Microeconomics

Links to each Chapter in this Document:

1.1 Competitive markets: Demand and supply

1.2 Elasticity

1.3 Government Intervention

1.4 Market Failure

1.1 Competitive markets: Demand and supply

A) Markets

1) Outline the meaning of the term market.

Any kind of arrangement where buyers and sellers of goods, services or resources are linked
together to carry out an exchange.

B) Demand and Supply

Law of Demand

2) Explain the negative causal relationship between price and quantity demanded.

● Law of demand - as the price of the good increases, quantity demanded falls; as the
price falls, quantity demanded increases
● The higher the price of a good, the less of it consumers are willing and able to buy; as
the price falls, the good becomes more affordable, and consumers are likely to want
and be able to buy more of it.
● since marginal benefit falls as quantity consumed increases, the consumer will be
induced to buy each extra unit only if its price falls.

3) Describe the relationship between an individual consumer’s demand and market

demand.

● Different consumers have different demand curves

● Market demand is the sum of all individual demands for a good

The Demand Curve

4) Explain that a demand curve represents the relationship between the price and the
quantity demanded of a product, ceteris paribus.

The demand of an individual consumer indicates the various quantities of a good (or
service) the consumer is willing and able to buy at different possible prices during a
particular time period, ceteris paribus.

The non-price determinants of demand (factors that change demand or shift the
demand curve)

5) Explain the six factors that may shift demand.

1. Income in the case of normal goods - A normal good is a good for which demand for it
increases in response to an increase in consumer income. An increase in income leads to a
rightward shift in the demand curve, and a decrease in income leads to a leftward shift.

2. Income in the case of inferior goods - An inferior good is a good for which the demand
falls as consumer income increases. An increase in income leads to a leftward shift in the
demand curve and a decrease in income produces a rightward shift.

3. Tastes

4. Price of substitute goods

5. Price of complementary goods

6. Demographic changes - If there is an increase in the number of buyers (demanders),

demand increases and therefore the market demand curve shifts to the right

Movements along and shifts of the demand curve

6) Distinguish between movements along the demand curve and shifts of the demand
curve and draw diagrams to show the difference between movements along the demand
curve and shifts of the demand curve.
 ● Whenever the price of a good changes, ceteris paribus, it leads to a movement along
the demand curve. This is referred to as an increase/decrease in quantity demanded.
● Any change in a non-price determinant of demand results in a shift in the entire
demand curve. This is called a change in demand

The law of supply

7) Explain the positive causal relationship between price and quantity supplied.

● The law of supply - as the price of the good increases, the quantity of the good
supplied also increases; as the price falls, the quantity supplied also falls
● The supply curve slopes upward - Higher prices generally mean that the firm's profits
increase, and so the firm faces an incentive to produce more output. Lower prices
mean lower profitability, and the incentive facing the firm is to produce less.

8) Describe the relationship between an individual producer’s supply and market

supply
 ● Different individual firms have different supply curves.
● Market supply is the sum of all individual firms’ supplies for a good.

The supply curve

9) Explain that a supply curve represents the relationship between the price and the
quantity supplied of a product, ceteris paribus.
The supply of an individual firm indicates the various quantities of a good a firm is willing
and able to produce and supply to the market for sale at different possible prices, during a
particular time period, ceteris paribus.

The non-price determinants of supply (factors that change supply or shift the supply
curve)

10) Explain the 9 factors that can change supply.

1. Cost of factors of production

If the price of a factor of production rises, production costs increase, production becomes less
profitable and the firm produces less; the supply curve shifts to the left, vice versa

2. Technology. A new improved technology lowers costs of production, thus making

production more profitable, so the supply curve shifts to the right.

3. Prices of related goods: competitive supply

Competitive supply of two or more products refers to production of one or the other by a
single firm; the goods compete for the use of the same resources, and producing more of one
means producing less of the other.
For example, a farmer, who can grow wheat or corn, chooses to grow wheat. If the price of
corn increases, the farmer may switch to corn production as this is now more profitable,
resulting in a fall in wheat supply and a leftward shift of the supply curve of wheat.

4. Prices of related goods: joint supply

Joint supply of two or more products refers to production of goods that are derived from a
single product, so that it is not possible to produce more of one without producing more of
the other. For example, butter and skimmed milk are both produced from whole milk; petrol
(gasoline), diesel oil and heating oil are all produced from crude oil. This means that an
increase in the price of one leads to an increase in its quantity supplied and also to an increase
in supply of the other joint product(s).

5. Producer (firm) expectations.

If firms expect the price of their product to rise, they may
withhold some of their current supply from the
market (not offer it for sale), with the expectation
that they will be able to sell it at the higher price
in the future; in this case, a fall in supply in the
present results, and hence a leftward shift in the
supply curve. If the expectation is that the price of
their product will fall, they increase their supply in
the present to take advantage of the current higher
price, and hence there is a rightward shift in the
supply curve.

6. Taxes (indirect taxes or taxes on profits).

Firms treat taxes as if they were costs of production.
Therefore, the imposition of a new tax or the
increase of an existing tax represents an increase in
production costs, so supply will fall and the supply
curve shifts to the left. The elimination of a tax
or a decrease in an existing tax represents a fall in
production costs; supply increases and the supply
curve shifts to the right.

7. Subsidies
The introduction of a subsidy or
an increase in an existing subsidy is equivalent
to a fall in production costs, and gives rise to a
rightward shift in the supply curve, while the
elimination of a subsidy or a decrease in a subsidy
leads to a leftward shift in the supply curve.
8. The number of firms.
An increase in the number of firms producing the good increases supply and gives rise to a
rightward shift in the supply curve; a decrease in the number of firms decreases supply and
produces a leftward shift.

9. ‘Shocks’, or sudden unpredictable events.

Sudden, unpredictable events, called ‘shocks’, can
affect supply, such as weather conditions in the case
of agricultural products, war, or natural/man-made
catastrophes. RWE - the Louisiana oil spill in
2010 resulted in a decrease in the supply of locally
produced seafood.

SS TT CC JEN

Movements along and shifts of the supply curve

11) Distinguish between movements along the supply curve and shifts of the supply
curve, and draw diagrams to show the difference between movements along the supply
curve and shifts of the supply curve.

● Movements along a supply curve can occur only as a result of changes in price. This
is called a change in quantity supplied.
● If there is a change in a non-price determinant of supply, supply will increase or
decrease, and the entire curve will shift to the right or to the left. This is called a
change in supply

C) Market Equilibrium
Equilibrium and changes to equilibrium

13) Explain, using diagrams, how demand and supply interact to produce market
equilibrium.

● Market equilibrium - When quantity demanded is equal to quantity supplied - the

forces of supply and demand are in balance, and there is no tendency for the price to
change.
● When there is a surplus, there will be a downward pressure on the price. The price
will keep falling until it reaches the point where quantity demanded is equal to
quantity supplied, and the surplus is eliminated.
● When there is a shortage, there will be an upward pressure on price. The price will
keep increasing until the shortage is eliminated; this will happen when quantity
supplied is exactly equal to quantity demanded.

14) Analyse, using diagrams and with reference to excess demand or excess supply, how
changes in the determinants of demand and/or supply result in a new market
equilibrium.

Example explanation for (a) increase in demand: D1 intersects S at point a, resulting in

equilibrium price and quantity P1 and Q1. a change in a determinant of demand that causes
the demand curve to shift to the right from D1 to D2 (for example, an increase in consumer
income in the case of a normal good). Given D2, at the initial price, P1, there is a movement
to point b, which results in excess demand equal to the horizontal distance between points a
and b. Point b represents a disequilibrium, where quantity demanded is larger than quantity
supplied, thus exerting an upward pressure on price. The price therefore begins to increase,
causing a movement up D2 to point c, where excess demand is eliminated and a new
equilibrium is reached. At c, there is a higher equilibrium price, P2, and greater equilibrium
quantity, Q2, given by the intersection of D2 with S.

D) The role of the price mechanism

Resource allocation

15) Explain why scarcity necessitates choices that answer the “What to produce?”
question.
There are limited amounts of resources, so we need to make choices on how to best allocate
resources to what to produce. How does a society make a choice about where to be on its
PPC? Who decides, and how is this decision carried out? In a market economy, it is simply
prices in free markets, resulting from the interactions of demanders and suppliers, which
make the decisions and carry them out.

16) Explain why choice results in an opportunity cost.

Choices involve an opportunity cost because of foregone (or sacrificed) alternatives that
could have been chosen instead.

17) Explain, using diagrams, that price has a signalling function and an incentive
function, which result in a reallocation of resources when prices change as a result of a
change in demand or supply conditions.

● Invisible hand - When markets operate under competitive conditions, market demand
and market supply, composed of numerous individual demanders and suppliers,
determine equilibrium prices and quantities for goods. This market mechanism,
working through prices, is known as the invisible hand of the market. The invisible
hand succeeds in co-ordinating the buying and selling decisions of thousands or
 millions of decision makers in an economy without any central authority. The "what
to produce" question of resource allocation is answered because firms produce only
those goods consumers are willing and able to buy, while consumers buy only those
goods producers are willing and able to supply.
● As signals, prices communicate information to decision-makers.
● As incentives, prices motivate decision-makers to respond to the information.

Suppose consumers decide they would like to eat more strawberries because of their health
benefits (a change in tastes); demand increases and the demand curve shifts to the right from
D1 to D2 in Figure 2.16(a). At the initial price, P1, this results in a shortage equal to the
difference between Q2 and Q1: the quantity demanded Q2, due to the increase in demand to
D2, is larger than quantity supplied, Q1. The price of strawberries therefore begins to rise,
and will continue to rise until the shortage has disappeared. This happens at price P2 and
quantity Q3, given by the point of intersection of the supply curve with the new demand
curve, D2. What has happened? The new, higher price signalled or conveyed information to
producers that a shortage in the strawberry market had emerged. The increase in price is also
an incentive for producers to increase the quantity of strawberries supplied; at the higher
price, strawberry production is more profitable, so producers move along the supply curve
from point A to point C, increasing quantity supplied from Q1 to Q3. But the new, higher
price is a signal and incentive for consumers: it signals that strawberries are now more
expensive, and is an incentive for them to buy fewer strawberries. They therefore move along
the new demand curve from B to C, buying fewer strawberries than at the original price P1
(Q3 is smaller than Q2). The increase in the price of strawberries resulted in a reallocation of
resources. More resources are now allocated to strawberry production.

E) Market Efficiency

Consumer Surplus

18) Explain the concept of consumer surplus.

 ● Consumer surplus is defined as the highest price consumers are willing to pay for a
good minus the price actually paid (the price actually paid is determined at the market
equilibrium by supply and demand).
● Consumer surplus represents the difference between total benefits consumers receive
from buying a good and the price paid to receive them.

19) Identify consumer surplus on a demand and supply diagram.

Producer Surplus

20. Explain the concept of producer surplus.

Producer surplus is defined as the price received by firms for selling their good minus the
lowest price that they are willing to accept to produce the good. (the lowest price
that the firm is willing to accept must be just enough to cover its cost of producing each extra
unit; this cost is known as marginal cost)

21. Identify producer surplus on a demand and supply diagram

Allocative Efficiency
22. Evaluate the view that the best allocation of resources from society’s point of view is
at competitive market equilibrium, where social (community) surplus (consumer
surplus and producer surplus) is maximized (marginal benefit = marginal cost).

● Social surplus, defined as the sum of consumer plus producer surplus, is maximized at
the point of competitive market equilibrium.
● If any quantity less than Qe were produced in Figure 2.17. If, say, Qb is produced, the
sum of consumer plus producer surplus would be smaller, as this sum would be equal
to the shaded area between the demand and supply curves only up to output Qb.
● If we interpret the demand curve as a marginal benefit (MB) curve, and the supply
curve as a marginal cost (MC) curve, then market equilibrium occurs where MB =
MC. The equality of MB with MC tells us that the extra benefit to society of getting
one more unit of the good is equal to the extra cost to society of producing one more
unit of the good.
● When this happens, society’s resources are being used to produce the ‘right’ quantity
of the good; in other words, society has allocated the ‘right’ amount of resources to
the production of the good, and is producing the quantity of the good that is mostly
wanted by society.
● This means that markets are achieving allocative (as well as productive) efficiency,
producing the quantity of goods mostly wanted by society at the lowest possible cost.
Society is making the best possible use of its scarce resources.
● To understand this, consider that if MB > MC, then society would be placing a greater
value on the last unit of the good produced than it costs to produce it, and so more of
it should be produced. If MC > MB, then it would be costing society more to produce
the last unit of the good produced than the value society puts on it, and so less should
be produced. If MC = MB, then just the ‘right’ quantity of the good is being
produced.
1.2 Elasticity

A) Price Elasticity of Demand (PED)

Price elasticity of demand and its determinants

1. Explain the concept of price elasticity of demand, understanding that it involves

responsiveness of quantity demanded to a change in price, along a given demand
curve.
● Price elasticity of demand (PED) is a measure of the responsiveness of the quantity of
a good demanded to changes in its price.

2. PED Formula

PED = % change in Qd / % change in price

3. State that the PED value is treated as if it were positive although its mathematical
value is usually negative.

4. Explain, using diagrams and PED values, the concepts of price elastic demand, price
inelastic demand, unit elastic demand, perfectly elastic demand and perfectly inelastic
demand.

● Price elastic - a large responsiveness of quantity demanded due to change in price

● Price inelastic - a small responsiveness of quantity demanded due to change in price
5. Explain the 5 determinants of PED

1. The number of substitutes a good has

The more substitutes a good (or service) has, the more elastic is its demand. If the price of
a good with many substitutes increases, consumers can switch to other substitute products,
therefore resulting in a relatively large drop (large responsiveness) in quantity demanded.

2. The closeness of its substitutes

For example, Coca-Cola® and Pepsi® are much closer substitutes than Coca-Cola and
orange juice; we say that Coca-Cola and Pepsi have greater substitutability. The closer two
substitutes are to each other, the greater the responsiveness of quantity demanded to a
change in the price of the substitute, hence the greater the PED, because it is easier for the
consumer to switch from one product to the other.

3. Degree of necessity - Necessities vs luxuries

The demand for necessities is less elastic than the demand for luxuries.

4. Length of time
The longer the time period in which a consumer makes a purchasing decision, the more
elastic the demand. As time goes by, consumers have the opportunity to consider whether
they really want the good, and to get information on the availability of alternatives to the
good in question.

5. Proportion of income spent on a good

 The larger the proportion of one’s income needed to buy a good, the more elastic the
demand.

6. Explain why PED varies along a straight line demand curve and is not represented by
the slope of the demand curve

On any downward-sloping, straight-line demand curve, demand is price-elastic at high

prices and low quantities, and price-inelastic at low price and large quantities. At the
midpoint of the demand curve, there is unit elastic demand. Therefore, the terms ‘elastic’
and ‘inelastic’ should not be used to refer to an entire demand curve (with the exception of
the three special cases where PED is constant throughout the entire demand curve).
Instead, they should be used to refer to a portion of the demand curve that corresponds to a
particular price or price range.

Applications of price elasticity of demand

8. Examine the role of PED for firms in making decisions regarding price changes and
their effect on total revenue.

● if demand is elastic, a 10% price increase will result in a larger than 10% decrease in
quantity demanded, and a 10% price fall results in a larger than 10% increase in
quantity demanded ->vice versa for inelastic demand
● Therefore, when demand is elastic, an increase in price causes a fall in total revenue,
while a decrease in price causes a rise in total revenue
● Therefore, when demand is inelastic, an increase in price causes an increase in total
revenue, while a decrease in price causes a fall in total revenue.
● Elastic PED (PED > 1): price and total revenue change in opposite directions.
● Inelastic PED (PED < 1): price and total revenue change in the same direction.
● When demand is unit elastic, a change in price does not cause any change in total
revenue.
● Total revenue is at a maximum when price is at the point where demand is unit elastic

9. Explain why the PED for many primary commodities is relatively low and the PED
for manufactured products is relatively high.

● Primary commodities are goods arising directly from the use of natural resources
 ● Many primary products are necessities so more inelastic demand (such as food, oil)
● Manufactured products usually have substitutes so more elastic demand
● Exception: medications are manufactured products,
yet their demand tends to be inelastic because they are
necessities and have no substitutes

Consequences of a low PED for primary commodities:

● Low price elasticity of demand,

together with fluctuations in supply over short

periods of time, creates serious problems for primary
commodity producers, because they result in large
fluctuations in primary commodity prices, and these
also affect producers’ incomes.

● Shifts in the supply curve result in large price

fluctuations when demand is inelastic, and much

milder ones when demand is elastic.

10. Examine the significance of PED for government in relation to indirect taxes.

● Tax revenue is larger when demand is inelastic.

● This result follows from the principle that when demand is inelastic (PED < 1), an
increase in price (here due to the increase in the tax) leads to a proportionately smaller
decrease in quantity demanded, and hence to an increase in total revenue (i.e. tax
revenue).

B) Cross Elasticity of Demand (XED)

Cross price elasticity of demand and its determinants

11. Explain the concept of cross price elasticity of demand, understanding that it
involves responsiveness of demand for one good (and hence a shifting demand curve) to
a change in the price of another good.
Cross-price elasticity of demand (XED) is a
measure of the responsiveness of demand for one
good to a change in the price of another good,
and involves demand curve shifts.

12. Calculate XED using the following equation.

XED = % change in Qd for good X / % change in price of good Y

13. Positive/negative value of XED significance to type of good

Positive XED - Cross-price elasticity of demand for two substitute goods is
positive (XED > 0) because the demand for one good
and the price of the other good change in the same
direction: when the price of one good increases, the
demand for its substitute increases.

Negative XED - Cross-price elasticity of demand for two complement goods is

negative (XED < 0) because the demand for one good
and the price of the other good change in opposite
directions: when the price of one good increases,
the demand for its complement good falls.

14. Explain that the (absolute) value of XED depends on the closeness of the relationship
between two goods.
Given two pairs of substitute goods, the larger the value of XED, the greater the
substitutability between two goods, and the larger the demand curve shift in the event of a
price change. For example, two substitute goods with a XED of + 0.7 are stronger substitutes
for each other than two goods with a XED of + 0.3.

The larger the absolute value of the negative

XED, the greater is the complementarity between two goods, and the
larger is the demand curve shift in the event of a
price change. Two goods with a XED of −0.8 are
stronger complements than two goods with a XED
of −0.5.
Applications of cross price elasticity of demand

15. Examine the implications of XED for businesses if prices of substitutes or

complements change.

1. Substitutes produced by a single business

e.g Coca-Cola and Sprite are both made by the same company so they must think
about whether decreasing the price of one may reduce the demand of the other

2. Substitutes produced by rival businesses

Coca-Cola would be interested in the XED between Coke and Pepsi. A large XED
would mean that if Coca-Cola
dropped its price, Pepsi would suffer a serious drop
in sales, whereas a low XED would mean that Pepsi
would not be seriously affected.

3. Substitutes and mergers between firms

Businesses producing close substitutes
with a high positive XED, might be interested in
merging because that way they would eliminate
the competition between them. For this
reason they might want to know the size of XED.

4. Complementary goods
Knowledge of XED for complementary products is also
useful for business pricing decisions. Products that have
a low absolute value of a (negative) XED are weakly
complementary and will not be of much interest.
However, a high absolute value of a (negative) XED
means that lowering the price of one good can result in
a large increase in demand and sales for the other.
Businesses producing strongly complementary goods
often collaborate.

5. Tax on a Complementary Good

If two goods have a relatively
high XED, a large tax on one could result in a
signifi cant decrease in sales of the other. For example,
increases in gasoline (petrol) taxes can have a large
impact on the demand for large cars.
C) Income Elasticity of Demand (YED)

Income elasticity of demand and its determinants

16. Explain the concept of income elasticity of demand, understanding that it involves
responsiveness of demand (and hence a shifting demand curve) to a change in income.
Income elasticity of demand (YED) is a measure
of the responsiveness of demand to changes in
income, and involves demand curve shifts.

17. Calculate YED using the following equation.

YED = % change in Qd / % change in Income

18.Show that normal goods have a positive value of YED and inferior goods have a
negative value of YED.
YED > 0 Income elasticity of demand is positive
(YED > 0) when demand and income change in
the same direction (i.e. both increase or both
decrease). A positive YED indicates that the good
in question is normal.

YED < 0 A negative income elasticity of demand

(YED < 0) indicates that the good is inferior:
demand for the good and income move in
opposite directions (as one increases the other
decreases).

19. Distinguish, with reference to YED, between necessity (income inelastic) goods and
luxury (income elastic) goods.
YED < 1: Necessities - If a good has a YED that is
positive but less than one, it has income inelastic
demand: a percentage increase in income
produces a smaller percentage increase in quantity
demanded. Necessities are income inelastic goods.
YED > 1: Luxuries - If a good has an YED that
is greater than one, it has income elastic
demand: a percentage increase in income
produces a larger percentage increase in quantity
demanded. Luxuries are income elastic goods.

Exception: What is a necessity and what is a luxury depends on

income levels. For people with extremely low incomes,
even food and certainly clothing can be luxuries.

Exception: As income increases, certain items that used to be

luxuries become necessities. For example, items like
coffee for many poor people in less
developed countries are luxuries, whereas for consumers
in developed countries they have become necessities

Applications of income elasticity of demand

20. Examine the implications for producers and for the economy of a relatively low YED
for primary products, a relatively higher YED for manufactured products and an even
higher YED for services.

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.
Producers interested in producing in an expanding
market may therefore want to know YEDs of various
goods and services.

In contrast to periods of economic growth, if an

economy is experiencing a recession (falling output
and incomes, see Chapter 8), goods and services with
high YEDs (YED > 1) are the hardest hit, experiencing
the largest declines in sales. Products with low YEDs
(YED < 1) can avoid large falls in sales, while inferior
goods (YED < 0) can even experience increases in sales.

As society’s income grows

over time, the demand for primary products/ agriculture grows
more slowly than the growth in income.

By contrast, manufactured products (cars,

televisions, computers, and so on) have a YED that is
usually greater than one (income elastic), so that as
society’s income grows, the demand for these products
grows faster than income.
Many services have even
higher YEDs, so the percentage increase in the demand
for these is much larger.

Therefore, over time, the share of agricultural

output in total output in the economy shrinks,
while the share of manufactured output grows. With
continued growth, the services sector expands at the
expense of both agriculture and manufacturing.

Hence, LEDCs usually

have a large primary sector due to the importance
of agriculture and extractive activities, while
manufacturing and services are far less important

The historical experience shows that

with economic growth, the primary sector becomes
less and less important, and is partly replaced by
manufacturing and services. As the economy grows
further, the relative importance of the primary sector
continues to shrink, and manufacturing becomes
increasingly replaced by services. Thus, while less
developed countries are usually dominated by
the primary sector, more developed countries are
dominated by services.

D) Price Elasticity of Supply (PES)

Price elasticity of supply and its determinants

21. Explain the concept of price elasticity of supply, understanding that it involves
responsiveness of quantity supplied to a change in price along a given supply curve.
Price elasticity of supply (PES) is a measure
of the responsiveness of the quantity of a good
supplied to changes in its price.

22. PES Formula

PES = % change in Qs / % change in price

23.Explain, using diagrams and PES values, the concepts of elastic supply, inelastic
supply, unit elastic supply, perfectly elastic supply and perfectly inelastic supply.
Elastic supply - large responsiveness of quantity supplied due to change in price
Inelastic supply - small responsiveness of quantity supplied due to change in price

24. Explain the 4 determinants of PES.

MAST
1. Length of time
An important factor determining PES is the
amount of time firms have to adjust their inputs
(resources) and the quantity supplied in response to
changes in price. Over a very short time, the firm may
be unable to increase or decrease any of its
inputs to change the quantity it produces. In this
case, supply is highly inelastic. For example, a fishing boat upon
its return from a fishing trip has only so many fish
to supply in the market. Even if the price of fish
rises, there can be no response in quantity supplied.
As the length of time that firms have increases, the
responsiveness of quantity supplied to price changes
begins to rise, and PES increases

2. Mobility of FOP
Another determinant of PES is the ease and speed
with which firms can shift resources and production
between different products. The more easily and
quickly resources can be shifted out of one line
of production and into another (where price is
increasing), the greater the responsiveness of quantity
supplied to changes in price, and hence the greater
the PES.

3. Spare capacity of firms

Sometimes firms may have capacity to produce that is
not being used (for example, factories or equipment
may be idle for some hours each day). If this occurs, it
is relatively easy for a firm to respond with increased
output to a price rise. But if the firm’s capacity is
fully used, it will be more difficult to respond to a
price rise. The greater the spare (unused) capacity, the
higher is PES (the more elastic the supply); & vice versa

4. Ability to store stocks

Some firms store stocks of output they produce but do
not sell right away. Firms that have an ability to store
stocks are likely to have a higher PES for their products
than firms that cannot store stocks.

Applications of price elasticity of supply

25. Explain why the PES for primary commodities is relatively low and the PES for
manufactured products is relatively high.
In general, primary commodities usually have a lower
PES than manufactured products. The main reason
is the time needed for quantity supplied to respond
to price changes. In the case of agriculture, it takes
a long time for resources to be shifted in and out of
agriculture.

Farmers need at least a planting season

to be able to respond to higher prices.

In most areas
there is a limited amount of new land that can be
brought into cultivation.

Under such conditions, what is needed is an increase in

output per unit of land cultivated (crop yields), but this
requires technological change in agriculture, involving
new seeds or other inputs that are more productive, and
takes a great deal of time.

In the case of other primary products, such as oil,

natural gas and minerals, time is needed to make
the necessary investments and to begin production.
Because of the costs involved, firms do not respond
quickly to price increases, and wait for a serious
shortage (excess demand) in the commodity to arise
before they take actions to increase production.

Consequences:
Price inelastic supply (low PES) of primary
products also contributes to price and income
instability for primary product producers, because of
higher price fluctuations
1.3 Government Intervention

A) Indirect Taxes

1. 4 reasons why governments impose indirect (excise) taxes.

1. source of government
revenue

2. method to discourage
consumption of goods that are harmful
for the individual

3. can be used to redistribute

income by focusing on luxury goods

4. method to improve the

allocation of resources (reduce allocative
inefficiencies) by correcting negative
externalities.

2. Distinguish between specific and ad valorem taxes. - Skip

3. Draw diagrams to show specific and ad valorem taxes, and analyse their impacts on
market outcomes.

See TB

4. Discuss the consequences of imposing an indirect tax on the stakeholders in a market,

including consumers, producers, government, society

Consumers - worse off because they are receiving less of the good
and paying more for it.

Producers - worse off because fall in the

price they receive (from P* to Pp), and by the fall in
the quantity of output they sell (from Q* to Qt). These
effects translate into a fall in their revenues
Government - gains revenue

Workers - A lower amount of output, from Q* to Qt, means that

fewer workers are needed to produce it; therefore, the
tax may lead to some unemployment. Workers are
worse off if they become unemployed

Society as a whole - Society is worse off as a result of the tax, because there
is an underallocation of resources to the production of
the good, however the tax may be able to correct negative externalities

B) Subsidies

5. Explain why governments provide subsidies, and describe examples of subsidies.

1. increase revenues to increase/support income of producers

2. make certain goods (necessities) affordable to low-income

consumers.

3. encourage
production and consumption of particular
goods and services (such as merit goods) that are beneficial to consumers and
society

4. can be used to encourage exports

of particular goods

5. support the growth

of particular industries in an economy

6. Subsidies are a method to improve the

allocation of resources (reduce allocative
inefficiencies) by correcting positive
externalities.

6. Draw a diagram to show a subsidy, and analyse the impacts of a subsidy on market
outcomes

7. Discuss the consequences of providing a subsidy on the stakeholders in a market,

including consumers, producers and the government.

Consumers - better off because of the fall in price of the good

from P* to Pc (Figure 4.8) and the increase in quantity
purchased

Producers - better off, because they receive a

higher price (Pp > P*) and produce a larger quantity
(Qsb > Q*), seen in Figure 4.8. The price and quantity
effects translate into an increase in revenues

The government - The government pays the subsidy, which is a burden

on its budget. To obtain the revenues for the subsidy,
the government may have to reduce expenditures
elsewhere in the economy (opportunity costs), or it may have to
raise taxes, or it may have to run a budget deficit

Workers
As output expands from Q* to Qsb, firms are
likely to hire more workers to produce the extra
output, therefore workers who find new jobs are
better off.

Society as a whole
Society as a whole is worse off because there is an
overallocation of resources to the production of the
good; Qsb > Q*.

Foreign producers
If the subsidy is granted on exports (goods sold to
other countries), it lowers price and increases the
quantity of exports. While this is positive for domestic
producers, it is negative for the producers of other
countries who may be unable to compete with the
lower price of the subsidised goods.

C) Price Controls

Price Ceilings

8. Explain why governments impose price ceilings, and describe examples of price
ceilings, including food price controls and rent controls.

9. Draw a diagram to show a price ceiling, and analyse the impacts of a price ceiling on
market outcomes.

See TB

10. Examine the possible consequences of a price ceiling, including shortages, inefficient
resource allocation, welfare impacts, underground parallel markets and non-price
rationing mechanisms.

1. Shortages

2. Non-price rationing
The term ‘rationing’ refers to a method of dividing up
something among possible users. In a free market, this
is achieved by the price system: 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 is
no longer able to achieve its rationing function. Some
demanders willing and able to buy the good at Pc in
Figure 4.12 will go unsatisfied. How will the quantity
Qs be distributed among all interested buyers? This
can only be done through non-price rationing
methods, which include the following:
• waiting in line and the first-come-first-served
principle: those who come first will buy the good
• the distribution of coupons to all interested
buyers, so that they can purchase a fixed amount
of the good in a given time period
• favouritism: the sellers can sell the good to their
preferred customers.

Underground (or parallel) markets

This involves involve
buying a good at the maximum legal price, and
then illegally reselling it at a price above the legal
maximum.

Underallocation of resources to the good

and allocative inefficiency

11. Discuss the consequences of imposing a price ceiling on the stakeholders in a market,
including consumers, producers and the government.

Price Floors

12. Explain why governments impose price floors, and describe examples of price floors,
including price support for agricultural products and minimum wages.

13. Draw a diagram of a price floor, and analyse the impacts of a price floor on market
outcomes.

14. Examine the possible consequences of a price floor, including surpluses and
government measures to dispose of the surpluses, inefficient resource allocation and
welfare impacts.

15. Discuss the consequences of imposing a price floor on the stakeholders in a market,
including consumers, producers and the government.
1.4 Market Failure

The meaning of market failure

Market failure as a failure to allocate resources efficiently

1. Examine the concept of market failure

A failure of the market to achieve allocative efficiency, resulting in an over-allocation of
resources (over-provision of a good) or an under-allocation of resources (under-provision of a
good)

Types of market failure

The meaning of externalities

2. Explain the concepts of marginal private benefits (MPB), marginal social benefits
(MSB), marginal private costs (MPC) and marginal social costs (MSC).

3. Describe the meaning of externalities as the failure of the market to achieve a social
optimum where MSB = MSC.
An externality occurs when the actions of
consumers or producers give rise to negative or
positive side-effects on other people who are not
part of these actions, and whose interests are not
taken into consideration.

If the side effects

on third parties involve benefits, there
arises a positive externality, also known as
external (or spillover) benefit

If they involve costs,

in the form of negative side-effects, there arises a
negative externality, also known as external (or
spillover) costs.

The demand curve is also a ‘marginal benefit

curve’ where marginal benefit is the benefit received
by consumers for consuming one more unit of the
good (see Figure 2.1(b), page 21). Since the benefits
derived from consuming the good go to private
individuals, who are the consumers buying the good,
the demand curve represents marginal private benefits,
shown as MPB

Marginal cost is the cost to producers of producing one

more unit of the good. The supply curve therefore
represents marginal private costs, appearing as MPC

If, however, there is an externality, additional

benefits or additional costs affecting third parties arise,
and the full benefits or full costs to society differ from
the private ones. These involve marginal social benefits
(MSB) that differ from marginal private benefits;
or marginal social costs (MSC) that differ from the
marginal private costs.

Negative externalities of production and consumption

4. Explain, using diagrams and examples, the concepts of negative externalities of

production and consumption, and the welfare loss associated with the production or
consumption of a good or service.
Negative externalities of production refer to
external costs created by producers - usually pollution

For each level of output, Q , social costs of

producing cement given by MSC are greater than the
fi rm’s private costs. - that's why the supply curve is shifted to
the left for MSC -> higher costs means left shift

MSC to the left of MPC

the shaded area represents the

welfare loss arising from the negative production
externality. For all units of output greater than Q opt,
MSC > MSB, -> diagram shows that society would be better off
if less quantity were produced.

The welfare loss is equal to the

difference between MSC and MSB for the amount of
output that is overproduced (Q m – Q opt).
It is a loss
of social benefits due to overproduction of the good
caused by the externality. If the externality were
corrected, so that the economy reaches the social
optimum, the loss of benefits would disappear.

It may
be useful to note that the point of the welfare loss
triangle always lies at the Q opt quantity of output.
(Q opt is where MSB = MSC in all cases)

----------------------------------------------------------------------------------------------------------------
Negative externalities of consumption refer to
external costs created by consumers. Smoking has
external costs that spill over onto society - second-hand smoking
and smoking-related diseases result in higher
than necessary health care costs that are an additional
burden upon society.

MSB to the left of MPB

The welfare (deadweight) loss resulting from negative

consumption externalities is the shaded area in
Figure 5.7(a), and represents the reduction in benefits
for society due to the overallocation of resources to
the production of the good. For all units of output
greater than Q opt, MSC > MSB, indicating that too much
of the good is produced. The welfare loss is equal to
the difference between the MSC and MSB curves for
the amount of output that is overproduced relative
to the social optimum (Q m – Q opt). It represents the
loss of social benefits from overproduction due to the
externality. If this externality were corrected, society
would gain the benefits represented by the shaded area.

5. Define demerit goods

Goods whose consumption creates external costs.
6. Evaluate, using diagrams, the use of policy responses, including market-based policies
(taxation and tradable permits), and government regulations, to the problem of negative
externalities of production and consumption

1. Regulations:
Regulations attempt to achieve one of the
following:
• limit the emission of pollutants by setting a
maximum level of pollutants permitted
• limit the quantity of output produced by the
polluting firm
• require polluting firms to install technologies
reducing the emissions.

The impact is to lower the quantity of the good

produced and bring it closer to Q opt in Figure 5.4 by
shifting the MPC curve upward towards the MSC
curve.2 Pollutant and output restrictions achieve this
by forcing the firm to produce less. Requirements to
install technologies reducing emissions achieve this by
imposing higher costs of production due to the purchase
of the non-polluting technologies.

Two market-based policies: taxes and

tradable permits.

2. Tax
The government could impose a tax on
the firm per unit of output produced, or a tax per unit
of pollutants emitted. In Figure 5.5(a), the tax results
in an upward shift of the supply curve, from S = MPC
to MSC (=MPC + tax). The optimal (or best) tax policy
is to impose a tax that is exactly equal to the external
cost, so the MPC curve shifts upward until it overlaps
with MSC. The new, after-tax equilibrium is given by the
intersection of MSC and the demand curve, D = MPB =
MSB, resulting in the lower, optimal quantity of the good
produced, Q opt, and higher, optimal price, Popt.

Two types of tax - tax per unit output and tax per
unit of pollutants - A tax per unit of
output is intended to work by directly correcting the
overallocation of resources to the good, resulting in
quantity Q opt. A tax per unit of pollutants is intended
to work by creating incentives for the firm to buy fewer
polluting resources (such as fossil fuels), and to switch to
less polluting technologies (alternative energy sources).

Carbon tax is a tax per unit of carbon emissions of fossil fuels.

A tax on carbon (or on emissions generally) has the
effect of creating incentives for producers to reduce
the amount of pollution they create by purchasing
resources that pollute less. This reduces the size of the
negative externality and increases the optimum
quantity of output. A tax on the output of the
polluter does not have this effect; it only reduces the
amount of output produced.

3. Tradable permits
Tradable permits are permits to pollute issued to firms
by a government or an international body. These
permits to pollute can be traded (bought and sold) in a
market. The permits to pollute can be bought and
sold among interested firms, with the price of permits
being determined by supply and demand. If a firm
can produce its product by emitting a lower level of
pollutants than the level set by its permits, it can sell
its extra permits in the market. If a firm needs to emit
more pollutants than the level set by its permits, it can
buy more permits in the market.

RWE: EU emissions tradable permits - 18 euros per tonne of CO2

Evaluation

Advantages of Market-based policies like taxes and tradable permits

1. Both taxes and tradable

permits have the effect of internalising the externality,
meaning that the costs that were previously external
are made internal, because they are now paid for
2. Taxes on emissions are superior
to taxes on output. Taxes on output only provide
incentives to producers to reduce the quantity of
output produced with a given technology and given
polluting resources, while taxes on pollutants provide
incentives to firms to economise on the use of polluting
resources (such as fossil fuels) and use production methods
that pollute less.

3. In the case
of tradable permits and tax on pollutants, the system creates incentives
for firms to cut back on their pollution if they can
do so at relatively low cost. If it is a relatively low
cost procedure for a firm to reduce its pollutant
emissions, it will be in its interests to do so and sell
excess permits, which will reduce externalities. However,
Firms that can only reduce pollution
at high cost will be forced to buy additional permits.

Disadvantages of Market-based policies like taxes and tradable permits

1. It is hard to create an effective tax policy as you need

to it is difficult to design a tax equal in value to the amount
of the pollution. It is difficult to measure the monetary
value of harm done by each pollutant

2. Even if taxes are imposed, some polluting firms

may not lower their pollution levels, continuing to
pollute even though they pay a tax, as some
firms face higher costs of reducing pollution will be less
likely to cut their pollutants, and so will pay the
tax.

3. Tradable permits has same problems of taxes - hard

to set a value a monetary value of harm done by each pollutant
the government
(or international body) to set a maximum acceptable
level for each type of pollutant, called a ‘cap’. This
task demands having technical information on
quantities of each pollutant that are acceptable from
an environmental point of view, which is often not
available. If the maximum level is set too high, it will
not have the desired effect on cutting pollution levels.
If it is set too low, the permits become very costly,
causing hardship for firms that need to buy them.

Advantages of Government regulations

1. Regulations have the advantage that they are simple

compared to market-based solutions, and can be
implemented more easily.

2. Regulations force polluting firms to comply and reduce pollution levels

(which taxes may not always do).

Disadvantages of Government regulations

1. As they do not allow the externality to be
internalised, regulations create no market-based
incentives, and therefore are unable to make
distinctions between firms that have higher or lower
costs of reducing pollution.

2. They are also unable

to provide incentives for firms to use less polluting
resources, and are thus unable to lower the size of
the externality.

3. Finally, there are costs of policing, and there

may be problems with enforcement.

----------------------------------------------------------------------------------------------------------------
-----------

Correcting negative externalities of consumption

To correct we need to get to Qopt

1. Government regulations
2. Negative Advertising - reduces demand
3. Market-based policies - Indirect tax

Evaluation

Taxes
1. indirect taxes are the preferred measure, as they internalise
the externality. Indirect taxes create incentives for
consumers to change their consumption patterns
by changing relative prices

2. One difficulty is measuring the value of the external costs. For example,
for passive smoking, an external cost
created by smokers, There are many
technical difficulties involved in trying to assess who
and what is affected, as well as determine the value of
the external costs, on the basis of which a tax can be
designed.

3. Another difficulty is that many of these demerit goods like oil and cigarettes
have inelastic demand
Advertising

1. Advertising has the advantage

that it is simpler

2. the cost to the government of advertising campaigns, which

are funded out of tax funds, meaning there are less
funds available for use elsewhere in the economy
(there are opportunity costs)

3. This method may not be effective

enough in reducing the negative externality

Regulations

1. regulations (such as prohibiting

smoking in public places) can be very effective
in reducing the external costs of smoking
2. However, they cannot be used to deal with other kinds of negative
consumption externalities. For example, it would
be very difficult to regulate petrol (gasoline)
consumption

Positive externalities of production and consumption

7. Explain, using diagrams and examples, the concepts of positive externalities of

production and consumption, and the welfare loss associated with the production or
consumption of a good or service.

Positive externalities of production refer to

external benefits created by producers.

The underallocation of resources to the production of

a good with a positive production externality leads to
a welfare loss. This loss is equal to the difference between the
MSB and MSC curves for the amount of output that is
underproduced relative to the social optimum
(Q opt – Q m).

MSC is to the right of MPC

----------------------------------------------------------------------------------------------------------------
--------------------------------------------

positive externality of consumption - external benefits are created by

consumers. For example, the consumption of education
benefits the person who receives the education, but
in addition gives rise to external benefits, involving
social benefits from a more productive workforce, lower
unemployment, higher rate of growth, more economic
development, lower crime rate, and so on. Similarly, the
consumption of healthcare services benefits not only
the person receiving the services but also society and
the economy, because a healthier population is more
productive, enjoys a higher standard of living and may
have a higher rate of economic growth.

When there is a positive consumption externality, the

free market underallocates resources to the production
of the good, and too little of it is produced relative to
the social optimum.

The welfare loss arising from a positive consumption

externality is the shaded area in Figure 5.13(a), and is
the difference between the MSB and MSC curves for
the amount of output that is underproduced relative
to the social optimum (Q opt – Q m). It represents the
loss of social benefits due to underproduction of the
good.

MSB is to the right of MPB

8. Define merit goods + 3 reasons for underprovision of merit goods

Goods whose consumption creates external benefits.

The good may have positive externalities. - In this case too little is provided by the
market.

Low levels of income and poverty - Some consumers may want certain goods or
services but
cannot afford to buy them.

Consumer ignorance - Consumers may be better

off if they consume certain goods and services but
they may be ignorant of the benefits, and so do not
demand them. For example, preventive health care
(such as immunisation, annual health check-ups)
can prevent serious diseases, but lack of knowledge
about the benefits may lead consumers to demand
too little of these services.

9. Evaluate, using diagrams, the use of government responses, including subsidies,

legislation, advertising to influence behaviour, and direct provision of goods and
services.

Correcting positive externalities of production

1. Direct gov provision of the good - help with R&D and provide training for workers
2. Subsidy

Evaluation of policies to correct positive

externalities of production

1. Government provision and subsidies are very effective in increasing the quantity
of the
good produced and consumed, and both have the
added advantage of lowering the price of the good to
consumers

2. direct government provision and granting of subsidies

involve the use of government funds that rely on tax
revenues. Governments generally have very many
possible alternative uses for these funds, each of which
has an opportunity cost.

3. Choices of what to subsidize should be made on the basis of economic

criteria, which would specify the amount of social
benefits expected in relation to the cost of providing
them, the objective being to maximise the benefits for
each good and service to be provided or subsidised for
a given cost. However, in practice it is very difficult to
measure the size of the external benefits, and therefore
to calculate precisely which goods and services should
be supported and the level of support they should
receive.

4. In addition direct provision and subsidies

are often highly political in nature, as different groups
compete with each other over who will receive the
most benefits. Governments are often susceptible to
political pressures and sometimes make choices based
on political rather than economic criteria.

Therefore, in the real world it is very unlikely that

governments are able to shift the MPC or MPB curves
by the amount necessary to correct the positive
externalities.
Correcting positive externalities of consumption

1. Direct gov provision of the good - education and health care (merit goods)

2. Subsidy

3. Legislation - many countries have legislation that makes education

compulsory up to a certain age

4. Advertising
The problem of underprovision of merit
goods by the market (defined above, see page 116)
can be addressed by all the methods noted above:
legislation, advertising, direct government provision
and granting of subsidies

Evaluation of policies to correct positive

externalities of production

Government Provision and Subsidies

1. Government provision and subsidies are very effective in increasing

the quantity of the
good produced and consumed, and both have the
added advantage of lowering the price of the good to
consumers

2. direct government provision and granting of subsidies

involve the use of government funds that rely on tax
revenues. Governments generally have very many
possible alternative uses for these funds, each of which
has an opportunity cost.

3. Choices of what to subsidize should be made on the basis of economic

criteria, which would specify the amount of social
benefits expected in relation to the cost of providing
them, the objective being to maximise the benefits for
each good and service to be provided or subsidised for
a given cost. However, in practice it is very difficult to
measure the size of the external benefits, and therefore
to calculate precisely which goods and services should
be supported and the level of support they should
receive.

4. In addition direct provision and subsidies

are often highly political in nature, as different groups
compete with each other over who will receive the
most benefits. Governments are often susceptible to
political pressures and sometimes make choices based
on political rather than economic criteria.

Legislation and Advertising

1. they can have very positive

effects in certain cases (such as legislation requiring
schooling up to a minimum age or advertising on the
importance of good nutrition) (RWE)

2. Sometimes, in other cases they are

ineffective (for example, they cannot on their own
increase consumption of health care services and
education to the optimum level)

3. they have
the further effect of raising the price of the good to
consumers, which may make the good unaffordable
for some consumer groups.

Therefore, legislation and

advertising sometimes can be used more effectively if
they are implemented together with direct provision
and subsidies. A good example is education, where
compulsory schooling up to a certain age (legislation)
goes together with direct government provision.

Lack of public goods

10. Distinguish between public goods (nonrivalrous and nonexcludable) and private
goods (rivalrous and excludable).

Rivalrous: its consumption by one person

reduces its availability for someone else; for
example, your computer, textbook, pencils and
clothes are rivalrous, because when you buy them,
another person cannot buy the same ones; most
goods are rivalrous.

Excludable: it is possible to exclude people

from using the good; exclusion is usually achieved by
charging a price for the good; if someone is unwilling
or unable to pay the price, he or she will not have the
benefit of using it; most goods are excludable.

A private good is rivalrous and excludable.

A public good is non-rivalrous and non-excludable. e.g. police force, national
defence, flood control, non-toll roads, fire protection

11. Explain, with reference to the free rider problem, how the lack of public goods
indicates market failure.

Public goods illustrate the free rider problem,

occurring when people can enjoy the use of a good
without paying for it. The free rider problem arises
from non-excludability: people cannot be excluded
from using the good. Public goods are a type of
market failure because due to the free rider problem,
private firms do not produce these goods (because they cannot make profit): the
market fails to allocate resources to their production.

12. Discuss the implications of the direct provision of public goods by the government.

● direct provision of public goods allows consumers to consume goods that would
otherwise not be provided by firms
Good
1. Resource allocation improves
2. No price exclusion - these goods like education are necessary for all individuals and it is
important that they are provided for free so that everyone can have access
3. All social benefits are likely to be considered - the government unlike the free market tries
to consider what society desires

Bad
1. Opportunity cost because government uses tax revenue to do this(RWE of billions spent on
NHS)
2. Difficult for governments to make good choices on what public good to produce and how
much of it as it is difficult to estimate the expected value of benefits to consumers
3. State run organizations tend to be wasteful/inefficient - because not running themselves for
profit

Possible Solution: encourage private sector to provide these goods

Common access resources and the threat to sustainability

13. Explain, using examples, common access resources.

Common access resources are
resources that are not owned by anyone, do not have
a price and are available for anyone to use without
payment.

Examples - clean air, lakes, rivers, fi sh

in the open seas, wildlife, hunting grounds, forests,
biodiversity, the fertility of the soil that occurs in
nature, open grazing land, the ozone layer, the stable
global climate

14 & 15. Apply the concept of sustainability to the problem of common access resources.
& Examine the consequences of the lack of a pricing mechanism for common access
resources in terms of goods being overused/ depleted/degraded as a result of activities of
producers and consumers who do not pay for the resources that they use, and that this
poses a threat to sustainability.

● Sustainability refers to the ability of something to be maintained or preserved

over time.
 ● The rivalry and non-excludability characteristics of common access resources
pose serious threats to the environment such as environmental degradation
and depletion.
● Rivalry means that consumption by some reduces availability for others.
● Nonexcludability means that consumers and producers use them abundantly
and often overuse them because they have no price due to the lack of a
pricing mechanism

If there is a price mechanism, then if a priced good becomes depleted and more scarce, then
the price will go up. Thus, we will consume less of the good, or technology will come along
to solve the problem.

The problem of common access resources like fish in the sea, is that there is a lack of
ownership rights of common access resources, so we cannot charge fishermen for fishing
fish. There is also an excludability problem, so we cannot prevent them from going and
getting fish.

16. Discuss, using negative externalities diagrams, the view that economic activity
requiring the use of fossil fuels to satisfy demand poses a threat to sustainability.

Sustainability refers to maintaining the ability of

the environment and the economy to continue to
produce and satisfy needs and wants into the future;
sustainability depends crucially on preservation of
the environment over time.

Draw negative externalities of production diagram and explain it

In the negative production externality diagram, the difference between the

MPC and MSC curves can be interpreted as the social
cost arising from the cement factory’s overuse of clean
air, water, sea life and ozone layer on account of its
dependence on fossil fuels; it can also be interpreted
as the cost to society of causing global warming

The burning of fossil fuels creates external costs/negative externalities in terms of

overuse of common access resources.

If it were possible to make the cement factory pay

for the overuse of these resources, the producer would
not necessarily stop its polluting activities entirely,
and would not stop using common access resources.
However, it would stop overusing them, thus leading to
a sustainable use of common access resources.

17. Discuss the view that the existence of poverty in economically less developed
countries creates negative externalities through overexploitation of land for agriculture,
and that this poses a threat to sustainability.

According to the Brundtland Report, poverty

is the most important cause of environmental
destruction, due to the overexploitation by poor people
of their scarce environmental resources.

Poor people lack modern agricultural inputs, and being too poor to
buy inputs that preserve the soil’s fertility, they deplete
the soil’s natural minerals, making soils less productive.

Poor people usually have higher birth rates and higher

population growth, creating pressures for them to open
up new lands for agriculture. With suitable agricultural
land becoming increasingly scarce, they cut down
forests (deforestation) in search of new farmland, they
move to fragile lands in mountains and hills, causing
soil erosion, and they overgraze animals on pasture
lands, depleting the nutrients there as well.

Lacking modern energy sources, they also cut down forests to

obtain firewood.

Poor people have limited abilities

to borrow to finance the purchase of inputs, and this
works against their ability to make improvements in
sanitation, irrigation, improved agricultural inputs
and land improvements, which would reverse or
reduce these types of environmental degradation

The production and consumption activities of

very poor people that endanger the environment
and sustainability can also be interpreted as negative
externalities involving overuse of common access
resources.
Draw negative externalities of production diagram and explain

MPC curve may be a

farmer’s private costs of farming, with the difference
between the MPC and MSC curves representing
overuse of forests that have been cleared for
agriculture, or the overuse of soil leading to depletion
of nutrients.

18. Evaluate, using diagrams, possible government responses to threats to sustainability,

including legislation, carbon taxes, cap and trade schemes, and funding for clean
technologies.

1. Legislation
Legislation (laws and regulations) intended to limit
threats to sustainability typically involve emissions
standards, quotas, licences, permits or outright
restrictions.
Examples include:
• restrictions on emissions from cars
• requirements for cars to use catalytic converters to reduce air pollution
• restrictions on emissions from factories and industrial production
• requirements for steel mills and electricity generating plants to install smokestack
scrubbers to reduce emissions
• banning the use of harmful substances (e.g. asbestos)
• restrictions regarding hunting seasons and hunting areas
• issuing licences or permits for particular activities (such as hunting)
• prohibiting construction (such as housing) or industry or agriculture in protected
areas
• restrictions on the quantity of logging
• restrictions in the form of quotas for fishing (maximum permissible quantity of fish
that can be caught) or in the form of the size of shipping fleets or total bans for
specific areas or specific times of
the year
establishment of protected areas for the protection
of biodiversity and endangered ecosystems.

Evaluation

Advantage 1: Regulations and restrictions have the advantage that

they are simple to put into effect and oversee.
Advantage 2: they can be quite effective,
such as in the case of restricting car emissions,
banning the use of harmful substances, restrictions
on hunting and establishment of
protected areas.

Advantage 3: In the case of emissions of industrial

production, they avoid the technical difficulties that
arise in the use of market-based solutions and force
polluters to cut emissions

Disadvantage 1: In the case of emissions of pollutants,

they do not offer incentives
to reduce emission or to increase energy efficiency
or to switch to alternative fuels

Disadvantage 2: they cannot

distinguish between high- and low-cost polluters,
which would limit the overall cost of reducing
pollution

Disadvantage 3: Costs of monitoring and supervision to

detect possible violations

2. Carbon taxes

fuels that emit more carbon are

taxed at a higher rate than those emitting less carbon.

Since the tax varies with carbon emissions, fossil

fuel users face the incentive to switch to fuels that
emit less carbon, or even no carbon

The external costs become smaller as a result of using

less polluting fuels, and as a result the optimum
quantity of the good produced increases.

RWE: Denmark, Finland, France, Ireland,

Netherlands, Poland, Sweden), as well as some states
in Canada and the United States
3. Cap and trade schemes

Cap and trade schemes refer to tradable permits

RWE: European Union Emissions Trading System and Kyoto Protocol

Evaluation of carbon taxes and cap and trade schemes

Difference: Carbon taxes fix the price of the pollutant
in the form of a tax on carbon and allow the quantity
of carbon emitted to vary, depending on how firms
respond to the tax; cap and trade schemes fi x the
quantity of the permissible pollutant, and allow its
price to vary, depending on supply and demand.

Carbon tax better than cap and trade schemes

Advantages of carbon tax over cap and trade schemes

1. Carbon taxes make energy prices more
predictable. - Under cap and trade schemes, the price of fossil fuels
might fluctuate even more than usual due to fluctuations in
the price of carbon. By contrast, since carbon taxes
fix the price of carbon emissions, the price of fossil
fuels is likely to be relatively more predictable. Price
predictability is important for businesses that need
to plan their costs ahead of time.

2. Carbon taxes are easier to design and

implement - Cap and trade schemes are difficult to
design and implement as they involve complicated
decisions such as setting the cap at the right level and
distributing the permits among all interested users.

3. Carbon taxes can be applied to all users of

fossil fuels. Cap and trade scheme proposals often
target one particular industry, or small group of
industries.

4. Carbon taxes do not offer opportunities for

manipulation by governments and interest
groups. For cap and trade schemes,
it is easy for government to manipulate the
distribution of permits for the benefit of preferred
groups and supporters

5. Carbon taxes do not require as much

monitoring for enforcement. Cap and trade
schemes require monitoring of emissions, otherwise
firms may try to cheat by emitting more pollutants than
they are permitted. Carbon taxes are easier to monitor
as they only involve payment of a tax depending on the
type and quantity of fossil fuels purchased.

6. Cap and trade schemes face strong political

pressures to set the cap too high.

7. Carbon taxes are less likely to be used to

restrict competition between firms. A possible
disadvantage of tradable permits over taxes is that
some firms could buy up more tradable permits
than they actually need, thus driving up their price,
in an effort to keep new firms from entering the
market

Disadvantages of carbon tax compared to cap and trade schemes

1. Carbon taxes may be too low

2. Carbon taxes cannot target a particular level

of carbon reduction. Since carbon taxes cannot
fix (or cap) the permissible level of carbon emissions,
they lead to uncertain carbon-reducing outcomes.

3. Carbon taxes are regressive

4. Carbon taxes need to be adjusted for inflation in order to be effective.

Contrarily, during periods of inflation (a rising price level), the
market will automatically result in rising prices of
tradable permits according to supply and demand,
which is an advantage. In the case of carbon taxes, an
upward adjustment would have to be decided on by
the government (or international body), which could
be politically and administratively more difficult.
4. Funding for clean energy

However, the very large potentials of clean energies

are nowhere close to being realised,
mainly because there are not enough appropriate
policies in place that would promote their greater
use (such as regulatory and market-based policies)

Even if these already existing technologies

were more widely used, it is believed that they are
nowhere close to enough to bring carbon emissions
to acceptable levels. This means there is an urgent
need for the development of new technologies

Government spending on energy

RD&D as a percentage of government spending
on total RD&D fell from over 20% in 1980 to less
than 4% in 2007.

Disadvantage - Funding for clean technologies clearly has

opportunity costs.

However, given its urgency

governments should make a greater effort to allocate
resources to technological innovations in this area,
and should also make efforts to promote private sector
funding and participation.

19. Explain, using examples, that government responses to threats to sustainability are
limited by the global nature of the problems and the lack of ownership of common
access resources, and that effective responses require international cooperation.

co-operation among governments is crucially

important as a method of controlling and preventing
negative consequences on certain resources,
such as the global climate and the ozone layer

cooperation among governments is

very important for the development and diffusion
of new technologies intended to deal with global
environmental issues.

Example - the ozone layer has suffered ozone

depletion due to human activities involving the production of
The ozone layer is an open access resource. No
one owns it, and no one can claim damages for its
destruction. The responsibility for its destruction
lies with polluting activities within virtually every
country, and the consequences of its destruction are
felt globally.

Example - global warming (same as ozone layer)

RWE - One of most successful examples of international

collaboration for the environment is the Montreal
Protocol, signed in 1987 and coming into effect in
1989, intended to phase out substances that have
caused depletion of the ozone layer. By 2009, all
member states of the United Nations had ratified
the agreement, and significant progress has been
made

RWE - Another major (but less successful) international

collaborative agreement for the environment is
the Kyoto Protocol of 1997–2012. Countries sign to agree to reduce emissions to fix
the problem of global warming and
climate change. It also contained provisions for
the development of a market of tradable emissions
permits, according to which each participating
country was to be assigned certain pollution
permits which it would be able to trade with other countries
However, the Kyoto
Protocol came under a lot of criticism and has not
been implemented in full. Many environmental
specialists argued that even if it were implemented,
the agreed reductions in emissions were too
small to have sufficient impact on the problem of
global warming.

RWE - A more successful example of a regional

collaborative arrangement is the European Union’s
cap and trade scheme for carbon, known as the
European Union Emissions Trading System (EU ETS),
which was initiated in January 2005. One permit, or EU
Allowance (EUA) permits the holder to release one
tonne of carbon dioxide. Each emitter of carbon is
allocated EUAs, which are traded in a rapidly growing
carbon market.