Market failure happens when the free market allocates resources inefficiently, so social welfare is not maximised. This occurs when the market fails to achieve allocative efficiency, where price equals marginal cost (P=MC).
An externality is a third-party effect not reflected in the market price.
When buyers and/or sellers do not have perfect information, leading to wrong decisions, eg moral hazard and asymmetric information (adverse selection) — the classic example is Akerlof's 'market for lemons' in used cars.
Demand is the quantity of a good consumers are willing and able to buy at a given price. The Law of Demand says price and quantity demanded are inversely related, giving a downward-sloping demand curve. A change in price causes a movement along the curve (extension or contraction). A change in a non-price factor shifts the whole curve: income, tastes, price of substitutes/complements, population, advertising, or expectations of future price changes.
Supply is the quantity producers are willing and able to sell at a given price, and the Law of Supply says price and quantity supplied are positively related, giving an upward-sloping supply curve. Movements along the curve come from price changes; shifts come from costs of production, technology, number of firms, taxes and subsidies, and weather (for agricultural goods).
Market equilibrium is where the demand and supply curves cross, so quantity demanded equals quantity supplied and there is no excess demand or excess supply. If price is above equilibrium there is excess supply (a surplus), pushing price down. If price is below equilibrium there is excess demand (a shortage), pushing price up.
PED measures responsiveness of quantity demanded to a change in price: PED = %change in quantity demanded / %change in price. It is almost always negative because of the inverse law, so examiners usually just quote the size (ignore the sign). If PED > 1 (ignoring sign) demand is price elastic; if PED < 1 it is price inelastic; if PED = 1 it is unit elastic. PED = 0 is perfectly inelastic (vertical curve); PED = infinity is perfectly elastic (horizontal curve). Key determinants: number and closeness of substitutes, proportion of income spent, necessity vs luxury, time period, and habit/addiction.
Income elasticity of demand (YED) = %change in quantity demanded / %change in income. YED > 0 means a normal good; YED < 0 means an inferior good; YED > 1 means a luxury (income elastic). Cross elasticity of demand (XED) = %change in quantity demanded of good A / %change in price of good B. Positive XED means substitutes; negative XED means complements; the bigger the number (ignoring sign) the stronger the relationship. Price elasticity of supply (PES) = %change in quantity supplied / %change in price, and is normally positive because supply and price move together; PES tends to be higher the longer the time period, because firms can adjust capacity.
National income measures the total value of output, income or expenditure in an economy over a year - the three methods (output, income, expenditure) should give the same figure. GDP (Gross Domestic Product) is the most common measure. Real GDP adjusts for inflation; nominal GDP does not. GDP per capita divides GDP by population to compare living standards between countries.
AD is total planned spending on goods and services in an economy at a given price level. The formula is AD = C + I + G + (X-M).
AD is drawn downward sloping against the price level because of three effects: the real balance effect (higher prices reduce the real value of savings, cutting spending), the interest rate effect (higher prices raise demand for money, pushing up interest rates and cutting I and C), and the international trade effect (higher domestic prices make exports less competitive, so X falls and M rises).
AS shows the total output firms are willing to supply at each price level.
A change in price level causes a movement along AD or AS. A change in a non-price factor (e.g. interest rates, consumer confidence, exchange rates, taxes, productivity, wages) causes the whole curve to shift.
Macroeconomic equilibrium is where AD meets AS, determining real output and the price level.
Governments and central banks use policy to hit four main objectives: economic growth, low unemployment, low and stable inflation, and a satisfactory balance of payments (plus a fifth in the UK: balanced public finances). The three main policy types are fiscal, monetary, and supply-side.
A country has absolute advantage if it can produce more output from the same resources than a rival.
Comparative advantage exists when a country can produce a good at a lower opportunity cost than another country, even without absolute advantage.
Comparative advantage is the real basis for mutually beneficial trade - it means both countries gain by specialising and trading.
Common mistake: students confuse absolute and comparative advantage - a country can have absolute advantage in everything but still gain from trade via comparative advantage.
Terms of trade (ToT) = (index of average export prices / index of average import prices) x 100.
A ToT above 100 means export prices have risen relative to import prices since the base year.
ToT can worsen for developing countries reliant on primary commodities, whose prices are volatile and often falling relative to manufactured imports.
Tariffs are taxes on imports, raising price and cutting quantity imported, generating government revenue but raising domestic prices.
Quotas are physical limits on import quantity - no government revenue is generated, but importers or foreign firms may gain quota rents.
Subsidies to domestic producers lower their costs, making them more competitive without directly taxing imports.
Other barriers: embargoes (total bans), excessive administrative/regulatory rules, and exchange rate manipulation.
Arguments for protectionism: infant industry protection, anti-dumping, protecting jobs, national security (defence industries), preventing structural unemployment.
Arguments against: raises prices for consumers, invites retaliation (trade wars), causes inefficiency (protects weak firms), reduces choice, can breach WTO rules.
A free trade area removes tariffs between members but each keeps its own external tariffs (e.g. USMCA).
A customs union removes internal tariffs and applies a common external tariff (e.g. the EU customs union).
A single market adds free movement of goods, services, capital and labour (the EU Single Market - the 'four freedoms').
Trade creation occurs when a customs union shifts production to a lower-cost member; trade diversion occurs when it shifts trade away from an efficient non-member to a less efficient member because of the common external tariff.
The WTO (World Trade Organization) oversees global trade rules and resolves disputes; it aims to reduce protectionism worldwide.
Economic growth (rising real GDP) is not the same as economic development (rising living standards, health, education, freedom).
The UN Human Development Index (HDI) combines life expectancy, education (mean/expected years schooling) and GNI per capita (PPP), scored 0 to 1.
Barriers to development include debt, primary product dependency, poor infrastructure, corruption, capital flight and civil conflict.
Strategies for development include trade liberalisation, aid, microfinance, FDI, and industrialisation via import substitution or export promotion.
Common mistake: assuming growth automatically means development - growth can occur with worsening inequality or environmental damage.