GCSE ECONOMICS (OCR)
Revision Guide: Unit 1
Markets at Work
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(A) The Basic Economic Problem
What is it?
The basic economic problem is the fact that RESOURCES are SCARCE (limited in supply) but WANTS are INFINITE
(never ending). As a result of this, consumers, producers and the government have to make CHOICES about how
to ALLOCATE scarce resources.
When we choice one thing, we often sacrifice or give-up something else. OPPORTUNITY COST is the highest
valued alternative that we forego because scarce resources allocated elsewhere.
What are resources?
Resources are all the elements that go into the production of goods and service. Resources are often known as the
FACTORS OF PRODUCTION. There are 4 factors of production:
(a) LAND: All natural resources used in production, for example building land, oil, water, wheat, apples
(b) LABOUR: The human contribution to production- i.e. workers!
(c) CAPITAL: Capital refers to man-made equipment that is developed to aid the production of other goods
and services. For example machines, computers, vehicles, shop fixtures, tills
(d) ENTERPRISE: The person(s) who has the initial business idea, raises the money and organises the other
factors of production.
Economic Systems
All economies face the basic economic problem. However, they may have different approaches to addressing it and
allocating resources. The approach they choose is known as an “economic system”
(a) PLANNED ECONOMY: All resources are owned by the PUBLIC SECTOR (the sector of the economy owned
and controlled by the government). The public sector determines what goods and services are made and
how. Goods and services are “shared out” amongst the population
(b) FREE-MARKET ECONOMY: All resources are owned by the PRIVATE SECTOR (the sector of the economy
owned and controlled by private individuals). Goods and services are allocated via the MARKET
MECHANISM, that is via demand and supply (prices)
There are pros and cons of planned and free-market economies:
Planned Economy
Free Market Economy
Pros
It is fair, everyone will get something
Theoretically, everyone can be given a
job
The government can provide merit
goods such as health and education, and
public goods such as defence
There is competition- this is good for
consumers (Low prices, better quality,
more choice, more innovation)
There is more incentive to be efficient as
low costs can allow low prices which
may be important if markets are
competitive
Cons
There is no incentive to be efficient
There will be little choice for consumers
or workers
There may be corruption
Economic growth tends to be great low
because of the lack of profit incentives
Inequality- there will be absolute and
relative poverty- poor people will be
reliant on charity and will have no choice
Public and merit goods may not be
provided/will be under
produced/consumed- eg not enough
access to education and health care
Environmental costs (eg pollution) is
likely and there is no incentive to look at
sustainable use of resources
In reality, most economies are mixed. This means there is a mixture of a public sector and a private sector owning
and allocating the scarce resources. The UK has a mixed economy that is moving towards being more free market:
Public Sector: Education, Health, Police, Defence
Private Sector: Water, Electricity, Gas, Rail, Airlines, Supermarkets, Clothes stores
Examples of how the UK has become more free-market: Privatisation; de-regulation; contracting out; Free Schools
and Academies
Understanding the key differences between the public and private sector
This can be summarised below:
Public Sector
Private Sector
Ownership
The government on
behalf of the people
(tax payers)
Private individuals
from:
Sole Traders (1)
Partnerships (2-20)
Private and Public
limited companies
(shareholders)
Control
A government
minister will oversee
control
Aims
To provide a good
quality public good
or service
To allow as many
people as possible
access to the good or
service
Owners/Shareholders Mainly to make a
will lead the strategic profit (unless it is a
direction.
charity)
Managers will
exercise control on a
day to day basis
Wider aims and
objectives (see later
notes)
Finance
Money will be raised
from the taxpayer.
Any losses will be
funded by the
taxpayer.
The business/area
could continue even
if it was loss making
Finance will be from:
Savings
Loans
Redundancy
payments
Share issue
The different sectors of the economy
Primary Sector
Secondary Sector
Tertiary Sector
Definition
The sector of the economy
responsible for extracting resources
from the natural environment
The sector of the economy that is
responsible for manufacturing and
construction (ie using the primary
resources to make goods and
services)
The sector of the economy
responsible for providing services to
consumers and to other businesses
Examples
Fishing, mining, farming
Textiles, Food manufacturing; Car
manufacturers;
Banking, Insurance, Leisure and
Tourism; Catering; Advertising and
Marketing
The UK now has a very large tertiary sector having been through a period of DE-INDUSTRIALISATION. This is the
process by which the secondary sector of the economy shrinks so that it produces less and employs fewer people.
The main reasons for de-industrialisation are:




Increased competition from abroad (globalisation)
Historically low levels of investment and productivity in the UK mean that our goods are more expensive and
poorer quality
Higher wage and tax levels in the UK have contributed to higher costs and therefore higher, less competitive
prices in the UK
As the UK has got more economically developed and richer, the demand for services has risen as they are
income elastic. Businesses have developed to meet this need.
Specialisation
Faced with the basic economic problem, it is important that scarce resources are used as efficiently as possible.
It can be argued that using resources in a more specialised way is more efficient and increases production. There are
different types of specialisation:
Specialisation of labour
(division of labour)
What is it?
The production process is
organised so that workers
all have a very specific (and
often quite narrow) job
role so that they repeat a
particularly task often
Potential Advantages
Increased productivity as a
result of expertise and
repetition. Time is not
wasted moving from one
job to another
Makes more efficient
(planned) use of scarce
capital
Product specialisation
A firm focuses its
production on one, or a
very narrow range of
products
Requires less training (in
unskilled contexts) as
workers only have to do a
limited range of tasks
The firm can buy resources
to make the product in
bulk
The firm gains a reputation
as an “expert” in the fieldthis can stimulate demand
and make it more price
inelastic
The above could
contribute to a degree of
monopoly power in the
market
The firm can have very
specialist buyers and
sellers and can focus its
research and development
budget on one product
Potential Disadvantages
Repetition leads to
boredom, de-motivation
and a reduction in
productivity
A break/weakness in the
chain (eg a an
unproductive worker)
could affect the whole
production process
For workers, wages may be
lower if tasks are unskilled
It is very risky “all the eggs
in one basket”- a decline in
the demand for the
particular good or service
would be catastrophic for
the firm
It cannot take advantage of
cross-subsidising products
It does not take advantage
of having existing
customers who may wish
to also buy a range of
products from the firm,
including compliments
(and impulse buys)
Consumers increasingly
want to buy a range of
products under one roof
for convenience- they may
go elsewhere
Regional specialisation
A particular region is
focussed on producing a
particular good or service.
This means that a lot of the
jobs in that area are
provided by the specialist
industry
Eg historically:
Sheffield – Steel
Lancashire- textiles
West Midlands- Cars
East Anglia- Shoes
International
specialisation
Countries specialise in
producing goods in which
they have an absolute or
comparative advantage
Firms in the industry may
benefit from external
economies of scale (the
idea that the growth of an
INDUSTRY) leads to lower
average costs. This will
arise because:
 There are skilled
workers in the
local area
 The local
infrastructure is
set up to meet the
needs of the
industry (roads
etc)
 Local banks are
financially
supportive of the
industry
 Suppliers move to
the region,
reducing transport
costs and making
supplies more
flexible
World output of goods is
increased as all countries
focus on what they are
good/efficient at and then
trade
The area is very vulnerable
to a fall in demand for the
product
Because Average Costs are
lower, prices may be lower
Countries may be unable
to access certain G&S if
trade is disturbed
Encourages free trade,
competition and choicegood for consumers
Takes account of the fact
that climates and resource
endowments vary between
countries
If demand falls there will
be high levels of regional
unemployment and the
regional problem may
arise:
Low demand for other G&S
in the area
Increased crime
Poor morale- low
educational attainment
Increased social problems
New firms are reluctant to
locate to the area because
of the above problems
There is a cycle that leads
to absolute and relative
poverty
Requires trade to allow the
exchange of goods and
services- this may be
affected at times of
war/unrest
Some products (such as
primary products) have
lower prices and more
unstable prices. Countries
specialising in these find it
hard to develop and grow
(LDC’s)
Countries will be
vulnerable if there is a
downturn in world demand
for the products that they
specialise in
Trade and international
competitiveness may be
undermined by
fluctuations in exchange
rates
The characteristics and functions of money
If countries/firms specialise in production, there has to be a means of exchanging goods.
Historically, this was done by BARTER and SWAPPING goods, but this was difficult for a number of reasons. MONEY
allows exchange to take place.
The Functions of Money (what it does)
A means of exchange
What does this mean
Money allows people to exchange
one good for another without finding
a “double of co-incidence of wants”
A unit of account
Money allows the value of one good
to be expressed in terms of another
A store of value
Money allows you to save
A method of deferred payment
You can “buy now pay later”
Example
I have a mountain bike to sell but
want a racing bike.
I sell the mountain bike for money.
I use the money to buy a racing bike
My racing bike was £500
Your racing bike was £100
My racing bike is 5 times more
valuable than your bike
I sell my mountain bike but cannot
find a racing bike I like. I put the
money I earn from the mountain
bike in the bank and save it until I
can find what I want
The shop allows me to buy the bike
on 12 months credit
The Characteristics of Money (what should effective money be like?)
Characteristic
Portable
Durable
Divisible
Non counterfeitable
What does it mean/why is it important?
You can easily carry it around
It lasts a long time and does not perish
You can break it into small bits to pay for cheap items
It is hard to forge it
(B) What are Competitive Markets?
The Spectrum of Competition
_______________________________________________________________________________________________
(1)
(2)
(3)
(4)
(5)
(1) Perfect Competition: Hundreds of firms operate in a market and sell identical products. There are no
barriers to entry so lots of new firms can enter the market.
(2) Competitive Markets: Large numbers of firms exist in the same market. They sell very similar/identical
products. Barriers to entry are very low. Examples: plumbers, hairdressers; builders
(3) Oligopoly: 3-8 large firms dominate an industry and account for a large proportion of market share. The
firms are big and benefit from significant economies of scale. This acts as a barrier to entry. Examples: Fast
Food; Mobile Phones; Supermarkets;
(4) Business Monopoly: 1 firm has more than 25% of market share and dominates the market. Barriers to entry
are very high
(5) Economic Monopoly: There is only 1 firm in a market such that the one firm has 100% market share. Often
firms are “natural monopolies” because barriers to entry are so high?
Sources of monopoly power
Monopolies tend to get their power and market share because of high barriers to entry:
Types of barriers to entry
Ownership of raw materials
Legal barriers to entry
Marketing barriers to entry
Technical barriers to entry
What does it mean?
One firm owns all the resources needed to make a
particular product, preventing other firms from entering
the market
There are legal things in place that give one firm
monopoly power. This may include patents, statutes and
copyright
One firm has a lot of marketing and advertising
resources. They use these to create such a strong brand
image and identity, that it makes it very difficult for a
new firm to break in
The existing firm is very large and benefits from
economies of scale. New firms, operating at much lower
outputs, know that they will not be able to produce at
such low costs and prices
Why are competitive markets seen as desirable?
Typically economists believe that competitive markets give better economic outcomes than monopolies which are
often seen as “bad”. In reality, it may be more complex than this.
Competitive Markets
Potential Gains
To Consumers:
 Prices will be low
 There will be more choice
 Quality may be improved
 There may be more
innovation and new products
as firms try and stay ahead
Potential Losses
To Firms:
 Prices are likely to be driven
much lower than in less
competitive markets- this
may reduce profit margins
 Lower profit margins may
mean that there are less
Monopolies
of competitors
To Firms:
 It may be easier to attract
workers as there are lots of
workers doing similar jobs.
This high supply of labour
may keep wages down
To the Economy
 Competition encourages
firms to be more efficient
and to keep their average
costs as low as possible
because prices will be lower.
Firms are likely to make
more careful/efficient use of
scarce resources
To Consumers:
 Firms are large and may
benefit from economies of
scale. Firms MAY choice to
pass on the benefits of this
to consumers in the form of
lower prices
 Product quality and range
may be higher than in
competitive markets. This is
because (a) The monopolies
have the profits to re-invest
in the business and in
product development and
(b) They have the incentive
to do so because they want
to maintain their monopoly
power and keep barriers to
entry as high as possible
To the Firm
 Prices are likely to be more
price inelastic. This means
that they can keep prices
higher
 The lack of competition
means higher prices and
hence higher profit margins
 The lack of competition
means that the monopoly
does not need to be as
careful about minimising
costs
 The monopoly does not have
to spend as many resources
on advertising and marketing
 The financial position of the
monopoly will be quite
stable, this may attract more
investors/finance
To the Economy
funds available for reinvestment
 Their products are likely to
be more price inelastic
 There is a constant pressure
to cut costs and be efficient.
This means that firms have
to spend a lot of time
managing resources and
ensuring labour productivity
is as high as possible. This
could cause conflict
 They may lose workers to
competitors if competitors
offer better wages/working
conditions/training etc
To Consumers
 Less competition is likely to
mean higher prices
 There will be less choice
 Product quality/customer
service may decline because
the monopoly has a captured
market (especially if it is a
natural monopoly)
To the Firm
 The lack of competitive
pressures may make the firm
become stale and
unresponsive to consumer
demand. If the product is
not a necessity, consumers
may move away from the
product over time
To the Economy
 The lack of incentive to be
efficient may mean that
scarce resources are not
being used as well as they
would be under a
competitive market. The
output of goods and services
may be lower than in a
competitive market
 The lack of competitive
forces may mean that scarce
resources are not being used
to respond to consumer
demand and to make the
goods and services that
consumers most want/value

Economic resources are
focussed on production and
not on marketing/advertising
Government Policies that can be used to increase competition/reduce monopoly
Policy
Ban all monopolies
How it works
Firms are not allowed to
own more than 25% of
market share
Advantages
Removes the
disadvantages of
monopolies (see above)
Privatisation
Makes public sector
monopolies private, and
thus opens them up to
competitive forces
Creates the benefits of
competition
Reduces the burden on the
tax payer of financing
nationalised industries
See also:
Contracting Out
De-Regulation
The government helps to
break down barriers to
entry
Removal of barriers to
A more natural way of
entry, naturally encourages introducing competition
competitive forces
Eg: De-regulation: Takes
away laws that previously
gave firms monopoly
power- eg Opticians
Regulation of Monopolies
Eg2: The government
forced BT to share its
phone lines with other
companies- reducing a
technical barrier to entry
Monopolies are allowed to
exist but a regulator is put
in place to ensure that
they do not exploit the
consumer and are run
efficiently
Examples: OFWAT, OGFAS,
OFCOM
Potentially allows us to
keep the benefits of
monopoly without having
the costs
Disadvantages
There is no incentive for
firms to be efficient,
innovate, get better
because success is
penalised!
Loses the potential gains of
monopolies (see above)
Concern that consumers
would be exploited by
private companies
Worry that some industries
are “natural monopolies”
Concern that non
profitable
products/services will go
It is very difficult to do this
in some industries where
there are very high natural
and technical barriers to
entry. It is easier to do it
when the main barrier to
entry is legal (ie a previous
law protecting the
monopoly power)
Regulators may be
expensive and
bureaucratic
Regulatory Capturesometimes over time the
regulators become “taken
in” by the industry and
stop looking at it
objectively
How are resources allocated in competitive markets
Resources will be allocated by MARKET FORCES.
Market forces are the forces of DEMAND and SUPPLY. Demand and supply interact to give EQUILIBRIUM PRICE and
EQUILIBRIUM OUTPUTS
The equilibrium price is 35 pence
The equilibrium output is 250
Equilibrium means that this is a stable market outcome where there is no tendency to change (unless demand and
supply change)
Demand
Demand is the amount of a good or service that a consumer is WILLING and ABLE to buy over a SPECIFIED PERIOD
OF TIME
Demand and Price
There is usually an inverse relationship between price and quantity demanded. This can be shown in a demand
schedule (table showing the relationship between price and Qd) and a demand curve.
The demand curve is downward sloping from left to right because it shows that quantity demanded usually rises and
price falls.
A change in price causes a MOVEMENT along the demand curve.
When price changes from $8 to $12 we will move up the demand curve and there is a CONTRACTION in quantity
demanded.
When price changes from $8 to $4 we will move down the demand curve and there is an EXTENSION in quantity
demanded.
The Conditions of Demand
These are the non-price factors that influence the demand for goods and services.
(1) INCOME
For NORMAL goods, a rise in income will lead to a rise in demand (and vice versa)
For INFERIOR goods, a rise in income will lead to a fall in demand (and vice versa)
(2) PRICE OF RELATED GOODS
Substitutes: Goods in rival demand (Pepsi v Coke). A rise in the price of a substitute, may lead to a rise in the
demand for our good and vice versa
Complimentary Goods: Goods in joint demand (CD and CD player). A rise in the price of a complimentary good may
lead to fall in the demand for our good and vice versa
(3) TASTE AND FASHION
This may be positive (a fashion craze) or negative ( a health scare, bad publicity, downturn in demand)
(4) ADVERTISING
Advertising can be persuasive and informative. Advertising is designed to stimulate the demand for a good or
service
(5) THE SIZE AND STRUCTURE OF THE POULATION
Size: How many people there are. The more people, the higher demand may be
Structure: The age distribution of the population. This may influence which products are demanded. For example,
an ageing population may lead to a rise in the demand for health care and SAGA holidays but a fall in the demand for
education and nightclubs!
Changes in the conditions of demand cause the whole demand curve to SHIFT
Elasticities of Demand
There are 3 key elasticities of demand:
(1) Price elasticity of demand: Measures how responsive quantity demand is to a change in the price of the
product
(2) Income elasticity of demand: Measures how responsive demand is to a change in income
(3) Cross elasticity of demand: Measures how responsive the demand for a good is to the change in the price
od a related good (substitute or compliment)
Price Elasticity of Demand
There are 3 alternatives.
(1) Demand is price elastic: A % change in price leads to a bigger % change in quantity demanded
(2) Demand is price inelastic: A % change in price leads to a smaller % change in quantity demanded
(3) Demand has unitary price elasticity of demand. Any % change in price leads to an identical % change in
quantity demanded.
What determines whether demand is price elastic or inelastic?
Demand is more likely to be price elastic if:
There are lots of substitutes
The good is a luxury
The good takes up a high proportion of your income
The good is durable (lasts a long time)
The good is heavily branded and has a lot of brand
loyalty
Demand is more likely to be price inelastic if:
There are few substitutes
The good is a necessity
The good takes up a small proportion of your income
The good is consumable (gets used up)
The good is not branded
Why is PED information useful?
(1) It can inform pricing decisions
If a product has price elastic demand, a firm can increase TOTAL REVENUE by putting prices DOWN.
If a product has price inelastic demand, a firm can increase TOTAL REVENUE by putting prices UP
If there is unitary elasticity of demand, changing price has no effect on TOTAL REVENUE and so is pointless
(2) It can inform stock decisions- for example a firm is told by a wholesaler that the price of tinned salmon has
risen. If the firm know that salmon is price elastic they will foresee a fall in demand and stock less
Income Elasticity of Demand
There are 3 outcomes:
(1) Demand is INCOME ELASTIC: A % change in income leads to a bigger % change in demand
(2) Demand is INCOME INELASTIC: A % change in income leads to a smaller % change in demand
Why is it important?
Knowledge of IED can inform firms about what is likely to happen when there are changes in income.
For example:
(a) A firm knows that it produces an INCOME ELASTIC good or service. If incomes fall (during a recession) they
may predict a downturn in demand and attempt to move into other markets- for example producing inferior
goods or income inelastic normal goods
(b) A firm knows that it produces INCOME INELASTIC good or service. This firm will not need to be as concerned
about changes in income levels
Cross Elasticity of Demand: Why is it important?
There are 3 alternatives:
(1) Demand is CROSS ELASTIC: A % change in the price of a compliment or substitute leads to a bigger %
change in the demand for our good. This is likely to happen when it is a very close compliment/substitute
(2) Demand is CROSS INELASTIC: A % change in the price of a compliment or substitute leads to a smaller %
change in the demand for our good. This is likely to happen when the goods are linked but not that
closely (or there is strong brand loyalty in place)
Knowledge of CED can alert a firm to how concerned they need to be about changes in the price of related products
and how they might adapt to this.
Examples
(1) McDonalds know that there is cross elastic demand between Big Macs and Whoppers. If the price of
Whoppers falls, McDonalds can predict a fall in demand for Big Macs. They will have to respond- either by
cutting the price of Big Macs or trying other offers and promotional deals
(2) HMV stock Wiis and Wii games. They know that the 2 have very cross elastic demand. If they know that the
price of Wiis is going to fall, they can predict a big rise in the demand for Wiis AND Wii games. This might
make them stock more of both products. They may also devise promotional offers that take advantage of
the link between the products.
Supply
Supply is the amount of a good or service that a producer is WILING and ABLE to produce over a SPECIFIED PERIOD
OF TIME
Supply and Price
There is a positive relationship between price and supply.
When price rises, producers are willing and able to supply more of a good or service because the potential to
make profit is greater
When price falls, producers are less willing and able to supply a good or service because they will make less profit
from it. They may wish to re-allocate their scarce resources into more profitable uses.
This can be shown is a supply schedule and a supply curve
A change in price will lead to a MOVEMENT along the supply curve.
A rise in price from £1 to £.50 will lead to a movement from B to C and an EXTENSION in quantity supplied
A fall in price from £1 to 50p will lead to a movement from B to A and a CONTRACTION in quantity supplied
The Conditions of Supply
These are the non-price factors that affect supply. They do so because they affect the firm’s willingness and ability
to supply.
(1) COSTS OF PRODUCTION
The higher the costs of production, the lower the profit margins will be. When costs increase, supply will be fall.
When costs fall, supply will increase
(2) TAXES AND SUBSIDIES
A tax is a sum of money that a business has to pay to the government. Tax acts like an extra cost of production. If
taxes rise, profits fall and supply will decrease. If taxes fall, profits will increase and supply will increase
A subsidy is a sum of money that the government gives to a business. This is usually to encourage the firm to do
something that brings external benefits, for example training or re-locating in an area of high regional
unemployment. A subsidy is an additional source of revenue for the firm. It therefore increases profit and increases
the willingness to supply
(3) TECHNOLOGY
Technology means new capital. New capital can increase supply because it makes firms more physically able to
produce more AND because it might make production cheaper, thus increasing profits and willingness to supply
(4) NATURAL FACTORS
Primary products will be particularly affected by things such as climate and natural disasters
Changes in the conditions of supply cause SHIFTS in the supply curve:
Price Elasticity of Supply
Price Elasticity of Supply measures how responsive supply is to a change in the price of the product. There are 3
alternatives.
(1) PRICE ELASTIC SUPPLY: A % change in price leads to a bigger % change in quantity supplied
(2) PRICE INELASTIC SUPPLY: A % change in price leads to a smaller % change in quantity supplied
(3) UNITARY ELASTICITY OF SUPPLY: A % change in price leads to an equal % change in supply
The factors affecting price elasticity of supply
Supply is more likely to be price elastic if...
The production process is short- eg making cakes
The firm is currently operating under capacity and has
spare resources to put into extra production
The firm makes a range of similar products- resources
can be switched from one product to another
In the long term. As time goes on, firms have time to
hire new workers, buy more supplies, lease bigger
premises etc
Supply is more likely to be price inelastic if...
The production cycle is long- eg building houses, growing
crops
The firm is already operating at full capacity
The firm cannot easily switch resources from other
products
In the short term- firms do not have the ability to quickly
get hold of the resources that they need to increase
production
Market Forces and the allocation of resources
In a free market economy, the interaction of demand and supply will determine how much of different products are
produced and at what price.
Prices, and equilibrium outputs will only change when there are changes in market conditions. This means that
there are changes in demand and supply.
Examples
Maximum and Minimum Prices
Sometimes the equilibrium prices reached by market forces may be considered to be too high or too low.
The government may decide to intervene to introduce a minimum or maximum price
Maximum Prices



Introduced when the government feels that market prices are too high
The government introduces a maximum price, above which prices are not allowed to go
For example, the government has, in the past, set a maximum price for rented accommodation to ensure
that everyone has access to shelter
Benefits of a maximum price
Theoretically keeps prices down so allows more people
to have access to the good and services
Potential Problems
May make the situation worse. At the lower price,
landlords are less likely to provided rented
accommodation (supply falls) but more people want it.
This creates excess demand (a shortage)
Stops firms from exploiting consumers with high prices
for necessity products
Minimum Prices




Introduced when the government is concerned that market prices may go too low
The government introduces a minimum price, below which the market price cannot go
Examples include: minimum prices in agriculture; the minimum wage
Some people think that the government should introduce a minimum price for alcohol to deter consumption
and reduce external costs
(Note, this graph is poorly labelled, don’t do this!)
Possible benefits of a minimum price
Minimum wage avoids exploitation of labour
Minimum price in agriculture ensures that farmers stay
in the market and secures domestic supply of primary
commodities
Minimum prices of demerit goods can reduce the
consumption of goods with external costs (eg alcohol)
Possible costs of a minimum price
May backfire and price people out of the market. The
higher price will contribute to excess supply
(C) How do firms operate in competitive markets
The objectives of firms
The aims and objectives of firms will depend on a range of factors, including:
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Whether the firm is in the private or public sector
The size/age of the firm
The state of the market/economy
However, key aims will include:
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Maximising profit
Increasing sales
Growth
Diversifying into new markets/expanding oversees
Survival
Providing a good quality customer service
Key terms in business economics
Total Revenue
Key Term
Definition
The amount of money earned from selling your product.
Average Revenue
Total Revenue = Price x Quantity Sold
AR is the amount earned on average per product made.
Profit
AR = TR/Output AR is the same as price!
The amount of money earned once costs have been
deducted
Total Costs
Profit = Total Revenue – Total Costs
Total Costs are the total out-goings that a firm faces in
order to produce its good or service
Fixed Costs
TC = Fixed Costs + Variable Costs
Costs which do not vary directly with output
Variable Costs
Examples: Rent, Insurance,
Costs which vary directly with output
Average Costs
Examples: Costs of raw materials, electricity costs
The cost of making one unit of a good
Break-even point
Competitiveness
For example if I make 10 cakes at a total cost of £20, the
average cost of each cake is £2
The point at which the firm is making neither a profit nor
a loss
TR= TC
How well a firm is able to compete with other firms. To
be competitive firms need:
Low prices; good investment to improve product quality;
innovation so that new products are constantly being
developed
Why is it important for firms to make profit?
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To satisfy shareholders and secure further investment
To ensure that there are funds for re-investment and future product development
To finance further growth of the firm
To cover costs
On the other hand, firms can survive for short periods of time without making profit
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If the economy is in recession, survival is a more realistic goal
If the firm is new, it may be unrealistic to expect them to make profit for 1-3 years
Public sector firms may be more focused on producing good quality public services even if these are not
profitable
Production and Productivity
Production is the process by which a firm converts inputs (factors of production) into outputs (goods and services)
The firm
Land, labour, capital and enterprise
Output (Goods and Services)
Productivity
Productivity is the RATE at which production occurs. A rise in productivity will occur if:
(a) A firm can produce more output with its existing resources
(b) A firm can produce its existing output with less resources
Labour productivity refers to how much output can be attributed, on average, to a unit of labour (ie one worker)
Labour Productivity can be calculated by: Output/Number of workers:
Output of cakes
100
120
150
200
Numbers of workers
10
10
10
10
Labour productivity has clearly increased over the time period shown
Labour productivity
10
12
15
20
How can a firm increase its productivity/labour productivity?
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Invest in better quality capital
Improved training
Offer clear reward systems and opportunities for promotion
Improved management
Use performance related pay- eg piece rate, commission, bonuses
Use more specialisation of labour/capital
Why is high productivity so important to a business?
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It produces more output. If sold, this will contribute to more revenue and profit
Rising productivity allows firms to operate at lower average costs. This MAY allow them to reduce prices and
become more competitive, thus increasing demand and market share
If a firm is producing at a lower average cost, it will be increasing its profit per unit. This will provide more
funds for re-investment and growth (see above)
Rising productivity may allow a firm to finance wage increases. This will secure worker morale and further
productivity. It will also allow the firm to attract the best quality workers
In the globalised economy, UK firms are competing with firms from the BRIC economies which have very low
costs and high productivity. If UK firms cannot match this, they will be uncompetitive and lose sales/market
share
The Growth of Firms
Reasons why firms may wish to grow in size
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To diversify and spread risk
To take advantage of higher levels of demand that exist
To tap into emerging markets
To take advantage of changing market conditions
To take advantage of economies of scale
To take advantage of globalisation and expand into overseas markets
To increase market share and develop greater monopoly power
How do firms grow in size?
Internal Growth
External Growth
What is it?
When a firm increases its output on
its own
When a firm increases its output by
joining with another firm
Example
The firm could:
 Take on more workers
 Take on a new shop
 Hire bigger premises
 Buy new capital
 Buy in more supplies
One bank merges with another bank
There are different types of
mergers/integration- see below
Mergers/Integration
Different types of merger bring different economic advantages
Type of Merger
Horizontal Merger
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Forwards Vertical Merger
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Backwards Vertical Merger
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Lateral Merger
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Conglomerate Merger
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Potential benefits to the firm
Increase market share
Reduces competition
Increased output means greater economies of
scale
Can rationalise- take the best bits from the two
companies
Can take control of the distribution network
May contribute to a degree of monopoly power
by acting as a barrier to entry for rivals
Can take control of suppliers- ensure that they
get resources/inputs at cost price
Can prevent rivals from having access to
resources
Spreads risk by diversifying the product range
slightly
Can take advantage of links between products in
marketing campaigns
Complete diversification and risk spreading
Economies and Diseconomies of Scale
The concept of economies of Scale is a central area in Economics and provides a clear rationale for why firms grow.
Internal Economies of Scale
Internal economies of scale refers to the reduction in AVERAGE COSTS that a firm experiences as a result of
increased output by the firm. This is shown below:
Between 0 and Q2 the firm is encountering economies of scale. The increase in output has lead to a reduction in
Average Costs.
There are a number of types/sources of Economies of Scale:
Type of Economies of Scale
Financial Economies of Scale
Marketing Economies of Scale
Technical Economies of Scale
Managerial Economies of Scale
Risk- Bearing Economies of Scale
Explanation
Large firms can benefit from cheaper loans and wider
sources of cheap finance (investment from shareholders)
The advantages that large firms get in relation to buying
and selling. Large firms can attract specialist buyers who
don’t waste money buying stock that will not sell. They
also have specialist sellers/marketing staff who ensure
that goods will sell. Big firms benefit significantly from
being able to “buy in bulk”
These are the advantages that large firms have when it
comes to the production process. Large firms can
employ specialist labour and capital which stimulates
productivity and reduces average costs
Large firms have the money/resources to attract the
most productive/efficient/specialist managers who make
the most effective business decisions and increase
efficiency over time
Large firms benefit from having wider, more diversified
product range. This means that they are better able to
withstand the risk of a fall in demand for one good or
service
Diseconomies of Scale
Diseconomies of Scale is the idea that it is possible for some firms to become TOO large, such that a rise in output
begins to lead to an increase in average costs. This can be shown on the diagram below, where diseconomies of
scale set in when output increases above Q2
Reasons for Diseconomies of Scale:
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As the firm increases, factor inputs (resources) become more scarce and hence more expensive
As the firm grows, communication and decision making becomes more difficult, contributing to inefficiencies
and rising costs
As the firm grows, worker morale and motivation declines as they feel like a “small cog in a big wheel”. This
may contribute to reduced productivity and higher average costs
External Economies of Scale
External economies of scale occur when a firm experiences lower average costs because the whole industry has
grown larger. This is particularly likely to be the case when an industry has grown in a particular region.
Why does this occur?
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The area will have a pool of skilled labour. Local colleges/training providers will offer courses to meet the
needs of the industry. This will reduce firm’s training costs and labour will be more productive and efficient
Suppliers are likely to move into the area to support the area. This will reduce transport costs and allow
firms flexible access to supplies
Local banks and financial institutions are more likely to be financially supportive of the industry because they
know that the local economy depends upon it- this may lead to lower interest rates and cheaper
loans/overdrafts
The local infrastructure (roads, rail and communication networks) are likely to receive the investment
necessary so that they support the development of the industry
An example:
Labour Markets
In a free market economy, wages are determined by the interaction of the demand for labour and the supply of
labour. Wage differentials (differences in wages) between jobs and locations occur because of differences in the
levels of demand for/supply of labour
The demand for labour
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The demand for labour is the demand for labour by employers
The demand for labour is downward sloping. Employers will take on more workers as wages fall
A change in wage will cause a movement along the demand for labour curve
Elasticity of demand for labour
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Measures how responsive the demand for labour is to a change in wage levels
If demand is wage elastic it means that a % change in wages will lead to a bigger % change in the demand for
workers. This is most likely to be the case when labour costs contribute to a high proportion of the firms
costs, where it is easy to substitute capital for labour and when the product has price elastic demand
(making it difficult to simply pass on the wage increase to consumers in the form of higher prices)
If demand is wage inelastic it means that a % change in wages will lead to a smaller % change in the demand
for workers. This is most likely to be the case when labour costs are a small proportion of total costs, when
labour cannot be easily replaced by capital and when the price of the product is price inelastic (making it
possible for the employer to pass on the wage increases in the form of higher prices so not reducing profits)
Labour demand (1) has wage inelastic demand. Labour demand (2) has wage elastic demand.
Factors causing a shift in the demand for labour
Whilst changes in wages cause a movement along the D(L) curve, other factors will cause the whole curve to shift
position. These other factors are:
(1) The demand for the product that labour produces. Labour is an example of “derived demand”- this means
that its demand comes from the demand for the product that it makes. For example, during the recession
there has been an increase in the demand for fast food such as McDonalds. This will have led to an increase
in the demand for McWorkers!
(2) Productivity. The higher labour productivity, the more workers that employers want to take on. This is
because workers are contributing to increased rates of production which become increased revenue and
profit.
The shift from D to D1 shows an increase in the demand for labour
The shift from D to D2 shows a decrease in the demand for labour
The Supply of Labour
The supply of labour shows the amount of workers who are willing and able to work at a given wage rate. The
supply of labour curve is upward sloping, indicating that more people are willing and able to work when wages are
higher.
A change in wage causes a movement along the supply of labour curve
Elasticity of Supply of Labour
If the supply of labour is wage elastic, this means that a % change in wages will lead to a bigger % change in supply.
This is more likely to be the case for unskilled jobs where lots of education and training are not required and there is
no need for any natural skill/talent. A wage elastic supply curve will upward sloping but relatively flat.
If the supply of labour is wage inelastic, this means that a % change in wages will lead to a smaller % change in
supply. This is more likely to be the case when there are high barriers to entry for getting into the job. These will
usually be lots of qualifications, training or unique talents. A wage inelastic supply curve will be upward sloping but
relatively steep
Factors causing a shift in the supply of labour curve
In addition to wages, other factors will cause shifts in the supply of labour curve. This means that any given wage,
the supply of labour is higher/lower in different situations.
(1) Education and Training: The more education and training required, the lower the supply of labour will be
(and the more inelastic it will be)
(2) Natural talents and abilities: Some jobs have very low (and wage inelastic) supply because they require
specialist talents that are unique/rare/hard to learn. This would include top fashion models and premiership
footballers
(3) Danger: If a job is perceived as dangerous the supply of labour is likely to be lower.
(4) Working conditions/hours/flexibility of the job: If working conditions are poor and hours are unsociable, this
may reduce the number of workers who are willing and able to do the job.
S3 shows lower supply than S2
Wage Determination
Wages are determined by the interaction of the demand and supply of labour. This will determine the equilibrium
wage rate and the equilibrium number of workers employed.
The equilibrium wage and number of workers employed will change if there are shifts in the demand and /or supply
of labour:
Using economic theory to explain wage differentials
Wage differentials is a posh way of saying differences in wages. Wages may differ between occupations and
between locations.
The exam will often ask a long question about this. A strategy:
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Always start by explaining how wages are determined:
In a free market economy, wages are determined by the interaction of the demand for labour and the supply
of labour. Wage differentials (differences in wages) between jobs and locations occur because of
differences in the levels of demand for/supply of labour
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Write a paragraph about the demand for labour, include a discussion of wage elasticity of demand if it is
relevant (link it to the context you are given, explaining why there may be different demands for labour)
Write a paragraph about the supply of labour, including a discussion of wage elasticity of supply if it is
relevant
Evaluate/draw a conclusion about what you think are the most significant factors in accounting for wage
differences
The Minimum Wage
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A minimum wage works by guaranteeing that all workers receive at least a minimum wage rate
The aim of this is to avoid the exploitation of workers and to provide a financial incentive for people to work
A minimum wage will only affect those industries where free market wages would fall below the level set.
These are most likely to be jobs involving unskilled workers
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In the diagram, the free market wage is W0. However the minimum wage is set above this at W1
Evaluating the impact of an imposition of a minimum wage
Workers
Firms
Consumers
Potential Gains
Low paid workers achieve a higher
wage, thus reducing relative poverty
and increasing living standards
There may be limited impact if:
Firms already pay above min wage
Firms employ few workers
Firms can easily pass on wage
increase to consumers in the form of
higher prices (where demand for the
product is price elastic)
If workers have higher incomes as a
result of the minimum wage, there
may be a rise in demand for the
firms goods
Some consumers in low paid jobs
have higher disposable income
Potential Losses
The worker may lose his/her job if
the employer responds to the
minimum wage by laying off workers
(E1-E2 above)
Even if the worker earns a higher
wage, they will be no better off in
real terms if minimum wages lead to
higher prices and inflation
Higher costs lead to lower profits
and less funds for re-investment
May have to compensate by putting
prices up- this will make them less
competitive compared to foreign
competitors (BRIC)
May face higher prices as firms pass
on wage increases
May be less new product
development/reduced quality
product because firms have less
profit to re-invest
Gross, Net, Real and Nominal Income
You need to be aware of these key terms
Key Term
Gross Income
Net Income
Nominal Income
Real Income
Definition/Explanation
Total income before taxes are removed.
Total income after taxes are removed
Money income, not taking into account inflation
Money income is adjusted to take account of inflation.
For example if inflation has been 2%, money income
needs to be reduced by 2% to reflect the fact that real
purchasing power has been reduced