H1_economics_notes_arranged_according_to_syllabus_.pdf

1.

The Central Economic Problem 1.1. Scarcity as the Central Economic Problem 1.1.1. Scarcity, choice and resource allocation ● Unlimited wants and limited resources leads to decisions having to be made ● Concurs an opportunity cost ○ Opportunity cost: cost of the next best alternative forgone ○ For consumers: limited purchasing power → limited goods and services that can be purchased and consumed → e.g. purchasing a bowl of noodles have the opportunity cost of purchasing a movie ticket ○ For producers: limited resources → limited types of goods and services that can be produced → e.g. production of phones have the opportunity cost of production of tablets ○ For governments: limited budget → limited choices to make when aiming to reduce inefficient allocation of resource (market failure) → e.g. spending more on education has the opportunity cost of spending on improving and maintaining infrastructure ○ Allocation of resources to one good/service means less resources or none available for the next best alternative (limited resources) 1.1.2. Rational decision making process by economic agents ● Three economic agents ○ Consumers who want to maximise utility (satisfaction) ■ All consumers (individuals) have preferences, which influence their decision between choices presented to them. Consumers have a preference list in order of which they will satisfy their wants ■ A rational individual chooses the action that provides the most net benefit ■ Decision making process involves the consideration of marginal private cost (price of the good/service, time taken to consume good/service, other goods/services forgone) and marginal private utility/satisfaction (happiness from consuming good, tangible benefits of good/service) ■ Consumption of a good/service occurs where marginal cost = marginal utility/satisfaction → consumer derives the most satisfaction from consuming that amount of good ● Consumer will consume additional units of a good/service until marginal cost = marginal

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utility → utility = 0, i.e. no additional satisfaction when one more unit of the good/service is consumed, when the cost of consuming the additional unit is more than the satisfaction/utility gained from the consumption of the good Producers want to maximise profits ■ Decision making process involves the consideration of the marginal private cost (price of factors of production, price of capital goods, price of labour, taxes to be paid, operating permits, pollution permits, opportunity cost of production of next best alternative forgone) and marginal private benefit (revenue to be made from the sale of the good/service) ■ Production occurs when marginal cost = marginal benefit, i.e. no additional benefit obtained when producing one more unit of the good, where cost of production is equal to the revenue gained from the sale of the good/service → profit = marginal revenue - marginal cost ● Firms will produce a good until marginal revenue = marginal cost → profit = 0 i.e. no additional revenue gained with the production of one additional unit of the good/service, when profits < 0 because marginal cost is greater than marginal revenue Governments want to maximise social welfare ■ Decision making process involves the consideration of marginal social benefit (reduction of negative, increasing positive externality, eliminating overconsumption and underconsumption to ensure efficient allocation of resources) against marginal social cost (effects of negative externality due to overconsumption of a demerit good, unreaped benefits of positive externality due to underconsumption of a merit good, non-provision of public goods) ■ Social welfare is maximised when marginal benefit = marginal cost, i.e. no additional benefit to society when one more unit of the good/service is produced/consumed, where cost of

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consumption/production to society is equal to benefits to society ● Society will have a socially optimal level of consumption/production where negative and positive externality due to over and underconsumption is eliminated, where marginal benefits = marginal costs, i.e. no additional gain in benefit with the additional consumption of one unit of the good/service, where an additional unit would result in a higher marginal cost than marginal benefit (overconsumption) There are constraints to the rational decision making process ○ It is assumed that decisions are made by rational agents with perfect information, but it is not always true in reality ○ Imperfect information ■ Misunderstanding true cost and benefits of a product ■ Uncertainty about costs and benefits ■ Complex information when buying specialist products ■ inaccurate/misleading information ■ Addiction ■ Lack of awareness ○ Asymmetric information ■ Producers know more than consumers or consumers know more than consumers Trade-offs are always considered in the rational decision making process ○ Opportunity cost → the next best good/service that can be consumed/produced forgone ○ Time taken to consume/produce goods ○ Cost of consuming/producing the good/service itself ○ It would be assumed that the benefits to be obtained outweighs the trade-offs, hence the consumption/production of the good/service The limitations of the rational decision making process (imperfect information) results in unintended consequences: ○ Negative externality → third parties not involved in the consumption/production of the good/service are negatively affected (reduced productivity, increased health risk) ■ Often associated with overconsumption of demerit goods/services

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1.1.3.

Cigarettes → second-hand smoke, pollution, cancer risk for families ● Sugary drinks → spillover effects healthcare issues suffered by the consumer that has to be dealt with by family members ● Anything that has an ​unintended​ negative effect on third parties, in addition to intended consequences (intended benefits) ○ Positive externality → third parties not involved in the consumption/production of the good/service are positively affected (increased productivity, increased health benefits, increased standard of living) ■ Often associated with underconsumption of merit goods/services ● Health drinks → better health ● Flood defence → whole community benefits ● Beekeeping → pollination of surrounding plants (intended consequence is honey for sale) ● Vaccines → herd immunity (intended consequence is just immunity for self) ● Education → higher wages make for better standard of living for family members (intended consequence is just more knowledge/qualifications for self) ● Anything that has an unintended positive effect on third parties, in addition to the intended benefits Concepts and tools of analysis ● Positive and normative economics ○ Positive economics is using what has and is happening in the economy to make statements about the future economic activity ○ Normative economics is ideological judgements about what may happen to future economic activity if public policy changes are made ● Microeconomics and macroeconomics ○ Microeconomics is the study of the behaviour of individuals (consumers) and firms (producers) in making decisions regarding allocation of scarce resources and the interactions between these individuals (consumers) and firms (producers)

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Analysis of market mechanisms that establish relative prices among goods and services and allocation of scarce resources among alternative uses ■ Shows conditions under which the free market leads to desirable allocations ■ Analysis of market failure, where the free market fails to achieve allocative efficiency ○ Macroeconomics is the study of the performance, structure, behaviour and decision making of the economy as a whole ■ Study of aggregated indicators: ● GDP (Gross Domestic Product): total market value of all final goods and services produced by a country’s economy within a geographical boundary ● Unemployment rates: proportion of the working labour force that is not employed ● National income: average income of a worker ● Price indices (General Price Level): cost of a fixed basket of goods and services consumed by a typical household Scarcity, choice and opportunity cost ○ Scarcity is the result of unlimited wants and limited resources ■ Limited resources include ● Current state of technology ● Finite sources of raw materials from the earth ● Finite amount of labour ○ Scarcity results in the need to make a choice, since not all wants can be met because of limited resources ○ A choice made results in an opportunity cost, where the next best alternative is forgone when a decision is made, since the next best alternative cannot be accommodated by the limited resources Production possibility curve ○ Depicts the maximum ratios of two goods that can be produced, given the limited amount of resources and wants for both goods

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At full employment, production of the two goods is on the curve, at the maximum possible ratio given current state of technology and factors of production ■ Curve shifts outwards when there is advancements in technology, or when there is an increase in the quantity or quality of factors of production, increasing ​productive capacity ○ Otherwise, the economy is producing at a point within the curve → production is not maximised ■ Point shifts towards the curve when the previously unemployed factors of production are utilised, increasing ​productivity Marginal cost, marginal benefit and marginalist principle ○ Marginal cost is the additional cost incurred with the production/consumption of one (concept of marginal) additional unit of the good/service ○ Marginal benefit is the additional utility/profit gained with the consumption/production of one additional unit of the good/service ○ Marginalist principle explains the discrepancy in the value of goods/services in their marginal utility ■ Value of a good/service given a set of constraints is the marginal value i.e. how much value the good/service has under a particular set of circumstances ■ Changes to this value upon the change (loosening or tightening) of those constraints is known as marginal change i.e. the change in the value of the good/service when the circumstances are changed ● Marginal value of water during periods of good rainfall is much lower than the marginal value of water during periods of drought, the difference in the marginal value is the marginal change when conditions change from time of abundance to time of scarcity ■ As an individual purchases more of a good/service, his marginal benefits falls as he has more of the good and less money, making him less willing and less able to purchase an additional unit of the good Maximisation of utility ○ Consumers have limited incomes (limited resources)

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2.

To maximise utility, they allocate their income such that the last dollar spent on a good/service purchased yields the same amount of extra marginal utility Maximisation of profits: marginal revenue = marginal costs ○ Producers have limited investments ○ To maximise profits, they allocate their resources (costs) such that the last dollar spent on a good/service produced yields the same amount of extra marginal revenue Maximisation of social welfare: marginal social benefit = marginal social cost ○ Society has limited resources ○ To maximise social welfare, they allocate their resources such that the last dollar spent on the consumption/production of a good/service yields the same amount of benefit to society ○ When marginal social benefit > marginal social cost, more benefit can be yield when consumption/production increases ○ When marginal social benefit < marginal social cost, less cost can be incurred when consumption/production decreases ○ When marginal social cost = marginal social benefit, social welfare is maximised since there is no additional cost incurred or additional benefits to be reaped

Markets 2.1. Price mechanisms and its applications 2.1.1. Price mechanism and its functions ● In a free market, the price and quantity of a good/service is dependent on the ​quantity demanded by consumers​ and the quantity supplied by producers ○ Quantity demanded by consumers depends on the willingness and the ability of the individuals to pay for the good/service at a certain price ○ Quantity supplied by producers depends on the willingness and ability of the firms to produce the good/service at a certain price ● Equilibrium is achieved where the demand and supply curve intersect, i.e. where the quantity demanded is equal to quantity supplied, at a price where both consumers and producers are willing and able to consume and produce the good/service ● Resource allocation in a free market

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2.1.2.

Since resources is scarce, resources will be allocated to goods/services with the highest demand, since individuals are utility-maximising and firms are profit maximising ○ Decision of what to produce will be influenced by consumers’ preference to maximise utility ■ I.e. consumers will consume the goods that maximises their utility only ○ Decision of how to produce will be decided by producers’ preference to maximise profits ■ Producers that can satisfy consumers or align with consumers’ preferences will stay in business as they are able to generate profit ○ Consumers’ preferences are communicated to producers and the producers will allocate the resources required to produce such goods/services ■ goods/services more preferred by consumers will be allocated more resources than goods/services less preferred by consumers ○ Producers allocate resources such that marginal cost does not exceed marginal revenue Interaction of demand and supply ● Consumers want to maximise utility and reduce marginal cost to derive greatest maximum utility, so they will have a greater demand for goods that are cheaper because they have a lower marginal cost. Consumers’ demands are determined by: ○ Tastes and preferences ■ Changing tastes and preferences will change the marginal utility of a good/service, hence the demand will change accordingly since the maximum utility to be yield changes ○ Incomes of consumers ■ Incomes directly dictate the purchasing power of consumers ● Higher income → higher disposable income → greater ability and willingness to consume more expensive goods to increase satisfaction → high demand ● Lower income → lower disposable income → less ability and willingness to consume expensive goods to increase satisfaction → low demand ○ Expectations of future prices ■ Prices are direct determinants of marginal cost

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If prices are expected to fall, marginal cost falls, maximum utility increases, consumers hold off purchasing good/service → demand decreases ■ If prices are expected to rise, marginal cost will increase, maximum utility decreases, consumers start buying good/service → demand increase ○ Price of good/service ■ If price is low, marginal cost is low, maximum utility is high, demand is high ■ If price is high, marginal cost is high, maximum utility is low, demand is low ○ Price of related goods/services ■ Fall in prices of a good will result in a rise in demand for complementary goods Producers aim to maximise profits by reducing marginal cost and increasing marginal revenue. supply determined by: ○ Weather conditions ■ For produce/meat: good weather conditions → greater harvest with the same amount of water (marginal cost) → increase in supply ○ Expected future prices ■ If prices are expected to rise, producers increase production to increase output to sell more during when price increases to increase profits, increasing supply ○ State of technology ■ When technology advances, producers are able to produce more efficiently and reduces overall marginal cost of production → profits increase → supply increase ○ Prices of related goods ■ For goods/services that are in competitive supply, if prices for demand for one use increases, supply for this use will increase, less will be allocated for other use(s), and supply for such use(s) will fall ○ Input prices ■ When prices of factors of production increases, supply decreases as cost of production increases ○ Government policies ■ Taxes will increase cost of production, reducing supply ■ Subsidies will decrease cost of production, increasing supply

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2.1.3.

Number of sellers ■ Increase in number of sellers will increase supply ● Equilibrium price and quantity is determined by the point at which the demand and supply curve intersect, where the quantity demanded by consumers is the same as the quantity supplied by producers at a certain price. ● Changes in demand changing market equilibrium ○ When demand increases, the demand curve shifts right → shortage at previous equilibrium price → unsuccessful consumers bid higher prices for the good/service → upward pressure on prices, price increases → other consumers not as able and willing to consume at the higher price reduce quantity demanded → producers increase production motivated by the increase in price, increasing quantity supplied → new equilibrium price and quantity obtained when shortage is eliminated ○ When demand decreases, the demand curve shifts left → surplus at previous equilibrium price → producers decrease prices to get rid of the surplus, downward pressure on prices, prices decreases → quantity supplied decreases to maintain profits → consumers more willing and able to consume more of the good/service and increase quantity demanded → new equilibrium price and quantity obtained when surplus is eliminated ● Changes in supply changing market equilibrium ○ When supply increases, supply curve shifts right → surplus at previous equilibrium price → producers reduce prices to get rid of surplus, applying downward pressure on price, prices decreases → other producers reduce quantity supplied due to lower prices to maintain profit → consumers more willing and able to consume at lower prices, increase quantity demanded → new equilibrium price and quantity obtained when surplus is eliminated ○ When supply decreases, the supply curve shifts left → shortage at previous equilibrium price → unsuccessful consumers increase price of bids for the good/service, putting upwards pressure on price → prices increase → other consumers unwilling and unable to consume at higher price, and reduce quantity demanded → producers increase quantity supplied to maximise profits from increasing prices → new equilibrium established at new price and quantity when shortage is eliminated Applications of demand and supply analysis to real world markets

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Responsiveness of consumers to changes in price is measured by PED (price elasticity of demand) ○ When consumers are highly responsive to changes in price, there is a more than proportionate change in quantity demanded when price changes (PED > 1) ○ When consumers are not responsive to changes in price, there is a less than proportionate change in quantity demanded when price changes (PED < 1) ○ PED is determined by ■ Proportion of income spent on the good/service ● High proportion → PED > 1 → change in price will result in a greater than proportionate change in quantity demanded of the good/service since purchasing power of consumers is highly affected by a change in the price of the good ○ Usually luxury goods ● Low proportion → PED < 1 → a change in price will result in a less than proportionate change in the quantity demanded of the good/service since purchasing power of consumers is not highly affected by a change in the price of the good ○ Usually necessities ■ Number of close substitutes ● Large number of close substitutes → PED > 1 → change in price will result in a greater than proportionate change in quantity demanded as consumers can purchase from other producers ● Little or no close substitutes → PED < 1 → change in price will result in a less than proportionate change in quantity demanded as consumers are not able to obtain the same utility from other goods ■ Time period ● Long run → PED > 1 → change in price will result in a more than proportional change in quantity demanded as there are now more substitutes due to advancement of technology ● Short run → PED < 1 → change in price will result in a less than proportionate change in

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quantity demanded as there are not many substitutes as technology is not advanced enough to produce close substitutes ■ Consumer inclination for habitual consumption ● Non habit forming good → PED > 1 → change in price results in a more than proportional change in the quantity demanded as consumers are able to easily reduce consumption of the good/service ● Habit forming good → PED < 1 → change in price results in a less than proportional change in quantity demanded as consumers are unable to easily reduce consumption of the good/service Responsiveness of producers to changes in price is measured by PES (price elasticity of supply) ○ When producers are highly responsive to change in prices, PES > 1, there is a more than proportionate change in quantity supplied when price changes ○ When producers are not highly responsive to change in prices, PES < 1, there is a less than proportionate change in quantity supplied when price changes ○ PES is determined by ■ Availability of factors of production ● Low availability of factors of production → PES < 1 → when price changes, there is a less than proportionate change in quantity supply as producers are unable to increase production due to limited availability of factors of production ● High availability of factors of production → PES > 1 → when price changes, there is a more than proportionate change in quantity supply as producers are able to increase production due to ready availability of factors of production ■ Length of production ● Lengthy production times → PES < 1 → when price changes, there is a less than proportionate change in quantity supplied because producers are unable to change productivity quickly

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Short production times → PES > 1 → when price changes, there is a more than proportionate change in quantity supplied as producers are able to quickly change productivity Mobility of factors ● Low mobility → PES < 1 → when price changes, there is a less than proportionate change in quantity supplied as producers are unable to allocate the resources to the production of the other good/services quickly ● High mobility → PES > 1 → when price changes, there is a more than proportionate change in the quantity supplied as producers are able to quickly reallocate resources to produce more of the other good Time period ● Short run → PES < 1 → when price changes, there is a less than proportionate change in quantity supplied as producers are unable to obtain factors of production to increase quantity supplied quickly ● Long run → PES > 1 → when price changes, there is a more than proportionate change in quantity supplied as producers have sufficient time to obtain the resources required for the production of the good/service Availability of stock ● Unavailable stock → PES < 1 → when price changes, there is a less than proportionate change in the quantity supplied as producers do not have stock that can be released immediately ● Available stock → PES > 1 → when price changes, there is a more than proportionate change in the quantity supplied as producers have available stock to release into the market immediately Availability of capital

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Low availability of capital → PES < 1 → when price changes, there is a less than proportionate change in quantity supplied as producers do not have additional capital to employ to increase production ● High availability of capital → PES > 1 → when price changes, there is a more than proportionate change in quantity supplied as producers have excess capital that can be immediately employed to increase production Rationale and impact of government intervention on consumers and producers ○ Taxes and subsidies ■ When government introduces taxes on production, cost of production increases, hence supply will decrease; when government introduces subsidies on production, cost of production decreases, hence supply will increase ■ When government introduces taxes on consumption, cost of goods and services will increase, hence demand will decrease; when government introduces subsidies on consumption, cost of goods and services will decrease, hence demand will increase ○ Price controls ■ When government introduces minimum prices, producers of the goods/services are ensured a minimum income, as the mechanisms of the free market would result in little or no profits. Minimum prices are set above free market equilibrium, forcing consumers to pay more for the good/service, ensuring that the producers have a sufficient income ■ When government introduces maximum prices, consumers are protected from high prices that would result from a free market. This prevents consumers from paying high prices for necessities such as water that are required for living. Maximum prices are set below free market equilibrium, forcing producers to set prices below the price ceiling, ensuring consumers are not exploited ○ Quality controls

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When government sets a quota, it limits the amount of a good/service that can be produced. A quota limits the production of the producer(s), hence preventing prices from falling too low. Quotas are used to control the production and consumption of demerit goods, to limit the negative externality by limiting production and hence consumption of the good/service Concepts and tools of analysis ● Price mechanism is when the price of a good affects the demand and supply for it. It is used to determine the allocation of scarce resources between ○ Prices perform a signalling function: it indicates when to allocate more resources and when to allocate less ○ Changes in price reflect surplus or shortage ○ Higher prices function as an incentive to increase production for producers as they want to maximise profits from the increase in price ● Consumer sovereignty ○ Consumer sovereignty decides what to produce, since firms respond to demands of consumers ● Ceteris paribus ○ The changing of one condition with all other conditions kept constant ● Effective demand ○ Effective demand is the demand for a good/service by people who are ​both ​willing and able to pay ○ It excludes those who are willing but unable ● Law of diminishing marginal utility ○ Law of diminishing marginal utility states that the marginal utility from every additional unit of good/service consumed decreases. This is due to the increasing cost and decreasing benefit per additional unit as the consumer has more of the good/service and less disposable income ● Demand curve illustrates the law of diminishing marginal utility ○ As quantity increases, the price decreases as consumers become less willing to pay for an additional unit of the good/service as the marginal utility decreases ● Change in demand vs change in quantity demanded ○ Change in demand is when quantity demanded changes independent of price

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2.2.

Usually due to entry of more consumers into the market via increased purchasing power or change in taste and preferences ○ Change in quantity demanded is when quantity demanded changes depending on the change in price ■ Demand remains constant, and the change in quantity demanded is due to price, not due to non-price determinants of demand Supply curve ○ Supply curve illustrates the law of diminishing marginal returns. ○ As production increases, marginal costs increase while marginal returns decrease. Hence to pay for the increasing marginal costs, producers have to increase the price of their good/service in order to maintain constant profit and cover the additional marginal cost of production Changes in supply vs change in quantity supplied ○ Change in supply is when change in quantity supplied is independent of change in price ■ Usually due to non price determinants like weather, taxes, number of sellers, etc ○ Change in quantity supplied is when change in quantity supplied is dependent on the change in price ■ A decrease in price will result in the decrease in the quantity supplied as producers aim to maximise profits, hence decrease production which decreases marginal cost of production ■ An increase in price will result in the increase in quantity supplied as producers are able to pay for the increase in marginal costs of production

Market failure 2.2.1. Efficiency and equity in relation to markets ● There is economic efficiency when a society yields the largest possible output from its limited resources, and deadweight loss is eliminated ● There is no overconsumption of demerit goods, and no underconsumption of merit goods i.e. deadweight loss due to over or underconsumption is eliminated, and society’s welfare is maximised ● Economic equity is when society distributes resources fairly across the people ● Economic efficiency may not result in economic equity and vice versa

2.2.2.

Market failure and its causes ● Public goods are goods that are non-excludable and non-rivalrous ○ Non-excludable: a non-payer cannot be prevented from consuming the good ○ Non-rivalrous: consumption of the good by an individual does not diminish the utility of the good for another individual ○ The free market fails to produce public goods due to the non-rivalrous in consumption characteristic. ■ The marginal cost of production of the good for the next individual is 0. ■ Since conditions for allocative efficiency is when price charged is equal to marginal cost of production, when marginal cost is 0, the principle of optimal resource allocation calls for the provision of the good at no charge. ■ However, since producers are profit maximising, no firm would be willing to produce the good as they are unable to attain any profits. Hence there is 0 production. ○ The free market fails to produce public goods due to the non-excludability in consumption characteristic ■ The marginal cost of consumption of the good for the next individual is 0 when the good purchased. Hence, there is a problem of free-riders ■ Since individuals can consume the good without paying, they are not willing to reveal the price they are willing to pay for the good, hence leading to concealed demand ■ Since the market mechanism relies on demand and supply to determine the production of the good, the system breaks down as there is concealed demand, resulting in no production of the good ● Negative externality arises when marginal social cost is higher than marginal private cost, assuming marginal social benefit = marginal private benefit ○ There is information failure when consumers make the decision to consume demerit goods, resulting in the overvaluation of the goods when they ignore or are unaware of the third party effects due to underestimation of external costs.

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Negative externality is when there is an external cost borne by third parties not involved in the consumption/production of the good and are not compensated for ○ There is hence a divergence between marginal social cost and marginal private cost as marginal social cost includes the marginal external cost of every additional unit of the good consumed/produced ○ For every additional unit of the good consumed/produced from the socially optimal equilibrium quantity to the free market equilibrium quantity, there is additional marginal external cost borne by the society, and the sum of all the marginal externality cost borne by society results in deadweight loss due to overconsumption leading to overallocation of resources and the loss in welfare of society, since marginal social benefit is lower than marginal social cost Positive externality arises when marginal social benefit is greater than marginal private benefit, assuming marginal social cost = marginal private cost ○ There is information failure when consumers make the decision to consume merit goods, resulting in the undervaluation of the good when they ignore or are unaware of the third party effects due to underestimation of external benefit ○ Positive externality is when there is an external benefit yield by third parties not involved in the consumption/production of the good ○ There is hence a divergence between marginal social benefit and marginal private benefit as the marginal social benefit includes the marginal external benefit of consuming/producing one additional unit of the good/service ○ For every additional unit of the good that is not consumed/produced from the socially optimal equilibrium quantity to the free market equilibrium quantity, there is an additional marginal external benefit that is not yield by society, and the sum of all the marginal external benefit not yield results in deadweight loss due to the underconsumption leading to underallocation of resources and the loss of welfare of society, since marginal social benefit is greater than marginal social cost Merit goods are goods that society considers to be socially desirable and intrinsically good for consumers.

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They bring about positive externality due to undervaluation by consumers, and hence have to be subsidised for consumers to internalise the external benefit and ensure socially optimal levels of consumption to maximise social welfare ● Demerit goods are goods that society considers to be socially undesirable and intrinsically bad for consumers ○ They bring negative externalities due to overvaluation by consumers, and hence have to be taxed for consumers to internalise the external cost and ensure socially optimal levels of consumption to maximise social welfare Government intervention in markets ● Government provision of public goods ○ Government takes over the production via direct provision ○ Government can also use tax revenue to pay for the production of the goods ○ Assuming perfect information, the right amount will be provided to society, solving market failure and maximising society’s welfare ○ Direct provision by government has limitations: ■ Market failure solved by government’s direct provision is based on the assumption of perfect information. Imperfect information can result in over or underestimation of the socially optimal quantity of the good needed, hence resulting in over or underproduction of the public good, and the problem of market failure will still exist. However, it will exist at a smaller extent than without government intervention ■ Government funding is from tax revenue. If the cost of direct provision is higher than tax revenue, the government will have a budget deficit that will become a burden on taxpayers since taxes would have to be raised. This can reduce future standard of living ■ There is opportunity cost incurred with direct provision, as the money spent on the production of the public good can be spent on other areas of development such as healthcare and education. ■ Since the individuals are not directly paying for the public good, there will be instances of abuse and misuse of the public good, resulting in excessive consumption beyond socially optimal levels and

result in a wastage of resources, hence inefficient allocation. ●

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Taxes ○ Taxes increases the cost of production/consumption of a demerit good by the value of the external cost, in order to ensure that the producer/consumer internalize the external costs and hence reduce production/consumption. Since external costs is internalised, deadweight loss is eliminated and there is efficient allocation of resources, maximising social welfare ○ Benefits of taxes: ■ Taxes still allow operation of the market, hence protects consumer sovereignty and allows for the decision of what to be produced and which price ■ It is fair as it forces only the individuals and firms consuming and producing the good to pay for the external cost, ensuring that they bear the full responsibility of the external cost ■ Taxes result in the increase in the cost of production, which would incentivise producers to innovate ways to produce goods with less external cost, since it would be able to save more if it is able to reduce the external cost more. ○ Taxes have limitations: ■ Taxes take up a bigger proportion of the lower income than it does higher income, hence can result in worsening of inequity and widening of the inequality gap ■ The value of tax can be hard to determine, as the effect on third parties can be extensive and lengthy. Hence it is difficult to accurately estimate the external cost, which makes it difficult to implement an accurate tax. Under-taxation will not solve overconsumption or over production, hence there will still be external costs and overallocation of resources, and market failure would not be fully addressed. (Over-taxation will result in the underconsumption or underproduction of the good, since quantity consumed and produced is now lesser than the socially optimal quantity, hence market failure is still not addressed.) Tradable permits ○ Rights given to firms to trade

3.

The National Economy 3.1. Introduction to macroeconomic analysis 3.1.1. Aggregate demand and aggregate supply ● Aggregate demand ○ Total desired spending on domestically produced goods and services by all sectors of the economy in a given period at different price levels ○ Include household, firms, government and the foreign sector ○ Components ■ C: consumer expenditure by households ■ I: investment expenditure by firms ■ G: government expenditure on goods and services ■ (X-M): net exports ○ Negative relationship between the real national output and the general price level ○ Change in GPL causes a movement along the AD curve ○ Determinants of C: ■ Disposable income ● Amount of income available for the household to spend or save ● After taxes ■ Interest rates ● Consumer appliances and cars are bought on credit ● Households spend more when interest rates are low and less when interest rates are high due to changing in willingness and ability ■ Availability of credit ● Credit easily obtainable → consumers spend more ● Credit less easily obtainable → consumers spend less ■ Consumers’ expectations of the future ● Expectations of rising prices → triggers spending than savings in current period ● Expectations of falling prices → triggers more savings than spendings in current period ● Optimism about future economic conditions → more spending

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Pessimism about future economic conditions → less spending ■ Size of wealth ● Wealthier → spend more ■ Distribution of income ● Different distributions of income lead to different marginal propensities to consume in different wage groups ■ Age distribution ● Young spend more ● Old spend less Determinants of I ■ Rate of interest ● Rise in interest rates makes it more expensive to borrow for investments → investments fall ● Extent of fall depends on interest elasticity of investment ○ Demand for investment is interest elastic, more than proportionate fall in the level of investment when the interest rate rises, ceteris paribus, as the increased cost of borrowing is not worth the increase in revenue ○ Demand for interest is interest inelastic, less than proportionate fall in the level of investments when the interest rates rises, ceteris paribus, as the increase in cost of borrowing is worth the increase in revenues ■ Cost and efficiency of capital equipment ● Cost of capital equipment falls or machines become more efficient due to technology → increase in investment expenditure ■ Business expectations ● More optimistic about future economic conditions → expect revenue to rise → increase investment ■ Government policies ● Reduction of corporate tax will increase firm’s profits after tax Determinants of G: ■ Government policies

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Fiscal policies ○ Tax rebates ○ Increased/reduced taxes ○ Determinants of (X-M) ■ Exchange rate ● Domestic good more expensive than foreign goods → imports increase → M increase while X decreases → (X-M) decrease ■ General price level ● Aggregate supply ○ Total output of the economy at different price levels ■ Consumer goods ■ Capital goods ■ Public goods ■ Traded goods ○ Determinants ■ Changes in labour force ● Labour force shrinks → FOP decreases -> AS falls, vice versa ■ Changes in input prices ■ Improvement in technology ■ Availability of capital goods ● Equilibrium level of national output and general price level is where the economy is performing, where GPL is at $x and nY/GDP is at $y 3.2. Standard of living 3.2.1. Standard of living and its indicators ● Material well being ○ Measured by the amount of goods that can be purchased/is quantifiable ○ Can be measured by GDP/GNI ■ Higher GDP → higher nY → higher disposable Y → higher purchasing power → more goods purchased → higher material standards of living ○ HDI ■ Three combined measurements ● GDP ● Education index ○ Mean years of schooling vs expected years of schooling ● Life expectancy ■ Higher value = better ○ Income distribution

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3.2.2.

Gini coefficient ● Measures income inequality ● Closer to 0 = better ● Closer to 1 = bad ● Non-material well being ○ non-quantifiable/hard to quantify ■ Happiness index ■ Education ■ Healthcare Factors affecting standard of living ● Economic growth ○ Actual growth ■ Growth experienced by the economy ● Increase in GDP from the previous year ○ Potential growth ■ Growth that can be attained in the future ● Improvements in technology ● Discovery of new mines ● Discovery of new sources of fuel ● etc ○ Sustainable growth ■ Potential growth of future generations not sacrificed to attain current growth ● Environmental degradation/pollution ● Uncontrolled extraction of rare earth minerals ● Etc ○ Inclusive growth (case of Singapore) ■ No groups of people are left behind ● Singapore shifting to high skilled industries → older workers get left behind as they do not have the necessary skill sets required → structural unemployment → no income → no means of increasing standard of living, therefore growth is not inclusive as it neglects such groups of people ● Price stability ○ Inflation ■ Prices of goods increase i.e. GPL increases ● Amount of goods that can be purchased with the same amount of money decreases ● Low inflation is a primary macroeconomic aim as it keeps producers motivated

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Low inflation of 2% increases profits → producers incentivized to increase production to reap the profits → increase production → AS increases → GDP/GPL increases → pp of consumers increase → AD increases → economic growth High inflation is undesirable ○ Decreases investments as investors are uncertain of the profitability of their investments as they are unable to predict increase in prices → I decreases ○ Purchasing power of consumers fall → C decreases

Deflation ■ Prices of goods decrease ● Deflation is not desriable ○ As prices fall, consumers spend less in anticipation of future price falls → C decreases ○ Investors are not confident of earning profits, hence decrease I ● Deflation can also be desirable ○ Prices of FOP decreases → production become cheaper → prodution increases → AS increases in the short run Employment ○ Full employment ■ All capital goods, and all available resources are utilised, economy is performing on the production possibility curve ○ Unemployment ■ Structural unemployment ● Skills of job seekers and skills required are a mismatch ● Occurs when there is a shift in the type of industries in the economy ■ Cyclical unemployment ● Increases and decreases with the business cycle

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Present when there is a contraction of the economy and can worsen the negative growth of the economy Frictional unemployment ● Typical job switching