Economics Help

Revision Guide
Welcome to the Economics Help free Revision Guide. If you find this revision guide useful, the author would appreciate a donation which you can make via www.economicshelp.org/blog/donate It is not permissible to copy this guide for others. It is only freely available from www.economicshelp.org/

You are welcome to leave feedback and ask further questions on Economics at: www.economicshelp.org/blog
Richard Tejvan Pettinger 29 Campbell Road mail@richardpettinger.com

www.economicshelp.org

AS MICRO ECONOMICS
AQA Edexcel OCR

Unit 1 Unit 1+ 2 Unit 4381 + 4382

Opportunity Cost Production Possibility Frontiers Positive / Normative Economics Market Mechanism Supply and Demand Elasticity Maximum and Minimum Prices Buffer Stocks Economies of Scale Efficiency Monopoly Market Failure Externalities Demerit / Merit goods Public Goods Taxes and Subsidies Pollution permits Providing public services Govt Failure

Housing Market (most useful for AQA Unit 3)

www.economicshelp.org

Basic Economic Concepts

Positive economics: This is a statement based on facts and testable theories e.g. RPI is 2% Normative economics: This is based on opinion or a value judgement e.g. govt should increase taxes Opportunity cost: This is the sacrifice foregone of the next best Alternative foregone e.g. opportunity cost of buying a CD is a book foregone.

Production Possibility Frontiers:

These show the maximum output that a simplified economy can produce if the economy is maximising the use of its resources and operating efficiently goods B PPF A services Point Point Point
goods

A = inefficient. B = Productively efficient. It is impossible to produce more goods without losing out on services C = impossible
goods

services

services

Constant Returns

Diminishing Returns

The above diagrams show different slopes of PPFs In the first one the opportunity cost of increasing goods is always constant therefore we say it has constant returns www.economicshelp.org

Demand
The individual Demand Curve illustrates the price people are willing to pay for a particular quantity of a good. A change in price causes a MOVEMENT ALONG the Demand Curve, E.g. if there is an increase in price from p2 to p1 then there will be a fall in demand from Q2 to Q1 P

P1 P2 D2 D1 Q1 Q2 Q

Shifts in the Demand Curve

This occurs when, even at the same price, consumers are willing to buy a higher quantity of goods. E.g. from D1 to D2. This will occur if there is a shift in the conditions of demand

A shift to the right in the demand curve can occur for a number of reasons:
1. An increase in disposable income, this can occur for a variety of reasons such as higher wages and lower taxes 2. An increase in the quality of the good e.g. computers are now more powerful 3. Advertising can increase brand loyalty to the goods and increase demand 4. An increase in the price of substitutes, e.g. if the price of Kodak films increase the demand for Fuji films will increase 5. A fall in the price of complements. E.g. a lower price of Play Station 2 will increase the demand for compatible games.

Evaluation:

For some luxury goods income will be an important determinant of demand. e.g. if your income increased you would buy more CDs but probably not salt. Advertising is important for goods in which branding is important, e.g. coca cola but not for bananas www.economicshelp.org

Supply
This refers to the quantity of a good that the producer plans to sell in the market. As price increases firms have an incentive to supply more because they get extra revenue (income) from selling the goods. If price changes, there is a movement along the supply curve, e.g. a higher price causes a higher amount to be supplied. P S1 S2 P2 P1

Q1

Q2

Shifts in the Supply curve:

An increase in supply occurs when more is supplied at each price, e.g. from S1 to S2. this could occur for the following reasons 1. An decrease in Costs of Production, this means business can supply more at each price, lower costs could be due to lower wages, lower raw material costs 2. An increase in the number of producers will cause an increase in supply 3. Expansion in capacity of existing firms, e.g. building a new factory 4. An increase in Supply of a complementary good e.g. beef and leather 5. Climatic conditions are very important for agricultural products 6. Improvements in technology, e.g. computers

7. Lower taxes reduce the cost of goods 8. Increase in govt subsidies will also reduce the cost of goods

www.economicshelp.org

Market Equilibrium
The Price Mechanism refers to how Supply and Demand interact to set the market price and the amount of goods sold If price was below the equilibrium at P2 then demand would be greater than the supply. Therefore there is a shortage of (Q2 Q1) Therefore firms will put up prices and supply more. As price rises there will be a movement along the demand curve and less will be demanded. P S

Pe P2

Market Equilibrium

Q Q1 Qe Q2

Therefore price will rise to Pe until there is no shortage and Supply = Demand

Movements to a new Equilibrium

If there was an increase in income the demand curve would shift to the right. Initially there would be a shortage of the good, therefore the Price and Quantity supplied will increase leading to a new equilibrium at Q2

P2 P1

D2 D1 Qe Q2 Q

www.economicshelp.org

The Price Mechanism

Factors that could explain a fall in the price of a good such as coffee The price of coffee would fall if there was a fall in demand and / or an increase in supply.

S S2

P1

P2 D2 Q1 The demand for coffee could fall for various reasons such as: i) ii) iii) iv) v) Lower incomes mean that consumers cannot afford to buy as much Less fashionable Decrease in the price of substitutes such as tea Fall in number of coffee shops Health concerns about caffeine D1 Q

The supply of coffee could increase for various reasons such as: i) ii) iii) iv) Increase in the number of suppliers Lower costs of production Govt subsidies Higher labour productivity in producing coffee, this will decrease the costs of production

Economic effects of an increase in the Price of Coffee

1. 2. 3. Q.D. will fall, but it will only be a small amount because demand is inelastic. Demand for substitutes will increase, however there are not any close substitutes for coffee there this will not be very significant If higher prices are caused by increased demand there will be an increase in income for firms producing and selling coffee.

www.economicshelp.org

Government Intervention in Markets

1. Maximum Prices.
Under certain circumstances the govt may wish to reduce the price below the market equilibrium. E.g. they could have a maximum price for renting houses. P S

Pe Max P

D
Q1 Qe Q2

The problem of Maximum prices is that: The lower price will cause a shortage therefore some tenants will be worse off because they cannot find any houses to rent. Therefore the govt would have to increase supply in order to overcome the shortage

2. Minimum Prices
This occurs when the govt wishes to raise the price above the equilibrium. For example in agricultural markets the govt often wishes to increase the income of farmers by increasing the price of goods. P S
Min P Pe

D
Q1 Qe Q2

The problem of Min prices is that They encourage farmers to increase supply leading to a surplus which is not bought on the market. Therefore the govt is obliged to buy the surplus Q2- Q1 to maintain the target price.

www.economicshelp.org

3. Minimum Wages:
This is similar principle to min prices. It is a policy designed to increase the wages of the lowest paid, reducing relative poverty.
Wage

S
Min Wage We

D
Q1 Qe Q2

Q labour

If labour markets are competitive then a min wage could cause unemployment of Q2- Q1. However in the real world a minimum wage may not cause unemployment because i) Demand for labour may be very inelastic ii) A higher minimum wage may increase worker productivity. This is because now wages are higher workers may feel more loyalty to the company

4. Buffer Stocks.
This is a policy designed to stabilise prices primarily in agricultural markets. The purpose of buffer stocks is: i) Protect farmers incomes by guaranteeing a min price Protect consumers from high prices by guaranteeing a maximum price level ii) Ensure adequate supplies of food

Buffer Stock
P

S1 S2

TP P1 D Q1 Q2

Target Price

www.economicshelp.org

10 If there was an increase in supply the equilibrium price would fall below the target price. To maintain the price at the target the govt will need to buy the surplus (Q2-Q1)* TP. This will effectively increase demand and therefore price This excess supply could be stored in a buffer stock if there was a shortage in the next year then the govt could sell from its buffer stock to reduce the price.

Problems of Buffer Stocks

1. It is expensive for the govt to buy the surplus and also to store it. 2. Some foodstuffs cannot be stored for a year 3. The govt may have poor information about how much to buy, e.g. it may be difficult to know whether there is going to be a shortage 4. A minimum price may encourage over supply amongst farmers

Why Prices are Volatile In Agricultural Markets

P S1 S2 P1 i) Demand for agricultural products is inelastic, this is because they are a small % of total income ii) Supply is inelastic P2 D Q iii) Supply can fluctuate due to variable factors such as the weather and disease

Advantages of govt intervention in Agriculture:

1. 2. 3. 4. 5. Stable prices help maintain farmers incomes Stability enables investment in agriculture Farming has positive externalities e.g. helps rural communities Stable prices prevent excess prices for consumers Food supplies are assured

Disadvantages of govt intervention in Agriculture:

1. 2. 3. 4. 5. 6. Cost of buying excess supply Min prices and Buffer stocks encourage over supply Govt subsidy to farmers may encourage inefficiency amongst farmers Some goods cannot be stored in buffer stocks Govts may have poor information e.g. what price to set Administration costs

www.economicshelp.org

11

Elasticity
Price Elasticity of Demand (PED) Elastic Demand
Demand is elastic if a change in price leads to a bigger % change in demand, the PED will therefore be greater than 1. P P = % change in Quantity Demanded % change in Price

D D

Q Elastic Demand PED > 1 Perfectly Elastic Goods which are demand elastic tend to have the following characteristics. 1. They are luxury goods 2. They are expensive and a big % of income e.g. sports cars and holidays 3. Goods with many substitutes and a very competitive market. E.g. if Simsburys put up the price of its bread there are many alternatives, so people would be price sensitive 4. Bought frequently

Inelastic Demand
These are goods where a change in price leads to a smaller % change in demand, therefore PED <1 e.g. 0.5 P P

D D Q Inelastic demand PED <1 Perfectly inelastic PED =0 Q

www.economicshelp.org

12 Goods which are demand inelastic tend to have some or all of the following features. 1. 2. 3. 4. They have few or no close substitutes, e.g. petrol, cigarettes. They are necessities They are addictive They cost a small % of income or are bought infrequently In the short term demand is usually more inelastic because it takes time to find alternatives

Using Knowledge of Elasticity

1. If demand is inelastic then increasing the price can lead to an increase in revenue. This is why OPEC try to increase the price of oil. P S2 S1 $30 Revenue was $15 * 100= $1,500 Revenue is now $30 * 80= $2,400 D Q
80 100

$15

PED = -20% / 100% = -0.2

Income Elasticity of Demand YED

This measures the responsiveness of demand to a change in income. e.g. if your income increase by 5 % and your demand for mobile phones increased 20% then the YED = 20/ 5 = 4.

Income Elasticity of Demand (YED) =

Inferior Good

% change in Q.D % change in Income

This occurs when an increase in income leads to a fall in demand. Therefore YED<0. E.g. clothes from charity shops, cheap bread This occurs when an increase in income leads To an increase in demand for the good, Therefore YED>0 This occurs when an increase in income causes a bigger % increase in demand, therefore YED>1. This means an increase in income leads to a smaller % increase in demand. Therefore 0> YED <1

Normal Good Luxury Good

Income inelastic

www.economicshelp.org

13

Cross Elasticity of demand

Cross Elasticity of Demand (XED)
= % change in Q.D good A % change in price good B

Substitute goods These are alternatives to a good. Therefore XED will be positive, Weak substitutes like tea and coffee will have a low XED. Tesco bread and Sainsburys bread are close substitutes so XED is higher

Complements goods, these are goods which are used together, therefore XED is negative. E.g. If the price of DVD players fall, then there will be a increase in demand for DVD disks,

Price Elasticity of Supply

This measures the % change in QS after a change in Price

Price Elasticity of Supply PES =

Inelastic Supply.

% change in QS % change in Price

This means that an increase in price leads to a smaller % change in demand Therefore PES <1 P S P S

Q Inelastic Perfectly inelastic

Supply could be inelastic for the following reasons

1. Firms operating close to full capacity. 2. Firms have low levels of stocks, therefore there are no surplus goods to sell 3. In the Short term, capital is fixed in the short run therefore firms do not have time to build a bigger factory. 4. If it is difficult to employ factors of production, e.g. if skilled labour is needed 5. With agricultural products supply is inelastic in the short run, because it takes at least 6 months to grow crops,

www.economicshelp.org

14

Elastic Supply This occurs when an increase in price leads to a bigger % increase in
supply, therefore PES >1 P P

Q Elastic Supply Perfectly Elastic

Supply could be elastic for the following reasons:

1. If there is spare capacity in the factory 2. If there are stocks available 3. In the long Run supply will be more elastic because capital can be varied 4. If it is easy to employ more factors of production

Multiple Choice Style Question

Q. PES is 2.0 for CDS: and the firm supplied 4,000 when the price was 30. If the price increased from 30 to 36, what will be the new Q? QS increases by 6, therefore as a % 6/30 = 0.2 = 20% 2.0 = % change in QS 20 40 = % change in QS = 5,600

Therefore new Q = 4000 *140/100

www.economicshelp.org

15

Market Failure
Market Failure This occurs when there is an inefficient allocation of resources in a free market Externalities: Social benefit Social Cost: These occur when a third party is affected by the decisions and actions of others. is the total benefit to society = Private Benefit (PMB) + External Benefit (XMB) is the total cost to society = Private Cost (PMC) + External Cost (XMC

Social Efficiency occurs when resources are utilised in the most efficient way. This will occur at an output where Social Cost (SMC) = Social Benefit. (SMB)

Positive Externalities
This occurs when the consumption or production of a good causes a benefit to a third party. When you consume education you get a private benefit. But there are also benefits to the rest of society. E.g you are able to educate other people and therefore they benefit as a result than your personal benefit. Social Benefit > Private Benefit

Therefore with positive externalities the benefit to society is greater

Positive Externality
P S = PMC = SMC

P2 P1

SMB = Social Benefit D = PMB = Private Benefit Q1 Q se Q

www.economicshelp.org

16 In a free market consumption will be at Q1 because private benefit = private cost However this is socially inefficient because Social Cost < Social Benefit. Therefore there is under consumption of the positive externality Social Efficiency would occur at Q se where Social Cost = Social Benefit For example: In the real world without govt intervention there would be too little education and public transport

Negative Externalities:
Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party. For Example if you play loud music at night your neighbour may not be able to sleep. If you produce chemicals but cause pollution then local fishermen will not be able to catch fish. This loss of income will be the negative externality. Therefore with a negative externality Social Cost > Private Cost

Negative Externality
P SMC S=PMC

P2 P1

D = PMB = SMB Q

Q se

Q1

In a free Market people ignore the external costs to others therefore output will be Q1 where D=S. This is socially inefficient because at Q1: Social Cost > Social Benefit Social Efficiency occurs at Q se where Social Cost = Social Benefit E.g. In a free market there would be over consumption of cars and cigarettes

www.economicshelp.org

17

Government intervention to overcome market failure

1. Taxes
P SMC = S + Tax S = PMC P2

Tax on a negative externality

P1 P0 D = PMB = SMB Q se Q1 Tax = P2 P0 : Supply curve shifts to the left consumers now pay the social cost SMC Market price increase from P1 to P2 Output will now be Q se where SMC = SMB Q

DISADVANTAGES of taxes i) ii) iii) iv) v) Difficult to measure the level of negative externality e.g. what is the cost of pollution from a car? If Demand is inelastic then higher taxes will not reduce demand much Taxes will cause inequality Cost of administration Possibility of evasion. E.g. with tax on disposing of rubbish there has been an increase in fly tipping (illegal dumping of rubbish)

ADVANTAGES of Taxes i) Provides incentives to reduce the negative externality such as pollution. E.g. cars have become more fuel efficient ii) Social efficiency, 1st best solution.(where MSC = MSB) iii) Taxes raise revenue for the govt, which can be spent on alternatives

www.economicshelp.org

18

2. Subsidies
This involves the government paying part of the cost to the firm to encourage more consumption, therefore supply shifts to the right.

Subsidy on a positive externality

P S = PMC = SMC S2 P2 P1 P0 SMB = Social Benefit D = PMB Q fm Q se Q

Subsidy = P2- P0 The supply curve shifts to S2 and Price falls to P0 People will now consume more at Q se

Advantages of Subsidies
a.) Increases social efficiency b.) Provides an alternative to negative externalities e.g. buses for cars

Disadvantages of Subsidies:
a.) Is expensive and the govt will have to increase taxes. b.) Difficult to estimate the benefits of the positive externality and therefore it is difficult for the govt to know how much subsidy to give c.) Giving subsidies to firms may encourage inefficiency as the firms can rely on govt aid

3. Pollution Permits.
These involve giving firms a legal right to pollute a certain amount e.g. 100 units of Carbon Dioxide per year. If the firm produces less pollution it can sell its permits to other firms. However if it produces more pollution it has to buy permits off other firms.

www.economicshelp.org

19 Therefore there will be a market for pollution permits. IF firms pollute a lot there will be low supply and high demand therefore the price will be high for permits. Therefore there is an incentive for firms to cut pollution

4. Laws Prohibiting undesirable behaviour

E.g. Legal Age for smoking Ban on drink driving simple and easy to understand When the danger is great it may be better to ban it all together When a decision needs to be taken quickly, a tax may be too cumbersome

Advantages of legal restrictions

Disadvantages of legal restrictions

there is little incentive for a firm to develop more efficient mechanisms it may be socially inefficient to ban everything

4. Advertising

The govt could advertise the dangers of smoking and alcohol, this may overcome problems of poor information consumers may have about demerit goods. However consumers could still ignore the govt

Merit Good

This is a good with 2 characteristics

i) people do not realise the true benefit of consuming the good ii) Usually these goods have positive externalities Examples include Health, education, In a free market they will be under consumed.

Demerit Good:

This also has 2 characteristics:

i) People dont realise or ignore the costs e.g. smoking, ii) Usually these goods have negative externalities. These are over consumed in a free market Examples include smoking, alcohol

Public Good:
i)

These goods have two characteristics:

Non-rivalry: When a good is consumed, it doesnt reduce the amount available for others. E.g. street lighting ii) Non- excludability: This occurs when it is not possible to provide a good without it thereby being possible for others to enjoy e.g national defence Therefore there is a free rider problem as people can consume without paying for them therefore in a free market they will not be provided www.economicshelp.org

20

Benefits of Govt providing Public Services

1. Merit Goods: people do not realise or underestimate the benefits of education 2. Positive Externalities. The consumption of health care services has benefits to the rest of society. Therefore will be underprovided in the private sector 3. Economies of scale in providing National Service 4. Providing an universal service leads to greater equality of distribution. In a free market some would be unable to afford to pay. 5. Minimum Service Standards: important for public services such as health. The private sector may cut costs by cutting quality of products

Government Failure.

This occurs when govt intervention leads to an inefficient allocation of resources. E.g. it could fail to overcome market failure and reduce economic welfare,. Govt failure can occur for various reasons: 1. Poor Information the govt may have poor info about the type of service to provide. 2. Political interference e.g. politicians may take the short term view rather than considering long term effects. 3. Admin cost of govt bureaucracy in running public services 4. Lack Of incentives: There is no profit motive working in the public sector this can lead to inefficiency. For example there could be overstaffing

Advantages of the private sector providing public services

1. Increased Demands being placed on the public sector due to demographic changes. If more people went private this would enable the NHS to have shorter waiting lists 2. Provides consumers with more choice. 3. If less people use the NHS it would enable the govt to lower taxes and reduce borrowing 4. Private Sector has profit incentive to cut costs and provide a more efficient service. E.G public bodies may have over staffing because of political fears about job cuts 5. Diseconomies of Scale in the NHS

Disadvantages of the private sector

1. It is difficult to introduce a profit motive into public services such as Health care, for example it is not practical to give performance related pay to nurses Also the private Sector may cut costs by reducing quality of service 2. May increase inequality 3. Health is a merit Good and will be underprovided in a free market

www.economicshelp.org

21

Efficiency
Productive Efficiency: This means it is impossible to produce more of one good than another this occurs on PPF. It will also occur at the lowest point on the firms AC curve Allocative Efficiency: This occurs when consumer preferences are met. This involves an optimal distribution of resources i.e. it is impossible to increase the economic welfare of on without reducing it for another. Economies of Scale: This occurs in the long run when increased output leads to lower average costs and therefore increased efficiency. E.g. by increasing output from Q1 to Q2 the firm is able to reduce Average costs from AC1 to AC2

LRAC = Total Cost Quantity

AC1 Long run average costs AC2 Q1 Q2

Types of economies of scale:

1. Specialization and division of labour: In large scale operations workers can do more specific tasks. With little training they can become very proficient in their task, this enables greater efficiency and lower average costs 2. Technical. If a firm has high fixed costs e.g. building a large factory then the firm will reduce average costs if it makes better use of its existing capacity. 3. Bulk buying: If you buy a large quantity then the average costs will be lower. This is because of lower transport costs and less packaging. 4. Financial economies. A bigger firm can get a better rate of interest than small firms 5. Spreading overheads. If a firm merged it could rationalise its operational centres. E.g. it could have one head office rather than two. 6. External economies of scale: This occurs when firms benefit from the whole industry getting bigger.

Diseconomies of Scale:
This occurs when increased output leads to higher average costs. This can occur due to factors such as difficulty of controlling workers in a big firm. Also in a big firm workers may become alienated with little motive to work hard

www.economicshelp.org

22

Monopoly:
This is a market structure with one dominant firm Monopoly power occurs when a firm controls over 25% of the market For a monopoly to occur there need to be barriers to entry, these are conditions which make it more difficult for a firm to enter a market: E.g.

1. Economies of Scale. A new firm would find it difficult to compete because its average costs would be much higher than the incumbent who has a higher output. 2. Natural Barriers e.g. only a few countries can produce diamonds 3. Brand Loyalty. Through advertising firms can make it more difficult for new firms to enter because they would have to spend a lot of money on advertising which is a sunk cost (non recoverable ) 4. Vertical Integration. By controlling supplies firms can deter entry 5. Legal Barriers e.g. patents or govt monopolies

Disadvantages of Monopolies
1. Higher Prices. Consumers have only a limited choice, therefore demand is inelastic. This enables the firm to increase prices, thereby causing a fall in consumer surplus 2. Allocative inefficiency. Firms dont respond to consumer needs and preferences. Therefore monopolies tend to be allocatively inefficient. 3. Productively inefficiency. Because competition is limited firms have less incentive to cut costs therefore could be Productively inefficiency 4. Monopolies can pay lower prices to suppliers E.g. car companies with monopoly power can pay lower prices to suppliers 5. Diseconomies of scale. If a firm gets too big and unwieldy average costs will start to rise

Advantages of Monopolies
1. Economies of Scale. If there are high fixed costs in the industry the firm will be able to benefit from economies of scale and lower average costs as output increases 2. Research and Development. A firm can use its supernormal profits to invest in new products which will benefit the consumer. This is important for many industries such as pharmaceuticals

www.economicshelp.org

23

Q. Discuss whether govt subsidies to bus companies would increase economic welfare? Model Answer
Subsidies involve the govt paying part of the firms cost therefore Supply shifts to the right and leads to an increase in demand. Buses have positive externalities. This means that when you travel by bus there is a benefit to a third party. For example if you travel by bus rather than car there will be a fall in pollution and congestion. Congestion costs the economy a lot because firms have an increase in costs and there is lost. Therefore the Social Benefit of travelling by bus is greater than the private benefit. However in a free market people ignore the social benefit therefore there is under consumption
P S = PMC S = S+ sub

Ps P1 P2
Q1 Q2 SMB D = PMB Q

Subsidy = Ps P2

In a free market the equilibrium output will be at Q1 where PMB = PMC. However social efficiency occurs at Q2 where SMC = SMB. Therefore there is a case for subsidising the buses to overcome market failure. A subsidy of (Ps P2) will shift supply to the right and increase demand to the socially efficient level Another argument for subsidising buses is that it is an important public service and it is important to ensure that all groups of people are able to use it, therefore the govt could subsidise cheap tickets for poor people to ensure greater equality. However the problem with subsidising buses is that giving subsidises to bus firms may encourage them to be inefficient. This is because the company has less need to cut costs because it can get money from the govt. However this may not necessarily occur, it could depend on how competitive the bus industry was.

www.economicshelp.org

24 Subsidising buses will mean the govt will have to increase taxes; this could cause disincentives in the economy, because higher taxes may reduce incentives to work. However this problem could be overcome by taxing goods with negative externalities like cars.

Another problem with govt intervention is that the govt may have poor information about how much to subsidise and who to give it to. Politicians are usually worse at making economic decisions because they do not have economic pressure but political pressures. A more significant problem is that demand for buses may be very inelastic. Buses only go certain routes therefore it is less suitable for some people, therefore making buses cheaper may not increase demand, it may be necessary to also increase the range of bus services and make them more attractive to consumers. To conclude there is a good economic reason to subsidise buses but the govt will need to be careful that it gives the correct amount and that it is not wasted. Furthermore to reduce congestion, it may be necessary to adopt other measures such as taxing cars.

COMMENTARY
To do well on this essay it is vital to
i) ii) iii) iv) Have a good understanding of market failure and externalities. Draw a suitable diagram for subsidising a positive externality Be able to discuss both sides of the argument. At least 2 or 3 disadvantages of subsidising buses is important Evaluate which points are the most important

A weak candidate will

i) ii) Talk of buses giving benefits to society without being specific about economic terms. Give only one side of the argument e.g. just write about why buses should be subsidised

www.economicshelp.org

25

The Housing Market

AQA UNIT 3

Nominal House Prices: This is the actual monetary value of the house Real House Price: This is the monetary value minus inflation Mortgage repayments: To buy a house people have to borrow money. Therefore they take out a mortgage, this loan is then paid back in monthly mortgage repayments Negative Equity: This occurs when there is a fall in the real value of the house. It means that if somebody wanted to sell their house they would get less for it in real terms than the original buying price. Capital gains: This occurs when people have an increase in the value of their assets such as your house. This leads to the wealth effect Wealth Effect: The most common form of peoples wealth is their house. Therefore if house prices increase people feel wealthier and therefore spend more causing an increase AD. Stamp duty: This is a tax that is paid on buying a new house. The more expensive it is the more tax that is paid

Equity Withdrawal: If house prices increase owners can take advantage of this by re-mortgaging their house giving people extra disposable income. For example if you bought a house for 100,000 you would have a mortgage for that amount. If the value of the house increased to 130,000 the bank will be willing to lend you an extra 30,000 Boom and Bust: This involves rapid changes in the economy, During a boom period house prices rise rapidly helping the economy to grow fast. However this causes inflation. If interest rates then rise then the economy will slow down causing a fall in house prices. (This occurred in the late 1980s and early 1990s) Recession: This occurs when there is a fall in economic growth for 2 consecutive quarters

www.economicshelp.org

26

Factors That effect House Prices

House prices are affected by a combination of supply and demand factors. S

P P2 P1

An increase in demand causes a big increase in price because supply is inelastic

D2 D1 Q1 Q2 Q

Demand Side Factors:

Demand for houses can increase for the following reasons An increase in real income. This could be due to higher wages or lower taxes 2. Lower interest rates. This will reduce the cost of having a mortgage. Interest rate are very important as mortgage repayments are usually the biggest part of a persons monthly spending. 3. An increase in consumer confidence in the economy 4. Lower Unemployment 5. Demographic factors such as an increase in the population or an increase in the number of single people wanting a house. In the UK this has occurred for various reasons such as: i) an increase in divorce rates ii) Increase in life expectancy therefore more old single people iii) Children leaving home early iv) Less marriage 6. An increase in the price of rented accommodation which is a substitute to buying a house 7. Inherited wealth. Many people use inherited wealth to buy houses 1.

www.economicshelp.org

27

Supply side Factors

1. In the short run Supply of housing is fixed because it takes time to build houses. Therefore in the short run demand affects prices more than supply However if the supply of housing is inelastic then an increase in demand will lead to a big increase in price.

In the long Run the supply of housing is affected by many factors

2. Availability of planning permission. This is difficult to obtain in rural areas 3. Opportunity cost for builders e.g. are there better returns from other types of investment 4. Existing houses may be knocked down because they are deemed unfit to live in. 5. An increase in the cost of building new houses will shift supply to the left

How The Housing Market effects the rest of the economy.

Housing is the biggest component of most households wealth. Therefore it has a big impact on the economy. The UK has one of the highest rates of property ownership in the UK. It is roughly 77% compared to 50% in France. If there is a boom (or increase) in the housing market then there will be a positive wealth effect as people enjoy capital gains. This will lead to an increase in AD, because people are more confident about the economy and some people will remortgage their house (equity withdrawal) to spend more money.
If there is an increase in AD there may be a multiplier effect which causes the increase in AD to be bigger than the initial effect

1. Effect on AD.

An increase in AD is likely to cause an increase in Real GDP, however this depends on the situation of the economy. In the below diagram there is spare capacity in the economy therefore there is an increase in Real GDP
Price Level

2. Effect on Economic Growth (Real GDP)

LRAS

P P AD Y1 Y2 Y AD

www.economicshelp.org

28 However if the economy is close to full capacity then the increase may only be small. Also the effect on AD depends upon other components of AD. For example if taxes are rising or exports are falling this will keep AD low despite rising house prices

An increase in house prices will cause an increase in the cost of mortgages and therefore will lead to an increase in the RPI. Also the increase in AD could cause demand pull inflation, However again it does depend upon the slope of the AS curve and other factors in the economy.

3. Effect on Inflation

4. The MPC is responsible for setting interest rates. It is committed to keeping

inflation within its target of RPIX 2.5% +/-1. If house prices are rising this may put pressure on inflation therefore they may be more likely to increase interest rates However house prices are only one factor affecting monetary policy High property values has caused a shortage of workers in London and the South East.

5. High House prices could cause some workers to be unable to afford to but houses.

6. Increased Supply of Houses: With High house prices there is a greater incentive to
build new houses. Therefore house-building firms will do well.

The Housing Market and Market Failure

a) Despite the shortage of houses the government has put a limit on building new houses. This is because new houses will cause the loss of green belt land. This loss of the environment could be said to be a negative externality b) Other negative externalities of new houses include increased traffic on the roads causing congestion and pollution. c) Those on low incomes may not be able to afford to buy or rent a house. This has become more of a problem with the boom in housing prices. d) Boom and Bust in the Housing Market. This involves rapid movements in the price of housing. In times of falling house prices, some house owners can experience negative equity causing lower AD. Rising house prices increase AD maybe causing inflation. Booms encourage speculation and make houses unaffordable for many people

www.economicshelp.org

29

Government Intervention in the Housing Market

1. 2. 3. Legislation about building houses on greenbelt land Govt subsidies for building houses. However this has been quite low in recent years. Provision of council houses. However in the 1980s many council houses were sold to the occupants at reduced prices. This has reduced the quantity of housing. Also council houses have often been associated with higher levels of crime and vandalism, especially in many of the new tower blocks built in the 1960s. To reduce fluctuations in house prices the MPC can change the interest rate. However the problem is that housing prices are only a small effect part of the economy. Despite recent increases in house prices (95-02) interest rates have not been cut because inflation has been low. Maximum Prices. The aim of this is to reduce the price of rented houses, however this could result in a shortage of houses in the rented sector. Also problem of black market Housing Benefit. Those on low incomes can apply for housing benefit which enables them to rent housing. Policies to reduce speculation in the housing market e) Stamp Duty (this is a tax on selling a house) f) Abolition of MIRAS ( this was a tax relief on having a mortgage)

4.

5.

6. 7.

Elasticity and Housing

Elasticity of Demand for Housing The sharp rises in house prices suggest that demand is quite inelastic because the higher prices have not discouraged demand. There are not many substitutes for housing . Renting is a possibility but in the UK people are keen to buy a house as it is a form of investment. Demand is more inelastic in popular areas such as London Elasticity of Supply for Housing: In the Short run supply will be inelastic because it takes time to build new houses. In the long run the supply of housing will be more elastic because increased prices will encourage people to buy them However in certain areas supply will be still inelastic because there is a shortage of space or space is protected by greenbelt land regulations Income Elasticity of demand Demand for housing tends to be income elastic. YED > 1 If incomes increase people tend to spend a higher % of their incomes on housing. This is because people want to get a better (and more expensive house) and some people may buy a 2nd home in the country

www.economicshelp.org

30

Are House Prices likely to fall in 2003?

YES
1. The ration of house prices to Incomes has risen to an all time high. This means that the average worker is unable to afford a house in many areas, this will lead to a fall in prices 2. Demographic factors suggest the population is likely to fall soon. Therefore there will be less people willing to buy houses. 3. Low Interest rates have helped keep the housing market strong however they may rise in the future as the economy picks up and inflation rises above its inflation target. 4. Rising house prices have encouraged speculation. This means people buy houses as a way to make capital gains. However as prices start to fall these people will start to sell causing a bandwagon effect of an ever increasing rate of falling house prices. 5. Some areas of the country are more vulnerable to falling prices these are the areas which saw the biggest increases in the 90s 6. With changing social attitudes. Couples may be more likely to live their parents for longer NO 1. The ratio of house prices to incomes has increased but this is sustainable because i) inherited wealth is increasingly being used to buy houses. ii) Housing has a high YED, therefore people are willing to spend a higher % of their income on housing 2. Despite a stagnant population there is an increasing tendency for smaller households e.g. single parents single old people and children leaving home earlier. 3. Supply of housing has not been increasing. The number of new house built was the lowest since the war, also many council houses built in the 1960s are being knocked down, because they were associated with various social problems 4. Many houses in London have been bought by foreigners

www.economicshelp.org

31

Q. Example of Essay Discuss how a boom in the Housing market affects other aspects of the economy?
A boom in the housing market involves a rapid increase in the prices of houses, for example in 2002 house prices increased by over 20%. In the UK more than 70% of households own their own house therefore housing is a significant component of household wealth. Thus as house prices rapidly increase their will be a positive wealth effect as household see their wealth rise. This is likely to encourage householders to increase spending for 2 reasons. Firstly people can re-mortgage their house and engage in equity withdrawal This involves borrowing more money against the increased value of the house, this can then be spent. Also rising house prices are likely to increase consumer confidence and therefore consumer spending will rise. Consumer spending is the biggest component(66%) of AD therefore the wealth effect of housing will cause AD to increase, this is likely to increase economic growth and possibly inflation as the diagram below shows. PL LRAS

P2 P1 AD1 Y1 Y2 Y Real GDP AD2

Higher growth may lead to a fall in unemployment as firms employ more workers. Also if there is more consumer spending this may adversely effect the balance of payments because consumers buy more imports, leading to a bigger deficit. The effect of rising house prices depends upon the position of the economy, if there is spare capacity and AS is increasing then inflation is unlikely to occur. However if the economy is close to full capacity then a further rise in AD will cause inflation. (Rising house prices were a factor behind the inflationary boom of the late 1980s) The next diagram shows this

www.economicshelp.org

32
Price Level

LRAS P2 P1 In this case rising house prices contribute to inflation AD2 AD1

Y1

Also the effects of rising house prices depends upon other components of AD. For example in 2002 growth of AD was moderate despite a housing boom. This was because other aspects of growth were low, e.g. manufacturing output was low and the global economy was weak. Therefore the UK experienced little inflation. In the 1980s rising house prices were accompanied by low interest rates and tax cuts, this did cause inflation. Because house prices can cause inflation, the MPC will look at house prices, amongst other things when setting interest rates. Rapidly rising house prices can also cause other problems, especially if the rises are concentrated in certain areas. Many important public sector workers are no longer able to afford to buy houses in areas such as London because prices are too high. Therefore hospitals and schools have struggled to attract staff.

Commentary
1. It is important to recognise increased house prices cause a wealth effect and therefore higher AD. 2. Many candidates say higher house prices cause a fall in demand for houses. This is wrong; it is the increased demand for houses that caused the prices to rise. 3. House prices can have a significant impact on growth and inflation. However the effect isnt certain, it depends on a few factors. Therefore it is important to evaluate the possibilities.

www.economicshelp.org

33