CHAPTER 1: NATURE OF THE BASIC ECONOMIC PROBLEM
UNLIMITED WANTS AND LIMITED RESOURCES
•
•
The basic economic problem is that unlimited wants exceed limited resources.
Scarcity is when there are insufficient resources to satisfy everyone’s wants. This is
because wants are unlimited while resources are limited.
SCARCITY
↓
BASIC ECONOMIC PROBLEM
(Wants > Resouces)
↓
CHOICE
↓
OPPORTUNITY COST
•
Opportunity cost is the next best alternative forgone when making a choice.
ECONOMIC GOODS AND FREE GOODS
•
•
Economic goods are products that require resources to produce and hence have an
opportunity cost. Eg: Cars, Pumpkins, Bottled Water, Public Libraries.
Free Goods are products that do not require any resources to produce and therefore
doesn’t have an opportunity cost. Eg: Water, Sunlight, Air.
CHAPTER 2: FACTORS OF PRODUCTION
•
Factors of Production are the economic resources of Land, Labour, Capital and Enterprise.
They are all limited in supply.
1. Land: The gifts of nature available for production.
Eg: Coal, Fish, The Ocean.
The return for land is rent.
2. Labour: The physical and mental human effort used in producing goods and services.
Eg: Bank Managers, Road Sweepers.
The return for labour is wages/salaries.
3. Capital/Capital Goods: The man-made goods used in producing goods/services.
Eg: Machinery, Tools.
The return for capital is interest.
∙ Consumer goods are man-made goods used for consumer’s personal satisfaction.
Eg: food, clothing.
Tip: To decide on whether a good is a capital or consumer good, you have to consider
1) Who uses the product (A company/A private individual)
2) The purpose of it’s use (To generate an income/ For personal satisfaction)
4. Enterprise: The willingness and ability to bear uncertain risks and to make decisions in a
business. Entrepreneurs organize the other Factors of Production(Land,Labour,Capital).
The return for enterprise is profit/loss.
MOBILITY OF FACTORS OF PRODUCTION
•
•
Occupational Mobility is the ability to change the use of factors of production.
Geographical Mobility is the ability to move factors of production from one location to
another.
1) Land is occupationally mobile, but is usually geographically immobile.
2) Labour can be occupationally mobile if they have the skills/education/experience to
change jobs.
Labour may be geographically immobile in some situations:
1. Difference in prices and availability of housing in certain areas.
2. Family ties.
3. Difference in education systems and language barriers.
4. Lack of information on availability of better jobs.
5. Border restrictions on movement of labour.
3) Capital goods that can be transported are geographically mobile.
Capital goods will be occupationally mobile only if they can be used in the production of
something else.
4) Enterprise is the most mobile factor of production. This is because they decide to change
the industry they operate in and can also decide to migrate or change locations
whenever they want to. Therefore, enterprise is mostly geographically and
occupationally mobile.
QUANTITY AND QUALITY OF FACTORS OF PRODUCTION
LAND
• Quality of Land: the quantity of land maybe reduced due to soil erosion. However, the
quantity of land may increase due to land reclamation.
Some forms of land are renewable resources while other forms of land may be nonrenewable. Renewable resources: resources that can be used again and again. Eg: water,
air, sunlight. Non-Renewable resources are reduced by use and cannot be used again
and again. Eg: gold, fossil fuels.
• Quality of land: the quality of land may be reduced due to land pollution. Eg: dumping
in rivers. On the other hand, the quality of land may be increased by applying fertilisers,
cleaning rivers, good drainage etc.
LABOUR
• Quantity of labour: the quantity of labour may be influenced in two key ways:
1. The number of workers
2. The number of hours worked
Labour force / Workforce: number of people in work and those actively seeking work. This
includes the people who are above the minimum working age and are below retirement age.
Eg: People between the ages of 16 and 66 in the U.K. It also does not include people who are
unable to work such as disabled persons.
Labour force = Employed population + Unemployed population
Factors determining the number of people employed:
1. Size of the population: large population = large labour force
2. Age structure of the population: high proportion of people too young or too old to work
= small labour force
3. Retirement age: higher retirement age = large labour force
4. School leaving age: raising the school leaving age = small labour force
5. Attitude to working women: positive attitude = large labour force
Factors determining the number of hours people work:
1. Length of the average working day: higher number of hours for full time work = large
labour force
2. Full time or part time work: higher number of people in part time work = smaller labour
force.
3. Duration of overtime: ability to work for more hours overtime = large labour force
4. Length of holidays taken by workers: longer maternity leaves = smaller labour force
5. Amount of time lost through sickness and illness: higher rates of COVID = smaller labour
force.
•
1.
2.
3.
4.
Quality of labour: quality of labour may be higher due to a number of reasons:
Better education
Better training
More experience
Better healthcare
Production / Output : the number of goods or services produced by the factors of production.
Productivity: the output per factor of production in an hour.
Labour productivity: output per worker hour.
Labour productivity =
Output
Number of hours worked by one worker
CAPITAL
•
Quantity of capital: buying new capital goods / investments increase the quantity of
capital. However, when capital becomes obsolete or worn out, this reduces the quantity
of capital.
Gross investment: value of the total output of capital goods produced.
Depreciation / Capital Consumption: value of capital goods that have worn out / become
obsolete.
Net investment: the value of extra capital goods produced.
Net Investment = Gross Investment – Depreciation
Negative Net Investment: when the value of capital goods produced is less than the value of
depreciation. (This means that the goods that have become obsolete or worn out have not been
replaced.)
•
Quality of capital: advancements in technology have resulted in higher quality capital
goods being produced. This has led to more output being produced by these capital
goods.
ENTERPRISE
•
Quantity of enterprise: several factors can increase the number of entrepreneurs:
1. More and better degree courses on business studies.
2. Lower corporate taxes
3. Reduction on government regulations
4. Motivated immigrants in search of better life.
•
Quality of enterprise: various factors can contribute to an increase in the quality of
entrepreneurs:
Better education
Better training
Better healthcare
Increased experience
1.
2.
3.
4.
OPPORTUNITY COST
•
Opportunity cost: the next best alternative forgone when making a choice.
When referring to opportunity cost, we refer to the value of the next best alternative. Ex: The
opportunity cost of buying a car is that you will not be able to renovate your home.
Influence of Opportunity cost on decision making
1. Opportunity cost and consumers: If a consumer decides to buy a product, they will look
at the options available and choose the product that best fits their needs and their
budget. The next best product that gets left behind is the opportunity cost.
2. Opportunity cost and workers: If a worker decides to take up a job, they will look at the
wage paid, number of working hours, chances of promotion and the job satisfaction they
will gain. The job that they do not choose to pursue will be the opportunity cost.
3. Opportunity cost and producers: If a producer chooses to grow carrots on a plot of land,
they cannot use that land, capital or labour to produce anything else. The next best
product that they could have produced will be their opportunity cost.
4. Opportunity cost and the government: If a government decides to spend tax revenue on
healthcare, it will not be able to spend on education. The opportunity cost will be the
reduced expenditure on education.
•
•
Economic Goods: the goods that require resources to produce and hence involve an
opportunity cost.
Free Goods: the goods that do not require resources to produce and hence do not
involve an opportunity cost.
PRODUCTION POSSIBILTY CURVES
•
Production possibility curve: a curve that shows the maximum possible output of two
types of products and combinations of those products that can be produced with
existing resources and technology. It is also known a production possibility frontier or
production possibility boundary.
Capital Goods
200
* A country can produce either
200 capital goods or 300
consumer goods or a combination
of both.
0
300
Consumer Goods
Production points
Good A
Point X: Output is being produced
100
Z
but resources are unemployed.
Y
Point Y: Maximum use of resources.
X
This is efficient output.
Point Z: Currently unattainable as
there are not enough resources
to produce at this point.
0
200
Good B
MOVEMENTS OF THE PPC
•
Movements of the PPC show reallocation of resources and the opportunity cost of these
decisions.
Ex: A country can produce either 500 agricultural goods or 300 manufactured goods or a
combination of both with its existing resources.
The country currently produces 400 agricultural goods and 150 manufactured goods.
It then decides to reallocate its resources to producing 300 agricultural goods and 200
manufactured goods.
In this case, a movement along the curve due to producing 50 extra manufactured goods has
resulted in an opportunity cost of 100 agricultural goods.
Agricultural goods
500
400
A
300
B
0
150 200 300
Manufactured goods
SHIFTS OF THE PPC
Shift to the right of the PPC
A shift to the right of a PPC occurs when the quantity or quality of resources increase.
Ex: Immigration of workers into a country (quantity) better training for workers (quality).
Capital Goods
* A shift to the right of a PPC shows an increase in
the productive potential of a country. However,
to take advantage, producers must employ the
new or better-quality resources. Only then will a
country have actual economic growth.
0
Consumer Goods
Shifts to the left of the PPC
A shift to the left of the PPC occurs when the quantity or quality of resources decrease.
Ex: Net emigration of workers, natural disasters.
Capital Goods
400
300
0
160
200
Consumer Goods
MACROECONOMICS AND MICROECONOMICS
•
•
•
•
Macroeconomics: the study of a whole country or economy.
Microeconomics: the study of households, firms and individual markets.
Market: an arrangement that brings buyers into contact with sellers.
Economic agents: decision makers in macroeconomics and microeconomics. This
includes households, firms, individual markets and governments.
Decision makers in microeconomics
•
Households are the buyers, consumers, savers and workers.
Consumers seek low prices and good quality products. Savers want their money to be safe and
give a good return. Workers want good working conditions and high pay.
•
Firms are businesses that produce goods and services, employ workers and other factors
of production.
Firms in the private sector try to make as much profit as possible.
•
Private sector: firms owned by individuals and shareholders.
Decision makers in macroeconomics
The economic agents in macroeconomics are only the government.
The government produces and provides certain products, provides financial benefits and taxes
and regulates the private sector.
The government also wants a strong economy and will therefore seek to improve the
performance of individual markers by taxing unhealthy products. Ex: taxes on cigarettes.
The connection between macroeconomics and microeconomics
Changes in microeconomics affect changes in the macroeconomy and vice versa.
Ex 1. Changes in microeconomics affecting macroeconomics: A decrease in the output of the
bakery industry will increase the level of unemployment.
Ex 2. Changes in macroeconomics affecting microeconomics: A reduction in the income tax rate
will lead to an increase in the demand for cars in the car industry.
THE ROLE OF MARKETS IN ALLOCATING RESOURCES
The 3 main questions
Due to the basic problem of unlimited wants, but limited resources, economies have to answer
3 main questions when allocating scarce resources.
1. What to produce?
2. How to produce?
3. For whom to produce?
•
Economic system: the means by which societies or governments allocate resources and
products across a region or country.
Types of economic systems:
1. Planned economies: (planned/ centrally planned/ command or collectivist economies).
• Planned economic system: an economic system where the government answers the
three main economic questions and land and capital are state owned. Resources in a
planned economy are allocated by directives.
• Directives: state instructions given to state owned enterprises.
2. Market economies: (market/ free market/ free enterprise economies)
• Market economic system: an economic system where consumers answer the three main
economic questions and land and capital are privately owned.
Consumers signal their preference to sellers through price mechanism. They will seek products
that are low in price and are high in quality.
Firms will seek to achieve the lowest cost method of production, while producing high quality
products. Firms will decide on which methods of production to use in order to achieve these
goals. Hence, they may decide to either use capital intensive or labour-intensive methods of
production.
Workers will choose which jobs to work and which skills to acquire.
Consumers who earn the highest incomes, workers who have the highest skills and firms that
have the lowest costs of production will benefit from market economies.
•
•
•
Price mechanism: when demand and supply interact to decide the allocation of
resources.
Capital intensive: the use of a higher proportion of capital as compared to labour.
Labour intensive: the use of a higher proportion of labour as compared to capital.
THE ROLE OF MARKETS IN ALLOCATING RESOURCES
The 3 main questions
Due to the basic problem of unlimited wants, but limited resources, economies have to answer
3 main questions when allocating scarce resources.
1. What to produce?
2. How to produce?
3. For whom to produce?
•
Economic system: the means by which societies or governments allocate resources and
products across a region or country.
Types of economic systems:
1. Planned economies: (planned/ centrally planned/ command or collectivist economies).
• Planned economic system: an economic system where the government answers the
three main economic questions and land and capital are state owned. Resources in a
planned economy are allocated by directives.
• Directives: state instructions given to state owned enterprises.
2. Market economies: (market/ free market/ free enterprise economies)
• Market economic system: an economic system where consumers answer the three main
economic questions and land and capital are privately owned.
Consumers signal their preference to sellers through price mechanism. They will seek products
that are low in price and are high in quality.
Firms will seek to achieve the lowest cost method of production, while producing high quality
products. Firms will decide on which methods of production to use in order to achieve these
goals. Hence, they may decide to either use capital intensive or labour-intensive methods of
production.
Workers will choose which jobs to work and which skills to acquire.
Consumers who earn the highest incomes, workers who have the highest skills and firms that
have the lowest costs of production will benefit from market economies.
•
•
•
Price mechanism: when demand and supply interact to decide the allocation of
resources.
Capital intensive: the use of a higher proportion of capital as compared to labour.
Labour intensive: the use of a higher proportion of labour as compared to capital.
The role of price mechanism
In a market economy, resource allocation is decided by price. Price is determined by the market
forces of demand and supply.
Demand: the willingness and ability to buy a product.
Supply: the willingness and ability to sell a product.
Market equilibrium: a situation where demand and supply are equal at the current price.
Market disequilibrium: a situation where demand and supply are not equal at the current price.
In the following example, observe how market moves from disequilibrium to market equilibrium
in the market for bananas when people realize the health benefits of eating bananas:
Market for bananas
Increase in demand
(Demand is now more than supply, so there is market disequilibrium)
↓
Rise in price
↓
Rise in profit
↓
Firms produce more
(Supply is increased to meet demand so there is market equilibrium)
↓
Firms hire more land, labour and capital
(Resource reallocation)
•
The price mechanism also allows economies to allocate/ration out products when their
supply falls short.
In the following example, observe how the market moves from disequilibrium to market
equilibrium when bad weather reduces the amount of potatoes harvested.
Market for potatoes
Decrease in supply of potatoes
(Supply is now less than demand, so there is a shortage causing market disequilibrium)
↓
Rise in prices until demand = supply
↓
Fewer consumers now want to buy potatoes
(Demand decreases resulting in market equilibrium)
DEMAND
DEMAND
INDIVIDUAL DEMAND
MARKET DEMAND
•
Demand: the willingness and ability to buy a product.
•
Demand and price are inversely related. This means that when prices rise, demand will
fall and when prices fall, demand will rise. Hence, price and demand have a negative
relationship.
•
•
•
PRICE ↑
DEMAND ↓
PRICE ↓
DEMAND ↑
Individual demand: the amount of a product one person would be willing and able to
buy at different prices.
Market demand: the total demand for a product at different prices. This is found by
adding up each individual’s demand (aggregation/aggregate demand).
A demand curve is a downward sloping curve that is drawn by plotting the quantity
demanded for a product at each and every price point. This curve shows the negative
relationship between price and demand. Always remember to accurately label diagrams
with the price on the vertical axis and quantity demanded on the horizontal axis.
Price
D
0
Quantity demanded
EFFECTS OF CHANGES IN PRICE OR OTHER CONDITIONS ON DEMAND
CHANGES RELATING TO THE DEMAND CURVE
MOVEMENT ALONG THE DEMAND CURVE
SHIFT OF THE DEMAND CURVE
(CAUSED BY A CHANGE IN
(CAUSED BY A CHANGE IN
THE PRICE OF THE PRODUCT ITSELF)
THE CONDITIONS OF DEMAND)
EXTENSION
CONTRACTION
SHIFT OF THE
SHIFT OF THE
IN DEMAND
IN DEMAND
DEMAND CURVE TO
DEMAND CURVE TO
THE RIGHT
THE LEFT
MOVEMENT ALONG THE DEMAND CURVE
Changes in the price of the product itself causes a movement along the demand curve.
•
Extension in demand (expansion in demand/ increase in quantity demanded):
A rise in the quantity demanded caused by a fall in the price of the product itself.
Price ($)
P
Extension in Demand
P1
D
0
•
Q Q1
Quantity Demanded
When price falls from P to P1, Quantity demanded increases from Q to Q1. This causes a
movement along the demand curve, which is known as an extension of demand.
•
Contraction in demand (decrease in quantity demanded): A fall in the quantity
demanded caused by a rise in the price of a product itself.
Price ($)
P1
P
D
0
Q1
•
Q
Quantity Demanded
A rise in price from P to P1, has caused a decrease in the quantity demanded from Q to Q1. This
movement along the curve is called a contraction in demand.
↓P
↑P
↑QD
EXTENSION
IN DEMAND
↓QD
CONTRACTION
IN DEMAND
CHANGES IN DEMAND
Factors other than a change in the price of a product will cause a change in demand. This is called
change in demand as the quantity demanded changes at each and every price point.
These changes will cause a shift of the demand curve. The demand curve shifts to the right when the
conditions of demand lead to an increase in demand. The demand curve shifts to the left when the
conditions of demand lead to a decrease in demand.
Shift of the demand curve to the right: A hot weather would increase the demand for ice cream at each
and every price. This increase in demand causes a shift of the demand curve to the right as shown
below.
Price ($)
D1
D
0
Quantity Demanded
Shift of the demand curve to the left: a period of rainy weather will decrease the demand for ice
creams at each and every price. This decrease in demand causes a shift of the demand curve to the left.
Price ($)
D
D1
0
Quantity Demanded
INCREASE IN DEMAND
SHIFT OF THE DEMAND CURVE TO THE RIGHT
DECREASE IN DEMAND
SHIFT OF THE DEMAND CURVE TO THE LEFT
CAUSES OF CHANGES IN DEMAND
1. Changes in incomes: an increase in incomes will give consumers higher purchasing power. This will
increase the demand for normal goods and decrease the demand for inferior goods.
Normal goods: A product whose demand increases as a consumer’s income increases. It has a
positive relationship with income. Eg: Gas Cookers.
Inferior goods: A product whose demand decreases as a consumer’s income increases. It has a
negative relationship with income. Eg: Kerosene Fuelled Cookers.
2. Changes in the price of related products: A fall in the price of a substitute good, will decrease the
demand for a certain good as the substitute is now cheaper. However, a fall in the price of a
complementary good will increase the demand for a certain good as it is now cheaper to use the
two goods together.
Substitute: a product that can be used in place of another. Eg: Rathi and Anchor
Complement: a product that is used together with another product. Eg: Gas cookers and gas
cylinders.
3. Advertising campaigns: a successful advertising campaign will increase the demand for a product by
attracting new consumers and by reminding/convincing existing consumers to purchase more of a
product.
4. Changes in population: changes in the age and size structure of a population can cause changes in
demand for products in a country.
Eg: Immigration of workers into a country will increase the demand for housing.
An increase in the number of older people in a country (ageing population) will increase the
demand for wheelchairs.
An increase in the birth rate of a country will increase the demand for diapers.
Ageing population: an increase in the average age of a population.
Birth rate: the number of live births per thousand of the population in a year.
5. Changes in taste and fashion: the demand for food, clothes and entertainment are mainly
influenced by taste and fashion trends. Eg: A rise in the number of vegetarians in the country will
decrease the demand for meat.
6. Changes in other factors: changes in other factors such as weather conditions, expectations about
future prices and special events can cause changes in demand for a product. Eg: The FIFA 2022 event
in Qatar increased the demand for flight tickets to Qatar.
SUPPLY
•
Supply is the willingness and ability to sell a product.
SUPPLY
INDIVIDUAL SUPPLY
•
•
•
•
MARKET SUPPLY
Supply and price are directly related. This means that when prices rise, supply rises and
when prices fall, supply also falls. Hence, this shows that price and supply are positively
related.
PRICE ↑
SUPPLY ↑
PRICE ↓
SUPPLY ↓
Individual supply: the amount of a product one person will be willing and able to supply
at different prices.
Market supply: the total supply for a product at different prices. This is derived at by
adding up each individual’s/firm’s supply (aggregation/aggregate supply).
A supply curve: an upward sloping curve that is drawn by plotting the quantity supplied
for a product at each and every price point. This curve shows the positive relationship
between price and supply. Always remember to accurately label diagrams with the price
on the vertical axis and quantity supplied on the horizontal axis.
Price
S
10
5
0
10
15
Quantity Supplied
EFFECTS OF CHANGES IN PRICE OR OTHER CONDITIONS ON SUPPLY
CHANGES RELATING TO THE SUPPLY
CURVE
MOVEMENT ALONG THE SUPPLY CURVE
SHIFT OF THE SUPPLY CURVE
(CAUSED BY A CHANGE IN THE PRICE OF THE
PRODUCT ITSELF)
(CAUSED BY A CHANGE IN THE
CONDITIONS OF SUPPLY)
CONTRACTION IN SUPPLY
EXTENSION IN SUPPLY
SHIFT OF THE SUPPLY CURVE TO
THE RIGHT
SHIFT OF THE SUPPLY CURVE
TO THE LEFT
MOVEMENT ALONG THE SUPPLY CURVE
Changes in the price of the product itself causes a movement along the supply curve.
•
Extension in supply (expansion in supply/ increase in quantity supplied):
A rise in the quantity supplied is caused by a rise in the price of the product itself.
Price ($)
S
P1
P
Extension in Supply
0
•
Q Q1
Quantity Supplied
When the price rises from P to P1, the quantity supplied also increases from Q to Q1. This causes
a movement along the supply curve, which is known as an extension in supply.
•
Contraction in supply (decrease in quantity supplied): A fall in the quantity supplied
caused by a fall in the price of a product itself.
Price ($)
S
P
Contraction in Supply
P1
0
Q1
•
Q
Quantity Supplied
When the price falls from P to P1, the quantity supplied also falls from Q to Q1. This causes a
movement along the supply curve, known as a contraction in supply.
P↑
QS↑
P↓
QS↓
EXTENSION IN
SUPPLY
CONTRACTION
IN SUPPLY
CHANGES IN SUPPLY
Factors other than a change in the price of a product will cause a change in supply. This is called
change in supply as the quantity supplied changes at each and every price point.
These changes will cause a shift of the supply curve. The supply curve shifts to the right when the
conditions of supply lead to an increase in supply. The supply curve shifts to the left when the conditions
of supply lead to a decrease in supply.
Shift of the supply curve to the right: A good harvest of rice, will cause the supply of rice to increase at
each and every price. This increase in supply causes a shift of the supply curve to the right as shown
below.
Price ($)
S
S1
0
Quantity Supplied
Shift of the supply curve to the left: the outbreak of a disease in crops will reduce the supply of rice at
each and every price point. This decrease in supply can be shown by a shift of the supply curve to the
left as shown below.
Price ($)
S1
S
5
0
INCREASE IN SUPPLY
DECREASE IN SUPPLY
Quantity Supplied
SHIFT OF THE SUPPLY CURVE TO THE
RIGHT
SHIFT OF THE SUPPLY CURVE TO THE
LEFT
CAUSES OF CHANGES IN SUPPLY
1. Changes in the costs of production. An increase in the costs of production will make it
difficult for firms to supply the same quantities as they used to, and may hence decrease
the supply of a product. The cost of production may change for two main reasons:
1. Change in the price of the factors of production. Eg: increase in the price of bread
from $2 to $4, will make it more expensive for cafes to make sandwiches and they
may reduce the number of sandwiches they make. This will decrease the supply of
sandwiches.
2. Change in the productivity of the factors of production. Eg: If the chef at a café used
to make 20 cappuccinos every hour and through his experience, he now makes 35
cappuccinos an hour, the café’s unit cost of coffee will decrease. This will allow the
café to increase its supply of cappuccinos.
•
Unit cost: the average cost of production.
Unit cost = Total cost
Output
•
•
•
2. Improvements in technology: technological advancements will allow firms to produce
products more cheaply as new technology improves the productivity of capital. These
more efficient and cost-effective methods will allow firms to supply more of a product
within a short period of time.
3. Taxes: an increase in the rates of tax in a country, either direct or indirect will reduce
the supply of products as firms must now spend part of their capital to pay taxes instead
of producing goods/services.
Tax: a payment to the government.
Direct taxes: taxes on the wealth and income of individuals and firms.
Indirect taxes: taxes on goods and services.
4. Subsidies: a subsidy given to firms to encourage the production of a certain good or
service will increase the supply of that product as firms now have more capital available
to produce these products.
However, the removal of a subsidy will decrease the supply of a product as they no
longer have as much capital as they used to produce the product.
5. Weather conditions and health of livestock and crops: Adverse weather conditions
such as floods and droughts will reduce the supply of most products as they will perish
in inclement weather. Also, if there are diseases spreading amongst livestock/crops, this
will also reduce the supply for most agricultural products.
6. Prices of other products: changes in the prices of other products can sometimes
influence the supply of certain products.
1. Increase in the price of similar products: an increase in the price of door handles will
encourage door hinge producers to shift to producing more door handles. This will
decrease the supply of door hinges without its prices changing at all.
2. Increase in the price of joint products: an increase in the price of wooden doors will
encourage firms to produce more wooden doors. As a result, the supply of saw dust
will increase as saw dust is a by-product of wooden doors. In this case, although the
price of saw dust did not change, its supply has increased.
7. Disasters and wars: natural disasters and wars destroy the factors of production such as
land and capital and claim the lives of many people who will be considered labour or
enterprise. Due to the decrease in factors of production, the supply of many products
will decrease.
8. Discoveries and depletion of commodities: the discovery of a new oilfield will increase
the supply of oil. However, the using up of a coal mine will reduce the supply of coal
mines in the future.
CHAPTER 9: PRICE DETERMINATION
•
•
Prices are determined by the market forces of demand and supply. Prices are set where
demand and supply curves intersect.
Equilibrium price: the price where demand and supply are equal. It is also known as the
market clearing price. There are no shortages or surpluses at this point.
Price
S
Equilibrium price is P.
P
D
0
•
Quantity
Disequilibrium: a situation where demand and supply are not equal.
SURPLUS
•
•
•
•
•
•
If a firm sets a price above the market price ($8), there will be a surplus of products in
the market as firms will be willing to supply more in order to maximize sales and profits.
Consumers will only buy 4000 units although the supply is at 10,000 units.
This surplus (6000 units) shows that a market is in a state of disequilibrium.
In order to sell more products, it will have to lower the price ($6).
This results in an extension in demand (from 4000 units to 7000 units) and contraction in
supply (from 10,000 units to 7,000 units).
The new equilibrium price will be $6, and the new equilibrium quantity will be 7000
units.
Price ($)
8
S
6
D
0
4000 7000 10000
Quantity
PRICE ABOVE MARKET PRICE
SURPLUS (S >D = Excess Supply)
DISEQUILIRBIUM
SUPPLIERS LOWER PRICES
EXTENSION IN DEMAND AND CONTRACTION IN SUPPLY
NEW EQUILIBRIUM PRICE AND QUANTITY
SHORTAGE
•
•
•
•
•
•
•
If a firm sets a price below the market price ($2), there will be shortage of the product as
consumers will demand more than suppliers are willing to supply at this price.
Suppliers will only supply 3000 units although consumers demand 5000 units.
This shortage shows that market is in disequilibrium.
In order to obtain the products, consumers will be willing to pay a higher price for the
product.
Suppliers will then raise the price ($4).
This results in a contraction in demand (from 5000 units to 4000 units) and an extension
in supply (from 3000 units to 4000 units).
The new equilibrium price will be $4 and the new equilibrium quantity will be 4000
units.
Price ($)
S
4
2
D
0
Quantity
3000 4000 5000
PRICE BELOW MARKET PRICE
SHORTAGE (D >S = Excess Demand)
DISEQUILIRBIUM
SUPPLIERS INCREASE PRICES
CONTRACTION IN DEMAND AND EXTENSION IN SUPPLY
NEW EQUILIBRIUM PRICE AND QUANTITY
CHAPTER 10: PRICE CHANGES
EFFECT OF CHANGES IN DEMAND- Changes in demand cause a change in price and a
movement along the supply curve.
INCREASE IN DEMAND
Price ($)
S
P1
P
x
y
D1
D
0
Quantity
Q
•
•
•
•
•
Q1
An increase in demand will cause the demand curve to shift to the right. (D to D1)
A shift of the demand curve to the right will create a shortage in the market of xy.
This shortage drives the price up. (P to P1)
The higher price results in an extension in supply until a new equilibrium price (P1) is
reached.
The new equilibrium quantity will increase to Q1.
DECREASE IN DEMAND
Price ($)
S
P
x
y
P1
D
D1
0
Q1
Q
Quantity
•
•
•
•
A decrease in demand will cause the demand curve to shift to the left. (D to D1)
A shift of the demand curve to the left will create a surplus in the market of xy.
This surplus forces the prices down. (P to P1)
The lower price results in a contraction in supply until a new equilibrium price (P1) is
reached.
The new equilibrium quantity will decrease to Q1.
•
EFFECT OF CHANGES IN SUPPLY- Changes in supply cause a change in the price and a movement along
the demand curve.
INCREASE IN SUPPLY
Price ($)
S
S1
P
x
y
P1
D
0
Quantity
Q
Q1
• An increase in supply will cause the supply curve to shift to the right (S to S1).
• A shift of the supply curve to the right will create a surplus in the market of xy.
• This surplus forces the prices down (P to P1).
• The lower price results in an extension in demand until a new equilibrium price (P1) is
reached.
• The new equilibrium quantity will increase to Q1.
DECREASE IN SUPPLY
• A decrease in supply will cause a shift of the supply curve to the left (S to S1).
• A shift of the supply curve to the left will cause a shortage in the market of xy.
• This shortage will drive up the prices (P to P1).
• This higher price results in a contraction in demand until a new equilibrium price (P1) is
reached.
• The new equilibrium quantity will decrease to Q1.
Price ($)
S1
S
P1
P
x
y
D
0
Q1
Q
Quantity
CHANGES IN DEMAND AND SUPPLY
•
The effect of a change in both demand and supply on the price will depend on the direction
and the size of the changes in both demand and supply.
For example: A period of hot weather will increase the demand for ice creams. At the same
time, an advancement in technology to produce ice creams faster, will increase the supply of
ice creams. In this situation, quantity of ice creams sold will definitely increase. However, the
effect on price will depend on the relative shifts of demand and supply.
1. If demand increases more than the increase in supply, then prices will rise.
Price ($)
S
S1
P1
P
D1
0
Q
D
Q1
Quantity
2. If supply increases more than the increase in demand, then prices will fall.
Price($)
S
S1
P
P1
D1
D
0
Quantity
Q
Q1
CHAPTER 11: PRICE ELASTICITY OF DEMAND
•
Price elasticity of demand is a measure of the responsiveness of quantity demanded
to a change in price.
PED = Percentage change in quantity demanded
Percentage change in price
PED = %
%
QD
P
Percentage change in quantity demanded = Change in quantity demanded x 100
Original quantity demanded
Percentage change in price = Change in price x 100
Original price
•
PED provides two types of important information:
1. Sign: The negative sign shows the negative relationship between quantity
demanded and price.
2. Size: The value of PED shows the size of the change in quantity demanded to a
change in price.
Eg: A decrease in price from $5 to $4 causes an increase in quantity demanded from 10 to 20
units.
%
QD = 10/10 x 100 = 100%
%
P = -1/5 x 100 = 20%
PED = 100% / 20% = -5
A PED figure of -5 shows that a 1% decrease in price will cause a 5% increase in quantity
demanded.
•
There are five types of Price Elasticity of Demand:
1.
2.
3.
4.
5.
TYPE OF PED
Elastic Demand
Inelastic Demand
Unit Elasticity of Demand
Perfectly Elastic Demand
Perfectly Inelastic Demand
PED VALUE
1 -∞
0 - 1
1
∞
0
1. Elastic demand: when a change in price causes a greater change in quantity
demanded.
• The PED figure will be greater than 1, but less than infinity.
• The demand curve will be shallow as a small change in price causes a greater
percentage change in quantity demanded.
Price ($)
P1
P
D
0
Quantity Demanded
Q1
Q
2. Inelastic demand: when a change in price causes a smaller changer in quantity
demanded.
• The PED figure will be less than 1, but greater than 0.
• The demand curve will be steep as a change in price will only cause a small change in
quantity demanded.
Price ($)
P1
P
D
0
Quantity Demanded
Q1
Q
3. Unit Elasticity of Demand: when a change in price causes an equal change in
quantity demanded.
• The PED figure will be 1.
Price ($)
P1
P
D
0
Q1
Q
Quantity Demanded
4. Perfectly Elastic Demand: when a change in price causes a complete change in quantity
demanded.
* PED will be infinity.
* The demand curve will be horizontal to show a complete change in quantity demanded.
* Different quantities can be demanded at the market price of P, however, if price changes at
all, quantity demanded will fall to 0.
Price ($)
P
D
0
Quantity Demanded
Q
Q1
5 Perfectly Inelastic Demand: when a change in price does not cause any change in
quantity demanded.
• PED will be 0.
• The demand curve will be vertical to show no change in quantity demanded.
Price ($)
D
P1
P
0
Q
Quantity Demanded
PED AND TOTAL REVENUE
1. Elastic demand: an increase in price causes a fall in total revenue. This is because
quantity demanded falls greater than the rise in price.
2. Inelastic demand: an increase in price will increase total revenue. This is because
quantity demanded will fall by a smaller percentage than the increase in price.
3. Unit elasticity of demand: an increase in price will cause total revenue to remain
unchanged. This is because although price has increased, the quantity demanded
falls by the same proportion as the increase in price.
4. Perfectly elastic demand: an increase in price will cause total revenue to fall to zero.
This is because the increase in price causes consumers to no longer demand that
product.
5. Perfectly inelastic demand: an increase in price causes an equal increase in total
revenue. This is because a 20% increase in price for example, will cause no change in
quantity demanded so total revenue will increase by the same amount as the price
increase (20%).
PED
TOTAL REVENUE
Elastic Demand
PRICE
CHANGE
P↑
Inelastic Demand
P↑
TR↑
Unit Elasticity
P↑
TR Unchanged
Perfectly Elastic
P↑
TR = 0
Perfectly Inelastic
P↑
TR ↑ by the same percentage
as price
TR↓
CHAPTER 11: PRICE ELASTICITY OF DEMAND
•
Price elasticity of demand is a measure of the responsiveness of quantity demanded
to a change in price.
PED = Percentage change in quantity demanded
Percentage change in price
PED = %
%
QD
P
Percentage change in quantity demanded = Change in quantity demanded x 100
Original quantity demanded
Percentage change in price = Change in price x 100
Original price
•
PED provides two types of important information:
1. Sign: The negative sign shows the negative relationship between quantity
demanded and price.
2. Size: The value of PED shows the size of the change in quantity demanded to a
change in price.
Eg: A decrease in price from $5 to $4 causes an increase in quantity demanded from 10 to 20
units.
%
QD = 10/10 x 100 = 100%
%
P = -1/5 x 100 = 20%
PED = 100% / 20% = -5
A PED figure of -5 shows that a 1% decrease in price will cause a 5% increase in quantity
demanded.
•
There are five types of Price Elasticity of Demand:
1.
2.
3.
4.
5.
TYPE OF PED
Elastic Demand
Inelastic Demand
Unit Elasticity of Demand
Perfectly Elastic Demand
Perfectly Inelastic Demand
PED VALUE
1 -∞
0 - 1
1
∞
0
1. Elastic demand: when a change in price causes a greater change in quantity
demanded.
• The PED figure will be greater than 1, but less than infinity.
• The demand curve will be shallow as a small change in price causes a greater
percentage change in quantity demanded.
Price ($)
P1
P
D
0
Quantity Demanded
Q1
Q
2. Inelastic demand: when a change in price causes a smaller change in quantity
demanded.
• The PED figure will be less than 1, but greater than 0.
• The demand curve will be steep as a change in price will only cause a small change in
quantity demanded.
Price ($)
P1
P
D
0
Quantity Demanded
Q1
Q
3. Unit Elasticity of Demand: when a change in price causes an equal change in
quantity demanded.
• The PED figure will be 1
Price ($)
P1
P
D
0
Q1
Q
Quantity Demanded
4. Perfectly Elastic Demand: when a change in price causes a complete change in quantity
demanded.
* PED will be infinity.
* The demand curve will be horizontal to show a complete change in quantity demanded.
* Different quantities can be demanded at the market price of P, however, if price changes at
all, quantity demanded will fall to 0.
Price ($)
P
D
0
Quantity Demanded
Q
Q1
5 Perfectly Inelastic Demand: when a change in price does not cause any change in
quantity demanded.
• PED will be 0.
• The demand curve will be vertical to show no change in quantity demanded.
Price ($)
D
P1
P
0
Q
Quantity Demanded
PED AND TOTAL REVENUE
1. Elastic demand: an increase in price causes a fall in total revenue. This is because
quantity demanded falls greater than the rise in price.
2. Inelastic demand: an increase in price will increase total revenue. This is because
quantity demanded will fall by a smaller percentage than the increase in price.
3. Unit elasticity of demand: an increase in price will cause total revenue to remain
unchanged. This is because although price has increased, the quantity demanded
falls by the same proportion as the increase in price.
4. Perfectly elastic demand: an increase in price will cause total revenue to fall to zero.
This is because the increase in price causes consumers to no longer demand that
product.
5. Perfectly inelastic demand: an increase in price causes an equal increase in total
revenue. This is because a 20% increase in price for example, will cause no change in
quantity demanded so total revenue will increase by the same amount as the price
increase (20%).
PED
TOTAL REVENUE
Elastic Demand
PRICE
CHANGE
P↑
Inelastic Demand
P↑
TR↑
Unit Elasticity
P↑
TR Unchanged
Perfectly Elastic
P↑
TR = 0
Perfectly Inelastic
P↑
TR ↑ by the same percentage
as price
TR↓
CHANGES IN PED
Changes in PED when price changes
•
•
An increase in price: when the price of a product increases, the demand for it
becomes more elastic as consumers become more sensitive to price changes.
Therefore, if prices continue to increase, the demand for that product will eventually
become perfectly elastic. This means that consumers will no longer want more of
that product after a certain price point.
A decrease in price: when the price of a product falls, the demand for it will become
more inelastic as consumers will be able to easily purchase the product without
spending too much. However, after a certain point, if prices continue to fall, demand
will be perfectly inelastic. This is because consumers will have a limit as to how much
of a product they can consume.
Price ($)
Perfectly Elastic Demand
Elastic Demand
Unit Elasticity
Inelastic Demand
0
Perfectly Inelastic Demand
Changes in PED when the demand curve shifts
•
A shift of the demand curve to the right: an increase in demand means that
consumers are eager to get a hold of the product. Therefore, they become less
sensitive to price changes. A shift of the demand curve to the right causes PED to
become more inelastic.
Price ($)
10
9
D1
0
20 30
D
40 50
Quantity Demanded
Eg: At demand curve D, a decrease in price from $10 to $9, would cause an increase in
quantity demanded from 20 to 30 units. The PED here will be:
%∆QD
%∆P
= 10/20 x 100 = 50%
= -1/10 x 100 = -10%
PED = 50%/-10% = -5
When the demand curve shifts right to D1, a decrease in price from $10 to $9, would cause
an increase in quantity demanded from 40 to 50 units. The PED here will be:
%∆QD
%∆P
= 10/40 x 100 = 25%
= -1/10 x 100 = -10%
PED = 25%/-10% = -2.5
The change in PED from 5 to 2.5 when the demand curve shifts to the right proves that PED
has become more inelastic as demand has increased.
•
A shift of the demand curve to the left: a decrease in demand means that
consumers now want less of a product than they used to. Therefore, they will
become more sensitive to price changes. A shift of the demand curve to the left
causes PED to become more elastic .
Price ($)
10
9
D
D1
0
Quantity Demanded
10
20
30
Eg: At demand curve D, a decrease in price from$10 to $9, causes an increase in quantity
demanded from 20 to 30 units. The PED here will be:
%∆QD = 10/20 x 100 = 50%
%∆P = -1/10 x 100 = -10%
PED = 50%/10% = -5
When the demand curve shifts left to D1, a decrease in price from $10 to $9, causes an
increase in quantity demanded from 10 to 20 units. The PED here will be:
%∆QD = 10/10 x 100 = 100%
%∆P = -1/10 x 100 = -10%
PED = 100%/-10%= -10
The change in PED from 5 to 10 when the demand curve shifts to the left proves that PED
has become more elastic as demand has decreased.
THE ROLE OF PED IN DECISION MAKING
Price is the main factor that affects the demand for a product. This is why economists,
producers, consumers and governments all study PED before making any decisions.
•
•
•
•
Consumers: consumers benefit from PED as it helps them to communicate to
producers their need for lower prices, higher quality and their ability to switch to
substitutes when their demand is elastic. This results in consumers getting better
quality products at the lowest possible prices.
Producers: producers will know whether to increase the price of a product or
decrease its price when it wants to increase total revenue.
Eg: If a product has an elastic PED, producers will have to decrease their prices in
order to increase total revenue. On the other hand, if a product has an inelastic PED,
producers will benefit from increasing its prices in order to increase total revenue.
Producers will also try to make their products more distinctive and unique as
consumers will find it difficult to switch to similar substitutes, hence making their
product more inelastic.
Governments: a government would need to study PED when deciding which
products to subsidise and which products to tax.
If a government wants to discourage the consumption of a product, it will be more
successful if it taxes a product with elastic demand as compared to inelastic demand.
(This is because products with inelastic demand will not have a major decrease in
quantity demanded just because of a rise in the price of the product through taxes.)
PRICE ELASTICITY OF SUPPLY
•
Price Elasticity of Supply is a measure of the responsiveness of the quantity supplied to
a change in price.
PES = Percentage change in quantity supplied
Percentage change in price
PES =
%
QS
%
P
Percentage change in quantity supplied = Change in quantity supplied
x 100
Original quantity supplied
Percentage change in price = Change in price x 100
Original price
•
PES provides two types of important information:
1.
Sign: The positive sign shows the positive relationship between quantity supplied and
price.
2.
Size: The value of PES shows the size of the change in quantity supplied to a change in
price.
Eg: An increase in price from $10 to $12 causes an increase in quantity supplied from 100 to
130.
%
QS = 30/100 x 100 = 30%
%
P = $2/$10 x 100 = 20%
PES = 30% / 20% = 1.5
A PES figure of 1.5 shows that a 1% increase in price will cause a 1.5% increase in quantity
supplied.
•
There are 5 types of Price Elasticity of Supply:
TYPE OF PES
Elastic Supply
Inelastic Supply
Unit Elasticity of Supply
Perfectly Elastic Supply
Perfectly Inelastic Supply
1.
2.
3.
4.
5.
PES VALUE
1-∞
0 – 1 (greater than 0, but less than 1)
1
∞
0
1.
Elastic supply : when a change in price causes a greater change in quantity supplied.
•
The PES figure will be greater than 1, but less than infinity.
•
The supply curve will be shallow as a small change in price causes a greater percentage
change in quantity supplied.
•
The supply curve will touch the vertical axis if extended.
Price ($)
S
P1
P
Quantity Supplied
0
Q
Q1
2.
Inelastic supply: when a change in price causes a smaller change in quantity supplied.
•
The PES figure will be less than 1, but greater than 0.
•
The supply curve will be steep as a change in price will only cause a small change in
quantity supplied.
•
The supply curve will touch the horizontal axis if extended.
Price ($)
S
P1
P
0
Quantity Supplied
Q
Q1
3. Unit Elasticity of Supply : when a percentage change in price causes an equal percentage
change in quantity supplied.
● The PES figure will be 1.
•
The supply curve will be a straight line that goes through the origin.
Price ($)
S
P1
P
0
Q
Q1
Quantity Supplied
4. Perfectly Elastic Supply : when a change in price causes a complete change in quantity supplied.
● PES will be infinity.
● The supply curve will be horizontal to show a complete change in quantity supplied.
● Firms would supply whatever quantities people demand at the given price.
● An increase in demand will not cause price to increase, only the quantity supplied will change. A fall in
demand, that causes a fall in price will cause quantity supplied to fall to 0.
Price ($)
S
P
0
Q
Q1
Quantity supplied
5.
Perfectly Inelastic Supply: when a change in price does not cause any change in quantity
supplied.
•
PES will be 0.
•
The supply curve will be vertical to show no change in quantity supplied.
Price ($)
S
P1
P
0
Quantity Supplied
Q
DETERMINANTS OF PES
There are 3 main factors that determine the PES of a product:
1. The time taken to produce it:
If a product takes a long time to produce, then the supply for the product will be inelastic. Eg:
Seats at a Cinema.
However, if the production can be quickly increased, then the supply will be elastic. Eg:
Production of T-shirts.
2. The cost of altering supply:
If it costs a lot to increase the supply of a product, then its supply will be inelastic. Eg: It will cost
a lot to increase the seats at a cinema as they will have to spend a lot to renovate/ build a new
cinema.
However, if the cost of increasing the supply of a product is low, then the supply will be elastic.
Eg: It will cost less to increase the production of t-shirts as it does not usually require new
machinery and equipment to produce a few more t-shirts.
3. The feasibility of storing it:
If it is difficult to store a product, then the supply for it will be inelastic. Eg: Agricultural products
such as mangoes cannot be stored.
However, if a product can be stored, then the supply will be elastic as supply can be increased or
reduced easily. Eg: Plates can be stored easily.
•
•
PES can vary with time.
In the long run, the PES for most products tend to become more elastic as suppliers can adjust
their supply, given more time. Eg: Suppliers can switch production to/from other products, build
new factories and offices/ sell off existing resources.
PES can vary with advances in technology.
New technology will allow PES for products to become more elastic by reducing the production
period and by lowering costs of production.
THE ROLE OF PES IN DECISION MAKING
•
Consumers: consumers benefit from PES being elastic as suppliers will quickly respond to
increases in demand without raising the price of the product by much.
Price ($)
P1
S
P
D D1
0
Quantity
Q Q1
•
•
Producers: producers benefit from PES being elastic as they will be able to earn higher profits by
quickly responding to increases in demand.
Governments: if governments want to encourage the consumption of a product, they will look
to subsidize products with price elastic supply. This is because producers will be able to use the
subsidy to easily increase their supply and thereby allow consumers to increase their
consumption of the product.
MARKET ECONOMIC SYSTEM
•
Market economic system: an economy where all firms are privately owned. All resources are
allocated by the market forces of demand and supply.
Changes in prices of products will change the allocation of resources by private sector firms.
•
Private sector: business organisations owned by shareholders or individuals.
Ex: An increase in demand for air travel and a fall in the demand for sea travel will result in less
resources being dedicated to sea travel and those resources being dedicated to air travel
instead.
The importance of competition:
1. Choice: market systems provides consumers with a variety of choice. Consumers are
sovereign as they get to decide what is produced, through their demand.
2. Competition: competition encourages firms to keep costs and prices low and target the
desires of consumers. Competition can be either actual or potential.
Actual competition: arises when there are rival firms in the industry.
Potential competition: when it is easy for firms to enter an industry, thereby threatening
firms in the market with competition.
3. Efficiency: market economic systems reward entrepreneurs who respond to market
conditions (carrot) and punish those who don’t (stick).
The importance of incentives:
1. Entrepreneurs: if entrepreneurs are quick to adjust to consumer demands, they are likely to
earn higher profits. They will therefore, innovate and expand.
2. Workers: workers will be keen to develop their skills and make themselves more geographically
and occupationally mobile, so that they will likely earn higher wages.
Advantages of a market economic system:
•
•
•
1. Consumer sovereignty: consumers have the power to decide what should be produced
through their demand.
2. Efficient allocation of resources: resources will quickly and automatically shift due to three
reasons:
Price mechanism- allows resources to switch to products where prices are rising.
Incentive for resources to move- workers and entrepreneurs will shift to markets in high
demand in order to earn higher wages and profits.
Carrot and stick- rewards and punishments will be faced if firms respond or fail to respond to
changing demands.
3. Choice and availability of substitutes: consumers can choose which firms to buy from and
workers can choose which firms to work for.
4. Low costs and low prices: if firms are able to keep their costs low, they will be able to
provide low prices. This will allow firms to sell more and earn more profits.
5. High quality of goods and services: competitive pressure motivates firms to improve
methods of production and increase the quality of products to make their products more
attractive to consumers.
Disadvantages of a market economic systems
1. Consumers and private sector firms will only take into account the costs and benefits to
themselves and not others. Eg: smoking
2. Abuse of market power: little to no competition in some industries may lead to limited or no
choice, higher prices, poor quality products, etc.
3. Inability to respond to consumer desires due to geographical immobility and lack of skills of
workers.
4. Free rider problem: non excludability of the usage of certain products do not encourage the
production of those goods and services by private producers as they cannot charge for it. Eg:
defence
• Free rider: someone who consumes a good/service without paying for it.
5. Detrimental effects of advertising: consumers may buy products they do not necessarily need
as they lack information. This leads to inefficient choices.
6. Unfair/inequitable outcomes: market economic systems can result in a lack of income for
consumers, uneven distribution of income, unemployment for the sick, disabled and elderly
people.
7. Differences in incomes will increase overtime: the rich can afford to save and buy shares
which will earn them dividends and interest. This allows parents to spend more on their
children’s education and provide better equipment for their education which will earn them a
higher income. However, the poor will continue to be poor as they will not be able to access a
high quality education.
Allocative efficiency
•
Allocative efficiency: when resources are allocated to produce the right products in the right
quantities. This seeks to maximise consumer satisfaction.
Price ($)
Quantity produced is at QD=QS
S
0
D
Quantity
Any quantity that is above or below the equilibrium quantity where QD=QS will be allocative
inefficiency.
Eg:
Price ($)
Price ($)
S
S
D
0
0
Q
Quantity
Under production: Quantity produced is lower
than the quantity demanded (shortage)
•
D
Q
Quantity
Over production: Quantity produced is higher
than the quantity demanded (surplus)
Market economic systems results in competition to avoid surpluses and shortages so that firms
earn the highest possible profits whilst making sure they do not go out of business.
Productive Efficiency
•
Productive efficiency: when products are produced at the lowest possible cost and making full
use of resources.
Incentives and threats of punishment will force firms to lower costs of production, increase sales
and gain more profit. This can be achieved only by eliminating wastage of resources.
This will result in a country producing on its production possibility curve.
Eg: Point A shows productive efficiency, while point B shows productive inefficiency.
Capital goods
Point A
Point B
0
Consumer goods
Dynamic Efficiency
Dynamic efficiency: when efficiency is occurring overtime as a result of investment and innovation.
This encourages firms to spend money on research and development and to innovate new methods of
production, and bring new products so that they can gain higher profits in the long run.
PLANNED ECONOMIES
Planned economies/ Command economies: an economic system where the government decides on the
allocation of resources.
The private sector is non-existent and only the government decides on what to produce, how to
produce and for whom to produce. All firms are owned by the public sector.
Advantages of a planned economy:
1. More even distribution of income: the gap between the rich and poor will not be great as the
government allocates the same resources such as education, healthcare and jobs for both the
rich and the poor.
2. Low level of unemployment: as the government provides jobs for individuals, it will make sure
that everyone in the workforce will have a job by setting wages and creating job openings.
3. No under-production of merit goods: goods that carry great social benefits will be produced in
larger quantities and maybe provided free of charge in order to make it widely available for
anyone who wishes to consume these goods eg: free university
4. Availability of public goods: the government does not worry about the problem of nonexcludability as the state does not look for financial incentives in production.
Disadvantages of a planned economy:
1. Lack of innovation: as the government does not have any competition, it will not seek to
innovate its products or methods of production and may also provide low quality goods and
services.
2. Inefficiency: as governments don’t look to make a profit, they will have poor planning and
maybe inefficient in the allocation of resources, in production methods and in providing goods
and services.
3. Needs of society may be ignored: the government only produces what it may think is necessary
for people. Thereby, not satisfying consumer needs such as entertainment that it regards not
important.
MARKET FAILURE
•
•
Market failure is when market forces fail to produce the products that consumers demand, in
the right quantities and at the lowest possible cost.
Market failure arises when markets are inefficient.
1. FAILURE TO TAKE INTO ACCOUNT ALL COSTS AND BENEFITS
•
If all costs and benefits are not taken into account, there will be underproduction or
overproduction of certain goods and services, meaning that resources are not being allocated
efficiently to meet society’s needs. This results in market failure.
SOCIAL COSTS VS. SOCIAL BENEFITS
In a free market economy, consumers and producers usually only look at the private costs and benefits
involved in production.
Private costs: costs borne by those directly consuming or producing a product.
Eg: For a producer, the cost of production.
For a consumer, the price of the good.
Private benefits: the benefits received by those directly consuming or producing a product.
Eg: For a producer, the profit.
For a consumer, the quality of the good.
However, the consumption and production of any product will almost always have external costs and
benefits involved for third parties.
Third parties: those not directly involved in the production or consumption of a product.
External costs: costs borne by those who are not directly involved in the production and consumption of
a product.
Eg: The effect of smoking a cigarette on a non-smoker’s lungs.
External benefits: the benefits enjoyed by those who are not directly involved in the production or
consumption of a product.
Eg: Setting up cameras in a house will deter robbers from entering the whole neighbourhood.
Social costs: the total costs to society of an economic activity.
Social Costs = Private Costs + External Costs
Social benefits: the total benefits to society from an economic activity.
Social Benefits = Private Benefits + External Benefits
Socially Optimum Output: the level of output where social costs equals social benefits and society’s
welfare is maximised.
EXTERNAL COSTS DEMONSTRATED ON A DEMAND AND SUPPLY DIAGRAM
If only private costs are taken into consideration when producing goods and services, there will be over
production, as supply will be high at supply curve S due to fewer costs. However, if external costs such
as air pollution, water pollution etc. were taken into consideration, the supply would be lower as shown
by supply curve S1.
Price ($)
Although the current quantity being produced is Q,
S1
the socially optimum level of output where SC=SB
S
would be Q1.
It is also the allocatively efficient output.
The gap between the two supply curves S and S1
D
are the external costs to society.
0
Quantity
Q1 Q
The gap between Q and Q1 shows
over-production.
EXTERNAL BENEFITS DEMONSTRATED ON A DEMAND AND SUPPLY DIAGRAM
If only private benefits are taken into consideration when producing goods and services, there will be
under production, as the demand for these goods and services will be low at demand curve D. However,
if social benefits are taken into consideration, the demand will be higher at demand curve D1.
Price ($)
S
D
0
D1
Quantity
Q Q1
Although the current quantity being produced is Q, the socially optimum level of output would be at Q1.
It is also the allocatively efficient output.
The gap between the two demand curves shows the external benefits to society.
The gap between the quantities Q and Q1 shows underproduction.
2. MERIT GOODS
•
Merit goods: products that are more beneficial to consumers than they themselves realise, and
have external benefits.
The failure of consumers to understand the full benefit of merit goods leads to the under
consumption (at quantity Q instead of Qx) of the merit good. This results in market failure.
Eg: Health check-ups are more beneficial to you than you realise, while others will also benefit
as you spend less time off work, and will prevent the spread of diseases.
Price ($)
S
Px
P
Dx
•
•
•
D
0
Q Qx
Qty
Dx shows the demand taking into account the external benefits, the ideal level of consumption
would therefore be where S and Dx curves meet, at Qx.
However, the quantity consumed is where S and D curves meet, at quantity Q.
This shows under consumption of a merit good.
3. DEMERIT GOODS
•
Demerit goods: products that are more harmful to consumers than they realise, and have
external costs.
Eg: Cigarettes are bad not only for the health of smokers, but also those around them.
Price ($)
S
P
Px
D
Dx
0
Qx
Q
Quantity
•
•
•
Over consumption of demerit goods when left to market forces results in market failure as
resources are allocated inefficiently to producing goods that should not be in demand: Dx shows
that demand should be lower than it actually is when taking into account the external costs.
The ideal consumption level would therefore be where Dx and S curves meet, at Qx.
However, the quantity actually consumed is where D and S curves meet, at Q. This shows over
consumption of the demerit good.
4. INFORMATION FAILURE
Information failure can occur in a number of ways:
1. Lack of information: if a producer, consumer or worker lacks information, they can make a poor
decision which will lead to inefficient use of resources. Eg: If a consumer is unaware of a
talented dentist in his town, he will waste time and fuel travelling out of town for a dentist’s
appointment.
2. Inaccurate information: if a consumer, producer, or worker makes a decision based on wrong
information obtained, they will allocate their relative resources inefficiently. Eg: If a taxi driver
migrates abroad being promised a job as a taxi driver, but is employed unknowingly by a
construction firm as a labourer, his driving skills will not be efficiently used as he was given
inaccurate information about his job.
3. Asymmetric information: if a consumer and producer do not have equal access to information,
resources maybe wasted and therefore, inefficiency occurs. Eg: If a car mechanic says that a
consumer’s car needs an expensive repair, the consumer might spend on it because he doesn’t
have the technical knowledge to fix it another way instead.
Due to information failure, inefficient decisions will be made on the part of the producers and
consumers which will lead to market failure.
5. NON-EXISTENCE OF PUBLIC GOODS
PUBLIC GOODS
Public goods: products that are non-rival and non-excludable.
•
Public goods have 4 main characteristics that discourage market economic systems from
producing these products. Due to this reason, governments often have to fund these public
goods through taxation.
1. Non-rivalry: when the consumption of a product does not decrease the availability of the
product for someone else.
Eg: A person walking under a street light does not reduce its availability for another person.
2. Non-excludability: when it is not possible to divide payers for the product from non-payers.
Eg: If a flood defence system is built around a coastal town, all house owners would be protected
whether they have paid for it or not.
Free rider: a person who takes advantage of non-excludability of goods by using it without paying for it.
3. Non-rejectability: it is not possible to reject the consumption of these products.
Eg: It is not possible to reject the services of the police.
4. The cost of supplying one quantity of a public good to consumer is often zero.
The non-existence of public goods in a market economy due to the above reasons, is a sign of market
failure.
PRIVATE GOODS
Private good: a product that is both rival and excludable.
Private goods, however, can be charged for even if they are provided free of charge by the government.
Eg: Although healthcare is free in most countries, it is not a public good as its use will decrease the
availability for another consumer (rival) eg: hospital beds. It is also excludable as it is possible to
separate payers from non-payers if they wish to do so. Therefore, free healthcare can be a merit good,
but not a public good.
All merit and demerit goods are private goods.
6 ABUSE OF MONOPOLY POWER
•
Monopoly: a single seller in a market.
If only one firm dominates a market, it is likely to be allocatively, productively and dynamically
inefficient as it does not have the competitive pressure to respond to consumer demands, keep
prices low or to improve its products. This leads to market failure as producers are inefficient
and consumers do not have a choice but to buy from them.
Abuse of monopoly power can also occur when a very few firms get together and control a
market, usually through price fixing.
•
Price fixing: when two or more firms agree to sell a product at the same price.
Prices are usually fixed at a much higher price than consumers would normally be willing to pay
for it. This leaves consumers with no choice but to purchase the products at a higher price,
thereby allocating resources inefficiently and resulting in market failure.
7 IMMOBILITY OF RESOURCES
If resources are immobile, it will be impossible to achieve allocative inefficiency as resources cannot be
switched from the production of one good/service to another. This will result in market failure.
Eg: The capital equipment and labour used in steel mining cannot be used in financial services even if
the demand for steel mining falls whilst the demand for financial services increases.
8 SHORT TERMISM
Due to short sighted approaches by firms in market economies looking for immediate gains to their
investments, they may not focus on the future and will invest where they can reap returns now instead
of planning for the future. This will result in resources being allocated only to consumer goods instead of
capital goods, which will result in market failure.
GOVERNMENT MEASURES TO ADDRESS MARKET FAILURE
1. MAXIMUM AND MINIMUM PRICES
•
Governments set price controls in order to avoid consumers and producers from being
exploited.
Maximum prices
•
•
•
•
A government sets a maximum price/ price ceiling in order to enable the poor to afford
basic necessities.
Maximum prices (Px) will be set below the equilibrium price (P).
This will allow more people to purchase the product. Consumers benefit from maximum
prices.
However, this will create a shortage as QD will be higher than QS. Governments will have to
allocate products through queuing, rationing or even a lottery to prevent the development
of illegal markets.
Price ($)
S
P
Px
Maximum price
D
0
Quantity
QS
QD
Minimum prices
•
•
•
•
•
A government sets a minimum price/price floor in order to save producers from being
exploited by being paid too little for their products.
Minimum prices will be set above the equilibrium price.
This represents the lowest price producers can get for a product.
This will attract more suppliers to supply the product. Suppliers will benefit from minimum
prices.
However, this will create a surplus as QS will be higher than QD. Governments will have to
buy the surplus.
Price ($)
S
Px
Minimum prices
P
D
0
Quantity
QD
QS
2. SUBSIDIES
•
•
•
Producers will be given subsidies to increase the supply of a product.
Subsidies will decrease prices, enabling more consumers to buy more of the product.
The effect of the subsidy depends on:
1. The size of the subsidy
2. The Price Elasticity of Demand of the product.
Effect of a subsidy on a product with Inelastic demand
Price ($)
S
P
P1
P2
S
S1
X
Y
D
0
Quantity
Q Q1
•
•
•
•
A subsidy will increase the supply from S to S1. This will decrease the price from P to P1.
The size of the subsidy is SY.
As the product is inelastic, if quantity demanded needs to increase, the price will have to fall
by a large proportion. Therefore, most of the subsidy is passed onto the consumer. Area
shaded in red (PSXP1).
The producers keep a small portion of the subsidy. Area shaded in green (P1XYP2).
Effect of a subsidy on a product with Elastic demand
Price ($)
S
S1
•
•
•
•
P
S
P1
X
P2
Y
0
Q
D
Q1
Quantity
A subsidy will increase the supply from S to S1. This will decrease the price from P to P1.
The size of the subsidy is SY.
As the product is Elastic, even a small decrease in price will cause quantity demanded to rise
by a large proportion. Therefore, only a small portion of the subsidy will be passed onto the
consumer. Area in red (PSP1X).
The producers will keep a larger portion of the subsidy to themselves. Area shaded in green
(P1XYP2).
3. TAXES
•
•
Taxes are implemented by governments to discourage the consumption of goods/services.
The effect of a tax depends on:
1. The size of the tax
2. Price elasticity of demand for the product.
Effect of a tax on a product with Elastic demand
Price ($)
S1
P1
S
T
P
X
P2
Y
D
0
Quantity
Q1
Q
•
•
•
•
If a government wants to discourage the consumption of a product, it will be more effective
to tax a product with Elastic demand.
The size of the tax is TY.
As the product is elastic, a small increase in price will cause a greater fall in quantity
demanded. Therefore, only a small portion of the tax burden will be passed onto the
consumer. Area in red (P1TXP).
The producers will bear a larger burden of the tax instead. Area shaded in green (PXP2Y).
Effect of a tax on a product with Inelastic demand
Price ($)
S1
S
P1
T
P
X
P2
Y
D
Quantity
0
•
•
•
•
Q1 Q
If a government is looking to raise revenue, it will be more effective to tax a product with
inelastic demand.
The size of the tax is TY.
As the product is inelastic, most of the tax burden will be passed onto the consumer. This is
because price will have to increase by a greater percentage is quantity demanded needs to
fall. The tax will be the area in red (P1TXP).
The producers will bear only a small burden of the tax. Area shaded in green (PXYP2)
4. COMPETITION POLICY
Governments introduce competition policies to promote competitive pressures and prevent firms
from abusing their market power. A few such policies may be:
•
•
Preventing mergers- governments prevent firms from merging so that they cannot operate
as a monopoly and exploit consumers
Removing barriers to entry- fewer barriers to entry mean that new firms can enter the
market and this threat will incentivise existing firms to be more efficient and keep prices
down
•
•
•
•
Regulation of monopolies- legislations may be passed to prevent monopolies from
exploiting consumers
Prohibition of uncompetitive practices such as predatory pricing or limit pricing.
Predatory pricing: firms setting a price below cost to drive out rival firms.
Limit pricing: setting the price low enough to prevent new firms from entering a market.
5. ENVIRONMENTAL POLICIES
•
•
A government may place restrictions on the amount of pollution allowed into the air, sea,
and rivers. It will fine any firms that exceed these limits.
Governments may also introduce tradable permits- each firm will be given a permit on the
amount that it can pollute.
If it exceeds this permit, it will have to buy a permit from another firm in order to pollute
some more. However, if it doesn’t exceed the permit, it can sell off its permit to another
firm.
This will encourage firms to pollute less so that they can sell their permits and gain a profit,
instead of polluting more and increasing costs due to purchasing permits. As a result,
pollution should fall.
6. REGULATIONS
Governments may impose regulations on the target audience for a product, the quality of
products and a firm’s staff management.
Regulations are always simple and easy to understand. However, it is both difficult and
expensive to check if these laws are being followed.
•
•
•
•
Governments may pass laws banning the sale of cigarettes to children, but it will need
policing to make sure it’s not sold to children.
Governments introduce regulations to meet a certain standard for their products, but it will
need a regulatory body to check on all products.
Governments place regulations on opening/closing hours for shops.
Governments regulate a minimum number of holidays for workers, but it will have to
appoint a government body to check if these rules are being followed.
7. NATIONALISATION AND PRIVATISATION
•
Nationalisation: transferring the ownership and control of an industry from the private
sector to the public sector.
Industries owned by the government are called public corporations or state owned
enterprises. These enterprises do not seek to make a profit, but to provide a service. All
funds and decision making comes from the government only.
Advantages of nationalisation:
1. The government takes account of social costs and benefits when making a decision.
2. They can increase output to increase economic output.
3. In industries where only one firm can operate, state owned enterprises will not abuse
monopoly power.
4. Ownership of an industry by only the government will make planning and coordination
easy. Eg: train timetables should be coordinated.
5. Survival of basic industries will be ensured, with low prices and good quality.
Disadvantages of nationalisation:
1. The large size of organisation will make it difficult to manage, control and make
decisions.
2. They may become inefficient, produce low quality products and charge high prices due
to lack of competition and the fact that they cannot go bankrupt.
3. State owned enterprises will have to be subsidized through tax revenue if they are loss
making.
•
•
•
•
•
•
•
Privatisation: transferring the ownership and control of an industry from the public sector
to the private sector.
Concerns about the performance of state owned enterprises has led to a number of
governments selling some industries to the private sector.
Advantages of privatisation:
Market forces allow firms to produce the products desired by consumers.
Existence of many firms in the industry gives consumers choice.
Firms try to reduce costs by increasing efficiency and lowers prices in order to gain more
consumers.
Threat of bankruptcy promotes efficiency.
Freedom from government regulation reduces administration costs.
The small size of companies leads to better communication and efficient decision making.
Disadvantages of privatisation:
•
•
Monopolies may be created which charge high prices, produce low quality products and
operate inefficiently.
Private sector firms may not take social costs and benefits into account.
•
Public companies, public corporations, public sector enterprises are all owned by the
government. Anything that says public is owned by the government except for “public
limited companies” only.
•
Public limited company: a private sector company that allows the general public to buy
its shares.
8. DIRECT PROVISION
•
•
Public goods such as street lights and defence that are non-rival, non-excludable and nonrejectable will not be produced by the private sector as they cannot charge consumers for
its consumption. Therefore, governments will produce and directly provide these public
goods to people.
Merit goods such as healthcare and education that have external benefits greater than
private benefits will be under produced in the private sector. Therefore, governments will
also produce them and directly provide them either free of charge or at subsidised prices.
9. PROMOTES FAIRNESS
Governments intervene to create fairness in an economy in the following ways:
•
•
Ensuring everyone has access to basic necessities such as free education by providing it free
of charge. This will reduce the inequality between the rich and poor as everyone will have a
minimum level of education.
Income inequality will be reduced by taxing the rich, and passing on benefits to the sick,
disabled and unemployed through benefits.
TYPES OF MARKET FAILURE AND WAYS GOVERNMENTS
INTERVENE TO CORRECT THEM
1. FAILURE TO TAKE INTO ACCOUNT ALL COSTS AND BENEFITS
Measures a government may use to eliminate market failure when all costs and benefits are not
considered:
• Road pricing schemes to limit the traffic and pollution from cars when SC>PC
• Providing free meals to encourage children to attend when SB>PB
2. MERIT GOODS
Measures a government may use to eliminate market failure through under consumption of
merit goods:
• Subsidise the industry: subsidies will be given to producers to increase the supply of merit
goods, thereby decreasing the prices of these goods. The lower prices will then encourage
consumers to consume more, thereby achieving the quantity that brings full benefits to
society.
• Provide the good free of charge: when merit goods are free, consumers will not hesitate to
consume the product and the government will be able to achieve the ideal level of
consumption. Eg: vaccines
• Legislations that make consumption compulsory: if the consumption of a good is immensely
important for a country, the government will pass laws that make its consumption
compulsory in order to achieve the ideal level of consumption. Eg: wearing seatbelts.
3. DEMERIT GOODS
Measures a government may use to eliminate market failure through over consumption of
demerit goods
• Taxation: by introducing taxes, governments will make it more expensive to produce
demerit goods. This will result in a fall in supply, thereby increasing the prices of demerit
goods. This high price will discourage consumers from buying demerit goods.
• Creating awareness on their detrimental effects: governments can create campaigns or
awareness programs on the external effects of demerit goods, which will decrease their
consumption.
• Banning the sale of demerit goods: sometimes, governments will completely ban the sale of
some demerit goods so that it is completely unavailable for people to purchase.
4. INFORMATION FAILURE
Measures a government can use to eliminate market failure through information failure:
• Governments can educate people on the availability of jobs, training programs etc.
• Governments will have strict laws on disclosure when it comes to doing business or
employing workers.
5. PUBLIC GOODS AND PRIVATE GOODS
Measures a government can use to eliminate market failure through the non-provision of public
goods:
• Providing public goods free of charge
6. ABUSE OF MONOPOLY POWER
Measures a government can take to eliminate market failure through abuse of monopoly power:
•
•
•
•
Promoting competition
Reducing the barriers to entry in a market
Making price fixing illegal
Preventing firms from merging.
7. IMMOBILITY OF RESOURCES
Measures a government may take to eliminate market failure through immobility of resources:
•
•
•
Providing investment grants to change the use of lands easily
Providing training programs free of charge for labour
Providing financial help and housing for workers who move to locations where labour is in
high demand.
8. SHORT TERMISM
Measures a government can take to eliminate market failure through short-termism:
•
•
Cutting taxes on firms in order to stimulate investments
Undertaking some investments by itself
CHAPTER 15: MIXED ECONOMIC SYSTEMS
•
Mixed economic systems seek to gain the advantages of both free market and planned
economies while avoiding the disadvantages of both economic systems.
EFFECTIVENESS OF GOVERNMENT INTERVENTION IN MIXED ECONOMIES
Advantages of government intervention:
•
Governments will always take into consideration social costs and benefits and therefore, will
make decisions to benefit the whole economy. It will carry out a cost benefit analysis (CBA) to
do this.
Cost benefit analysis (CBA): a method of assessing investment projects which take into account social
costs and benefits.
Disadvantages of government intervention:
•
•
•
•
•
•
•
•
Government failure may occur as it is difficult to calculate the most efficient quantity of public
goods and merit goods. Overestimation will result in inefficiency.
The time to make decisions will be influenced by political factors including corruption.
Government sector firms are less incentivised as they do not have a profit motive. This results in
economic inefficiency.
If taxes earned on incomes are high, it will demotivate people from earning a lot. Instead, if
unemployment benefits are high, people would prefer to not work and get these benefits.
High taxes on firms will reduce entrepreneur’s willingness and ability to invest.
As the state funds public sector businesses, they may not keep their costs down.
Delays in government decision makes it difficult to complete projects on time.
Government expenditure always involves a significant opportunity cost. Eg: The decision to
spend on building a school, will make it unable for a government to build a hospital.
CHAPTER 16: MONEY
Money: an item which is generally acceptable as a means of payment.
For a particular thing act as money, it doesn’t need to have an intrinsic value, but, it should possess
certain characteristics and should be able to carry out certain functions.
Characteristics of Money:
1.
2.
3.
4.
5.
6.
Generally acceptable: people should accept the item as money.
Limited in supply: money should not be available everywhere like leaves or stones.
Durable: money should last for long periods of time.
Portable: money should be easy to carry around.
Homogenous: all notes and coins should look the same.
Recognisable: people should easily be able to tell if the item is money.
Functions of Money:
1. Medium of exchange: people use money to exchange goods and services. For ex: we would sell
a cow, and use that money to buy rice.
2. Store of value: people use money to store their wealth. For ex: instead of saving eggs laid by a
chicken at home, we would sell them and save the money earned from it.
3. Unit of account: people use money to place a value on an item. For ex: if you were to sell ice
creams, you would say an ice cream costs $2, two ice creams cost $4 and so on.
4. Standard of deferred payment: people would use money to borrow and lend. For ex: A person
would borrow money from someone to buy a car and pay back the money later instead of
borrowing a car from them and having to give it back.
CHAPTER 16: BANKING
COMMERCIAL BANKS
•
COMMERCIAL BANKS: banks which seek to make a profit by providing banking services to
households and firms.
Functions of a commercial bank:
1. Accept deposits
Commercial banks accept deposits in two main ways:
(i)
Current accounts: this allows easy and immediate access to the money deposited. It
also allows to receive and make payments from this account. However, interest is
not paid on money deposited in a current account.
(ii)
Savings / Deposit account: this allows people to save money and earn interest on
money saved. However, a period of notice often has to be given before they want to
withdraw any cash from such an account.
2. Lend Money
Commercial banks allow borrowing in two main ways:
(i)
(ii)
Overdrafts: this enables people to spend more money than they actually have in their
account. It is mostly used to cover short term gaps between income and expenses from
accounts. However, the interest charged on overdrafts are usually very high.
Loans: this enables people to borrow money for a specific purpose and is meant to be repaid
over a specific period of time. The interest charged is lower than an overdraft. However, the
borrowers may be asked to provide a security/ collateral which can be seized and sold by
the bank if the borrower fails to repay the loan.
3. Receive and Make Payments
Banks act as agents by allowing to receive and make payments. This includes credit cards, debit
cards, standing orders and online banking.
Other functions of a commercial bank include:
4. Providing and changing foreign currency
5. Safekeeping of important documents and small valuables
6. Administration of customer wills
7. Providing financial advice and handling tax forms
8. Sell insurance on assets
9. Providing mortgages for the purchasing of houses
Overall, banks mainly function as financial intermediaries by accepting deposits from those with more
money than they want to currently spend and lend it to those who need to currently spend more than
they have at hand.
LENDERS
BANK
BORROWERS
Key Aims of Commercial banks:
1. Profits for shareholders: banks charge a higher rate of interest when they lend than they offer
to those who save in order to make a profit.
2. Liquidity: ability to turn assets into cash quickly. Banks need to hold a certain amount of liquid
assets in case customers want to withdraw more cash than the bank currently holds.
ISLAMIC BANKS
•
Islamic banks are prohibited from rewarding interest to those who save and from charging
interest from those who borrow due to Islamic laws.
These banks employ Islamic sharia scholars that approve financial products including loans. Those who
save in Islamic banks will be rewarded with profits from loans given out with the cash they have
invested.
CENTRAL BANKS
•
Central bank: a government owned bank which provides banking services to the government
and other commercial banks. Only one central bank can exist in a country.
Functions of a central bank:
1. Acts as a banker to the government: tax revenue is paid into the central bank and payments by
the government for goods and services are made out of the central bank.
2. Operates as a banker to the commercial banks: the central bank allows commercial banks to
settle debts between each other and to borrow from the central bank.
3. Acts as a lender of last resort: it lends to banks that are short of cash.
4. Manages the national debt: the central bank borrows on behalf of the government, and repays
government loans when they are due.
5. Holds the country’s reserves of foreign currency and gold: this is done by the central bank to
influence the exchange rates.
6. Issues bank notes: it prints notes, mints coins and destroys money that is no longer suitable for
circulation.
7. Implements the government’s monetary policy: central banks keep inflation low by controlling
the money supply and by influencing the interest rates charged by commercial banks.
8. Controls the banking system: central banks regulate and supervise the commercial banks.
9. Represents the government: central bank employees attend meetings with the World Bank,
IMF and other countries on behalf of the government.
CHAPTER 17: SPENDING, SAVING AND BORROWING OF
HOUSEHOLDS
SPENDING
•
•
Disposable income: income after income tax has been deducted and state benefits
received.
As income rises, people usually spend more in total, but less as a percentage of their
income.
Influences on the amount of spending:
1. Wealth- wealth influences spending in four main ways:
i) Wealth that generates incomes such as dividends from shares will provide money to be
spent.
ii) Ability to cash in wealth such as the sale of a car or withdrawing money from a bank
account allows money to be spent
iii) Ability to use wealth as security to obtain loans allows people to spend money from that
loan
iv) Wealth gives people confidence that allows them to spend
2. Confidence- if people are more optimistic about their future career prospects or income,
they are likely to spend more.
3. Rate of interest- a charge for borrowing money and a payment for lending money.
When interest rates rise, it is more expensive to borrow, so people would spend less.
However, if interest rates fall, it will be cheaper to borrow and therefore, people would
borrow and spend more.
4.
Distribution of income – a more even distribution of incomes means both the rich and poor
and spend, thus increasing spending/expenditure in a country.
5. Advances in technology- new products being released such as iPhones, TVs etc. encourage
people to spend more and buy these products.
• When people are very poor, they cannot afford to save. All of their disposable income will be
spent on buying basic necessities such as food, housing and clothing. This sometimes results
in dissaving.
•
•
•
•
Dissaving: when people are spending more than they earn by either drawing from their past
savings or borrowing from other people’s savings.
Spending in total and spending as a percentage of income
As incomes increase, the total amount spent increases, but the percentage of income spent
decreases.
Eg: A rich person who earns $100,000 a month would spend $20,000.
A poor person who earns $500 a month would spend $300 in order to survive.
The rich person spends more in total ($20,000) than the poor person ($300).
However, the rich person spends less as a percentage of their income (20%) than the poor
person (60%).
Percentage spent by the rich person: $20,000/$100,000 x 100 = 20%
Percentage spent by the poor person: $300/$500 x 100 = 60%
Average Propensity to Consume (APC)
•
•
Average propensity to consume (APC): the proportion of household disposable income that
is spent.
Consumption: spending by households on consumer goods and services.
APC =
Consumption
Disposable Income
DISPOSABLE INCOME ($)
CONSUMPTION($)
120
200
270
100
200
300
APC
1.2
1.0
0.9
Relationship between disposable income and consumption
Consumption
Y
* Area shaded in yellow is C>Y
* Area shaded in green is Y>C
C
0
Z
* Point Z is where C=Y
Disposable income
Patterns of Spending/ Expenditure
1. Different income groups
• The poor spend a higher proportion of their income on food and clothing.
• The rich will spend more in total on food and clothing due to a greater variety, but
only a small percentage of their income. The rich would, however, spend more in
total and as a proportion, on luxury items, jewelry, foreign holidays etc.
2. Different countries
• In poor countries, a greater proportion of income is spent on food and other
necessities.
However, in richer countries, a greater proportion of income is spent on luxuries.
• The cultural values of different countries can also cause differences in spending
patterns. A country that values cultural activities will spend more in total and as a
percentage on cultural festivals and traditions, than a country that doesn’t.
3. Different household compositions, age and tastes
• A household with children is more likely to spend a higher proportion on education,
recreation and eating out.
• Older people are likely to spend a higher proportion on medical care. Whilst
teenagers are more likely to spend on clothing and entertainment.
SAVING
•
•
Contractual savings: when people sign a contract, agreeing to save a certain amount
on a regular basis. Eg: insurance policies and pension schemes
Non-contractual savings: when savings are not on a contract basis and therefore
varies with time. These type of savings are heavily influenced by interest rates. Eg:
placing money in bank and accounts, buying government securities, shares and
property.
Reasons for saving:
1. Target savers: some people save in order to achieve a certain target. Eg: to buy a
car
2. To save for retirement: some people save so that they can use this money when
they can no longer work.
3. For children’s future: people save in order to send their children to a good
university, get them married etc.
4. For precautionary reasons: people save so that they can use that money in case of
an unforeseen need. Eg: medical emergencies, job loss etc.
5. To take advantage of any unforeseen opportunities. Eg: to be able to buy a piece of
land when it becomes available.
6. To increase their current income: the more people save, the more interest they will
receive which will increase their income.
7. To benefit from a rise in the value of assets: savings in the form of shares, government
bonds or a house ensures that it will increase in value and profit the owner when
they sell these assets.
Influences on saving:
1. Income: as disposable income rises, the total amount and percentage of disposable
income saved rises.
2. Wealth: if people are wealthier, they will find it easy to save. Eg: if you own a house, you
can save easily as you do not need to spend on rent.
3. Rate of interest: non-contractual savings will increase when interest rates rise as the
reward for saving is higher.
4. Tax on savings: if tax is not charged on interest on savings, people will save more.
5. Range and quality of financial institutions: a greater variety of saving schemes and
confidence in these institutions will increase savings.
6. Age structure: a country will more middle aged people will see an increased saving
pattern as compared to a country with more young or old people.
7. Social attitudes: in some countries, saving is viewed as a good thing, whilst in some
other countries people prefer to spend all their money.
Saving in total and saving as a percentage of income
•
•
As incomes increase, the total amount saved usually increases, and the percentage of
income saved also increases.
Eg: A rich person who earns $100,000 a month would spend $20,000 thereby saving
$80,000. (80% savings)
A poor person who earns $500 a month would spend $300 thereby saving $200. (40%
savings)
Average Propensity to Save (APS)
Average propensity to save/ savings ratio: the proportion of household disposable income
that is saved.
APS =
Savings
Disposable Income
DISPOSABLE INCOME ($)
CONSUMPTION ($)
120
200
270
100
200
300
SAVINGS ($)
-20
0
30
APS
-0.2
0.0
0.1
Relationship between disposable income and savings
Saving
S
+
Disposable Income
0
Z
*Area shaded in yellow is dissaving
_
*Area shaded in green is saving
*Point Z is where savings is 0
BORROWING
•
•
•
Borrowing moves income from people who do not want to spend their income now to
people who need more money than they currently have.
The cost of borrowing is the interest payable.
Sometimes, people must provide a security or collateral when borrowing.
Reasons for borrowing:
1. Financial difficulties: people borrow when they run into financial difficulties in
order to maintain their living standards. They borrow hoping to pay back when
their income rises soon.
2. To achieve a target: people may borrow to buy a car or to go on a holiday.
3. To buy a house: Mortgages are loans taken out to buy a house.
4. To finance education: loans may be taken to finance their own education or
their children’s education.
Influences on borrowing:
1. Availability of loans and overdrafts: the more options there are to borrow, borrowing
will increase.
2. The rate of interest: A rise in the rate of interest will decrease borrowing as it will be
expensive to borrow.
3. Confidence: the more confident people are about their future earnings, the more they
will borrow.
4. Social attitudes: Some countries/ groups that worry too much about the risks of
getting into debt will have a lower rate of borrowing than other countries.
CHAPTER 18: WORKERS
FACTORS INFLUENCING AN INDIVIDUAL’S CHOICE OF OCCUPATION:
1. Wage factors: factors that involve monetary benefits related to the job.
2. Non- wage factors: factors that include non-monetary benefits related to the job.
Wage factors:
1. Wages: this maybe in the form of wages/salaries/ pay which is given for a particular job.
• Wage rate: the basic wage a worker receives per unit of time or output.
Wages maybe paid according to a time rate system (based on the number of hours worked)
or piece rate system (based on the number of items they produce)
2. Over time: this is a payment for any extra time worked in addition to the standard working
hours. The overtime rate is usually higher than the wage rate. This is in addition to the standard
wage.
3. Bonuses: this is an extra payment for a job well done. This includes producing above a standard
level, finishing a job ahead of time etc. This is in addition to the standard wage.
4. Commissions: this is when a percentage of the sales value is paid to the sales people. This is in
addition to the standard wage.
Non-wage factors:
1. Job satisfaction: some occupations provide a high degree of satisfaction and so, workers opt
for those jobs although the pay maybe not be high. Eg: nurses, teachers.
2. Type of work: some people prefer non-manual work as compared to manual work. Some
may opt for work in safe environments as compared to dangerous environments such as
deep-sea diving.
3. Working conditions: some people work for a lower pay if the working environment is
pleasant.
4. Working hours: most people prefer occupations that offer flexibility in working hours such as
working part time, working hours during school hours etc. However, some jobs have odd
working hours such as catering, nursing etc.
5. Holidays: many people prefer to take up teaching as an occupation as it offers the longest
holidays.
6. Pensions: some people opt for jobs that pay pensions after they retire. Pensions are mostly
paid in government jobs such as the police force.
7. Fringe benefits: some jobs provide free meals, housing, health schemes etc. which make
these jobs more attractive to workers.
8. Job security: many civil servants often have a high degree of job security. Also, firms that
sign long term contracts encourage employees to work for their firms.
9. Career prospects: although some jobs may not pay well initially, they offer good career
prospects if they continue to work for these firms.
10. Size of the firms: some people prefer to join large firms that will allow them to climb up the
corporate ladder. On the other hand, some will opt to work for small firms that have a
friendlier working environment.
11. Location: people may choose an occupation that’s close to their home as it will save them
time and money while travelling to and from work.
FACTORS LIMITING AN INDIVIDUAL’S CHOICE OF OCCUPATION:
1. Occupational immobility
2. Geographical immobility
CHAPTER 18: WORKERS
WAGE DETERMINANTS
1. Demand and Supply
The demand and supply for labour determines the wages for an employee.
Wage rates for doctors:
Price ($)
S
P
D
0
Quantity
Q
* The demand for doctors is inelastic as they cannot be replaced by anyone else.
* The supply of doctors is also inelastic as it requires a lot of time and effort to qualify as a doctor.
* This results in higher wages being paid to doctors as compared to many other professions.
Wage rates for cleaners:
Price ($)
S
P
D
0
Quantity
Q
•
•
•
The demand for cleaners is elastic as they can be easily replaced by other workers.
The supply of cleaners is also elastic as anyone can easily be trained to do their jobs.
This results in cleaners earning lower wages as compared to other professions.
2. Relative bargaining powers of employers and workers
If employers are able to bargain more in comparison to employees, they will be able to pay low wages to
their workers.
On the other hand, if employees have relatively higher bargaining power than their employers, they are
likely to earn higher wages. Employees are likely to have stronger bargaining powers if they belong to a
trade union or professional organization (eg: doctors) or if they work for the public sector as
governments are more willing to negotiate than private organisations.
3. Government Policies
Government labour market policies such as national minimum wage, policies to promote economic
growth and several laws can affect workers’ wages.
•
•
•
National minimum wage: a minimum rate of wages to be paid for an hour’s work, fixed by
the government for the whole economy.
A national minimum wage will increase wages for low paid workers which will raise their
motivation and hence their productivity. This, combined with higher demand for products
arising from higher wages, can increase demand for labour.
Policies, which promote economic growth tend to pushup wages throughout the economy
as they increase demand for labour in order to increase output.
Some laws can increase the demand and thus, wages for certain professions. Eg: A law
requiring car drivers to take a test every ten years will increase demand for driving
instructors and push up their wages.
4 .Public Opinion
•
•
•
The general public agrees that jobs which involve long periods of study and training should
be rewarded with higher wages. Eg: doctors.
The public also agrees that jobs with a high level of risk should be paid higher wages. Eg:
firefighters
A government seeking to gain or maintain popular support, will also pay higher wages in
order to increase their chances of re-election.
1. Discrimination
Discrimination occurs when a group of workers is treated unfavourably in terms of employment, the
wage rate, the training received and/or promotional opportunities.
There are a number of reasons for this:
•
•
Women tend to be less well qualified than men, but this is changing in a number of
countries with more women now going to university than men
Women tend to be more heavily concentrated in low-paid occupations eg: teaching
•
•
Women are less likely to belong to trade unions and professional organizations
Women are still discriminated against.
Wages in a market with discrimination will be low as shown as follows:
Wages ($)
D
Supply
D1
W
W1
Demand
Demand with discrimination
0
Quantity of labour
Q1
Q
REASONS FOR CHANGES IN EARNINGS
1. Changes in demand and supply of labour
Changes in demand for labour
An increase in demand for labour results in an increase in wages. The demand for labour may
increase due to the following reasons:
•
•
•
An increase in demand for a product increases the demand for labour as labour is derived
demand. Eg: Increase in demand for flights will increase the demand for pilots.
Higher productivity increases the return from hiring workers thereby increasing the demand
for labour.
A rise in the price of capital such as machinery will increase the demand for labour as it is a
substitute.
Wages ($)
S
W1
W
D1
D
0
Q Q1
Qty of labour
Changes in supply of labour
A decrease in the supply of labour will result in an increase in wages. The supply for labour may
decrease due to the following reasons:
•
•
•
•
A fall in the labour force. If there are fewer workers, employers will have to increase wages
in order to recruit workers
A rise in the qualifications or length of training required to do the job will reduce the number
of people eligible for the job.
A reduction in the non-wage benefits of a job will reduce the number of people willing to do
the job eg: increase in the working hours will decrease the supply of workers.
A rise in the wage or non-wage benefits in other jobs will result in a decrease in supply of
workers in a job as they will switch to different occupations.
Wages ($)
S1
S
W1
W
D
0
Q1 Q
Qty of labour
2. Changes in the stages of production
As the stages of production in a country develop, it is likely that wages will increase. This is
because secondary sector workers are usually paid more than primary sector workers and
tertiary sector workers are paid more than secondary sector workers.
Eg: A primary sector worker such as a farmer will earn a higher wage if he gets a secondary
sector job such as a builder, and will get an even higher wage if he gets a tertiary sector job such
as an accountant.
3. Changes in bargaining power
If a union is formed for workers who previously didn’t have a union, they will now have more
bargaining power which will allow them to obtain higher wages.
4. Changes in government policy
Changes in government policies can change the wages rates in a number of ways:
• Increasing the national minimum wage will increase the wages of low paid workers.
• Improved education standards in a country may raise the wages of skilled workers, as it may
decrease costs of production through increased productivity.
• Government policies on immigration making it easier for migrants to work in a country will
decrease the wages as supply of labour will rise.
• Introduction of anti-discrimination laws in regard to wages will increase the wages in the
country.
• Advances in technology in a country will usually decrease the wages being paid as machines
will be able to replace humans. However, in some areas of work such as the demand for
deliver drivers in regards to online shopping will increase which will increase their wages.
5. Changes in public opinion
If the public feels that women should be paid more, wages will increase. Also if the public
regards a certain job such as teaching very valuable, they will pay higher wages to teachers.
6. Changes in the earnings of individuals overtime
Many workers earn higher wages as they grow older as their skills and experience increases.
However, some older workers may decide to work less demanding jobs, which result in a lower pay.
Some firms may also pay reduce their workers’ wages if they experience financial difficulties overtime.
EXTENT TO WHICH EARNINGS CHANGE
Earnings change mainly due to changes in the demand and supply of labour.
The extent of this change is mainly due to two factors:
1. The size of the change in demand/supply
2. The elasticity of demand for labour/elasticity of supply of labour
• Elasticity of demand for labour: a measure of the responsiveness of demand for labour to a
change in the wage rate.
• Elasticity of supply of labour: a measure of the responsiveness of supply of labour to a
change in the wage rate.
Factors influencing the elasticity of demand for labour:
• Proportion of labour costs: if labour costs take up a small proportion of the total costs of a
firm, the demand for labour would be elastic.
• The ease with which labour can be substituted: if labour can easily be substituted with
capital, its demand is likely to be elastic.
• Elasticity of demand for the product produced: an increase in wages will increase the costs
of production for a good which will increase the price of the product.
If the demand for the product is elastic, an increase in price causes a greater decrease in
demand for the product and its labour, making the demand for labour elastic.
• The time period: over a long time period, demand for labour will be elastic as firms will be
able to substitute labour.
Factors influencing the elasticity of supply of labour:
• The qualifications and skills required: the more qualifications required, the more inelastic
the supply of labour will be.
• The length of training period: a long training period may mean only a few people qualify for
the job. Thus, the supply of labour will be inelastic.
• The level of employment: if most people in a country are employed, the supply for labour
will be inelastic as higher wages will need to be paid in order to convince workers to switch
jobs.
• The mobility of labour: the more geographically and occupationally mobile labour is, the
more elastic the supply of labour will be.
• The degree of vocation: if workers are strongly attached to their jobs, the supply of labour
will be inelastic even if wages fall.
• The time period: overtime, the supply of labour will become elastic as workers will be willing
to move, and will gain the qualifications, training and experience required to switch jobs.
SPECIALISATION AND DIVISION OF LABOUR
•
•
Specialisation: the concentration on particular products or tasks. Eg: Neurosurgeons.
Division of labour: workers specialising in particular tasks in the production of goods/services.
Eg: cutting department, sewing department etc. in a garment factory.
Advantages of specialisation:
•
•
•
•
•
•
•
Practice makes perfect: as a worker repeatedly performs a task, they become good at it and the
output per worker increases.
Decrease in costs of production: practice leads to higher output per worker and therefore, lower
unit costs.
Easy to train: when a worker has to be trained only to do a specific job, it requires less effort and
time to train them.
Time saved: workers will not have to move from one place to another to complete their task and
this will save time.
Easier to design machinery: machinery will be needed only to help a worker complete a certain
task. Eg: an iron instead of a machine that cuts, prints, sews, irons, packs etc.
Very skilled workers who earn high wages: specialisation results in the worker being more skilled
in their job which will give them the experience and ability to earn higher wages.
Less stress: specialising in less demanding jobs can reduce the pressure on workers.
Disadvantages of specialisation:
•
•
•
Boredom: employees may easily get bored as they repeat the same task again and again. This
may result in more sick days taken off.
Increase in costs of production: boredom and increased time off work due to this will result in
increased costs of production.
Inability to find other jobs: if workers specialise only on one job, they will be unable to get
another job if the demand for their task falls or gets replaced by machinery.
CHAPTER 19: TRADE UNIONS
•
Trade union: an association which represents the interests of a group of workers.
There are 4 main types of trade unions:
1.
2.
3.
4.
Craft unions: workers with particular skills from a number of industries. Eg: plumbers
General unions: workers with a range of skills from a range of industries.
Industrial unions: all workers from a particular industry. Eg: rail industry.
White collar unions: workers from particular professions. Eg: doctors.
The role of trade unions
•
•
•
•
•
•
•
Negotiate on behalf of member with their benefit of collective bargaining.
Protect or improve workers’ rights, wages, job security, working hours and working conditions.
Provide information on a range of issues for their members. Eg: information on pensions
Help with education and training schemes.
Take measures to increase demand for the product produced by them and therefore, their
labour.
Provide benefits including strike pay, legal advice and sickness pay.
Pressurising governments to adopt legislations. Eg: national minimum wage.
•
Collective bargaining: representatives of workers negotiating with employers’ associations.
Arguments trade unions put forward
•
•
•
•
•
That members are working harder and have increased productivity.
That an industry whose profits have risen can afford to pay higher wages to its workers.
Comparability argument. That employees receive a pay rise to keep their pay in line with similar
workers. Eg: doctors and nurses.
To maintain their real income so that workers need a wage rise to meet the increased cost of
living.
Real income: income adjusted for inflation.
Factors affecting the strength of a trade union
•
•
•
High level of economic activity: if output and income are increasing in a country, that means
employment levels will be high. Therefore, a higher wage needs to be paid to recruit new
workers.
High number of workers: the more members, the more funds a union will have to finance its
activities.
High level of skill: it will be difficult to replace workers and will be expensive to train unskilled
workers.
•
•
Consistent demand for the product produced: it will be difficult for a company/ industry if
essential workers take trade union action.
Favourable government legislation: if laws allow industrial action, unions will be in a stronger
position.
Types of industrial action taken by trade unions
•
Industrial action: when workers disrupt production to put pressure on employers to agree to
their demands.
1. Over time bans: refusing to work outside of working hours
2. Work to rule: undertaking the tasks required by their contracts only.
3. Strike: employees stopping work to put pressure on an employer to agree to their demands.
Strikes can be official or unofficial. Official strikes are strikes agreed upon by trade unions.
Unofficial strikes are strikes not approved by the union.
Governments seek to avoid strikes through arbitration. This is a third party seeking to reach
an agreement. Strike action can be measured in 3 main ways:
1. The number of strikes
2. The number of workers involved
3. The number of working days lost
Trade unions may also try to influence the supply of labour by operating closed shops in order to get
employers to give in to their demands.
•
•
Closed shop: when employers can only employ those workers who are members of the trade
union.
Open shop: when employers are free to recruit workers regardless of whether they are union
members or not.
Advantages of trade unions
•
•
•
•
•
•
Less time consuming and less stressful to negotiate with a union as compared to several
workers.
Unions are a useful channel of communication.
Unions encourage workers to engage in training and education which results in increased
productivity.
Unions improve health and safety of workers resulting in increased productivity.
Unions act as an outlet to channel employees’ grievances.
Improvements in pay through unions benefits non-union labour as well.
Disadvantages of trade unions
•
•
•
Industrial action can result in lost production and revenue for firms.
Firms costs will rise
Firms flexibility will decrease
CHAPTER 20: FIRMS
•
Firm: a business entity, also known as an organisation.
•
Industry: a group of firms producing the same product.
Firms can be classified in a number of ways:
1. Stages of production – classified by the stage of production it is producing in.
• Primary sector: involved in the extraction and collection of raw materials. Eg: coal mining
• Secondary sector: involved in the processing of raw materials into finished goods. Eg: garment
factories
• Tertiary sector: involved in providing services. Eg: banking services
• Quaternary sector: involved in the collection, processing and transmission of information. Eg: IT
industry
2. Ownership of firms – classified by who owns the firm.
• Private sector firms: owned by private individuals
• Public sector firms: owned by the government
3. Size of firms – whether a firm is large or small. The size of a firms can be influenced by:
• Age of the firm: most new firms are small, while older firms tend to be large.
• Availability of financial capital: if a firm has large capital, it is likely to be a large firm as
compared to a small firm which will have a smaller amount of financial capital.
• Type of business organisation: most sole trader or partnership businesses are small as they find
it harder to raise capital as compared to public limited companies which are big as they can
easily raise capital by selling shares.
• Internal economies and diseconomies of scale: if a firm is experiencing economies of scale, it
will have lower long run average costs which will allow it to be large in size. However, if a firm
fears diseconomies of scale, it may choose to remain small in size.
• Size of the market: firms operating in large markets can grow to be large in size. However, firms
operating in small, niche markets cannot grow large.
Reasons for a firm to remain small:
•
•
•
•
Small size of the market: a small market size will not allow firms to grow as their customer base
will be small. Eg: luxury yatch companies.
Preference of consumers: sometimes firms remain small as consumers prefer small firms. Eg:
hairdressers
Owner’s preference: sometimes owners prefer to own small firms in order to reduce stress and
maintain control over their firms.
Flexibility: firms may remain small so that they can take decisions and make changes easily.
•
•
•
•
•
Technical factors: when little to no capital is required to establish a business, there are low
barriers to entry. This will allow many new, small firms to exist in the market.
Lack of financial capital: some firms may want to grow large, but will be forced to remain small
due to a lack of financial capital.
Cooperation between small firms: if small firms choose to get together when purchasing tools,
raw materials etc., they may benefit from bulk purchasing discounts and will therefore choose
to remain small.
Specialisation: firms that deal with specialist products remain small in order to provide a top
quality specialist service.
Government support: governments usually support small firms with subsidies and so firms may
remain small in order to reap these benefits.
CAUSES OF GROWTH OF FIRMS
Growth
Internal growth
Growth in existing markets
Diversification
External growth
Horizontal merger
Vertical Merger
Vertical
Vertical
Merger
Merger
Forwards
Backwards
•
Internal growth: increase in the size of a firm as a result of enlarging existing plants or opening
new ones.
•
External growth: increase in the size of firms as a result of it merging with or taking over
another firm.
Horizontal Mergers
•
Horizontal merger: taking over or merging with a firm in the same stage of production.
Eg: Toyota
merging with
Honda
Advantages of horizontal mergers:
•
•
•
•
Economies of scale due to large scale of production. Eg: discounts for bulk buying.
Increased market share as the firm gets to enjoy the consumers from the company they bought
over as well.
Rationalisation: eliminating unnecessary resources such as plants or equipment. Eg: the new
company will only need one office space now.
Save on managerial staff eg: only one human resource manager will be required.
Disadvantages of horizontal mergers:
•
•
•
Diseconomies of scale due to the company growing too big.
Difficulty in controlling the staff and other activities as the firm may be too big now.
Difficulty in integrating the two firms eg: if the two firms were in two different countries, it will
be difficult to share one office space etc.
Vertical Mergers
•
•
•
•
•
•
•
•
•
•
•
Vertical merger: taking over or merging with a firm in the same industry, but a different stage of
production.
Vertical merger forwards: taking over or merging with a firm that is in a latter stage of
production. Eg: An apple farm taking over a fresh fruit shop.
Advantages of vertical merger forwards:
Ensuring there are sufficient outlets to sell manufactured products.
Ability to store and display products well resulting in more customers.
Ability to develop and market new products to match consumer tastes.
Vertical merger backwards: taking over or merging with a firm in an earlier stage of production.
Eg: Tyre manufacturer taking over a rubber farm.
Advantages of vertical merger backwards:
Ability to ensure a steady and good quality supply of raw materials/ goods.
Ability to secure goods at a reasonable price.
Ability to restrict the access of products to rival firms.
Disadvantages of vertical mergers:
Management problems as managers may not be familiar with the different industries, stages of
production etc.
Different sizes of firms may require upsizing or downsizing of resources such as factories.
Conglomerate Mergers
•
•
•
Conglomerate merger: a merger between firms producing different products. Eg: Toyota
merging with Nestle.
Advantages of a conglomerate merger:
Diversification: branching out a firm’s operations to more than one industry so that even if an
industry is declining, the firm can earn through another industry.
Disadvantages of a conglomerate merger:
Managing two firms in different industries can be very challenging.
Advantages of Mergers to Consumers:
•
•
Economies of scale will lower costs for producers and hence the prices for consumers may be
decreased.
Increased efficiency through mergers will result in innovation and high quality products for
consumers.
Disadvantages of Mergers to Consumers:
•
•
Diseconomies of scale can result in higher costs for producers and therefore higher prices for
consumers.
Decrease in choice for consumers as firms join together and competitors’ products are
eliminated.
CHAPTER 20.1: ECONOMIES AND DISECONOMIES OF SCALE
•
•
•
Economies of scale: lower long run average costs as a result of growth.
Internal economies of scale: lower long run average costs resulting from a firm growing in size.
External economies of scale: lower long run average costs as a result of an industry growing in
size.
•
•
Diseconomies of scale: higher long run average costs as a result of growth.
Internal diseconomies of scale: higher long run average costs resulting from a firm growing in
too large in size.
External diseconomies of scale: higher long run average costs resulting from an industry
growing too large in size.
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INTERNAL ECONOMIES AND DISECONOMIES OF SCALE
1. U-shaped curve: average costs fall at first, reach an optimum point, and then average costs rise.
(economies of scale, and then diseconomies of scale)
Costs
LRAC
EOS
DEOS
0
Output
2. Downward slope: average costs fall over a big range of output. (economies of scale)
Costs
0
EOS
LRAC
Output
3. L-shaped curve: average costs quickly fall to their lowest point and then remain constant. (economies
of scale, then constant)
Costs
EOS
0
LRAC
Output
Types of internal economies of scale
1. Buying economies: firms that have grown in size will need more quantities of raw materials/
capital equipment now which will enable them to benefit from bulk discounts when buying.
2. Selling economies: the total costs of packing and transporting will be lower when more items
are being dispatched as compared to the costs of distributing/selling a small quantity.
3. Managerial economies: large firms will find it cheaper to employ specialist managerial staff as
their pay can be divided over a large quantity of output. Eg: a manager overseeing the
production of 10,000 t-shirts a day is cheaper as compared to paying a manager to oversee the
production of 20 t-shirts a day.
4. Labour economies: division of labour is possible when producing a large number of output.
5. Financial economies: large firms find it easier to raise finance either through the public selling of
shares or easily obtaining a bank loan due to the confidence banks have in lending to a large
company.
6. Technical economies: it is cheaper to go for large, technologically advanced machinery if it will
contribute in producing a large amount of output, as compared to buying equipment for a small
amount of output.
7. Research and development economies: firms will find it feasible to invest in researching
efficient methods of production and in the development of new products.
8. Risk bearing economies: since large firms produce a large number of output, losses can be
borne by more products and won’t be felt much by the firm.
Types of internal diseconomies of scale
1. Difficulty controlling the firm: managing a firm that is too large will be complex, and decision
making will be slower and more expensive due to the various managers that decisions and
instructions have to go through.
2. Communication problems: it will be difficult to ensure that messages have reached all staff
members, and employees may not get the opportunity to communicate their views and ideas to
the management.
3. Poor industrial relations: workers in large firms face a lack of motivation as they don’t feel a
sense of belonging, more time is required to solve their problems and diverse opinions may
leave many workers unsatisfied.
EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE
1. External economies of scale: causes a downward shift of the firm’s LRAC curve. (Due to lower
costs from changes in industry’s output, not the firm’s output.)
Costs
LRAC
LRAC1
0
2.
Output
External diseconomies of scale: causes an upward shift of the LRAC curve. (Due to rise in costs
from the industry’s output growing too large, not the firm’s output)
Costs
LRAC1
LRAC
0
Output
Types of external economies of scale
1. Skilled labour force: there will be a pool of skilled labour trained by other firms in the industry
available to choose from.
2. A good reputation: an area can gain a good reputation for a product if the industry grows. Eg:
Dankotuwa town for porcelain.
3. Specialist suppliers for raw materials and capital goods: when an industry grows, suppliers will
know exactly what raw materials and capital equipment firms need and will provide those goods
to suit the industries’ needs better. These industries are known as ancillary industries.
4. Specialist services: universities or training centres will provide specialist services that train and
educate workers relating to the industry that has grown.
5. Specialist markets: specialist selling places may pop up when an industry grows, to enable the
selling of these goods. Eg: corn exchanges.
6. Improved infrastructure: when an industry grows, the government will improve roads, buildings
etc in those areas to enable the movement of goods and services into and out of these industrial
zones.
Types of external diseconomies of scale
1. Increased congestion: when an industry grows, more vehicles will move around these areas
resulting in heavy traffic and congestion.
2. Higher prices of land, labour and capital: increased demand by firms due to the industry
growing large will push up the prices for factors of production, making it unaffordable to
operate in these industries.
CHAPTER 21: FIRMS AND PRODUCTION
Influences on the factors of production employed:
1. Type of product produced
2. Productivity of the factors of production
3. Cost of the factors of production
Altering factors of production:
Some factors of production can be substituted eg: labour and capital. In such cases, a rise in the
productivity of capital would enable producers to reduce the number of employees and switch to
capital. Also, a fall in the cost of factors of production such as the cost of labour will result in the
employment of more labour as compared to capital.
Some factors of production are fixed and cannot be switched easily. Eg: a factory.
Combining the factors of production:
It is important to achieve the right combination of factors of production. Eg: the number of hairdryers
should be in relation to the number of hairdressers in a salon.
Factors influencing the demand for capital goods:
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Price of capital goods: a rise in the price of capital goods will cause a contraction in demand for
capital goods.
Profit levels: if profit levels are high, firms will have the ability to buy more capital goods,
thereby increasing demand.
Corporation tax: a cut in corporation tax means demand for capital goods will increase as more
finance is now available for investment.
Real disposable income: increase in real disposable income will lead to an increase in
consumption, resulting in increased demand for goods and services. This will increase the
demand for capital goods in order to produce these goods and services.
Interest rates: a fall in interest rates will lead to higher investment as it is cheaper to borrow
and invest on capital. Also, fall in interest rates will increase consumer consumption and thereby
demand for capital goods to produce more goods and services.
Firms’ future expectations: if firms are confident that sales will rise, they will increase
investment on capital goods to produce more output.
Advances in technology: this will lead to increased investment as the productivity of capital
goods would’ve increased with advancements in technology.
Factors influencing the demand for land:
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Productivity of land: the most fertile land will have higher demand and will receive higher rent
for agriculture. Land in city centres is more productive for retailing and will have high demand
and higher rates of rent.
Availability of water: since water is becoming scarce, accessibility to water drives up the
demand for land.
Labour intensive production
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Labour intensive production: the production process employs more labour as compared to
capital.
Reasons for labour intensive production:
Large supply of labour resulting in lower cost of labour in a country.
Small scale production: it is not feasible to invest in expensive machinery if producers only
produce small quantities.
Consumers prefer handmade products: sometimes consumers are willing to pay a higher price
for custom made products rather than mass produced products.
Flexibility of labour: workers can be directed on what to do and they can change their tasks
when necessary.
The size of labour can be easily adjusted.
Feedback: labour can provide feedback on the methods of production, quality of output etc.
Capital intensive production
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Capital intensive production: the production process employs more capital as compared to
labour.
Reasons for capital intensive production:
Advances in technology: this has increased the number of tasks that capital can undertake as
compared to labour and has also made capital equipment more affordable.
Uniformity in production: capital goods will always produce products that are uniform and are
not subject to human error.
Technical economies: lower long run average costs due to a high level of efficiency as machinery
can work for long amounts of time unlike labour which will need breaks and has a maximum
number of working hours.
Capital does not engage in industrial action.
Capital does not need time off being ill or for personal reasons.
Production and productivity
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Production: the total amount of output produced.
Productivity: the amount of output produced per worker or per machinery.
CHAPTER 22: FIRMS, COSTS, REVENUE AND OBJECTIVES
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Fixed costs: costs which do not change with output in the short run. Eg: rent
Costs
TFC
0
Output
*Average fixed costs: total fixed cost divided by output. As output increases, fixed costs are divided over
a large number of output, which decreases the fixed cost per unit.
Costs
AFC
0
•
•
Output
Variable costs: costs that change with output. Eg: cost of raw materials.
Total variable costs increase as the output produced increases.
Costs
TVC
0
Output
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Average variable cost: total variable cost divided by output. In the short run, average variable
costs fall and then rise.
Costs
AVC
0
•
Output
Total cost: the total amount spent on factors of production to produce a product.
Total cost = Fixed costs + Variable costs
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In the short run, some factors of production cannot be altered. Therefore, total costs will always
have a fixed cost even when there is 0 units of output.
Costs
TC
VC
FC
0
•
Output
In the long run, all factors of production can be altered and therefore, total cost can be 0 when
no units of output are being produced.
Costs
TC
0
Output
•
Average total cost: in both the short run, and the long run, the average total cost curve is Ushaped.
Cost
ATC
0
Quantity
PRICE AND REVENUE
Price: the amount of money that has to be given to obtain a product.
Average Revenue: total revenue divided by the quantity sold. This is the same as price.
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Average revenue in a market with perfect competition will remain the same.
Revenue
AR
0
Quantity
Total revenue: the total amount of money received from selling a number of products.
•
Total revenue in a market with perfect competition will keep rising as the quantity sold rises.
Revenue
TR
0
Quantity
•
Average revenue in a monopoly market will fall as quantity sold rises as a lower price has to be
offered in order to sell a higher quantity.
Revenue
AR
0
•
Quantity
Total revenue in a monopoly market will rise at first, reach a peak level, and will fall beyond that
point.
Revenue
TR
0
Quantity
OBJECTIVES OF FIRMS
1. Survival: new firms try to survive and cover costs. Also, during an economic crisis, many firms,
old and new will have survival as their key objective.
2. Growth: some firms target growth in order to gain from economies of scale, capture market
share and gain more popularity in the market for being a large firm.
3. Social welfare: many state-owned firms take into account social costs and social benefits and
thereby, try to achieve social welfare.
4. Profit satisficing: firms sometimes sacrifice profit in the short run, in exchange for investment
and better gains in the long run.
5. Profit maximization: many firms try to earn the largest profit by either reducing costs of
production or by increasing revenue.
Ways to reduce costs of production:
1. Reducing wastages
2. Increasing the productivity of factors of production
3. Increasing the size of a firm through mergers or takeovers and thereby gaining from
economies of scale
4. Creating an inelastic demand for the firm’s products.
Ways to increase revenue:
1. Reducing prices
2. Increasing demand for the firm’s products. This maybe through improving the quality of
products, diversification etc.
3. Increasing the size of a firm and thereby reaching more consumers resulting in higher demand
and revenue.
4. Advertising: successful advertising campaigns help reach a bigger audience for the product,
create awareness etc., which increases revenue.
CHAPTER 23: MARKET STRUCTURE
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Market structure: the conditions which exist in a market including the number of firms.
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Competitive markets: a market with a high number of buyers and sellers. This means that firms
are free to enter and exit the market. (Low barriers to entry and exit)
COMPETITIVE MARKETS
Behaviour of Competitive Markets
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Tries to keep prices low due to fear of consumers switching to rival products.
Gain competitive advantages by quickly responding to changes in demand.
High level of competition results in competitive prices and therefore, low profits.
If supernormal profits (higher than normal profits) are made, it will attract more firms into the
industry. This will increase supply, which will lower price and return profits to a normal level.
If demand falls, it will drive some firms out of the market due to the losses faced, this fall in
supply will increase prices and restore normal profits.
Performance of competitive markets
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High level of competition results in a high level of efficiency. This results in lower costs of
production, enabling firms to sell at lower prices.
Responsiveness to consumer demand will enable firms to gain a high profit.
Firms producing at a larger scale will have lower costs (economies of scale) which will enable
them to earn higher profits.
MONOPOLIES
Monopoly: a market with a single supplier. Sometimes, a firm with 25% or more market share is also
considered a monopoly.
Characteristics of a monopoly
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The firm is the industry (it owns 100% of the market)
High barriers to entry and exit.
It is a price maker. It sets the price levels in a market and controls the market supply (its’ output
is the industry’s output)
Creation of monopolies
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Highly successful cost cutting and responsiveness to consumer demands in the past.
Mergers or takeovers: this eliminates competition and one firm is now in control of the market.
Monopolistic powers being granted by the government. Eg: railways.
Patents: when a product is unique, it is patented so that no other firm can produce this product.
Why do monopolies continue?
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Barriers to entry prevent new firms from entering. This includes legal barriers such as
government legislation.
Scale of production: a large scale of production will require expensive machinery which is
unaffordable for new firms. Also, a large scale of production results in economies of scale which
enables the monopoly to produce at a lower unit cost and sell for a lower price.
Successful branding and advertising. This makes consumers familiar with the existing monopoly
and they will not be willing to try new brands. Monopolies may also sell at many retail outlets
which will be difficult for new firms to approach.
Barriers to exit: long term contracts will deter new firms as they cannot leave easily if they are
making losses. Sunk costs that cannot be recovered when a firm exits a market (eg: advertising)
also prevent new firms from setting up in a market.
Behaviour of monopolies
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Supernormal profits as they are the price makers. They can decide what price they want to set
based on the elasticity of demand for the product.
Performance of a monopoly
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Inefficiency: the absence of competition can enable monopolies to push up prices, sell low
quality products and fail to respond to consumer demands due to the confidence that
consumers cannot switch to substitutes.
Efficiency: production on a large scale results in economies of scale and prevents the wasteful
duplication of capital equipment.
Ability to spend on research and development will enable monopolies to produce new products
and shift to cost effective methods of production, which will enable them to earn higher profits.