The market system Revision Notes

The Role of Assumptions in Economics

Economic assumptions are simplifying statements that help economists create models and theories to understand complex economic phenomena. They allow economists to focus on specific relationships between variables without being overwhelmed by the infinite number of factors present in the real world. These assumptions are vital for constructing logical arguments and making predictions. A key assumption is *ceteris paribus*, meaning 'all other things being equal', which allows economists to isolate the effect of one variable on another.

Common Economic Assumptions and Their Implications

Many economic models rely on common assumptions. For example, consumer rationality assumes individuals make choices to maximise their utility, while profit maximisation assumes firms aim to maximise their profits. These assumptions, though simplifications, enable the development of powerful predictive models. However, it's important to recognise that if these assumptions are not met in reality, the conclusions derived from the models might be limited. For instance, behavioural economics challenges the assumption of perfect rationality, showing that psychological factors often influence decision-making.

Evaluating Assumptions

When evaluating an economic model or theory, it is crucial to examine the underlying assumptions. Are they realistic? Do they hold true in the specific context being studied? The realism of assumptions can affect the applicability and accuracy of a model's predictions. If assumptions are too unrealistic, the model may only provide theoretical insights without much practical relevance. However, even unrealistic assumptions can be useful for illustrating economic principles in a simplified manner before adding layers of complexity.

Definition of External Costs of Production

External costs of production, or negative production externalities, are costs imposed on third parties (those not directly involved in the production or consumption of a good) by the production of a good or service. These costs are not reflected in the market price and are not borne by the producer or consumer.

Examples and Consequences

Common examples include air pollution from factories, water contamination, noise pollution, and habitat destruction. When these costs exist, the private marginal cost (PMC) of production is less than the social marginal cost (SMC). This leads to market failure, specifically overproduction and overconsumption from society's perspective, because the market price does not account for the full social cost. The equilibrium quantity produced by the market will be greater than the socially optimal quantity.

Diagrammatic Representation

In a supply and demand diagram, the private marginal cost (PMC) curve represents the private supply curve. The social marginal cost (SMC) curve lies above the PMC curve, reflecting the external cost. The vertical distance between SMC and PMC represents the external cost per unit. The market equilibrium occurs where PMC intersects demand (PMB), resulting in a quantity (Qm) greater than the socially optimal quantity (Qs), which occurs where SMC intersects demand (SMB). This difference (Qm - Qs) represents the overproduction due to the external cost.

Policy Responses to External Costs

Governments can intervene to address external costs through various measures. These include taxation (e.g., carbon tax) to internalise the external cost, regulation (e.g., emission limits), tradable permits, and property rights definition. Each policy aims to shift the burden of the external cost back to the producers and consumers, thereby reducing production towards the socially optimal level and improving market efficiency.

Demand and Supply Basics

Demand represents the quantity of a good or service consumers are willing and able to buy at various prices over a specific period. The law of demand states that, ceteris paribus, as price increases, quantity demanded decreases. Supply represents the quantity producers are willing and able to sell at various prices. The law of supply states that, ceteris paribus, as price increases, quantity supplied increases.

Market Equilibrium

Market equilibrium is achieved when the quantity demanded equals the quantity supplied. The price at which this occurs is the equilibrium price, and the corresponding quantity is the equilibrium quantity. On a demand and supply diagram, it's the intersection point of the demand and supply curves. At equilibrium, there is no excess demand (shortage) or excess supply (surplus).

Market Disequilibrium: Surplus and Shortage

A surplus occurs when the market price is above the equilibrium price, causing quantity supplied to exceed quantity demanded. Producers accumulated unsold stock, leading them to lower prices. A shortage occurs when the market price is below the equilibrium price, causing quantity demanded to exceed quantity supplied. Consumers are unable to buy desired quantities, leading them to bid up prices. Both situations push the market towards equilibrium.

Shifts in Equilibrium

Changes in non-price determinants of demand (e.g., income, tastes, price of substitutes/complements) shift the demand curve. Changes in non-price determinants of supply (e.g., costs of production, technology, number of suppliers) shift the supply curve. Each shift leads to a new equilibrium price and quantity. For example, an increase in demand (rightward shift) leads to a higher equilibrium price and quantity, assuming supply remains constant.

PED Calculation and Interpretation

Price Elasticity of Demand (PED) is calculated as: % Change in Quantity Demanded / % Change in Price. The sign is typically negative, but the absolute value is used for interpretation. If |PED| > 1, demand is price elastic (responsive). If |PED| < 1, demand is price inelastic (unresponsive). If |PED| = 1, demand is unit elastic. If |PED| = 0, demand is perfectly inelastic (vertical demand curve). If |PED| = infinity, demand is perfectly elastic (horizontal demand curve).

Factors Affecting PED

Several factors determine the PED of a product. The availability of close substitutes is crucial: more substitutes lead to more elastic demand. The proportion of income spent on the good also matters; goods that represent a large portion of income tend to have more elastic demand. Time is another factor; demand tends to become more elastic in the long run as consumers have more time to find substitutes or adjust their consumption habits. Lastly, whether a good is a necessity or a luxury plays a role; necessities usually have inelastic demand, while luxuries have elastic demand.