Managing the Economy

4.1 Economic objectives of the governmentLearning Objectives

Understand what the economic objectives of the government areUnderstand why these objectives are importantUnderstand how ethics affect the government’s objectivesUnderstand how economic indicators in the UK are measured

4.1 Economic objectives of the governmentObjectives are aims or goals that the government would like to achieveIf they achieve these then their economy is performing wellThis is how the government’s performance is judgedGovernment feels that if these objectives are achieved it will be beneficial for the people and the country as a wholeThere are 4 main objectives

Economic growthFull employmentLow and stable pricesBalance of payments

Economic objectives – economic goals that the government wishes to achieve to get good economic performance

Economic GrowthEconomic growth is measured by an increase in national income (an increase in GDP)Governments would like to have high growth Increases in income means better standards of livingThe problem is that high increases can lead to high consumer spending which leads to high prices (inflation)The government has to make a trade off and accept a lower rate of growthIn the UK a good rate of growth tends to be about 2.5%

GDP – total value of goods and services produced by an economy in one year

GDP / National Income

Full EmploymentDo you think it is possible to get full employment?Full employment is not quite the same as zero unemploymentFull employment is achieved when those who are actively looking for employment can find employmentIf everyone is employed there is more income available to spend

This could lead to rising pricesAgain this conflicts with the other objectiveGovernment needs to make a trade off – it has to accept low levels of unemployment to prevent inflation

Unemployment – all those of working age who are not currently working and are not in full-time education

Full employment – where all those seeking work are in employment

More spending = more demand for goods and services = more jobs = less unemployment

Stable PricesWhy would government want stable prices?It causes uncertaintyFirms like to be able to predict their costs and if they can’t then they may not invest

They won’t develop new technologyThey won’t growThe economy won’t grow

Consumers may put off spendingNational income will reduceThere will be less goods and services created leading to?Less employment

If prices of goods that are exported go up the country will be less competitive

Less countries will buy exports (because they are more expensive)The balance of payments may worsen (more imports than exports)

Inflation – a persistent increase in general price levels

Stable prices – the average level of prices is stable

Balance of PaymentsIf a country imports more than it exports it is buying more than it is selling

More money is flowing out of the economy than is flowing inThe economy is shrinking (not growing)

The money for the buying has to come from savings or must be borrowedIf there is more borrowing there will be more debtThis is not necessarily a problem

If the percentage of borrowing is lower than the amount that is earned (national income) the country will be able to pay back the debtAs long as loans are available it should not be a problem

If there is a high deficit and it lasts many years there could be a problemIf credit becomes difficult to find there could be a problem

Balance of payments – exports minus imports

How ethical issues affect the achievement of government objectivesThe UK government believes that it is ethically right to minimise povertyThey also want to minimise income inequality (the gap between the rich and poor)The main way they do this is through income taxation and welfare benefits (take from the rich and give to the poor)Those with a higher income pay a higher taxThose on a lower income receive benefitsThe government has to be careful not to raise taxes too high

High earners would have no incentive to work long hoursThis means that there will never be complete equality

ethics – the informal code of how we should behave – decisions we all make about what is morally right or morally wrong

Make a poster that includes all

of this!

Research time!In groups of 4s – assign a leaderDo some research on economic growth in the UKAreas of research (you could divide this within your team)

Definition of economic growthHow is it measured?Why is growth important?What are the benefits of growth?What are the costs of growth?Does growth conflict with other economic objectives?What % growth does the UK aim for?How has growth in the UK changed over the last 10 years?How does it compare with other countries (EU, China, India etc)How can an economy grow (in the long run and the short run)?The problems with growth

Make notes for your foldersMake sure you all have a full set of notes that can be discussed in class

Economic GrowthEconomic growth is measured in GDP – Gross Domestic ProductGDP is the total value of the goods and services that a country producesIf GDP increases we say that there is growthThe UK aims to get around 2.5% growth per annum They want higher living standards the population but an increase in GDP does not necessarily mean that everyone will be better offThere may be increased inequalityGovernment will aim to redistribute some of the income from those earning large amounts to those that are less fortunateIn the UK growth has allowed them to almost eliminate absolute poverty but there is still some relative poverty

Absolute poverty – those with incomes lower than the level of needed for necessities

Relative poverty – those on lower incomes than the country’s average

Economic Growth benefitsEconomic growth can reduce crime as the incentive to commit crime is reducedEconomic growth means that if people and businesses are earning more they can collect more taxesThe taxes can be used to spend on areas such asImproving educationProviding better health servicesProviding health education to the poorer sections of society that tend to have health problemsImproving transport links such as new roads, railway links and airportsBritain is planning to build HS2 which will connect the north to the south and the rest of europe

High speed rail has dramatically improved inter-city transport all over the world in the last 50 years. HS2 will see Britain adopt the worldwide standard and finally see the major cities of the Midlands and the North connected to the extensive, Europe-wide high speed network.

HS2 is vital for Britain's prosperityThe transport secretary argues that the high-speed rail link is essential for the future economic wellbeing of the country north and southGuardian – 14./7/2013

Economic Growth costsHigher economic growth means higher outputThis may have negative effects on the environment such as pollution from higher factory outputThat China's air and water are badly polluted following three decades of breakneck growth is not news. But January's (2013) record-setting bout of smog got worldwide news coverage and was so bad some longtime foreign residents left the countryTraffic congestion can cause problems are more people can afford carsHouse prices can rise so that first time buyers can find it very difficult to buy housesThose that benefit most from growth tend to be already earning over average wages – income inequality can increase

Economic Growth costsThose that benefit most from growth tend to be already earning over average wages – income inequality can increaseDoes income inequality matter?

University of Michigan philosopher, Elizabeth Anderson says “It basically creates a multi-class society — a society in which you have people who have to flatter and endear themselves and have to be servile. And other people dominate.”Toyama (University of California) says that eliminating suffering is what matters most. Beyond that, extreme wealth is an incentive for people to work harder.

He is talking about redistribution – government taxing the rich and distributing it to the poor to eliminate the suffering

When inequality becomes extreme, it undermines democracy argues the late philosopher John Rawls. One person, one vote — yeah. But one person with millions to spend has much more influence.Pogge (Yale Professor) says The size of the rich-poor gap matters -Some inequality is acceptable to pretty much everyone these days. No one is arguing for a fully equal society. But the degree of inequality really does matter when you’re trying to determine whether inequality is moral or amoral. When extreme inequality sets in, that’s when social and political problems follow.

Growth conflicts with other economic objectivesIf we have growth we have spending This spending pushes increases demand which increases pricesResources such as labour are more fully used (unemployment reduces) which means these resources become more scarceAs they become more scarce the price (the wages) increaseAs wages increase the cost of production increasesThese costs will be passed onto the consumerIf average price levels increase this means we have inflationThe objective of low inflation may fail

Growth conflicts with other economic objectivesIf consumers have more to spend they will spend more on importsThis is because the UK has a high propensity to spend on imports (they like spending on imports)If more is spent on imports than exports there will be a worsening of the balance of paymentsThe objective of improving the balance of payments fails unless growth is as a result of an increase in exports but this is rare in the UK

Economic CycleThe UK objective is to have 2.5% growth on average per yearOver time there will be different rates and the pattern tends to be cyclical (it is repeated) as seen in the diagram belowThe stages of the economic cycle are boom, recession, slum and recovery

Economic Cycle - BoomDuring a boom economic growth will be above averageConsumer spending is likely to be high as people feel confident and will borrow money to spendBecause people are spending there is a high demand for goods and servicesIf there is a high demand for goods and services there will be a high demand for labour to make themUnemployment will be falling or lowBusinesses will also be confident and will start to investPrices may start to rise (inflation)

RecessionIn the UK a period of recession is defined as 2 quarters (6 months) of negative growthGrowth is below the average rateConsumer spending is likely to be low as people lose confidence in the future and worry about losing their jobsBecause people are not spending so much there is a low demand for goods and servicesIf there is a low demand for goods and services there will be a low demand for labour to make themUnemployment will increase Businesses will also be less confident and will stop investingPrices may start to fall (inflation will reduce) Balance of payments may improve because there is less spending on importsThis depends on what happens to exports

SlumpIf the recession continues and worsens it could turn into a slumpConsumer confidence will be very low because they have no confidence in the economyThey will put off spendingThey will feel very insecure about their jobs in the futureInflation may be very low or falling unless prices of oil or other external factors are increasingBusinesses will hold onto their cash in case there is another recession and won’t investUnemployment is likely to be highPrices may even begin to fall (deflation)Imports will suffer and the BoP is likely to improve

RecoveryThis is when economic growth starts to get betterGrowth will be positive againConfidence will start to return to both consumers and businessesConsumers will start to spend moreBusinesses will start to invest some of the cash they have been holding backUnemployment should stop rising but may take some time to recoverInflation may start to increase

Research time!In groups of 4s – assign a leaderDo some research on Inflation in the UKAreas of research (you could divide this within your team)

Definition of inflationHow is it measured?What causes inflation?What % inflation rate does the UK aim for?Who has responsibility for controlling inflation in the UK?How do they do it?How has inflation in the UK changed over the last 10 years?What is the inflation rate now?What is hyperinflation and deflation?Which countries have suffered from this?What are the costs of inflation?

Make notes for your foldersPrepare a PowerPoint presentation to be given to the class

Inflation Watch Inflation Videos (4)http://www.youtube.com/watch?v=-d0-8tr6DGo&list=PLsl

yOrpjJ0z2H8B-ZjGgFjNCZHcHqASmrhttp://www.youtube.com/watch?v=7I48BA9-iu4&list=PLsl

yOrpjJ0z2H8B-ZjGgFjNCZHcHqASmrhttp://www.youtube.com/watch?v=aSWgRuJJ9-chttp://www.youtube.com/watch?v=-pwincsv4E0

Second Macroeconomic objective – Stable prices This is all about inflationBy the end of this section you will understand

How a rise in the cost of living affects the value of moneyHow changes in the value of money are measuredWhat is the Retail Price Index (RPI) and the Consumer Price Index (CPI)The meaning of inflationWhy it is important to keep inflation stableWhat causes inflationWhat policies can government use to keep inflation stable

The value of moneyThe value of money is the goods and services we can buy with moneyIf the amount of goods and services you can buy with a sum of money changes then there has been a change in the value of moneyIf prices are rising we say there has been a rise in the cost of living

it costs us more to live because we can get less for our moneywe can buy less for £1 this year than we did in the previous year

If prices are falling we say that there has been a fall in the cost of living

Getting more goods and services for our money – for our £1 we are buying more than the previous year It is costing us less to live

The amount we can buy for a certain sum of money is called the purchasing power of moneyIn 1970 I could have bought 11 loaves of bread for £1, by 2000 I could have bought around 2 and this year I would be lucky to get 1 http://www.bankofengland.co.uk/education/inflation/prices/prices.htm

Measuring changes in the value of moneyIt does not mean that we are worse off if the cost of living goes up (if prices go up)Our standard of living depends on both prices and our wagesIf prices go up and our wages stay the same our standard of living has gone downIf prices go up and our wages go up at the same rate then our standard of living remains the sameIf prices go up and our wages go up at a higher level then our standard of living goes upSo…if prices are rising the value of money is going down but standards of living could be rising, falling or staying the same.

What does this picture show?

1970 2000

The Retail Price Index (RPI)Government uses the RPI to measure changes in the value of moneyOver a number of years it measures the price of a typical basket of goods that a family spends its money on If there is a general rise in prices then the index will rise and the country will experience inflationInflation is not about one or two goods/services rising in price – it is about the whole basket of goods – a ‘general’ rise in pricesHowever remember that prices (in general) always rise from year so even if inflation is falling it does not mean that there is not a rise in prices it just means that the prices are not rising as fast as they were before

How is the RPI worked out?Government chooses a particular date and calls that the base date. The year in which the base date occurs is called the base yearThey then work out what is contained in a typical basket of goods – the things that an ordinary family would buy on a regular basisThey then record the price of each good and give it a weight according to the importance of this good to the family (the percentage of income spent on each good).

If more of the family’s income is spent on food this will have the highest weighting and so a change in price will have a bigger effect on the index

Then the price of the whole basket is worked out and is given an index number of 100 in the base yearThe price of the basket in future years is shown as a percentage change from the base year.

If the RPI is 105 in the year after the base year then the basket of goods has gone up 5%If the RPI was 110 the following year there has been a rise in the prices of goods of 10% since the base year

• What is the rate of inflation in year 2?

• What is the rate of inflation in year 2?

• 20%

Problems with working out the RPIThere is no such thing as a typical family – we all buy differently for example poorer people may spend more of their income on food than the rich; the elderly will have completely different buying patterns than the youngThe items in the basket change all the time - new things such as computers etc have to be added. As well as adding new items government also rebases the RPI from time to timePrices vary from place to placeBuying habits change over time so weightings need to be adjustedA large part of the RPI is the price of housing however this changes according to changes in interest rates – this can distort the RPI figure

Consumer Price Index (CPI)Another price index introduced by the government in recent years is the CPIOne of the reasons that the UK government started to use the CPI as well as the RPI is that it removes a couple of the problems we just discussedIt does not include spending by the elderly and does not include spending on housing and so it is seen as a truer measure of inflationThe Government uses these indices to work out how much it should pay in benefits to the elderly, to the poor, in pensions, tax allowances etcThese benefits will have an effect on people’s incomes and therefore what they spend which in turn will have an affect on the prices of goods (supply and demand!!)This is why people say that the price rises reported by changes in the RPI are overstated (are larger than they should be) and the CPI is better.Also other European countries use the CPI so it is a good way of comparing inflation from country to country

Why does government want to control inflationWhat does this diagram illustrate?

Why does government want to control inflation

What does this diagram illustrate?A rise in prices (inflation) pushes workers to demand higher wages which pushes up production costs which are then passed onto consumersAgain higher prices lead to workers demanding higher wages which pushes up production costs which pushes up pricesThis become a vicious cycle where prices keep getting pushed up

The problems caused by inflationInflation is unfair to creditors (people who are owed money)

If money is lent at a fixed interest rate and prices start to rise the value of the interest paid will fallMoney used to repay the loan will be worth less than at the time it was borrowed

Inflation is unfair on saversThe value of people’s savings will fall in times of inflation unless the interest rates are above the rate of inflationSavers will be put off saving

Inflation causes a fall in investmentBusinesses will not invest if there is uncertainty about prices – if they can’t forecast the costs or the revenues of a project they may be reluctant to investUncertainty leads to less investment which will mean less growth in production and less growth in employment

The problems caused by inflationInflation may cause industrial unrest

Workers may ask for rises in wages to make up for the rise in cost of livingThe rise they ask for may be to cover the increase in prices they see today and in addition what they expect in the future (if they have seen continual rise in inflation)If wages increase firm’s costs go up and their prices will increase leading to further inflation – this is known as wage-price spiralIf employers try to resist increasing wages this may lead to industrial action (strikes etc)

Inflation may increase imports and decrease exports

If prices are rising a country may become uncompetitive internationally leading to a decrease in exportsIf prices are lower in other countries imports will increase – firms will always try to buy the cheapest inputs to keep their costs down so they may buy these from abroad

The problems caused by inflationInflation could become hyperinflation

If inflation starts to rise rapidly people may lose faith in money – it becomes worthlessBy the end of 1923 the value of the German Mark was halving in value every hourThe price of a newspaper reached 20,000 million MarksThis has happened in other countries such as Argentina and Israelhttp://www.bankofengland.co.uk/education/inflation/map/map.htm

The causes of inflationCost push inflation

When a factor of production increases in price the cost of production increases which pushes up the price of the good or service e.g. oil or wages

Demand-pull inflationWhen supply cannot keep up with demand for goods and services prices will be pushed up

Rapid increases in the money supplyMoney supply is the total amount of money in the economyIf people/businesses have more money they will demand more goods and servicesIncreases in demand will push prices up

Government policies to deal with inflationThe correct policy to deal with inflation will depend on what is causing itMonetary policy (changing interest rates by the central bank)

Government can reduce consumer and business spending by increasing the interest rateThe cost of borrowing increases so less is borrowedThe problem is that if people stop spending and businesses stop investing this will have a negative effect on growthIn the UK the Bank of England’s MPC are in charge of monetary policy

Fiscal policy (government spending or taxes)Government can stop spending so muchIt can also raise taxes so consumers have less income to spend which would reduce consumer demandThe problem is that this could cause unemployment – as demand for goods decreases demand for labour will decrease

Monetary policy is the main tool used to fight inflation

Research time!INDIVIDUAL WORK!!Do some research on Balance of Payments (BoP) in the UKAreas of research

Definition of BoPHow is it measured?What affects the Balance of PaymentsDoes the UK have a surplus, balance or deficit?Why does it have this?What is the UK doing to improve its BoPWho are the UK’s trading partnersWhat does it export/import most?

Make notes for your folders

Balance of Payments

GCSE Yr11 Econ

What is the Balance of Payments? The balance of payments (BoP) records the many financial transactions that are made between consumers, businesses and the government in the UK with people across the world. The BoP is Exports minus ImportsThe BoP figures tell us about how much is being spent by British consumers and firms on imported goods and servicesIts also tells us how successful UK firms have been in exporting to other countries and markets.It is an important measure of the relative performance of the UK in the global economy (the 4th Macroeconomic objective)

The importance of exports for the economy Why is the export sector of the economy vital for the UK? GDP: An increasing share of Britain’s national output is exported overseas as the nation becomes more integrated into the global economy.

If British companies can successfully sell goods and services overseas, the rise in exports boosts national income and will help reduce unemployment.

Manufacturing industry: Export sales are particularly important for manufacturing industry

exports are over fifty per cent of total production. Thousands of jobs depend directly on the performance of the export sector and

even more are affected in industries that supply materials to the manufacturing industry.

Regional economic health: The relative success of failure of export industries is important for certain regions of the UK.

When export sales dip, output, employment and living standards come under threat and threaten to widen the existing north-south divide.

The importance of exports for the economy The UK has a deficit on its BoPThe UK has a surplus on trade of services (invisible trade)This surplus is not big enough to make up for the deficit on the trade of goods (visible trade)Overall it imports more than it exports

Reasons for the UK deficit?This is partly because British people have a ‘high propensity to import’ which means they really like importing foreign goods

When incomes are high consumer demand is strong, the volume of imported products grows quickly so during a boom or recovery the BoP may get worse

This means that when income falls (during a recession) the BoP may improve

Long-term decline in the capacity of manufacturing industry because of de-industrialisation

There has been a shift of manufacturing production to lower-cost emerging market countries and then export products back into the UK.

Many UK businesses have out-sourced assembly of goods to other countries whilst retaining other aspects of the supply chain such as marketing and research within the UK.

In the UK North Sea Oil and Gas production has fallen and so there has been a sharp rise in imports of oil and gas

Does it matter if exports are falling?Here are some of the main effects of a fall in export sales: Reduction in GDP: A decrease in exports means less income flowing into the countryLost jobs: There will be a loss of employment if exporting industries require less labour and if UK businesses lose market share and output to cheaper imports from overseas. Dip in business confidence and investment: exporting companies will lose confidence if their overseas orders are decreasing. They will be put off investment in future growthReductions in inflationary pressure: If exports fall, GDP will fall and so will price levels Overall, a decline in exports will leave the economy with spare productive capacity – resources that they are not using such as unemployment unless extra spending on goods and services can be found in other parts of the economy.

What can be done to improve the BoP?Encourage consumers to buy British – the UK government can support UK advertising campaigns and encourage public broadcasting companies like the BBC to produce programmes e.g. cookery programmes where chefs buy local and BritishIncrease productivity so that manufacturing firms become more competitive

Incentives like grants or tax relief to encourage development in areas where employment is low

Tax relief on research and development to help improve innovation of products and processes

Reduce or remove laws that protect workers such as ‘unfair dismissal’ so that firms can hire and fire more easily

All of these things are called supply side policies – they improve the productivity of the economy (allow the supply to increase hence supply side)

Encourage research and development into alternative fuels and drilling techniques so that oil and gas exports can be reduced

For example fracking is a new way of getting gas that would increase the availability of gas in the UK and reduce imported gas

Wind turbines or Solar panels may reduce electricity imports

Government Policies

Policies used to achieve the 4 macroeconomic objectives

Fiscal policyFiscal Policy is taxation or government spendingGovernment can use taxation to change consumer spending (C) If they can increase C they can increase aggregate demand (AD) and maybe help the economy out of recessionIf AD increases then so does GDP (growth)How can they use taxation to increase consumer spending?If people have more disposable income they can spend moreIf the government decreases income taxes there will be more disposable income and therefore they can spend moreThe other tax they can reduce is VATIf VAT is reduced then goods will cost less and people can spend moreFiscal policy could also be used to cut back on spending that is causing inflation but they don’t often do this; they use monetary policy to do that (later)

Aggregate Demand (AD) is the total demand in the economy. AD = GDP

Fiscal policyGovernment spending is also part of ADIf they increase their spending then G will increase and so will ADThat means more growthThe problem with the spending is that the money needs to come from tax or borrowingIf they tax more they will reduce spendingIf they borrow more they will get into debtIn the UK they didn’t want to use government spending to get out of the recession because the country was already in so much debt Aggregate Demand

(AD) is the total demand in the economy. AD = GDP

Monetary PolicyMonetary policy is controlling interest ratesMonetary policy is traditionally used to control inflationIf AD increases then prices go up and so we get inflationInflation reduces the value of money so the Bank of England tries to control it and keep it around 2% It does this by putting the interest rates up and downIf the interest rates go up then consumer spending will go downThis is because their disposable incomes will be less; it will cost them more to use their credit cards or to get loans and mortgage payments will increaseIf their spending decreases then so will inflationThe problem with increasing interest rates is that the cost of borrowing to businesses increases and so they may decide to put off investingThis will affect the long term growth of the economy

Monetary PolicyIf the interest rates go down then consumer spending will go upThis is because their disposable incomes will be increase; it will cost them less to use their credit cards or to get loans and mortgage payments will lessIf their spending increases then so will inflationSo if inflation is getting too low (and growth is very slow) the Bank of England may lower interest ratesThis only really works if consumers have confidence in their futureOtherwise they may decide to save any extra income they have

Supplyside policiesSupplyside is all about increase how much an economy can supply or produceThis is called an economy’s productive potentialIf it can produce more it can grow more in the futureSupplyside policies are used to get long term growth Government cannot really do much directly. It is really up to businessesIt can create the right conditionsThere are two ways to increase the country’s productive potential

1. Increase the quantity of factors of production

2. Increase the quality of factors of production

Supplyside policiesThe main way of increasing the number of factors of production is to increase the number of people in your workforceThis can be done by allowing immigrationOr by helping the long term unemployed back to workThe government has just announced that it will make those that are on long term unemployment benefits to do community service work and go to the job centre to look for jobs every dayGovernment is also trying to make it easier for firms to hire more people by changing some of the laws that make firm’s nervous to hire such as ‘unfair dismissal’

Supplyside policiesThe main way of increasing the quality of factors of production is to invest in training and developmentGovernment won’t do this directly but they can encourage firms to do it by giving them tax reliefThey can also encourage firms to invest in research and development so that they can find ways of improving processesThis will also allow firms to innovate and bring new products to market

Supplyside policiesOne way that government can directly help the country increase its productive potential is to invest in new infrastructureInfrastructure is roads, airports, sea ports, trains and train networks, communications networks etcIf there is good infrastructure goods and services can be moved around the countryFor example if companies can easily get their goods to airports or sea ports because government has invested in high speed trains or a good road network they can then exports and increase their sales

If they increase their sales this is money coming into the country (an increase in GDP) which helps the government achieve one of their macro objectives (growth)

At the same time exports are increasing so the balance of payments is improving

Supplyside policiesThe current UK government wants to build a new rail network called HS2 which will link major cities throughout the UKThe UK is already connected to Europe by train but the network within the country is quite old and slowThere are social benefits (private benefits plus external benefits)What do you think these are?

Businesses can get their products to market much faster and therefore sell more

Businesses get better and quicker access to European markets and other international markets (if it links with airports) – sell more

If businesses can sell more this will lead to an increase in GDP

If businesses can export more there will be an improvement on the balance of payments

Individuals could live in one city and work in another giving labour mobility - if there are jobs available but not in your area you can find an alternative more easily – leads to less unemployment

Overall the productive potential of the country is increasing

Supplyside policiesIn the short term there will be very high social costs

It will be very expensive to build and use tax money that might be used to build hospitals or other infrastructure

The railway lines will be built through land where there is housing that will need to be demolished and countryside that is currently unspoilt

There will be additional pollution (negative externality)

Should they go ahead?The government will need to see if the social benefits outweigh the social costs before going ahead It is likely that the short term costs will be higher than the short term benefits but in the long term the benefits will be much higher and this project will increase the productive potential of the country and therefore increase long term GDP (Growth is the most important objective of the country)

Market Failure

Learning Objective:To understand the different types of

economiesTo gain a general understanding of the

different types of market failure

Learning Outcome / Success CriteriaName the different types of market failureGive examples of the different type of market

failure

What do you know about the different types of economies?

Two main systems today Free market Mixed economy

Free market Economic activity occurs through

private business and private individuals

Businesses exist to make profit Competition helps to keep prices

low and quality high Consumers can buy whatever

they want if they have the money Governments exist but are more

concerned with making sure the law is complied with

Free market economy – a system where all economic decisions are taken by private individuals

Drawbacks of a free market economy? Some businesses may monopolise the

market and not provide low prices and high quality

Consumers may not be able to afford vital goods (poverty and inequality are more likely)

Mixed Economies Almost the same as a free market

economy but governments take a bigger part

They provide services that are deemed vital like health and education

All developed countries operate as mixed economies

The balance between private business and government differs between countries

Mixed economy – a system that is partly a free market economy but also has government involvement in economic decisions

How could we define the perfect market? A free market that supplies exactly what

consumers demand So market failure can be

1. When the free market fails to provide at all

2. When the free market provides too much

3. When the free market provides too little4. When the free market provides but it

has an effect on a third party that is not involved in the production or consumption (that effect can be good or bad)

On the next slide I am going to show you some examples of market failure

In pairs, I want you to take 10 minutes to Decide what kind of market failure each

one is Think about the reasons why the market

fails E.g. what would make the market fail

to provide?

Market Failure: a failure of the market to allocate resources efficiently

1

2

3 4

So which is number 1? It is a vaccination service It is known as a merit good Merit goods are often services The government thinks that merit goods

provide positive benefits for both the people that use them and society as a whole

Why in this case? They should be consumed to a greater

degree Because the market doesn’t provide enough

(because there is not enough demand) the government has to step in

How can it supply more? It can provide them directly It can subsidise them so that there is no

direct cost to the consumer Why no direct cost? Because they pay indirectly through taxes

Merit goods are products that society values and judges that society should have regardless of whether an individual wants them – they are under consumed by society because the benefits of the good are not fully appreciated by society

Information failure: merit goods Merit goods are products that society values and judges that society should have regardless of whether an individual wants themIt is important to remember that to classify a good as a merit good will require society to make a value judgementThe UK government believes that individuals may not act in their own best interest in part because they do not have the full information on the long term benefits (information failure)Merit goods are an example of partial market failure – where the free market will lead to the provision of a product but in the wrong quantity leading to a misallocation of resourcesGovernment will seek to encourage more consumption of merit goods

Why is this a merit good?If the government didn’t provide schools would everyone pay for it?Maybe you would be too poor to afford it and leave your kids at homeThe market would not provide enough so government has to step in

Education and healthcare in the UK would not be produced in sufficient quantity by a free market because consumers would not want to purchase enough of these services. This is because they may not have enough knowledge to assess the true private benefits.

Private benefit – the benefit to private businesses or individuals

Why are these Merit Goods?

Would government provide or subsidise these services to the same extent?

Some will be more important than others and will gain more funding

Positive externalities

Merit goods tend to have positive externalities - that is they have positive benefits to those not involved in the transaction

The social benefits are greater than the private benefits

In the case of the library the benefit to a person (private benefit) is to become better educated

The external benefits are that the economy may grow because the labour force is better educated and more efficient

The social benefit is both of these put together.

Private benefit – the benefit to private businesses or individuals

Social benefits = private benefits plus external benefits

External benefit– the benefit to the third party not involved

So which is number 2 – over/under provided, 3rd part effects, not provided?

It is fast food It is known as a demerit good The government thinks that demerit goods

are bad for both the people that use them and society as a whole

Why? They should be consumed to a lesser

degree Because the market provides too much

(there is too much demand) the government decides to step in

How can it reduce supply? It could ban them It could educate consumers on the harm Anything else? It could put a tax on them How would that work?

Demerit goods are those products that society deems as bad for you - again a value judgement is being made

Why are these Demerit Goods?

If government chose tax to reduce alcohol consumption would it tax the same % as cigarettes?

Cigarettes may be seen as more harmful than others and have higher taxation

So which is number 3? Over/under provided, 3rd part effects, not provided? It is a factory creating pollution It is known as a negative externality What is the cost imposed on the third party here? The pollution may cause harm to society – the fumes may cause ill health to those that are not

involved in the production When the firm decides how much to provide what will it think about? It is a profit maximiser Costs will be the most important thing – if costs are low profit will be high It only thinks about its private costs; not the cost to society Together all the firms in the market provide too much so the government feels the need to step in What could it do to get the market to supply less (and therefore pollute less)?

Negative Externality: costs imposed on a third party not involved with the consumption or production of the good

What can government do to fix externalities?Regulation – government can set restrictions and inspect to see these are being upheld. If not large fines may be leviedPollution permits – essentially using the market to address the problem rather than through regulation.

Government issues or sells permits to firms allowing them to pollute to a certain limitThis increases their costsBut…they can be traded to reduce the costcreates an incentive to be clean because they can sell on remaining allocation. Firms that pollute will have higher costs than those that are clean

Regulation is the stick and the pollution permit is the carrotDownside –

Both need teams of inspectorsFirms may move to countries that do not penalise e.g. India

Negative externalitiesWhy is this a negative externality?What is the private cost?What is the external cost (the cost to the third party)The social cost is both of these added togetherIn a perfect market the private costs would be the same as the social costsBecause the social cost is larger than the private cost there is market failure

Private cost – the cost to private businesses or individuals

Social costs = private costs plus external costs

External cost– the cost to the third party not involved

Negative externalitiesWhy is this a negative externality?What is the private cost?What is the external cost (the cost to the third party)The social cost is both of these added togetherIn a perfect market the private costs would equal what?They would equal the social costsBecause the social cost is larger than the private cost there is market failure

Negative externalitiesWhy is this a negative externality?What is the private cost?What is the external cost (the cost to the third party)The social cost is both of these added togetherIn a perfect market the private costs would equal what?They would equal the social costsBecause the social cost is larger than (?) there is market failure ? = the private cost

So which is number 4? Over/under provided, 3rd part effects, not provided?

It is a light house It is known as a public good There is a missing market Why would the market not provide it? Watch this mjmfoodie video (3 mins) ..\..\..\..\videos\foodie\micro\Episode 33

- Public Goods (Version 2 - amplified audio) - YouTube.flv

Public Good: goods that would not be provided by the free market

Public goodsPure public goods have three main characteristics:Non-excludability:

The benefits of public goods cannot be confined to those who have paid for itNon-payers can enjoy the benefits of consumption at no financial cost to them

Non-rivalry in consumption: Consumption of a public good by one person does not reduce the availability of a good to othersIn other words, if the good is provided for one person it must be provided for others

Non-rejectableIf a public good is provided, we cannot avoid it

Why would the ‘market for viewing the sunset’ be a missing market?

Why are these public goods?Non-excludablity?Non-rivalrous?Non-rejectable?

Why is this park bench a public good?Non-excludablity?Non-rivalrous?Non-rejectable?

Could we make it into a private good?Watch this video!! ..\..\..\..\videos\public goods\PAY SIT the private bench (HD) on Vimeo.flv

The Welfare Stateand its alternativesGCSE Econ Unit 12

What is the welfare state?This refers to various forms of benefits payments and services which are designed to help those in needThe benefits are paid for by tax revenue collected from the governmentThose who earn higher than average incomes pay a greater proportion of their income as tax than those on below average incomes

Welfare State: financial or practical help for those who need most support

Over 65s can claim if they need help with personal care due to illness or disability

Given to people who have to look after someone with substantial caring needs

Given to families with children under 16

helps with some of the extra costs caused by long-term ill-health or a disability if you’re aged 16 to 64.

Universal Credit will eventually replace:Income-based Jobseeker’s AllowanceIncome-related Employment and Support Allowance; Income Support; Working Tax Credit; Child Tax Credit;Housing Benefit

Benefits of the welfare statePoverty is reduced

Money and help is given to those who cannot work and earn their own income e.g. unemployed, elderly, disabled, retired etc

The poorest members of society avoid falling into absolute poverty

Inequality is reduced The money comes from higher earners in

the form of tax revenue This distributed to the poorest proportion

of the population This should reduce the gap between the

rich and the poor This is seen as ethically correct In addition, societies with more equal

distribution of income suffer fewer social problems e.g. crime

Benefits of the welfare stateOverall health of the population is increased

Everyone in the UK benefits from the welfare state because everyone has access to education and health care

The NHS provides healthcare and medical treatment free of charge (apart from prescription charges)

If healthcare was left to private firms some lower income people may not be able to afford to buy it which would mean their health would suffer

If the population is healthy it is more productive

If it is more productive it creates more income

More income means more GDP = economic growth

The welfare state improves the health of the poorer segments of the population

Downsides (costs) of the welfare stateRemoval of incentives to find work

Some people think that if you give the unemployed benefits that it will remove the incentive for them to work

In some cases the benefits will almost provide the same income as from low paid jobs

It is possible that some will not search for jobs as urgently as if there was no (or smaller) benefits

High Taxation Those in employment on average and above

average incomes will pay a higher proportion of their income in tax than if there was no welfare state

Some believe that this is unfair They believe that this is unfair

Alternatives to the welfare stateIncrease the role of the voluntary sector

Most politicians agree that there should be a welfare state but some argue for reform

The first idea is to get the voluntary sector (charity sector) more involved

Charities in the UK employ over ½ million workersModify the welfare state

Make benefits universal It is expensive to work out who should have and

who shouldn’t have benefits and how much they should have It would be less costly to give to all

Child benefit was once universal but how if one person in the family earns over 50,000 they don’t get it

Have benefits only for those meeting certain conditions Only those who need benefits receive them Saves money but is expensive to administer