4.4 The Economy at Work

Types of economies: Free-Market Economic activity occurs through private business and private individuals ONLY. Businesses exist to make a profit for their owners and they will produce whatever maximises profits. Competition between businesses helps to keep prices low and the quality of goods high. Consumers can buy whatever they want if they have enough income. If not, they will go without. Governments still exist but will be mainly concerned with ensuring that laws are complied with.

Types of economies: Free-Market Benefits of a Free-Market Economy Drawbacks of a Free-Market Economy

Types of economies: Mixed Operate similarly to free-market economies, however, governments also participate in a mixed economy. Governments provide certain services seen as vital for the economy (ie: health & education) If these services were left to the free market, people may not be able to afford them and could miss out on vital services. All developed countries operate as mixed economies – however, the balance between private businesses and the government differs between countries.

Market Failure A Market = an arrangement for which a buyer and a seller can conduct a transaction together Market Failure occurs when markets fail to allocate resources efficiently – this means that the prices of goods and the quantities produced are not at the level that ensures that economic welfare is kept as high as possible. (IE: if a market fails, some goods may be under-produced or not even produced at all).

How can markets fail?!?!?! Not all our values are “market” values – some types of goods are valued differently by society than the monetary value placed on them by the market Merit Goods + Services are those that are not produced in sufficient quantities in a free market (IE: Education and Healthcare) Demerit Goods are generally over-provided by the market – demand for these is high because individuals are not good at seeing the negative consequences of the consumptions (IE: illegal drugs and tobacco) Public Goods would not be produced at all if the market was left to operate freely. This is because it would be very hard for businesses to generate any profit at all through the provision of public goods because it is hard to stop people benefitting from their provision once given. Anyone could still benefit from the service as long as someone else paid, others are not prevented from consuming the public good at the same time. (IE: Street Lighting and the Armed Forces)

How can markets fail?!?!?! Lack of Competition – this leads to market failure because the lack of competition leads to inefficiencies in how businesses operate. With little or no competition, there is less incentive for firms to improve the quality of output and to keep prices low.

How can markets fail?!?!?! Externalities Externalities exist when the costs of producing goods, and the benefits gained from consuming goods, don’t match the true costs and benefits to society. FOR EXAMPLE: a business that pollutes the environment will only pay the costs of production and will NOT pay directly for the pollution it creates – this is a cost the rest of society has to pay in terms of dirty air and poisoned rivers. Negative Externalities: occur when the cost to society exceeds the private cost to the business. The external cost is paid by the rest of society. It does not result in an actual payment of money, but society suffers from this external cost. (SOCIAL COST) Positive Externalities: occur when the benefits to society from consumption of a product exceed the private benefits to the individual consumer. FOR EXAMPLE: the private benefits to a town of having a large business set up would include the business gaining profits, but the local society would gain in terms of the employment opportunities and the extra income generated (SOCIAL BENEFITS)

What can governments do about externalities? EXAMPLES: Car drivers don’t pay for the negative externalities caused by exhaust fumes. Taxes placed on petrol attempt to reduce this external cost as the higher price for petrol should mean that fewer car journeys take place. Society benefits from a well-educated population because those educated usually earn more. Therefore, the UK government gives assistance to encourage more people to attend university by giving grants.

Economic Cycle In the UK, average economic growth is approx 2.5% per year. However, the actual rate of growth varies over time. The economic cycle shows how economies grow at different rates and this pattern will be repeated in a cyclical manner. The stages of the economic cycle are: Boom – Recession – Slump – Recovery

Boom Economic growth will be above average Consumer spending is likely to be high and rising as people feel confident and are more likely to borrow money to finance more spending Unemployment is likely to be falling or low Investment will rise as businesses seek to expand Likely to be upward pressure on prices because of the increased demand for goods – as a result, inflation will start to rise.

Recession Economic growth will start to fall below the average growth rate, although the rate of economic growth will still be positive (ie: national income will still be rising, but at a lower rate) Consumer spending will slow down and unemployment will start to rise. Business investment, inflation, imports may start to fall from their peaks but may still be rising (at a slower rate) The definition of what a recession is can vary between countries. In the UK, a recession only occurs when there is negative economic growth for two consecutive quarters of the year.

Slump Growth will be low or even negative Consumer spending will be low and could actually be falling. This is likely to be because consumers feel pessimistic and insecure about their jobs, and the chances of keeping their jobs in the future. Inflation is likely to be low +/or falling as businesses attempt to encourage more spending by keeping prices unchanged or even cutting them. In some slumps, prices may even begin to fall over time (deflation) With low consumer spending, imports are likely to be low in growth or even falling – which could mean that the balance of payments moves into surplus (where exports exceed imports)

Recovery Economic growth will start to rise towards the average level again. Confidence will return to customers and businesses which means consumer spending and business investment will begin to rise again. Unemployment is likely to stop rising and may even begin to fall, although the level of unemployment may still be high. Inflation will stop falling