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Edexcel Economics AS NOTE

Edexcel Economics AS NOTE

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ECONOMICS

UNIT 1

Unit 1
1.3.1 What is the nature of economics?
Q.Understand the problem of unlimited wants and finite resources.
Students should understand that the economic problem is faced by consumers,
producers and the government.
SCARCITY
People’s wants are infinite, but the resources with which they will fulfill these wants are limited. Hence,
economic agents such as individuals, firms and govt have to make choices and can only obtain a limited
amount of such economic goods at any moment in time, e.g. a family has to live on a fixed budget, it
can’t have everything it wants. This concept of scarce resources and infinite wants is called Scarcity.

Q.Distinguish between renewable and non-renewable resources.
Students should understand the meaning of sustainable resources

Renewable resources are any desirable items found in nature that can be naturally replenished over
a useful period of time. E.g. water.
If a renewable resource is being economically exploited in such a way that it will not diminish or run
out, then that is given a special name- “SUSTAINABLE RESOURCES”, e.g. forests are a sustainable
resource as long as it survives and replenish itself over and over again despite economic activities such
as deforestation, farming. However, it will cease to be a sustainable resource if the rate of harvest is far
greater than the rate at which it is renewed, so that it get’s depleted over time. e.g. if the whole forest
is cleared to make a runway.
Resources which are diminishing over time due to economic exploitation and are not replaced over time
are called NON-RENEWABLE RESOURCES/ NON-SUSTAINABLE RESOURCE. e.g. oil,coal,gas,gold,land.











ECONOMICS
UNIT 1


Q. Use production possibility frontiers to depict opportunity cost, economic growth and
the efficient allocation of resources.
Marginal analysis is required to depict opportunity cost. A basic definition of economic
growth is required along with knowledge of the factors which might cause the
production possibility frontier to shift outwards or inwards.
Combinations of output of goods X and Y (e.g. Agricultural products vs
Military products) lying inside the PPF occur when there are unemployed
resources or when the economy uses resources inefficiently. In the diagram
above, point X is an example of this. We could increase total output by
moving towards the production possibility frontier and reaching any of
points C, A or B.
 Point D is unattainable at the moment because it lies beyond the PPF. A country would require
an increase in factor resources, or an increase in the efficiency (or productivity) of factor
resources or an improvement in technology to reach this combination of Good X and Good Y. If
we achieve this then output combination D may become attainable.

 Producing more of both goods would represent an improvement in our economic welfare
providing that the products are giving consumers a positive satisfaction and therefore an
improvement in what is called allocative efficiency

 Reallocating scarce resources from one product to another involves an opportunity cost, which
increases as we move down the curve(for good Y).
Moving from point C to A,the MARGINAL COST(which means ” ADDITIONAL” costs) of producing 5 more
units of good X, e.g. 15 to 20 would be the fall in production of 10 units of good Y,e.g. 30 to 20 now.
 All points on the PPF are at PRODUCTIVE AND ALLOCATIVE EFFICIENCY.
ECONOMICS
UNIT 1



PRODUCTIVE EFFICIENCY
Productive efficiency can be defined as producing goods and services for the lowest cost. Productive
efficiency is said to occur on the production possibility frontier. On the PPF curve, it is impossible to
produce more of one good without producing less of another ,i.e. it involves an opportunity cost as
production is happening using the least amount of resources.
Here, point X is productively inefficient because you can produce more goods Y or goods X without an
opportunity cost. Productive efficiency only exists if there is TECHNICAL EFFICIENCY, but not all
technically efficient outputs are productively efficient!
E.g. Uchchash employs 2 workers and a machine to make 10 shoes,paying altogether 1000TK,whereas
Nirjash makes 10 shoes using 5 workers but at a lower cost of 400TK.Hence Uchchash is techinically
efficient but productively inefficient.
ALLOCATIVE EFFICIENCY
Allocative efficiency occurs when there is an optimal distribution of goods and services. This involves
taking into account consumer's preferences. For example, there is no point in being productively
efficient if all resources are diverted to making guns. We could be producing on a production
possibility frontier but, if it is all guns, society may not have enough food and health care.
That is, it occurs at an output level where the MARGINAL BENEFIT = MARGINAL COST.
This is because the price that consumers are willing to pay is equivalent to the marginal utility that they
get. Therefore the optimal distribution is achieved when the marginal utility of the good equals the
marginal cost.

If the opportunity cost for producing two products is constant, then we draw the PPF as a straight line.
The gradient of that line is a way of measuring the opportunity cost between two goods.




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With economies of scale, the PPF would appear inward, with opportunity costs falling as more is
produced of each respective product. Specialisation in producing successive units of a good determines
its opportunity cost (say from mass production methods or specialization of labor)


Explaining Shifts in the Production Possibility Frontier
OUTWARD SHIFTS :
1. There are improvements in productivity and efficiency perhaps because of the introduction of
new technology
2. Iincreased HUMAN CAPITAL of labor force due to better training and higher quality of
education, which leads to better quality of goods and services produced.
3. More factor resources are exploited perhaps due to an increase in the size of the workforce or a
rise in the amount of capital equipment available for businesses

INWARD SHIFTS:
e.g. by destruction of infrastructure during war, rapid fall in the number of workers in a population can
reduce potential output,global warming can have a devastating effect on agriculture which will affect all
production.
** In microeconomics, the PPF shows the options open to an individual, household, or firm in a two-
good world. By definition, each point on the curve is productively efficient, but, given the nature of
market demand, some points will be more profitable than others. Equilibrium for a firm will be the
combination of outputs on the PPF that is most profitable.[17]

**From a macroeconomic perspective, the PPF illustrates the production possibilities available to a
nation or economy during a given period of time for broad categories of output. However, an economy
may achieve productive efficiency without necessarily being allocatively efficient. Market failure (such
as imperfect competition or externalities) and some institutions of social decision-making (such as
government and tradition) may lead to the wrong combination of goods being produced (hence the
wrong mix of resources being allocated between producing the two goods) compared to what
consumers would prefer, given what is feasible on the PPF.


ECONOMICS
UNIT 1

Q. Understand the advantages and disadvantages of specialisation and the division of
labour.
AS students are not expected to have an understanding of international specialisation
and comparative advantage.
Specialization is a system of organization where economic units such as households or nations are not
self-sufficient but concentrate on producing certain goods and services and trading the surplus with
others. Specialisation happens at all levels:
 The specialization of tasks within extended families in many of the world’s poorest countries
 Within businesses and organizations
 In a country – Bangladesh is a major producer and exporter of textiles; Norway is a leading oil
exporter. And Ghana is one of the biggest producers of cocoa in the world.
 In a region of a country – for many years the West Midlands has been a centre for motor car
assembly, there has been huge investment in recent years in the Mini plant at Oxford
Advantages :
1. Increase in LABOR PRODUCTIVITY AND CAPITAL PRODUCTIVITY- workers only need to gain
skills of a narrow range of tasks,which enable them to be far more productive than if they
were jack-of-all-traders.The increased productivity, meaning lower labor unit cost
decreases cost of production and saves time, which gets passed on to consumers with
lower market prices.
2. Saving Time: By devoting time to a single task, a person avoids the loss of time incurred in
shifting from one job to another. Also, time is saved by not “fumbling around” with a task
that one is not trained to do.
3. Specialization makes use of differences in ability. - Workers are free to specialize in a job
best suited to them. If a worker has some special natural ability, then he can choose a job
which utilizes this particular skill so that he may perform better.If Uchchash is
strong,athletic,he can choose a job in the sports industry, whilst if Nirjash is charismatic and
rational, then he may choose to be a lawyer.
4. A bigger market- Specialisation on an international scale increase the size of the market
offering opportunities for economies of scale ,increases competition(hence control inflation
by keeping prices low).

Disadvantages:
1. 1)Monotony- if jobs are divided too much,the work can become tedious and
boring.Workers then feel alienated from their work.This will result in poorer quality of
work and less output per person.Workers will do everything to avoid work-going to
toilet often,reporting for sick,taking frequent breaks during work,etc.

2. 2)Putting all the eggs in one basket- an over-specialised country will be in a great crisis
if the demand of its product falls in the world market suddenly and it will have then few
options to switch production into a different product,at least in the short run. This
might lead to high structural unemployment and put the economy into recession. Over-
specialisation also means that a country needs to import goods and services which it
doesn’t produce from abroad. Also,a breakdown in a part of the production chain can
cause chaos within the whole system,e.g Toyota stopped production of cars completely
when an ancillary firm, supplying brake parts was destroyed in a fire.




ECONOMICS
UNIT 1

Q. Understand the advantages and disadvantages of a free market economy and why
there are mixed economies.
Students are not expected to have an understanding of centrally planned economies
A free market economy is an economy where resources are allocated(to solve the basic economic
problem) by market forces and price mechanism, and there is no government ownership or
intervention.
A mixed economy is where resources are partly owned and allocated by the government(public sector)
and partly by individual economic agents(private sector).Both the free market mechanism and
government planning process allocate significant proportions of total resources.
The advantages of a free market economy
1. EFFICIENCY - Most of their industries are assumed to be perfectly competitive and so
allocative and productive efficiency will occur. Consumers cast their SPENDING VOTES
(expenditure) when they purchase goods and services. Firms receive these spending votes
and use them to buy factors of production, and in turn cast their spending vote(factor
rewards) which determines how much income each individual consumer has to spend.
Decisions about what to produce are made by the people who will actually consume the
goods. Planners are less likely to make the correct decisions across the whole economy.
2. Choice -Firms will produce whatever consumers are prepared to buy. The consumer is
sovereign. Due to the free enterprise factor, there are no restrictions on what the firms can
produce. However,the range of choice available varies with income levels.People belonging
to first decile groups have a great deal of choice than those of lower decile groups.
3. Innovation -Firms will always be looking to produce something new to get ahead of their
competitors. Profits also provide an incentive to reduce costs and be innovative to improve
quality.Companies which fail to innovate and produce high quality goods are likely to be
driven out of business by more efficient firms. However,in practice,markets tend to be
OLIGOPOLISTIC in structure,which manipulate the market through advertising and other
forms of marketing to exploit consumers.
4. Higher economic growth rates-History tells us that countries which are more towards free
market econmy,e.g.USA have the highest growth rates than those of centrally planned
economies,e.g. North Korea.
5. Market economies can adjust to change easily

The disadvantages of a free market economy (for which govt intervenes and
mixed economies exist)
× No incentive to provide public goods-Public goods cannot be provided privately because of the
FREE RIDER PROBLEM,resulting due of their two characteristics, non-diminishability and non-
excludability. E.g. street ligting,police service,defence,judiciary.
× Underproduction of Merit goods(MARKET FAILURE), like health and education, tend to be
under provided in a free market. Consumption of merit goods is POSITIVE EXTERNALITY , where
the social benefit from consumption exceeds the private benefit. The govt. intervenes to
ECONOMICS
UNIT 1

encourage consumption of such goods, keeping their prices low in the market through giving
subsidies and increasing demand through advertising social campaigns.

× Unequal distribution of wealth- in a pure free market economy,resources are allocated to
those with spending power. Individuals with no source of income,e.g. handicapped,orphans,old
people,abandoned children pay the ultimate penalty for their economic failure-they die from
starvation,cold or disease.People can find support through charity,but it is unlikely that it would
be provided by individuals in sufficient amounts. Free market economy operates in self-interest
only,so there is no incentive to provide goods and services to these people in society. Govt
intervenes by providing old age homes, orphanages, providing welfare benefits, and charging
citizens in the form of taxes to pay these.Govt also tries to minimize the gap between rich and
poor by charging the rich with high direct tax and transferring the money through benefits to
the poor.
× Overproduction of Demerit goods (MARKET FAILURE)- economic agents in a pure free market
economy do not take account the social costs affiliated in the production process,e.g. air
pollution.Also,market mechanism tends to overprovide demerit goods,e.g. drugs,alcohol.These
bear large NEGATIVE EXTERNALITIES. Crimes increases, health costs rises, valuable human
economic resources are destroyed and family and relatives suffer distress. Consumers
themselves suffer and are unable to stop as they are addicted. Govt intervenes to correct this
market failure by banning drugs,strictly controlling supply of alcohol by regulations or decrease
demand by using the price system(charging high indirect tax to keep market price high),mass
advertising to raise awareness.
ECONOMICS
UNIT 1


Q. Distinguish between objective statements and value judgements on economic
issues.
Students should know that value judgements influence economic decision making and
policy
Positive Statements

+A positive statement is an economic statement about what is and contains no indication of approval
or disapproval. They can be proven true or false by objective use of evidence, reason and logic.
e.g. Unemployment in Bangladesh rose by 15% last year.
Normative Statements
+ A normative statement expresses a value judgment about whether a situation is desirable or
undesirable. They cannot be supported or refuted.They are opinions of how economies and markets
should work. Statements that include indicator words such as: should, ought, or prefer are likely to be
normative rather than positive.
E.g. The Minimum Wage needs to be replaced with a Living Wage of £8 per hour.

Q. Understand how a change in price causes a movement along a demand curve.
Students are not expected to have an understanding of utility theory or indifference
curve analysis.

Law of Demand- states that there is an inverse relationship between quantity demanded and the
price of a good or service ,certeris paribus.
An increase in demand is shown by a RIGHTWARD SHIFT in demand curve,an increase in QUANTITY DEMANDED refers to a
change in quantity demanded resulting from a change in price and would be shown as MOVEMENT ALONG THE DEMAND
CURVE!!Ceteris paribus,if PRICE FLUCTUATE(only),then quantity demanded is affected,movement ALONG demand curve
occur,NO SHIFTS! But if other factors,such as RISE IN INCOME,CHANGE IN PRICE OF
SUBST,COMPLEMENT,etc.,FASHION,SEASON,anything other than price itself,then SHIFTS OCCUR(more is demanded at each
price.)!
ECONOMICS
UNIT 1


There are two reasons why more might be demanded even when the price of a good or service is
increasing.

· Ostentatious consumption:
A higher price may be regarded as a reflection of product quality and some consumers are prepared to
pay this for the “snob value effect”. Examples might include diamonds, designer clothes, and sports
racing cars like lambourghani, porche, Ferrari.
Goods of ostentatious consumption are known as Veblen Goods and they have a high-income elasticity
of demand. That is, demand rises more than proportionately to an increase in income or an increase in
price.

· Speculative Demand:
With speculative demand, a buyer hopes for a rise in price leading to a profit
Speculative demand for housing and for shares comes into this category and we have also seen, in the
last few years, strong speculative demand for many of the world’s essential commodities.


+ Effective demand

+Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an
ability to pay for it

+ Latent Demand

+Latent demand exists when there is willingness to buy among people for a good or service, but where
consumers lack the purchasing power to be able to afford the product.

+ Derived Demand

+The demand for a product X might be connected to the demand for a related product Y – giving rise
to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for
new vehicles and other manufactured products, so that when an economy goes into a recession, so we
expect the demand for steel to decline likewise.

Steel is a cyclical industry which means that market demand for steel is affected by changes in the
economic cycle and also by fluctuations in the exchange rate.

Q. Understand factors which may cause a shift in the demand curve, for example,
changes in the price of substitutes or complementary goods; changes in real income
and tastes.
FACTORS THAT CAUSES SHIFTS IN DEMAND CURVE (MARKET DEMAND) :
· Changing prices of a substitute good
Substitutes are goods in COMPETITIVE DEMAND and act as replacements for another product,e.g. coca
cola and pepsi cola,gas and oil(in long run),beef and pork.
e.g. Price of Coffee q ,then Demand for Tea q
ECONOMICS
UNIT 1

· Changing price of a complement
Two complements are in JOINT DEMAND – e.g. DVD players and DVDs, iron ore and steel.
Price of DVDs + Demand for Dvds q,then demand for DVD players q
· Changes in the REAL income of consumers
For NORMAL GOODS,
If Income q then Purchasing Power q,so Demand for Goods & Services q
For INFERIOR GOODS,
If Income q,then Demand for Goods & Services +
**Discretionary income is disposable income less essential payments like electricity &
gas and mortgage repayments.So if cost of these utilities q,then people’s discretionary
income level + so that they can afford to buy less goods and services now.
· Changes in Population
Population size q,then Aggregate Demand q
· Changes in fashion
Demand for items such as wigs,trousers,electronic products changes time to time as
they go in and out of fashion.
· Changes in LEGISLATION
Govt. might change legislation, such as removing entry barriers, structural bottlenecks,
a particular good, e.g. seat belts,anti-pollution equipments,books to increase demand
for that good.
The govt. sometimes influence the housing market, by allowing TAX RELIEFS on interest
paid on mortgages when houses are bought ,to effectively lower the cost of monthly
repayments,thus such intervention affects demand for housing significantly.
· ADVERTISING & MARKETING
This has a very powerful influence on consumer demand as it affects consumer choice,
aware them of what products are available to buy, and displays competition.
· Changes in Interest Rates
Many products, are bought on credit using borrowed money, thus the demand for
them may be sensitive to the rate of interest charged by the lender. Therefore if the
Bank of England decides to alter interest rates – the demand for many goods and
services may change. Washing machines, Plasma TV, Car, House, Refrigerator are all
INTEREST SENSITIVE items.
E.g HOUSING MARKET- most houses are bought with a mortgage. When potential
buyers look at the price of the house, they tend to focus on the monthly repayments on
the mortgage instead of the actual housing price.In the short term,the demand for
housing is influenced by interest rates rather than house prices.
· Consumer Expectations
A newly formed expectation of higher future prices may cause consumers to buy now in
order to “beat” he anticipated price rises, thus increasing current demand. That is
often what happens in so-called hot real estate markets. Buyers rush in because they
think the price of new homes will continue to escalate rapidly.
ECONOMICS
UNIT 1

Q. Explain price, income and cross elasticities of demand. Understand factors that
influence elasticities of demand and their significance to firms and government.
Students may have to calculate and interpret numerical values of price, income and cross
elasticity of demand.
Understand the relationship between price elasticity of demand and total revenue.
Students should understand the significance of elasticity to firms and government in terms
of the imposition of indirect taxes and subsidies; changes in real income and changes in the
price of substitute and complementary goods.

PRICE ELASTICITY OF DEMAND- measures the responsiveness of demand after a change in price,
under condition of ceteris paribus. It’s measured by the formula :




Or,

** Since changes in price and quantity usually move in opposite directions, usually we do not bother to
put in the minus sign. Thus, the price-elasticity coefficient of demand PED will always be a negative
number for normal goods. We are more concerned with the co-efficient of elasticity of demand.









ECONOMICS
UNIT 1

A decrease in the price of a good normally results in an increase in the quantity demanded by
consumers because of the law of demand, and conversely, quantity demanded decreases when price
rises. As summarized in the table above, the PED for a good or service is referred to by different
descriptive terms depending on whether the elasticity coefficient is greater than, equal to, or less than
−1. That is, the demand for a good is called:
^ Perfectly inelastic (Ed = zero),there is no response in demand to a change in price.


^ relatively inelastic when the percentage change in quantity demanded is less than the
percentage change in price (so that Ed > - 1);
^ unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when the percentage
change in quantity demanded is equal to the percentage change in price (so that Ed = - 1);

^ relatively elastic when the percentage change in quantity demanded is greater than the
percentage change in price (so that Ed < - 1)

ECONOMICS
UNIT 1

^ perfectly elastic (Ed= infinite),consumers are prepared to buy all they can at a given price but
none at all at a higher price.


= Factors affecting price elasticity of demand

1. The number of close substitutes – the more close substitutes there are in the market, the more
elastic is demand because consumers find it easy to switch.
2. The cost of switching between products – there may be costs involved in switching. In this
case, demand tends to be inelastic. For example, mobile phone service providers may insist on a
12 month contract.
3. Luxury vs Necessity – necessities tend to have an inelastic demand whereas luxuries tend to
have a more elastic demand.e.g. it means little to the average person if the price of a
lambourghini doubles, but affected seriously when the price of staple food such as rice has
increased.
4. The proportion of a consumer’s income allocated to spending on the good – products that
take up a high % of income will have a more elastic demand .e,g the PED of marker pens is likely
to be relatively elastic to a teacher who buys it frequently compared with a normal housewife.
5. The time period allowed following a price change – demand is more price elastic, the longer
that consumers have to respond to a price change. They have more time to search for cheaper
substitutes and switch their spending.e.g. the demand for oil is likely to be price inelastic in the
short-run,as consumers have little choice but to buy oil and run their cars,trains or heating
systems.But in the long run,it becomes less inelastic as consumers may have switched to other
forms of energy-coal,gas.
6. Whether the good is subject to habitual consumption – consumers become less sensitive to
the price of the good of they buy something out of habit (it has become the default choice). E.g.
Computer games sold on DVDs tend to be price inelastic in the long run.
7. Peak and off-peak demand - demand is price inelastic at peak times , and more elastic at off-
peak times – this is particularly the case for transport services. e.g. price inelastic during school
hours early in the morning and price elastic during noon.
8. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for
petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be
more elastic following a price change.





ECONOMICS
UNIT 1

PED and Total Revenue/Expenditure & its importance to firms & Govt
Total Revenue= P xQ
Note what happens to total revenue when price changes. If total revenue changes in the
opposite direction from price, demand is elastic. If total revenue changes in the same direction
as price, demand is inelastic. If total revenue does not change when price changes,
demand is unit-elastic.



As you move right ,total
revenue(TR) rises. The
increase in quantity sold
more than compensate for
the fall in price. Here,
demand is ELASTIC.
However, when the mid-
point is reached and
demand becomes unit
elastic, TR stops rising and
is at its maximum point.
The remaining part is
inelastic: the increase in
quantity demanded is no
longer sufficient to
compensate for the
decrease in price, and TR
falls. Thus, if a firm is aware
of the PED of its products ,it
can anticipate consumer
response to its price
changes, which may be a
powerful strategic tool.
ECONOMICS
UNIT 1


PED importance for Govt.
Effect of PED on the incidence of VAT :
If Demand is ELASTIC, then most of the incidence of VAT falls upon the Producer :
Demand is elastic,একটু দাম বাড়লেই মানু ষ কম ককলন,so,SELLER কনলের উপর BURDEN টা
ববকি বনয!
If Demand is INELASTIC,then most of the burden of tax falls upon the Consumer:









ECONOMICS
UNIT 1

INCOME ELASTICITY OF DEMAND
+measures the responsiveness of quantity demanded to a change in price.It’s calculated by





or :

Normal goods have a positive income elasticity of demand so as consumers’ income rises more is
demanded at each price i.e. there is an outward shift of the demand curve
INCOME q, Demand q

Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income
increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4.
Demand is rising less than proportionately to income.
Income q,Demand q (but not much)
Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than
proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise
in the demand for new kitchens. The income elasticity of demand in this example is +1.25.
Income q,Demand q(VERY MUCH)

Inferior Goods

Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises.
Typically inferior goods or services exist where superior goods are available if the consumer has the
money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in
supermarkets and the demand for council-owned properties.

The income elasticity of demand is usually strongly positive for
o Fine wines and spirits, high quality chocolates and luxury holidays overseas.
o Sports cars
o Consumer durables - audio visual equipment, smart-phones
o Sports and leisure facilities (including gym membership and exclusive sports clubs).

In contrast, income elasticity of demand is lower for
o Staple food products such as bread, vegetables and frozen foods.
o Mass transport (bus and rail).
o Beer and takeaway pizza!
o Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.
Giffen Good

+a special type of inferior good where demand increases when price increases.e.g. Bread(staple food)
Bread is a staple food for low income households.When its price rises,it would not deter people from
consuming less as it is a necessity.Poor people now have so little extra money to spend on other foods
such as beef,or luxury food that they would abandon their demand for these instead and buy more
bread to fill up their stomachs.The result is ,Price of Bread q,Qt. Demanded q!!



ECONOMICS
UNIT 1

Explanation:

= INCOME EFFECT: If the price of a good rises, the real income of consumers will fall.They will not
be able to buy the same basket of goods and services as before. Consumers can react to this fall
in real income in one of 2 ways- buy less of that normal good; if it’s an inferior good, then buy
more of it.
= SUBSTITUTION EFFECT: If the price of a good rises, consumers will buy less of that good and
more of others because it now relatively more expensive than other goods, and vice-versa.
**For a NORMAL GOOD,INCOME & SUBST. EFFECT BOTH WORK IN THE SAME DIRECTION.
For an INFERIOR GOOD,THEY WORK IN OPPOSITE DIRECTIONS.A rise in price leads to a fall in qt.
demanded because the relative price of this good has risen(SUBSTITUTION EFFECT).However,it leads to
a rise in qt. demanded as consumer’s real income level have fallen.The SUBST. EFFECT outweighs the
INCOME Effect,so that the overall result is QT. Demanded +
But for GIFFEN GOOD,INCOME EFFECT outweighs SUBST. effect,and Qt. Demanded q when Price q


Type of Good Effect on Quantity Demanded when PRICE q
SUBSTITUTION EFFECT INCOME EFFECT OVERALL EFFECT
NORMAL
good
FALL FALL FALL
Inferior good FALL RISE FALL (subst >Income)
Giffen good FALL RISE RISE (Income >subst)

Product ranges and longer term trends

Income elasticity of demand will vary within a product range. For example the YED for own-label foods
in supermarkets is less for the high-value “finest” food ranges.

There is a general downward trend in the income elasticity of demand for many basic products,
particularly foodstuffs. One reason is that as a society becomes richer, there are changes in tastes and
preferences. What might have been considered a luxury good several years ago might now be regarded
as a necessity. e,g, in many western countries, Internet access is considered to be a necessity, whilst it
was a luxury a few years ago!


+ Income elasticity and the pattern of consumer demand

= As we become better off, we can afford to increase our spending on different goods and
services. The income elasticity of demand will also affect the pattern of demand over time.
= For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the
proportion of a consumer’s income spent on that product will go up.
= For normal necessities (income elasticity of demand is positive but less than 1) and for inferior
goods (where the income elasticity of demand is negative) – then as income rises, the share or
proportion of their budget on these products will fall
= For inferior goods as income rise, demand will decline and so too will the share of income spent
on inferior products.

Cross Elasticity of Demand(CPed)
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UNIT 1

+a measure of the responsiveness of quantity demanded of a good to a change in price of
another related good.It’s measured :




or,

× Complements have ALWAYS –VE CPed (Price of Good X q,Demand for Good Y +) due
to Joint Demand
× Substitutes have ALWAYS +VE CPed (Price of Good X q Demand for Good Y q) due to
Competitive Demand
× Unrelated goods have ZERO CPed

- The stronger the relationship between two products, the higher is the co-efficient of
cross-price elasticity of demand. When there is a strong complementary relationship
between two products, the cross-price elasticity will be highly negative.e.g. Computer
games and Graphics Hardware
- Lower the XED, weaker the Substitute good

















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Q. Understand the factors which may cause a shift in the supply curve, for example,
changes in the costs of production, the introduction of new technology, indirect taxes
and government subsidies.
Producer cartels may be a significant determinant of supply in some markets, for
example, oil.
Students should be able to apply both specific and ad valorem taxes to a market.
FACTORS THAT SHIFTS THE SUPPLY CURVE

1. Changes in Costs of Production
Lower costs of production mean that a business can supply more at each price. For example a
magazine publishing company might see a reduction in the cost of its imported paper and inks.
These cost savings can then be passed through the supply chain to wholesalers and retailers
and may result in lower market prices for consumers.
2. Technology
Production technologies can change quickly and in industries where technological change is
rapid we see increases in supply and lower prices for the consumer.
3. Prices of other goods
Changes in price of goods which are in JOINT SUPPLY affect the supply of a particular good.e.g.
Price of Beef q,More Cows are Reared in farms, so Cow Supply q,More cows slaughtered and
hence Supply of Leather(Joint supply good) q
4. Government taxes and subsidies
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5. Expectation of future events
If firms expect future prices to rise,then they may restrict supply and stockpile goods to earn
high profits later.If they expect disruptions to their future production because of a strike,they
may stockpile raw materials, paying them with borrowed money,increasing production costs
and hence reducing supply.
6. Weather
Weather plays a crucial role in determining supply especially in the agricultural markets.Bad
weather reduces crop yield and supply;good weather might result in bumper harvest and
increased supply.
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7. Producer Cartels
In some markets, producing firms or producing countries band together, usually to restrict
supply, which allows them to raise prices and increase their profits or revenues. e.g. OPEC
which restricts oil supply onto world markets.


Q. Explain price elasticity of supply; understand factors that influence price elasticity of
supply.
Students may have to calculate and interpret numerical values of price elasticity of
supply.
Q. Distinguish between the short run and long run in economics and understand its
significance to price elasticity of supply.
PRICE ELASTICITY OF SUPPLY
+ measures the responsiveness of quantity supplied to a change in price.





^ If supply is elastic, producers can increase output without a rise in cost or a time delay
^ If supply is inelastic, firms find it hard to change production in a given time period.
^ When Pes > 1, then supply is price elastic
^ When Pes < 1, then supply is price inelastic
^ When Pes = 0, supply is perfectly inelastic
^ When Pes = infinity, supply is perfectly elastic following a change in demand

= What factors affect the elasticity of supply?
1. Spare production capacity: If there is plenty of spare capacity then a business can increase
output without a rise in costs and supply will be elastic in response to a change in demand. The
supply of goods and services is most elastic during a recession, when there is plenty of spare
labour and capital resources.
2. Stocks of finished products and components: If stocks of raw materials and finished products
are at a high level then a firm is able to respond to a change in demand - supply will be elastic.
Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in
the market.
3. The ease and cost of factor substitution: If both capital and labour are occupationally mobile
then the elasticity of supply for a product is higher than if capital and labour cannot easily be
switched. A good example might be a printing press which can switch easily between printing
magazines and greetings cards.
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4. Time period and production speed: Supply is more price elastic the longer the time period that
a firm is allowed to adjust its production levels. In some agricultural markets the momentary
supply is fixed and is determined mainly by planting decisions made months before, and also
climatic conditions, which affect the production yield. In contrast the supply of milk is price
elastic because of a short time span from cows producing milk and products reaching the
market place.


Q.Explain equilibrium price and quantity and how they are determined.
Students should understand that shifts in demand and supply curves will change the
equilibrium price and quantity


At Equilibrium price,
PLANNED DEMAND
= PLANNED SUPPLY,
and there is no
tendency to change.



Q. Distinguish
between
consumer and
producer
surplus.
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UNIT 1

Students should understand how changes in demand or supply might affect consumer
and producer surplus.
Illustrate consumer and producer surplus on a demand and supply diagram.
Consumer Surplus
· Consumer surplus is a measure of the welfare that people gain from consuming
goods and services
· Consumer surplus is the difference between the total amount that consumers
are willing and able to pay for a good or service (indicated by the demand
curve) and the total amount that they actually do pay (i.e. the market price).
· Consumer surplus is shown by the area under the demand curve and above the
equilibrium price as in the diagram below.
Consumer surplus and price elasticity of demand
- When the demand for a good or service is perfectly elastic, consumer surplus is zero because
the price that people pay matches what they are willing to pay.
- In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not
respond to a price change. Whatever the price, the quantity demanded remains the same.
- The majority of demand curves are downward sloping. When demand is inelastic, there is a
greater potential consumer surplus because there are some buyers willing to pay a high price to
continue consuming the product. This is shown in the next diagram.
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UNIT 1



** Consumer surplus can be used frequently when analyzing the impact of government intervention in
any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of
road pricing schemes such as the London congestion charge or a rise in air passenger duty.



ECONOMICS
UNIT 1

PRODUCER SURPLUS
- Producer surplus is a measure of producer welfare

- It is measured as the difference between what producers are willing and able to supply a
good for and the price they actually receive

- The level of producer surplus is shown by the area above the supply curve and below the
market price and is illustrated in the diagram below

- Pm is the minimum price that this producer requires to supply the product to the market

- As the price rises, there is a great incentive to supply – production will expand as a business
moves up their supply curve

- Assuming the the market has reached an equilibrium at quantity Q1 and price P1, then the level
of producer surplus is shown by the shaded/labelled area.

- Total revenue = price per unit x quantity sold = P1 x Q1


Producer surplus and changes in demand and supply
We first consider the effects of a change in market supply – for example caused by an improvement in production
technology or a fall in the cost of raw materials and components used in the production of a good or service


ECONOMICS
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When Demand q,


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Q. Understand the rationing, incentive and signalling functions of the price mechanism
for allocating scarce resources.
The price mechanism may be considered in the context of product, commodity and
labour markets.
Functions of the Price Mechanism
**Adam Smith’s Invisible Hand
+Adam Smith, one of the Founding Fathers of economics described the “invisible hand of the price mechanism”
in which the hidden-hand of the market operating in a competitive market through the pursuit of self-interest
allocated resources in society’s best interest.

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

The price mechanism plays three important functions in a market:

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


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2/ Transmission of preferences
 Through their choices consumers send information to producers about the changing
nature of needs and wants
 Higher prices act as an incentive to raise output because the supplier stands to make a
better profit.
 When demand is weaker in a recession then supply contracts as producers cut back on
output.
3/ Rationing function
 Prices serve to ration scarce resources when demand in a market outstrips supply.
 When there is a shortage, the price is bid up – leaving only those with the willingness
and ability to pay to purchase the product.
4/Incentive
 Higher prices tempt producers to expand their supply to maximize profits.For this,firms
may have to take more workers, invest in new capital equipment to increase
production.On the demand side,such high prices discourage consumption as consumers
get fewer goods per TK spent.
 A prolong fall in prices may drive some firms out of the market as the business is no
longer profitable for them to supply.



Q. Apply the price mechanism in markets, such as goods, services, commodities or
labour
Students should be able to apply the determinants of demand and supply to various
markets, for example, price of stock market shares, oil, precious metals and
agricultural commodities.
Markets in Action - Market for Oil

Oil is one of the most heavily traded commodities in the world. Fluctuating prices have important effects for oil
producers/exporters and the many countries that remain dependent on oil as a key input in their energy,
manufacturing and service industries.
Demand for Oil
= Cyclical demand: When global economic growth is strong, the demand for crude oil
increases. There is a positive relationship between world GDP and total demand for
crude. Fast-growing emerging market countries,e.g. China have provided the bulk of
the extra demand for crude in recent years although the world’s biggest economy –
the United States – has also added to total demand. More recently the global
recession caused a fall in demand for crude oil and a sharp fall in prices
= Rising living standards: The sustained rise in living standards in many countries has
contributed to increasing demand for energy and other oil-related products.
= Prices of substitutes: Demand for crude oil is affected by the relative prices of and
availability of economically viable oil substitutes such as bio fuel.
= Changes in climate – e.g. affecting the demand for heating oil. It is often said that if
the winter in North America is fierce, then the price of crude rises as the USA and
Canadian economies raise their demand to fuel household heating systems and
workplaces
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= Market speculation: There is always a speculative demand for oil. Indeed one of the
features of the most recent spike in oil prices has been the high level of demand by
hedge funds and other investors pouring into the international petroleum
exchanges to buy up surplus oil futures contracts. They hope that by the time the
contracts are ready to be fulfilled, they will have made a large profit. Speculation
involves risk, prices can do down as well as up. The scale of speculative activity has
been open to question – some of it has been encouraged by the depreciation in the
value of the US dollar. This is because oil is priced in dollars – so overseas investors
holding other currencies can buy more barrels of oil as the dollar declines.

Nearly two thirds of global crude oil production is consumed by leading industrialised
nations – i.e. the nations that make up the Organisation of Economic Cooperation and
Development (OECD). But a rising share of demand comes from emerging economies
including China, Brazil, Russia and India.
Derived demand for oil

Crude oil is bought not for its own sake but for its uses including:
- Gasoline: used in motor spirit/petrol
- Middle Distillates e.g. diesel – used in vehicles and other motors/engines and jet
fuel
- Kerosene – cooking/heating
- Heating Oil
- Fuel Oil: boiler fuel for industry, power and shipping
- Other: lubricants, bitumen etc
The supply of oil

Supply is a flow concept – what matters for the oil market is how many barrels of oil per
day are being extracted from reserves and how much of that is able to be refined for
different uses.

In short, the short-run supply of crude oil is affected by a series of different factors
1. Profit motive: The production decisions of OPEC and Non-OPEC countries.
2. Spare capacity: The level of spare production capacity in the oil sector.
3. Stocks: The level of crude oil stocks available for immediate supply from the
refineries
4. External shocks: The effects of production shocks e.g. loss of output from rig
closures or disruption of oil supplies due to war and terrorist attacks.

Taking a longer-term perspective, the long run world oil supply is linked to
a) Reserves: Depletion of proven oil reserves – the faster that demand grows, the
quicker the expected rate of depletion. Peak oil theory claims that the world has
long since past the peak of new discoveries of oil and that most oil producing
nations will see a long-term decline in crude oil output in the years ahead.
b) Exploration: Investment spending on exploring, finding and exploiting new oil
reserves. When oil prices are high and are expected to stay strong, it makes
financial sense to invest in exploring for new reserves, even though these may not
come on stream for some years.
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c) Technology: Technological change in oil extraction which affects the costs of
extraction and the profitability of extracting and then refining the oil.
The interaction between oil demand and supply in the short run

Higher oil demand matched against an inelastic short run supply invariably drives prices
higher – this is shown in the diagram below. An increase in demand causes a fall in stocks at
refineries and pushes prices higher. This acts as a signal to suppliers to expand production.
However there are time lags between a change in price and extra supplies coming on
stream.
The demand for oil is also price inelastic at least in the short term. This combination of an
inelastic demand and supply helps to explain some of the volatility in world oil prices.

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