits e.g. should younger workers be buying into pension schemes when we can only guess at economic conditions in 40 years time?

Complex information e.g. choosing between makes of computers requires specialist knowledge of hardware. Do I buy an Apple or PC computer? The problems of choosing a quality second hand car or when deciding whether or not to buy a property.

Inaccurate or misleading information e.g. persuasive advertising may ‘oversell’ the benefits of a product leading to more consumption than is optimal. Spam mail can be a cause of misinformation for consumers. Read this Tim Harford article on spam!

Addiction e.g. drug addicts may be unable to stop consumption of harmful substances Health warnings for snacks in bid to improve consumer information The food industry has made its first move towards issuing health warnings for snack foods. The decision comes as food companies come under in-creasing pressure to provide more information about the nutritional value of their products amid concern about rising levels of obesity. It marks a shift in the food industry’s attitude towards consumers. Food companies have argued that consumer education is not their job but soft drink producers have agreed to a voluntary ban on advertising to children in Europe. They also said they would provide better nutritional information on beverages. Food and drink manufacturers have already made efforts to cut down on fats, salts and sugars, and provide more nutritional information.

Source: Adapted from news reports Asymmetric Information For markets to work, there needs to be symmetric information i.e. consumers and producers have the same level of knowledge about the products, and they know everything there is to know about them. Asymmetric information occurs when somebody knows more than somebody else in the market. This can make it difficult for the two people to do business together Examples include the following:

Warranties: The miss-selling of extended warranties by high street retailers on domestic electrical goods such as televisions and dishwashers

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Sub-prime mortgages: A lender does not know how likely a borrower is to repay their loan.

A car insurance company cannot tell the risks associated with each single driver

A motorist approaching a toll-road may not know how busy it is compared to substitute roads that do not charge a motorist for use.

A used-car seller knows more about the quality of the car being sold than do buyers. The mini case study below covers this example!

The Market for Lemons Assume that used cars come in two types: those that are in good repair, and duds (or “lemons” as Americans call them). Suppose further that used-car shoppers would be prepared to pay $20,000 for a good one and $10,000 for a lemon. As for the sellers, lemon-owners require $8,000 to part with their old banger, while the one-owner, careful-driver old lady with the well-maintained estate won't part with hers for less than $17,000. If buyers had full information they could strike fair trades with the sellers, the old lady getting a high price and the lemon-owner rather less. If buyers cannot spot the quality difference, though, there will be only one market for all used cars, and buyers will be ready to pay only the average price of a good car and a lemon, or $15,000. This is below the $17,000 that good-car owners require; so they will exit the market, leaving only bad cars. This result, when bad quality pushes good quality from the market because of an information gap, is known as “adverse selection”. A great many markets, including those for shares, labour and insurance, often resemble a used-car sale more closely than a McDonald's restaurant.

Source: Adapted from the Economist, October 2001

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Poverty and Inequality in Resource Allocation Going without “In the UK people can become poor as a result of social and economic processes, such as unemployment and changing family structures. Poverty is not simply about being on a low income and going without – it is also to do with being denied hood health, education, good housing and social activities, as well as basic self-esteem”

Source: Child Poverty Action Group In a market economy an individual’s ability to consume goods & services depends upon his/her income. An unequal distribution of income and wealth may result in an unsatisfactory allocation of resources and can also lead to alienation and encourage crime with negative consequences for all. The free-market system will not necessarily respond to the needs and wants of those with insufficient economic votes to have any impact on market demand because what matters in a market based system is your effective demand for goods and services. When we are discussing inequality and poverty, we cannot escape making value judgements. Absolute poverty Absolute poverty measures the number of people living below a certain income threshold or the number of households unable to afford certain basic goods and services. What we choose to include in a basic acceptable standard of living is naturally open to discussion. Relative poverty Relative poverty measures the extent to which a household’s financial resources falls below an average income level. Although living standards and real incomes have grown because of higher employment and sustained economic growth, there is little doubt that Britain has become a more unequal society over the last 20-25 years. Poorer families have a lower life expectancy People from poorer backgrounds are unhealthier and die earlier than the rich, according a study measuring the link between health and wealth. Poorer people in their fifties were 10 times more likely to die earlier than those who are richer, according to a report from the Institute of Fiscal Studies (IFS). The poor often have to stop work early due to ill health, the group added and this increases the risk of these groups suffering income poverty during their retirement years.

Source: BBC news and Institute for Fiscal Studies The most commonly used threshold of low income in Britain is 60% of median household income after deducting housing costs. The distribution of income in the UK In the UK there is a large degree of income inequality. For example, in 2008/09, income before taxes and benefits of the top fifth of households in the UK was £73,800 per year on average compared with £5,000 for the bottom fifth, a ratio of 15 to one. After taking account of taxes and benefits, the gap between the top and the bottom fifth was reduced with average income of £53,900 per year and £13,600, respectively, a ratio of four to one. This shows that the tax and benefits system works in a progressive way to reduce the scale of income inequality. The gap between lowest and higher income groups can be seen in this chart produced by the UK Statistics Commission:

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Another way of showing this income data is in the table below – this shows the distribution of disposable income by household income quintile. The data is for 2008-09. Bottom Fifth Next Fifth Middle Fifth Next Fifth Top Fifth % share of disposable income 7 12 16 22 42

The Poverty Trap The poverty trap affects people living in households on low incomes. It creates a disincentive to look for work or work longer hours because of the effects of the income tax and welfare benefits system. For example, a worker might be given the opportunity to earn an extra £60 a week by working ten additional hours. This boost to his/her gross income is reduced by an increase in income tax and national insurance contributions. The individual may also lose some income-related welfare benefits and the combined effects of this might be to take away over 70% of a rise in income, leaving little in the way of extra net or disposable income. When one adds in the possible extra costs of more expensive transport charges and the costs of arranging child care, then the disincentive to work may be quite strong. Government Policies to Reduce Poverty Policies to reduce relative poverty normally focus on (a) changes to the tax and benefits system and (b) policies designed to increase employment and reduce unemployment. When evaluating different policies to reduce poverty consider some of these related issues:

• Cost

• Effectiveness

• Impact on others in the economy

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1. Changes to the tax and benefits system: For example, increases in higher rates of income tax would make the British tax system more progressive and reduce the post-tax incomes of people at the top of the income scale. The risk is that higher rates of taxation may act as a disincentive for people to earn extra income and might damage enterprise and productivity.

2. A switch towards greater means-tested benefits: Means testing allows welfare benefits to go to those people and families in greatest need. A means-test involves a check on the financial circumstances of the benefit claimant before paying any benefit out. This would help the welfare system to target help for those households on the lowest incomes. However means tested benefits are often unpopular with the recipients.

3. Linking the state retirement pension to average earnings rather than prices: This policy would help to relieve relative poverty among low-income pensioner households. Their pension would rise in line with the growth of average earnings each year

4. Special employment measures (including New Deal): Government employment schemes seek to raise employment levels and improve the employment prospects of the long-term unemployed.

5. Increased spending on education and training: Unemployment is a cause of poverty and structural unemployment makes the problem worse. There are millions of households in the UK where no one in the family is in any kind of work and this increases the risk of poverty.

6. The National Minimum Wage: The National Minimum Wage (NMW) was introduced in April 1999. It is a statutory pay floor - employers cannot legally undercut the NMW. Since 1999, the beneficial impact of the minimum wage has been concentrated on the lowest paid workers in service sector jobs where there is little or no trade union protection.

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Government Intervention in the Market

Laissez faire economics In a free market system, governments take the view that markets are best suited to allocating scarce resources and allow the market forces of supply and demand to set prices. The role of the government is to protect property rights, uphold the rule of law and maintain the value of the currency. Competitive markets often deliver improvements in allocative, productive and dynamic efficiency – but there are occasions when they fail – providing a case for intervention. Intervention in the market The main reasons for policy intervention are:

(1) To correct for market failure

(2) To achieve a more equitable distribution of income and wealth

(3) To improve the performance of the economy There are many ways in which intervention can take place – some examples are given below Government Legislation and Regulation Examples include:

• Laws on minimum ages for buying cigarettes and alcohol • The Competition Act which penalizes businesses found guilty of price fixing cartels • Statutory national minimum wage • A new law in Scotland banning under-18s from using sun-beds • Equal Pay Act and acts preventing other forms of discrimination • Changes in the law on cannabis • Maximum CO2 emissions for new vehicles, laws which restrict flight times at night • Government appointed utility regulators who may impose price controls on privatized

monopolists e.g. telecommunications, the water industry The economy operates with a huge and growing amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Free market economists criticize the scale

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of regulation in the economy arguing that it creates an unnecessary burden of costs for businesses – with a huge amount of “red tape” damaging the competitiveness of businesses. Regulation may be used to introduce fresh competition into a market – for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom. This is known as market liberalization. Direct State Provision of Goods and Services What is best provided by the market? And what might be more appropriately provided by the government sector of the economy? Privatisation has radically changed the public or government sector of the economy although since the current Labour government came to power, there has been a huge rise in total public sector employment, in part the result of a large rise in government spending on the national health services. The following businesses remain part of the public sector:

a. British Nuclear Fuels plc - an international company, owned by the British government, concerned with nuclear power.

b. Network Rail - Network Rail is a "not for dividend" company that owns the fixed assets of the UK railway system that formerly belonged to British Rail, the now-defunct British state-owned railway operator. Network Rail owns the infrastructure itself, railway tracks, signals, tunnels, bridges, level crossings and most stations, but not the rolling stock. Network Rail took over ownership by buying Railtrack plc, which was in "Railway Administration", for £500 million from Railtrack Group plc.

c. East Coast Rail Line. In June 2009 the government announced that it was nationalising the East Coast rail line previously operated by National Express.

d. The Royal Mail - Royal Mail has been a state-owned company since 1969 and remains a public limited company wholly owned by the UK government. The Royal Maul is regulated by PostComm which has the power to grant licences to new competitors entering the deregulated market for household and business mail services. The market was opened up to full competition in January 2006. The Royal Mail retains a universal service commitment.

e. The Tote – a betting business that remains in state ownership and has done since it was created by an act of parliament in 1928. The government has announced plans to privatise the business but this has not yet been completed in part because of difficult stock market conditions following the credit crunch and the recession.

f. Northern Rock - In the autumn of 2007 the government announced the nationalisation of Northern Rock - all shares in the business were handed over to the Treasury. The main justification for the decision was that Northern Rock's business model had failed but that the economic and social consequences of allowing the business to go bust were too severe - hence the need for government intervention. Weeks earlier Northern Rock ran into a financial crisis which led to the first run on a major UK bank since the nineteenth century. It was forced to ask the Bank of England for emergency funding. With nationalisation, the debts of the bank were taken onto the public sector finances. These loans and guarantees were estimated to be worth more than £50bn. In the months since the nationalisation, Northern Rock has been downsizing its activities, reducing the size of its mortgage loans book and making several thousand employees redundant.

g. Bradford and Bingley - In September 2008 the UK government nationalised Bradford and Bingley - it took control of the bank's £50bn mortgages and loans, while B&B's £20bn savings unit and branches was bought by Spain's Santander.

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h. Royal Bank of Scotland: On the 13 October 2008 the UK government announced its plan to save the Royal Bank of Scotland from failing. It agreed a bail out of the bank in return for taking a seventy per cent stake in the business. The government also has a 43 per cent stake in Lloyds Banking Group.

State funding can also be used to provide merit goods and services and public goods directly to the population e.g. the government pays private sector firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network. Fiscal Policy Intervention Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy.

• Indirect taxes can be used to raise the price of de-merit goods and products with negative externalities designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level

• Subsidies to consumers will lower the price of merit goods. They are designed to boost consumption and output of products with positive externalities – remember that a subsidy causes an increase in market supply and leads to a lower equilibrium price

• Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development. Or a reduction in corporation tax (a tax on company profits) designed to promote new capital investment and extra employment

• Changes to taxation and welfare payments can be used to influence the overall distribution of income and wealth – for example higher direct tax rates on rich households or an increase in the value of welfare benefits for the poor to make the tax and benefit system more progressive

Intervention designed to close the information gap Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. Government action can have a role in improving information to help consumers and producers value the ‘true’ cost and/or benefit of a good or service. Examples might include:

(1) Compulsory labelling on cigarette packages with health warnings to reduce smoking

(2) Improved nutritional information on foods to counter the risks of growing obesity

(3) Anti-speeding television advertising to reduce road accidents and advertising campaigns to raise awareness of the risks of drink-driving

(4) Information campaigns on the dangers of addiction and binge-drinking

(5) Home Information Packs for home-buyers These programmes are really designed to change the “perceived” costs and benefits of consumption for the consumer. They don’t have any direct effect on market prices, but they seek to influence “demand” and therefore output and consumption in the long run. Increasingly adverts are becoming more hard-hitting in a bid to have an effect on consumers. Intervention and Stakeholders As an economist, whenever you are required to discuss the costs and benefits of an example of government intervention it is worth asking yourself “who are the major stakeholders in this issue?”

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A stakeholder is any person or organization that has a legitimate interest in a specific project or policy decision. The decisions of government, businesses and other non-governmental organisations inevitably affect different groups within society. Increasingly, many businesses are taking into account the effects of their actions not just on the value that such decisions create for shareholders – but also to a broader range of stakeholder groups. Typically stakeholder issues come into play on major infrastructural projects where a cost benefit analysis might be undertaken to assess the likely social costs and benefits – it is important to bring as many stakeholders into the picture as possible – many people might be affected, Examples of stakeholders you might think of bringing into a discussion

1. Employees of a business / organisation (who may / may not be members of a union) 2. Communities where a business is located or affected directly by a decision 3. Suppliers to a particular business (e.g. back down the supply chain) 4. Shareholders and other investors / financiers 5. Creditors (people owed money) 6. Government (and through them – taxpayers) 7. Trade unions (and the workers they represent) 8. Professional associations 9. NGOs and other advocacy groups (i.e. World Bank, IMF, Pressure Groups) 10. Prospective employees 11. Prospective customers 12. Local communities 13. National communities 14. International community 15. Competitors within a market

Topical issues where the stakeholder concept might be considered important Stakeholders affected by all kinds of issues including the following:

1. Increasing the national minimum wage 2. Rise in the London Congestion charge and expansion of the congestion charge zone 3. The building and opening of Heathrow Terminal 5 4. Government investment in wind farm technology 5. Reforms to the EU’s common agricultural policy 6. Possible introduction of a tax on aviation fuel for flights inside the EU 7. Key decisions on developing new towns to help meet the demand for housing 8. Food export bans and export taxes (e.g. India increasing the tax on exported rice) 9. Decisions to lower import tariffs on goods and services coming into the UK 10. Changes to rules on mortgage lending as a result of the credit crunch 11. Removing the 10% starting rate of income tax 12. Higher tuition fees for UK students at English universities

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Intervention in Action – The UK Housing Shortage

The elasticity of housing supply in the UK is low – one of the lowest in Europe – current policy is focused on improving the elasticity of supply so that house building is more responsive to changes in market demand.

1. A loosening of planning restrictions: Relaxation of planning constraints for new housing – including relaxation of the greenbelt restrictions. There is no shortage of land in the UK, merely a shortage of land on which it is possible to build new homes.

2. Building homes on brown-field sites: Financial incentives for construction companies to build on brown-field sites (e.g. previously developed land).

3. Encouraging self-build schemes: Self-build homes work out cheaper in the long run and they give people the satisfaction of building a home to their own specification and design.

4. Build more social housing: Allowing each local authority (council) greater freedom to borrow money to fund the construction and supply of social housing may help to reverse the collapse in the building of council properties over the last ten to twenty years. Increased funding for the 1,400 housing associations responsible for building and maintaining nearly 3 million homes in the UK is also an option.

5. Increased innovation and productivity in house-building industry: Encouraging more innovation in the building industry – for example innovations that make it possible to build new homes attractively at higher densities (i.e. more properties per square acre).

6. Reducing the number of empty homes – There are several options for this including compulsory purchase orders if owners of properties allow their properties to remain empty and unused for 6 months or more – these properties could then be made available to people on housing waiting lists at sub-market rents.

7. Tax breaks for investors willing to make rented properties available at affordable rents. Evaluation on the effects of government intervention

a) Value judgements: Be aware of the use of ‘value judgements’ in discussions about government intervention – many people want a particular intervention because of their own vested interests.

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b) Changing prices to change incentives and behaviour: Many interventions work though the price mechanism by changing the relative prices / relative costs of day-to-day decisions

a. E.g. raising the price of fuel to curb consumption

b. Offering a subsidy to bio-fuel producers

c. Using tariffs to change the relative prices of imports in a domestic economy

c) Social science: Economics is a social science and the effects of intervention cannot be calibrated / forecast with great accuracy – people’s behaviour is subject to change – remember the ‘law of unintended consequences’!

d) Combinations of policies: One single intervention is unlikely to produce a solution to deep-rooted economic and social problems – try to build a variety of policy options into your discussion e.g. policies that work on market demand and market supply

e) The power of markets: Is government intervention always necessary? Market forces can be really powerful in finding profitable solutions to problems – don’t underestimate the importance of innovation and invention – government’s rarely have all of the answers and the new economics of mass collaboration offers powerful insights into the impact that collusive behaviour can have e.g. in fast-tracking ideas linked to reducing carbon emissions

f) Costs and benefits: You cannot go far wrong in an evaluation question by trying to identify and then discuss the costs and benefits of government intervention – some of which only become apparent over long time periods

g) The ‘law of unintended consequences’: Government intervention does not always work in the way in which it was intended or the way in which economic theory predicts it should. Part of the fascination of studying Economics is that the “law of unintended consequences” often comes into play – events can affect a particular policy, and consumers and businesses rarely behave precisely in the way in which the government might want!

Judging the effects of intervention – a useful check list To help your evaluation of government intervention – it may be helpful to consider these questions:

1. Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources? E.g. does it improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity?

2. Effectiveness of a policy: i.e. which policy is most likely to meet a specific economic or social objective? For example which policies are likely to be effective in reducing road congestion?

3. Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example, would it be equitable for the government to increase the top rate of income tax to 50 per cent in to make the distribution of income more equal?

4. Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we rely on in future years.

Tutor2u Blog Articles on Government Intervention

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Indirect Taxation An indirect tax is imposed on producers (suppliers) by the government. Examples include duties on cigarettes, alcohol and fuel and also VAT. A tax increases the costs of production causing an inward shift in the supply curve. The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier may be able to pass on some or all of this tax onto the consumer through a higher price. This is known as shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of demand and supply.

• In the left hand diagram, demand is elastic so the producer must absorb most of the tax

and accept a lower profit margin on each unit. When demand is elastic, the effect of a tax is to raise the price – but we see a bigger fall in quantity. Output has fallen from Q to Q1.

• In the right hand diagram demand for the product is inelastic and therefore the producer is able to pass on most of the tax to the consumer by raising price without losing much in the way of sales.

The table below shows the demand and supply schedules for a good Price (£)

Quantity Demanded Quantity Supplied (Pre-tax)

Quantity supplied (Post-tax)

10 20 1280 600 9 60 1000 400 8 150 850 150 7 260 600 50 6 400 400 5 600 150 4 900 50

Price

Quantity

S1

Q1

Price

Quantity

D1

S + Tax

P2

Q2 Q1

P1 D1

Q2

P1

A Tax when Demand is Price Inelastic A Tax When Demand is Price Elastic

S + Tax

P2

S1

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1 What is the initial equilibrium price and quantity?

Price = £6

Quantity = 400

2 The government imposes a tax of £3 per unit. The new supply schedule is shown in the right hand column of the table – less is now supplied at each and every market price

3 Find the new equilibrium price after the tax has been imposed New price =£8

4 Calculate the total tax revenue going to the government Tax revenue = £450

5 How have consumers been affected by this tax?

There has been a fall in quantity traded and a rise in the price paid by consumers – this leads to a fall in economic welfare as measured by consumer surplus

Who pays the tax? The burden of taxation

The Government would rather place indirect taxes on commodities where demand is inelastic because the tax causes only a small fall in the quantity consumed and as a result the total revenue from taxes will be greater. An example of this is the high level of duty on cigarettes and petrol.

Price

Quantity

S1

Q1

Price

Quantity

D1

S + Tax

P2

Q2 Q1

P1 D1

Q2

P1

A Tax when Demand is Price Inelastic A Tax When Demand is Price Elastic

S + Tax

P2

S1

When demand is inelastic, the producer is able to pass on most or perhaps all of an indirect tax to the consumer by raising the market price. Conversely when demand is price elastic, the producer cannot pass on much of the tax to the consumer, they must absorb the majority of the tax themselves

P3

P3

The burden of an indirect tax paid by the consumer

The burden of an indirect tax paid by the producer

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• Specific taxes: A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint of beer or the tax per packet of twenty cigarettes. Another example is air passenger duty

• Ad valorem taxes: Where the tax is a percentage of the cost of supply – e.g. value added tax currently levied at the standard rate of 15%. In the diagram below, an ad valorem tax has been imposed on producers. The equilibrium price rises from P1 to P2 whilst quantity falls from Q1 to Q2.

Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve. This is because the tax is a percentage of the unit cost of supplying the product. So a good that could be supplied for a cost of £50 will now cost £58.75 when VAT of 17.5% is applied whereas a different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied. The absolute amount of the tax will go up as the market price increases. Tobacco tax is an example of a product on which both specific and ad valorem taxes are applied. Indirect taxes and black markets One of the disadvantages of indirect taxes, particularly the so-called ‘sin taxes’ levied on tobacco and alcohol, is that they can give rise to a black market in the goods in order to avoid the tax, and this is a source of government failure. According to estimates by HM Revenue & Customs, up to 54 per cent of hand rolling tobacco and 17 per cent of cigarettes consumed in the UK are smuggled, costing the Treasury £3 billion in lost tax revenue in 2007-08 alone. With the current fiscal deficit, the British Treasury needs that revenue!

Source: Tutor2u Economics Blog, Penny Brooks, March 2010 Tutor2u blog articles on indirect taxation

Price

Quantity

Demand

Supply + Ad valorem tax

P1

Q1

S1

P2

Q2

An ad valorem tax causes a pivotal shift in the

producer’s supply curve

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Producer Subsidies A subsidy is a payment by the government to suppliers that reduce their costs of production and encourages them to increase output. The subsidy causes the firm's supply curve to shift to the right. The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output. Occasionally the government can offer a direct subsidy to the consumer – which has the effect of boosting demand in a market

Different Types of Producer Subsidy (1) A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum

price offered to farmers such as under the old Common Agricultural Policy (CAP).

(2) An input subsidy which subsidises the cost of inputs used in production – e.g. an employment subsidy for taking on more workers.

(3) Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry or a loss-making airline.

(4) Bail-outs e.g. for financial organisations in the wake of the credit crunch

(5) Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e.g. as part of a regional policy designed to boost employment.

To what extent will a subsidy feed through to lower prices for consumers? This depends on the price elasticity of demand for the product. The more inelastic the demand curve the greater the consumer's gain from a subsidy. Indeed when demand is perfectly inelastic the consumer gains most of the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price. When demand is relatively elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a much lower market price.

Price

Quantity

Demand

P1

Q1

S pre subsidy

P2

Q2

S post subsidy

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Economic and Social Justifications for Subsidies Why might the government be justified in providing financial assistance to producers in certain markets and industries? How valid are the arguments for government subsidies?

(1) To keep prices down and control inflation – in the last couple of years several countries have been offering fuel subsidies to consumers and businesses in the wake of the steep increase in world crude oil prices.

(2) To encourage consumption of merit goods and services which are said to generate positive externalities (increased social benefits). Examples might include subsidies for investment in environmental goods and services.

(3) Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply.

(4) Subsidies to slow-down the process of long term decline in an industry e.g. fishing or mining

(5) Subsidies to boost demand for industries during a recession e.g. the car scrappage scheme

Economic Arguments against Subsidies The economic and social case for a subsidy should be judged carefully on the grounds of efficiency and fairness. Might the money used up in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an opportunity cost and in the long run there might be better ways of providing financial support to producers and workers in specific industries. Free market economists argue that subsidies distort the working of the free market mechanism and can lead to government failure where intervention leads to a worse distribution of resources.

Price

Quantity

Demand

P1

Q1

S pre subsidy

Price

Quantity

D2

P1

Q1

S pre subsidy

S post subsidy

S post subsidy

P2

P2

The effect of a subsidy on the market price is greatest when demand is inelastic When demand is price elastic, a subsidy will have more of an effect on quantity traded

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(i) Distortion of the Market: Subsidies distort market prices – for example, export subsidies distort the trade in goods and services and can curtail the ability of ELDCs to compete in the markets of rich nations.

(ii) Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary

(iii) Financial Cost: Subsidies can become expensive – note the opportunity cost!

(iv) Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or tax-payers) who themselves may have derived no benefit from the subsidy.

(v) Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i.e. it delays much needed reforms.

(vi) Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments.

(vii) There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects.

Case Study: The Car Scrappage Scheme

Monthly output figures for cars made in the UKUnited Kingdom Passenger Car Production

Passenger cars, for home market Passenger cars, for exportSource: Society of Motor Manufacturers and Traders

Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr07 08 09 10

0

10000

20000

30000

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A scrappage subsidy is a “pay-to-scrap” scheme where a government offers a financial incentive to car buyers if they scrap a car that has reached a specified age and in its place they are offered a payment towards the cost of a new vehicle. Scrappage subsidies have become more popular during the 2009 recession. Germany offers a Euro 2,500 payment for cars more than nine years old and France offers a Euro 1,000 payment. In the United States, a ‘’Cash for clunkers’ bill offers up to £3600 for US consumers to buy new, more fuel-efficient vehicle assembled in the US and up to £5400 for 100mpg or more plug-in hybrids. Customers buying cars built outside of the country will only receive a maximum of £2900. And in Slovakia where there has been huge foreign direct investment into their fledgling motor industry,

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incentives worth Euro 1,000 to Euro 1,500 are available. The UK launched its own scheme in April 2009 offering £2,000 towards the cost of a new car replacing nine year old vehicles. Arguments for a scrappage subsidy

(1) It is a direct incentive for consumers to buy a new vehicle - a targeted subsidy (2) Stimulating demand will help keep car plants open and producing vehicles at a time when

the credit crunch and rising unemployment has caused a collapse in new vehicle demand and production

(3) There are environmental benefits if consumers swap older for newer - more fuel efficiency vehicles that emit less c02 per km travelled

(4) Crushing (and recycling) used cars reduce the risks of a sharp fall in second hand car prices caused by vast over-supply

(5) Some of the financial costs of the subsidy would be recouped by the revenue from the VAT charged on new car purchases

Arguments against a scrappage subsidy

(1) Distortion of market competition, why should the car industry be in receipt of a subsidy and other sectors miss out? If cars can be scrapped for a payment why not old televisions?

(2) The payment brings forward demand that might have occurred anyway and risks a sharp fall-off when incentives end. Economists call this a deadweight loss - a benefit is being given to people who would (eventually) have bought a new car anyway

(3) There are extra costs of crushing / disposing of vehicles that was still roadworthy and usable

(4) There is an opportunity cost to financing a scrappage scheme - the money might be better spent developing greener public transport alternatives

(5) Subsidies might be a catalyst for protectionism i.e. only giving subsidies for new vehicles produced within the domestic economy and not for importers. For example the Malaysian government finances 50% of their scrappage scheme, which pays owners of older vehicles to turn them in and purchase new cars from Malaysian produced Protons and Peroduas. In the UK, nearly 90 per cent of new cars are imported. UK made vehicles is exported to countries that may not have a similar pay to scrap scheme in place.

(6) We must also consider the C02 emissions created by the manufacturing of new cars A scrappage scheme would be great news for recycling plants and car dealerships and perhaps just the fillip that our motor industry needs. But for many people such a scheme is a poorly judged scheme for a failing industry that already suffers from over-capacity. Tutor2u blog articles on subsidies

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Maximum Prices The government or an appointed industry regulator can set a maximum price in an attempt to prevent the market price from rising above a certain level. To be effective a maximum price has to be set below the free market price. One example might be when shortage of foodstuffs threatens large rises in the free market price. Other examples include rent controls on properties – for example the system of rent controls still in place in Manhattan in the United States. Price capping also happens when the competition authorities judge that consumers are being exploited by businesses using their monopoly power. A maximum price seeks to control the price – but also involves a normative judgement on behalf of the government about what that price should be. An example of a maximum price is shown in the next diagram. The normal equilibrium price is shown at Pe – but the government imposes a maximum price of Pmax. This price ceiling creates excess demand equal to quantity Q2-Q2 because the price has been held below the equilibrium.

It is worth noting that a price ceiling set above the free market equilibrium price would have no effect whatsoever on the market – because for a price floor to be effective, it must be set below the normal market-clearing price. Maximum prices and consumer and producer welfare How does the introduction of a price ceiling affect consumer and producer surplus. This is shown in the next diagram. At the original equilibrium price consumer surplus = triangle ABPe and producer surplus equals the triangle PeBC. Because of the maximum price ceiling, the quantity supplied contracts to output Q2. Consumers gain from the price being set artificially lower than the equilibrium, but there is a loss of consumer welfare because of the reduction in the quantity traded. At P max the new level of consumer surplus = the trapezium ADEPmax. Producer surplus is reduced to a lower level Pmax EC. There has been a net reduction in economic welfare shown by the triangle DBE.

Rent £s

Quantity of Rented Property

Demand

Supply

P max

Q1

Pe

Price (Rent) Ceiling

Q2

Free Market Equilibrium

Excess Demand

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Black Markets Ticket touting is nothing new, but the rise of online ticket-exchanges has expanded the market by making it much easier for sellers and buyers to find each other. Last year Britons purchased £100m worth of resold tickets; this year the market will top £250m.

Source: EconoMax, January 2008 A black market (or shadow market) is an illegal market in which the market price is higher than a legally imposed price ceiling. Black markets develop where there is excess demand for a commodity. Some consumers are prepared to pay higher prices in black markets in order to get the goods or services they want. When there is a shortage, higher prices act as a rationing device.

• Good examples of black markets include tickets for major sporting events, rock concerts and black markets for children’s toys and designer products that are in scarce supply.

• There is also evidence of black markets in the illegal distribution and sale of computer software products where pirated copies can often dwarf sales of legally produced software.

Rationing when there is a market shortage Rationing when there is a maximum price might also be achieved by allocating the good on a ‘first come, first served’ basis – e.g. queues of consumers. Suppliers might also allocate the scarce goods by distributing only to preferred customers. Both of these ways of rationing goods might be considered as inequitable (unfair) – because it is likely that eventually those who might have the greatest need for a commodity are unlikely to have their needs met. Another problem arising from the maintenance of a maximum price is that in the long run, suppliers might respond to a maximum price by reducing their supply – the supply curve becomes more

Price

Quantity

Demand

Supply

P max

Q1

Pe

Price Ceiling

Q2

Consumer surplus at the equilibrium market

i

Producer surplus at the equilibrium market price

A

B

C

D

E

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elastic in the long term. This is illustrated in the next diagram which looks at the effect of a maximum price for rented properties.

If landlords decide that they cannot make a satisfactory rate of return by selling rented properties in the market because of the maximum price, they might decide to withdraw some properties from the market. At the maximum rent, the long run supply curve shows a smaller quantity of rented properties available for tenants – which with a given level of market demand cause the excess demand (shortage) in the market to increase. The quality of rented properties might deteriorate over time because landlords decide to cut spending on maintenance and improvements. The end result would be a loss of allocative efficiency because there are fewer properties on the market and the quality is getting worse – fewer people’s needs and wants are being met at the prevailing market price. Although maximum prices such as rent controls are still in place in many countries, in the UK, rent controls were essentially abolished in the late 1980s. And, over the last fifteen years the government has actively sought to encourage an expansion in the total supply of rented properties provided by both private sector landlords and also registered social landlords such as housing associations. The rapid growth in the buy-to-let property market has also contributed to a huge increase in the supply of properties available for letting in the majority of towns and cities in the UK.

Rent £s

Quantity of Rented Property

Demand

Supply (short run)

P max

Q1

Pe

Price (Rent) Ceiling

Q2

Free Market Equilibrium

Excess Demand (short run)

Supply (long run)

Q3

Excess Demand (long run)

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Minimum Prices A minimum price is a price floor below which the market price cannot fall. To be effective the minimum price has to be set above the equilibrium price. Perhaps the best example of a minimum price is the minimum wage which was introduced into the UK ten years ago.

How does a minimum wage work? Employers cannot legally undercut the current minimum wage rate per hour. This applies both to full-time and part-time workers. A diagram showing the possible effects of a minimum wage is shown below. The market equilibrium wage for this particular labour market is at W1 (where demand = supply). If the minimum wage is set at Wmin, there will be an excess supply of labour equal to E3 – E2 because the supply of labour will expand (more workers will be willing and able to offer themselves for work at the higher wage than before) but there is

a risk that the demand for workers from employers (businesses) will contract if the minimum wage is introduced.

The main aims of the minimum wage

1. The equity justification: That every job should offer a fair rate of pay commensurate with the skills and experience of an employee.

2. Labour market incentives: The NMW is designed to improve incentives for people to start looking for work – thereby boosting the economy’s labour supply.

Adult Rate (for workers aged 22+)

1 Apr 1999 £3.60 1 Oct 2000 £3.70 1 Oct 2001 £4.10 1 Oct 2002 £4.20 1 Oct 2003 £4.50 1 Oct 2004 £4.85 1 Oct 2005 £5.05 1 Oct 2006 £5.35 1 Oct 2007 £5.52 1 Oct 2008 £5.73

Wage Rate (W)

Employment of Labour (E) Number of people employed

Demand for Labour

Labour Supply

W min

E1

W1

Minimum Wage (Wage Floor)

E2 E3

Free-market equilibrium wage

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3. Labour market discrimination: The NMW is a tool designed to offset some of the effects of persistent discrimination of many low-paid female workers and younger employees.

Possible disadvantages of a minimum wage Although all political parties are now committed to keeping the minimum wage, there are still plenty of economists who believe that setting a pay floor represents a distortion to the way the labour market works because it reduces the flexibility of the labour market

1. Competitiveness and Jobs: Firstly a minimum wage may cost jobs because a rise in labour costs makes it more expensive to employ people and higher labour costs. It will be interesting to observe whether the minimum wage is said to have caused extra unemployment during the current economic downturn.

2. Effect on relative poverty: Is the minimum wage the most effective policy to reduce

relative poverty? There is evidence that it tends to boost the incomes of middle-income households where more than one household member is already in work whereas the greatest risk of relative poverty is among the unemployed, elderly and single parent families where the parent is not employed.

Can a minimum wage actually increase employment? The answer is yes – depending on the circumstances in the labour market when a pay floor is introduced and also on what happens to the productivity of labour when a high (statutory) rate of pay is introduced. There are two main explanations for the possibility of higher employment

2. The Keynesian argument that higher wage rates will increase the disposable incomes of lower-paid workers many of whom have a high propensity to consume. Thus they will increase their spending and this will feed through the circular flow of income and spending

3. The efficiency wage argument that raising pay levels for low-paid employees may have a positive effect on their productivity. In addition to the psychological benefits of being paid more, businesses may take steps to improve production processes, workplace training etc if they know that they must pay at least the statutory pay floor.

The importance of elasticity of demand and supply of labour The impact of a minimum wage on employment levels depends in part on the elasticity of demand and elasticity of supply of labour in different industries. If labour demand is inelastic then the contraction in employment is likely to be less severe than if employers’ demand for labour is elastic with respect to changes in the wage level. In the next diagram we see the possible effects of a minimum wage when both labour demand and labour supply are elastic in response to a change in the market wage rate. The excess supply created is much higher than in the previous diagram.

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Evidence on the minimum wage – has it worked?

1. Employment: For most of the years since the NMW was launched, unemployment has been falling. The jobless total is now increasing at a rapid rate but the main cause has been the domestic and global economic recession.

2. Inflation: In many sectors firms find it hard to pass on higher wage costs to final consumers – limiting the inflationary effect of the minimum wage

3. Wage costs: The minimum wage affects only a small proportion of workers and the effects on the wage bills of most businesses is not a significant factor in their employment decisions. In the short term, the demand for labour tends to be inelastic with respect to changes in wages

4. Discrimination: The minimum wage has had an impact on the earnings of part-time female workers.

5. Productivity: It is hard to identify any strong positive effect on labour productivity - but efficiency gains have been made in most low-paying industries, a trend which started before the minimum wage was introduced.

Wage Rate (W)

Employment of Labour (E)

Demand for Labour

Labour Supply

W min

Q1

W1

Minimum Wage (Wage Floor)

Q2 Q3

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Buffer Stock Schemes

Spot Price (daily) Index of prices, GSCI: Goldman Sachs Commodity IndexWorld Cotton Prices

Source: Reuters EcoWin

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The prices of agricultural products such as wheat, cotton, cocoa, tea and coffee tend to fluctuate more than prices of manufactured products and services. This is largely due to the volatility in the market supply of agricultural products coupled with the fact that demand and supply are price inelastic. One way to smooth out the fluctuations in prices is to operate price support schemes through the use of buffer stocks. But many of them have had a chequered history. Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low. The diagram below illustrates the operation of a buffer stock scheme. The government offers a guaranteed minimum price (P min) to farmers of wheat. The price floor is set above the normal free market equilibrium price. Notice that the price elasticity of supply for wheat in the short term is very low because of the length of time it takes for producers to supply new quantities of wheat to the market. (Indeed in the momentary period, we would draw the supply curve as vertical indicating a fixed supply). If the government is to maintain the guaranteed price at P min, then it must buy up the excess supply (Q3-Q1) and put these purchases into intervention storage. Should there be a large rise in supply due to better than expected yields at harvest time, the market supply will shift out – putting downward pressure on the free market equilibrium price. In this situation, the intervention agency will have to intervene in the market and buy up the surplus stock to prevent the price from falling. It is easy to see how if the market supply rises faster than demand then the amount of wheat bought into storage will grow. Advantages of a successful buffer-stock scheme:

(1) Stable prices help maintain farmers’ incomes and improve the incentive to grow legal crops (2) Stability enables capital investment in agriculture needed to lift agricultural productivity

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(3) Farming has positive externalities it helps to sustain rural communities (4) Stable prices prevent excess prices for consumers – helping consumer welfare

The problems with buffer stock schemes In theory buffer stock schemes should be profit making, since they buy up stocks of the product when the price is low and sell them onto the market when the price is high. However, they do not often work well in practice. Clearly, perishable items cannot be stored for long periods of time and can therefore be immediately ruled out of buffer stock schemes. Other problems are:

(1) Cost of buying excess supply can cause a buffer stock scheme to run out of cash (2) A guaranteed minimum price might cause over-production and rising surpluses which has

economic and environmental costs (3) Setting up a buffer stock scheme also requires a significant amount of start up capital, since

money is needed to buy up the product when prices are low. There are also high administrative and storage costs to be considered.

• The success of a buffer stock scheme however ultimately depends on the ability of those

managing a scheme to correctly estimate the average price of the product over a period of time. This estimate is the scheme’s target price and obviously determines the maximum and minimum price boundaries.

• But if the target price is significantly above the correct average price then the organization

will find itself buying more produce than it is selling and it will eventually run out of money. The price of the product will then crash as the excess stocks built up by the organization are dumped onto the market.

• Conversely if the target price is too low then the organization will often find the price rising

above the boundary, it will end up selling more than it is buying and will eventually run out of stocks

Price

Quantity

Demand

Supply

P min

Q1

Pe

Price Floor (Guaranteed)

Q4 Q3

S2

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Government Failure

A failure of the free market and the price mechanism to deliver an allocatively efficient allocation of scarce resources is normally regarded as justification for government intervention. This intervention is designed to correct for instances of market failure and achieve an improvement in economic and social welfare. But what if intervention leads to further inefficiencies? What if government policies prove to be costly to implement but ineffective in achieving their desired outcomes? What happens if intervention distorts markets still further leading to a further loss of allocative efficiency? What is Government Failure? Even with good intentions governments seldom get their policy application correct. They can tax, control and regulate but the outcome may be a deepening of the market failure or even worse a new failure may arise. Government failure may range from the trivial, when intervention is merely ineffective, but where harm is restricted to the cost of resources used up and wasted by the intervention, to cases where intervention produces new and more serious problems that did not exist before. The consequences of this can take many years to reverse. Government failure in a non-market economy The collapse of the Soviet Union in the late 1980s marked the failure of command or state-run economies as a means of allocating resources among competing uses. The essence of a command economy was that the state planning mechanism would decide what to produce and how to produce it and for whom to produce. Government failure occurred when the central planners produced products that were not wanted by consumers – a loss of allocative efficiency, since there was no price mechanism to signal changes in consumer preferences and demand. Another fundamental failing of the pure command economy was that there was little incentive for workers to raise productivity; poor quality control; and little innovation by firms as no profit motive existed. Command economies also suffered massive environmental de-gradation because they did not posses structures for valuing the environment and giving consumers and producers the right incentives to protect their environmental heritage.

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All of these economies are now moving towards the western mixed economy, though at varying speeds and with varying success. Ten countries became new members of the European Union in May 2004, some of them former state-run economies in the Eastern Block. Countries such as Hungary, the Czech Republic and Poland are all moving towards a market based system for the allocation of resources through privatisation and market liberalisation. Causes of Government Failure Government intervention can prove to be ineffective, inequitable and misplaced. (a) Political self-interest The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation of resources. For example decisions about where to build new roads, by-passes, schools and hospitals may be decided with at least one eye to the political consequences. The pressures of a looming election or the influence exerted by special interest groups can foster an environment in which inappropriate spending and tax decisions are made. - e.g. boosting welfare spending in the run up to an election, or bringing forward major items of capital spending on infrastructural projects without the projects being subjected to a full and proper cost-benefit analysis to determine the likely social costs and benefits. Critics of current government policy towards tobacco taxation and advertising, and the controversial issue of genetically modified foods argue that government departments are too sensitive to political lobbying from the major corporations. (b) Policy myopia Critics of government intervention in the economy argue that politicians have a tendency to look for short term solutions or “quick fixes” to difficult economic problems rather than making considered analysis of long term considerations. For example, a decision to build more roads and by-passes might simply add to the problems of traffic congestion in the long run encouraging an increase in the total number of cars on the roads. The Commission for Integrated Transport has criticised the Government for a failure to develop a properly integrated transport policy. They clearly believe that government failure is endemic in our transport industry – although we should remember that their view is normative, based on value judgements! Secondly criticisms of the huge increases in state spending on the National Health Service. Government critics argue that much of the extra spending is being “lost” in higher pay and administration rather than finding its way into improving front-line health services. The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural economic problems. Critics of government subsidies to particular industries also claim that they distort the proper functioning of markets and lead to inefficiencies in the economy. For example short term financial support to coal producers to keep open loss-making coal pits might prove to be a waste of scarce resources if the industry concerned has little realistic prospect of achieving a viable rate of return in the long run given the strength of global competition. (c) Regulatory capture. This is when the industries under the control of a regulatory body (i.e. a government agency) appear to operate in favour of the vested interest of producers rather can consumers. Some economists argue that regulators can prevent the ability of the market to operate freely. We might

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find examples of this in agriculture, telecommunications, the main household utilities and in transport regulation. For example, to what extent has the system of agricultural support known as the Common Agricultural Policy operated too much in the interests of farmers and the farming industry in general? And as a result, has the CAP worked against the long-term interest of consumers, the environment and developing countries who claim that they are being unfairly treated in world markets by the effects of import tariffs on food and export subsidies to loss-making European farmers? (d) Government intervention and disincentive effects Free market economists who fear government failure at every turn argue that attempts to reduce income and wealth inequalities can worsen incentives and productivity. They would argue against the National Minimum Wage because they believe that it artificially raises wages above their true free-market level and can lead to real-wage unemployment. They would argue against raising the higher rates of income tax because it is deemed to have a negative effect on the incentives of wealth-creators in the economy and generally acts as a disincentive to work longer hours or take a better paid job. (e) Government intervention and evasion A decision by the government to raise taxes on de-merit goods such as cigarettes might lead to an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey markets where trade takes place between consumers and suppliers without paying tax. Equally a decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of drugs and a substantial loss of social welfare arising from over consumption. (f) Policy decisions based on imperfect information How does the government establish what citizens want it to do in their name? Can the government ever really know the true revealed preferences of so many people? Our current electoral system is not an ideal way to discover this! Turnout in every type of election, (local, national, European etc) is falling, there is general disinterest in the political process. Furthermore, people rarely vote purely out of their own self-interest or on the basis of a well informed and rational assessment of the costs and benefits of different government policies. Proponents of government failure argue that the free market is the best way of finding out

(a) What consumer preferences are and

(b) Aggregating these preferences based on the number of people that are willing and able to pay for particular goods and services.

Often a government will choose to go ahead with a project or policy without having the full amount of information required for a proper cost-benefit analysis. The result can be misguided policies and damaging long-term consequences. How does the government know how many extra houses need to be built in the UK over the next twenty years? Is building thousands of extra homes in an already congested South-east the right option? Are there better solutions? There have been plenty of instances of government housing policy having failed in previous decades! (g) The Law of Unintended Consequences The law of unintended consequences is that actions of consumer and producers — and especially of government—always have effects that are unanticipated or "unintended."

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Particularly when people do not always act in the way that the economics textbooks would predict – this is of course the essence of a social, behaviour science – we do not live our lives in sanitised laboratories where all of the conditions can be controlled. The law of unintended consequences is often used to criticise the effects of government legislation, taxation and regulation. People find ways to circumvent laws; shadow markets develop to undermine an official policy; people act in unexpected ways because or ignorance and / or error. Unintended consequences can add hugely to the financial costs of some government programmes so that they make them extremely expensive when set against their original goals and objectives. (h) Costs of administration and enforcement Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular policy might be largely swamped by the administrative costs of introducing it. Key points about government failure

1. Free market economists are distrustful of intervention. They believe that the price mechanism should be given freedom to operate

2. Often we can accuse the government of policy failure only with the benefit of hindsight 3. Limited information - no government has the resources and information available to it to

make fully-informed, objective judgements. That is the nature of politics.

4. Government failure is most likely to occur when decisions are made in the vested interest of special interest groups, at the expense of other groups (the result is a loss of equity)

Using the cost-benefit principle in AS micro economics The cost-benefit principle is one of those core ideas that can be brought into so many discussions both in micro and macroeconomics – you should be using it in your papers tomorrow. The cost-benefit principle says that you should take an action if, and only if, the extra benefit from taking it is greater than the extra cost Here are some examples where the principle might be built into your analysis and evaluation

1. Costs and benefits of subsidies e.g. the bio-fuel debate or subsidies for industries affected by globalisation

2. Costs and benefits of indirect taxes e.g. environmental taxes or taxes designed to curb demand for / consumption of de-merit goods

3. Costs and benefits of the introduction of competition into a market e.g. postal market liberalisation

4. Costs and benefits of an increase in government spending on public goods and merit goods such as flood defence schemes, free entry to museums and galleries

5. Costs and benefits of different strategies designed to reduce income and wealth inequality e.g. the national minimum wage or a rise in the top rate of income tax

6. Costs and benefits of the introduction of carbon trading as a way of reducing CO2 emissions

7. Costs and benefits of different policies designed to reduce unemployment e.g. comparing the effectiveness of investment in training with an employment subsidy for the long term unemployed

8. Costs and benefits of major infrastructural projects such as new motorways, London 2012

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9. Costs and benefits of a decision to relax planning controls on new house-building

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Case Study: Are biofuels an example of government failure?

Market failure arises when the market mechanism fails to produce an efficient allocation of resources. Government failure occurs when in an attempt to correct market failure the government’s policies produce a net welfare loss. Put simply government intervention makes things worse rather than better. However, what may look like government failure may rather be an example of government policy which results in an outcome that is better than if there had been no intervention at all.

In recent years there have been examples of this allegedly occurring, the European Union’s (EU) common fisheries policy to preserve fish stocks is one. Fish stocks have continued to decline but would things have been even worse in the absence of any policy at all?

However, the UK government’s policy towards energy produced from biofuels could be an example of government failure. Most advanced economies are keen to be seen to be doing something to reduce CO2 emissions and many have emissions targets.

The EU has a 20-20-20 target: a 20% cut in emissions of greenhouse gases by 2020, compared with 1990 levels; a 20% increase in the share of renewables in the energy mix; and a 20% cut in energy consumption. Responding to an EU directive the UK has introduced the Renewable Transport Fuels Obligation (RTFO) which requires suppliers of fossil fuels to ensure that a specified percentage of the road fuels they supply in the UK are made up of renewable fuels. The target for 2009/10 was 3.25% by volume.

The Renewable Fuels Agency has calculated that biodiesel, derived from Malaysian palm oil and when used in a power station, generates 48 grams per mega joule of energy delivered. For gas, the CO2 emissions are 68 grams, and for coal, it is 112 grams. As a result UK power stations burning a vegetable oil such as palm oil receive government subsidies worth up to £100 per megawatt hour to encourage the use of this form of renewable energy.

However, to produce palm oil, tropical rainforests in countries such as Malaysia and Indonesia have been cleared at an alarming rate. Palm oil is grown on areas of cleared rainforest which means that huge volumes of carbon dioxide, methane and other greenhouse gasses from disturbed soil are released. The environmental pressure group Greenpeace estimates that rainforest clearance in Indonesia alone releases the equivalent of 1.8 billion tonnes of carbon dioxide into the atmosphere-about 4% of global emissions.

When the extra emissions resulting from the destruction of the rainforest and the transportation by ship of the palm oil are added the emissions produced from burning this type of biofuel, it comes to 202 grams of CO2 per mega joule of energy produced. Hence it could be argued that subsidising energy produced from palm oil drives deforestation and results, if the C02 calculations are correct, in government failure.

The government failure arises from total CO2 emissions for subsidised biofuel being higher than for burning unsubsidised coal and gas. This government failure could only be avoided if biofuel energy comes from biofuels that are sustainably sourced.

Source: EconoMax, Bob Nutter, Spring 2010

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Glossary Ability to pay The idea that taxes should be levied on a person according to how well that person

can shoulder the burden. The ability to pay principle is often used as the justification for a fair tax.

Abnormal profit Abnormal profits are when profits exceed the amount a firm must receive to carry on production. Also known as supernormal profit.

Absolute poverty Absolute poverty measures the number of people living below a certain income threshold or the number of households unable to afford certain basic goods and services. The United Nations definition is a severe and persistent deprivation of basic human needs

Acquisition One business buys ownership and control of another firm, a takeover

Ad valorem tax An indirect tax based on a percentage of the sales price of a good or service. The best known example in the UK is Value Added Tax which is 20%. Other examples include Insurance Premium Tax and the ad valorem tax on cigarettes. Stamp duty on house purchases is also an ad valorem tax. An increase in an ad valorem tax causes an inward pivotal shift in the supply curve for those producers affected

Adam Smith One of the founding fathers of modern economics. His most famous work was the Wealth of Nations (1776) - a study of the progress of nations where people act according to their own self-interest - which improves the public good. Smith's discussion of the advantages of division of labour remains a potent idea in the economic literature.

Adverse selection Where the expected value of a transaction is known more accurately by the buyer or the seller due to an asymmetry of information; e.g. health insurance

Alienation A sociological term to describe the estrangement many workers feel from their work, which may reduce their motivation and productivity. It is sometimes argued that alienation is a result of the division of labour because workers are not involved with the satisfaction of producing a finished product, and do not feel part of a team. Alienation in the workplace may contribute towards diseconomies of scale

Allocative efficiency Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production. The technical condition required for allocative efficiency is that price = marginal cost. When this happens, total economic welfare is maximised.

Anti competitive behaviour

Anti-competitive practices are strategies operated by firms that are deliberately designed to limit the degree of competition inside a market. Such actions can be taken by one firm in isolation or a number of firms engaged in some form of explicit or implicit collusion. Where firms are found to be colluding it would be seen to be against the public interest.

Asking price The price at which a security, commodity or currency is offered for sale on the market - generally the lowest price the seller will accept.

Asymmetric information

Occurs when somebody knows more than somebody else in the market. Such asymmetric information can make it difficult for the two people to do business together. A situation in which some agents have more information than others and this affects the outcome of a bargain between them

Automation A production technique that uses capital machinery / technology to replace or enhance human labour

Average cost Average or unit cost (AC) is the total cost divided by the number of units of the commodity produced.

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Average cost pricing Where a business sets price by adding a profit mark-up to the average cost of production

Average fixed cost Fixed costs are costs of production which are constant whatever the level of output. Average fixed costs are total fixed costs divided by the number of units of output, that is, fixed cost per unit of output

Bargainous Costing less than is usual or than might be expected; cheap or relatively cheap

Barriers to entry Barriers to entry are the factors which make it difficult or expensive for new firms to enter a market or an industry in order to compete with existing suppliers. Examples of barriers to entry include the effect of patents; brand loyalty among consumers; the high costs of buying capital equipment and also the need to win licences to operate in certain markets.

Barter The practice of exchanging one good or service for another, without using money

Black market A black market (or shadow market) is an illegal market in which the market price is higher than a legally imposed price ceiling. Black markets can develop where there is excess demand (or a shortage) for a commodity. Some consumers are prepared to pay higher prices in black markets in order to get the goods or services they want.

Bottlenecks Any factor that causes production to be delayed or stopped – may reduce the price elasticity of supply of a product

Brand A distinctive product offering which is created by the use of a logo, symbol, name, design, packaging or combination thereof. The key in designing and building a brand is to differentiate it from competitors.

Buffer stock One way to smooth out the fluctuations in prices is for the government to operate price support schemes through the use of buffer stocks. Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low.

Bulk buying Bulk buying is the purchase by one organisation of large quantities of a product or raw material, which often results in a lower price because of their market power and because it is cheaper to deal with one customer and the deliveries can be on a larger scale.

Buyer’s market A market that favours buyers because supply is plentiful relative to demand and therefore prices are relatively low. The opposite of a seller's market.

By-product A by-product is a good or service that is produced as a consequence of producing another good or service.

Capacity building Efforts to develop human skills or infrastructures within a community or organisation

Capacity utilisation The extent to which a business is making full use of existing factor resources

Capital goods Producer or capital goods such as plant (factories) and machinery and equipment are useful not in themselves but for the goods and services they can help produce in the future. Distinguished from "financial capital", meaning funds which are available to finance the production or acquisition of real capital

Capital intensive A production technique which uses a high proportion of capital to labour

Capitalist economy An economic system organised along capitalist lines uses market-determined prices to guide our choices about the production and distribution of goods. One key role for the state is to maintain the rule of law and protect private property.

Carbon capture and storage

the process of trapping and storing carbon dioxide produced by burning fossil fuels

Carbon credits An allowance to a business to generate a specific level of emissions – may be traded in a carbon market

Cartel A cartel is a formal agreement among firms. Cartels usually occur in an oligopolistic

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industry. Cartel members may agree on such matters as price fixing, total industry output, market shares, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits or combination of these. Cartels are illegal under UK and European competition laws.

Ceteris paribus To simplify and enable analysis, economists isolate the relationship between two variables by assuming ceteris paribus - i.e. that all other influencing factors are held constant.

Collusion Collusion is any explicit or implicit agreement between suppliers in a market to avoid competition. The main aim of this is to reduce market uncertainty and achieve a level of joint profits similar to that which might be achieved by a pure monopolist.

Command and control The use of law and regulation backed up by inspection and penalties for non-compliance.

Common resources Goods or services that have characteristics of rivalry in consumption and non-excludability - grazing land or fish stocks are examples. The over-exploitation of common resources can lead to the "tragedy of the commons"

Competition policy Government policy directed at encouraging competition in the private sector: e.g. the investigation of takeovers or restrictive practices

Competitive market A competitive market is one where no single firm has a dominant position and where the consumer has plenty of choice when buying goods or services. There are few barriers to the entry of new firms which allows new businesses to enter the market if they believe they can make sufficient profits.

Competitive supply Goods in competitive supply are alternative products a firm could make with its resources. Egg a farmer can plant potatoes or carrots. An electronics factory can produce VCRs or DVDs.

Complementary goods

Two complements are said to be in joint demand. Examples include: fish and chips, DVD players and DVDs, iron ore and steel,

Composite demand Composite demand exists where goods or services have more than one use so that an increase in the demand for one product leads to a fall in supply of the other. The most commonly quoted example is that of milk which can be used for cheese, yoghurts, cream, butter and other products. If more milk is used for manufacturing cheese, ceteris paribus there is less available for butter.

Conspicuous consumption

Conspicuous consumption is consumption designed to impress others rather than something that is wanted for its own sake.

Consumer durable A good such as a washing machine or a digital camera that lasts a period of time, during which the consumer can continue gaining utility from it.

Consumer sovereignty

Consumer sovereignty exists when the economic system allows scarce resources to be allocated to producing goods and services that reflect the wishes of consumers. Sovereignty can be influenced and distorted by the effects of persuasive advertising

Consumer surplus Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods. Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually pay (the market price)

Consumption The act of using goods and services to satisfy wants. This will normally involve purchasing the goods and services

Contestable market A market that has no entry barriers - firms can enter or leave an industry without significant cost.

Costs Costs are those expenses faced by a business when producing a good or service for a market. Every business faces costs - these must be recouped if a business is to make a profit from its activities. In the short run a firm will have fixed and variable costs of production.

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Cross price elasticity of demand

Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the price of good Y (a related good). With cross price elasticity we make an important distinction between substitute products and complementary goods and services.

Cyclical demand

Demand that change in a regular way over time depending on the part of the trade cycle that a country is in or the time of year.

Deadweight loss The loss in producer and consumer surplus due to an inefficient level of production perhaps resulting from market failure or government failure

Demand Demand is defined as the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. Each of us has an individual demand for particular goods and services.

Demand curve A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. For normal goods, more of a product will be demanded as the price falls. This is because at lower prices, consumers can afford to purchase more with their income. A fall in prices causes an increase in a consumers' real income. Secondly, a fall in price makes one good relatively cheaper than a substitute encouraging consumers to switch their demand in favour of the lower priced product.

De-merit goods The consumption of de-merit goods can lead to negative externalities which causes a fall in social welfare. The government normally seeks to reduce consumption of de-merit goods. Consumers may be unaware of the negative externalities that these goods create - they have imperfect information.

Derived demand The demand for a product X might be strongly linked to the demand for a related product Y - giving rise to the idea of a derived demand. For example, the demand for coal is derived in part on the demand for fossil fuels to burn in the process of generating energy

Diminishing returns The Law of Diminishing Marginal Returns states that, as more of a variable factor (e.g. labour) is added to a fixed factor (e.g. capital) a firm will reach a point where it has a disproportionate quantity of labour to capital and so the marginal product of labour will fall, thus raising marginal costs

Discretionary spending

Non-essential spending or spending that is not automatic - for example a going out for an unplanned meal at a restaurant

Disposable income Personal income that remains after direct taxes and government charges has been paid.

Diversification The reduction of risk achieved by replacing a single risk with a larger number of smaller unrelated risks

Division of labour The specialization of labour in specific tasks and roles, intended to increase the productivity of labour.

Downsizing A reduction in an organisation’s workforce

Economic efficiency Economic efficiency is about making the best use of our scarce resources among competing ends so that economic and social welfare is maximised over time

Economic planning Government policies aimed at influencing trends in the economy.

Economy of scale Reductions in the long run average cost of production arising from an increase in the scale of production. Both producers and consumers stand to gain from economies of scale. Businesses can bring down their average costs by producing on a larger scale. This opens up the possibility of them making bigger profit margins and a competitive advantage in their chosen markets.

Economy of scope Economies of scope occur where it is cheaper to produce a range of products.

Effective demand Demand in economics must be effective. Only when a consumers' desire to buy a product is backed up by an ability to pay for it do we speak of demand. For

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example, many people would be willing to buy a luxury sports car, but their demand would not be effective if they did not have the financial means to do so. They must have sufficient purchasing power.

Elastic demand Demand for which price elasticity is greater than 1

Elastic supply Where the price elasticity of supply is greater than +1

Elasticity of supply

Price elasticity of supply measures the relationship between change in quantity supplied and a change in price.

Emission tax A charge made to firms that pollute the environment based on the quantity of pollution they emit

Entrepreneur An entrepreneur is an individual who seeks to supply products to a market for a rate of return (i.e. a profit). Entrepreneurs will usually invest their own financial capital in a business and take on the risks associated with a business investment.

Equilibrium Equilibrium means ‘at rest’ or ‘a state of balance’ - i.e. a situation where there is no tendency for change. The concept is used in both microeconomics (e.g. equilibrium prices in a market) and also in macroeconomics (e.g. the equilibrium level of national income)

Excess demand The difference between the quantity supplied and the higher quantity demanded when price is set below the equilibrium price. This will result in queuing and an upward pressure on price

Excess supply When supply is greater than demand and there are unsold goods in the market. Surpluses put downward pressure on the market price.

Excise duties Excise duties are indirect taxes levied on our spending on goods and services such as cigarettes, fuel and alcohol. There are also duties on air travel, car insurance.

Excludability The property of a good whereby a person can be prevented from using it

External cost External costs are those costs faced by a third party for which no appropriate compensation is forthcoming. Identifying and then estimating a monetary value for air and noise pollution is a difficult exercise - but one that is increasingly important for economists concerned with the impact of economic activity on our environment.

External growth When a company increases its sales and profits by buying other companies, rather than from its own operations.

Externalities Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid. Externalities occur in nearly every market and industry and can cause market failure if the price mechanism does not take into account the full social costs and benefits of production and consumption.

Factor incomes Factor incomes are the rewards to factors of production. Labour receives wages and salaries, land earns rent, capital earns interest and enterprise earns profit. These payments are the incentive that is used to persuade the owners of these factors of production to supply them to the market.

Financial economy of scale

Small firms often have to pay higher interest rates on loans since they are perceived by financial organizations to carry a higher level of risk. Firms therefore have to pay a risk premium on their loans. The smaller firm may find it more difficult to raise money through selling new shares than a larger firm.

Finite resources There are only a finite number of workers, machines, acres of land and reserves of oil and other natural resources on the earth. Because resources are finite, we cannot produce an infinite number of goods and services. By producing more for an ever-increasing population, we are in danger of destroying the natural resources of the planet. This will have serious consequences for the long-term sustainability of economies throughout the world and potentially enormous implications for our living standards and the quality of life.

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First mover advantage

This is a theory which says that the first company to introduce a new product to market, has the opportunity to extract the greatest long term benefit from the product introduction compared to that which following companies would be able to gain.

Fixed costs These costs relate to the fixed factors of production and do not vary directly with the level of output. Examples of fixed costs include: rent and business rates, the depreciation in the value of capital equipment (plant and machinery) due to age and marketing and advertising costs.

Flexible working A workforce that is multi-skilled and able to work variable hours in response to changing demand

Free market A system of buying and selling that is not under the control of the government, and where people can buy and sell freely, or an economy where free markets exist, and most companies and property are not owned by the state

Freemium a business model, especially on the Internet, whereby basic services are provided free of charge while more advanced features must be paid for

Game theory The study of the strategic choices between firms, applicable when the outcome for one firm depends on the behaviour of the others

Geographical immobility

People may also experience geographical immobility – meaning that there are barriers to them moving from one area to another to find work

Gini Coefficient The Gini coefficient measures the extent to which the distribution of income (or, in some cases, consumption expenditures) among individuals or households within an economy deviates from a perfectly equal distribution. The coefficient ranges from 0 -meaning perfect equality -to 1- complete inequality.

Globalisation Globalisation describes a process by which economies, societies, and cultures have been drawn together through a worldwide network of communication and trade. In economic terms, globalisation refers to the coming together of national economies into the international economy through trade, foreign direct investment, capital flows, and the spread of technology.

Government failure Policies that cause a deeper market failure. Government failure may range from the trivial, when intervention is merely ineffective, but where harm is restricted to the cost of resources used up and wasted by the intervention, to cases where intervention produces new and more serious problems that did not exist before. The consequences of this can take many years to reverse.

Health rationing Health rationing occurs when the demand for health care services outstrips the available resources leading to waiting lists and delays for health treatment. Rationing may take place in various ways - for example health service practitioners may ration the resources to patients on the basis of clinical need. In private sector markets, health care will be available on the basis of willingness and ability to pay.

Hedging Hedging is the process of protecting oneself against risk. For example, a company who owes money to an overseas company may want to hedge against the risk that the exchange rate moves against them. They could do this by taking out a future contract for the purchase of foreign exchange at a fixed future rate

Horizontal equity Horizontal equity requires equals to be treated equally e.g. people in the same income group should be taxed at the same percentage rate

Horizontal integration Where two firms join at the same stage of production in one industry. For example two car manufacturers may decide to merge, or a leading bank successfully takes-over another bank

Incentives Incentives matter enormously in any study of microeconomics, markets and market failure. For competitive markets to work efficiently economic agents (i.e. consumers and producers) must respond to price signals in the market.

Incidence of a tax The incidence of tax is a measure of how the final burden of a tax is shared out. If demand for a good is elastic and a tax is imposed then the tax may fall mainly on

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the producer as they will be unable to put prices up by much without losing a lot of demand.

Income Income represents a flow of earnings from using factors of production to generate an output of goods and services. For example wages and salaries are a factor reward to labour and interest is the flow of income for the ownership of capital.

Income elasticity of demand

Income elasticity of demand measures the relationship between a change in quantity demanded and a change in real income. The formula for income elasticity is: percentage change in quantity demanded divided by the percentage change in income.

Indirect tax An indirect tax is imposed on producers (suppliers) by the government. Examples include excise duties on cigarettes, alcohol and fuel and also value added tax. Taxes are levied by the government for a number of reasons - among them as part of a strategy to curb pollution and improve the environment. A tax increases the costs of a business causing an inward shift in the supply curve. The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit.

Inelastic demand When the price elasticity of demand is less than 1

Inelastic supply When the price elasticity of supply is less than +1

Inferior good For normal products, more is demanded as income rises, and less as income falls. Most products are like this but there are exceptions called inferior products. They are often cheaper poorer quality substitutes for some other good.

Informal economy Undeclared economic activity which forms the shadow economy

Information failure Information failure occurs when people have inaccurate, incomplete, uncertain or misunderstood data and so make potentially ‘wrong’ choices. Consumers can never be expected to have a full-informed view about the products they are faced with in each and every market. Searching for information is time consuming and carries an obvious opportunity cost. Likewise, producers do not have full information about the products and prices being charged by their competitors.

Innovation The commercial development of exploiting new or improved goods and services.

Inputs Labour, capital and other resources used in the production of goods and services

Intellectual property Intellectual property (IP) is the legal property rights over creations of the mind, both artistic and commercial, and the corresponding fields of law. Under intellectual property law, owners are granted certain exclusive rights to a variety of intangible assets, such as musical, literary, and artistic works; ideas, discoveries and inventions; and words, phrases, symbols, and designs. Common types of intellectual property include copyrights, trademarks, patents, and trade secrets.

Internalised Internalising is where any spill-over effects from economic activity are absorbed by the consumer or firm themselves. This may arise for example, where a pollution tax has been charged on the good that makes them pay the external costs themselves

Inventories A company's unsold products, finished and unfinished, and the raw materials used to make them

Invisible hand The 18th Century economist Adam Smith - one of the founding fathers of modern economics, described how the invisible or hidden hand of the market operated in a competitive market through the pursuit of self-interest to allocate resources in society's best interest. This remains the central view of all free-market economists, i.e. those who believe in the virtues of a free-market economy with minimal government intervention.

Joint supply Joint supply describes a situation where an increase or decrease in the supply of one good leads to an increase or decrease in supply of another by-product. For example an expansion in the volume of beef production will lead to a rising market supply of beef hides. A contraction in supply of lamb will reduce the supply of wool.

Just in time Production that produces goods to order. The business does not hold any significant level of stock, either of finished products or required supplies e.g. raw

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materials, components

Land Land is the natural resources available for production. Some nations are endowed with natural resources and specialise in the extraction and production of these resources – for example – the development of the North Sea Oil and Gas in Britain and Norway.

Latent demand Latent demand exists when there is willingness to purchase a good or service, but where the consumer lacks the purchasing power to be able to afford the product. Latent demand is affected by persuasive advertising - where the producer is seeking to influence consumer tastes and preferences.

Law of demand

The law of demand is that there is an inverse relationship between the price of a good and demand. As prices fall we see an expansion of demand. If price rises there should be a contraction of demand.

Local monopoly A monopoly limited to a specific geographical area

Long run A period of time in which all inputs may be varied but the basic technology of production is unchanged.

Loss leader An item sold at a give-away price in order to attract customers into a store

Lump sum tax A tax that is the same amount across all income levels.

Manufacturing Manufacturing is the use of machines, tools and labour to make things for use or sale. The term may refer to a range of human activity, from handicraft to high tech, but is most commonly applied to industrial production, in which raw materials are transformed into finished goods on a large scale

Marginal cost Marginal cost is defined as the change in total costs resulting from increasing output by one unit. Marginal costs relate to variable costs only. Changes in fixed costs in the short run affect total costs, but not marginal costs.

Marginal revenue The increase in revenue resulting from an additional unit of output.

Market conditions These are characteristics of an industry sector, e.g. retail, which can affect buyers and sellers in that sector. Factors to consider include, for example, the number of competitors in the sector, if there is a surplus then new companies may find it difficult to enter the market and remain in business

Market equilibrium Equilibrium means a state of equality between demand and supply. Without a shift in demand and/or supply there will be no change in market price. Prices where demand and supply are out of balance are termed points of disequilibrium. Changes in the conditions of demand or supply will shift the demand or supply curves. This will cause changes in the equilibrium price and quantity in the market.

Market failure Market failure exists when the competitive outcome of markets is not efficient from the point of view of the economy as a whole. This is usually because the benefits that the market confers on individuals or firms carrying out a particular activity diverge from the benefits to society as a whole.

Market incentives Market signals that motivate economic actors to change their behaviour (perhaps in the direction of greater economic efficiency)

Market power Market power refers to the ability of a firm to influence or control the terms and condition on which goods are bought and sold. Monopolies can influence price by varying their output because consumers have limited choice of rival products.

Market shortage Where demand exceeds supply at a given price

Market supply Market supply is the total amount of an item producers are willing and able to sell at different prices, over a given period of time egg one month. Industry, a market supply curve is the horizontal summation of all each individual firm’s supply curves.

Maximum price The Government can set a legally imposed maximum price in a market that suppliers cannot exceed - in an attempt to prevent the market price from rising above a certain level. To be effective a maximum price has to be set below the free

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market price. One example of a maximum price might be for foodstuffs when a shortage of essential foodstuffs threatens a very large rise in the free market price.

Means tested benefits Welfare payments which are only paid to households who can prove they are poor

Merit good A merit good is a product that society values and judges that everyone should have regardless of whether an individual wants them. In this sense, the government (or state) is acting paternally in providing merit goods and services. They believe that individuals may not act in their own best interests in part because of imperfect information about the benefits that can be derived.

Minimum efficient scale

The plant size that minimises a firm's average costs of production in the long run

Minimum price

A minimum price is a legally imposed price floor below which the normal market price cannot fall. To be effective the minimum price has to be set above the normal equilibrium price. A good example of this is minimum wage legislation currently in force in the UK.

Mixed economy An economy which has characteristics of a market economy but where the state still has control over certain sectors

Monopolistic competition

Competition between companies whose products are similar but sufficiently differentiated to allow each to benefit from monopoly pricing.

Monopoly A pure monopolist is a single seller of a product in a given market or industry. In simple terms this means the firm has a market share of 100%. The working definition of a monopolistic market relates to any firm with greater than 25% of the industries' total sales

Monopsony A situation in a market where the buyer has power or leverage against the seller. Typically this happens when the buyer is purchasing a large volume of a product relative to total sales. They may be able to use their buying power to drive down the price paid or to negotiate other favourable conditions with the producer.

Moral hazard When people take actions that increase social costs because they are insured against private loss: sometimes it is called hidden action due to the agent’s actions being hidden from the principal.

Natural monopoly A market situation in which economies of scale are such that a single firm of efficient size is able to supply the entire market demand

Needs Humans have many different types of wants and needs e.g: economic, social and psychological. In economics the focus is on studying how material wants and needs are satisfied: A need is something essential for survival egg food satisfies hungry people. A want is something desirable but not essential to survival egg cola quenches thirst. Household (consumer) wants and needs are satisfied (met) by consuming (using) products i.e. goods or services.

Negative externality Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid.

Niche market A specialist section of a larger market e.g. hand-made chocolates

Non price competition Competing not on the basis of price but by other means, such as the quality of the product, packaging, customer service, etc.

Non-renewable resources

Non-renewable resources are resources which are finite and cannot be replaced. Minerals, fossil fuels and so on are all non-renewable resources

Non-rival consumption

Non-rivalry means that the consumption of a good by one person does not reduce the amount available for others. An example could be air. Non-rivalry is one of the key characteristics of a public good

Normal goods Normal goods have a positive income elasticity of demand so as consumers' income rises, so more is demanded at each price level. Normal necessities have an

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income elasticity of demand of between 0 and +1. Normal luxuries have an income elasticity of demand > +1 i.e. the demand rises more than proportionate to a change in income.

Normative statements Normative statements express an opinion about what ought to be. They are subjective statements rather than objective statements - i.e. they carry value judgments. For example, the level of duty on petrol is too unfair and unfairly penalizes motorist

Objectives A specific target an organisation sets itself to achieve through its activity

Oligopoly An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is high with typically the leading five firms taking over sixty per cent of total market sales.

Opportunity cost Opportunity cost measures the cost of any choice in terms of the next best alternative foregone.

Ostentatious consumption

Some goods are luxurious items where satisfaction comes from knowing both the price of the good and being able to flaunt consumption of it to other people!

Out-sourcing Outsourcing is subcontracting a process, such as product design or manufacturing, to a third-party company

Overhead Business costs–such as rent and utilities–that don't directly relate to the production or sale of goods and services. Overhead is sometimes called indirect cost or indirect expense

Pareto efficiency In neoclassical economics, an action done in an economy that harms no one and helps at least one person. The theory suggests that Pareto improvements will keep adding to the economy until it achieves a Pareto equilibrium, where no more Pareto improvements can be made

Paywall Arrangement whereby access is restricted to users who have paid to subscribe to a website

Peak pricing When a business raises prices at a time when demand is strongest

Penetration pricing Where a firm choose to set a low price to gain market share / brand recognition

Persuasive advertising

Designed to manipulate consumer preferences and therefore cause a change in demand

Perverse demand curve

A perverse demand curve is one which slopes upwards from left to right. Therefore an increase in price leads to an increase in demand. This may happen where goods are strongly affected by price expectations or in the case of Giffen goods

Pigouvian tax A tax placed on a good with negative externalities so that the external cost is internalised: the polluter pays principle. The tax is set equal to the marginal negative externality

Planned economy In a planned economy, decisions about what to produce, how much to produce and for whom are decided by central planners working for the government rather than allocated using the price mechanism.

Polluter pays principle The government may choose to intervene in a market to ensure that the firms and consumers who create negative externalities include them when making their decisions egg first parties are forced to internalise external costs & benefits through indirect taxes.

Positional goods Goods which are at least in part demanded because their possession or consumption implies social or other status of those acquiring them

Positive externalities Positive externalities exist when third parties benefit from the spill-over effects of production/consumption e.g. the social returns from investment in education & training or the positive benefits from health care and medical research.

Positive statement Positive statements are objective statements that can be tested or rejected by referring to the available evidence. Positive economics deals with objective explanation. For example: “A rise in consumer incomes will lead to a rise in the

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demand for new cars.” Or “A fall in the exchange rate will lead to an increase in exports overseas.”

Poverty trap The poverty trap affects people on low incomes. It creates a disincentive to look for work or work longer hours because of the effects of the tax and benefits system.

Price elasticity of demand

Price elasticity of demand measures the responsiveness of demand for a product following a change in its own price.

Price elasticity of supply

Price elasticity of supply measures the relationship between change in quantity supplied and a change in price.

Price mechanism The price mechanism is the means by which decisions of consumers and businesses interact to determine the allocation of resources between different goods and services.

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Price signals Price signals are a vital part of a market system. Changes in price act as a signal

about the way resources should be allocated. For example a rise in price encourages producers to switch into making that good but encourages consumers to use an alternative substitute product (therefore rationing the product).

Private benefit The rewards to individuals, firms or consumers from consuming or producing goods and services. Also known as internal benefits

Private cost The costs of an economic activity to individuals and firms. Also known as internal costs.

Privatisation Selling off a state run industry to the private sector

Producer surplus Producer surplus is a measure of producer welfare. It is measured as the difference between what producers are willing and able to supply a good for and the price they actually receive. The level of producer surplus is shown by the area above the supply curve and below the market price.

Production possibility frontier

A production possibility frontier (PPF) or boundary shows the combinations of two or more goods and services that can be produced using all available factor resources efficiently

Productive efficiency The output of productive efficiency occurs when a business in a given market or industry reaches the lowest point of its average cost curve. Output is being produced at minimum cost per unit implying an efficient use of scarce resources and a high level of factor productivity.

Productivity A measure of efficiency, expressed as output per unit of input, for example output per person employed

Profit Profits are made when total revenue exceeds total cost. Total profit = total revenue - total cost. Profit per unit supplied = price = average total cost. The standard assumption is that private sector businesses seek to make the highest profit possible from operating in a market

Property rights Property rights confer legal control or ownership of a good. For markets to operate efficiently, property rights must be clearly defined and protected - perhaps through government legislation and regulation. If an asset is un-owned no one has an economic incentive to protect it from abuse. This can lead to what is known as the “Tragedy of the Commons” i.e. the over use of common land, fish stocks etc which leads to long term permanent damage to the stock of natural resources.

Public bads Public bads would include environmental damage and global warming which affects everyone – no one is excluded from the dis-benefits of others polluting economic activity.

Public goods Pure public goods have two main characteristics

1. Non-rival – consumption of the good by one person does not reduce the amount available for consumption by another person. E.g. terrestrial television services provided by the BBC

2. Non-excludable – Where it is not possible to provide a good or service to one person without it thereby being available for others to enjoy – if you cannot exclude the non-payers, profit-motivated businesses may decide not to supply these products e.g. defence systems, lighthouse protection

Pure public goods are not provided at all by the private sector - hence – market failure due to ‘missing markets’. This is partly due to the ‘free rider’ principle. The usual solution is for the government to supply public goods either directly or indirectly

Public sector Government organisations that provide goods and services in the economy - for example through state education and the national health service.

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Purchasing power A measure of money's value in terms of what it can buy. Purchasing power tends to change over time, mainly because of inflation.

Quota A quota is a limit on the quantity or volume of a product can be supplied to a market. Typically a quota is applied as a form of government intervention in markets for example when a government wishes to limit the number of imports coming into a country. Or perhaps as part of a strategy designed to limit the over-exploitation of a natural resource. A good example of this is the quota given to fishing business in the North Sea.

Real income effect The amount by which the quantity demanded falls as a result of the decline in real income from a price increase

Redistribution Measures taken by government to transfer income from some individuals to others

Relative poverty Relative poverty measures the extent to which a household's financial resources falls below an average income threshold for the economy

Scale The production level achieved by a business. Changes in scale take place in the long run

Scarcity Scarce means limited. Our resources of land labour capital and enterprise are finite. There is only a limited amount of resources available to produce the unlimited amount of goods and services we desire.

Screening An action taken by an uninformed party to induce an informed party to reveal information

Self sufficiency Where people try to meet their own wants and needs without producing a surplus to trade

Seller’s market A market where demand exceeds supply, allowing the sellers of a product to have greater control over prices, terms, etc. The opposite of a buyer's market.

Shortage A situation in which quantity demanded is greater than quantity supplied

Signalling Prices have a signalling function because the price in a market sends important information to producers and consumers

Social benefit The benefit of production or consumption of a product for society as a whole. Social benefit = private benefit + external benefit

Social cost The cost of production or consumption of a product for society as a whole. Social cost = private cost + external cost

Social efficiency The socially efficient output is the level of output where the marginal cost of an extra unit of production is equal to the value placed by society on its consumption (the average revenue). This occurs when resources are utilised in the most efficient way. This will happen at an output where Social Cost (SMC) = Social Benefit. (SMB)

Social media Websites and applications used for social networking

Spare capacity Spare capacity is a situation where a firm or economy can produce more with existing resources. When there is plenty of spare capacity, elasticity of supply tends to be high

Specialisaton A method of production where a business or area focuses on the production of a limited scope of products or services in order to gain greater degrees of productive efficiency within the entire system of businesses or areas. Many countries specialize in producing the goods and services that are native to their part of the world. This specialization is the basis of global trade as few countries produce enough goods to be completely self-sufficient

Specific tax A lump sum tax on the amount sold per unit. An example is the duty on beer

Speculation Speculation is the activity of buying a good or service in anticipation of a change. For example, foreign exchange dealers may buy a currency because they believe that the value of the currency will change to their advantage, so that they can sell it once again for a profit.

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Spill-over effects External effects of economic activity, which have an impact on outsiders who are not producing or consuming a product

Stakeholders

Stakeholders are groups who have an interest in the activity of a business e.g. shareholders, managers, employees, suppliers, customers, government and local communities. Different stakeholders have different objectives e.g. owners want maximum profits, customers low prices and workers high wages and rising living standards.

State monopoly A monopoly that is owned and managed by a government.

Subsidiary A company that is owned and controlled by another company, called the parent company.

Subsidy Subsidies represent payments by the government to suppliers that have the effect of reducing their costs and encouraging them to increase output. The effect of a subsidy is to increase supply and therefore reduce the market equilibrium price.

Substitutes Substitutes are goods in competitive demand and act as replacements for another product

Substitutes in production

A substitute in production is a product that could have been produced using the same resources. Take the example of barley. An increase in the price of wheat makes wheat growing more attractive. The pursuit of the profit motive may cause farmers to use land to grow wheat rather than barley.

Supply Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period. The basic law of supply is that as the market price of a commodity rises, so producers expand their supply onto the market.

Supply chain The supply chain of production is the different stages of making, distributing and selling a good or service from the production of parts, through to the final product through to distribution and sale of the product.

Supply shock An event that directly alters firms' costs and prices shifting the supply curve either to the right (lower costs) or to the left (higher costs). Examples include unexpected changes in the global prices of commodities such as oil, gas and hard metals.

Tastes The preferences of consumers

Tax incidence The manner in which the burden of an indirect tax is shared between participants in the market i.e. consumers and producers

Technical efficiency Technical efficiency = production of goods and services using the minimum amount of resources or number of factor inputs (land, labour and capital).

Time lags Time lags often occur in the production process, particularly in agriculture, when decisions about the quantity to be produced are made well ahead of the actual sale. Demand and the price may change in the interval, creating a problem for the producer.

Transactions cost The costs that parties incur in the process of agreeing and following through on a deal

Transfer payments Government welfare benefits made available through the social security system

Value judgement A view of the rightness or wrongness of something, based on a personal view.

Variable cost Variable costs vary directly with output. I.e. as production rises, a firm will face higher total variable costs because it needs to purchase extra resources to achieve an expansion of supply. Common examples of variable costs for a business include the costs of raw materials, labour costs and consumables.

Willingness to pay The maximum price a consumer is prepared pay to obtain a product

Working capital Resources used up in production such as raw materials and components

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