Distribution of income and wealth Notes IGCSE,GCEO,GCSE

Introduction

Income and Wealth

• Income is a flow of factor incomes such as wages and earnings from work; rent from the ownership of land and interest & dividends from savings and the ownership of shares
• Wealth is a stock of financial and real assets such as property, savings in bank and building society accounts, ownership of land and rights to private pensions, equities, bonds etc

Absolute poverty

Absolute poverty measures the number of people living below a certain income threshold or the number of households unable to afford certain basic goods and services. What we choose to include in a basic acceptable standard of living is naturally open to discussion.

Relative poverty

Relative poverty measures the extent to which a household’s financial resources falls below an average income level. The official poverty line is drawn at an income of 60% of the median level. Although living standards and real incomes have grown because of higher employment and sustained economic growth, there is little doubt that Britain has become a more unequal society over the last 20-25 years.

Mean and median income in the UK

For 2009 the figures (in £s per week) were as follows:

• Median income = £407 per week
• Mean income = £507 per week
• The official poverty line is 60% of the media = £244 per week

6 per cent of individuals live in households with disposable incomes of £1,000 per week or more and this helps to explain why the mean value for household income exceeds the median.

Income inequality in the United Kingdom

These figures are drawn from the latest survey on poverty and inequality produced by the Institute for Fiscal Studies (www.ifs.org.uk)

• Inequality has remained steady over the course of the recent recession
• Taking the 13-year period of Labour government as a whole, income inequality as measured by the Gini coefficient has increased but at a slower rate than in the 1980s
• Looking over Labour’s 13 years in office, headline rates of relative poverty fell from 19.4% in 1996–97 to 17.1% in 2009–10
• The fraction of children in poverty fell from 26.7% in 1996–97 to 19.7% in 2009–10. This still leaves the rate of child poverty well above the previous government’s target to halve child poverty by 2010
• Using the official relative poverty measure of having an income below 60% of median income, in the UK in 2009–10, there were 13.5 million individuals in relative poverty

The Gini Coefficient

• The Gini coefficient is a commonly-used measure of income inequality that condenses the entire income distribution for a country into a single number between 0 and 1: the higher the number, the greater the degree of income inequality.
• A value of 0 corresponds to the absence of inequality, so that, having adjusted for household size and composition, all individuals have the same household income.
• In contrast, a value of 1 corresponds to inequality in its most extreme form, with a single individual having all the income in the economy
• The value for the Gini-coefficient varies enormously across different countries – the next chart tracks what has happened to the coefficient for the UK since the mid 1990s

The Lorenz Curve

The further the Lorenz curve lies below the line of equality, the more unequal is the distribution of income.
 There are problems with the Lorenz curve – particular if we are inaccurate in our measure of incomes.

Gini coefficients for a selection of countries
(Data is taken from the World Bank databank, most recent published data is used, mainly for 2008-09)

Country Name	Gini Value	Country Name	Gini Value
Brazil	53.9	China	41.5
Thailand	53.6	India	36.8
Mexico	51.7	Indonesia	36.8
Kenya	47.7	Poland	34.2
Malaysia	46.2	Hungary	31.2
Argentina	45.8	Ukraine	27.5
Uganda	44.3	Belarus	27.2
Russian Federation	42.3	United Kingdom	36.1

The gap between lowest and higher income groups can be seen in this chart produced by the UK Statistics Commission:

Another way of showing this income data is in the table below – this shows the distribution of disposable income by household income quintile. The data is for 2008-09.

	Bottom Fifth	Next Fifth	Middle Fifth	Next Fifth	Top Fifth
% share of disposable income	7	12	16	22	42

Inequality of original income (i.e. before taking account of taxes and benefits) has followed a different pattern. It rose fairly steadily throughout the 1980s and has been relatively stable since then. The Gini Coefficient for disposable income is lower than for original income because of the equalising effects of our progressive tax and benefits system.

The Distribution of Wealth

• The distribution of wealth is more unequal than the distribution of income
• Over 90% of marketable wealth is in the hands of just half the population and over a fifth of wealth is concentrated among the richest one per cent of households
• Looking at global inequalities in wealth, a study from the UN World Development Report published in November 2006 found that the richest 2% of adults in the world own more than half of all wealth.
• According to the report, “Wealth is heavily concentrated in North America, Europe and some countries in the Asia Pacific region, such as Japan and Australia.”

Explaining the scale of income and wealth inequality in the UK

Proportion of people whose income is below various fractions of median household disposable income
	< 60% of median income	< 50% of median income
1961	12.8	7.4
1971	13.6	6.3
1981	12.1	4.5
1991	20.1	11.7
2001	17.0	9.7
2004	16.8	9.4
Source: Social Trends 36

There are numerous explanations both for the existence and persistence of a huge divide in incomes and wealth within the UK. Most of them are economic in origin, but some are linked to social change.

A summary is provided below:

(1) Differences in pay in different jobs and industries

• High growth industries have enjoyed above average increases in pay and earnings. These include (until recently) financial and business services and information technology. Jobs where labour demand is high and there are shortages of skilled labour tend to offer more generous pay packages for employees.
• The worst paid jobs are still found in lower-skill service sector industries - often where there is little trade union protection and where job insecurity is endemic.
• Globalisation and the rise in the number of high-skill jobs in areas such as finance and technology have boosted demand for skilled labour, enabling individuals with special skills to earn higher wages. In 1973, US chief executives were, on average, paid 26 times the median income. Now they command more than 300 times the median
• There remains a big difference in average hourly wages flowing to groups with different levels of education. This table shows evidence drawn from the UK labour market in 2010.

	Median hourly pay (£)	Pay gap to GCSE
Degree	16.10	100%
Higher education	12.60	56%
A Levels	10.00	24%
GCSE grades A*-C	8.68	8%
Other qualifications	8.07	0%
No qualification	6.93	-14%
Source: Labour Force Survey, October-December 2010

(2) Falling relative incomes of people dependent on state benefits

• State welfare benefits such as the state pension and unemployment assistance normally rise in line with retail prices (they are index-linked) rather than with earnings.
• Therefore, households dependent on welfare assistance see their relative incomes fall over time.
• This is a problem for thousands of pensioner households and also for large families on low incomes since for both groups it is widely recognised that the inflation that they have experienced has been well above the national figure for consumer price inflation.
• Not only have they fallen behind in relative terms – but their real incomes have taken a hit from the sharp surges in food and utility bills over the last two or three years
• In 2008/09, 29 per cent of all pensioners in the UK had no pension provision other than state retirement pension

(3) The effects of unemployment

• Unemployment is a key cause of relative poverty
• A serious problem is the increase in the number of households where no one is in paid employment and where a family is dependent on state welfare aid.
• Pockets of high long-term unemployment are nearly always associated with an increased risk ofpoverty. London is a good example of this – huge wealth and poverty frequently live cheek by jowl.
• Many adult workers in the labour market have either no skills or limited skills and this affect their employability and expected lifetime earnings and risk of persistent poverty.

UK population, age 22-64, by highest qualification, per cent
	2010
Degree	25
Higher education	10
A Levels	21
GCSE grades A*-C	20
Other qualifications	12
No qualification	11
Source: Labour Force Survey, October-December 2010

(4) Changes to the tax and benefit system

• Changes to direct and indirect taxes have contributed to an increase in relative poverty. Income tax rates have fallen over the last two decades
• The top marginal rate of tax fell from 83% in 1979 to 40% in 1988 where it remained for over twenty years – it has since risen back to 50%
• Tax reductions allow people in work to keep a higher proportion of their earned income. The benefits from lower taxes have flowed disproportionately to people on above-average incomes because of a fall in the progressive nature of the UK’s direct tax system.
• There has been a switch towards indirect taxes in recent years including higher rates of value added tax and higher excise duties on petrol, alcohol and cigarettes.
• Some of these indirect taxes have a regressive effect on the distribution of income. A good example of this has been the real-term increase in the level of excise duty on cigarettes and the proposed rises in vehicle excise duty.

Policy options to change the distribution of income and wealth

There are many policy options available to a government if it wants to change the final distribution of income and wealth in a country.

• The introduction of a National Minimum Wage and a series of increases in its value
• Tax Credits designed to boost work incentives for low-income households who opt to work
• Minimum Income Guarantees for Pensioners and increases in the real value of Winter Fuel Payments – designed to alleviate “fuel poverty” among old people
• Active employment policies for young people, the long-term unemployed, lone parents and disabled people – a long-term strategy designed to increase employment opportunities
• Increased spending on training - UK government expenditure on education and training has doubled in real terms over the last 24 years, from £43 billion in 1987/88 to £87 billion in 2010/11
• Increased spending on early-years education - The proportion of children aged under five enrolled in all schools in the UK has increased from 21 per cent in 1970/71 to 62 per cent in 2009/10

Demand for labour,Gce o' level notes

Introduction

Labour Demand – Marginal Revenue Product

• How many people should a business look to employ?
• Theories of the demand for labour try to analyse links between the demand for labour and a variety of economic factors. We start with the marginal revenue productivity theory of the demand for labour.

Marginal Revenue Product (MRPL) measures the change in total revenue for a firm from selling the output produced by additional workers.

MRPL = Marginal Physical Product x Price of Output per unit

• Marginal physical product is the change in output resulting from adding an extra worker.
• The price of output is determined in the product market – in other words, the price that a business can get in the market for the goods and services that they have produced.

A numerical example of marginal revenue product is shown in the next table:

Labour people employed	Capital (K) Units of capital	Total Output(Q) units	Marginal Product Units	Price per unit of output when sold (£)	Marginal revenue product = MPP x P (£)
0	5	0	/	5	/
1	5	30	30	5	150
2	5	70	40	5	200
3	5	120	50	5	250
4	5	180	60	5	300
5	5	270	90	5	450
6	5	330	60	5	300
7	5	370	40	5	200
8	5	400	30	5	150
9	5	420	20	5	100
10	5	430	10	5	50

• We are assuming in this example that the firm is operating in a perfectly competitive market such that the demand curve for finished output is perfectly elastic at £5 per unit.
• Marginal revenue product follows directly the behaviour of marginal physical product. Initially as more workers are added to a fixed amount of capital, the marginal product is assumed to rise.
• However beyond the 5th worker employed, extra units of labour lead to diminishing returns. As marginal physical product falls, so too does marginal revenue product. For example the 5th worker taken on adds $450 to total revenue whereas the 9th worker employed generates just £100 of extra income.

The story is different if the firm is operating in an imperfectly competitive market where the demand curve is downward sloping. In the next numerical example we see that as output increases, the firm may have to accept a lower price per unit for the product it is selling. This has an impact on the marginal revenue product of employing extra units of labour. One again though, a combination of diminishing returns to extra labour and a falling price per unit causes marginal revenue product (eventually) to decline. In our example below, it starts to fall once the 7th worker is employed.

Labour	Capital (K)	Output (Q)	MPP	Price (£)	MRP = MPP x P (£)
0	5	0		10.0
1	5	25	25	9.60	240
2	5	60	35	9.00	315
3	5	100	40	8.70	348
4	5	150	50	8.20	410
5	5	210	60	7.90	474
6	5	280	70	7.70	539
7	5	360	80	7.00	560
8	5	430	70	6.80	476
9	5	450	20	6.50	130
10	5	460	10	6.00	60

MRP theory suggests that wage differentials result in part from variations in the level of labour productivity and also the value of the output that the labour input produces.
The main assumptions of the marginal revenue productivity theory of the demand for labour are:

• Workers are homogeneous in terms of their ability and productivity (clearly unrealistic!)
• Firms have no buying power when demanding workers (they have no monopsony power.)
• Trade unions have no impact on the labour supply (the possible impact on unions on wage determination is considered in later chapters.)
• The physical productivity of each worker can be accurately and objectively measured and the market value of the output produced by the labour force can also be calculated. 
• The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate. This means that the marginal cost of taking on extra workers is assumed to be constant.

The profit maximising level of employment
Now we consider how many people a business might decide to employ. The profit maximising level of employment occurs when a firm hires workers up to the point where the marginal cost of employing an extra worker equals the marginal revenue product of labour. I.e. MCL = MRPL.
This is shown in the labour demand diagram shown below.

Limitations of MRPL theory of labour demand

1. Measuring productivity: Often it is hard to measure productivity because no physical output is produced or the output may not be sold at a market price. This makes it tough to place a true valuation on the output of each extra worker. How does one go about valuing the final output of people employed in teaching, social care or the armed forces? It is easier to measure output in industries where a tangible product is produced each day.
2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state of labour demand and supply. Over five million public sector workers for example fire-fighters, pharmacists, council workers, nurses and teachers have their pay set according to decisions of independent pay review bodies with “market forces” having only an indirect role in setting pay-rates.
3. Self employment and Directors’ Pay: There are over three million people classified as self-employed in Britain. How many of these people set their wages according to the marginal revenue product of what they produce? And what of those people who have the ability to set their own pay rates as directors or owners of companies? Recently we have had fierce debates about the huge level of bonus payments paid to city workers many of whom were behind the risk-taking that contributed towards the credit crunch. Was their pay justified on the grounds of marginal revenue product? How does one go about measuring the marginal revenue product of people working in complex financial markets?

Shifts in the Demand for Labour

The number of people employed at each wage level can change and in the diagram below we see an outward shift of the labour demand curve. The curve shifts when there is a change in the conditions of demand in the jobs market. For example:

• A change in demand for a product which means that a business needs to take on fewer workers
• A change in the productivity of labour
• A change in the level of national insurance contributions made by employers or other costs of employing people such as health and safety legislation and training levies
• A change in cost and productivity of machinery and technology which might be able to produce or provide a good or service in place of the labour input.

Labour as a Derived Demand

• The demand for labour is a derived demand i.e. the demand depends on the demand for the products they produce.
• When the economy is expanding, we expect to see a rise in the aggregate demand for labourproviding that the rise in output is greater than the increase in labour productivity.
• In contrast, during a recession or a slowdown, the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production.

In a recession, business failures, plant shut downs and short-term redundancies lead to a reduction in the derived demand for labour. The construction industry is an example of the derived demand for labour. The decade long property boom in the UK has led to rising prices, output and employment but since 2008 the property market has been in recession leading to many thousands of job losses.

Case Study: Pay Cuts in a Recession

The recession is having a huge effect on the UK labour market. Unemployment is rising at a very fast rate; the number of unfilled vacancies has dropped. And the total number of people in a job either full time or part time is now on the slide. How best should business respond to the recession in terms of the pay and conditions they offer to their employees.

Pay cuts and pay freezes are being flagged up as an increasingly common option by businesses struggling to survive. Staffs working for the publisher Penguin who earn over £30,000 have had their salaries frozen. Premiership rugby clubs in Britain have agreed to freeze their salary cap at £4m. And a new survey from the British Chambers of Commerce covering 300 member firms found that 43% plan to freeze wages and salaries in the coming year. Nearly one business in ten will go a step further and attempt to cut basic pay and salaries – a measure almost unprecedented in the experience of today’s workers.”

There are many broader economic effects of a situation in which wage packets and salaries are either held constant or cut.

• Pension incomes:
• A series of pay cuts this year and next may affect the value of pensions of people who are on final salary schemes. This will be fiercely resisted by trade unions - especially those representing workers in the state sector
• Productivity and efficiency:
• Will reductions in pay lead to lower productivity? Pay cuts of 10 per cent or a freeze on wages (which amounts to a cut in real pay) could have a negative effect on worker morale.
• Equity
• Will pay cuts be across the board from executive level through to shop floor workers?
• Impact on consumer demand:
• Will a squeeze on real take-home incomes lead to an even deeper cut in consumer spending - aggravating the extent of the recession in the domestic economy? Many businesses will be using a mixture of layoffs, reduced hours, less overtime and wage freezes - all of which have a negative effect on average earnings

An inward shift of labour demand ought to bring about a reduction in the real value of wages and salaries in a competitive labour market. But wage freezes or cuts are not yet common across most industries. Some employers are trying more imaginative ways to reduce their payroll expenses. Some have offered their workers longer holidays or sabbaticals on a fraction on their annual pay. Others have slashed the amount of overtime available. Many employers recognise that - having strained hard to recruit their best workers - it would be foolish and counter-productive to get rid of them in a recession, whose duration few are confident in predicting.

Elasticity of Demand for Labour

Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the wage rate. The elasticity of demand for labour depends on:

1. Labour costs as a % of total costs: When labour expenses are a high proportion of total costs, then labour demand tends to be elastic. In many service jobs such as call-centres, labour costs are a high proportion of the total costs of a business.
2. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs. When specialised labour or capital is needed, then the demand for labour will be more inelastic. For example it might be fairly easy and cheap to replace security guards with cameras but a hotel would find it almost impossible to replace hotel cleaning staff with machinery!

The price elasticity of demand for the final output produced by a business: If a firm is operating in a competitive market where final demand for the product is price elastic, they may have little market power to pass on higher wage costs to consumers. 

gcse economics - the big picture: business and trade cycle

The economy tends to experience different trends. These can be categorised as the trade cycle and may feature boom, slump, recession and recovery

BOOM: A period of fast economic growth. Output is high due to increased demand, unemployment is low. Business confidence may be high leading to increased investment. Consumer confidence may lead to extra spending.

SLUMP: A period when output slows down due to a reduction in demand. Confidence may begin to suffer.

RECESSION: A period where economic growth slows down and the level of output may actually decrease. Unemployment is likely to increase. Firms may lose confidence and reduce investment. Individuals may save rather than spend.

RECOVERY: A period when the economy moves between recession and a boom.

WHAT HAPPENS IN A BOOM?

- Businesses produce more goods
- Businesses invest in more machinery
- Consumers spend more money. There is a FEELGOOD FACTOR
- Less money is spent by the Government on unemployment benefits
- More money is collected by the Government in income tax and VAT
- Prices tend to increase due to extra demand (page)

WHAT HAPPENS IN A RECESSION?

- Businesses cut back on production
- Some businesses may go bankrupt
- Consumers spend less money. Fall in FEELGOOD FACTOR
- Individuals may lose their jobs
- More money is spent by the Govt on unemployment benefits
- Less money is collected by the Govt in income tax and VAT
- Prices start to fall

These GCSE Economics revision notes have been kindly provided by Peter Davies of Mill Hill School, Ripley Keep Up-todate with your GCSE Economics - Subscribe Free to Economics in the News by Email

What is price mechanism?

Introduction

Adam Smith’s Invisible Hand

Adam Smith, one of the Founding Fathers of economics described the “invisible hand of the price mechanism” in which the hidden-hand of the market operating in a competitive market through the pursuit of self-interest allocated resources in society’s best interest.

This remains a view held by free-market economists who believe in the virtues of an economy with minimalgovernment intervention.

The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses

The price mechanism plays three important functions in a market:

1/ Signalling function

• Prices perform a signalling function – they adjust to demonstrate where resources are required, and where they are not
• Prices rise and fall to reflect scarcities and surpluses
• If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand
• If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

In the example on the right, an increase in market supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve

2/ Transmission of preferences

• Through their choices consumers send information to producers about the changing nature of needs and wants
• Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
• When demand is weaker in a recession then supply contracts as producers cut back on output.

One of the features of a market economy system is that decision-making is decentralised i.e. there is no single body responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic market system.

3/ Rationing function

• Prices serve to ration scarce resources when demand in a market outstrips supply.
• When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product. Be it the demand for tickets among England supporters for an Ashes cricket series or the demand for a rare antique, the market price acts a rationing device to equate demand with supply.
• The popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market.

Mixed and Command Economies and Prices

• Most economies are mixed economies, comprising not only a market sector, but also a non-market sector, where the government (or state) uses planning to provide public goods and services such as police, roads and merit goods such as education, libraries and health.
• In a command economy, planning directs resources to where the state thinks there is greatest need. Following the collapse of communism in the late 1980s and early 1990s, the market-based economy is now the dominant system in most countries – even though we are increasingly aware of many imperfections in the operation of the market.

Prices and incentives

• Incentives matter! For competitive markets to work efficiently all ‘economic agents’ (i.e. consumers and producers) must respond to appropriate price signals in the market.

• Market failure occurs when the signalling and incentive functions of the price mechanism fail to operate optimally leading to a loss of economic and social welfare. For example, the market may fail to take into account the external costs and benefits arising from production and consumption.  Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision to buy and consume a product.

Secondary markets

• Secondary markets occur when buyers and sellers are prepared to use a second market to re-sell items that have already been purchased.
• Perhaps the best example is the secondary market in tickets for concerts and sporting-events.

Do ticket touts provide a valuable service to a market? Or should they be banned by law?

Government intervention in the market mechanism

• Often the incentives that consumers and producers have can be changed by government intervention in markets
• For example a change in relative prices brought about by the introduction of government subsidies and taxation.

Agents may not always respond to incentives in the manner in which textbook economics suggests.

The “law of unintended consequences” encapsulates the idea that government intervention can often be misguided of have unintended consequences! (See the final chapter on government failure) 

Market failure and public goods

Public Goods

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

When the market fails to provide certain goods and services, there is a clear case for government intervention.

The nature of public goods

Public goods are services which must be provided collectively for two main reasons:

• Non-excludability - the goods cannot be confined to those who have paid for it
• Non-rivalry in consumption - the consumption of one individual does not reduce the availability of goods to others

Examples of pure public goods include flood control systems, street lighting and national defence. A flood control system, such as the Thames Barrier, cannot be confined to those who have paid for the service. Also, the consumption of the service by one household will not reduce its availability to others. If left to the free market mechanism, no public goods would be provided and, as a result, there would be a clear market failure. No individual consumer would pay for a product that could be consumed for free if another household decided to purchase it. 

The benefits of the Thames Barrier cannot be confined only to those people who have paid for it

Quasi-public goods: These are products that are essentially public in nature, but do not exhibit fully the features of non-excludability and non-rivalry. The road network in the UK is currently available to all, but could be made excludable via a system of electronic road pricing. There is also non-rivalry in consumption, but only up to an extent. Once the road becomes congested there is rivalry in consumption.

Environmental public goods: An example of an environmental public good is public open space, which nobody would provide on their own, even though everybody benefits from it being available. Street lighting is another example of a public good.

The Air-Waves – a Quasi Public Good
The airwaves are essentially owned by the government of a particular country. Do they count as a pure public good? Normally the answer would be yes. One person’s use of the airwaves rarely reduces the extent to which other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and access to the networks provided by the main mobile phone companies can become slow. In this sense the airwaves can be treated a crowded non-pure public good.
The government controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised £22 billion in doing so. The government was using the auction process to ration the airwaves through a licence system. Although the government has monopoly control in the sense that it controls the issue of licences, it did not set the market price. This was determined by the auction process, and the fact that at the end of a bidding war, the major mobile phone companies were prepared to pay such a high price for a licence to allow them to operate in the market, is evidence of the private benefit (or anticipated future profit) that the companies expected to make from selling 3rd generation contracts to customers.
The fact that these telecoms companies may have greatly misjudged the actual market demand for third generation mobile phone services is not the result of the auction process itself. The government decided that the income from the sale of these licences would be used to repay a slice of the national debt, providing a bonus for current and future generations in terms of reducing the annual interest payments on government debt.

An example of a quasi public good - the air-waves can become congested

Finding an Equilibrium Allocation of Public Goods that Maximises Social Welfare

Finding the socially efficient level provision of public goods is a hugely difficult process. First we must seek a valuation of the willingness and ability of consumers to pay for public goods which involves estimating the individual demand curves for each consumer and then aggregating to find the “market demand curve” – a reflection of the social marginal benefit (or valuation) that consumers place on each extra unit of a public good that is made available.
In the diagram below we consider a non-pure public good whose marginal cost of supply does rise gently as output is increased. If the market fails to provide a sufficient quantity of a public good, then there is a loss of economic (social) welfare.

Case Study: The BBC as a public good

Broadcasting is a good example of a public good. Let us remind ourselves of the three main characteristics of a public good.

Firstly it is non-rival, meaning that the consumption of a public good or service by one individual does not preclude consumption by another individual. Secondly, consumption is non-excludable. This means that consumption by one individual makes it impossible to exclude any other individual from having the opportunity to consume. Effectively the marginal cost of providing a pure public good to an extra user is zero, and this implies that, in order to achieve allocative efficiency, the charge for the product should be zero. Of course, in this situation, private sector businesses are unlikely to consider providing pure public goods because they will not be able to make any profit at a zero price, and many consumers can take a free ride on such goods because of non-excludability. The provision of pure public goods is therefore a cause of market failure. Left to the free market, public goods are under-provided and under-consumed leading to a loss of social welfare.

Traditional analogue broadcasting differs from encrypted digital broadcasting in the sense that digital broadcasters can now exclude non-payers using set-top boxes. But even when Britain moves fully to digital when the analogue signal is turned off in a few years, the broadcasting services will continue to be completely non-rival and it is this that really matters in the context of the services that the BBC provides. One extra person consuming programmes on BBC1 or BBC2 has no effect at all on the ability of people to consume other services provided by the BBC.

Paying for a public good - the licence fee debate

At the moment, around 23 million households in Britain pay an annual licence fee. All of these people are stakeholders in the debate about the future funding of the BBC and the vast majority use one or more BBC services at least once a week. The fee is a means of providing collective payment for a public good. We know that there are fee-dodgers who try to take a free-ride by avoiding payment, but there are well established although costly means to enforce the licence fee and take non-payers to court.

According to research undertaken by the BBC as part of the Charter Review, on rough estimates, about 17 million households value BBC television, radio and internet services at more than the current licence fee of £122. These are gainers from the existence of the BBC. In contrast, the study finds that 6 million people value the BBC at less than the current licence fee. These are losers – they are paying more than the utility that they get and many such people may resent having to pay the licence fee when they have paid for theirBSkyB subscription and have already deserted the BBC for other digital or commercial channels. The BBC study estimates that the net consumer surplus created by the BBC is well over £2bn/year, or ¼% of GDP.

The most likely groups to think the licence fee represents good value for money for their household are those aged over 60 and those in the higher AB social groups. Groups more likely to think the fee represents poor value for money are those with multi-channel television access, people aged 31-45, people in the C2DEs social groups and younger people of Black or Asian origin. People in C2DE social groups are far more likely to have an income below the median, and therefore the question of raising the licence fee becomes important because a sharp rise in its level would affect people’s ability to pay.

Television	Radio	Other
BBC 1	Radio 1	BBC Online
BBC 2	Radio 2	World Service
BBC 3	Radio 3	BBC Scotland
BBC 4	Radio 4	BBC Northern Ireland
Cbeebies	Radio Five Live	BBC Wales
CBBC	Five Live Extra	BBC English Regions
BBC News 24	1Xtra
BBC Parliament	6 Music
	BBC 7
	Asian Network
	6 Nations services
	40 local and regional services

For millions of people, the value that they derive from the BBC’s output does exceed the price they currently have to pay via the licence fee. Would they be happy to pay a significantly higher fee in the future? Much would depend on the quality and range of broadcasting that the BBC is able to deliver. Assuming a constant range, reliability and quality of services, a large rise in the BBC licence fee would reduce total consumer surplus. The BBC study estimates that if the fee was raised by forty per cent from £122 to £170, up to four million people would no longer value BBC services as much as the higher compulsory fee, consumer surplus would be reduced and the BBC’s services might end up being under-consumed.

This, in a nutshell, is the argument against the introduction of a subscription-based system for funding the BBC. It would exclude several million people from consuming their services and would probably result in a net loss of social welfare.

What is the best way to finance broadcasting? Should the licence fee remain compulsory?

Criticisms of the licence fee

Opponents of the licence fee argue that

1. It is a regressive form of taxation – everyone pays the same flat charge, regardless of their disposable income, the number of televisions they own or the extent to which they watch television in general and BBC services in particular
2. As fewer people watch the BBC, the case for a licence fee diminishes. Indeed as technology develops, it become even harder to sustain a compulsory licence fee when people have moved predominantly to alternative sources of information through the internet, digital channels, broadband and their mobile phones
3. The costs of collection and evasion are high including £150 million per year chasing licence-fee evaders

What are the alternatives for funding the BBC?

• Moving to a subscription base system (technology may allow this in the future).
• Allowing advertising and sponsorship of programmes similar to the ITV model.
• Greater emphasis on selling BBC programmes overseas through BBC Worldwide and sales of DVDs to generate increased revenue for the BBC.
• Funding the BBC entirely through direct taxation and scrapping the licence fee.
• A tax on the revenues of other commercial broadcasters to part-fund the BBC’s services – reflecting the public service nature of much of the BBC’s output.

Of these alternatives, introducing advertising is least preferred among people surveyed. A sizeable majority of viewers (over sixty per cent according to a recent MORI poll) regard advertising as an intrusion to their enjoyment of programmes, and few think that the BBC should move to this form of finance. And there are worries that the total size of the TV advertising market is not large enough to absorb the entry of the BBC as a supplier of advertising slots. It might well damage the financial viability of ITV for example. In any case, advancing technology now allows viewers to skip advertising when they have pre-recorded programmes.

On the whole, there is a preference for keeping the licence fee (a system of funding used in many other countries) although there are concerns among older groups about their ability to pay for it. But without a sizeable increase in its value, there is little doubt that BBC revenues will soon be overtaken permanently by Sky and this will damage the BBC’s ability to bid for live television events including the rights for sports such as soccer, cricket and golf.

Public Goods and the Free Rider Problem

Consumers have an incentive to not reveal their willingness and ability to pay for public goods if they believe that they will be expected or required to contribute to financing the public good accordingly by the government. After all, if the public good is supplied, it will be available to them just as it would be to anyone else because pure public goods are non-excludable.  This is the essence of the “free rider problem”: the incentive which consumers have to avoid contributing to financing public goods in proportion to their valuation of such good.

Good examples to use include TV licence dodgers and people who choose to evade the Council Tax but who still receive local authority services. Another example might be a group of residents in a block of flats who all stand to benefit from the refurbishment of an adjacent playground or better lighting and security systems, but who individually might try to avoid payment and benefit once the improved amenities are in place.

Given the nature of the free rider problem, public goods are often financed through some form of enforcement, notably the compulsory nature of the TV licence fee, management fees for residents living in blocks of accommodation or the signing of international treaties on the environment.  .

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What is Government Failure?

Introduction

A failure of the free market and the price mechanism to deliver an allocatively efficient allocation of scarce resources is normally regarded as justification for government intervention.

This intervention is designed to correct for instances of market failure and achieve an improvement in economic and social welfare.

But what if intervention leads to further inefficiencies? What if government policies prove to be costly to implement but ineffective in achieving their desired outcomes? What happens if intervention distorts markets still further leading to a further loss of efficiency?

What is Government Failure?

Even with good intentions governments seldom get their policy application correct. They can tax, control and regulate but the outcome may be a deepening of the market failure or even worse a new failure may arise

Government failure may range from the trivial, when intervention is merely ineffective, but where harm is restricted to the cost of resources used up and wasted by the intervention, to cases where intervention produces new and more serious problems that did not exist before. The consequences of this can take many years to reverse.

Government failure in a non-market economy

The collapse of the Soviet Union in the late 1980s marked the failure of command economies as a means of allocating resources among competing uses. The essence of a command economy was that the state planning mechanism would decide what to produce and how to produce it and for whom to produce. Government failure occurred when the central planners produced products that were not wanted by consumers – a loss of allocative efficiency, since there was no price mechanism to signal changes in consumer preferences and demand.

Another fundamental failing of the pure command economy was that there was little incentive for workers to raise productivity; poor quality control; and little innovation by firms as no profit motive existed. Command economies also suffered massive environmental de-gradation because they did not posses structures for valuing the environment and giving consumers and producers the right incentives to protect their environmental heritage.

Example of Government Failure – Fisheries Policy in the European Union
Few policies have attracted as much criticism and contempt as the Common Fisheries Policy of the European Union. To many it is a prime example of government failure; a policy with good intentions that has failed to achieve its objectives and caused much deeper problems for the European fishing industry.
At the heart of the problem is overfishing – the ‘tragedy of the commons’ - 30% of EU fish stocks are beyond safe limits.
The EU quota system does not work well in restoring fish stocks and the EU fishing sector suffers from overfishing, fleet overcapacity, heavy subsidies and decline in the volume of fish caught. Many European governments seek to protect the interests of their own fishing businesses rather than agree on a policy that will benefit the EU sea fishing industry as a whole.
Over-fishing is a cause of market failure arising from a failure to enforce agreed fishing quotas and the absence of enforceable property rights for what is perceived to be a common ownership of a natural and renewable resource.
One key demand for reform is to end dumping of discarded fish. Currently, up to half the catch of some species has to be discarded because vessels have exceeded their quota, or because the fish are undersized.

Causes of Government Failure

Government intervention can prove to be ineffective, inequitable and misplaced.

(a) Political self-interest

The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation of resources.

For example decisions about where to build new roads, by-passes, schools and hospitals may be decided with at least one eye to the political consequences. 

The pressures of a looming election or the influence exerted by special interest groups can foster an environment in which inappropriate spending and tax decisions are made. - e.g. boosting welfare spending in the run up to an election, or bringing forward major items of capital spending on infrastructural projects without the projects being subjected to a full and proper cost-benefit analysisto determine the likely social costs and benefits. Critics of current government policy towards tobacco taxation and advertising, and the controversial issue of genetically modified foods argue that government departments are too sensitive to political lobbying from the major corporations.

(b) Policy myopia

Critics of government intervention in the economy argue that politicians have a tendency to look for short term solutions or “quick fixes” to difficult economic problems rather than making considered analysis of long term considerations. 

For example, a decision to build more roads and by-passes might simply add to the problems of traffic congestion in the long run encouraging an increase in the total number of cars on the roads.

The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural economic problems.

Critics of government subsidies to particular industries also claim that they distort the proper functioning of markets and lead to inefficiencies in the economy. For example short term financial support to coal producers to keep open loss-making coal pits might prove to be a waste of scarce resources if the industry concerned has little realistic prospect of achieving a viable rate of return in the long run given the strength of global competition. 

(c) Regulatory capture

This is when the industries under the control of a regulatory body (i.e. a government agency) appear to operate in favour of the vested interest of producers rather can consumers

Some economists argue that regulators can prevent the ability of the market to operate freely. We might find examples of this in agriculture, telecommunications, the main household utilities and in transport regulation.

For example, to what extent has the system of agricultural support known as the Common Agricultural Policy operated too much in the interests of farmers and the farming industry in general? And as a result, has the CAP worked against the long-term interest of consumers, the environment and developing countries who claim that they are being unfairly treated in world markets by the effects of import tariffs on food and export subsidies to loss-making European farmers?

(d) Government intervention and disincentive effects

Free market economists who fear government failure at every turn argue that attempts to reduce income and wealth inequalities can worsen incentives and productivity. They would argue against the National Minimum Wage because they believe that it artificially raises wages above their true free-market level and can lead to real-wage unemployment. They would argue against raising the higher rates of income taxbecause it is deemed to have a negative effect on the incentives of wealth-creators in the economy and generally acts as a disincentive to work longer hours or take a better paid job.

(e) Government intervention and evasion

A decision by the government to raise taxes on de-merit goods such as cigarettes might lead to an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey markets where trade takes place between consumers and suppliers without paying tax

Case Study: The Unintended Economic Effects of a Tariff

In 2005 the US government slapped anti-dumping tariffs on the imports of Chinese furniture. At the time, imports accounted for 58% of the market for beds and similar items.

What happened next was probably not in the plans of US lawmakers and the local furniture manufacturers who supported the tariffs. Although imports from China did fall sharply, a number of Chinese manufacturers moved their plants to different countries, Vietnam being the main choice. The result was that as of 2010, imports now account for 70% of the total market!

A decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of drugs and a substantial loss of social welfare arising from over consumption.

(f) Policy decisions based on imperfect information

• How does the government establish what citizens want it to do in their name?  Can the government ever really know the true revealed preferences of so many people?
• Often a government will choose to go ahead with a project or policy without having the full amount of information required for a proper cost-benefit analysis. The result can be misguided policies and damaging long-term consequences.
• How does the government know how many extra houses need to be built in the UK over the next twenty years? Is building thousands of extra homes in an already congested South-east the right option? Are there better solutions? There have been plenty of instances of government housing policy having failed in previous decades!

(g) The Law of Unintended Consequences

• The law of unintended consequences is that actions of consumer and producers — and especially of government—always have effects that are unanticipated or "unintended."Particularly when people do not always act in the way that the economics textbooks would predict
• The law of unintended consequences is often used to criticise the effects of government legislation, taxation and regulation. People find ways to circumvent laws; shadow markets develop to undermine an official policy; people act in unexpected ways because or ignorance and / or error. Unintended consequences can add hugely to the financial costs of some government programmes so that they make them extremely expensive when set against their original goals and objectives.

(h) Costs of administration and enforcement

Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular policy might be largely swamped by the administrative costs of introducing it.

Key points about government failure

• Free market economists are distrustful of intervention. They believe that the price mechanismshould be given freedom to operate
• Often we can accuse the government of policy failure only with the benefit of hindsight
• Limited information - no government has the resources and information available to it to make fully-informed, objective judgements. That is the nature of politics.
• Government failure is most likely to occur when decisions are made in the vested interest of special interest groups, at the expense of other groups (the result is a loss of equity)

Using the cost-benefit principle in AS micro economics

The cost-benefit principle is one of those core ideas that can be brought into so many discussions both in micro and macroeconomics – you should be using it in your papers tomorrow.

The cost-benefit principle says that you should take an action if, and only if, the extra benefit from taking it is greater than the extra cost

Here are some examples where the principle might be built into your analysis and evaluation

• Costs and benefits of subsidies e.g. the bio-fuel debate or subsidies for industries affected by globalisation
• Costs and benefits of indirect taxes e.g. environmental taxes or taxes designed to curb demand for / consumption of de-merit goods
• Costs and benefits of the introduction of competition into a market e.g. postal market liberalisation
• Costs and benefits of an increase in government spending on public goods and merit goods such as flood defence schemes, free entry to museums and galleries
• Costs and benefits of different strategies designed to reduce income and wealth inequality e.g. the national minimum wage or a rise in the top rate of income tax
• Costs and benefits of the introduction of carbon trading as a way of reducing CO2 emissions
• Costs and benefits of different policies designed to reduce unemployment e.g. comparing the effectiveness of investment in training with an employment subsidy for the long term unemployed
• Costs and benefits of major infrastructural projects such as new motorways, London 2012
• Costs and benefits of a decision to relax planning controls on new house-building

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