Theory of The Firm – Profit Maximization

Marginal revenue displays the added revenue from each product sold, the reason the line has a negative gradient is the factor that as there is a greater quantity supplied there is a lower price, as the product is less scarce. When marginal revenue crosses the x-axis in a graph it can be noted that every product produced from that point on-wards takes away from revenue.

Through the understanding of the nature of marginal revenue, we can produce a model curve for a firm’s total revenue. It can be noted that the x-intercept of the marginal revenue graph represents the point at which the total revenue graph is at the peak.


Marginal cost displays the added cost from each product sold due to the factors of production being employed such as labour, materials, etc. Marginal cost represents all of the variable costs of the firm, and how there is an increase in cost when more is produced. However, average total cost allows us to see what the firm should actually pay for production.


Average total cost involves the average variable and fixed costs. The curve displayed above is of the average total cost in the short term. The curve is in a negative gradient as long as marginal costs do not exceed the average total cost, the initial negative gradient can be explained as average fixed costs declines as quantity produced increase, as factors such as the factory are becoming more efficient. The reason the gradient increases is because of the greater increase in marginal cost whereas average fixed cost does not radically change to counteract. This is further explained by the law of diminishing marginal returns.

The understanding of average total cost allows us to use the profit maximization point of marginal cost and marginal revenue graph to analyse what the total revenue is and what the total cost is, enabling the actual portion of profit from production.

There are two examples below, the first one display’s firms operating at point of profit making, and the second an example of loss making. Notice the distinct difference between them as the gradient of average revenue or the position of average total cost. As there are a variety of factors present in the positioning and gradients of each curve and line, it is important to look at what are the points to look at for profit maximization The average revenue line is used as it represents the demand curve, and the average total cost curve is used as it represents the operating costs of the term when a given quantity is supplied. This allows revenue to be worked out through price x quantity, where the quantity at profit maximization meets the average revenue line and average total cost curve.

Graphs to be edited




Introduction to Theory of The Firm

Fixed Costs → do not vary with output
Variable Costs → vary with output

Revenue of a firm is always dependent on the output.

Materials         → Variable Cost (leather, stitching, etc.)
Capital             → Fixed Cost (sewing machines, leather tanner, etc.)
Labour             → Fixed/Variable Cost (depends on type and payment)
Transport         → Fixed Cost (short term)
Marketing        → Fixed Cost (does not vary with output)
Factory            → Fixed Cost (same size, does not vary with output)

Factory p1

Short Term: The length of time in which one factor of production is fixed (factory determines whether or not the firm operates in the short term or the long term).

Long Term: The length of time over which at least one factor of production becomes variable (i.e. need a new factory to increase output).

The Law of Diminishing Marginal Returns:



This graph shows how output increases over the initial short term, but in the long term output decreases. This can be explained by several factors, such as there are only so many facilities, employees waiting to use machines, rate of productivity declines as employees may begin chatting to each other or the machinery is now inefficient.

The classic example is “too many cooks in the kitchen”, if the oven is used by one cook the other cook cannot use it, if one cook used all the fish the other cook cannot use it, etc. The limitation of output increases over time due to inherent problems.

If this graph meets the x-axis and goes below it, it identifies the result of less productivity. As at any point below the x-axis adding a greater amount of a factor of production subtracts from the total output.

As a consequence of The Law of Diminishing Marginal Returns:



Shown above is the example of how adding a unit of labour increases the costs involved in production. The reason marginal cost is at the trough while marginal productivity is at the peak is because the cost of introducing more labour was small in comparison to the increased output. Therefore it can be stated that the cost is counteracted by the increase in output.

This is evident if the following example is given, at one unit of labour 100 baseballs are outputted, as there is an additional unit of labour introduced there is an additional 150 baseballs outputted, this counteracts the cost of hiring the additional unit of labour as the output has increased by 150%.


For Marginal Revenue it can be noted that as price decreases, quantity increases. This is because for the producer to sell the next good they will have to reduce the price of their good, in the sense of revenue you have to lower the price to sell more. As there is more supply the price drops as the good is less scarce.

Profit Maximisation: This is where Marginal Revenue is equal to Marginal Cost (MR=MC, Q-P)

At point Q1 there is greater marginal revenue then marginal cost, this is still a point of profit but if you stop at point Q1 you forsake possible profit and this is highlighted by the blue triangle. This is why it is worthwhile for the producer to increase one of the factors of production to increase the marginal cost with the goal of reaching the point of profit maximisation.

At point Q2 there is a greater marginal cost whereas, there is less marginal revenue. This point can be seen as equally inefficient as point Q1, as again there is loss represented by the green triangle. However it can be argued that it is better to be on this side as through this you achieve a greater market share, which is a long term interest.


Every firm will attempt to reach the point of profit maximisation, the price of the product does not matter to the firm, and the interest is in profit.


Marginal Revenue: The extra revenue that an additional unit of product will bring.

Marginal Cost: The extra cost that an additional unit of product will bring.


The introduction of average revenue allows the producer to see where the price of the good should be in order for the firm to maximize profit. The average revenue can be identified as demand, and while it is in the interest of the firm to maximize profit the accurate pricing of the good is essential.

Average Revenue: Total revenue per unit of output. When all output is sold at the same price, average revenue will be the same as price.


10 Terms to Know For Microeconomics

Production Possibility Frontier (PPF):

A production possibility frontier represents where resources can be allocated to produce certain amounts of a good in comparison to another good. It represents the choice the market has in production between two different goods, limited by the factor that certain resources are scarce.


When there is surplus of labour which does not get utilised by the market. There are two manners in which to define unemployment. The first being the classic definition which states that if the price of employment increases above equilibrium there is more labour supplied but less demand. The second definition is “cyclical unemployment” where there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.


Infrastructure is the physical structures that are required for the operation of society and enterprise; it provides the means for an economy to function.


Supply is the total amount of a good or service available for consumption at a given price at a certain moment in time.  The basis of the law of supply which states that as the price of good or service increases, the quantity supplied also increases.


Demand is a consumer’s desire and willingness to purchase a good or service at a given price at a certain moment in time. The basis of the law of demand which states that as the price of a good or services decreases, the quantity demanded increases.

Market Failure:

Market Failure is when there is the inefficient allocation of resources, the existence of a negative externality on either the consumption or production of a good or service, and the existence of a monopoly power.


An effect to a third party which was not accounted for in the price of the original transaction of the good, this can be either positive or negative.

Consumer & Producer Surplus:

Consumer surplus is where a consumer was willing to pay a price above equilibrium but only had to pay the equilibrium price, and producer surplus is where a producer was willing to produce at a price below equilibrium but was able to sell their good at equilibrium price.  Represented by the graph below:

P7 - Social Surplus

Public Good:

A public good is typically provided by the government, and it is meant to be non-rivalrous and non-excludable. Meaning that anyone can have access to it, you do not directly pay for it, and one person using it does not affect your usage of it. Some examples are street lighting, beaches, benches, and air.

Indirect Tax:

An indirect tax is paid through the consumption of good or services, whereas a direct tax is on your income. Examples of indirect taxes are Value Added Tax, Sales Tax, and Excise Tax. They provide a source of government income, and are a manner in which a negative externality can be resolved.

The Wine Trade


2012 saw the fully fledged re-emergence of the lucrative fine wine trade. At the forefront of development of the fine wine trade stands a company which has been trading wine since 1698. Berry Bros & Rudd have their original store located in London, and their expansion can be found in Hong Kong. They do offer high quality wine for purchase and consumption, but where they have created the greatest profit is the interest in fine wine as a long term investment.

The majority of fine wines available for investment come at a variety of prices; however they recommend a starting price of approximately £10,000. The attractiveness of the fine wine trade can be found in two areas, the first is boasting rights to having the finest collection of vintage and fine wine, as well as creating a relatively safe long term investment. The best wines only rise in price over time, and this is where the investment potential lies.

What really began to create a booming trade is the possibility of trading wines between investors; this started trade in order to gain new bottles by trading a currently owned bottle as well as an additional sum of money, in order to have a new more lucrative wine in the investment portfolio.

The credentials of this type of investment are still questionable especially if one is hoping to create a proper investment out of fine wine, the two deciding factors in the price of wine is the availability and critic opinion.

For an example a selected wine is Ch. Latour 1993 – Pauillac

The wine was made to a limited number of 200 cases which equates to 1,200 bottles. This can be analysed as the creation of perfectly inelastic supply, as the supply is at a fixed quantity. This particular vintage will never be produced again, and this is what helps to determine the value of wine.

The demand for the wine is decided by two factors the most important being the “Robert Parker Rating”, this rating will be the realisation of the demand for the bottle. The rating is done by Robert Parker the most internationally acclaimed wine critic. A bottle with a 90+ rating (out of 100 and 50 being deemed an “unacceptable wine”) means that there will be an instant increase in demand. Then what makes fine wine a lucrative investment is the factor of time, as demand increases over time as the value increases. This is shown in the graph below:

There are exceptions to the model below, some wines after passing a certain age are considered to lose their finesse and flavouring so they begin to slowly depreciate in value. Some wines are also subject to hype which tends to cause an upward shift in demand.


A growing part of the trade is “En primeur” which is the acquisition of the wine before it has been bottled. This is becoming popular with those unable to buy bottles at peak prices, as prices are extremely low in the “En primeur” stage as there is the possibility that the wine ends up with bad quality, or fails to reach the status of a “fine” wine.

There is also the stage of initial valuation, before the wine is released for rating. This establishes what the producer believes the base price of the wine should be. Certain regions have experienced higher initial valuations for their wines, due to the difficulty of production and the result of extremely high quality wine. The wine trade is beginning to take on considerable form, and soon may rival the extremely well developed whisky trade. What some investors may find most disappointing is that the majority of the time they never taste the fine wines they trade, as opening the bottle will completely eradicate any value of the bottle.

The main aspect of the wine trade is that there is no longer a physical trade of the wine, the trade is done through bonded warehouses as this allows the wine to be exemopt from VAT and other taxes that different countries might levy. The exsistence of private fine wine collectors is rare, and this is what differentiates a fine wine investor and collector.

Berry Bros & Rudd have two royal warrants, and their biggest competitors Lay & Wheeler (wine merchants since 1854) are beginning to stock many single bottles with a valuation above £15,000. But what has increased the interest in wine as an investment commodity is the creation of London International Vintners Exchange (liv-ex), they created they Fine Wine 100 index which tracks the price of the most sought after wines in the world. This is a booming market which has already outperformed the FTSE 100 during various months throughout 2011 and 2012. The creation of the Fine Wine Index has led to a lot of foreign investment into European wines, especially from China. The reason behind this is the fact that fine wine has long held a status of opulence in Europe, and wine was never a big part of Asian culture. This has led to both the increased consumption of fine wine, and increased investment as highlighted by the liv-ex annual report of 2011.

However, times have changed and it is important to look at how the index has evolutionised. Between 2000 and 2010 the index traditionally offered double returns, this is similar to highly rated and investment grade bonds. It can be noted that in late 2010 the index began to shoot up and this was driven by new entrance in the market from Asia as previously mentioned. This created a hype around the fine wine index which brought to public attention in 2011 and 2012, however it can be noted that the index began to fade out by mid 2012 to levels that the index was in early 2010 before it became a trend. This can be attributed to the commodity charecteristic of wine.

I would argue that the characteristic of wine as a commoditiy is a hybrid between the investment chareteristics of percious metals and stones, and art. Precious stones and metals are always considered scarce by the market and always highly valued by society, but unlike wine they benefit from the fact that they do not expire. But this is where the artistic attribute comes in which keeps the value of wine for a given period of time, as each vintage of wine in unique, it is impossible to find two vintages alike whether it be fine or simple wine. This is why wine as a commodity for investment began to fade, as art can be maintained but wine after a certain amount of years simply expires and its value is wiped off.

Fine Wine has displayed itself at times as a worthwhile commodity to invest in, however the question remains what will become of the market once the traditional fine wine is consumed or begins to degrade,  and what will replace it?

Lay & Wheeler:

Berry Bros & Rudd:

Live Wine Stock:

Updated: 22/01/13

Economics IB Unit 1 Review

Section 1.1

Define: Nature of Market

The market is the place at which consumers can purchase the goods or services that producer’s supply. In the case of modern markets they are based around the “free-market” system where supply is dependent on the creation or existing demand.

Free Market vs. Command Economy

Command Economy is where the government becomes involved in all transactions between consumers and producers, with disregard to the pricing mechanisms in the free market they may set supply at a constant amount or set price ceilings or floors and create subsidies.

The free market will allow the pricing mechanism of the balance of supply and demand to decide the cost of goods and services. This is known as ceteris paribus, the equilibrium of the market is where the supply intersects demand; therefore supply is equal to demand at a given price.


The Law of Demand: The Law of Demand states that as the price of a good or service decreases then more people will want to consume the good or service. Whereas when the price increases less people are able to afford the good or service therefore a lesser quantity demanded.

Demand is generalised for the market, in a sense it incorporates all the individual demand curves of consumers and averages it to show market demand. For example my personal demand for bread may be relatively elastic in comparison to the market demand as others rely upon bread and therefore express an inelastic relationship.

Demand Curve: The basis of the demand curve is that as the price increases the quantity demanded is smaller, whereas as the price decreases the quantity demanded increases due to two factors:

  1. The product is more affordable therefore a wider range of consumers can express effective demand for the product or service.
  2. The opportunity cost of the product is lower, meaning that if I spent £5 on coffee it would mean I could not spend that £5 elsewhere, but now the coffee costs £2.50 which means that I still have £2.50 left to spend on other products.

P1 - elasticities of demand

Determinants of Demand

Demand can be determined by several factors, of which price is not included

Micro Determinants

  • Trend/Hype
  • Branding
  • Substitutes or Complementary
  • Addiction
  • “Better Living” or “Greater Utility”

Macro Determinants

  • Seasonal
  • Laws
  • Population Growth
  • Income increase/decrease
  • Tax
  • Technological Change

Movements on Demand vs. Shifts of Demand

A movement on the demand curve is related to the change of price, in relation to the quantity demand. As known if the price increases there will be less quantity demanded and vice-versa.

A shift of demand however is when the change in price can be affected by a change in the quantity demanded not as a result of the change in price. For example the demand curve would shift outwards when the product has become trendy, or the price of the substitute good may have increased, or it has become summer and in the case of ice cream more popular. It would shift inwards in the case of the substitute good becoming cheaper, or a that the product is no longer “trendy” or laws have made it illegal to consume the good in certain places or in certain amounts.


Law of Supply: As the price of a good or service increases, the manufacturer is willing to produce more therefore supply increases proportionally to price.

Supply is generalised for the market, one supplier may be willing to produce a given amount at a certain price and it may differ between suppliers of that one good or service, the market represents the average supply relationship of the good or service.

Supply Curve: Suppliers want to supply more of a good at a higher price as they have the ability to create greater revenue from selling more while at a higher price.

When the supply curve is inelastic it means that due to factors of production and scarcity that the supplier may not be able to immediately react to an increase in price through greater demand as they will not be able to produce more of the good or service.

When the supply curve is elastic it means that there is an ease of production and supply of that good or service meaning that if there is a change in price more of the good can be made or provided in the timespan to increase the supply to meet the demand.

P2 - elasticities of supply

Non-Price Determinants of Supply:


  • Change in the cost of the factors of production (e.g. wheat costs more so to make bread costs more)
  • A change in the price of products or services the firm could have provided


  • Government Law restricting or allowing supply (restricting = quotas, allowing = subsidies)
  • Improvement in technology allowing the produced more efficiently
  • Indirect taxes

Movements on Supply vs. Shifts of Supply

There is a movement on the supply curve when there is a change in the price of the product itself based on price signals, this will lead to a change in the amount of the good or service being supplied.

A shift in supply is when there is a change in the firm’s ability to supply the product, so the quantity supplied changes therefore having an effect on price.

The Combination of Supply & Demand Creating Market Equilibrium

The use of supply and demand in the case of the free market is the central pricing mechanism of goods and services. Market equilibrium, represents where the quantity demanded meets the quantity supplied and where all other things are equal.

This is the system that is considered to be the most efficient in allocating resources, but can be subject to government intervention in the case of market failure (see section 1.3)

It is through market equilibrium that we find our solution to the “economic problem”. This is the solution of three main points

  1. What to produce
  2. How much to produce
  3. For whom or what to produce

This solves the issue of the factors of production which are:

Land, Labour, Capital, and Enterprise


Market Equilibrium:

The market equilibrium is where supply meets demand, in formal terms the quantity demanded is equal to the quantity being supplied and therefore at market equilibrium.

P5 - equilibrium

Here it is shown that demand has significantly dropped due to a price increase of the supply, without a shift in demand or supply. This leads to less effective demand meaning that less people are able to consume the product/service at the new price. This leads to a supplier surplus as they have unconsumed goods or services. So quantity supplied is greater than quantity demanded. This can occur in price floors (minimum)

P4 - Surplus

Here it is shown that demand has increased as the price of the good or service has decreased, this is based on a change of price in supply without a shift in demand or supply. Since the product or service is cheaper more consumers can express effective demand. Therefore, the quantity demanded is greater than the quantity supplied, this can occur in price ceilings (maximum)

P3 - Shortage

The Role of Price Mechanism

Scarcity: When something is both desired and limited

This solves the issue of what to produce, as what is desired is produced and its cost is associated with how limited the good or service is. As there is no good or service which is infinite this is why there is price.

Choice results in opportunity cost as we give up spending disposable income elsewhere when we spend it on a certain good or service. It can be considered as the actual cost as we give something else up.

Psychology: Less choice greater utility, against the belief that we will be happier with more choice.

Market Efficiency:

The market is considered to be functioning efficiently at the point of equilibrium as no resources are being wasted or underused, following this there is the Production Possibility Frontier (PPF) which overviews the allocation of resources in relation to the most efficient production method to meet the demand of certain goods.


In the diagram on the right is the production possibility frontier for the production of guns or butter. Any point on the curve represents a certain amount of guns being produced in the utilization of resources in comparison to butter. There is a point of equilibrium where as much of the resource is used between making butter and guns. At point A the market is inefficient as there is the underutilization of resources, whereas at point x it is impossible due to the scarcity of resources. On most occasions the PPF is a curve; however it can be a linear negative line if opportunity cost is constant.

P6 - PPF

In a worked example it may be capital goods vs. consumer goods. This is an important example as the two products are complementary; capital goods are used to create consumer goods, such as pizza ovens producing pizza. This is when the PPF can become useful in showing how resources are allocated and utilized in the interest of market efficiency.

Consumer Surplus vs. Producer Surplus:

In the graph below the combination of both the red and blue sections can be considered as the social surplus.

P7 - Social Surplus

Consumer surplus takes into consideration all consumers below the demand curve but above equilibrium price as there was a consumer who was willing to pay price 10 to consume the good but only had to pay price 5 and this is the consumer surplus. The producer surplus is any point above supply but below the equilibrium. This is because there was a producer willing to supply at 1 but gets to sell at 5 which is their surplus.

This is an important concept in relation to market failures, government intervention and elasticity’s. As it shows whether society as a whole is better or worse off, or if due to certain policies or change in elasticity a consumer is better off or a producer. There is a greater interest in surplus being equal rather than greater surplus for one side of society.

Allocative Efficiency:

Is when there is the maximisation of social surplus, by increasing both producer and consumer surplus. This is in the interest of creating competitive yet efficient markets. This is the point where the marginal benefit (Mb) is equal to the marginal cost (Mc).

Section 1.2 Elasticity’s

Price Elasticity of Demand

P8 - PED

The price elasticity of demand is what determines the elasticity of the demand curve as function of the percentage change in quantity demanded to the ratio of the percentage change in price. It involves how demand responds to a change in price.

PED will be treated as a positive number but in graphs it will be plotted as a negative to the nature of the law of demand.

If it is greater than 1 it is elastic if it is smaller than 1 it is inelastic.

IF PED = 1 it is unitary it means that demand is perfectly inversely proportional (1%:1%)

IF PED = 0 it is perfectly inelastic (vertical)

IF PED = ∞ it is perfectly elastic (horizontal)

PED varies along a straight line as it is percentage change rather than the given unit to calculate the percentage change you take the difference divided by the original multiplied by 100.

Price Elasticity of Supply

P9 - PES


The price elasticity of supply is what determines the elasticity of the supply curve as a function of the percentage change in quantity supplied to the ratio of the percentage change in price. It involves how supply responds to a change in price.

If the percentage change in Q is greater than the percentage change in P it is elastic, and vice versa

%Q > %P = elastic

%Q < %P = inelastic

IF PES = 1 it is unitary it means that supply is perfectly proportional to price (1%:1%)

IF PES = 0 it is perfectly inelastic

IF PES = ∞ it is perfectly elastic

Primary commodities are price elasticity of supply inelastic as they have limiting factors of production, such as potatoes there may be an increase in demand but factors of production limit the amount that can be produced. Whereas when price elasticity of supply is elastic there are no restraining factors of production, such as manufacturers of goods, they can keep factories open longer or simply make more.

Cross-Elasticity of Demand (XED)

P10 - XED

XED looks at how goods can be substitutes or complementary to each other.

When XED is Positive the two goods are substitutes (consuming one = not consuming the other)

When XED is Negative the two goods are complementary (consuming one = consuming the other)

The value of XED is completely dependent on how related the goods are to each other, for an example butter and guns are completely unrelated, however pizza and burgers are.

When the goods are completely unrelated XED is given a value of 0

XED takes into account the price sensitivity of one goods effect on the demand of the other good.

Income Elasticity of Demand (YED)

P11 - YED

How responsive demand is when there is a change in income!

YED looks at how a change in income affects the quantity of a specific good demanded. This can be applied in a variety of cases where certain goods may only be accessible to wealthy consumers. But if there is a positive change in income they may be able to exert greater demand for a specific good.

Normal Goods = Positive YED

Inferior Goods = Negative YED

When YED < 1 = Income inelastic good (a necessity such as bread, petrol, water)

When YED > 1 = Income elastic good (luxury items and services)

When YED < 0 = Inferior goods (second hand clothes) This happens because when there is a positive increase in percentage change in income, there will be a negative percentage change in quantity demanded.

1.3 Government Intervention

Indirect Tax:

An indirect tax is a tax taken by the government through the consumption of goods or services, rather than direct tax which is directly from income.

There are many examples of indirect taxes, such as VAT, Sales Tax, Excise Tax (Sin Tax), and Duty.

Why is there indirect tax?

  • Source of Government Revenue: Can keep income tax lower due to revenue from excise tax
  • An attempt to reduce consumption of goods that have a negative effect unaccounted for in the original price. (discouragement of consumption of de-merit goods)
  • Helps to redistribute income, if it is percentage ad valorem tax luxury goods have more tax on them. This is the case with VAT as it is 20% in the UK and only paid on new products that are manufactured.

There are ad valorem taxes, but there are also constant taxes which have a tendency to be regressive. An example of constant can be noted in cigarettes for example there could be an added price of $5 on any base price.

IF it is a “solid” tax there is a shift in the supply curve

IF it is an “ad valorem” tax there is an inelastic response in supply

What is Tax Incidence?

Tax incidence is the effect on producer and consumer welfare after the tax is applied.

  • Inelastic PED means that most of the tax incidence is on consumers
  • Elastic PED means most of the tax incidence is on producers
  • Inelastic PES means that most of the tax incidence is on producers
  • Elastic PES means that most of the tax incidence is on consumers

When shown on graphs you can adjudge who loses and gains from the tax, as well as seeing what the government gains through the tax.


Governments provide subsidies when they believe a good is being under produced and under consumed. A subsidy allows there to be greater provision of the good or service largely in the case of merit goods which the government feels need to be provided more, at the same price for the consumer while the government pays the increase in price.

Subsidies can be given to firms or groups through various means such as soft loans, tax breaks, or even direct cash payment.

Why Subsidise?

Increase revenues for producers, while creating more supply for consumers at the same affordable prices. This reason is often found in agriculture where the government realises that people need more of a certain good at the same price.

Subsidies can encourage the consumption of merit goods which have an external benefit to society, such as aiding the payment of university degrees by allowing cheap low interest loans to students.

Can improve the allocation of resources, moving them where there is a positive externality, and can also help export market flourish within the sector. To an extent can help industries lift off such as the renewable energy sector receiving subsidies in the interest of cheaper renewable energy.

The creation of subsidy has the effect of shifting supply, increasing the amount supplied at the cost to the consumer. The government through whichever method of subsidy pays the price Pp for the quantity Sb to be supplied to the consumer.

P12 - Subsidy

What are issues with subsidy?

The issue of subsidies arises when they are removed, and the difficulty involved in the government accurately judging to what extent the subsidy should be allowed. The government to an extent eliminates competition from other firms if the subsidy is firm specific. There also arises the economic issue of scarcity, and the limited factors of production. As over-fishing receives subsidies but fish stocks have dramatically declined over the past few years, showing that the subsidy should be removed before edible fish stocks become extinct.

Price Controls:

The creations of price floors or ceilings by the government to either raise the price above equilibrium or below.

Price Ceiling (maximum): This is marked below equilibrium, usually creating a shortage of the good or service. Through this the price is lowered from the equilibrium price and not allowed to go back up.

Examples of price ceilings can be found for food or house rents. Historically price ceilings for house rents were imposed in various cities around the world most notably in New York City. In the example of NYC the local government set a price ceiling on the rent of property in Manhattan. This had effectively reduced the soaring prices of property, however with an increase in income more people were able to exert effective demand but there was a mass shortage of people willing to rent out property at those low prices. The result of this led to the creation of a black market, people started leasing to their friends or even friend of friends with informal contracts. The local government had started to realise what was occurring but could not force people to put their property on the market, and had eventually removed the price ceiling. People began to cue for property (not literally cueing but put on waiting lists)

Main effects of Price Floor

  • Shortage
  • Increased Demand but Lower Cost
  • Creation of Black Market
  • Market Inefficiency as part of the social surplus triangle is lost.

Price Floor (minimum): This is marked above equilibrium, usually creating a surplus of the good or service. Through this the price is raised above the equilibrium price and not allowed to drop down.

Examples of price floors is most commonly found in the usage of minimum wage, this is used to increase the wage workers are paid so they can keep up with the cost of living, and ensuring that workers cannot be exploited by firms. This is in place in many western democracies such as the U.S. or the U.K.

If labour is considered to be in the supply and demand concept of analysing the labour market, the introduction of minimum wage would mean there will be a surplus of labour (unemployment) this is because the price of labour has increased but the demand for labour remains unchanged. It means that firms may not hire as many people as they have higher wage demands to meet, however if the MRPL diagram is considered minimum wage does not always lead to unemployment.

There is a scenario where a black market is created, in this manner it would be the employment of illegal immigrants as they are not guaranteed the same protection and wage as regular workers. The black market undermines the creation of the minimum wage, as it is unlikely that employers would hire less people when they need more people. This means that there is the willingness to give up a percentage of revenues to continue meeting labour demands of the firm.

In the supply and demand of labour graph similar to the situation in price ceilings there is welfare loss due to the introduction of the minimum wage.

Market Failure:

Market failure is when the market does not efficiently allocate resources. When the price of product does not truly represents its cost to society or benefit to society.

It is the failure to reach Allocative efficiency where resources are being utilised to meet demand accurately while not causing unaccounted for negative or positive effects to a third party.

Market failure can be the over consumption of de-merit goods, or the under consumption of merit goods.  It can also be the under-allocation of resources to provide a good.  It is due to market failure that there are public goods, things that we need but fail to price accurately and so the government provides them.

What are externalities?

There are two types of externalities positive and negative.

Positive: When the consumption of the product or service has a positive benefit to a third party unaccounted for in the original transaction. An example of this is education, as through education one can find the cure for cancer which is priceless.

Negative: When the consumption of the product or service has a negative result to a third party and this is unaccounted for in the original transaction. An example of this is the pollution from factories, where the price we pay for the product does not represent the cost of the damage down to the environment.

Marginal Private Cost (MPC) is the supply curve when the cost of the externality is unaccounted

Marginal Social Cost (MSC) is the supply curve when the cost of the externality is shown

When the supply curve shows MPC and MSC it is the solution of the externality

Marginal Private Benefit (MPB) is the demand curve when the cost of the externality is unaccounted

Marginal Social Benefit (MSB) is the demand curve when cost of the externality is shown usually for positive externalities when the marginal private benefit and the benefit to society (3rd party) are accounted for.

Market failure can be shown when MPC = MPB but when MSC is shown but that MPB does not meet MSC. The difference between MSC and MPC is where the loss of welfare occurs, in the aim of solving the negative externality is when supply is shifted so that less is consumed. This is shown in the following graphs.

P13 - MSB Market Failure

Graph two shows the solution of the externality, whereas graph one displays that there is an externality and welfare loss.  In the solution shown in graph two there is the reduction of quantity demanded of the good, and this would be employed when there is the over-consumption of de-merit goods.

There are many solutions to negative externalities, the first point in the manner in which to solve them is to see if it is a negative externality due to the consumption of the product or service, or the supply of the product or service.

There are two ways to go about solving an externality, the first manner is to reduce the demand for the de-merit good, or to reduce demand for the good through a change in price of the good through tax or law.

Negative Externality Pollution:

In the case of pollution there has been the creation of tradable permits, these permits allow firms to pollute up to the limit set by the permit. The supply of them is perfectly inelastic as there is a fixed amount of the permits; this is in the interest of capping how much pollution there is within the country.  The fact that the permits are tradable makes them rivalrous, and therefore leads to an increase in price of the permits. Now it seems that it is a viable solution to pollution, however the issue is policing the permits which is extremely difficult to do as it is hard to tell whether the pollution is due to the firm.

Another issue with permits is that it is difficult to decide on what the maximum pollution should be, as it is not in the interest of the government to stifle the prosperity of certain markets. As well as there being a difficulty in handing out the permits initially to now show favouritism to large corporations.

Negative Externality Smoking:

In the case of smoking the externality is caused by the consumption of cigarettes. The first manner in which to reduce the demand for cigarettes is the informing of the public of the dangers of smoking and the creation of smear campaigns to discourage smokers. It has also become popular to introduce laws to prohibit smoking in certain locations, therefore discouraging smokers from smoking in the first place.

The other manner in which to solve the externality of smoking and create government revenue to help combat the externality of smoking is through the use of tax. Through increasing the price of cigarette packs there is an inwards shift of the supply curve of cigarettes, meaning that fewer consumers can exert effective demand to consume. However with this arises the issue of how much to tax, is it fairer to tax the consumer more or the producer more, and should it be location specific. All these issues make it difficult to correctly solve the externality, especially since not everyone gets cancer from smoking so why should one pay for it if it does not happen.

In the case of tax being introduced to solve an externality you can see the tax on the consumer is between the new equilibrium and the old equilibrium and the tax on the produce is from the new equilibrium down to the point of the supply line where the new equilibrium lies.  (Shown below)

P14 - Solving externality

Solving Positive Externalities:

This is rather simple as for positive externalities you want to reduce the price of the good or service while providing more. The best example is education where the government aims to provide more at a price that everyone can pay for, this encourages people to go to education and generally has a beneficial outcome to society.

There is also the case of healthcare, when you solve positive externalities you are removing the welfare loss of when the externality remains unsolved, so you increase the social benefit.

Governments are likely to provide subsidies and help for the creation and consumption of merit goods such as better education, healthcare, and quality of living. This is because the aim is to increase our benefit from society. The free market tends to undervalue merit goods such as education and healthcare, which is why the government ensures that they are consumed through laws and creation of supply.

Lack of Public Goods:

Public goods are non-rivalrous and non-excludable. This means that a public good can be consumed by anyone, and if it is consumed by one person it does not mean another person cannot consume it. The majority of public goods are provided by the government as they are under-consumed, under-provided, and are a necessity. An example of a public good is road lights, lighthouses, road signs, benches, parks, beaches, etc.

Private goods are always rivalrous and excludable, as if one person consumes it, it may mean that another person cannot. It also means that certain people cannot afford the good therefore making it exclusive to those with high disposable incomes.

The free-rider problem occurs when public goods are used, but there is no contribution to the government for the usage of these goods. As public goods are provided by the government through the usage of tax revenue, if someone who does not pay tax consumes the public good they are free riding. The best example is that of public transport, if someone jumps on a train without paying for a ticket they are free riding, but if they pay for the ticket they are taking their cost into account.

Public goods raise the issue of what should be a public good and to what extent should it be a public good, matters like transport have a tendency to be mixed between public and private, “impure public goods”.

When public goods are provided by the government there is the issue of creating a market that lacks any competiveness, and requires further government intervention to maintain it. This is why roads deteriorate and are not repaired, or why street lights may not work or are not as efficient but are not replaced.

Government compares marginal benefit vs. marginal cost, if they are equal the good is taken into consideration to be provided, but if the marginal cost is higher than the marginal benefit then it is not worth for the good to be  provided as a public good.

Common Access Resources:

Common access resources are resources that are free to use and relatively abundant, examples are:

  • Water, air, sunlight, lakes, rivers, oceans, nature, etc.


This is the issue of sustaining our economic activity as our natural capital is limited and must be protected. Sustainability is the protection of our economic resources to ensure future production, and the limiting of negative externalities.

The Lack of Price Mechanism for CAR’s (common access resources):

These resources tend to have the greatest abundance on our planet, such as water or air. We as consumer have a tendency to not fully realise the value of these resources to us on a daily basis, and the fact that there are no substitutes and the fact that it is non-rivalrous means that it can be exploited. This can be noted in the issue of pollution as we are ruining the quality of our air, and therefore exploiting a resource and causing it to degrade as a result of our production. The lack of paying for this is the creation of the negative externality in pollution, as causing air quality to degrade has adverse effects on our environment.

Fossil Fuels:

Usage of fossil fuels is problematic due to the scarcity of fossil fuels as our demand for them increases to meet our growing energy requirements. The issue of sustainability comes in when we attempt to determine how much longer we can depend of fossil fuels as our source of energy, and what affects our usage has on the environment.

The solving of the negative externality in the consumption of fossil fuels is carbon tax, which aims to account for the damage done to the environment by considering how much carbon dioxide is introduced into the atmosphere through the burning of fossil fuels. There are several issues with this; it is difficult to tell what is naturally occurring or occurring due to consumption. It is also difficult to price the tax correctly as it is complex in nature to try and foretell what will happen to our environment.

The issue here arises as no one owns common access resources meaning that it is up to the international community to ensure that they are maintained in a sustainable manner, a way in which we do not exploit our natural resources to the point where we suffer adverse environmental damage in the quest for economic growth.


Poverty can lead to the over exploitation of land for the purpose of agriculture, as people attempt to break out of poverty. However this is unsustainable economic activity, as there is the result of damage the local environment, further intensifying the degree of poverty.

Asymmetric Information:

Consumers and Producers do not have the same information, or one party may be misinformed. This can lead to the under allocation of resources to provide certain goods.

If markets were completely unregulated there would be the issue of misinforming the consumer in the interest of the producer. An example could be the production of a hazardous clothing material, the consumer does not know it is hazardous but the producer does but still sells it in the interest of revenue. This is where the government attempts to come in and help consumers stay informed, this is done by forcing producers to be explicit about the information they have on their products regarding quality and safety.