Market failure happens when the free market allocates resources inefficiently, so the market fails to maximise total welfare (consumer plus producer surplus). This is different from government failure, which is when intervention makes things worse, not better.
An externality is a spillover cost or benefit affecting a third party not involved in the transaction.
Pure public goods have two key properties: non-excludability (you cannot stop people who have not paid from using it) and non-rivalry (one person's use does not reduce availability for others). Classic examples: street lighting, national defence, flood defences. This causes the free-rider problem, meaning private firms will not supply them, so the government usually must. Quasi-public goods (like a toll road or a quiet beach) only partially meet these criteria.
Information gaps (asymmetric information) occur when one party in a transaction knows more than the other, leading to under- or over-consumption. Example: used car markets (the 'lemons' problem), private health insurance, and merit/demerit goods being mis-valued because consumers underestimate/overestimate private benefits or costs.
Demand is the quantity of a good consumers are willing and able to buy at a given price over a period. The Law of Demand states that as price falls, quantity demanded rises, ceteris paribus, giving a downward-sloping demand curve.
A change in price causes a movement along the demand curve. A change in any other determinant (income, tastes, price of substitutes/complements, population, advertising, expectations) causes the whole curve to shift left or right.
Supply is the quantity producers are willing and able to sell at a given price over a period. The Law of Supply states that as price rises, quantity supplied rises, giving an upward-sloping supply curve. Non-price determinants (costs of production, technology, taxes/subsidies, number of firms, weather for agriculture) shift the whole curve.
Market equilibrium is where demand equals supply, giving the equilibrium price and quantity. Excess demand (price below equilibrium) pushes price up; excess supply (price above equilibrium) pushes price down. This is the price mechanism performing three functions: signalling, incentivising and rationing.
PED = %change in quantity demanded / %change in price. It is normally negative but usually quoted as an absolute value.
Key determinants: number and closeness of substitutes, proportion of income spent, necessity vs luxury, time period (more elastic long run), addictiveness.
Consumer surplus is the area between the demand curve and the price line (benefit consumers get above what they pay). Producer surplus is the area between the supply curve and the price line (revenue above the minimum firms would accept). Total welfare/community surplus is the sum of both, maximised at free market equilibrium in a competitive market with no externalities.
Firms face short-run and long-run costs. In the short run at least one factor (usually capital) is fixed, so total cost splits into fixed costs (FC, do not change with output, eg rent) and variable costs (VC, rise with output, eg raw materials, labour).
In the long run all factors are variable, so firms can change scale. Long-run average cost (LRAC) curves are U-shaped due to economies of scale (falling LRAC) then diseconomies of scale (rising LRAC).
Firms maximise profit where MC = MR. This is the single most tested rule in this topic — always check output is set where the MC curve crosses the MR curve, then read price off the AR curve above that point.
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 - this is the circular flow of income.
AD is total planned spending on goods and services in an economy at a given price level.
AS shows total output firms are willing to supply at each price level.
Macro policy is the government and Bank of England trying to hit four objectives: low and stable inflation, low unemployment, economic growth, and a healthy balance of payments. OCR expects you to know the tools, the targets and the trade-offs between them.
Run by the Bank of England's Monetary Policy Committee (MPC), 9 members, meets 8 times a year.
Set by the Chancellor via the Budget and Autumn Statement.
Aims to shift long-run aggregate supply (LRAS) rightwards, raising the trend rate of growth without triggering inflation.
Trade lets countries exploit comparative advantage: producing a good with a lower opportunity cost than a trading partner. Even if one country is absolutely better at everything (absolute advantage), both sides gain by specialising in their comparative advantage good and trading. The theory assumes no transport costs, perfect factor mobility and homogeneous goods, which rarely hold in reality.
The terms of trade (ToT) index = (average export price index / average import price index) x 100. A rise in ToT means exports buy more imports, but if it is driven by a weaker currency or falling productivity elsewhere it can also signal problems. Trade patterns are shaped by factor endowments, exchange rates, non-price competitiveness and trading blocs like the EU or WTO membership.
For: protects infant industries, safeguards jobs and strategic industries (e.g. food, defence), prevents dumping (selling below cost to kill competition), and can correct a large trade deficit.
Against: raises prices for consumers, invites retaliation (trade wars), causes inefficient resource allocation, reduces choice and can protect uncompetitive firms long-term (the infant industry may never grow up).
Development is broader than growth (rising real GDP): it includes rising living standards, health, education and reduced poverty. Key measures: HDI (Human Development Index, combines income, life expectancy and education, scored 0 to 1), GNI per capita, and the Gini coefficient for inequality (0 = perfect equality, 1 = perfect inequality).
Primary product dependency, debt burdens, poor infrastructure, corruption, capital flight, and unfair trade terms (protectionism by developed nations against developing-country exports) all restrict growth. Strategies to promote development include trade liberalisation, aid, debt relief, FDI, microfinance, and industrialisation policies (import substitution vs export-led growth).