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Introduction This is the 2005 edition of our Course Companion for the Edexcel AS Economics Unit 1 Module on Markets and How They Work. The Course Companion is designed as a complement to your studies in AS Economics and should not be regarded as a substitute for taking effective notes in your lessons. Points raised and issues covered in class analysis and discussion invariably go beyond the narrow confines of this guide. Economics being the subject that it is, events and new economic policy debates will inevitably surface over the next twelve months that take you into new and exciting territory. Providing you understand many of the core concepts and ideas available to an economist, you will be in a good position to understand many of the new issues that arise and you will build an awareness of the problems in developing strategies and policies to combat some the main economic and social problems of our time. Economics is a dynamic subject, the issues change from day to day and there is a wealth of comment and analysis in the broadsheet newspapers, magazines and journals that you can delve into. The more reading you manage on the main issues of the day the wider will be your appreciation of the theory and practice of economics.
Publisher Notice Edexcel AS Economics Course Companion 2005 Published by: Tutor2u Limited. 19 Westwood Way Boston Spa Wetherby West Yorkshire LS23 6DX www.tutor2u.net Online Learning Resource of the Year 2003 (BETT Awards) 1st Edition First published 1 September 2004 © Tutor2u Limited 2004. All rights reserved. ISBN 1-84582-001-0
Unit 1: Markets and How They Work
© tutor2u 2004
Edexcel AS Economics Course Companion 2005
Table of contents 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. Positive and Normative Economics......................................................................................... 4 Economic Resources............................................................................................................ 6 Scarcity and Choice in Resource Allocation .............................................................................10 Opportunity Cost, Production Possibiility, Choices and Trade-Offs ...............................................13 Economic Efficiency ...........................................................................................................17 Specialisation & Comparative Advantage................................................................................20 Consumer Surplus..............................................................................................................25 Producer Surplus...............................................................................................................28 Functions of the Price Mechanism .........................................................................................30 Theory of Demand .............................................................................................................34 Theory of Supply ...............................................................................................................40 Market Equilibrium ............................................................................................................44 Price Elasticity of Demand ...................................................................................................50 Price Elasticity of Supply.....................................................................................................55 Income Elasticity of Demand................................................................................................58 Cross Price Elasticity of Demand ...........................................................................................62 Inter-relationships between Markets.....................................................................................66 Supply and Demand Application 1 - Oil Prices..........................................................................70 Supply and Demand Application 2 - House Prices .....................................................................76 Indirect Taxation...............................................................................................................88 Subsidies.........................................................................................................................94
Unit 1: Markets and How They Work
© tutor2u 2004
Edexcel AS Economics Course Companion 2005
For example • • • • • The level of duty on petrol is too unfair and unfairly penalizes motorists Drivers of 4x4 vehicles should pay higher road tax and a higher congestion charge if they drive into London The government should increase the national minimum wage to £6 per hour in order to reduce relative poverty. Positive and Normative Economics Positive Statements Positive statements are objective statements that can be tested or rejected by referring to the available evidence. The retirement age should be raised to 75 to combat the effects of our ageing population The government ought to provide financial subsidies to companies manufacturing and developing wind farm technology Value judgements and economic policy When you are reading articles on economics. For example: • • • • • • A rise in consumer incomes will lead to a rise in the demand for new cars A fall in the exchange rate will lead to an increase in exports overseas If the government raises the tax on beer.-4- 1. it is important to be able to distinguish where possible between objective and subjective statements and evaluate the relevance of what is said. they carry value judgments. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . this will lead to a fall in profits of the brewers A reduction in income tax will improve the incentives of the unemployed to search for work A rise in average temperatures will increase the demand for chicken The level of poverty in the UK has increased because of the fast growth of executive pay Normative Statements Normative statements express an opinion about what ought to be. Value judgements play a huge role in the development of different government policies in virtually every area of our economic life. They are subjective statements rather than objective statements – i. Positive economics deals with objective explanation.e.
in other words. and junction 19 near Knutsford in Cheshire. The government is considering approval for the construction of a 50-mile dual-lane "expressway". running parallel to the existing M6 from Birmingham to Manchester. The new toll lanes would be an alternative to widening the M6 from three to four lanes between junction 11A near Cannock.org. and a debate about the relative merits of alternatives for reducing road congestion. Staffordshire. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .cpre. Objective economic analysis can be used to identify some of the economic and social costs and benefits of such a proposal.-5- In July 2004 the government announced that it was in favour of building a second motorway toll road on a lengthy section of the M6 motorway as part of a strategy to reduce traffic congestion. The environmental pressure group Friends of the Earth (http://www.org.uk/home. In contrast.uk/) said it was "an assault on the countryside" and Transport 2000 (http://www. whether there should be a toll road. the Campaign for the Protection of Rural England (http://www. We can use economic theory to predict how a "pay as you go" motorway might affect the incentives of individuals and businesses that use this stretch of road.uk/) said that the proposal was "a terrible day for the environment".html) welcomed the announcement of the new toll road provided it delivered extra road capacity quickly. the Confederation of British Industry (http://www.org.foe. We can undertake a cost-benefit analysis to consider whether or not a second toll road will bring net economic benefits to the economy as a whole.org.transport2000.cbi.uk/) described the toll scheme as "barmy". Normative economics concerns what ought to happen.
The situation remains serious despite drastic measures – according to some estimates the number of young North Sea cod in early 2003 was the lowest for 20 years threatening the sustainability of the British fishing industry. Economic Resources Finite resources There are only a finite number of workers. Other countries have a much smaller natural factor endowment and may be more reliant on importing these resources. acres of land and reserves of oil and other natural resources on the earth.-6- 2. water is a cause for deep concern in many parts of the world. we are in danger of destroying the natural resources of the planet. This will have serious consequences for the long-term sustainability of economies throughout the world and potentially enormous implications for our living standards and the quality of life. One such issue is the huge threat posed by the global shortage of water Threat to water supplies “From disappearing lakes and dwindling rivers to military threats over shared resources. The main factors of production Factors of production are the resources we have available to produce goods and services. Supplies are threatened by overuse. The pressure will only increase as populations grow” Adapted from BBC Online (2004) At the heart of improving resource sustainability is the idea of de-coupling – i. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . we cannot produce an infinite number of goods and services.e. machines. Because resources are finite. increasing the efficiency with which resources are used in producing goods and services and trying to break the link between ever-increasing output and resource depletion. Adapted from BBC online and newspaper reports (2003) Organisations such as Friends of the Earth seek to highlight the permanent damage to the stock of natural resources available throughout the world and the dangers from rapid economic development and global warming. the British government decided to ban cod fishing in the North Sea for three months in an attempt to curb the decline in fish stocks. bad management and changing weather patterns. the environmental benefit from a temperate climate or the ability to harness wind and solar power. By producing more for an ever-increasing population. In the spring of 2001. Land Land includes all of the natural resources available for production – for example the ability to exploit fertile farm land. Some nations are richly endowed with natural resources and then specialise in the extraction and production of these resources – for example – the development of the North Sea Oil and Gas in Britain and Norway or the high productivity of the vast expanse of farm land in Canada and the United States. Common resources: Has the cod industry had its chips? A collapse in cod and herring fish stocks in the North Sea has forced up the market price of cod and herring.
factories and other buildings – all of which are capital goods designed to increase the productive potential of the economy in future years. Fixed capital is a broad term that includes machinery. plant and equipment.-7- Labour Labour is best defined as the human input into the production process. Each factor used in production can expect some reward. under-investment. Interest from savings held in banks. New items of capital machinery. Working capital refers to stocks of finished and semi-finished goods (or components) that will be either consumed in the near or will be made into finished consumer goods. training and work experience they have received. A summary appears below: Income Income represents a flow of earnings from using factors of production to generate an output of goods and services. What matters is both the size and quality of the workforce. building societies and other accounts 3. Wages and salaries from work often supplemented by overtime and productivity bonuses 2. The reward to this risk-taking is the profit made from running the business. buildings or technology are generally used to enhance the productivity of other factors of production (e. improved technology in farming has vastly increased the productivity of our agricultural sector. It is inevitable that some workers are more productive than others because of the education. Many economists agree that entrepreneurs should be classed as specialised part of the factor input 'labour'. investment is not the money that people put into the stock market or other financial assets. Entrepreneurship An entrepreneur is an individual who seeks to supply products to a market for a rate of return (i. the term capital means investment in capital goods that are then used to produce other goods in the future. and a quarter behind the French. raising productivity is one of the key long-term aims of Chancellor Gordon Brown Closing the Productivity Gap “Chancellor Gordon Brown is looking to trade union and business leaders to work out how to boost Britain's economy. The main sources of income for individuals and households are the following: 1. An increase in both the size and the quality of the labour force is vital if a country wants to achieve sustained economic growth. Dividends from share ownership Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Indeed. resistance to change and complacency” Capital To an economist.e. new technology. investment in information and communication technology can increase the efficiency of workers across many industries). Gordon Brown blamed the shortfall on the "old British problems" of low skills. Productivity in the UK falls behind competitors such as the United States by a third. to make a profit).g. Entrepreneurs will usually invest their own financial capital in a business (for example their savings) and take on the risks associated with a business investment. Instead. Factor Rewards Factors of production are used to create output to be sold in markets. And.
0 10. If you own properties.0 5558. The latest available data shows that 94% of the total marketable wealth in this country is held by 50% of the population. Labour and Wages Most people have the ability to do some form of work. The government also has an effect on people’s disposable (“after-tax”) income by taxing incomes and by offering welfare benefits to households on low incomes and to other benefit recipients. the other half of our population can lay claim to only 6% of total wealth. In industries and occupations where labour is not particularly Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . The table below provides evidence for this showing the average level of the FTSE 100 index (the index of the leading one hundred companies listed on the UK stock market) together with the annual percentage change in the Nationwide house price index. The distribution of income and wealth in the UK is highly unequal. but a growing problem of affordability for people looking to enter the housing market for the first time on relatively low incomes. schools and hospitals It is important to distinguish between income and wealth. If they are of working age and actively seeking a job then they are included in the working population. bank and building society accounts Marketable wealth .6 Inequality in the distribution of income and wealth Factor rewards are rarely if ever distributed equitably in any country. Rent income from the ownership of property For the majority of people.8 19.5 4595. There has been an explosion of interest in recent years in the buy-to-let sector of the housing market with hundreds of thousands of people buying properties and then letting them out to tenants.consumer durables that can be sold for a price Social capital . if you receive a higher wage or salary from your job then this adds to your monthly income.5 19. The result has been a jump in housing wealth for people with mortgages. For example. or by making contributions to a pension fund then you are adding to your financial wealth. then you can derive some income from renting. the last few years has been a disappointing time for stock market investors with poor returns on stocks following the collapse of the dot. Wealth Wealth is defined as a stock of assets that generates a flow of income and can be held in a variety of forms by individuals. particularly in London and the South East.2 4049.9 UK House Prices % change (Nationwide house price index) 13. most of their regular income comes from their employment.-8- 4.social infrastructure such as transport systems. If this is saved in a bank. FTSE 100 Stock Index Year 2000 2001 2002 2003 Average level 6370.com share bubble in the spring of 2000. Put another way. firms and also the nation as a whole: • • • Financial wealth . If you have shares in companies listed on the stock market – you expect to receive dividend income every few months. In the UK in recent years we have seen a sustained boom in the UK housing market leading to sharp rises in average house prices. Being wealthy can also generate income. Of course the value of financial wealth can fluctuate over time.stocks and shares. if you have money in a savings account – you will be paid interest. In contrast.
and the entrepreneur takes what is left. This after-tax profit is called net profit. Millions of workers in the UK are paid hourly wages well below the national average. The national minimum wage (currently £4. Capital and Interest Businesses often need to borrow money to fund new capital. This is called gross profit. it becomes less worthwhile to borrow money because any project will have to make more money than before to be profitable since more interest is now being paid. Economists often assume that one of the main objectives of a business is to achieve maximum profits from selling their output to consumers. This is not always the case! Some businesses are looking to achieve the highest market share.80 for all adult workers) seeks to address some of the problems associated with low pay. so wages are lower. The reward for investing money is called interest. There is growing interest in the concept of ethical businesses and corporate social responsibility where the traditional assumption of businesses driven solely by the profit motive is challenged and where businesses are encouraged to take account of their economic. Taxes then have to be paid to the government. Interest rates can of course go up or down. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . On the other hand. Low interest rates reduce the opportunity cost of using funds to invest and therefore should stimulate an increase in the demand for credit. If the interest rate is high. some people have skills that are quite rare. and these people will command high salaries in the modern labour market. Increasing market share might mean sacrificing some profits in the short run by cutting prices and under-cutting rival suppliers in the market. social and environmental impacts.-9- scarce. Enterprise and Profit In return for having the ideas that bring together the factors of production and taking the risk in putting funds into a business the entrepreneur takes any money that the business has left after the other factors of production have received their rewards.
10 - 3.and who not? Should there be a minimum wage? If so. All societies face the economic problem of having to decide: (i) What goods and services to produce: Does the economy uses its resources to operate hospitals or hotels? Do we make CD-players or produce more coffee? Does the National Health Service provide free IVF treatment for thousands of childless couples? Or. who said in 1935 "Economics is a social science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. understanding the causes of inequality of income and wealth. one another." The purpose of economic activity The central purpose of economic activity is the production of goods and services to satisfy consumer’s needs and wants i. to satisfy people’s need for consumption both as a means of survival but also to meet their growing demands for an improved lifestyle or standard of living.e.economist. this author can never say with much certainty what will be taught to students on any given day because we cannot predict what will be the major Economics stories in the news that require some further understanding and insight! On one day is it analysing the causes of currency fluctuations. theories and relationships that explain how people. businesses and governments behave in our own world. as a social science attempts to give us some concepts.. replacing labour with capital?) Who is to receive goods and services: What is the best method of distributing (i. If the supply of a good or service is low. ideas.com) defines economics as "The study of the production. distribution and consumption of wealth in human society" Another superb definition comes from the late Lionel Robbins.e.it will have a market value. Scarcity and Choice in Resource Allocation What is Economics? If you ask twenty economists this question you are likely to get at least twenty five competing views! There is no single unified interpretation of what Economics is as a subject. at what level should it be set? (ii) (iii) Scarcity Let us start with a basic rule of economics! If something is scarce . or under-taking a cost-benefit analysis of the economics of wind farms! Economics. sharing) products to ensure the highest level of wants and needs are met? Who will get expensive hospital treatment . That is.e. Scarcity and choice – the fundamental economic problem The basic economic problem is about scarcity and choice: there are only a limited amount of resources available to produce the unlimited amount of goods and services we desire. The Economist's Dictionary of Economics (http://www. providing there is sufficient demand from consumers. Goods and services that are in plentiful supply will have a lower market value because supply can Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . the market price will rise. And as a teacher of Economics. do we choose instead to allocate millions of pounds each year to providing beta-interferon to sufferers of multiple sclerosis? How best to produce goods and services: What is the best use of our scare resources of land labour and capital? Should school playing fields be sold off to provide more land for housing? Is it an improvement in economic efficiency to replace bank staff with a greater use of online banking services? (I. economics is the study of the trade-offs involved when choosing between alternate sets of decisions.
choosing more of one thing means giving up something else in exchange. choices have to be made on a daily basis by individual consumers. Housing: Choices about whether to rent or buy a home – a huge decision to make and one full of uncertainty given the recent volatility in the British housing market! There are costs and benefits to renting a property or choosing to buy a home with a mortgage. cheaper food and a wider range of cosmetic health care treatments. Whenever there is excess supply in a market. we expect to see prices falling. Indeed the development of society can be described as the uncovering of new wants and needs . For a perspective on the achievements of countries in meeting people’s basic needs. Data for each country can be accessed and cross-country comparisons can be made. the Human Development Index (http://hdr. Working: Choosing between full-time or part-time work. a ferry or an airline when travelling to Europe Rational consumers – seeking to maximise their own welfare Our working assumption is that consumers make choices about what to consume based on the objective of maximising their own welfare. more meals out at restaurants.e. or to take a course in higher education lasting for at least three years – how have these choices and commitments been affected by the introduction of university tuition fees? 3. the prices of new cars in the UK have been falling for several years. education and health services. Insatiable human wants and needs Road space throughout the world is becoming increasingly scarce as the demand for motor transport increases each year – are there effective solutions? Human beings want better food. They demand the latest digital technology.undp. For example. more frequent overseas travel. Opinion polls consistently show that the majority of the electorate expect government policies to deliver improvements in the standard of education. We will see later on when we discuss the possibility of market failure that very often. human needs and wants are infinite. better cars.org/) produced annually by the United Nations is well worth reading. firms and governments. transport. decisions by people about which products to Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Making Choices – Trade-offs Because of scarcity. the National Health Service and our transport system.in simple terms. Making a choice made normally involves a trade-off . a limited budget) and they seek to allocate their funds in a way that improves their own standard of living. They have a limited income (i.. Both decisions involve a degree of economic risk. housing.which producers attempt to supply by using the available factors of production. Of course in reality consumers rarely operate in a perfectly informed and rational way. For example: 1. (Whether voters are really prepared to pay for these services through higher taxes is another question!) Whilst our economic resources are limited. Because wants are unlimited but resources are finite. 2. choice is an unavoidable issue in economics.11 - easily meet the demand from consumers. Transport and travel: The choice between using Euro-Tunnel.
how and for whom to produce are based on custom and tradition Land is typically held in common ie private property is not well defined 2.. and sets production targets and growth rates according to its own view of people's wants. Traditional economy: Where decisions about what. The state allocates resources. There are four categories of economic system. Do we always learn from our mistakes? To what extent are our individual choices influenced and distorted by the effects of persuasive advertising? Multinational companies have advertising and marketing budgets that often run into hundreds of millions of pounds. Household income depends on the market value of an individual’s work 3. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . As consumers we have all made poor choices about which products to buy. The public sector typically supplies public. We are all influenced by them to a lesser or greater degree. Mixed economy: Some resources are owned by the public sector (government) and some resources are owned by the private sector.12 - purchase and consume are actually based on imperfect or incomplete information which can lead to a loss of satisfaction and welfare not only for consumers themselves but society as a whole. Planned or command economy: Resources are owned by the state. Income distribution is decided by the state. An increase in demand raises price and encourages firms to switch additional resources into the production of that product. Prices play little or no part in informing resource allocation decisions and queuing rations scarce goods. Free market economy: Where households own resources and markets allocate resources through the price mechanism. quasi-public and merit goods and intervenes in markets to correct perceived market failure. The amount of goods and services consumed by households depends on their income. Economic Systems An economic system is the network of organisations used by a society to resolve the economic problem of what how and for whom to produce. 1. 4.
Making use of scarce farming land: The opportunity cost of using arable farmland to produce wheat is that the land cannot be used in that production period to harvest potatoes • • The Production Possibility Frontier A production possibility frontier (PPF) or boundary shows the combinations of two or more goods and services that can be produced using all available factor resources efficiently. the extra output gets smaller – and more of Good X has to be given up in order to produce the extra output of Good Y. A PPF is normally drawn on a diagram as concave to the origin because the extra output resulting from allocating more resources to one particular good may fall. Government spending priorities: The opportunity cost of the government spending nearly £20 billion on interest payments each year on the national debt is the extra money that might have allocated to the National Health Service. education or to improving the UK transport network. economic resources are used up in the production of it and there must be an opportunity cost involved..13 - 4. Opportunity Cost. firms and the government. as more resources are allocated towards Good Y. We may have to accept lower living standards now. Investing today for consumption tomorrow: The opportunity cost of an economy investing resources in new capital goods is the current production of consumer goods given up. Choices and Trade-Offs Opportunity Cost There is a well known saying in economics that “there is no such thing as a free lunch”.e. Even if we are not asked to pay a price for consuming a good or a service. I. Production Possibiility. as we move down the PPF. This is known as the principle of diminishing returns Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . • • Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost wages foregone. to accumulate increased capital equipment so that long run living standards can improve. Many examples exist for individuals. Opportunity cost measures the cost of any choice in terms of the next best alternative foregone.
if we increase our output of Good X (i. The PPF does not always have to be drawn as a curve. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . we have to give up more of Good Y to achieve gains in the output of good X.e.e. Point X is an example of this. or an increase in the efficiency (productivity) of factor resources or an improvement in technology to reach this combination of Good X and Good Y. A country would require an increase in resources. Point D is unattainable at the moment because it lies beyond the PPF. then we draw the PPF as a straight line. Because of the shape of the PPF the opportunity cost of switching resources increases – i. If the opportunity cost for producing two products is constant. A or B. a movement along the PPF from point A to point B) then fewer resources are available to produce good Y. 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 Opportunity Cost and the PPF Reallocating scarce resources from one product to another involves an opportunity cost.14 - Combinations of output of goods X and Y lying inside the PPF occur when there are unemployed resources or when the economy uses resources inefficiently.. If we achieve this then output combination D may become attainable. The gradient of that line is a way of measuring the opportunity cost between two goods. Free Goods Not all goods have an opportunity cost. If we go back to the previous PPF diagram. We could increase total output by moving towards the production possibility frontier and reaching any of points C. Free goods are not scarce and no cost is involved when consuming them.
Cool air might appear to be free – but in fact it is often an expensive product to supply! External Costs In the case of air pollution there is an external cost to society arising from the contamination of our air supplies.. the labour involved in its design. shops and schools. production. Identifying and then estimating a monetary value for air pollution is a difficult exercise – but one that is increasingly important for economists concerned with the impact of economic activity on our environment. And. External costs are those costs faced by a third party for which no compensation is forthcoming. air-conditioning systems cool the air before it is “consumed”. distribution and maintenance and the energy used up in powering the system. Explaining Shifts in the Production Possibility Frontier The production possibility frontier will shift when: • • There are improvements in productivity and efficiency perhaps because of the introduction of new technology or advances in the techniques of production) 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 to use © tutor2u 2004 Edexcel AS Economics Course Companion 2005 Unit 1: Markets and How They Work .15 - Fresh air – a free good Is fresh air an example of a free good? Ordinarily the answer is yes – yet we know that air can become contaminated by pollutants. in thousands of offices. With air conditioning. We will consider this issue in more detail when we study externalities and externalities and market failure. scarce resources are used up in providing the “product” – for example the capital machinery and technology that goes into manufacturing the air conditioning equipment.
Technology. education. prices and consumer welfare Improved technology should bring market prices down and make products more affordable to the consumer. As a result of this.g. i. research and development Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . manufacturing and the construction industry 3. and mining 2. agriculture. insurance.g. there is an improvement in the state of technology which shifts the PPF outwards and means that more of good X can be produced for a given output of good Y.e. output possibilities have increased and we can conclude (providing the good provides positive satisfaction to consumers) that there is an improvement in economic welfare.16 - In the diagram below. Secondary sector: This involves the production of goods in the economy.. A price war between leading personal computer suppliers has also driven prices down further. Primary sector: This involves extraction of natural resources e. finance. This has been the case in the market for personal computers and digital products. quarrying. forestry. transforming materials produced by the primary sector e. Quaternary sector: The quaternary sector is involved with information processing e. Tertiary sector: the tertiary sector provided services such as banking. The exploitation of economies of scale and improvements in production technology has brought prices down for consumers and businesses.g. Sectors of production in the economy Production of goods and services can be classified into four groupings 1. retail. fishing. education and travel and tourism 4.
This can be illustrated using a production possibility frontier – all points that lie on the PPF can be said to be allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available. Thus P2 is not an allocative efficient allocation of resources for this market whereas P1. In the diagram on the next page. At this point.17 - 5. The technical condition required for allocative efficiency is that price = marginal cost. the total area of consumer and producer surplus is maximised. Economic Efficiency What is economic efficiency? There are several meanings of the term economic efficiency but they generally relate to how well a market or the economy allocates scarce resources to satisfy consumers. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . In the diagram above. the market equilibrium price is deemed to be allocative efficient. When this happens. the combination of output shown by Point A is allocatively efficient – but at the output combination denoted by the letter X we can increase production of both goods by making fuller use of existing resources or increasing the efficiency of production.. the market is in equilibrium at price P1 and output Q1. Using the Production Possibility Frontier to show allocative efficiency Pareto defined allocative efficiency as a position where no one could be made better off without making someone else at least as worth off. Allocative efficiency Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production. but there also would be an even greater loss of consumer surplus. total economic welfare is maximised. suppliers were able to restrict output to Q2 and hike the market price up to P2. sellers would gain extra producer surplus by widening their profit margins. If for example.
Productive Efficiency Productive efficiency refers to a firm's costs of production and can be applied both to the short and long run production time-span. an increase in the level of capital investment allowing consumers to track precisely where their parcels are in the delivery chain and general improvements in the quality and reliability of services in local. At a macroeconomic level. innovation and research and development can lead to improvements in dynamic efficiency and this might translate into higher sales in key export markets. if it is impossible to move to another allocation which would make some people better off and nobody worse off. At this point we maximise social welfare. the resulting equilibrium throughout the economy will be Paretoefficient. A faster pace of invention.e.18 - An allocation is Pareto-efficient for a given set of consumer tastes. Social Efficiency The socially efficient level of output and or consumption occurs when social benefit = social cost. regional.. The existence of negative and positive externalities means that the private optimum level of consumption or production often differs from the social optimum leading to some form of market failure and a loss of social welfare. national and international parcel deliveries – this represents an improvement in dynamic efficiency. For example – the opening up of the market for parcel deliveries has had an impact on price and output levels (these are changes in static efficiency). resources and technology. It is achieved when the output is produced at minimum average total cost (ATC) i. However we have also noticed the entry of new suppliers into the market. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . when a firm is exploiting most of the available economies of scale. Productive efficiency exists when producers minimise the wastage of resources in their production processes. If every market in the economy is a competitive free market. Dynamic Efficiency Dynamic efficiency occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available. a dynamically efficient economy is increasingly successful in improving existing products and also at developing new products.
This divergence between private and social costs of production can lead to market failure. A private producer who opts to ignore the negative production externalities might choose to maximise their own profits at point A.19 - In the diagram below the socially optimum level of output occurs where the social cost of production (i.e. the private cost of the producer plus the external costs arising from externality effects) equals demand (a reflection of private benefit from consumption.. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
Assuming constant returns to scale (i. the opportunity cost of each extra unit means having to give up four freezers. Comparative Advantage and the Gains from Specialisation and Trade We introduce at this point the idea of comparative advantage and consider how this principle can be used to illustrate the potential gains from trade In the example shown in the table below we assume that there are two countries each producing two commodities. If it decides to specialise in dishwashers.20 - 6. an extra freezer can be achieved by giving up only ¼ of a dishwasher. the UK can produce in absolute terms more of both. For Italy. For the UK. This suggests that the absolute level of factor efficiency (or productivity) is higher in the UK. On this basis. the opportunity cost ratio is lower for the UK – and this suggests that the UK has a comparative advantage in the production of dishwashers. The output produced when half of the available resources are divided between each industry in each country is shown in the first part of the table.. freezers and dishwashers. Specialisation & Comparative Advantage The gains from trade between nations International trade is beneficial when there are differences between countries in the relative costs of producing goods and services. Comparative advantage – the importance of relative costs The pre-specialisation output shows that the UK can produce more of both goods than can Italy. What about a decision to produce extra freezers? Consider the opportunity cost of this for both countries. However what matters more in terms of the potential benefits from specialization and trade are the relative costs of production for each country. Each country has the same factor resources available allocated to the production to two goods. the opportunity cost is that we must give up 2 freezers. If wages and other costs are similar. then for the UK. each extra freezer means giving up ½ of a dishwasher. there are potential gains in economic welfare if free trade can take place between countries.e. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . output is proportionate to the inputs allocated to each industry). for every extra dishwasher produced. then we would expect the UK to be able to produce these goods at a lower unit cost than in Italy. If countries opt to specialise in the production of certain commodities and if they can achieve a much higher output as a result. Here the relative cost advantage lies with Italy – it has a comparative advantage in specialising in freezers. even though as we have seen. Consider the same scenario for Italy. Consider the opportunity cost for the UK if it decides to produce extra dishwashers.
The result is that the total output of freezers rises from 1800 to 2000 and the total production of dishwashers increases from 700 to 800. the extra output will be more than proportionate to the increased resources given over to an industry. Freezers 000s per year 1150 850 2000 Dishwashers 000s per year 550 250 800 Freezers 000s per year 1000 800 1800 Freezers 000s per year 400 1600 2000 Dishwashers 000s per year 500 200 700 Dishwashers 000s per year 800 0 800 Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .e.. In our example from the previous page. Once again we make a working assumption that there are constant returns to scale from reallocating resources – in other words that resources in the UK currently employed producing freezers are equally productive (efficient) when they are re-deployed to increase output of dishwashers. Specialisation based on comparative advantage has led to an increase in the total output of both goods. Others might point to the risk of decreasing returns. even though the total factor resources made available has not changed. Some economists would argue that in fact specialisation will lead to increasing returns to scale. we assume that Italy specialises completely in the production of freezers and manages to double its output to 1600. i. particularly if some of the factor resources such as labour and capital used in one industry is not perfectly mobile and capable of being utilised in another. The UK possessing an absolute advantage in each. decides to part-specialise focusing most of its resources in dishwashers.21 - Half of total resources in each country are allocated to each industry Pre Specialisation Output UK Italy Total Production Post Specialisation Output UK Italy Total Production Terms of Trade: 3 Freezers for 1 Dishwasher Post Specialisation and Trade UK Italy Total Production UK exports 250 dishwashers in exchange for 750 freezers Italy exports 750 freezers in exchange for 250 dishwashers Post trade (exchange) both countries have the opportunity to consume more of both goods We now move on to consider the potential gains from both countries specialising in the products in which they possess a comparative advantage.
Italy has exported 750 of its 1600 freezers and received in exchange 250 dishwashers. It is left with 850 freezers and 250 dishwashers. How do we find such a terms of trade? We go back a step to consider the internal opportunity cost ratios for each country – in other words. instead of getting only 2 freezers for each dishwasher it gives up. For the UK. The law of comparative advantage says countries specialise in producing the goods and services they make relatively cheaply. The two diagrams on the next page take us through the worked example we have used in explaining comparative advantage. The UK has sold (exported) 250 of its dishwashers to Italy and in return it has imported 750 freezers. For the UK with a surplus of dishwashers. an acceptable rate of exchange of freezers for dishwashers and vice versa.. The final part of the table on the previous page shows how the distribution of the two goods might look after exchange has taken place. the opportunity cost of each extra dishwasher is 2 freezers. The differences in the gradient of the PPF illustrate the differences in relative costs of production. for Italy the same choice involves an opportunity cost of 4 freezers. the rate at which each country must give up freezers for dishwashers if it did not trade with another country.22 - How can these two countries now benefit from trade (exchange)? Much depends on the two nations finding mutually beneficial terms of trade i. We have shown on the back of certain assumptions that specialisation and trade at an acceptable terms of trade can lead to an increase in the output of both goods presumably leaving consumers better off than they were before. but instead simply reallocated resources within its own economy. In the first diagram we plot the original PPF for both the UK and Italy. An acceptable trade would be 3 freezers for each extra dishwasher because Italy having specialised in freezers now only has to give up 3 freezers in exchange for each dishwasher. leaving the UK with 1150 freezers (150 more than it had at the start) and 550 dishwashers (50 higher than at the beginning). This neat piece of theory utilises the concept of comparative advantage and lies at the heart of much of the traditional theory of international trade. Showing the Benefits of Specialisation and Trade using a PPF We can illustrate the potential benefits from specialisation and trade by making use of the production possibility frontier.e. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . a gain of 50 of each item when we compare the post-trade output with the prespecialisation output. a trade of 3F:1D means that it will get more freezers in exchange when it exports dishwashers to Italy.
.23 - PPF FOR THE UK Freezers PPF FOR ITALY 2000 1600 1000 500 1000 Dishwashers 200 400 Dishwashers 3000 PPF FOR THE UK Freezers PPF FOR ITALY 2000 1600 1000 500 1000 Dishwashers 200 400 533 Dishwashers Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
. notice that the effective PPF for each country has shifted out implying that consumers in both countries now have more of both goods available. Perfect occupational mobility of factors of production – i. We assume that there are no externalities arising from production and/or consumption of the goods involved We assume that there are zero or insignificant transportation costs Despite the fact that these assumptions can be questioned or broken down. If we change these assumptions then the results of our work example might turn out to be different. doubling the input leads to a doubling of output) – the gains from trade will be greater if economies of scale can be exploited – we will consider economies of scale when we get into the core of business economics 3. the fundamental principle of comparative advantage and the gains from specialisation and exchange remain firm and they have plenty of applicability in both domestic and international economic policy-making. some inputs are specific to particular industries and factors of production are not perfectly mobile – so workers and capital inputs switching from one sector of the economy to another might lead to a loss of economic efficiency / productivity at least in the short term 2. a country’s labour and capital inputs can be used in each industry with no loss of overall efficiency. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . 1. the effect is shown in the second diagram. In reality. and suggesting an improvement in economic welfare and living standards. Assumptions behind this theory Our worked example of the gains from specialisation based on the principle of comparative advantage is based on a number of assumptions which may not hold true in reality. Constant returns to scale (i.e.24 - When specialisation occurs and both countries trade at a terms of trade of 3 freezers for each dishwasher.e.
When demand is inelastic. the quantity demanded remains the same. Consumer Surplus Consumer Surplus Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services.25 - 7. This is shown in the diagram below: Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . The level of consumer surplus is shown by the area under the demand curve and above the ruling market price as illustrated in the diagram below: Consumer surplus and price elasticity of demand When the demand for a product is perfectly elastic. This is most likely to happen in perfectly competitive markets where each individual firm is a ‘price taker’ in their chosen market and must sell as much as it can at the ruling market price. 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 pay (the market price). In contrast. there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. Whatever the price. when demand is perfectly inelastic. consumer surplus is infinite.. Demand is totally invariant to a price change. consumer surplus is zero because the price that people pay matches precisely the price they are willing to pay. or a measure of the benefits they derive from the exchange of goods. The majority of demand curves are downward sloping.
. a lower price and an increase in the quantity traded in the market. In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply. This is shown in the diagrams above. then consumer surplus will alter.26 - Changes in demand and consumer surplus When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity. Following an increase in demand from D1 to D2. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . There is a higher level of consumer surplus because more is being bought at a higher price than before. the equilibrium market price rises to from P1 to P2 and the quantity traded expands.
If a businessman is desperate to fly from Newcastle to Paris in 24 hours time. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-flow together with the guarantee of a seat being filled. then sellers may engage in price discrimination – the aim of which is to extract from the purchaser. the higher the price. What impact has their entry into the market had on consumer surplus? Have you benefited from you perceive to be lower prices and better deals as a result of using e-commerce sites offering large discounts compared to high street retailers? Price discrimination and consumer surplus Producers often take advantage of of consumer surplus when setting prices.27 - Consumer surplus can be used frequently when analysing 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. You will always get a better deal / price with airlines such as EasyJet and RyanAir if you are prepared to book weeks or months in advance. Airlines are expert at practising this form of yield management. extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day. If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products. thereby turning consumer surplus into extra revenue. We shall consider the issue of monopoly in more detail when we come on to our study of markets and industries. and exploiting variations in elasticity of demand for different types of passenger service. The nearer the time to take-off. Applications of consumer surplus Consider the entry of Internet retailers such as Last Minute and Amazon into the markets for travel and books respectively. One of the arguments against firms with monopoly power is that they exploit their monopoly position by raising prices in markets where demand is inelastic. the price they are willing to pay. extracting consumer surplus from buyers and increasing profit margins at the same time. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher..
28 - 8. 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: 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. It is measured as the difference between what producers are willing and able to supply a good for and the price they actually receive. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .. Producer Surplus Producer Surplus Producer surplus is a measure of producer welfare.
.29 - We now consider the effects on producer surplus of a rise in market demand assuming that conditions of supply remain unchanged: Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
This is the essence of economics! The price mechanism plays three important functions in any market-based economic system: The signalling function Firstly. So an outward shift of demand ought to lead to an expansion along the market supply curve. while consumers will react to the resulting higher price by reducing demand for the good or services. an increase in market supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve Conversely. if market prices are rising because of stronger demand from consumers. for example. This means that market prices adjust to demonstrate where resources are required. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . and where they are not. In the second example on the right.30 - 9. prices perform a signalling function. Functions of the Price Mechanism The invisible hand – the workings of the price mechanism The price mechanism is a term used to describe the means by which the many millions of decisions taken each day by consumers and businesses interact to determine the allocation of scarce resources between competing uses. a rise in the costs of production will induce suppliers to decrease supply. Consider the left hand diagram below. this is a signal to suppliers to expand their production to meet the higher demand. producers stand to earn higher revenues and profits from selling more games at a higher price per unit. Prices rise and fall to reflect scarcities and surpluses.. So. The market demand for computer games increases and as a result.
Instead state planning directs resources to where the state thinks there is greatest need. consumers and producers) must respond to appropriate price signals in the market. For competitive markets to work efficiently all economic agents (i. consumers are able through their expression of preferences to send important information to producers about the changing nature of our needs and wants. Be it the demand for tickets among England supporters at Euro 2004. then market supply contracts. When there is a shortage of a product. markets and instances of market failure. most modern economies are mixed economies. The phenomenal success of EBAY is testimony to the power of the auction process as a rationing and market clearing mechanism as internet usage has grown. the price mechanism plays little or no active role in the allocation of resources. However. the market price acts a rationing device to equate demand with supply. the price is bid up – leaving only those with sufficient willingness and ability to pay with the effective demand necessary to purchase the product. how to produce and for whom. how much to produce. We are assuming here that producers do actually respond to these price signals! The rationing function Prices serve to ration scarce resources when demand in a market outstrips supply. the market may fail to take into account the external costs and benefits arising from production and consumption. those who believe in the virtues of a free-market economy with minimal government intervention. higher market prices act as an incentive to raise output (production) because the supplier stands to make a higher profit.e.. Adam Smith and the Invisible Hand The 18th Century economist Adam Smith was one of the founding fathers of modern economics. the causes and consequences of market failure. i. comprising not only a market sector. but also a nonmarket sector. When demand is strong. Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .31 - The transmission of preferences Through the signalling function.e. Prices and incentives Incentives matter enormously in our study of microeconomics. This remains the central view of all free-market economists. For example.e. In a command economy. The growing popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market. roads and health. He described how the invisible or hidden hand of the market operated in a competitive market through the pursuit of selfinterest to allocate resources in society’s best interest. The price mechanism is the only allocative mechanism solving the economic problem in a free market economy. where the government (or state) uses the planning mechanism to provide goods and services such as police. Market failure occurs when the signalling and incentive function of the price mechanism fails to operate optimally leading to a loss of economic and social welfare. The reality is that state planning has more or less failed as a means of deciding what to produce. The market economy is now the dominant economic system – even though we are increasingly aware of imperfections in the operation of the market – i. or the demand for a rare antique. When demand is weak.
Is an aviation tax the most effective way of controlling pollution? Or could incentives for producers and behaviour by consumers wanting to travel by air be changed through other more effective and efficient means? Agents may not always respond to incentives in the manner in which textbook economics suggests. Suppose for example that the government decides to introduce a new tax on aviation fuel in a bid to reduce some of the negative externalities created by the air transport industry. The “law of Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Government intervention in the market Often the incentives that consumers and producers have can be changed by government intervention in markets.. How will airlines respond? a. will they change their behaviour in the market? 3. Our individual preferences may also be distorted and shaped by the effects of persuasive advertising and marketing to create artificial wants and needs. For example a change in relative prices brought about by the introduction of government subsidies and taxation. Can they absorb the tax and seek cost-savings elsewhere in their operations? 2. Will they pass on the tax to consumers? b. If the tax raises price for air travellers.32 - to buy and consume a product. 1.
.33 - unintended consequences” encapsulates the idea that government policy interventions can often be misguided of have unintended consequences! See the revision focus article on government failure. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
An interesting case study in changing market demand is the market for third-generation mobile phones. but where the consumer lacks the purchasing power to be able to afford the product. Latent demand is affected by advertising – where the producer is seeking to influence consumer tastes and preferences.34 - 10. The demand from consumers for such services has so far fallen well short of expectations causing the leading players to cut their prices and write off some of the debts accumulated when they bid such huge figures for the 3G licences. Consider the market for pay-per-view boxing events – the companies promoting these events must price carefully so that they tap into the largest possible market. Each of us has an individual demand for particular goods and services. What price are you willing to pay to view a world championship boxing event? How much are you prepared to spend to watch Premiership soccer on a pay-per-view basis? Or would you be willing and able to pay to watch Elton John perform live through subscription channels? The concept of willingness to pay is crucial to the theory of demand for goods and services. In 2000 the leading telecoms companies paid in total over £22 billion pounds to win licences to operate third generation (3G) mobile phone networks in the UK. Eventually though the market demand for mobile phones will reach saturation point – every product has a life-cycle. Market demand Market demand is simply the sum of the individual demand for a product from each consumer in the market. If more people enter the market. For example. Derived Demand The demand for a product X might be strongly linked to the demand for a related product Y – giving rise to the idea of a derived demand. Mobile phones and mobile phone services Market demand for mobile phones has expanded rapidly over the last few years as call costs have fallen.. They must have sufficient purchasing power. Only when a consumers' desire to buy a product is backed up by an ability to pay for it do we speak of demand. but their demand would not be effective if they did not have the financial means to do so. many people would be willing to buy a luxury sports car. For example. then demand at each price level will rise. Likewise the demand for steel is strongly linked to the demand for Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Demand at each market price reflects the degree of value consumers place on item and their expected satisfaction gained from purchase and consumption. the demand for coal is derived in part on the demand for fossil fuels to burn in the process of generating energy. Effective Demand and Willingness to Pay Demand in economics must be effective. 3G services went live in March 2003 and it will be interesting to see how the level of market demand evolves over the next couple of years. Theory of Demand Demand Demand is defined as the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. Willingness to pay is also evident in the growing use of auctions in selling the rights for broadcasting sports events and in buying and selling scarce works of art. Latent Demand Latent demand exists when there is willingness to purchase a good or service.
1. for a normal good. The Demand Curve A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. Steel is a highly cyclical industry – the demand for steel is sensitive to changes in the business cycle and fluctuations in the exchange rate. there should be a contraction of demand. The Law of Demand There is an inverse relationship between the price of a good and demand. so we would expect the demand for steel to decline likewise. Provided that the good is normal. 2. more is demanded as price falls: 1. The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain current consumption for less expenditure. 2. The Substitution Effect: There is also a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and so some consumers switch their spending from the good in competitive demand to this product. The major producer of steel in the UK is Corus. Corus has found it difficult to compete on cost and price with lower-cost steel producers in EU and non-EU countries and as a result output and jobs have fallen.35 - new vehicles and many other manufactured products. packing and the transport sector. more of a product will be demanded as the market price falls. some of the resulting increase in real income is used by consumers to buy more of this product. we see an expansion of demand If price rises. so that when an economy goes into a downturn or recession. As prices fall. In recent years. from agriculture. They produce for a very wide range of different industries.. aerospace and construction industries to consumer goods producers. For normal goods. There are two reasons why. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
T. Shifts in the Demand Curve Caused by Changes in the Conditions of Demand There are two possibilities: either the demand curve shifts to the right or it shifts to the left. Pn…Pn-1. less is demanded at each price.when these change.. Y.36 - The demand curve is normally drawn in textbooks as a straight line suggesting a linear relationship between price and demand but in reality. they use real-time evidence from markets to estimate the demand conditions and they accumulated experience of market conditions gives them an advantage in constructing demand-price relationships. the demand curve can shift. 2. a rise in price causes a contraction of demand. When this happens. P. Many other factors can affect total demand . When this happens. In the diagram below we see two shifts in the demand curve: 1. D1 – D3 would be an example of an outward shift of the demand curve (or an increase in demand). A change in the price of a good or service causes a movement along the demand curve. A fall in the price of a good causes an expansion of demand. A movement from D1 – D2 would be termed an inward shift of the demand curve (or decrease in demand). the demand curve will be non-linear! No business has a perfect idea of what the demand curve for a particular product looks like. Factors influencing Demand The conditions of demand for a product in a market can be summarised as follows: D = f (Pn. E) Where: • Pn = Price of the good itself © tutor2u 2004 Edexcel AS Economics Course Companion 2005 Unit 1: Markets and How They Work . more is demanded at each price. This is explained below.
The development of the internet has helped to increase price transparency thereby making it easier for consumers to compare relative prices in markets. a rise in the price of Esso petrol should cause a substitution effect away from Esso towards competing brands. Changing price of a complement Two complements are said to be in joint demand. A fall in the monthly rental charges of cable companies or Vodafone mobile phones might cause a decrease in the demand for British Telecom services. In 2003. • Change in the income of consumers Most of the things we buy are normal goods. But searching for price information to get the best deal in the market can be time consuming and always involves an opportunity cost.g.. DVDs can be played on stand-alone boxes. An excellent example of shifts in demand arising from changing consumer preferences is the change in demand for pre-recorded DVDs and VHS format in the UK. their ability to purchase goods and services increases. scanners and software applications. over 208 million DVDs were sold in contrast to just 63 million videos. Consumers will tend over time to switch to the cheaper brand or service provider. Examples include: fish and chips. laptops and games consoles. personal computers. One might expect that a fall in the charges from one car rental firm such as Budget might affect the demand for car rentals from Avis Hertz or Easycar. Much depends on whether consumers have sufficient information about prices for different goods and services. For example. iron ore and steel. then consumer demand will be sensitive to price changes. Change in tastes and preferences Consumers’ tastes can be volatile leading to unexpected fluctuations in demand. and this causes an outward shift in the demand curve. The charts below track this major shift in the pattern of demand in the market – although it should be noted that the total value of sales has grown significantly on the back of the explosion in demand for DVD players and DVDs. When it is easy and cheap to switch. A fall in the price of a complement to Good Y should cause an increase in demand for Good Y. prices of Substitutes and Complements Y = Consumer incomes – including both the level and distribution of income T = Tastes and preferences of consumers P = The level and age-structure of the population E = Price expectations of consumers Changing price of a substitute good Substitutes are goods in competitive demand and act as replacements for another product. success and hard work! • A rise in the price of a complement to Good X should cause a fall in demand for X. For example an increase in the cost of flights from London Heathrow to New York would cause a decrease in the demand for hotel rooms in New York and also a fall in the demand for taxi services both in London and New York. DVD players and DVDs. When an individual’s income goes up. For example a reduction in the market price of computers should lead to an increase in the demand for printers.7 million DVD players in 11 million UK homes. When incomes fall there will be a decrease in the demand for most goods.37 - • • • • • Pn…Pn-1 = Prices of other goods – e. In the summer of 2004 it was estimated that there were now 15. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
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 raise interest rates – the demand for many goods and services may fall. Examples of “interest sensitive” goods include household appliances. new furniture and motor vehicles.. electronic goods. Exceptions to the law of demand Does the demand for a product always vary inversely with the price? There are two possible reasons why more might be demanded even when the price of a good or service is increasing. We consider these briefly – ostentatious consumption and the effects of speculative demand. Ostentatious consumption Some goods are luxurious items where satisfaction comes from knowing both the price of the good and being able to flaunt consumption of it to other people! A higher price may also be regarded as a reflection of product quality and some consumers are prepared to pay this for the “snob value effect”.38 - Changes in interest rates Many goods are bought on credit using borrowed money. Examples might include Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . The demand for housing is affected by changes in mortgage interest rates.
adding to the upward pressure on prices. but also the potential rise in market price leading to a capital gain or profit. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Only 475 bottles have been produced and bottles have been selling for £47. demand rises more than proportionately to an increase in income. Speculative Demand The demand for a product can also be affected by speculative demand in the marketplace. Consider the case of VI which is considered to be the most exclusive perfume in the world. potential buyers are interested not just in the satisfaction they may get from consuming the product. designer clothes. That is. Here. and top of the range cars.. When prices are rising. The speculative demand for housing and for shares might come into this category.39 - perfumes. speculative demand may grow. Goods of ostentatious consumption have a high-income elasticity of demand.500 each – a classic case of paying through the nose for an exclusive good.
If the price of the good varies. The basic law of supply is that as the market price of a commodity rises. as the price rises from P1 to P2 there is an expansion of supply. so producers expand their supply onto the market.. therefore a higher price is needed to justify the extra output and cover these extra costs of production 3. If the market price falls from P1 to P3 there would be a contraction of supply in the market. Higher prices send signals to firms that they can increase their profits by satisfying demand in the market. 2. New entrants into the market: Higher prices makes it more profitable for other firms to enter the market leading to an increase in supply available for consumers to buy Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . we move along a supply curve. The profit motive: When the market price rises (for example after an increase in consumer demand). Production and costs: When output rises. it becomes more profitable for businesses to increase their output. Producers are responding to price signals when making their output decisions. A supply curve shows a relationship between price and quantity a firm is willing and able to sell. In the diagram above. a firm’s production costs may rise. Explaining the Law of Supply There are three main reasons why supply curves for most products are drawn as sloping upwards from left to right giving a positive relationship between the market price and quantity supplied: 1. Theory of Supply Definition of Supply Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period.40 - 11.
For example a publishing company might see a reduction in the cost of imported paper and inks. if costs increase. Conversely. Energy is typically 5% of the cost of basic industrial processes. businesses cannot supply as much at the same price and this will cause an inward shift of the supply curve. These cost savings can be passed through the supply chain to wholesalers and retailers and may result in lower prices for consumers. electricity makes up 8% of the cost of making glass. 15% of cement and 20%-plus of bricks. An example would be the rising expense of supplying electricity following a rise in the price of crude oil or gas. In 2004 it was announced that the wholesale price of electricity is expected to rise by 10-20% in order to meet the UK government’s targets for reducing CO2 emissions.. though more for some. then it becomes more expensive for British Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . there is a decrease in supply meaning that less will be supplied at each price Changes in the costs of production Lower costs of production mean that a business can supply more at each price. If the supply curve shifts to the right (from S1 to S2) this is an increase in supply.41 - Shifts in the Supply Curve The supply curve can shift. For example if the pounds falls by 10% against the Euro. more is provided for sale at each price. Higher electricity prices will increase input costs for many industries causing a fall in market supply and higher prices if these costs are passed on to consumers further up the supply chain A fall in the exchange rate causes an increase in the prices of imported components and raw materials and will (other factors remaining constant) lead to a decrease in supply in a number of different markets and industries. If the supply curve moves inwards from S1 to S3. For example. A car manufacturer might benefit from a stronger exchange rate because the cost of imported components and new technology is lower.
. and higher prices for paints imported from Eastern Europe. Changes in production 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. Government taxes and subsidies Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .42 - car manufacturers to import their rubber and glass from Western European suppliers.
An example of this is the fishing quota introduced by the EU Commission as part of the European Common Fisheries Policy.. This is designed to reduce market supply and force the price upwards. lower yields and therefore a decrease in supply.43 - Climatic conditions and production yields For commodities such as coffee. Take the example of barley. Sometimes producers may deliberately limit supply through output quotas. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . In part the quota is designed to protect fish stocks from permanent depletion and therefore offer protection for the long term viability of the European fishing industry. An increase in the price of wheat makes wheat growing more financially attractive. climatic conditions can exert a great influence on market supply. The profit motive may cause farmers to grow more wheat rather than barley. Favourable weather will produce a bumper harvest and will increase supply. The number of producers in the market and their objectives The number of sellers (businesses) in an industry affects market supply. supply increases causing downward pressure on price. Changes in climate can have a dramatic effect on prices for agricultural goods such as coffee. Change in the prices of a substitute in production A substitute in production is a product that could have been produced using the same resources. When new businesses enter a market. tea and cocoa. Unfavourable weather conditions will lead to a poorer harvest.
Demand and supply schedules can be represented in a table. supply exceeds demand and at a price below P1. In the diagram above. The weekly demand and supply schedules for T-shirts (in thousands) in a city are shown in the next table: Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . prices where demand and supply are out of balance are termed points of disequilibrium.. In other words. Market Equilibrium Concept of Market Equilibrium Equilibrium means a state of equality between demand and supply. At any price above P1.44 - 12. The example below provides an illustration of the concept of equilibrium. This will cause changes in the equilibrium price and quantity in the market. Changes in the conditions of demand or supply will shift the demand or supply curves. demand exceeds supply. Without a shift in demand and/or supply there will be no change in market price. the quantity demanded and supplied at price P1 are equal.
An increase in consumers’ income or their wealth 3. A fall in interest rates (i. If the current market price was £8 – there would be excess supply of 12.000 T-shirts at each price.e.000 units 3. A change in fashion causes the demand for T-shirts to rise by 4.. The new equilibrium price becomes £4 with 18. A rise in the price of a substitute or a fall in the price of a complement 2. the new equilibrium price is £6 per tee shirt with an equilibrium quantity of 14. borrowing rates on bank loans or mortgage interest rates) Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . The next row of the table shows the higher level of demand. If the current market price was £3 – there would be excess demand for 8. The equilibrium price is £5 where demand and supply are equal at 12. Assuming that the supply schedule remains unchanged.45 - Price per unit (£) Demand (000s) Supply (000s) New Demand (000s) New Supply (000s) 8 6 18 10 26 7 8 16 12 24 6 10 14 14 22 5 12 12 16 20 4 14 10 18 18 3 16 8 20 16 2 18 6 22 14 1 20 4 24 12 1. The entry of new producers into the market causes a rise in supply of 8.000 units 2.000 units 4. Changing consumer tastes and preferences in favour of the product 4.000 at each price.000 units 5.000 units bought and sold Changes in Market Demand The demand curve may shift to the right (increase) for several reasons: 1.
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5. A general rise in consumer confidence and optimism The outward shift in the demand curve causes a movement (expansion) along the supply curve and a rise in the equilibrium price and quantity. Firms in the market will sell more at a higher price and therefore receive more in total revenue. The reverse effects will occur when there is an inward shift of demand. A shift in the demand curve does not cause a shift in the supply curve! Demand and supply factors are assumed to be independent of each other although some economists claim this assumption is no longer valid! Shifts in market supply
The supply curve may shift outwards if there is 1. A fall in the costs of production (e.g. a fall in labour or raw material costs) 2. A government subsidy to producers that reduces their costs for each unit supplied 3. Favourable climatic conditions causing higher than yields for agricultural commodities 4. A fall in the price of a substitute in production 5. An improvement in production technology leading to higher productivity and efficiency in the production process 6. The entry of new suppliers (firms) into the market which leads to an increase in total market supply available to consumers The outward shift of the supply curve increases the supply available in the market at each price and with a given demand curve, there is a fall in the market equilibrium price from P1 to P3 and a rise in the quantity of output bought and sold from Q1 to Q3. The shift in supply causes an expansion along the demand curve.
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Important note for the exams: A shift in the supply curve does not cause a shift in the demand curve. Instead we move along (up or down) the demand curve to the new equilibrium position. The inward shift in supply shown in the left-hand diagram above would be caused by the reverse of the factors listed above, for example a rise in production costs, the introduction of a government tax on producers or difficult climatic conditions that reduce production for farmers. A fall in supply might also be caused by the exit of firms from an industry perhaps because they are not making a sufficiently high rate of return by operating in a particular market. The equilibrium price and quantity in a market will change when there shifts in both market supply and demand. Two examples of this are shown in the next diagram:
In the left-hand diagram, we see an inward shift of supply (caused perhaps by rising costs or a decision by producers to cut back on output at each price level) together with a fall (inward shift) in demand (perhaps the result of a decline in consumer confidence and incomes). Both factors lead to a fall in quantity traded, but the rise in costs forces up the market price. The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market.
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The picture opposite shows daily trading at the International Metal Exchange in London – which sets the prices of commodities such as tin, copper and zinc. The London Metal Exchange provides a global forum for all those who wish to manage the risk of future price movements in non-ferrous metals. The Exchange has developed standardised contracts which assume that on falling due they will result in metal either being delivered or received. Visit the London Metal Exchange web site to find out more about how markets there operate: http://www.lme.co.uk Brands of metal that meet rigorous quality standards are stored in approved warehouses around the world so that metal can change hands - but in reality most contracts are settled out without that taking place. All the trading associated with the Exchange means that the market is highly liquid, transparent and the prices published are seen as a true reflection of demand and supply by trade and industry. Moving from one equilibrium to another Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand outlined in the diagrams in previous pages are reflective of changes in conditions in the market. So an outward shift of demand (depending upon supply conditions) leads to a short term rise in price and a fall in available stocks. The higher price then acts as an incentive for suppliers to raise their output (termed as an expansion of supply) causing a movement up the short term supply curve towards the new equilibrium point. We tend to use these diagrams to illustrate movements in market prices and quantities – this is known as comparative static analysis. The reality in most markets and industries is much more complex. For a start, many firms have imperfect knowledge about their demand curves – they do not know precisely how demand reacts to changes in price or the true level of demand at each and every price level. Likewise, constructing accurate supply curves requires detailed information on production costs and these may not be available. The importance of elasticity of demand The price elasticity of demand will influence the effects of shifts in supply on the equilibrium price and quantity in a market. This is illustrated in the next two diagrams. In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward shift of supply – which leads to a large rise in equilibrium price and quantity and only a relatively small change in the market price. In the right hand diagram, a similar increase in supply is drawn together with an inelastic demand curve. Here the effect is more on the price. There is a sharp fall in the price and only a relatively small expansion in the equilibrium quantity.
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The time period allowed following a price change – demand tends to be more price elastic. 5. 4. The huge range of package holiday tours and destinations make this a highly competitive market in terms of pricing – many holiday makers are price sensitive 2. then demand responds more than proportionately to a change in price i. The % of a consumer’s income allocated to spending on the good – goods and services that take up a high proportion of a household’s income will tend to have a more elastic demand than products where large price changes makes little or no difference to someone’s ability to purchase the product. For example a 20% increase in the price of a good might lead to a 30% drop in demand. the percentage change in demand is exactly the same as the percentage change in price). the percentage change in demand from A to B is smaller than the percentage change in price).e.e. The price elasticity of demand for this price change is –1. Different values for price elasticity of demand 1. If Ped = 0 then demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes – the demand curve will be vertical 2.e. the longer that we allow consumers to respond to a price change by varying their purchasing decisions.. The cost of switching between different products – there may be significant transactions costs involved in switching between different goods and services. In this case. in an economic recession we can cut back on discretionary items of spending 4. If Ped > 1. In the short run.e.50 - 13. the more elastic is the demand for a product because consumers can more easily switch their demand if the price of one product changes relative to others in the market. demand is elastic.5 What Determines Price Elasticity of Demand? 1. If Ped is between 0 and 1 (i. If Ped = 1 (i. economists usually do not bother to put in the minus sign. The degree of necessity or whether the good is a luxury – goods and services deemed by consumers to be necessities tend to have an inelastic demand whereas luxuries will tend to have a more elastic demand because consumers can make do without luxuries when their budgets are stretched. The formula for calculating the co-efficient of elasticity of demand is: Percentage change in quantity demanded divided by the percentage change in price Since changes in price and quantity nearly always move in opposite directions. The number of close substitutes for a good / uniqueness of the product – the more close substitutes in the market. the demand may be inelastic. then demand is said to unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level. For example. We are concerned with the co-efficient of elasticity of demand. then demand is inelastic. demand tends to be relatively inelastic. Producers know that the change in demand will be proportionately smaller than the percentage change in price 3. mobile phone service providers may include penalty clauses in contracts or insist on 12-month contracts being taken out 3. I. Price Elasticity of Demand Price Elasticity of Demand (Ped) Ped measures the responsiveness of demand for a product following a change in its own price. because it takes time for consumers both to notice and then to respond to price fluctuations Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
Consider for example the charges made by car rental firms during the course of a week. The breadth of definition of a good or service – if a good is broadly defined. the consumer becomes much less sensitive to the price of the good in question. the demand for petrol or meat. demand is often fairly inelastic. examples such as cigarettes and alcohol and other drugs can come into this category 7. Demand is more elastic at off-peak times.demand tends to be price inelastic at peak times – a feature that suppliers can take advantage of when setting higher prices. Train fares are also higher on Fridays (a peak day for travelling between cities) and also at peak times during the day 8. leading to lower prices for consumers. Whether the good is subject to habitual consumption – when this occurs. But specific brands of petrol or beef are likely to be more elastic following a price change Demand curves with different price elasticity of demand Elasticity of demand and total revenue for a producer The relationship between price elasticity of demand and a firm’s total revenue is a very important one.. Clearly. or the cheaper deals available at hotels at weekends and away from the high-season. i. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .e. The diagrams below show demand curves with different price elasticity and the effect of a change in the market price. Peak and off-peak demand .51 - 6.
.e. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .25) When demand is elastic – a fall in price leads to a rise in total revenue . a fall in price leads to higher total consumer spending / producer revenue Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit. The % change in demand = 13.for example a 10% fall in price might cause demand to expand by only 25% (Ped = +2. Price £ per unit 20 18 16 14 12 10 8 6 Quantity Units 200 280 360 440 520 600 680 760 Total Revenue £s 4000 5040 5760 6160 6240 6000 5440 4560 13 9 5 1 -3 -7 -11 Marginal Revenue £s Consider the price elasticity of demand of a price change from £20 per unit to £18 per unit.665 (i. quantity demanded and total revenue for a supplier. The % change in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i. highly elastic).e. As price falls. the total revenue initially increases. In this situation when demand is price elastic. in our example the maximum revenue occurs at a price of £12 per unit when 520 units are sold giving total revenue of £6240.52 - • • When demand is inelastic – a rise in price leads to a rise in total revenue – for example a 20% rise in price might cause demand to contract by only 5% (Ped = -0. inelastic).5) The table below gives a simple example of the relationships between market prices.3% following a 20% fall in price – giving a co-efficient of elasticity of – 0. A fall in price when demand is price inelastic leads to a reduction in total revenue.
2 and the firm lowers price by 20% Ped is -4.5 and the firm raises price by 4% Ped is -0. Ped is elastic and a firm raises price. In the left hand diagram. Consider the two charts above. The producer must absorb the majority of the tax itself (i. Good examples include the excise duty on cigarettes (cigarette taxes in the UK are among the highest in Europe) alcohol and fuels. the effect of a tax is still to raise the price – but we see a bigger fall in equilibrium quantity. accept a lower profit margin on each unit sold). Here we consider the effects of indirect taxes on a producers costs and the importance of price elasticity of demand in determining the effects of a tax on market price and quantity. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .. With an indirect tax. the supplier may be able to pass on some or all of this tax onto the consumer through a higher price.e. The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit. Ped is elastic and a firm lowers its price. A tax increases the costs of a business causing an inward shift in the supply curve. Output has fallen from Q to Q1 due to a contraction in demand.0 and the firm lowers price by 15% Elasticity of demand and indirect taxation What happens to total revenue? Total revenue increases Total revenue increases Total revenue decreases Total revenue decreases Total revenue increases Total revenue decreases Total revenue increases Many products are subject to indirect taxation imposed by the government. This is known as shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of demand and supply. When demand is elastic. the demand curve is drawn as price elastic.53 - Change in the market Ped is inelastic and a firm raises its price. Ped is -1.4 and the firm raises price by 30% Ped is -0.
This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.54 - In the right hand diagram above. Ped <1 over most of the range of this demand curve) and therefore the producer is able to pass on most of the tax to the consumer through a higher price without losing too much in the way of sales.g. The price rises from P1 to P2 – but a large rise in price leads only to a small contraction in demand from Q1 to Q2..e. demand is assumed to be price inelastic (i. Usefulness of price elasticity for producers How can businesses make use of price elasticity of demand? Firms can use price elasticity of demand (PED) estimates to predict: • • • • The effect of a change in price on total revenue & expenditure The likely price volatility in a market following unexpected changes in supply – important for commodity producers The effect of a change in indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer Information on the price elasticity of demand can be utilised as part of a policy of price discrimination (or yield management). peak and off peak rail travel Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
55 - 14. When Pes > 1. when there is plenty of spare labour and capital resources available to step up output as the economy recovers. • • If supply is elastic. When Pes = infinity. supply is perfectly inelastic 4. The formula for price elasticity of supply is: Percentage change in quantity supplied divided by the percentage change in price 1.. (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 quickly by supplying these stocks onto the market . In some agricultural markets for example. Supply curves with different price elasticity of supply Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Conversely when stocks are low. then supply is price elastic 2. (3) The ease and cost of factor substitution If both capital and labour resources are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily and quickly be switched (4) Time period involved in the production process Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. supply will be inelastic in response to a change in demand. supply is perfectly elastic following a change in demand Factors that Affect Price Elasticity of Supply (1) Spare production capacity If there is plenty of spare capacity. When Pes < 1. the momentary supply is fixed and is determined mainly by planting decisions made months before. producers can increase output without a rise in cost or a time delay If supply is inelastic. and also climatic conditions. a business should be able to increase its output without a rise in costs and therefore supply will be elastic in response to a change in demand. which affect the overall production yield. When Pes = 0. The supply of goods and services is often most elastic in a recession. Price Elasticity of Supply Price elasticity of supply Price elasticity of supply measures the relationship between change in quantity supplied and a change in price. dwindling supplies force prices higher and unless stocks can be replenished. firms find it hard to change production in a given time period.supply will be elastic. then supply is price inelastic 3.
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or the impact of higher duties on cigarettes on the demand for tobacco and associated externality effects 2. Government intervention in the market: The effects of the government introducing a minimum price (price floor) or maximum price (price ceiling) into a market Elasticity of demand and supply also affects the operation of the price mechanism as a means of rationing scarce goods and services among competing uses and in determining how producers respond to the incentive of a higher market price. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a market e. The elasticity will affect the ways in which price and output will change in a market. the effectiveness of the congestion charge in reducing road congestion. Some relevant issues that directly use elasticity of demand and supply include: 1. And elasticity is also significant in determining some of the effects of changes in government policy when the state chooses to intervene in the price mechanism. The key is to understand the factors that determine the responsiveness of consumers and producers to changes in price. Changes in the exchange rate: The impact of changes in the exchange rate on the demand for exports and imports 3.. Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly power can raise prices in markets to extract consumer surplus and turn it into extra profit (producer surplus) 4.57 - The non-linear supply curve Useful applications of price elasticity of demand and supply Elasticity of demand and supply is tested in virtually every area of the AS economics syllabus.g.
audio visual equipment. The income elasticity of demand is usually strongly positive for • • • • • • Wines and spirits Consumer durables . particularly foodstuffs. The formula for calculating income elasticity: % change in demand divided by the % change in income Normal Goods Normal goods have a positive income elasticity of demand so as consumers’ income rises. It also affects the extent to which changes in economic growth affect the level and pattern of demand for different goods and services. low-priced own label foods in supermarkets and the demand for council-owned properties. The income elasticity of demand in this example is +2.4.e. Examples include the demand for cigarettes. Demand is rising less than proportionately to income. the demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 16% rise in the demand for restaurant meals.0. Income elasticity of demand measures the relationship between a change in quantity demanded for good X and a change in real income. Demand falls as income rises. vegetables and frozen foods Mass transport (bus and rail) Beer and takeaway pizza Product ranges: However the income elasticity of demand varies within a product range.. Long-term changes: There is a general downward trend in the income elasticity of demand for many products. 2. The results are important since the values of income elasticity tell us something about the nature of a product and how it is perceived by consumers. Typically inferior goods or services tend to be products where there are superior goods available if the consumer has the money to be able to buy it. so more is demanded at each price level i. Inferior Goods Inferior goods have a negative income elasticity of demand. Luxuries have an income elasticity of demand > +1 i. there are changes in consumer perceptions about different goods and services together with changes in consumer tastes and preferences. Normal necessities have an income elasticity of demand of between 0 and +1 for example. there is an outward shift of the demand curve 1. One reason for this is that as a society becomes richer.e. if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0. For example the Yed for own-label foods in supermarkets is probably less for the high-value “finest” food ranges that most major supermarkets now offer. Income Elasticity of Demand Income elasticity of demand (Yed) How sensitive is the demand for a product to a change in the real incomes of consumers? We use income elasticity of demand to measure this. 3rd generation mobile phones and new kitchens Sports and leisure facilities (including gym membership and sports clubs) In contrast. You would also expect income elasticity of demand to vary across the vast range of vehicles for sale in the car industry and also in the holiday industry. Demand is highly sensitive to (increases or decreases in) income. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . income elasticity of demand is lower (but still positive) for Staple products such as bread.58 - 15.
In other words.19 0.03 Price elasticity of demand (Ped) n/a -0. The business cycle means incomes rise and fall.69 -0. Now as real price levels have come down and incomes have grown.2 0.uk The income elasticity of demand for most types of food is pretty low – occasionally negative (e.02 0.55 -0. Luxury products with a high income elasticity experience greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the economic cycle Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .1 1. the demand for these products among consumers is not sensitive to changes in the product’s price or changes in consumer income.37 -0.16 -0.gov. A few decades ago. for margarine) and likewise the own price elasticity of demand for most foodstuffs is also inelastic. so millions of consumers are able to fly overseas on short and longer breaks.17 0. Consider the market for foreign travel.59 - What might have been considered a luxury good several years ago might now be regarded as a necessity (with a lower income elasticity of demand).19 0.45 n/a Income elasticity of demand (Yed) 0.37 Source: DEFRA http://www.g. All countries experience a business cycle where actual GDP moves up and down in a regular pattern causing booms and slowdowns or perhaps a recession.defra. For many an annual holiday overseas has become a necessity and not a discretionary item of spending! Estimates for income elasticity of demand The table below shows the estimated price elasticity of demand and income elasticity of demand for a selection of foods: Product All Foods Carcase meat Fruit juices Tea Instant coffee Margarine Share of budget (% of household income) 15.45 -0.15 0. How do businesses make use of estimates of income elasticity of demand? Knowledge of income elasticity of demand for different products helps firms predict the effect of a business cycle on sales. long-distance foreign travel was regarded as a luxury out of the reach of the majority of households..2 0.
8 5.0 2.0 1.4 7. as incomes rise.1 3. but because of differences in income elasticity of demand.6 1. whose income elasticity of demand exceeds +1.8 1.3 3.7 8.60 - The UK economy has enjoyed a period of sustained economic growth over the last twelve years. etc Health Transport Of which Cars Travel Of whichAir Communications Recreation & culture Travel Other.1 1. For normal luxury goods.8 3.0 1.3 14. Income elasticity and the pattern of consumer demand Over time we expect to see our real incomes rise. And as we become better off.2 1.1 15.5 13. So average real incomes have increased.3 5.5 3.6 3.2 5.8 2.4 1. the share or proportion of their budget on these products will fall UK Consumer Spending Shares by Volume (%) Food Alcohol & tobacco Of which Alcohol Tobacco Clothing & footwear Household goods.9 4.5 5.5 7.7 2003 9. 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.6 10.0 6.8 2.6 15..1 6. But the income elasticity of demand will also affect the pattern of demand over time. Clearly what is happening to the relative prices of these products will play a key role in shaping our consumption decisions.3 5. including package holidays Unit 1: Markets and How They Work © tutor2u 2004 1980 14.0 4. the proportion of a consumer’s income spent on that product will rise.4 1.5 1.5 Edexcel AS Economics Course Companion 2005 . we can afford to increase our spending on different goods and services. consumer demand for products will have varied greatly over this period.5 4.8 3.0 1990 11.0 1.1 6.4 1.
1 12.2 9.61 - UK Consumer Spending Shares by Volume (%) Education Restaurants & hotels 1980 1.3 Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .6 2003 1.4 12.7 1990 1..
Indeed in 2004. With cross price elasticity we make an important distinction between substitute products and complementary goods and services Substitutes: With substitute goods such as brands of cereal or washing powder.. We are mainly concerned here with the effect that changes in relative prices within a market have on the pattern of demand. the prices of new cars have been falling.62 - 16. For example. Prices of digital cameras have dropped sharply over the last five years and consequently they are much more affordable to consumers. Data on price indices for new cars and second hand cars is shown in the chart below. Kodak announced that it planned to stop selling its APS and re-loadable 35 mm film cameras in the United States. Demand for digital cameras has soared but conversely demand for disposable cameras and traditional 35mm film cameras declined. in recent years. Cross price elasticity for two substitutes will be positive. India. Canada and Western Europe and refocus their production and sales of 35 mm film cameras into 'emerging markets' such as China. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . This should increase the demand for new cars and (ceteris paribus) reduce the demand for second hand cars and mass transport services such as bus travel. Eastern Europe and Latin America. an increase in the price of one good will lead to an increase in demand for the rival product. A similar example would be the market for digital cameras. Cross Price Elasticity of Demand Cross Price Elasticity of Demand (Cped) Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the price of good Y (a related good).
the cross-price elasticity will be highly negative. Switching to renting The increasing cost of houses has meant the number of people renting property has risen by 18% over the last 10 years. More than two million households now live in private rental accommodation – 327. the North and Wales.000 more than 10 years ago. Adapted from news reports. For example with two close substitutes. The cross price elasticity of demand for two complements is negative The stronger the relationship between two products. Likewise when there is a strong complementary relationship between two products. particularly in greater London. The small case study below suggests that rising house prices have eventually caused a switch in consumer demand towards rented properties. leading to an expansion in market demand for DVD videos. partly because of a sharp fall in housing affordability. the higher is the co-efficient of cross-price elasticity of demand. Unrelated products have a zero cross elasticity.63 - Complements: With goods that are in complementary demand..Prices continued to rise fastest in Scotland. compared with three out of five in 1994. The average cost of a home in the UK home has risen to £154.299. with an improving labour market in the south. such as the demand for DVD players and DVD videos. July 2004 Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . the cross-price elasticity will be strongly positive. when there is a fall in the price of DVD players we expect to see more DVD players bought. Cross price elasticity of demand and the housing market Another good example of cross price elasticity of demand is the relative demand for buying a property and renting accommodation in the UK housing market. First-time buyers are struggling to buy – just two in five people buying their first home are now aged between 18 and 30. The typical rented property is now occupied by single adults in their 30s with a high disposable income. leading to a modest resurgence.
many of whom have made adjustments to their business model and pricing strategies to cope with the increased competition. soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements.. popcorn. For example. When consumers become habitual purchasers of a product. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . the cross price elasticity of demand against rival products will decrease. of a two-for-one cinema ticket offer on the demand for popcorn.64 - How can firms make use of cross price elasticity of demand? Pricing strategies for substitutes: If a competitor cuts the price of a rival product. This reduces the substitution effect of a given price change and makes demand less sensitive to price. There are many aims behind this. many businesses spend huge amounts of money every year on persuasive advertising and marketing.e. The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into the cinema. This has been a major challenge to the existing and well-established national air carriers. If firms have a reliable estimate for Cped they can estimate the effect. increase their total revenue and turn consumer surplus into higher profit. pop corn costs pennies to make but sells for more than a pound. two or more airlines competing with each other on a given route will have to consider how one airline might react to its competitor’s price change. Pricing strategies for complementary goods: For example. Advertising and marketing: In highly competitive markets where brand names carry substantial value. say. firms use estimates of cross-price elasticity to predict the effect on the quantity demanded and total revenue of their own product. Will many consumers switch? Will they have the capacity to meet an expected rise in demand? Will the other firm match a price rise? Will it follow a price fall? Consider for example the cross-price effect that has occurred with the rapid expansion of low-cost airlines in the European airline industry. Popcorn has a high mark up i. including attempting to shift out the demand curve for a product (or product range) and also build consumer loyalty to a brand. The result is that firms may be able to charge a higher price.
.65 - Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .
package holidays for example).66 - 17. (New lost cost airlines have entered the market and existing airlines have expanded their route network and fleet capacity). In this revision focus we will consider some examples of such inter-relationships and bring in concepts such as • • • • Cross price elasticity of demand for substitutes and complements Derived demand Composite demand Joint supply A change in market supply and demand in two markets In the first example we consider the huge increase in the market supply of low-cost flights available from airports across the United Kingdom. Assuming that British tourists can choose to holiday at home or overseas and regard the two products as substitutes. fluctuations in supply and demand conditions in one market inevitably affect the incentives and decisions made by producers and consumers in other markets. Inter-relationships between Markets Inter-relationships between markets Supply and demand analysis can be used to explain and understand inter-relationships between different markets and industries. Consider the possible effect on the domestic UK tourist industry. A fall in the relative price of airline flights increases the market demand for overseas holidays (short city breaks. The market supply of flights has shifted out to the right.. Assuming other factors remain constant (for example the exchange rate and the growth of incomes in other countries whose tourists might choose the UK as a venue for a holiday). probably by far more than the increase in market demand. The net result is a reduction in the average real price of flights to short-haul destinations in Europe. then the effect is to reduce the Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . For example.
Sony led the global digital camera market in 2003. storing and printing their images. so too does demand for printing paper. The growth of market demand for digital cameras Consider this example using an extract drawn from an article in USA Today in April 2004: Global demand for digital cameras is expected to climb 39% in 2004 and top 100 million units by 2008. profit margins and leading to the risk of excess capacity in the UK tourist industry. The dramatic year-overyear rise in shipments is likely to slow each year as the market becomes more mature and as mobile phone makers increase the picture-taking powers of their handsets. which record images on memory chips instead of film. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Demand-side threat to other markets: The change in consumer demand represents a competitive threat to mobile phone manufacturers – they are having to respond by becoming more innovative in terms of what their mobile phone handsets can do Macroeconomics and market effects Another good example of inter-relationships is how macroeconomic developments in one country affect the prices of goods and services that we consume in our own economy.. Complementary products: As demand for digital cameras increases. Consider the recent phenomenal growth of the Chinese economy and the impact that it has had on demand for and prices of many important internationally-traded raw materials and commodities. Demand for digital cameras. What are the inter-relationships between markets in this example? 1. followed by Olympus and Eastman Kodak. according to an industry report. If others follow suit. Substitute products: The growing demand for digital cameras is causing a fall in demand for analogue cameras that rely on taking film to developers – some producers including Eastman Kodak have stopped producing traditional film cameras due to falling demand. continues to grow as consumers become more comfortable with capturing. inks and other accessories used by people who want to print out their favourite images from their desktop or notebook PC 3.67 - demand for holidays in the UK – putting downward pressure on prices. then market supply will also shift inwards 2. with higher resolution at prices comparable to current levels. Point-and-shoot digital camera makers are expected to counter by offering more potent cameras. with an 18% share of units shipped. Canon was second at 16% share.
813 cement plants . The demand for labour is derived from the final demand for the goods and services that we employ labour to produce. For example. China consumed 55 percent of the world's cement. China's growing demand for oil has been one reason crude prices are so high.68 - Chinese growth drives up world commodity prices China’s voracious appetite for raw materials has driven up prices worldwide and created shortages.and they still aren't enough to supply the cement for mammoth projects such as the Three Gorges Dam on the Yangtze River or the stadiums and housing for the 2008 Beijing Olympic Games.more than the rest of the world combined .. the demand for steel is strongly linked to the market demand for new cars. Consider how rising oil prices can feed through to related markets: Derived demand The demand for a product X might be strongly linked to the demand for a related product Y. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . China has 4. In 2003. the construction of new buildings and many manufactured products. 40 percent of its steel and 25 percent of its aluminium. Talk of an economic slowdown engineered by the Chinese government is pricking up ears from Chilean copper mines to Minnesota soybean fields.
Conversely in a recession. butter and other products. ceteris paribus there is less available for butter. residential properties. common land and so forth.. yoghurts. use in petrochemicals etc.69 - So when the economy is enjoying a strong upturn in aggregate demand. The most commonly quoted example is that of milk which can be used for cheese. so too the demand for labour increases. Composite demand Composite demand exists where goods or services have more than one use so that an increase in the demand for one product leads to a fall in supply of the other. Another good example is land – land can be developed in many different ways – for commercial property. as real national output declines. Likewise oil has numerous alternative uses – for heating oil. petrol fuel. For example an expansion in the volume of beef production will lead to a rising market supply of beef hides. Joint supply Joint supply describes a situation where an increase or decrease in the supply of one good leads to an increase or decrease in supply of another. farming. If more milk is used for manufacturing cheese. cream. so we see a fall in the demand for labour at each prevailing wage rate. A contraction in supply of lamb will reduce the supply of wool Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . leisure facilities.
affecting the demand for heating oil. China now accounts for 7. 2. They hope that by the time the contracts are ready to be fulfilled. they will have made a large profit. purchasers hoping for a rise in prices on world markets). Market speculation: There is also a speculative demand for oil (i. A basic study of the oil market is a useful application of the principles of supply and demand analysis..g. Indeed one of the features of the most recent spike in oil prices through the spring and summer of 2004 has been the high level of speculative demand by hedge funds and other investors pouring in the international petroleum exchanges to buy up any surplus oil futures contracts. Theory: what determines crude oil prices? Oil is one of the most heavily traded commodities in the world.e.1% of world oil demand and a third of the increase in global oil demand in 2003 is due to the growth in the Chinese economy. then we might expect to see a shift in demand away from crude oil towards the emerging substitutes 3. Changes in climate – e. the demand for oil rises. then the price of crude is almost certain to rise as the USA and Canadian economies raise their demand for oil to fuel household heating systems and workplaces 4. If in the longer term. reliable and relatively cheaper substitutes for oil can be developed.70 - 18. Prices of substitutes: Demand also affected by the relative prices of oil substitutes (e. The demand for oil 1. It is often said that if the winter in North America is particular fierce. 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. the market price of gas). Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . not just for the British economy but for the global economy as a whole.g. manufacturing and service industries. Cyclical demand: There is a strong link between the demand for oil and the rate of global economic growth because oil is an essential input into many industries – when the economy is expanding. Fast growth of national output in energy-intensive sectors has led to a surge in demand for crude oil into the Chinese economy. 15% more than a year ago. China’s burgeoning economy guzzled about 6m barrels per day in the first quarter of 2004. Supply and Demand Application 1 .Oil Prices The importance of oil The ramifications of changes in the price of crude oil traded on the international petroleum exchanges can be far-reaching. The best recent example of this is the extreme growth of the Chinese economy.
oecd.com and http://www. But a rising share of oil demand is coming from the emerging market economies including China. the highest for 13 years.org). the 24 nations that make up the Organisation of Economic Cooperation and Development (http://www. amid fears that economic growth was stimulating an increase in oil demand that producers were struggling to fulfil.. An alternative is to suggest that more oil can be supplied elastically at a fairly constant price until the capacity limit is reached. as production gets close to capacity limits.ft.iea. the short-run supply of crude oil is affected by a series of different factors 1. Just under one fifth of total demand comes from the European Union. when the short run supply curve becomes vertical. there is only one way that prices can head – higher! This headline in a recent edition of the Financial Times says it all! Oil prices moved beyond $40 a barrel yesterday.org – June 2004 Who are the main consumers of oil? The chart below provides a very broad summary. The data shown in the chart below covers the year 2002. the oil industry is supplying from a known level of oil reserves and a given stock of capital used to extract that oil). said that further investment in oil exploration and refining was needed to sustain higher oil consumption from the global economy Adapted from news reports and http://www. In short. Profit motive: The production decisions of OPEC and Non-OPEC countries (see revision notes on OPEC below) Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .71 - The basic economics of oil prices is straightforward! When the global demand for crude oil is rising and if short term supplies of oil in the international markets cannot keep pace with demand.e. The short run supply curve is normally drawn on the basis of a given state of production technology and fixed capital inputs (i. The supply of oil When we consider the global market supply of oil we need to make a distinction between short-term and longer-term supply to the international markets. One possible way of modelling this is to assume the supply curve for oil is non-linear (shown in the left hand diagram below). so the short run supply of oil becomes more inelastic. There is inevitably a short-run limit on daily oil supply and. Chinese demand has soared even higher in the intervening period. The International Energy Agency.e. Nearly two thirds of global crude oil production is consumed by the leading industrialised nations – i.
a high level of stocks means that extra oil supplies can be released onto the market quickly when demand fluctuates 4.72 - 2. even though these may not come on stream for some years. The role and impact of the OPEC cartel Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .. This combination of an inelastic demand and supply helps to explain some of the volatility in world oil prices. Spare capacity: The level of spare production capacity in the oil sector 3. Reserves: Depletion of proven oil reserves – the faster that demand grows. An increase in demand causes a fall in oil stocks at the major international refineries and pushes prices higher. 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 of oil invariably drives market prices higher – this is shown in the diagram below.g. loss of output from rig closures or disruption of oil supplies due to war and terrorist attacks) Taking a longer-term perspective.e. 3. the quicker the expected rate of depletion 2. When oil prices are rising and are expected to stay strong for the foreseeable future. the long run world oil supply is linked to 1. However there are time lags between a change in price and extra supplies coming on stream. identifying and then exploiting new oil reserves. The demand for oil is also price inelastic. Exploration: Investment spending on exploring. Stocks: The current level of crude oil stocks (inventories) available for immediate supply from the major oil refineries – i. This acts as a signal to suppliers to expand production. External shocks: The effects of production shocks (e. it makes financial sense to invest more resources in exploring for new reserves.
Oil is produced in nearly every corner of the world. OPEC sets quotas for how much crude oil they want to produce with the aim of stabilising the price at a target level. Saudi Arabia is the nation with the highest production possibilities and some Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . in the spring of 2004. in the short term. the extent to which. most OPEC countries are producing pretty close to their short run capacity..73 - The Organization of Petroleum Exporting Countries (OPEC) accounts for around 40% of current world supply. The chart below shows production levels for April 2004 together with estimates of spare capacity for OPEC – in other words. This gives OPEC a pivotal influence in shaping the direction of oil prices – but only when the cartel acts together to control production and balance supply and demand in the international market. This includes Europe. The evidence from the previous chart is that. The evidence in recent months is that the OPEC group of countries have been exceeding their planned quotas by up to 2 million barrels per day. and nearly every region has been expanding oil production in the last decade. Even this high level of production though has been unable to stop crude oil prices surging above $40 per barrel. where Norwegian oil companies are achieving a rapid increase in oil extraction and also Russia now one of the world’s largest oil suppliers. Non-OPEC countries account for the largest portion of total supply. they might be able to raise production levels and boost output should they want to and in response to the price signals sent from the petroleum exchanges. There are always major doubts about OPEC’s ability to keep to output limits.
Middle Distillates: a. Diesel . To this extent. Production limits: The decision by OPEC to hold back on oil production at the start of 2004 – although there is now pressure on OPEC to expand their output quotas. Heating Oil 5. The key point from the previous chart however is that the short run supply of crude oil is pretty inelastic when the major producers are close to their capacity limits. The more an industry relies on oil. Other: lubricants.a major external shock to the global economy (particularly if oil prices remain that high). because one pound of sterling now buys more dollars than it did a couple of years ago. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .e. the OPEC producers are quite close to their short run production limits The microeconomic consequences of higher oil prices Crude oil has many uses in many different markets and industries. Major consumers of oil are desperate to guarantee their supplies and are buying forward contracts 3. the price of the oil that we import when translated from US dollars into pounds is not quite as steep. The price increase has not been as great in euro or sterling terms because of a depreciation of the US dollar against these two currencies. bitumen etc For those industries that use oil as a key input into their production process. then a rising price acts as a supply-side shock – leading to higher input costs i. Fuel Oil: boiler fuel for industry. a rise in their variable costs of production. So changes in the global price of oil inevitably have an effect on the microeconomics of particular sectors of the economy Main uses for crude oil: 1. Saudi Arabia could expand supply beyond ten million barrels per day within the space of a few months. the dollar price of crude oil has surged by over 30% . So why have oil prices increased so sharply? The answer is a mix of demand and supply-side factors. A strong recovery in global GDP growth – fuelling an increase in the demand for many essential raw materials and energy products including oil. investors are buying up stocks when they become available and thus driving the price higher. Kerosene – cooking/heating 4. Speculative demand for oil. Jet fuel 3.vehicles and other motors/engines b. the bigger will be the impact of a rise in oil prices on its costs and profitability. Why have crude oil prices risen so sharply in 204? Since January 2004. and hence the bigger the fall in its production is likely to be in the long run. the fall dollar (or the appreciation of sterling) has helped to insulate the British economy from some of the effects of the high price of black gold. Crude oil is traded in dollars – so although the dollar price of crude has jumped above $44 per barrel. power and shipping 6.. Fear about the future supply of oil given the political crisis in the Middle East is also causing higher prices. Because oil inventories (stocks) are low. 1.74 - industry experts believe that if really pushed. However as we saw earlier. A significant influence has been fast growth in the emerging market economies notably China 2. Gasoline: motor spirit/petrol 2.
bp. depending on factors such as the amount of protective hedging they have in place (i.org http://news.com/energy/ http://www. In May 2004 for example. then the supplier may choose to pass on some or all of any rise in variable costs to the consumer of the final product.stm http://www.uk/1/hi/business/3768971.opec.co.iea. absorbing the cost rise and seeking ways to reduce other costs is the best approach.do?categoryId=95&contentId=2006480 http://www. whether they have purchased oil in the futures market) and where they find themselves in the fleet replacement cycle with the introduction of more fuel-efficient aircraft.e.org/ http://news.stm Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .bbc. An airline's fuel bill typically accounts for 12-16 per cent of its total expenditure and is second only to its labour costs. particularly when demand is elastic and there is a fierce battle for market share in the industry.co. however.stm http://news. The extent to which a business is able to pass on an increase in costs depends on the price elasticity of demand for their products.bbc.uk/1/hi/business/904748. Search the web Here are some recommended web links to news articles and relevant web sites that will help to broaden and deepen your understanding of this topic Web link Bloomberg energy prices BP Statistical Review of World Energy 2004 International Energy Agency Oil markets explained Oil prices rise to record highs OPEC The OPEC cartel in profile URL http://www. For some. The impact of the surging oil price varies greatly from airline to airline around the world.uk/1/hi/business/3550590. British Airways decided to impose a £5 surcharge per passenger to compensate for the effects of high oil prices on their cost base..com/subsection. Not every airline has chosen to do this.co.bloomberg. If demand is price inelastic.75 - The increase in costs causes a profit maximising firm to increase price and reduce the equilibrium level of output.bbc.
A Buyers Market When demand for housing is weak during an economic downturn or perhaps when much of the available housing has become unaffordable. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Auctions account for 5% of all property transactions in the UK and they are becoming more popular with both buyers and sellers such as local councils. area or region is high and when there is a shortage of good quality properties (i.. They have the luxury of a much wider choice of housing available and they should be able to negotiate a price that is lower than the published price. That said. at property auctions across the country it was possible to pick up some high quality housing at very low prices. supply-side factors tend to be important in the long run. Demand-side factors tend to be more important that supply-side factors when influencing prices in the housing market in the short run. During the last housing market recession in the early 1990s. Sellers may require a quick sale and this puts extra bargaining power into the hands of buyers. These days. This is because of the importance of the willingness and ability of potential home-buyers to make an offer to purchase a particular property. “Under the Hammer” – the latest genre of housing programme for day-time television provides great viewing for economists who want to understand the psychology of would-be purchasers enticed into the market for individual properties. The housing market in the UK is segmented. cheaper and more open than other ways of buying a property. a growing number of properties are bought and sold using an auction mechanism. A Sellers Market When market demand for properties in a particular locality. It is worth remembering that virtually every individual property has unique characteristics in the marketplace which affects potential demand and value.House Prices Introduction This section focuses on the demand and supply side factors that determine property prices in a market. Indeed early potential buyers may come straight in with an offer in excess of the asking price in order to avoid the possibility of losing the property that they want. Each housing transaction depends on • And • The actual price that the buyer is willing and able to pay.76 - 19.e. supply is said to be scarce) then the balance of power in the market shifts towards the seller. The auction process is often quicker. The seller will often have a reservation price for a property – that is the minimum price that they are prepared to accept from a potential buyer. Each day there are literally hundreds and thousands of separate interactions between buyers and sellers with prices being offered and agreed before a final transaction is made. Supply and Demand Application 2 . The determination of price levels in local housing markets are great examples of microeconomics in action. and when there is a glut of properties available on the market (excess supply). who are putting property through auctioneers. the balance of power switches to potential buyers. Sellers can wait for offers on their property to reach (or exceed) their minimum selling price. The price that the seller is willing to agree for their property with the buyer Buyers place offers for a property that the seller can either accept or reject. There will be excess demand in the market for good properties. Thousands of homes were up for sale by building societies who had repossessed properties from home-owners unable to keep up with their mortgage commitments.
Semi-detached v Detached properties A study by economists at the Nationwide Building Society found that if a semi-detached property was sold. However for the majority of properties. Clearly the final asking price depends on • • The price that the potential buyer is willing and able to pay for a particular property The price that the seller (supplier) is willing to accept for the property The market price of a property depends on many factors. For example. For two identical properties in the same street. Some of these are thought to add extra value to a property when it is eventually put on the market Location location location! The desirability and affluence of the neighbourhood is inevitably a subjective judgement. libraries and other sites of public interest A local state school with an excellent GCSE and A level exam record can add several thousand pounds to average house prices in an area. In March 2002.77 - The Demand for Housing The demand for housing represents the quantity of properties that homebuyers are willing and able to buy at a given price in a given time period. The housing market operates on the basis of an offer system – for a transaction to be completed successfully. an extra bathroom could add as much as 10% to the market price. the greater the value that is contributed by a second bathroom. in the same area was bought. with all the same features. However. Number of bedrooms A rise in the number of bedrooms can add value to a property . and a detached property the same size. it could cost more than 10% more. the potential buyer must agree with the seller on a price. the more bedrooms a property has. in a two bedroomed house a second bathroom would be less desirable than one in a five bedroomed house.e.e. from loft conversions and the construction of conservatories) have a greater impact on the market value than creating more bedrooms from the same floor space. the price is determined by a negotiation process between buyer and seller. Convenience of a second bathroom Prices tend to be higher for properties with more bathrooms. economists found that parents were prepared to spend many thousands of pounds extra for properties located within the catchment areas for highly-rated schools. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .. Extensions to a property (i. Some new property developments are sold in blocks to buyers – for example a new block of flats might become available on the market and purchasers are asked to make an offer for them at a price close to the list price. Factors influencing this would include • • • • Unemployment rates Local crime statistics and the overall reputation of an area (i. leisure centres.but the “valued added” is limited by the total floor space available. is it considered an improving area?) The accessibility of local shopping and transport networks The quality of local schools and hospitals and other civic amenities such as parks.
because of the shortage of space and the price of land a garage will add more to a property in London and the South East than one in Scotland. or are convinced that you need to live in a specific area (perhaps to live within a school catchment area or because you want to be close to friends and family). more than doubles the contribution it makes to the value of a property. For example. two avenues that are often considered are adding. the failure to do some basic DIY before putting a property on the market can have a negative effect on the price that a would-be buyer is prepared to offer for a property.0. The price elasticity of demand for a property depends on the availability of close substitutes – for example the supply of rented housing. although this is true for the UK as a whole there will inevitably be exceptions for different regions and localities. Income Elasticity of Demand for Housing Evidence suggests that the income elasticity of demand for housing in the UK is positive. buyers are still willing to pay a premium for the benefit of living in a new home. we expect demand to be inelastic. And. Income elasticity of demand varies across different types of property – but the data suggests that the aggregate demand for housing in Britain is sensitive to the macroeconomic cycle and that changes in the growth of real GDP and unemployment can have a big effect on demand from year to year. Specific local factors can often have a dramatic effect on house prices.imf. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Adding a double garage. Homeowners often exaggerate the effect that individually-styled home improvements can have on a property’s market value! Equally. The International Monetary Fund (www. This is likely to reflect that new properties have builder's warranties that will cover some of the repair and maintenance costs associated with newly constructed properties. or enlarging a garage. The elasticity of demand tells us much about consumers’ willingness to pay. If you have set your heart on a particular property. although another recent study from PriceWaterhouseCoopers finds that the Yed is closer to +0. The land available for a double garage is often at a premium . and will tend also to incorporate modern building technology.org) report on the UK economy published in March 2003 quoted research work which finds that estimated long-run income elasticity of demand range from +1. rather than a single one. When housing is regarded as a necessity and when there are few close substitutes available..7 through to +3. However. For example the types of businesses located near residential areas. Either way. the impact of new road and by-pass developments and other projects that require planning permission and fluctuations in the strength of the local and regional economy. This may well force up the eventual market price when a transaction is agreed. and would therefore generate an extra premium over newer houses.9 in the long run. Estimates for income elasticity of demand may have been influenced by the strong speculative demand for housing which is a characteristic of the British owner-occupied housing sector.there is a trend towards two or three car family units. Price Elasticity of Demand for Housing Price elasticity of demand measures the responsiveness of demand for a product to a change in its own price. demand for housing grows when real incomes are rising. In rural locations good quality period properties are likely to be the most sort after. and adding central heating. then you will be far less sensitive to the market price and demand will become inelastic. many households make use of the extra garage space to add extra utilities such as extra freezer units. New properties can command a price that is around 7% higher than an equivalent second hand property. Again this will vary between different regions.78 - Home improvements When improving a property. New and second hand homes Despite the recent fashionable trend towards period properties.
The income elasticity of demand for property is higher for the most expensive properties (i. as does demand for more expensive properties as people move “up market”. Recent changes in the overall level of UK house prices are shown in the chart above.. As living standards rise.e.79 - Price An elastic demand for housing Supply Price An inelastic demand for housing Supply P1 P2 D1 D2 Q1 Quantity Q2 Quantity Aggregate Demand for Housing The total market for owner-occupied housing in Britain is generally regarded to be sensitive to changes in demand and supply. demand for housing expands. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . The Growth of Real Incomes and Earnings Privately owned housing is a normal good. The strength of these factors often explains differences in house price inflation between and within the regions of the United Kingdom. luxury housing) although consumers may actually become less sensitive to price.
employment and confidence are critical in determining the direction of house prices. We will now consider two of them – housing affordability and mortgage interest rates: Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . These factors. They also affect the relative rate of return on different forms of financial investment. If expectations for the future performance of the economy deteriorate and people become less optimistic about their own financial circumstances. Rising unemployment for example can reduce demand for all types of housing because confidence is low. Unemployment in the UK is currently at a thirty year low with less than 900. incomes. Real GDP has increased every year since 1991 and the economy is now nearly thirty per cent bigger than it was at the end of the last recession. Economic Growth When the economy is enjoying sustained growth and rising prosperity.000 people counted as unemployed during the claimant count measure and just 5% of the workforce out of a job using the labour force survey measure. In areas when unemployment is persistently above the national average.80 - Interest Rates Since most homes are purchased with the aid of a mortgage. incomes are likely to be lower and confidence among buyers will be negatively affected (see the section in the Study Companion on regional house variations). Consumer confidence Consumer confidence is vital in the housing industry. When these three factors are rising the conditions are normally in place for sharp upward movements in prices.. for example the return from saving in a bank or building society account rather than using spare funds to purchase properties subsequently used for letting to other tenants. The British economy is currently enjoying the longest phase of economic growth for over forty years. The rate of economic growth has slowed down in 2002 and 2003 but a recession has been avoided (in contrast to our near neighbours France and Germany) and growth is forecast to pick up quite strongly during 2004. However other economic variables also come into play. they may be tempted to delay entry into the market for property. improved confidence raises the number of homebuyers and shifts the balance of power in the market towards the seller if properties are in short supply. changes in interest rates affect demand for housing. Unemployment Financing a house purchase involves making a long-term commitment through a mortgage lender.
The acceleration in house prices in the late 1990s and early years of the new decade has taken the affordability measure up above 4. One approach shown in the chart above is to calculate the ratio of house prices to average incomes. Mortgage Interest Rates and Housing Demand What is a mortgage? A mortgage is a loan to finance the purchase of a commercial or residential property. Again when prices and interest rates are low by historical standards. The main reason is that mortgage interest rates are lower than at any time in the last twenty years. compared to 46% in the late 1980s. affordability worsened because of rampant house price inflation. potential homebuyers will be attracted into the market in the expectation that they can keep up with their mortgage commitments. Many fixed rate loans and virtually all discounted offers have a sting in the tail in that people are required to remain with the chosen mortgage lender¹s variable rate for some years after the initial deal expires.. Mortgages are generally linked to the income of the borrower and the property is used as security for the loan. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . in 2002. a fixed rate loan or a discount rate. According to figures released by the Council of Mortgage Lenders.5-times average incomes – the highest figure for a decade. most housing experts believe that housing in the UK remains affordable by historical standards. This then opens up the supply of lower-priced housing on the market and provides incentives for younger firsttime buyers to find their ideal starter-property. which offers a discount on the variable rate. Variable and fixed rate mortgages The mortgage choices available to home-buyers are a variable rate. A second approach in measuring housing affordability is to calculate the percentage of disposable income taken up by monthly mortgage repayments. Because most homes are purchased using a mortgage.81 - Housing Affordability Affordability can be expressed in several ways. In the housing boom of the late 1980s. Rising prices have “priced many people out of the market” There are significant regional variations in the figures and wide differences between local areas – but despite this. this encourages people to move up the housing ladder into more expensive properties. Prices then collapsed during the recession of the early 1990s before stabilising over the next few years. only 37% of new households in England could afford to buy a house. Notice here the inter-relationships between different parts of the housing market. if prices are low relative to incomes.
the standard variable mortgage rate was 15. the Standard Variable Rates varied from 15. the average rate was 6.5%. Further information on different kinds of housing mortgages are available from the Guardian Money Site • Mortgage rates normally follow the trend in base interest rates set by the Bank of England although they don’t have to necessarily.75%.4%. In the 1990s.4% to 6. Historical background At the beginning of the 1990s. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . This offers some protection from the threat of rising interest rates.5%. In the 1960s. Discount rate mortgages: peg the interest rate to a fixed amount below the variable rate.82 - • Fixed rate mortgages: fix the monthly interest repayment over a set period of time. The intensity of competition in the market for mortgage lending also dictates whether the main lenders immediately follow through a Bank of England rate change with alterations in their own lending terms and conditions. for the 1970s. the Building Societies Association stopped setting the official mortgage rate and a free market was possible for the first time by 1986. the mortgage cost reverts to the lender's standard variable rate. the average rate had risen to 12. In November 1984. Back in the 1950s. By the 1980s. Much depends on how successful the mortgage lenders are in attracting fresh savings deposits that they can use to lend out to new borrowers.07%. After the end of the fixed rate period.. it was 10. regardless of what happens to interest rates. it was 5% and there were only six rate changes over the decade.
Expectations of future price movements and housing demand Expectations of changing prices can have a considerable bearing on the demand for all types of property. Anyone who takes out a mortgage worth more than 75% of the house’s market value must also take out insurance to protect the lender against the borrower not paying the mortgage. Thousands of existing homeowners took advantage of the chance to re-mortgage their properties with a new finance supplier and reduced their monthly repayments at the same time.. This is because they have a lower level of accumulated savings. Should housing to be regarded as a consumer durable that provides a flow of Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . or two-and-a-half time’s joint income. Most lenders are prepared to lend 95% of the property's estimated market value but most charge less interest with a bigger deposit. Typically first-time buyers in the market take out mortgages that are a higher percentage of the asking price for the property. One feature of the UK housing market in the latter part of the 1990s was greatly increased competition between mortgage lenders including competition from other countries inside the European Union and the opening up of online mortgage finance via the internet. Consider this basic question.83 - Potential homeowners are normally limited to borrowing three times their first income plus half of the second income.
Supply is also restricted by the limited availability of skilled labour such as bricklayers and electricians and other factor inputs needed in the construction process.. These factors. Supply-side Factors in the UK Housing Market Supply-side factors are important in setting price levels at a local and national level. Why is housing supply so inelastic? Construction companies cannot suddenly plan and then build thousands of new homes in areas when there is an increase in consumer demand. One reason is the impact of planning regulations and constraints on new housing developments – where local authorities may restrict the building of new property in accordance with their local housing plans. This implies that house prices in the short term are determined almost exclusively by demand factors. as an investment that we expect will provide us with substantial capital gains? The answer is probably a mix of the two! Rising prices in the late 1990s and the early years of the new decade has made housing a desirable form of investment. together with time delays in construction projects mean that the supply of newly built properties is limited. Indeed in 2002 the number of new homes that came onto the market was at one of the lowest levels for nearly forty years. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Large increases in house prices do not seem to lead to significant increases in the amount of land made available for housing developments. The evidence is that the pace of new house building in the UK has not increased at all since the housing market came out of recession in 1994-95. Changes to the system of housing taxes and subsidies Government economic policies affect the housing sector many ways ranging from benefits for council taxpayers on low incomes to the payment of stamp duty on the most expensive properties.84 - services to the owner over a long period? Or should we think of a house purchase. Price Elasticity of Supply of New Housing The supply of new housing is price inelastic in the short run.
the “pent-up demand” for properties carrying desirable postcodes can send housing values soaring. Often the level of housing supply impacts on property valuations in a highly localised way. Conversely when there is a large rise in the market supply of housing we expect to see lower prices for a given level of market demand.85 - Price A fall in supply puts upward pressure on equilibrium house prices S2 S1 S3 P2 An increase in housing supply causes prices to fall (ceteris paribus) P1 P3 Housing Demand Q2 Q1 Q3 Quantity Supply of Older Housing The supply of older properties plays a key role in affecting the balance of demand against supply. Particular areas of a town or city can become hugely popular but if supply is limited. This depends on the number of people putting their homes on the market when they move from an area or people choosing to upgrade to a more expensive house with a particular area. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 ..
we expect to see downward pressure on prices and a further increase in the equilibrium quantity of houses bought and sold. The size of the rented sector in Britain is substantially below other European countries. overtime payments and employer national insurance contributions etc) Costs of purchasing land for housing development Costs of purchasing building components and raw materials Costs associated with achieving the required planning consent from local authorities The number of construction companies in the market and their business objectives The extent to which the construction industry is able to achieve economies of scale in house building and reduce their constructions costs by implementing innovation in building projects Government taxation and subsidy of new housing developments (e. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . there is upward pressure on market prices. But there are signs that the private “buy-to-let” market has reversed the long run trend.g. As supply becomes more elastic over time (shown in the right hand diagram in the figure above) assuming the conditions of demand remain unchanged. or a rise in incomes following a fall in unemployment.. grant aid and other forms of public funding for housing developers building properties for key workers / public sector employees and financial support for other forms of social housing) Rented Housing Currently less than one third of properties in the UK are available for rent from private landlords or from local authorities or housing associations. Factors Affecting New Housing Supply These can be summarised as follows: • Costs of production for construction companies o o o o • • • Employment costs (including wages.86 An Outward Shift in Housing Demand – Long Run Market Supply is more elastic Price An Outward Shift in Housing Demand – Short Run Market Supply is inelastic Price SRS SRS LRS P1 P2 P1 P2 D2 D1 Q1 Q2 Quantity Q1 Q2 Q3 D2 D1 Quantity When demand for housing increases perhaps because of an inflow of population into the area.
An Expansion of Buy-To-Let Schemes “Buy-to-let” occurs where people purchase properties and then let them out to tenants. The economic recession of the early 1990s forced thousands of people to abandon their owner-occupied status and enter the rental market – they then faced severe shortages of decent quality accommodation.87 - 1988 Housing Act – The End to Rent Controls For many years. The 1988 Housing Act ended the system of rent controls. By the mid 1980s it became clear that the shrinking size of the rented sector was acting as a constraint on the growth of the economy and was forcing up rent levels for families on low incomes. There are now more than two and a half million households living in a property rented from a private landlord. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . From the mid 1990s onwards the UK rented sector was changed by an explosion in the demand for buy-to-let properties. Landlords could now set their rents freely although it also meant that private tenants had reduced security of tenure.. the effect of rent controls was to reduce the supply of privately rented housing available for tenants. This has the effect of increasing the market supply of rented properties.
the supplier may be able to pass on some or all of this tax onto the consumer through a higher price. the effect of a tax is to raise the price – but we see a bigger fall in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand. alcohol and fuel and also value added tax. The producer must absorb most of the tax itself (i. In the left hand diagram. demand is elastic meaning that demand is responsive to a change in price.Indirect Taxation What are indirect taxes? An indirect tax is imposed on producers (suppliers) by the government.88 - 20. Taxes are levied by the government for a number of reasons – among them as part of a strategy to curb pollution and improve the environment.e. accept a lower profit margin on each unit sold). This is known as shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of demand and supply. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax. In the right hand diagram above demand for the product is inelastic and therefore the producer is able to pass on most of the tax to the consumer through a higher price without losing too much in the way of sales.. When demand is elastic. A tax increases the costs of a business causing an inward shift in the supply curve. Examples include excise duties on cigarettes.
7 billion of tax revenue for the British Government. Consider the next two diagrams. Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .. In 2000. An example of this is the high level of duty on cigarettes and petrol. Taxation. tobacco duty brought in £5. elasticity of demand and government revenue The Government would rather place indirect taxes on commodities where demand is inelastic because the tax causes only a small fall in the quantity consumed and as a result the total revenue from taxes will be greater.89 - Who pays the tax? The burden of taxation We make use of supply and demand diagrams to show the actual burden of the tax – in other words from whom does the government get its revenue when a tax is introduced.
. The new supply schedule is shown in the right hand column of the table – less is now supplied at each and every market price Find the new equilibrium price after the tax has been imposed Calculate the total tax revenue going to the government How have consumers been affected by this tax? There has been a fall in quantity traded and a rise in the price paid by consumers – this leads to a fall in economic welfare as measured by consumer surplus New price =£8 Tax revenue = £450 3 4 5 Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .90 - Illustrating the effects of a producer tax The table below shows the demand and supply schedules for a good Price (£) 10 9 8 7 6 5 4 Quantity Demanded 20 60 150 260 400 600 900 Quantity Supplied (Pre-tax) 1280 1000 850 600 400 150 50 Quantity supplied (Post-tax) 600 400 150 50 1 What is the initial equilibrium price and quantity? Price = £6 Quantity = 400 2 The government imposes a tax of £3 per unit.
Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .91 - Examples of indirect taxes in the UK Value added tax VAT standard rate VAT domestic fuel rate Insurance Premium Tax Excise duties Beer (pint) Wine (75cl bottle) Spirits (70cl bottle) 20 cigarettes Unleaded petrol (litre) Unleaded petrol (litre) for ultra-low sulphur Specific duty Ad valorem (22% of retail price) 27. an ad valorem tax has been imposed on producers.1p 119p 548p 194p 93 48..5% 5% 5% Air passenger duty Low rate (for destinations within the EU) £10 High rate (for destinations outside the EU) £40 Source: Institute for Fiscal Studies “Fiscal Facts” for 2003-04 http://www.uk Specific taxes A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint of beer is 27.org.ifs.82p 17.1 pence or 194p per packet of twenty cigarettes. The market equilibrium price rises from P1 to P2 whilst quantity traded falls from Q1 to Q2.5% or Insurance Premium Tax which is taxed at 5%. In the diagram below.82p 45. Another example is the air passenger duty which imposes a standard tax of £10 for flights within the European Economic Area (EEA) and £40 for flights outside of the EEA Ad valorem taxes Where the tax is a percentage of the cost of supply – the best example of this is value added tax currently levied at the standard rate of 17.
4 55. the specific duty on cigarettes has nearly doubled from 105 pence in 1994 to 200 pence after the March 2004 Budget.3 VAT Total Tax Tax as % of Price Specific Duty as % of Total Tax 56. Tobacco taxation is a good example of a product on which both specific and ad valorem taxes are applied.7 165.6 In recent years the government has encouraged a switch away from direct taxation on income towards indirect taxes on the goods and services that we buy and then consume.92 - Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve. When we add value added tax to the equation.75 when VAT of 17. the Air Passenger Duty and the Landfill Tax Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 . Over the last ten years.4 80.0 54. Total taxation as a percentage of the price has remained fairly stable over the last decade at 80 – 81 per cent.7 Specific Duty 104.4 66.5% is applied whereas a different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied. The absolute amount of the tax will go up as the market price increases. A wider range of indirect taxes has been introduced including the Insurance Premium Tax.0 81. the total tax on a standard packet of twenty cigarettes has grown from 186 pence in 1994 to 365 pence in 2004.4 83. So a good that could be supplied for a cost of £50 will now cost £58. The data below is taken from information produced by the UK Customs and Excise and breaks down the taxation of cigarettes for a typical brand in the mid-price category. This is because the tax is a percentage of the unit cost of supplying the product.6 365.6 Ad Valorem Duty 46.6 54.8 34.9 81.2 199. Taxation on Cigarettes Typical Brand In Mid Price Category (for a pack of 20 cigarettes) Typical Price 1994 2000 2004 Mar 232 367 449 Pre-tax Price 46.7 66.3 80.. Cigarette taxation in the UK is the highest among European Union nations.6 300.7 98.9 185.
stm http://news.uk/1/hi/uk/3903347.uk/1/hi/business/3931403.co.co..uk/1/hi/world/europe/3762769.co. August 2004 Search the web Here are some recommended web links to news articles and relevant web sites that will help to broaden and deepen your understanding of this topic Web link French tobacco tax hits sales WHO urges tougher tobacco rules Smoking curbs – the global picture Tolls could replace congestion tax Calls for fuel tax on aviation How green are Mr Brown’s taxes? URL http://news.bbc. The average cost of a packet of twenty cigarettes is now around five euros (£3. The latest official figures show that tobacco sales have dropped by 20 per cent since the government introduced a 30 per cent increase in tobacco duties in October 2003.uk/1/hi/world/3758707. Adapted from news reports.bbc.co.uk/1/hi/business/3224305.stm http://news.stm http://news. But tobacconists in regions bordering France's neighbours claim that their businesses have been badly hit by the tax increases.bbc.stm Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .bbc.93 - Taxes hit tobacco sales in France Smokers are reducing their demand for cigarettes or turning to crossborder trade for their supplies following a sharp rise in tobacco taxation in France.50).uk/1/hi/sci/tech/3625931.co.co.stm http://news.bbc. The anti-smoking campaign was launched by President Jacques Chirac in an effort to cut down on smoking-related diseases and cancer.bbc. The average cost of a pack of cigarettes in Spain is 50% less. while prices in Germany and Italy are around 70% of those in France.stm http://news.
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A question of subsidy Should government money be used in subsidies to help businesses in financial trouble? The age-old issue of the arguments for and against subsidy has resurfaced in recent years as several sectors of the economy have experienced difficulties. They range from farming to coal mining to steel production and the aviation industry. The consensus seems to be that subsidies may create more problems than they solve. And, that an existing market failure that might be used as part justification for a subsidy can serve to deepen the problem, giving rise to the existence of government failure arising from intervention in the price mechanism. Subsidies can have the effect of distorting the allocation of scarce resources and damage the competitiveness of markets in the long-run. The European Union and State Aid State subsidies are certainly an important issue within the European Union. The EU Competition Commission is concerned to gradually reduce the scale of state aid given to businesses operating within the EU. The aim is to provide more of a “level playing field” between competing suppliers. There remain loop-holes in the system because state aid is permitted if it is part of a restructuring process for industries in long-term decline or where there is substantial excess capacity. The subsidy issue is also important as the European Union has recently expanded to twenty five nations in May 2004. The majority of the new entrants to the EU are transition economies, still in the process of making the adjustment from state-owned and state-financed production to the position of a largely private-owned economy having to compete in European markets. Government Subsidy A subsidy is a payment by the government to suppliers that reduce their costs of production and encourages them to increase output. The effect of a government subsidy is to increase supply and (ceteris paribus) reduce the market equilibrium price. The subsidy causes the firm's supply curve to shift to the right. The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output. Occasionally the government can offer a direct subsidy to the consumer – which has the effect of boosting demand in a market Different Types of Producer Subsidy (1) A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price offered to farmers (2) An input subsidy which subsidises the cost of certain inputs used in production – e.g. an employment subsidy for taking on more employees (3) Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry (4) Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e.g. as part of a regional policy designed to boost employment
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Showing the effect of a subsidy to producers
To what extent will a subsidy feed through to lower prices for consumers? This depends on the price elasticity of demand for the product. The more inelastic the demand curve the greater the consumer's gain from a subsidy. Indeed when demand is perfectly inelastic the consumer gains most of the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price. When demand is relatively elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a much lower market price.
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The Economic and Social Justifications for Subsidies Why might the government be justified in providing financial assistance to producers in certain markets and industries? How valid are the arguments for government subsidies? (1) To control the rate of inflation and boost the real living standards of some groups of consumers – for example lower income households. (2) To encourage the provision and consumption of merit goods and services which are said to generate positive externalities (increased social benefits). Under-consumption or provision of merit goods can lead to market failure causing a loss of social welfare (3) Maintain or increase the revenues (incomes) of producers during times of special difficulties in markets (consider some of the examples mentioned below) (4) Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply (5) Subsidies to smooth or slow-down the process of long term structural change/decline in an industry (for example in farming, coal, fishing and steel) (6) Boost employment for certain groups of workers e.g. the long term unemployed Subsidies in the News Current issues regarding subsidies (1) The railways: Government financial help to the ailing railway industry in the UK has accelerated since 2000 the year of the Hatfield rail disaster. In 2001 total state aid to the UK railway sector was Euro 6.8 billion, over twice the level of 1997 and nearly two-thirds of total UK government financial assistance. Much of the extra state funding is required to over-haul the track infrastructure and meet requirements for improving passenger safety. Network Rail is the successor the Railtrack which was forced into administration in October 2001. Network Rail is run on a not-for-profit basis whose funding for rail maintenance comes from the Strategic Rail Authority (SRA) and from access charges to the train operating companies. The SRA also offers subsidies to the majority of the train operating companies to ensure the provision of loss-making services. (2) The coal industry: There has been a huge decline in the scale of coal production in the UK over the last twenty years. Much of our demand for coal now comes from cheaper imports from countries such as South Africa and demand has also been affected by the switch towards gas partly on grounds of the environmental effects of using sulphur-rich coal. Is there a case for continued subsidy of what remains of our coal industry? Thousands of jobs still depend directly or indirectly on keeping the few remaining pits open even if, on economic grounds, there is little justification in maintaining production. On grounds of equity, the government may decide that further financial assistance is required to prevent structural unemployment and poverty in areas where coal mining is still an important source of employment. There may also be a strategic motivation behind subsidies - to give the UK an alternative fuel supply if gas and oil are cut off. (3) Agriculture:
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bring with them some huge problems. and to keep trade balances positive. Inevitably the reduction in production subsidies will affect some farmers more than others. insurance policies and price supports.removing the direct link between how much farmers produce and the subsidy that they can claim. Subsidies can range from simple ad valorem payments to companies based on the size of their export sales. export subsidies may crowd out competing trade from other countries whose governments are too poor to retaliate Adapted from the Economist. Farmers will be paid an income to reflect their contribution to maintaining the rural environment and subject to them meeting tough standards for good farming practice. At the heart of the reforms is the concept of decoupling . Might the money used up in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an opportunity cost and in the long run there might be better ways of providing financial support to producers and employees in specific industries. however. There will be a switching of CAP funds away from production incentives towards rural economic development and diversification. The Fischler Reforms to the CAP agreed in June 2003 are now being implemented and seem certain to have a significant effect on the farming industry in the years to come. These policies. Any company coddled by a subsidy has less incentive to improve its costs (and hence make the subsidy unnecessary). Going too far in support of trade Several economic justifications are offered for the existence of export subsidies. This adapted article from the Economist (published in December 2000) considers some of the disadvantages of export subsidies used by both developed and developing countries. The Economic Arguments against Producer Subsidies The economic and social case for a subsidy should be judged carefully on the grounds of economic efficiency and also fairness (or equity). Besides harming domestic producers in poor importing countries. All countries subsidise their agricultural sectors to one degree or another. Export subsidies distort the free trade in goods and services and can severely curtail the ability of ELDCs to compete in the markets of industrialised countries © tutor2u 2004 Edexcel AS Economics Course Companion 2005 Unit 1: Markets and How They Work . Farmers in the UK currently receive around £2 billion worth of subsidy under the Common Agricultural Policy (CAP).this can lead to a misallocation of resources – many economists believe that the free-market mechanism works best. to complex systems of tax credits. We need to be careful to measure and evaluate who gains from any particular subsidy and who pays. And artificially low prices supported by subsidies may force more efficient producers in importing countries out of business. to promote employment. to compensate for protectionism abroad. December 2000 (i) Distortion of the Market: Subsidies distort market prices . They include the need to nurse infant industries. Free market economists argue that government subsidies distort the workings of the free market mechanism and can eventually lead to government failure where government intervention actually leads to a worse distribution of resources.. loans. The future of many smaller scale farmers remains in doubt.97 - Farm subsidies invariably give rise to strong opinions and controversy. Tax revenues used for subsidies are distributed in a way that makes them regressive.
it delays much needed economic reforms Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects.98 - (ii) (iii) (iv) (v) (vi) (vii) Arbitrary Assistance: Decisions about which groups or industries receive a subsidy can be arbitrary – if tourism is supported. why not the British steel industry? Financial Cost: Subsidies can become expensive – note the opportunity cost! Who pays? Who benefits?: The final cost of a subsidy usually falls on consumers (tax-payers) who themselves may have derived no benefit from the subsidy Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i. for example by direct income support through the tax and benefit system Unit 1: Markets and How They Work © tutor2u 2004 Edexcel AS Economics Course Companion 2005 .e..
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