H2 Econs Market Failure + Macro + Globalisation

README:Thoselongparagraphsinwhichseparatepointsarenumbered(like1),2),3))arehowImemorisedtheANALYTICALexplanationsforEcons.Theymayormaynotbeapplicableforyoursyllabus/yourschool.Pleasedoaskyourteachersbeforehand! Defineallocativeefficiency:- Allocativeefficiencyisasituationwherethecombinationofgoods/servicesproducedmaximizesthetotaleconomicwelfareofsociety 1) Howdoesthemarket allocategoodsandservicesthroughitssignalling, rationingandincentivefunctionsof price. NOTABOUTWHY/HOWthemarket mayleadtoefficient allocationof resources Howdoesthefreemarketallocategoodsandservices?Throughitssignaling,rationingandincentivefunctions Signalingrole:Helpstodecidedwhat*andhowmuch*toproduce Assumingaperfectlycompetitivemarket,thereisconsumersovereignty - Consumers‘vote’forwhattheywantfirmstoproducethroughtheirpurchasesand‘vote’againstaproductbynotbuyingthem.Throughtheuseof‘dollarvotes’,consumersdeterminewhatandhowmuchtoproduce→Firmsrespondtothesedollarvotesbyproducingonlythesegoodsatthepricesthattheythemselvesarewillingtoaccept-- Duetotheeconomicconceptofscarcity,firmswilldevotescarceresourcestoproduceagoodonlyifitisprofitable.Howmuchofagoodisactuallyproducedisdeterminedbythepricemechanismfindingthepriceatwhichquantitydemandedequalstoquantitysupplied - Changesinpricesignaltoproducersifmoreorlessresourcesshouldbeallocatedtoproduction,priceswillriseandfalltoreflectshortagesandsurplusesrespectivelyandfirmswilladjusttheirproductionlevelsaccordingly PLEASEGIVEEXAMPLE:- Sayconsumersincreasedemandforagoodlikecarsduetohigherincomes→Riseindemandindicatesahigherwillingnessandabilitytopayahigherprice

- Riseindemandleadstoshortageatinitialprice,causingupwardpressureonprices→incentivisesfirmstoincreasequantitysuppliedbecauseitmeansahigherprofitmargin…alsomeanstheyaregettingmorethantheyneedtocovertheirmarginalcostofproduction→henceexplainingthehigherprofitability.Thisriseinprofitability,signalledbyhigherprice incentivisessprofit-motivatedcarfirmstoexpandproductioninresponsetothechangeinpreference.Thisisindicatedbythediagramasthehigherpriceleadstohigherquantitysupplied(upwardmovementalongsupplycurve) - Theywillthereforehiremorefactorsofproductionlikelabor→andhencemorecarswillbeproduced Consumer-sideThisriseinpriceisalsoasignalandincentiveforconsumers- TheriseinpricesignalstoconsumersthatthenetMBfromconsumingthegoodisnowlowerandthusincentivisesthemtoconsumelessinresponsetothehigherprice(indicatedbydiagram,downwardmovementalongdemandcurve)- Thus,quantitysuppliedrisesandquantitydemandedfallsuntilshortageiseliminatedathigherprice PRICESALSODETERMINEHOWGOODISPRODUCEDiftherearechangesinpriceoffactorinputs- Profit-maximizingfirmstypicallyuseamixoflaborandcapitalintheirproduction,buttheywillstillreacttorelativefactorpricestodeterminehowtoproduce- Ifforinstancelaborismoreabundantthancapitalthereforeitischeaper,assumingthattheyhavethesameproductivity→firmswillbeincentivisedtousemorelabour-intensivemethodsofproduction Rationing- Inpursuitofprofits,firmswillonlyselltheiroutputtothosewhoarewillingandabletopayapricethatminimallycoverstheirmarginalcosts.Hence,marketpricethusdeterminesforwhomthegoodsareproducedasthosegoodswillonlybedistributedtothosewiththewillingnessandabilitytopaymarketequilibriumprice 2) Howdoesthefreemarket leadtoefficient allocationof resources? Considerthemarginalistprinciple DDcurve→Representsmaximumpriceconsumersarewillingandabletopayforvariousquantitiesofagood.Buthow?/why?Dotheydeterminethatprice

Appliedtoconsumers, Inpursuitofself-interest,arationalconsumerwillseektomaximizetheirnettotalprivatebenefitsfrombuying/consumingagood/servicegivenhislimitedincome(scarcityidea)- HewillbuyanadditionalunitofagoodaslongastheMPB(whichistheadditionalutilityderivedfromconsuminganadditionalunitofthegood)exceedsthemarginalprivatecost(whichisthepriceconsumerspayforthegood) Therefore,themaximumpriceaconsumerwouldbewillingtopayforonemoreunitofagoodwouldrepresentthemarginalutilitythathederivesfromconsumingthatadditionalunit.THEREFOREMarketdemandcurveisthesameastheMPBcurveforconsumers Appliedtoproducers,Supplycurvealsorepresentstheminimumpricethatproducersarewillingandabletoacceptforvariousquantitiesofthegood. How/whydotheydeterminethatminimumprice?Inthepursuitofself-interest,arationalproducerseekstomaximizethetotalprofitsfromproducing/selingagood/service.- ProducerwillbewillingtosellanadditionalunitofagoodaslongastheMPB(whichistheadditionalrevenuefromsellinganadditionalunitwhichisequaltopriceconsumerspay)exceedstheMPC(whichisthemarginalcostofproduction) Therefore,minimumpricethataproducerwouldbewillingtoaccepttoproduceonemoreunitofagoodwouldrepresenttheMCheincursfromproducingan***additionalunit.MarketsupplycurveisthesameasMPCofproducers Here’stheanalyticalpart- Assumingnoexternalities,theMPCincurredbythefirmswillbethesameasMSCincurredbysocietyasawhole,whiletheMPBenjoyedbyconsumersisthesameastheMSBenjoyedbysocietyasawhole.- Assuch,inaperfectlycompetitivemarketfora***privategood,thedemandcurvewillreflectbothMPBandMSBwhilstsupplycurvereflectsbothMPCandMSC WIththethreeaforementionedassumptions(perfectcompetition,privategood,noexternalities)→Themarketequilibriumatpointeisalsosociallyoptimalequilibrium,whereMSB=MSC.AtoutputQe,society’swelfareismaximizedandallocativeefficiencyisachieved. TOGOFURTHERINANALYSIS,youalsoneedtoexplainwhywelfareismaximizedatQeandwhathappensifmarketoutputislessormorethanQe

ForunitsQ1(togetQ1ujustchooseaquantityshorterthanequilibrium)toQe,MSB>MSC.ThismeansthatforeveryadditionalunitofoutputfromQ1toQe,theadditionalsatisfactiontosocietyisgreaterthantheadditionalcostincurred.- HighlighttheTSBfrombetweenQ1toQeandthentheTSC- Hence,therewillbeanetincreaseinsociety’swelfareofareaxyzifsocietyistoproduceandconsumeQ1toQeunits..therefore,atQ1,society’swelfareisnotmaximizedduetounderconsumption.AnyoutputlevelsmallerthanQeishencenotallocativelyefficient IfmarketoutputismorethanQe.ForunitQ2(justchoosequantitylargerthanequilibrium)- MSC>MSB.ThismeansthatforeveryadditionalunitfromQetoQ2,theadditionalsatisfactiontosociety,theTSBisgivenby…whereasTSCisgreaterat… - Therefore,thereisanetlossinsociety’swelfareofareaexythatisincurredbecausesocietyproducedandconsumedQetoQ2units.Therefore,society’swelfareisnotmaximised.AnyoutputlevelaboveQeishencenotallocativelyefifcient THEREFORE,forthefreemarkettoallocateresourcesefficiently,the3assumptionsofprivategood,absenceofexternalities,andperfectlycompetitivemarketsmusthold AllocativeefficiencycanalsobeachievedwherethesumofCSandPSismaximised,butthisisn’ttooanalytical Relevantverystandardquestiontopoint2).Explainwhyallocativeefficiencymaybeachievedinfreemarket Causesofmarketfailure1) Externalities2) Imperfectinformation3) ImmobilityofFOP4) Marketdominance5) Publicgood 3) Extrernalityreferstopositiveor negativeimpact onathirdpartynotinvolvedintheconsumptionor productionof agood.

Positiveexternality:ReferstobeneficialimpactonathirdpartynotinvolvedintheproductionorconsumptionofagoodNegativeexternality:Refersnegativeimpactonthirdpartiesnotinvolvedintheproductionofrocnsumptionofthegoods ExternalitiescauseadivergencebetweenMPCandMSCorMPBandMSB Marginalexternalbenefit(alwaysmustdescribe)-additionalbenefitenjoyed,fromtheproductionofconsumptionoftheadditionalunitofthegood,bythirdpartiesnotinvolvedintheproductionorconsumptionofthegood Marginalexternalcost-additionalcostimposedbybytheproductionorconsumptionoftheadditionalunitofagood,onthirdpartiesnotinvolvedintheproductionorconsumptionofthatgood Youshouldknowhowtodescribeallofthisalready PLEASEmakesuretogiveexamplesofexternalitiesetc.- PositiveexternalitycausestheMSBtobegreaterthanMPB,sinceadditionalbenefitstosociety(MSB)includesbothprivatebenefitstoindividualsconsumingandexternalbenefitstoindividualsnotconsuming- Graphically,theexistenceofMEBcausestheMSBcurvetobehigherthanMPBcurve,whereMEBistheverticaldistancebetweentheMSBandMPBcurves Citizensnotinvolvedinproductionorconsumptionof(vaccines,healthcare,education,R&D)enjoypositiveexternality,whichisdefinedasanexternalbenefittothirdpartiesnotinvolvedintheconsumptionof