ECONOMICS HL EOT 1 - EXAM MATERIAL

UNIT 3 - Elasticities

3.1 Price elasticity of demand (PED)

- A measure of the responsiveness of quantity of a good demanded to a change in its
price.

- If quantity demanded is highly responsive to change in price - demand is price elastic

- If quantity demanded is not very responsive to change in price - demand is price

inelastic.

- PED = percentage change in quantity demanded/ percentage change in price

- Final quantity - initial quantity/ initial quantity / nal price - initial price/initial price

- Sign of PED: price and quantity demanded are negatively related hence, any
percentage increase in price gives leads to a percentage decrease in quantity
demanded.

- PED and the demand curve: On the assumption that two demand curves are drawn on
the same diagram, the one that is steeper is said to be relatively price-inelastic and the
atter one is said to be elastic.

Interpreting calculation of PED (always ignore the minus sign)

• If PED < 1, demand is price inelastic
• If PED > 1, demand is price elastic
• If PED = 0, demand is perfectly price inelastic (change in price
has no impact on quantity demanded, suggests that there are
absolutely no substitutes)
• If PED = ♾, demand is perfectly price elastic (change in price
leads to zero quantity demanded, ample substitutes, demand is
only there at one price)
• If PED = 1, demand has unitary price elasticity (demand is
proportional to change in the price; change in quantity = change in
price)

Variation of PED along the demand curve

On a straight line demand curve, PED decreases as you move downwards:

- Demand is price elastic at high prices and low quantities. At high prices and low
quantities, percentage change in Q is relatively large while percentage change in
P is relatively small.

- Demand is price inelastic at low prices and large quantities

- At the midpoint of the demand curve, there is unit elastic demand.

- PED at any point = 1/slope x P/Q

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 Determinants of price elasticity of demand
• Substitutes: in general, the greater number and availability of close substitutes there are
for a good or service, the higher the value of its PED will tend to be. By contrast, goods
and services with less substitutes are relatively price inelastic.The closer two
substitutes are, the greater the responsiveness because it is easer to switch from one
product to another.

• The breadth of de nition of the product: if a good or service is broadly de ned such as
food, demand tends to be price inelastic. However, speci c changes in prices of
speci c foods can lead to a price elastic demand such as an increase in price of Pepsi.

• Necessity vs luxury: products that are regarded as essential tend to be relatively price
inelastic, such as food, water and medicine. By contrast, luxury products are not
essential hence, they are generally price elastic. The degree of necessity also depends
on the timeframe in question, for example, during covid, the demand for masks is very
high, thus, making it relatively price inelastic.

• Habits, addictions, fashions and tastes: if a product is habit forming (such as tobacco)
or highly fashionable, its PED tends to be relatively price inelastic.

• Length of time: longer the time period given to a consumer to make a decision, the
more elastic the demand as consumers have the opportunity to consider their choices
and decide if they really want the good or not. People who own motor vehicles are
unlikely to get rid of them with an increase in prices of fuel. However, if there is a
continual hike in prices, people may seek alternatives.

• Income: the larger the proportion of income that the price of a product represents, the
greater the value of its PED tends to be. For example, a 25% increase in price of rice
will have a demand that’s relatively price inelastic in comparison to a 25% increase in
price of plane tickets.

Applications of PED

1. PED and total revenue:

- Demand is elastic (PED > 1): An increase in price causes a fall in total revenue, while a
decrease in price causes a rise in total revenue. This is so because, an increase in
price results in a proportionately larger decrease in quantity demanded. As seen in
the graph, an increase in price from p1 to p2 leads to the loss of B and the gain of C
where B is greater than C hence, total revenue falls.

- Demand is inelastic (PED < 1): An increase in price causes an increase in total revenue,
while a decrease causes a fall in total revenue. This is because an increase in price
causes a proportionately smaller decrease in quantity demanded. As seen in the
graph, an increase in price leads to the loss of B and the gain of C where C is greater
than B hence, total revenue rises.

- Demand is unit elastic (PED=1): a change in price does not cause any change in total
revenue.

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2. PED and rm pricing decisions
Depends on the nature of PED of the product, inelastic allows for higher prices and
vice versa.

3. PED and indirect taxes

- The lower the PED for the taxed good, the greater the government tax revenues.
When a tax is imposed, it has the e ect of shifting the supply curve upward.
This is because for every level of output the rm is willing and able to supply, it
must receive a price that is higher than the original price by the amount of tax.
Indirect taxes are therefore, usually imposed on goods like cigarettes and petrol 

(Low PED).

PED and primary commodities vs manufactured products

- Primary commodities: goods arising directly from the use of natural resources,
or the factor of production ‘land’. Agricultural, shing and forestry products as
well oil, coal, minerals etc.

- Many primary commodities have a low PED, usually lower than manufactured
goods.

- Manufactured products: goods produced by labour working with capital as well

as raw materials.

- Many primary commodities have relatively low PED because they are
necessities and have no substitutes (food, oil etc.) The PED of manufactured
products is relatively high because they may not be necessities and also usually
have substitutes.

3.2 Income elasticity of demand (YED)

- A measure of the responsiveness of demand to changes in income.

- YED = percentage change in quantity demanded/ percentage change in income

- Final quantity - initial quantity/ initial quantity / nal income - initial income/initial
income

Sign of income elasticity of demand: normal or inferior goods

- YED > 0, indicates that the good is normal, demand increases with an increase in
income. Most goods are normal goods.

- YED < 0, indicates that the good is inferior, as income increases, demand for these
goods fall such as switching from bus rides to buying a car (normal good).

Numerical value of YED: necessities, luxuries and services

- YED < 1: Necessities, hence, income inelastic demand. Percentage increase in income
produces smaller percentage increase in quantity demanded.

- YED > 1: luxuries and services, hence, income elastic demand. Percentage increase in
income produces larger percentage increase in quantity demanded.

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The Engel curve
- With income on the vertical axis and quantity on the horizontal
axis, YED > 0 is the upward sloping part of the curve showing an
increase in quantity with an increase in income (indicates normal
good), and YED < 0 which is the downward sloping part, shows a
decrease in quantity with an increase in income (indicates inferior
good).

- Using the curve to distinguish between a luxury and necessity by

imagining each segment of the curve and extending backward to
touch either the horizontal or vertical axis:

• YED > 1 if the line touches the vertical axis which indicates a luxury or service.

• YED < 1, if the line touches the horizontal axis which indicates a necessity.

- The Engel curve shows that at very low incomes, a good may be a luxury; as income
increases it becomes a necessity and nally at high income levels It becomes inferior.

Applications of YED
- YED and producers: the rate of expansion of industries

• During a period of economic growth: The higher the YED for a good or service, the
greater the expansion of its market is likely to be in the future. The lower the YED, the
smaller the expansion.

• During a recession: goods and services with high YEDs are hardest hit, experiencing
decline in sales. Products with low YEDs can avoid large falls in sales, while inferior
goods (YED < 0)can even experience increases in sales.

- YED and the sectoral structure of the economy

• Primary sector (agriculture, forestry, shing and extractive industries) goods have a YED
that is income inelastic.

• Secondary/ manufacturing sector have a YED that is usually greater than one. Tertiary/
services sector also usually have higher YEDs, so with increase in income, the
percentage increase in the demand for these is much higher.

• Therefore, over time, the share of agricultural output as a portion of total output in the
economy shrinks, while the share of manufactured output grows.

• As an economy grows, the relative importance of the primary sector continues to

shrink.

3.3 Price elasticity of supply (PES)

- A measure of the responsiveness of the quantity of a good supplied to a change in its
price. If there is a relatively large responsiveness of quantity supplied, supply is referred
to as being elastic and vice versa.

- PES = percentage change in quantity of a good supplied/ percentage change in price

- Final quantity - initial quantity/ initial quantity / nal price - initial price/initial price

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 Range of values for PES
- If PES < 1, supply is price inelastic; quantity supplied
is relatively unresponsive to price

- If PES > 1, supply is price elastic; quantity supplied is

relatively responsive to price

- If PES = 0, supply is perfectly price inelastic (change

in price has no impact on quantity supplied, suggests
that there is no capacity for suppliers to raise output)

- If PES = ♾, supply is perfectly price elastic (any

change in price leads to an in nitely large response in
quantity supplied)

- If PES = 1, supply has unitary price elasticity (supply is

proportional to change in the price)

Determinants of PES
- Length of time: As the length of the time that rms have increases, the responsiveness
of quantity supplied to price change begins to rise and PES increases. (Larger amount
of time to adjust input, larger the PES).

- Mobility of factors of production: The more easily resources can be shifted out of one
line of production and into another (where price is increasing), the greater the
responsiveness of quantity demanded hence, higher the PES.

- Spare capacity of rms: The greater the spare capacity, the easier it is for rms to
respond to an increase in price hence, higher the PES.

- Ability to store stocks: Firms that have an ability to store inventory (stocks) are likely to
have a higher PES for their products.

- Rate at which costs increase: The slower the rise of cost of producing more output, the
easier it will be for rms to expand their output so supply will be elastic.

Applications of PES
- PES in relation to primary commodities and manufactures products:

• Primary commodities usually have a lower PES than manufactured products because
they need more time to respond to price changes. In agriculture for example, limited
land, weather and other conditions are extremely hard to control hence, it becomes
di cult for farmers to respond to an increase in price.

- Short term and long-term price elasticises of supply:

• Over longer periods of time, the PES of agricultural goods for example, is larger.
Therefore, the longer the time producers have to make adjustments, the greater the
responsiveness of quantity supplied to price changes.

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 UNIT 4 - Government intervention in microeconomics (Refer to textbook
while doing this chapter, points of referral are in blue)

Some terms
- Command and control: refers to government laws and regulations that must be
followed.

- Forms of intervention: price ceilings, price oors, indirect taxes, subsidies, direct
provision of services, command and control regulation and legislation, and
consumer nudges.

- Price controls: refer to the setting of minimum or maximum prices by the

government so that prices are unable to adjust to their equilibrium level
determined by demand and supply. They often result in shortages and
surpluses.

- Price ceilings: refers to setting a legal maximum price below the equilibrium
price, in order to make goods more a ordable to people on low income.

- Welfare loss (deadweight loss): represents social surplus or welfare bene ts that
are lost to society because resources are not allocated e ciently.

- Price oors: a minimum price set above the equilibrium price, in order to provide
income support to farmers or to increase the wages of low-skilled workers.

- Indirect tax: imposed on spending to buy goods and services. They are paid
partly by consumers. Burden is shared between consumers and producers and
are paid to the government.

- Subsidy: A subsidy refers to assistance by the government to individuals or

groups of individuals, such as rms, consumers, industries or sectors of an
economy. A subsidy granted to a rm has the e ect of increasing the price
received by producers, causing them to produce more, and lowering prices paid
by consumers, causing them to buy more.

4.1 government intervention in markets

- Government intervention is to compensate for the inability of markets to carry out all
socially desirable economic activities e ectively.

- Governments earn revenue from indirect taxes, taxed on goods and services. The
lower the PED for a good, the greater amount of tax revenue earned hence why
ciggaretes, alcohol and petrol are highly taxed.

- Governments may provide support to rms, small rms that require nancial
assistance to be able to compete with large rms, rms in an industry whose growth
the government would like to encourage such as environmentally friendly energy
production and the protection of domestic rms from foreign competition via imports.
In order to do these things they may o er subsidies and price oors and when imports
become a threat they may o er trade protection such as tari s and quotas.

- Provide support to households on low incomes: subsidies, price ceilings, direct

provision of services such as free education, transfer payments including
unemployment bene ts, child bene ts etc.

- In uence levels of production of rms: price oors and subsidies to increase

production; indirect taxes to decrease production.

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 - In uence levels of consumption of households/ consumers: to increase
consumption governments use subsidies, direct provision of services, nudges or
command and control methods; to reduce consumption they use indirect taxes,
nudges or command and control methods such as prohibiting smoking in public.

- Correct market failures: market failures occur when the market produces quantities of a
good or service that are too large or too small in relation to what society most prefers.

- Promote equity (equality) through redistribution of wealth and income.

4.2 Price controls

- Once they are imposed, they do not allow a new equilibrium to be established, forcing
persistent market disequilibrium.

Price ceilings
• A government may in some situations set a legal maximum price for a particular
good. This means that the price that can be legally charged by sellers of the
good must not be higher than the legal maximum price.

• Price celling is set by the government at a level below the equilibrium price,
leading to excess demand (shortage).

• In order for a price ceiling to have any e ect, it must be set below the equilibrium
price.

• Consequences of price ceilings on markets:

- A price ceiling does not allow the market to clear; it creates a situation of
disequilibrium where there is a shortage.

- Shortages: At the price ceiling, not all interested buyers who are willing and able
to buy the good are able to do so because not enough is being supplied.
Shortage = Qd - Qs

- Non-price rationing: in a free market, rationing is achieved by the price system

where those who are willing and able to pay for a good will do so, and the good
is rationed among users according to who buys it, this is called price rationing
however. Once a shortage arises due to a price ceiling, the price mechanism no
longer achieves its rationing function. Some demanders will go unsatis ed
hence, in order to distribute quantity amongst interested buyers, non-price
rationing methods such as the rst come rst serve principle, distribution
of coupons to all interested buyers so that they can purchase a xed
amount in a given time period and favouritism occurs where sellers sell to
preferred customers.
- Underground or parallel markets: involves buying/selling transactions that are
unrecorded and are usually illegal. They involve buying a good at the maximum
legal price and illegally reselling at a price above the legal maximum. This
happens because people who were not able to buy the good at price ceiling still
want it and are hence, willing to pay a higher price. These markets are
inequitable and frustrate the objective of a price ceiling.

- Under allocation of resources to the good and allocative ine ciency: Here not
enough resources are allocated to the production of the good, resulting in
underproduction relative to the social optimum.

Read negative welfare impacts on page 116

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 Essentially, a price ceiling creates a welfare loss, indicating that the price ceiling
introduces allocative ine ciency due to an under allocation of resources to the
production of the good. Shown by equilibrium quantity > quantity supplied.
Marginal bene t > marginal cost indicates that society is not getting enough of the
good.

• Consequences of price ceilings for stakeholders:

- Consumers: consumers partly gain and partly lose

- Producers: Producers are worse o because with the price ceiling because they
sell a smaller quantity of the good at a lower price, leading to an obvious
decrease in revenue.

- Workers: The fall in output from Qe to Qs means that some workers are likely to
be red, resulting in unemployment.

- Government: No direct gain or loss; may gain popularity among consumers who
are better o .

Rent controls and food price controls

Rent controls
A maximum legal rent on housing, below the market-determined level of rent (price of
rental housing). It is enforced in order to make housing more a ordable to low-income
earners.

Consequences:

- Housing becomes more a ordable to low income earners.

- Shortage of housing

- Long waiting list of interested tenants

- Underground markets are created where tenants sublet their apartments at rents above
the legal maximum.

- Low quality housing as it becomes unpro table for landlord to maintain and renovate
units as low rents result in low revenue.

Food price controls

Some governments use food price controls as a method to make food more a ordable to
low income earners, especially during times when food prices are rising rapidly.

Consequences:

- Shortages

- Non-price rationing methods to deal with shortages

- Development of underground markets

- Falling farmer incomes due to low revenues

- More unemployment in the agricultural sector

- Misallocation of resources

Calculations: read pages 119 & 120

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 Price oors: setting a legal minimum price
• A legally set minimum price is called a price oor.

• The price that can be legally charged by sellers of the good must not be lower
than the price oor.

• A surplus arises as the quantity rms are willing and able to supply is greater
than the quantity that consumers are willing and able to demand.

• A price oor must be above the equilibrium price in order for it to have an a ect.

Why are price oors used?

1. To provide income support for farmers by o ering them prices for their
products that are above market determined prices. Unstable incomes arise
from unstable agricultural product prices, which are due to low price
elasticities of demand and low price elasticities of supply for agricultural
products. Therefore, governments set price oors for certain products, with the
objective of raising prices above the equilibrium market price.

2. To protect low-skilled, low-wage workers by o ering them a minimum wage

that is above the market determined level.

Consequences for markets

• Surpluses: A price oor results in disequilibrium where there is a surplus and a
common practise for the government is to buy the excess supply which causes
the demand curve to shift to the right (D plus government purchases). The
government must do this to maintain the price oor, if not the price will fall back
to the equilibrium. To get rid of surpluses governments may provide the option
to store it or to export the surplus however, in order to do either, an additional
cost is incurred hence, making it problematic. Look at gure 4.6 on page 121.

• Firm ine ciency: ine cient rms with high costs of production do not face
incentives to cut costs because high price o ers protection against low cost
competitors.

• Overallocation of resources to the production of the good

• Negative welfare impacts: loss of bene ts due to allocative ine ciency caused
by overallocation of resources to the production of the good. Here marginal
cost is greater than marginal bene t at the point of production hence,
indicating that quantity produced is larger than optimum. Refer to diagrams on
page 122 and read negative welfare impacts

Essentially, a price oor creates welfare loss, indicating that the price oor
introduces allocative ine ciency due to an overallocation of resources to the
production of the good. Also MB < MC, indicating that society is getting too much
of the good.

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 • Consequences of price oors for stakeholders:

- Consumers: consumers are worse o , they must pay a higher price while buying
a lower quantity, also indicated by loss of some consumer surplus.

- Producers: Producers gain as they receive a higher price and produce a larger
quantity and since the government buys the surplus, overall revenue increases.
Producers are also less likely to go out of business if they are ine cient.

- Workers: Workers likely to gain as employment increases with greater

production of a good.

- Government: Burden on government budget as they buy surpluses, resulting in

less funds available to spend on other activities. There are further costs of
storing the surplus or subsidising it for exports.

- Stakeholders in other countries: bottom of page 123

Read calculations from textbook page 124 and 125

Minimum wages
A law that determines the minimum price of labour (wage rate) that an employer
must pay with the objective of guaranteeing an adequate income to low-income,
mostly unskilled workers. Look at gure 4.9 on page 125

Consequences for the economy

• Labour surplus and unemployment: minimum wage in labour market creates a

surplus of labour and results in unemployment, corresponds to people who
would like to work but are not employed. Higher wage rates make it more
attractive to workers hence, leading to a movement up the supply curve.

• Illegal workers at wages below minimum wage

• Misallocation of labour resources: The imposition of a minimum wage a ects the

signals and incentives for unskilled labour, whose wage is a ected by the price
oor. Industries that rely heavily on unskilled workers are more a ected.

• Misallocation in product markets: Firms relying heavily on unskilled workers

experience an increase in cost of production, leading to a leftward shift in their
product supply curve.

Consequences for stakeholders

• Firms: Worse o as they face higher costs of production

• Workers: Some gain because they receive higher wages than previously and
some lose because they lose their job.

• Consumers: worse o because increase in labour costs leads to a decrease in

supply of products causing higher product prices and lower quantities.

Read setting xed prices on page 126 (bottom right) and look at gure 4.10 on
page 127

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 4.3 Indirect taxes
- An indirect tax is imposed on spending to buy goods and services. They are paid partly
by consumers. Burden is shared between consumers and producers and are paid to
the government.

- Types of indirect taxes:

➡ Excise taxes: imposed on particular goods and services (usually demerit) such as
petrol, alcohol and cigarettes.

➡ Taxes on spending (most goods and services): general sales tax and value added
taxes.

The e ect of indirect taxes on allocation of resources

- Taxes imposed on particular goods lead to an increase in the price paid by consumers,
causing them to reduce spending on these taxed goods. In turn, these indirect taxes
also lower the price received by producers, causing them to produce less. Therefore,
by changing price signals and incentives, excise taxes a ect the allocation of
resources.

Reasons for the imposition of an indirect tax:

- Source of government revenue: The lower the PED for a good, greater the
government revenue generated.

- Method to discourage consumption of demerit goods: Taxing these goods is likely

to reduce their consumption however, the extent to which these taxes are successful in
reducing consumption depends on the PED.
- Excise taxes can be used to redistribute income: some excise taxes focus on
luxury goods with the objective of taxing goods that can only be a orded by
high income earners. Hence, some degree of income redistribution is achieved
as income inequality is narrowed.

- Excise taxes are a method to improve allocation of resources by correcting

negative externalities.

Types of indirect tax:

- Speci c tax: xed amount per unit of the good or service sold.

- Ad valorem tax: xed percentage of the price of a good or service; amount of

tax increases as price of good increases.

A tax imposed on a good or service is paid by the rm to the government hence,

leading to an upwards parallel shift of the supply curve.

Read “illustrating and analysing impacts of an indirect tax on market outcomes”

page 129

Market outcomes due to tax:

- Equilibrium quantity produced falls

- Equilibrium price increases

- Consumer expenditure increases per unit

- Firms revenue falls

- Government receives tax revenue

- Under allocation of resources to the production of the good

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 Consequences of indirect taxes on various stakeholders
- Consumers: worse o as they receive less of the good and are paying more for
it.

- Producers ( rms): Worse o as they experience a fall in their revenue as they sell
lower quantities and receive a lower price per unit.

- The government: Government earns revenue, hence, gains from this taxation.

- Workers: Tax may lead to unemployment as a decrease in output requires fewer

workers.

- Society as a whole: Imposition of indirect tax results in reduced consumer and

producer surplus, part of which is transformed into government revenue and
part of which is welfare loss. Welfare loss in this case is the result of under
allocation of resources to the production of the good, also indicated by
MB>MC. Too little is produced and consumed relative to social optimum.

Look at gure 4.12 on page 130 and read calculations on pages 131, 132 and 133

4.4 Subsidies

- A subsidy refers to assistance by the government to individuals or groups of

individuals, such as rms, consumers, industries or sectors of an economy.

- Subsidies can be in the form of direct cash payments, low-interest/ interest free loans,
provision of goods and services by the government below market prices.

E ect on allocation of resources

- A subsidy granted to a rm has the e ect of increasing the price received by
producers, causing them to produce more, and lowering prices paid by consumers,
causing them to buy more.

Reasons for granting subsidies

- Can be used to increase revenue of producers
- Can be used to make certain goods a ordable to low income earners: subsidies
have the e ect of lowering the price of a good paid by consumers, thus making it more
a ordable.

- Can be used to encourage production and consumption of g&s that are believed to be
desirable for consumers: a subsidy has the e ect of increasing the quantity of a good
produced and consumed.

- Subsidies can be used to support the growth of particular industries in an economy.

- Can be used to encourage exports of particular goods as they lower the price paid by
consumers which in hand, lowers export prices allowing for an increase in exports.

- Method to improve the allocation of resources by correcting positive externalities.

Impact on market outcomes and consequences

for stakeholders
A subsidy works to decrease the rms’ cost of
production, thus causing a downward shift of the S
curve. This is a downward parallel shift of the
supply curve by the amount of the subsidy to the
new curve S2= S1-subsidy. This is the exact
opposite to indirect tax. The demand curve remains
constant, creating a new equilibrium with supply
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 curve S2.

The market outcomes due to the subsidy are the following:

• equilibrium quantity produced and consumed increases from Q* to Qsb

• the equilibrium price falls from P* to Pc; this is the price paid by consumers

• the price received by producers increases from P* to Pp

• the amount of the subsidy is given by (Pp − Pc) × Qsb, or the amount of subsidy per
unit multiplied by the number of units sold; this is the entire shaded area, and
represents government spending to provide the subsidy

• there is an overallocation of resources to the production of the good: Qsb is greater

than the free market quantity, Q*.

Consequences of subsidies on various stakeholders

- Consumers: better o as they experience a fall in price of the good and an
increase in quantity purchased.

- Producers ( rms): better o as they receive a higher price and produce a larger
quantity.

- The government: Government pays the subsidy, hence, a burden on its budget.
To obtain revenue for the subsidy, the government may reduce expenditure
elsewhere, raise taxes or run on a budget de cit.

- Workers: As output expands, rms likely to hire more workers to produce extra
output.

- Society as a whole: The granting of a subsidy results in greater consumer and

producer surplus however, society loses due to government spending on the
subsidy. Since the loss from government spending is greater than the gain in
consumer and producer surplus, it leads to welfare loss which re ects allocative
ine ciency due to the overallocation of resources to the production of the good.
This can be seen via MB < MC, too much is being consumed relative to social
optimum. Look at gure 4.16 on page 136.

- Foreign producers: If subsidy is granted on exports, it lowers price and

increases the quantity of exports. A positive for domestic producers however,
negative for the producers of other countries, making it di cult for them to
compete with low prices of imports.

READ CALCULATIONS ON PAGE 138, 139 and 140

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 UNIT 5 - Market failure and socially undesirable outcomes

Some terms
- Market failure: refers to the failure of the market to allocate resources e ciently.

- Externality: occurs when the actions of producers or consumers give rise to

negative or positive side e ects on people who are not part of these actions and
whose interests are not taken into consideration.

- Social optimum: refers to the best situations from the point of view of allocative
e ciency.

- Marginal private cost (MPC): refers to cost to producers of producing one more
unit of a good.

- Marginal private bene ts (MPB): refers to the bene t received by consumers for
consuming one more unit of the good

- Marginal social cost (MSC): refers to the cost to society of producing one more
unit of a good.

- Marginal social bene t (MSB): refers to bene ts to society from consuming one
more unit of a good.

- Negative consumption externalities: refer to external costs created by

consumers.

- Welfare loss: represents the reduction in bene ts for society due to the
overallocation of resources to the production of the good.

- Demerit goods: goods considered undesirable for consumers, but which are
over-provided by the market.

5.1 The meaning of common pool resources

Common pool resources are resources that are not owned by anyone, do not have a
price and are available for anyone to use without payment or other restrictions. Examples
include: clean air, bio diversity, ozone layer, stable global climate etc.

Market failure with regards to common pool resources includes ozone depletion, global
warming, disruption of marine ecosystem and wildlife endangerment.

Sustainable development: refers to development that meets the needs of the present
without compromising the ability of future generations to meet their own needs.

- Sustainable resource use: resources used at a rate that allows them to reproduce
themselves so that they do not deplete or degrade.

Maximum Sustainable Yield (MSY) of common pool resources: the maximum use that can
be made of the resource that is also sustainable, in that the resource can reproduce itself.

Overuse of common pool resource: leads to negative production externality

Government response to threats to sustainability: legislation such as quotes and bans,

market based policies such as pigouvian and carbon taxes and tradable permits.

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 5.2 Market failure and externalities: diverging private and social bene ts and costs

Market failure refers to the failure of the market to allocate resources e ciently. It results
in allocative ine ciency, where too much or too little of goods and services are produced
and consumed. There is over-provision or under-provision of goods and services.

Understanding externalities:
- Occurs when the actions of producers or consumers give rise to negative or
positive side e ects on people who are not part of these actions and whose
interests are not taken into consideration.

- If the side e ects on third parties involve bene ts: arousel of a positive
externality or external/spillover bene t.

- If the side e ects involve costs (negative side e ect): arousel of a negative
externality or external/spillover costs.

- When MSC = MSB, there is allocative e ciency and the

socially optimum output is produced. When there is no
externality, the competitive free market leads to an outcome
where MPC=MSC=MPB=MSB, indicating allocative e ciency.

- An externality creates divergence between MPC and MSC or

between MPB and MSB. This leads to an outcome where
MPB=MPC however, MSB is not equal to MSC hence,
indicating allocative ine ciency.

5.4 Negative consumption externalities

The external costs created by consumers.

- When there is a consumption externality, marginal private bene t curve does not re ect
social bene ts.

- The e ect of a negative consumption externality on society can be thought of as

‘negative bene ts’, causing the MSB curve to lie below the MPB curve. The vertical
di erence between MSB and MPB represent the
external costs.

- The market determines an equilibrium quantity,

Qm, and price, Pm, given by the intersection of the
MPB and MPC curves. However, social optimum is
Qopt and Popt, determined by the intersection of
the MSB and MSC curves.

- When there is a negative consumption externality,

the free market over allocates resources to the
production of the good. This is shown by Qm >
Qopt and MSC > MSB at Qm.

Welfare loss of negative consumption externalities

- Welfare loss: represents the reduction in bene ts for society due to the
overallocation of resources to the production of the good.

- For all units of output greater than Qopt, MSC > MSB, indicating that too much
of the good is produced.

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 - Calculating welfare loss: welfare loss = area of the shaded
triangle which is the height (external cost per unit or MPB-
MSB) multiplied by the width (amount of overproduction =
Qm-Qopt) divided by 2. Therefore in this case,

(6-4) x (100-70)/2 = 2 x 30/2 = $30

Common pool resources

- Overuse of common pool resources: common pool resources

such as clean air may be overused by consumers through
activities such as air travel which results in signi cant and
rapidly increasing greenhouses gases.

Policies to correct negative consumption externalities and

prevent overuse of common pool resources

- Market-based policies:

• The imposition of indirect Pigouvian taxes on goods whose

consumption creates external costs such as cigarettes and
petrol.

• This results in a (decrease in supply) upward shift of supply

curve from MPC to MPC + tax. If tax = external cost, MPC
+tax curve intersects MPB at Qopt, reducing quantity
produced and consumed. The price increases from Pm to
Pc therefore, the tax allows allocative e ciency to be
achieved.

• Advantages: Indirect taxes internalise the externality,

changing relative prices, the taxed good becomes relatively more expensive
thus, changing consumption patterns allowing consumption to be reduced.

• Disadvantages:

‣ It is di cult to measure the value of external costs, as it is hard to determine who

and what is a ected as well as to determine the value of the external cost.

‣ Some goods whose consumption leads to negative consumption externalities

have inelastic demand. Therefore, imposition of tax may work to increase
government revenue but not necessarily decrease consumption. However, this
increase in tax revenue can be used to nance education programmes to
discourage consumption of the goods.

- Government legislation and regulation:

• Regulations can be used to prevent/limit consumer activities

that impose costs on third parties such as legal restrictions
preventing smoking in public places.

• This may allow for the demand curve = MPB to shift towards
the MSB curve until demand overlaps with MSB. This would
eliminate externality, reducing quantity produced and
consumed and dropping prices to Qopt and Popt.

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 • Advantages: May be e ective such as prohibiting smoking in public places.

• Disadvantages: Cannot be used to deal with other negative consumption

externalities such as regulating petrol consumption.

- Education and awareness creation:

• Can be used to try to persuade consumers to buy fewer goods with negative
externalities, such as anti-smoking campaigns or campaigns to avoid unhealthy
food. Examples could be promoting the use of public transport or providing
information about the amount of carbon produced by air travel.

• The e ects are same as government legislation and regulation.

• Advantage: simpler than other methods

• Disadvantages:

‣ Involves government expenditure on campaigns, reduces available fund for other

activities.

‣ Such methods may not be e ective enough.

- Nudges:

• Can be used in ways similar to education and awareness creation. Encouraging

consumers to rely less on goods with negative externalities. For example,
unhealthy foods can be placed in less accessible places in shops or graphic
images can be used on cigarette boxes.

• May have an e ect of shifting the MPB (demand curve) to MSB

• Disadvantages:

‣ Not enough is known about how consumers respond to particular nudges and
choice architecture.

‣ Particular nudges may not have the same e ect across income and cultural
groups.

Therefore, correction of negative consumption externalities involves either

decreasing supply and shifting the MPC curve upward via indirect taxes or by
decreasing demand and shifting MPB curve towards MSB curve via regulations,
education and awareness creation or nudges. Both scenarios tend to lead to
production and consumption at Qopt and the achievement of allocative e ciency.

It is often that the government makes use of several polices in-sync such as
utilising tax revenues from the imposition of a pigouvian tax to nance education
and awareness creation programmes.

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UNIT 7- Market failure and socially undesirable outcomes III

7.1 Introduction to rms, industries and market structures

- Firm: an organisation that employs factors of production to produce and sell a good or
service.

- Industry: A group of one or more rms producing identical or similar goods or services
in an industry.

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 MACROECONOMICS

3.1 Measuring economic activity and illustrating its variations

The circular ow of income model

The circular ow of income shows that in any given time period, the value of output
produced in an economy is equal to the total income generated in producing that output,
which is equal to expenditures made to purchase that output.

• Leakages and injections:

- Leakages refers to money owing out/withdrawals, including saving, taxes and import
spending.
- Injections refer to money owing in, including investment, government spending and
export spending.
- Saving and investment: Saving leaks out of the ow of consumer expenditure, passes
through nancial markets and is injected back into the expenditure ow as investment.

- Taxes and government spending: Taxes are paid to the government (instead of being
used to buy good/services) and government spending on various activities comes back
into the ow as an injection.

- Imports and exports: imports represent leakages because they are spending that leak
out to other countries and exports represent an injection because they are spending by
foreigners who buy domestically produced goods.

- If leakages are greater than injections (size of model decreases): fewer goods and
services are purchased, rms cut back on output, they buy fewer factors of production,
unemployment increases and household income is reduced.

- If injections are larger than leakages (size of model increases): rms begin to produce
more by purchasing more factors of production, unemployment falls and household
income increases.

Measures of economic activity

Measurement of economic activity involves measuring an economy’s notional income or
value of output, known as national output/ aggregate output. There are three ways to
measure the value of national output:

• Expenditure approach (gross domestic product): Gross domestic product (GDP) is

de ned as the market value for all nal goods and services produced in a country over
a time period. It includes spending by the four components, C + I + G + (X-M).

• The income approach: This approach adds up all income earned by the factors of
production within a country over a time period. This includes wages, rent, interest and
pro ts earned by labour, land, capital and entrepreneurship.

- The output approach: measures the same of the value of each good and service
produced in the economy over a particular time period to obtain the value of total
output produced. It includes the value of all nal goods and services.

GDP vs GNI
- GDP refers to the total value of all nal goods and services produced within a country
over a period of time, regardless of who owns the factors of production.

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 - GNI refers to the total income received by residents of a country, equal to the value of
all nal goods and services produced by the factors of production, supplied by the
country’s residents regardless of where the factors are located.

Nominal vs Real
- Nominal (GDP & GNI) are measured in terms of prices at the time of measurement and
does not account for changes in price.

- Real (GDP & GNI) is a measure of value that takes into account changes in price over
time, when a variable is being compared over time, it is important to use real values.

Per capita gures and purchasing power parity

- Per capita: Useful as a summary measure of the standard of living in a country because
they provide an indication of how much of total output/income in the economy,
corresponds to each person in the population on average.

- Purchasing power parities: special exchange rates used to eliminate the in uence of
price di erences on the value of output or income.

Calculations
• Calculating nominal GDP (expenditure approach): C + I + G + (X-M)
• Calculating GNI: GDP + net income from abroad (income from abroad - income sent
abroad)

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