Econ - Micro Econ(1)

8/3/2019 Econ - Micro Econ(1)

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AS

MICRO ECONOMICS

AQA Unit 1

Edexcel Unit 1+ 2

OCR 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)



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services services

B

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 foregonee.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 theeconomy is maximising the use of its resources and operating efficiently

Point A = inefficient.

Point B = Productively efficient. It is impossible to produce more goodswithout losing out on services

Point C = impossible

Constant Returns Diminishing Returns

The above diagrams show different slopes of PPFs In the first one the opportunitycost of increasing goods is always constant therefore we say it has constant returns

goods goods

goods

services

A

C

PPF



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Q1 Q2

P

Q

D1

P1

P2

D2

Demand

The individual Demand Curve illustrates the price people are willing to payfor 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 indemand from Q2 to Q1

Shifts in the Demand Curve

This occurs when, even at the same price, consumers are willing to buy a higherquantity 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 suchas 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 increasethe demand for Fuji films will increase

5. A fall in the price of complements. E.g. a lower price of Play Station 2 willincrease 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 butprobably not salt.

Advertising is important for goods in which branding is important, e.g.coca cola but not for bananas



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P

P1

S1

Q

P2

Q1 Q2

S2

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 getextra revenue (income) from selling the goods.

If price changes, there is a movement along the supply curve, e.g. ahigher price causes a higher amount to be supplied.

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 ateach 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



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P

Pe

S

Q

Q1 Qe Q2

P2

P

P1

S

Q

Qe Q2

P2

D1

D2

Market Equilibrium

Market Equilibrium

The Price Mechanism refers to how Supply and Demand interact to set the marketprice and the amount of goods sold

If price was below the equilibrium at P2 then demand would be greater thanthe supply. Therefore there is a shortage of (Q2 Q1)

Therefore firms will put up prices and supply more. As price rises there willbe a movement along the demand curve and less will be demanded.

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 andQuantity supplied will increase leading to a new equilibrium at Q2



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P

P1

S

QQ1

P2

D1

S2

D2

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 insupply.

The demand for coffee could fall for various reasons such as:

i) Lower incomes mean that consumers cannot afford to buy as muchii) Less fashionableiii) Decrease in the price of substitutes such as teaiv) Fall in number of coffee shopsv) Health concerns about caffeine

The supply of coffee could increase for various reasons such as:

i) Increase in the number of suppliersii) Lower costs of productioniii) Govt subsidiesiv) Higher labour productivity in producing coffee, this will decrease the costs

of production

Economic effects of an increase in the Price of Coffee

1. Q.D. will fall, but it will only be a small amount because demand isinelastic.

2. Demand for substitutes will increase, however there are not any closesubstitutes for coffee there this will not be very significant

3. If higher prices are caused by increased demand there will be an increasein income for firms producing and selling coffee.



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P

MaxP

Pe

Q

D

S

Q1 Qe Q2

Min P

Pe

Q

D

S

Q1 Qe Q2

P

Government Intervention in Markets

1. Maximum Prices.

Under certain circumstances the govt may wish to reduce the price belowthe market equilibrium. E.g. they could have a maximum price for rentinghouses.

The problem of Maximum prices is that:

The lower price will cause a shortage therefore some tenants will beworse off because they cannot find any houses to rent. Therefore thegovt would have to increase supply in order to overcome the shortage

2. Minimum PricesThis occurs when the govt wishes to raise the price above the equilibrium.For example in agricultural markets the govt often wishes to increase theincome of farmers by increasing the price of goods.

The problem of Min prices is that

They encourage farmers to increase supply leading to a surplus whichis not bought on the market. Therefore the govt is obliged to buy thesurplus Q2- Q1 to maintain the target price.



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Min Wage

We

Q labour

D

S

Q1 Qe Q2

Wage

P

Target Price

QD

TP

P1

Q1 Q2

3. Minimum Wages:

This is similar principle to min prices. It is a policy designed to increasethe wages of the lowest paid, reducing relative poverty.

If labour markets are competitive then a min wage could causeunemployment of Q2- Q1.

However in the real world a minimum wage may not causeunemployment because

i) Demand for labour may be very inelasticii) A higher minimum wage may increase worker productivity. This is

because now wages are higher workers may feel more loyalty to thecompany

4. Buffer Stocks.

This is a policy designed to stabilise prices primarily in agriculturalmarkets. The purpose of buffer stocks is:

i) Protect farmers incomes by guaranteeing a min priceProtect consumers from high prices by guaranteeing a maximum pricelevel

ii) Ensure adequate supplies of food

S2

S1Buffer Stock



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P

S2

S1

D

P1

P2

i) Demand for agricultural products isinelastic, this is because they are asmall % of total income

ii) Supply is inelastic

iii) Supply can fluctuate due to variablefactors such as the weather and disease

If there was an increase in supply the equilibrium price would fall below thetarget 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 inthe 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 bedifficult 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

Advantages of govt intervention in Agriculture:

1. Stable prices help maintain farmers incomes

2. Stability enables investment in agriculture

3. Farming has positive externalities e.g. helps rural communities

4. Stable prices prevent excess prices for consumers

5. Food supplies are assured

Disadvantages of govt intervention in Agriculture:

1. Cost of buying excess supply

2. Min prices and Buffer stocks encourage over supply

3. Govt subsidy to farmers may encourage inefficiency amongst farmers

4. Some goods cannot be stored in buffer stocks

5. Govts may have poor information e.g. what price to set

6. Administration costs

Q



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P

D

D

P

QQ

P P

QQ

D

D

Elasticity

Price Elasticity of Demand (PED) = % change in Quantity Demanded% change in Price

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.

Elastic Demand PED > 1 Perfectly Elastic

Goods which are demand elastic tend to have the following characteristics.

1. They are luxury goods2. 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. ifSimsburys put up the price of its bread there are many alternatives, sopeople would be price sensitive

4. Bought frequently

Inelastic Demand

These are goods where a change in price leads to a smaller % change indemand, therefore PED


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P

S1

S2

D

Q

$30

$15

80 100

Goods which are demand inelastic tend to have some or all of the followingfeatures.

1. They have few or no close substitutes, e.g. petrol, cigarettes.2. They are necessities

3. They are addictive4. They cost a small % of income or are bought infrequently

In the short term demand is usually more inelastic because it takes timeto find alternatives

Using Knowledge of Elasticity

1. If demand is inelastic then increasing the price can lead to an increase inrevenue. This is why OPEC try to increase the price of oil.

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 increased20% then the YED = 20/ 5 = 4.

Income Elasticity of Demand (YED) = % change in Q.D% change in Income

Inferior Good This occurs when an increase in income leads to a fallin demand. Therefore YED0

Luxury Good This occurs when an increase in income causes a bigger% increase in demand, therefore YED>1.

Income inelastic This means an increase in income leads to a smaller %increase in demand. Therefore 0> YED


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P P

Q

SS

Q

Inelastic

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 ishigher

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 = % change in QS% change in Price

Inelastic Supply.

This means that an increase in price leads to a smaller % change in demandTherefore PES


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S

P

Q

P

Q

S

Elastic Supply

This occurs when an increase in price leads to a bigger % increase insupply, therefore PES >1

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

PES is 2.0 for CDS: and the firm supplied 4,000 when the price was 30.

Q. 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 QS20

40 = % change in QS

Therefore new Q = 4000 *140/100 = 5,600



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P

Q 1 Q seQ

SMB = Social Benefit

D = PMB = Private Benefit

S = PMC = SMC

P1

P2

Market Failure

Market Failure This occurs when there is an inefficient allocation of resourcesin a free market

Externalities: These occur when a third party is affected by the decisions andactions of others.

Social benefit is the total benefit to society =Private Benefit (PMB) + External Benefit (XMB)

Social Cost: 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 whereSocial Cost (SMC) = Social Benefit. (SMB)

Positive Externalities

This occurs when the consumption or production of a good causes a benefit toa 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 otherpeople and therefore they benefit as a result

Therefore with positive externalities the benefit to society is greaterthan your personal benefit. Social Benefit > Private Benefit

Positive Externality



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Q se Q1

P1

P2

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 betoo little education and public transport

Negative Externalities:

Negative externalities occur when the consumption or production of agood causes a harmful effect to a third party.

For Example if you play loud music at night your neighbour may not beable to sleep.

If you produce chemicals but cause pollution then local fishermen will notbe able to catch fish. This loss of income will be the negative externality.

Therefore with a negative externality Social Cost > Private Cost

In a free Market people ignore the external costs to others therefore outputwill 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

SMC

S=PMC

Q

P

D = PMB = SMB

Negative Externality



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Q se Q1

P1

P2

P0

Government intervention to overcome market failure

1. Taxes

DISADVANTAGES of taxes

i) Difficult to measure the level of negative externality e.g. what is the cost ofpollution from a car?

ii) If Demand is inelastic then higher taxes will not reduce demand much

iii) Taxes will cause inequality

iv) Cost of administration

v) Possibility of evasion. E.g. with tax on disposing of rubbish there has beenan 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

SMC = S + Tax

S = PMC

Q

P

D = PMB = SMB

Tax on a negative externality

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



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P

Q fm Q seQ

SMB = Social Benefit

D = PMB

S = PMC = SMC

P1

P2

P0

S2

2. Subsidies

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

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 itis difficult for the govt to know how much subsidy to give

c.) Giving subsidies to firms may encourage inefficiency as the firms can relyon 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.

Subsidy on a positive externality



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Therefore there will be a market for pollution permits. IF firms pollute alot there will be low supply and high demand therefore the price will behigh for permits.

Therefore there is an incentive for firms to cut pollution

4. Laws Prohibiting undesirable behaviour

E.g. Legal Age for smokingBan on drink driving

Advantages of legal restrictions

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

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 aboutdemerit 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 goodii) 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: These goods have two characteristics:

i) Non-rivalry: When a good is consumed, it doesnt reduce theamount 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 toenjoy e.g national defence

Therefore there is a free rider problem as people can consume withoutpaying for them therefore in a free market they will not be provided



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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 sector3. 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 toprovide.

2. Political interference e.g. politicians may take the short term view rather thanconsidering 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 thiscan 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 demographicchanges. If more people went private this would enable the NHS to haveshorter waiting lists

2. Provides consumers with more choice.

3. If less people use the NHS it would enable the govt to lower taxes and reduceborrowing

4. Private Sector has profit incentive to cut costs and provide a more efficientservice. E.G public bodies may have over staffing because of political fearsabout 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 Healthcare, for example it is not practical to give performance related pay to nursesAlso 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



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Q

Long run average costs

Q1 Q2

AC1

AC2

Efficiency

Productive Efficiency:This means it is impossible to produce more of one good than another thisoccurs 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 optimaldistribution of resources i.e. it is impossible to increase the economic welfareof on without reducing it for another.

Economies of Scale:

This occurs in the long run when increased output leads to loweraverage costs and therefore increased efficiency. E.g. by increasing outputfrom Q1 to Q2 the firm is able to reduce Average costs from AC1 to AC2

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 greaterefficiency 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 firms5. Spreading overheads.

If a firm merged it could rationalise its operational centres. E.g. it couldhave 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 bigfirm. Also in a big firm workers may become alienated with little motive towork hard

LRAC = Total Cost

Quantity



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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 areconditions which make it more difficult for a firm to entera market: E.g.

1. Economies of Scale.

A new firm would find it difficult to compete because its average costswould be much higher than the incumbent who has a higher output.

2. Natural Barrierse.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 asunk 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. Thisenables 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 beProductively inefficiency

4. Monopolies can pay lower prices to suppliersE.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 whichwill benefit the consumer. This is important for many industries such aspharmaceuticals



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S = S+ sub

Q

SMB

D = PMB

S = PMCP

Q1 Q2

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 tothe right and leads to an increase in demand.

Buses have positive externalities. This means that when you travel by busthere is a benefit to a third party. For example if you travel by bus rather than carthere will be a fall in pollution and congestion. Congestion costs the economy alot because firms have an increase in costs and there is lost. Therefore the SocialBenefit of travelling by bus is greater than the private benefit.

However in a free market people ignore the social benefit therefore there isunder consumption

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 casefor subsidising the buses to overcome market failure. A subsidy of (Ps P2) will shiftsupply to the right and increase demand to the socially efficient level

Another argument for subsidising buses is that it is an important public serviceand it is important to ensure that all groups of people are able to use it, therefore thegovt could subsidise cheap tickets for poor people to ensure greater equality.

However the problem with subsidising buses is that giving subsidises to busfirms may encourage them to be inefficient. This is because the company has lessneed to cut costs because it can get money from the govt.However this may not necessarily occur, it could depend on how competitive the busindustry was.

Ps

P2

P1

Subsidy = Ps P2



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

Another problem with govt intervention is that the govt may have poorinformation about how much to subsidise and who to give it to. Politicians are usuallyworse at making economic decisions because they do not have economic pressure butpolitical 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, thereforemaking buses cheaper may not increase demand, it may be necessary to also increasethe range of bus services and make them more attractive to consumers.

To conclude there is a good economic reason to subsidise buses but the govtwill 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 suchas taxing cars.

COMMENTARY

To do well on this essay it is vital to

i) Have a good understanding of market failure and externalities.ii) Draw a suitable diagram for subsidising a positive externalityiii) Be able to discuss both sides of the argument. At least 2 or 3 disadvantages

of subsidising buses is importantiv) Evaluate which points are the most important

A weak candidate will

i) Talk of buses giving benefits to society without being specific abouteconomic terms.

ii) Give only one side of the argument e.g. just write about why busesshould be subsidised



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The Housing MarketAQA UNIT3

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 amortgage, 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 termsthan the original buying price.

Capital gains:This occurs when people have an increase in the value of their assets such asyour house. This leads to the wealth effect

Wealth Effect:The most common form of peoples wealth is their house. Therefore if houseprices increase people feel wealthier and therefore spend more causing anincrease AD.

Stamp duty:This is a tax that is paid on buying a new house. The more expensive it is themore tax that is paid

Equity Withdrawal:If house prices increase owners can take advantage of this by re-mortgagingtheir house giving people extra disposable income. For example if you boughta house for 100,000 you would have a mortgage for that amount. If the valueof the house increased to 130,000 the bank will be willing to lend you anextra 30,000

Boom and Bust:This involves rapid changes in the economy,

During a boom period house prices rise rapidly helping the economy togrow fast. However this causes inflation. If interest rates then rise then theeconomy 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



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P

P1

S

Q

Q1 Q2

P2

D1

D2

Factors That effect House Prices

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

Demand Side Factors:

Demand for houses can increase for the following reasons

1. 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 personsmonthly 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 inthe number of single people wanting a house. In the UK this has occurred forvarious reasons such as:

i) an increase in divorce ratesii) Increase in life expectancy therefore more old single peopleiii) Children leaving home earlyiv) 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

An increase in demandcauses a big increasein price becausesupply is inelastic



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Price Level

AD

LRAS

Y

AD

P

P

Y1 Y2

Supply side Factors

1. In the short run Supply of housing is fixed because it takes time to buildhouses. Therefore in the short run demand affects prices more than supply

However if the supply of housing is inelastic then an increase indemand 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 areas3. Opportunity cost for builders e.g. are there better returns from other types of

investment4. 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 abig impact on the economy. The UK has one of the highest rates of propertyownership in the UK. It is roughly 77% compared to 50% in France.

1. Effect on AD.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 inAD, because people are more confident about the economy and some people will re-mortgage 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

2. Effect on Economic Growth (Real GDP)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



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However if the economy is close to full capacity then the increase may onlybe 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

3. Effect on InflationAn 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 causedemand pull inflation, However again it does depend upon the slope of the AS curveand other factors in the economy.

4. The MPC is responsible for setting interest rates. It is committed to keepinginflation within its target of RPIX 2.5% +/-1.

If house prices are rising this may put pressure on inflation therefore they maybe more likely to increase interest rates

However house prices are only one factor affecting monetary policy

5. High House prices could cause some workers to be unable to afford to but houses.High property values has caused a shortage of workers in London and the SouthEast.

6. Increased Supply of Houses: With High house prices there is a greater incentive tobuild 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 newhouses. 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 hasbecome more of a problem with the boom in housing prices.

d) Boom and Bust in the Housing Market. This involves rapid movements in theprice of housing.

In times of falling house prices, some house owners can experience negativeequity causing lower AD.

Rising house prices increase AD maybe causing inflation. Booms encourage

speculation and make houses unaffordable for many people



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Government Intervention in the Housing Market

1. Legislation about building houses on greenbelt land

2. Govt subsidies for building houses. However this has been quite low in recentyears.

3. Provision of council houses. However in the 1980s many council houses weresold to the occupants at reduced prices. This has reduced the quantity ofhousing.

Also council houses have often been associated with higher levels of crimeand vandalism, especially in many of the new tower blocks built in the 1960s.

4. 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 theeconomy. Despite recent increases in house prices (95-02) interest rates havenot been cut because inflation has been low.

5. 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

6. Housing Benefit. Those on low incomes can apply for housing benefit whichenables them to rent housing.

7. Policies to reduce speculation in the housing markete) Stamp Duty (this is a tax on selling a house)f) Abolition of MIRAS ( this was a tax relief on having a mortgage)

Elasticity and Housing

Elasticity of Demand for Housing

The sharp rises in house prices suggest that demand is quite inelastic becausethe higher prices have not discouraged demand.

There are not many substitutes for housing . Renting is a possibility but in theUK 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 newhouses.

In the long run the supply of housing will be more elastic because increasedprices will encourage people to buy them

However in certain areas supply will be still inelastic because there is ashortage 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 onhousing. This is because people want to get a better (and more expensivehouse) and some people may buy a 2nd home in the country



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Are House Prices likely to fall in 2003?

YES

1. The ration of house prices to Incomes has risen to an all time high. Thismeans 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 howeverthey may rise in the future as the economy picks up and inflation risesabove its inflation target.

4. Rising house prices have encouraged speculation. This means peoplebuy houses as a way to make capital gains. However as prices start to fallthese people will start to sell causing a bandwagon effect of an everincreasing rate of falling house prices.

5. Some areas of the country are more vulnerable to falling prices these arethe areas which saw the biggest increases in the 90s

6. With changing social attitudes. Couples may be more likely to live theirparents for longer

NO

1. The ratio of house prices to incomes has increased but this is sustainablebecause

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 smallerhouseholds e.g. single parents single old people and children leavinghome earlier.

3. Supply of housing has not been increasing. The number of new housebuilt was the lowest since the war, also many council houses built in the1960s are being knocked down, because they were associated withvarious social problems

4. Many houses in London have been bought by foreigners



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LRAS

AD2

AD1

Y1 Y2

P2

P1

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 asignificant component of household wealth. Thus as house prices rapidly increasetheir will be a positive wealth effect as household see their wealth rise. This islikely to encourage householders to increase spending for 2 reasons. Firstly peoplecan re-mortgage their house and engage in equity withdrawal This involvesborrowing more money against the increased value of the house, this can then bespent. Also rising house prices are likely to increase consumer confidence andtherefore consumer spending will rise.

Consumer spending is the biggest component(66%) of AD therefore the wealth effectof housing will cause AD to increase, this is likely to increase economic growth andpossibly inflation as the diagram below shows.

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 isspare capacity and AS is increasing then inflation is unlikely to occur. However if theeconomy is close to full capacity then a further rise in AD will cause inflation. (Risinghouse prices were a factor behind the inflationary boom of the late 1980s) The nextdiagram shows this

PL

Y Real

GDP



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AD2

LRAS

AD1

P2

P1

Also the effects of rising house prices depends upon other components of AD. Forexample 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 theglobal 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, amongstother things when setting interest rates.

Rapidly rising house prices can also cause other problems, especially if the rises areconcentrated in certain areas. Many important public sector workers are no longerable 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 andtherefore 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 torise.

3. House prices can have a significant impact on growth and inflation. Howeverthe effect isnt certain, it depends on a few factors. Therefore it is important toevaluate the possibilities.

Price Level

YY1

In this case risinghouse prices

contribute to

inflation



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Econ - Micro Econ(1)

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