A rational agent wants to maximise their utility.

To do this, they will try to maximise their total utility.

Traditional theory says that firms will try and maximise profits, and this is how most of their utility is gained.

Survival.

To reinvest profits.

To offer managers and staff members better rewards.

Maximising revenue.

Maximising market share (and gaining monopoly power).

Ethical objectives (e.g. supporting the local economy).

Governments

Consumers

Governments should act in ways that best serve the population and, roughly speaking, try to maximise overall welfare.

Achieving economic growth.

Reducing inflation.

Reducing or eliminating unemployment.

Achieving a balance between payments in and payments out (equilibrium).

Consumers

Consumers are said to act rationally and maximise utility within the limits of their income.

Different consumers will have different interpretations of utility. One consumer might prioritise financial security (e.g. in saving for a property). Another consumer might want flashy clothes.

Consumers may also want to maximise their work-life balance (i.e. maximising their income while enjoying as much free time as they can). Consumers act as workers when they do this.

Price elasticity = % change in quantity demanded ÷ % change in price.

Unitary elasticity is where the PED = 1.

PED is almost always negative as an increase in price would result in a decrease in demand. But you may see some questions refer to it as positive for ease.

Cross-price elasticity of demand is when a change in the price of one good can change the quantity demanded of another.

Cross-price elasticity of demand = % change in quantity demanded of good A ÷ % change in the price of good B.

If XED is close to zero this would suggest that the goods are unrelated.

If a product is price elastic in demand:

Decreasing price = increases total revenue.

Increasing price = decreases total revenue.

Decreasing price = decreases total revenue.

Increasing price = increases total revenue.

When a firm's profits increase, it is incentivised to produce more output. This is because the more it produces, the more profit it will earn.

So, when costs of production fall, a firm will be incentivised to supply a higher quantity at a given price.

This is shown by a rightward shift in the supply curve.

The PPF shows economy at its maximum productive potential.

Society can choose any two goods on or inside the PPF.

The opportunity cost is the slope of the PPF.

The PPF is curved because of the law of diminishing returns.

As you increase units of one resource and keep other factors constant, the marginal benefit from the extra units will eventually start to decline.

Changes in the price of inputs (these will affect the cost of production).

A discovery of a new technology (allowing the firm to produce at a lower cost).

Changes in Government policy.

Taxes are treated as a cost by businesses.

Higher costs decrease supply.

So taxes decrease supply.

The PPF shifts outward if there is economic growth.

This is because the productive capacity of the economy has increased.

E.g. this could be caused from improvements in technology.

But this improvement isn't necessarily equal across all products.

E.g. an improvement in the technology to produce cars isn't necessarily going to affect the ability to produce butter.

The trade-offs occur when producing on the PPF.

To produce more of one good, you must produce less of another.

For example, if an economy is producing at point A and wants to increase the number of Good X they produce, they must give up producing some of good Y.

The PPF shows the economy working at its maximum potential.

If there are any points underneath the PPF, this means not all economic resources are being deployed.

Point A is a point outside the PPF. It is not currently possible to produce at this point.

Point B is a point on the PPF. At this point, all available factors of production are being fully used. All points along the PPF like point B are productively efficient.

Point C is inside the PPF. At this point, there are factors of production being underemployed.

Rise in price

Better technology and more efficient production

Government subsidies

This type of market allocates scarce resources based on the price mechanism.

The benefits of this:

It is efficient - only the highest value products are in demand. So firms are incentivised to produce as efficiently as they can.

It rewards entrepreneurship.

Consumers have greater choice of products because of the increased levels of innovation.

Inequitable - what is fair in the free market may not necessarily be fair in reality.

Missing markets - goods we need in society may not be produced if they cannot generate a profit.

Monopolies may arise.

Government is in charge of resource allocation. North Korea has a command economy.

This can correct the inequalities that exist in the free market.

There could also be a possible reduction in unemployment.

They can break up monopolies.

Negatives of command economies

Less efficient - the government is not a profit maximising entity. So the incentive for entrepreneurship and efficiency pushing activities is reduced.

Asymmetric information - the government may not actually know what is best because of asymmetric information.

Choice restriction.

Products that are likely to perish because of weather conditions will have a more inelastic supply.

E.g crops and agriculture.

Recessionary period

This is the only price where the amount consumers want to buy is equal to the amount producers want to sell.

If the market is at equilibrium, there is no reason to move away.

Supply and demand (market forces) dictate the equilibrium quantity and price in a free market.

Disequilibrium is when the market is not at a stable price and quantity.

If the market is not at equilibrium, economic pressure arises to move the market towards a stable price and quantity.

E.g if petrol prices were to rise above their equilibrium level, the market would respond and the quantity demanded would fall.

The supply line represents the cost of producing a good or service.

At the market price, firms who can produce the good or service at or below the market price will supply it to the market.

The sum of the extra money earned above the cost of production is the producer surplus.

The demand line represents the value that consumers place on a particular good or service.

At the market price each consumer who values the good or service at or above that price will buy and consume it. A number of consumers value the good or service above the market price and gain utility from the good compared to keeping the money they paid for it.

The sum of all the extra benefit consumers in a market get from buying and consuming a good or service is the consumer surplus.

Excess supply and demand occur at disequilibrium.

The higher price makes it more profitable for petrol producers, so output expands.

The difference between the quantity demanded and quantity supplied is now the excess supply.

When quantity demanded exceeds quantity supplied, there is excess demand.

The market price is unstable when there is excess demand or supply.

Excess supply will force producers to cut the price because it is better to sell at a lower price than not at all. Others will follow.

Excess demand will signal to producers they can generate more profit by raising the price and will do so.

So excess demand and supply can lead to price change.

When a tax is imposed, the producer may pass on some of this cost to the consumer in the form of a higher price (grey area on the diagram) and absorb the rest (red area).

The proportion of the tax passed onto the consumer depends on the elasticity of demand. The more inelastic the demand, the more of a tax is passed on and less 'absorbed'.

Indirect taxes generate revenues for governments. These revenues can then be spent on capital investment (e.g hospitals for the NHS) or transfer (or welfare) payments.

If demand is perfectly inelastic, the quantity consumed won't change and tax revenues will increase. However, the burden of a tax would fall completely on consumers. If this was a market made up of mainly poor consumers, then this may not be a good intervention for the government. However, this would need a value judgment.

The price mechanism shows how demand and supply interact.

A change in the price of a good will change the quantity demanded.

The price mechanism is free from bias because it is not governed by one human, but lots of different agents interacting.

Incentive function: rising prices encourage firms to expand their level of output because of higher profits.

Signalling function: if the price of a good changes, this signals to the consumer or producer that they should change their level of consumption or production.

Rationing function: resources are scarce. The price of a good rations that good. This limits supply to those who are willing and able to pay for it.

If demand was perfectly inelastic, then the demand curve would be vertical.

The quantity demanded would not change but the price paid would rise.

The burden of the tax would fall completely on the consumer.

If demand was perfectly elastic (horizontal demand curve), then the burden would fall completely on the producer.

Local markets: In a local marketplace for fruit, if one market stall sells apples for £20 and sells out of 1,000 apples. Then this is a signal for that firm to increase production and sell more apples. It also signals to competitors that they should start selling apples.

National markets: If Amazon lists a book at £10, but nobody buys it, then there is a signal that nobody demands that book at £10. Either people don't want the good or they are buying it elsewhere at a lower price. There is an incentive to reduce the quantity produced or to reduce the sale price.

Global markets: If the USA can produce steel for £100/ton and sells it for £1,000/ton, this is a signal to nations like China and India that they can make profits by producing steel. They have an incentive to produce steel and enter the market.

Market failure is when the price mechanism leads to a misallocation of resources.

Resources are misallocated when they are not devoted to the use that will give society the most welfare.

Complete market failure happens where, unless the good or service is provided outside the mechanism, there wouldn't be a market for it.

E.g a country's military services.

Partial market failure happens when the private sector may partially provide it but at the wrong price or quantity.

E.g private healthcare vs NHS.

This is a 'good' externality created in the consumption of a good.

The marginal social benefit is the total benefit of consuming a good or service to society. MSB = MPB + Externality.

If the consumption externality is positive, then the marginal social benefit is more than the marginal private benefit.

Consumers do not account for the benefit of the externality and this good will be under-consumed.

E.g. school education is a positive consumption externality because students become more productive for employers.

This is a 'bad' externality created in the consumption of goods/services (e.g cigarettes).

The marginal social benefit is the total benefit of consuming a good or service to society. It is equal to the marginal private benefit plus the value of the consumption externality.

If the consumption externality is negative, then the marginal social benefit is less than the marginal private benefit and the good will be overconsumed (vs the socially optimal level).

These are externalities incurred when producing a good or service.

Marginal social cost = Marginal private cost - Production externality. MSC is the total cost of producing a good or service to society.

If the production externality is positive, then the social cost is less than the private cost and the good will be underproduced.

These are externalities created when producing a good or service.

If the production externality is negative, then the social cost is greater than the private cost and the good will be overproduced (vs the socially optimal level).

E.g a factory producing noise and air pollution is likely to have a social cost larger than the private cost.

Governments may want people to consume more things like education, which have positive externalities.

Subsidies or free state provision may be used to encourage the consumption of merit goods.

Demerit goods like cigarettes may be overconsumed.

Taxes or bans may be interventions to solve this issue.

In a market-based economy, a consumer's ability to consume goods and services depends on their income and wealth.

If a consumer has a low income, they may not be able to afford basic goods to satisfy their needs.

The market is under-providing these goods and this can be a source of market failure.

Subsidies can correct market failure by encouraging the consumption and production of a good with positive externalities.

This is represented on the diagram by a shift to the right in supply, toward a more socially optimal level.

Subsidies can reduce the cost of a product and allow a firm to exploit economies of scale.

This will improve long-run efficiency and competitiveness abroad.

Consumer preferences may change as a result of a subsidy.

Subsidies may encourage laziness from producers because they do not need to be as efficient.

There is also an opportunity cost to a subsidy.

Elasticity of demand determines how effective a subsidy is.

Subsidised goods may be of a lower standard than alternatives they're trying to replace.

This system can put a cap on the level of pollution.

The lower the pollution of a firm, the more they can benefit. This encourages firms to lower their pollution levels.

Governments make revenue.

There is a cost to implementing the scheme.

Deciding on the level of pollution is difficult.

The market for permits is subject to failure also.

Governments can set an optimal limit on pollution by allocating permits to firms.

These permits can be traded through the price mechanism.

The European Union emissions trading system (ETS) is a way to do this. EU member governments are issued with permits to allocate to firms.

The ETS annually cuts the number of permits. This incentivises firms to reduce emissions because they may be forced to buy more permits for not doing so.

The government either provides state provisions itself (e.g. state education) or provides free goods or services to the public that it's bought from the private sector (e.g. private health services offered free to NHS patients).

The government pays for goods/services through tax revenues. It then offers them to the public for free.

Examples:

The National Health Service (NHS).

Police service.

Secondary school education.

State provision can reduce inequality by redistributing money from the wealthy to the poor. This is something the market doesn't always do.

Without state provision, some services might not exist as they aren't profitable.

E.g. some train routes that aren't profitable do not exist.

Value judgements need to be made about what the state can and can't provide well.

Without a drive for profit, there is less incentive to make a service as efficient as possible. The economic incentives for efficiency could be eroded.

There is an opportunity cost of providing one service over another.

With asymmetric information, there is a risk of government failure.

Resources are needed to implement government intervention.

If the cost is too high, the intervention may not be worthwhile.

Daniel Kahneman's inside view explains why governments may frequently underestimate the cost of their projects. The Scottish parliament in Holyrood was forecast to cost £10-40M but cost £414M.

The private sector has the incentive to maximise profits, but individuals working for governments rarely get the benefits.

Governments are also very large and may suffer from material diseconomies of scale.

In a world of perfect information, governments should be able to make the right decisions to improve allocation.

Asymmetric information limits the governments ability to critically assess market failures and possible solutions.

So the right decision isn't always made and government failure can arise.

Government failure is the result of a policy trying to correct a market failure that has led to a misallocation of resources.

This means there is a welfare loss to society.

E.g the council might charge people for some forms of waste disposal.

This may increase fly-tipping, which is a worsening of the initial pollution externality.