Managing the economy

When we start this unit, it is important to recall the basic economic concepts from the previous chapters as well as lessons from O Level tutorials. In particular, do spend some time revising the following topics:
1. Scarcity
2. Opportunity cost
3. Production Possibilities Frontier
4. Factors of production, specialisation and division of labour
5. Objective and value judgements
6. Demand and related elasticity measures
7. Supply and elasticity
8. Price determination and simple curve shifts

Having revised the above, we can go for the topics of discussion for this particular unit- Managing the economy:

1. Measuring the performance of developed and developing countries

– Measuring Economic Growth.
– Measuring Inflation
– Measuring unemployment
– Balance of Payments
– Human Development Index
– Other measures of development

2. Income and wealth

– Circular flow of income
– Wealth and its relationship to income

3. Aggregate Demand

4. Aggregate Supply

5. Determining the price level and equilibrium level of real output

6. Causes, costs and constraints on economic growth

7. Macroeconomic objectives of governments

8. Demand-side macroeconomic policy instruments

9. Supply-side policies

10. Glossary of Unit 2 : Managing the economy

Unit 1 of A level tutorials complete!

Unit: Unit 1( Competitive Markets- How they work and why they fail)


  1. What is the nature of economics?
  2. Production Possibilities Curve – illustrations of various economic concepts.
  3. Specialisation and division of labour
  4. Determinants of Demand
  5. Elasticity of Demand
  6. Determinants of Supply
  7. Determining the Price, Functions of Prices, Consumer/Producer Surplus
  8. Price Changes Explained
  9. Incidence of Taxation and Subsidies
  10. Wage rate determination in labour market
  11. Market Failure
  12. How governments attempt to correct market failure
  13. Government Failure

How governments attempt to correct market failure

When the forces of market fail to allocate resources efficiently, the government may attempt to intervene to correct the market failure. There are several ways in which government can intervene in the market:

Type of Intervention How it works Strengths Weaknesses
Taxation Reduces supply and therefore increases price, to discourage production /consumption of a good that has negative externalities. Works through the price mechanism. Easy to understand. Can be expensive to collect. Difficult to know the correct level of tax to set, as it should equal the external costs (= difficult to measure). Ineffective if PED is inelastic, as tax will have to be very high to reduce equilibrium quantity. Can be regressive.
Subsidy Increases supply and therefore reduces price, to encourage production /consumption of a good with positive externalities. Works through the price mechanism. Easy to understand. Expensive for government — incurs an opportunity cost. Difficult to know correct subsidy to provide as it should equal external benefits. Producers may pocket the money and not increase supply.
State Provision Government directly provides a good or service, funded through tax revenue, in order to provide goods which have positive externalities or are public goods. Increases fairness of access to services such as healthcare and education, which have many positive externalities attached. Without Government provision, public goods wouldn’t be provided. Trustworthy provided with common standards. Expensive for Government — incurs opportunity cost. State monopoly can result in inefficiency (eg through bureaucracy etc). Difficult to maintain consistent standards.
Buffer Stocks Government purchases commodities if a floor price is reached and sells commodities if a ceiling price is reached. Ensures fair income for producers and fair prices for consumers.
  • storage is expensive
  • transport to and from storage is expensive
  • it works only if goods are non-perishable
  • it is nearly impossible to ensure that the amount kept in storage will equal the amount required for release in the future to lower prices
Regulation Government imposes rules regarding the production, sale or use of a good/service, and backs this up legally by fines/ prison sentences etc. Aims to tackle negative externalities. Easy to understand and often easy to monitor/police. Expensive to monitor/police. Firms may ignore fines if they are not large enough. Can be anti competitive. Often difficult to ‘pin the blame’ on the appropriate person, therefore unfair.
Pollution Permits An efficient amount of pollution is agreed, and a corresponding number of permits released — these can be traded amongst firms so that low polluters can sell to high polluters and make a profit. Aims to tackle negative externalities. Uses the market mechanism, therefore efficient. Requires little Government intervention, therefore cheap to run. Difficult to set correct amount of pollution and therefore right number of permits.
Extended Property Rights Aims to identify who is responsible for paying for external costs, therefore reducing negative externalities. The economist Ronald Coase argued that it didn’t matter whether the producer or the consumer took responsibility — either would be an efficient outcome. Once property rights are allocated, no more Government intervention needed in theory, therefore cheap. Difficult to allocate property rights when they have never existed before. Some property rights cannot be allocated, eg carbon emissions cause global warming, but no-one ‘owns’ the world and it would be
politically undesirable for this to happen.

Market Failure

What is market failure?

When the market forces of demand and supply fails to allocate resources efficiently, we say that there is market failure.

Why do markets fail?

Negative externalities (or external costs) exist when the social costs of an economic action are greater than the private costs. For example, a toy manufacturer located on the banks of a river will incur a number of private costs of production (eg raw materials, labour, running machinery etc)
but may also impose costs on third parties, such as noise from delivery lorries and an ugly factory affecting the quality of life of local residents or pollution being pumped into the river. Social costs = private costs + external costs.
Positive externalities (or external benefits) exist when the social benefits of an economic action are greater than the private benefits. For example, the education received by a child means that he or she can get a job which pays a reasonable income (ie there is a private benefit to education); however, that child’s education may also benefit wider society if he or she become a doctor and is able to treat people so that they can return to work (ie there is also a social benefit). Social benefits = private benefits + external benefits.

Cost benefit analysis (CBA) is an investment appraisal tool that applies the externalities idea. Major projects, such as staging the London 2012 Olympics, or the building of a new motorway, are often controversial. To decide whether a project should go ahead or not, planners work out the private and external costs (to give social costs), and the private and external benefits (to give social benefits). If social costs exceed social benefits, then the project shouldn’t go ahead. If social benefits exceed social costs, then the project might go ahead. In practice, however, it is very difficult to value external costs and benefits because different people have different opinions as to their value (ie it can be normative). It is also very costly to undertake a CBA. Finally, politicians may adopt rent-seeking behaviour, where they decide to press ahead with a project where social costs are high because it might win their party votes.

Public goods
Non-rival means that consumption of a good/service does not prevent another person from also
consuming that good/service, eg the provision of a streetlight demonstrates non-rivalry, because if one person uses the light provided by the streetlight it does not prevent another person from also benefiting. However, if a person eats a chocolate bar, then someone else cannot also eat the same chocolate bar.
Non-excludable means that once a good is provided, it is impossible to stop people from using it,
eg once a lighthouse is provided, then ships at sea cannot be prevented from benefiting from it.
However, if a car manufacturer provides a new model of car, people can be excluded from purchasing
one if they do not have enough disposable income with which to buy the car.
Goods that are both non-rival and non-excludable are called public goods. Goods that are rival and
excludable are private goods. Goods that are either non-rival or non-excludable but not both are
quasi-public goods.
Public goods have to be provided by the government, because since people cannot be prevented from using them, no-one has any incentive to pay to provide them as they cannot make a profit. Thus there is market failure. People who use public goods without paying for them are known as free-riders.

Imperfect information
For markets to work, there needs to be perfect and symmetric information ie consumers and producers have the same level of knowledge about the products, and they know everything there is to know about them. In many cases, however, information may be asymmetric (producers know more than consumers) or incomplete/imperfect. In these situations, we have market failure. In the private healthcare market, doctors know more than patients about healthcare and treatments (asymmetric information). There is an incentive, therefore, for doctors to prescribe more expensive treatment than is necessary in order to increase their profits. This is an inefficient use of resources. Many consumers in the healthcare market take out insurance to help pay for treatment; this, however, leads to a problem of moral hazard, where they take more risks and therefore require more treatment because they are insured. Again, this is a consequence of asymmetric information in the market where consumers know more than insurers about their intended future actions.
In many markets, such as the tobacco, alcohol or pensions markets, providers of these goods
and services often withhold information deliberately from consumers. For example, many tobacco
companies knew of the link between tobacco and lung cancer before consumers were aware of it,
and continued to advertise tobacco as being ‘healthy’ and ‘sociable’, leading to over-consumption of
tobacco, and therefore market failure. In the pensions market, many consumers do not understand
the workings of the pensions market, and that the type of fund into which they pay money may
result in a loss of money rather than a gain, should stock markets fall. Thus, consumers’ information
is incomplete, and an inefficient market outcome results.

Labour immobility
The labour market is not very efficient, and market failure results from the inability of workers to easily move between jobs. There are a number of reasons for this. Geographical immobility refers to the inability of workers to move around the country in search of work. This may be due to the high percentage of home ownership in the UK (rather than rented accommodation like in continental Europe) and the lengthy process required to sell and buy a house. High UK house prices also prevent people from moving. It may also be due to social reasons, such as not wanting to move away from family or not wanting to uproot children from good schools. The UK government provides housing subsidies for Key Workers (nurses, teachers etc) in areas where house prices are high, but many of the available homes are in undesirable areas and waiting lists are long. Occupational immobility refers to the inability of workers to move between jobs due to lack of appropriate skills or training. As the economy has shifted from having a manufacturing base to a service-sector base, many low-skilled manual workers have found themselves without jobs. Schemes such as the government’s New Deal for Labour have tried to tackle this by providing training programmes and courses, but many people cannot afford to spend their time in training rather than work.

Commodity markets
These are the markets concerned with raw materials, such as precious metals and minerals, and agricultural products. Agricultural markets in particular are prone to strong fluctuations in prices, as supply can be unpredictable (owing to the weather and crop diseases). There is also a time-lag problem, owing to the fact that crops can take up to a year to grow and animals several years to raise meaning that farmers have to base their decisions on how much to plant or raise, and therefore sell in the future, based on current prices. So, if the price of wheat is very high this year, farmers will plant large wheat crops for reaping next year, but this increased supply will force down the market price, which in turn encourages them to plant less, thus reducing supply and forcing prices back up. These fluctuating prices are bad for producers, because it leads to unstable income, and also bad for consumers, for whom many of these goods are necessities.

Governments can tackle these problems in a number of ways. Firstly, they could introduce a minimum price, where goods cannot be sold at a price below this. Minimum prices are set above the market price. This means that supply will exceed demand, and so there will be a glut or surplus.
Secondly, they could use a buffer stock, which entails a price ceiling and a price floor. If the price of the commodity drops too low (probably through high supply), then the government or buffer stock
authority purchases large quantities of the good and stores it, in order to reduce the supply available
to the market and raise the market price. If the price becomes too high, the government or buffer
stock authority release the good onto the market from storage, thus increasing supply and lowering
price. However, there are a number of problems with buffer stock schemes:
• storage is expensive
• transport to and from storage is expensive
• it works only if goods are non-perishable
• it is nearly impossible to ensure that the amount kept in storage will equal the amount required
for release in the future to lower prices (many buffer stock schemes end up storing too much, creating butter mountains, grain mountains and wine lakes).