Solutions To Titley

Part 1 The basic economic problem

Activities: Guidance and answers
Activity 1.1 Needs and wants
1 The needs they have in common are food, clean water, shelter, security.
2 The household in B will not be able to satisfy all its needs.
3 Wants of family A would include a nice home and garden, many different
household goods, a car, holidays, good education and health care, a good
choice of restaurants, sports and leisure activities, etc.
4 Wants of family B would included a better home, more food, household
goods, good education and health care.
5 There are not enough resources to produce all the goods and services
everyone needs and wants.
6 Our needs have to be satisfied in order to survive. Our wants are good to have
but are not necessary to preserve life.
7 Human needs and wants will increase over time as the world population grows.
Activity 1.2 What do we need and what do we want?

Your completed table may look like the following.
Need Want Reason

Bread Bread is food
Televisions Televisions provide entertainment but are not essential for survival
Water Water is essential for human survival
Shelter Modern house Some form of shelter is essential for survival, but many people aspire to live in
large, modern family homes
Clothing/shoes Clothing/shoes Basic forms of clothing provide the human body with warmth and protection
from the sun and extreme weather. However, many people want many different
fashionable clothes
Car Cars are a luxury. Some people in developed countries, however, view cars as
essential for travel to and from work, and for other activities
Jewellery Jewellery is a luxury
Video and audio discs These satisfy wants for entertainment
Newspapers Non-essential
Computer Non-essential
Books Non-essential
Matches While the ability to light and start fires is essential for many people – for cooking
and warmth – matches are not essential to create fire although extremely helpful
Meeting our needs for food, clean water and shelter is essential to our survival.
Satisfying our wants gives pleasure but is not essential to human survival.
1
© Brian Titley 2018: this may be reproduced for class use solely for the purchaser’s institute
Activity 1.3 What’s the big problem?

Article How does it illustrate the basic economic
problem?
Local anger as an area of ancient woodland is Land is scarce and has alternative uses. The
sold to a property developer to build new homes benefit of the woodland will be lost forever if
it is cut down to build homes. However, people
need homes to live in to provide shelter. Keeping
the woodland will mean the benefit of new
homes will be foregone.
China closes mines and warns its rare-earth Rare-earth minerals are non-renewable natural
minerals are running out resources. They are finite in supply and no more
will be available once they have been used
up in the production of other goods to satisfy
human needs and wants. Future generations
may therefore have to go without many of the
products they are used in.
BMW halts car production BMW had to stop production of its cars when
one of its suppliers could not supply it with
steering systems. This shows that cars are
economic goods. Scarce resources must be
used up in their production. Cars can only
be produced and wants for cars satisfied if
sufficient resources are available to do so.
Building new schools ‘must be top priority’ for Population growth is increasing human needs
government or wants for education. More resources will
be required to increase the number of school
places and teachers. Because resources are
scarce, this means reallocating some from other
uses. Providing more school places therefore
means giving up some other goods or services.
‘One meal a day’: Consumers on low incomes Because resources are scarce, consumers cannot
are being forced to choose between food and satisfy all their needs and wants for goods
paying power bills and services. Some consumers on low incomes
cannot even satisfy all their needs. They
must choose how to allocate them between
purchases of different goods and services to
meet their needs. The more they spend on
power for lighting and heating, the less they
will be able to spend on food. The opportunity
cost of meeting their needs for power is the
benefit they forego from eating less food.
2
Activity 1.4 Classifying resources

1
Land Labour Capital

Oil Advertising people Telephones
Cotton Ship’s crew Shops
Fertile soil Bank clerks Lorries
Orange trees Orange pickers Printing machines
Oranges Packaging designers Factory buildings
Coal Accountants Insecticide sprays
Water Warehouse workers Squeezing machines
Wood Shop assistants Power stations
Lorry drivers Roads
Calculators
2 Some of the resources used in the production of cars might include the following.
Land Labour Capital

Oil (for plastics, paints and lubricants) Designers Factories
Sand (for glass) Production line workers Offices
Rubber (for tiles, tubes and seals) Mechanics Computers
Metal ores Engineers Industrial robots
Leather Car sales personnel Paint-spraying equipment
Cotton Accountants Trucks
Marketing personnel Spanners
Drills
Activity 1.5 Getting mobile

Resource Factor of Factor Factor mobility? Reasons for factor mobility?
production? reward?
Computer Labour Wages Quite mobile Although they have very specific skills and cannot
programmers change occupation easily, computers are used in so
many different ways in different firms and industries
A combine Capital Interest Geographically mobile Can only be used to harvest crops but can be moved
harvester from one field to another
Cotton Land / natural Rent Immobile once planted It is possible to plant seeds in different locations but not
Mobile once harvested where it is too cold, too hot or too wet. However, once
planted they are immobile until they are harvested.
Thereafter the raw cotton can be transported by road,
rail or ship to many different locations to be processed
for use in the production of clothes, fishing nets, coffee
filters, book binding, paper and other products
An oil Capital Interest Immobile Can only be used for drilling and extracting oil in a
platform fixed location
A woodland Land / natural Rent Immobile The woodland is immobile but harvested wood is
mobile. It can be used in the production of many
different products in many different locations.
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Activity 1.6 The next best thing

You many have many different next best alternatives. Here are ours.
What I have just bought What I could have bought instead
Large flat-screen television A video projector
Four-bedroomed house Four-bedroomed apartment
Cakes and sweets Ice cream
A ticket to the World Cup Final A ticket to the Cricket World Cup Final
Activity 1.7 Free to choose?

1 Although not all children in Bangladesh are poor and clearly some European
children also live in poverty and lack basic goods and amenities, the most
likely answers are as follows.
Free to choose? Children in Bangladesh European children

Can go to a soccer match ✘ /
Can eat in a restaurant ✘ /
Can catch their own food / ✘
Can drive a car ✘ /
Can visit foreign countries ✘ /
Can own their own house ✘ /
Can obtain medical help when needed ✘ /
Can receive an Economics education ✘ /
Can receive a daily paper ✘ /
Can be independent ✘ /
Can receive radio and television ✘ /
2 Most people in European countries enjoy much higher standards of living

than many people in Bangladesh. European economies are larger and income
per head much higher. In Bangladesh many people have to survive on very
low incomes and what they can produce for themselves. Bangladesh is one
of the world’s most densely populated countries: resources are very scarce
but they are also not used as productively as they could be. About a third of
the country also floods annually during the monsoon rain season, hampering
economic development.
Activity 1.8 The cost of making choices

1 The opportunity cost to the factory owners is 400 glass jars foregone.
2 The opportunity cost to the factory workers is the benefit associated with
working on the farm instead.
3 The opportunity cost to society is the farmland, the peace and quiet, and clean
air foregone.
4
Activity 1.9 Shift it!

1
Article Increase in resources and Decrease in resources and
productive capacity? productive capacity?
Many developing countries ‘Richer’ developed countries – Developing countries – loss of
are losing their better- inward migration of skilled skilled labour and entrepreneurs
educated nationals to richer labour and entrepreneurs due to outward migration
countries …
Approximately 75 percent of Decrease in land … ‘due to
land in Uganda could be used environmental degradation
for agriculture … through soil erosion and nutrient
loss’.
Mass migration to England … Increase in migrant labour
New oil reserves ... Increase in land/natural
discovered resources for Canada, Norway,
Cuba, Brazil, Russia and Israel
2 A national economy that has more resources available than previously and
has increased its productive capacity should be able to produce more goods
and services. However, its total output will not increase or will not increase
by as much as it could if the additional resources are not used or are not
allocated to their best or most efficient uses. As a result, the economy will be
producing at a point below its new PPC.
5

Assessment: Model answers fall if there is a reduction in the amount
of resources it has available, for example,
1 (a) The opportunity cost of a decision or action due to the destruction of its factories, roads
is the benefit of the next best alternative and other infrastructure or the depletion of
foregone. For example, an area of land its non-renewable natural resources. This
can be used to grow corn or cabbages. The is shown by the inward movement of its
opportunity cost of using the land to grow PPC closer towards the origin, from PPC1
corn will therefore be the foregone benefit to PPC2.
that would have been gained from growing
cabbages instead. (d) Emigration involves a loss of population as
people move to other countries. This will
(b) The economic problem can never be reduce the labour force of the country if
solved because human wants for goods they are of working age. This represents
and services will always exceed the a loss of productive resources and as
natural resources available to produce a result the capacity of the country to
them. Resources are finite while produce goods and services will be reduced,
human wants are without limit and will especially if the loss is highly skilled labour
continue to grow as the global population because it is generally more productive than
expands. Even if more resources become unskilled labour. A loss of skilled labour
available, for example, through the may also deter multinational companies
discovery or production of more natural from investing in the country. Existing
resources or from an increase in the ones may also relocate their operations to
global working population, there will still other countries if they cannot hire enough
not be enough to produce everything workers with the right skills in the country.
we want.

The loss of labour will also mean there
(c)
The economy in the diagram below can will be fewer people remaining in work
use its scarce resources to produce any in the country to support those who are
combination of consumer goods and unable to work including children,
capital goods along or below its production old-age pensioners and the long-term sick
possibility curve (PPC1). At any point on or disabled. These people will depend on
its PPC1, the economy will be producing those in work to produce the goods and
as much total output as it possibly can by services they need and want, and to pay
using its resources as fully and efficiently as taxes to the government that can be used
possible. to finance schools, public healthcare and
state pensions. Therefore, as the working
population of a country falls, the burden on
PPC1 those remaining in work to help support
those not in work will increase.
PPC2
Consumer goods

A loss of entrepreneurs to other countries
will also reduce the productive capacity
of the country because it is likely to result
in the closure of some firms and fewer
firms being created in future. Not only
will this reduce the quantity and variety
of goods and services being produced but
0
it is also likely to result in an increase in
Capital goods unemployment and falling living standards.
However, the productive capacity of the
However, it is possible that emigration
economy and therefore its total output will may benefit the country. For example,
1
if the country is overpopulated then a on involves giving up the opportunity to

loss of population can reduce problems use it to grow fruit instead. The opportunity
of overcrowding and improve the living cost of a decision to use resources one way
standards for the remaining population. is therefore the benefit we forego or give up
The emigration of dependents such as from the next best use of those resources.
old-age pensioners will also help to reduce
(c)
An increase in education could improve
the burden on the working population
both the quantity and quality of labour in
and the cost of state pensions. This would
an economy. More people may be able to
allow the government to increase public
attend schools and colleges to learn the
spending on other groups in society or
basic skills and knowledge they need to get
other sectors of the economy.
a job if more places and more teachers are

If unemployed workers move to other made available. If the quality of education
countries to find jobs, then unemployment also improves it will also help people to
in the country will fall and this will also develop additional and higher-level skills
help to reduce government spending and knowledge.
on unemployment benefits or welfare

An increase in the total number of people
payments. If those same workers send back
willing and able to work will increase the
some of their wages to their families in the
capacity of the economy to produce goods
country, then this can improve their living
and services. If the quality of labour is also
standards. If they also learn valuable skills
improved, each worker will also be capable
while they are working elsewhere, those
of producing more, further enhancing
skills will be available to the country if and
the potential of the economy to produce
when those emigrants return. This will
goods and services. Both effects will shift
help to improve the future mobility and
its production possibility curve to the right
productivity of its labour force.
(from PPC1 to PPC2 in the diagram below).

There are clear problems associated with a
loss of skilled labour from a country. It will
reduce its productive capacity and living
standards are also likely to fall. However,
a loss of unemployed labour or the
Consumer goods
emigration of people who have retired from PPC2

work could prove beneficial.
PPC1
2 (a) Enterprise is a factor of production. It involves
organizing the production of other goods and
services. To do so requires combining and
directing other factors of production – land,
labour and capital – into firms to carry out
productive activities. If done successfully, the 0
Capital goods
reward for enterprise is profit.
(b)
The true cost of something is what we
However, an increase in education may
have to give up to get it. This is because we reduce the total supply of labour in the
cannot satisfy all our wants. Human wants economy in the short run if it involves
for different goods and services are without young people now spending more years in
limit. In contrast, the natural, human and education and therefore joining the labour
other resources needed to produce goods and force when they are older. Further, the
services are finite or limited in supply. This resources used to provide more education
means every economy must choose which may be wasted if the skilled workers it
goods and services to produce with their produces move to other countries to find
limited or scarce resources and, therefore, work because of a lack of suitable jobs in
which human wants they will satisfy and the economy. This would have the effect of
which ones they will not. For example, a shifting the PPC inwards towards the origin.
decision to use an area of land to build houses
2
(d) Building roads provides vital infrastructure that can be used more productively. For
in an economy. They can increase both example, trucks can make more deliveries
the mobility and productivity of factors in the same time if they spend less time
of production, thereby expanding the stuck in traffic jams. It will also help to
potential of the economy to produce a reduce transport costs, that in turn could
greater volume and variety of goods and help to reduce prices.
services. This is because roads will improve

However, a decision to use resources to
connections and travel times between
build more roads involves an opportunity
different areas of the economy and
cost. For example, the same resources could
potentially also neighbouring countries,
have been used to build more schools or
allowing people and goods to move
other vital capital infrastructure such as a
between them faster and more efficiently.
new airport; both of which may be more
Firms located in one area of the economy
beneficial to the economy in the long run,
can therefore trade more easily and with a
especially if the economy already has an
greater number of different suppliers and
extensive road network and additional
consumers located in other areas. Firms will
roads would be under-used.
also benefit from an increase in a supply of
labour; they are able to attract labour from
However, in many economies more roads
further away as it becomes quicker and may simply create more noise and pollution
cheaper for workers to travel. because they expand the demand for road
travel by enabling more cars and other

The construction and future maintenance
vehicles to travel, faster and further than
of new roads will create jobs and help
before. They may also cause some people
to reduce unemployment. This in turn
and firms to switch from rail services to
will raise incomes and living standards.
road travel.
Government spending on unemployment
benefits can be reduced, allowing taxes to
A decision to build more roads in an
be cut or public spending on other projects economy therefore needs to be based on a
or areas to increase. proper assessment of their likely costs and
benefits compared to other uses of the same

Building new roads can also reduce traffic
resources.
congestion and pollution on existing ones.
A reduction in travel times frees up time
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Part 2 The allocation of resources

Activity 2.1 Tropical trouble
Your groups may have discussed the following problems and solutions.
1 Scarcity of resources relative to the needs and wants of the survivors.
2 This activity involved deciding how best to allocate resources to different
uses. For example, is shelter a priority or is finding and storing more food of a
priority? Therefore, it also involves deciding which needs and wants to satisfy
with the available resources.
At one extreme you could rely on survival of fittest. Those able to gather the
most food and resources will survive while the old, sick or injured are unlikely to.
Alternatively, resources can be gathered by the able-bodied and then shared out
equally between all the survivors or on the basis of need. Decisions on how best
to use resources and whose needs and wants to satisfy first can also be taken by
a committee.
Activity 2.2 Problem solving

This activity involves completing a table of decisions on what, how and for whom
to produce using scarce resources based on your discussions in activity 2.1.
Together these activities should illustrate that decisions on how best to allocate
scarce resources can be centrally planned or left up to the market (i.e. survival of
the fittest), or some combination of these systems.
Activity 2.3 An introduction to the workings

of a market system
1 The main aim is profit.
2 Firms decide what to produce by asking: for which product is consumer
demand rising? Which product is the most profitable?
3 Firms decide how to produce goods and services by combining available
resources in the most efficient way possible so as to maximize output and
minimize production costs.
4 Teenagers without sufficient money could not satisfy their wants for shoes.
5 They will be unemployed.
Activity 2.4 Food for thought

1 The market for food products consists of all those producers willing and able
to supply food products and all those consumers willing and able to buy them.
2 Consumer wants for healthier, organic food products are rising and they are
falling for less-healthy options.
3 Consumers are becoming more health-conscious and concerned about the
impact of intensive farming methods on the environment and about the
maltreatment of animals.
1
4 The prices and profitability of many organic food products is rising.

5 More resources are being allocated to the production of organic food products.
Activity 2.5 What is your individual demand?

1 Your demand schedule may be similar to the following.
Possible price of a chocolate bar (cents) Your demand per month

200 1
150 2
100 3
50 5
25 6
2
Price of a chocolate bar (cents)
200
150
100
50
0
1 2 3 4 5 6
Quantity of chocolate bars per week
3 a, b and c apply.
Activity 2.6 Market demand curve

1 50
Price ($)
40
30
20
10
0
50 100 150 200 250 300 350 400 450
Quantity of orange light bulbs (thousands) per month
2 a around 170,000 b around 300,000

3 a around 27 cents b around 8 cents
4 The market demand curve slopes downwards because as prices rises
consumers cannot afford to buy as many.
5 A market demand curve shows the total quantity all consumers of the
product would be willing and able to buy at different prices. An individual
demand curve only shows what one consumer would be willing and able
to buy. A market demand curve for a product is therefore the sum of all
individual demand curves for the same product.
2
Activity 2.7 What causes a shift in demand?

1
Article 1a Factor that has changed 1b Impact on demand

Income tax cut in Malaysian Income after tax has Increase in demand for many
Budget increased products
World population growth Increase in number of Increase in demand for many
consumers products
Demand for online music Fall in price on personal Increase in demand for music
services soars music players downloads
Australia raises interest rate Increase in cost of borrowing; Fall in demand for many
increase in return to saving goods and services as
demand for loans falls and
people also save more
India tries to keep its cool Hot weather Increase in demand for ice
cream and soft drinks
2
Price per can of fizzy drink
D D1
D D1
Quantity of cans per day
DD = market demand curve before hot weather; D1D1 = market demand

during hot weather
Activity 2.8 Competing or complementary?

Products Possible substitutes Products Possible complements
Electric oven Gas oven Flat-screen televisions Video players
Woollen jumpers Fleeces Fountain pens Ink
Gas supplies Electricity Guitars Strings
iPods Other digital music players Toothbrushes Toothpaste
Rail journeys Bus travel Computers Software
3
Activity 2.9 The market supply curve

Price per tankard ($)
20
16
12
0
100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 1600
Quantity of tankards per month
1 Supply extends as price rises and supply contracts as price falls.

2 A fall in price will cause an extension in supply.
3 A rise in price will cause a contraction of supply.
4 a Around 1,000 per month b Around 500 per month.
5 a $12 b $12 × 700 = $8,400 per month
6
Output of tankards per Total cost ($) Total revenue ($) Profit ($)
month
100 600 600 0
300 1,800 2,400 600
700 4,000 8,400 4,400
1,100 6,200 17,600 11,400
1,600 9,000 32,000 23,000
The market supply curve for tankard slopes upwards to the right – i.e. market
supply extends as price rises – because producers can make more profit as
price rises.
Activity 2.10 What causes a shift in supply?

• The most profitable crop to grow is cabbages.
• Farmers should grow more potatoes; the supply of cabbages will fall.
• Farmers should grow more cabbages; the supply of potatoes will fall and the
supply of cabbages will rise.
• The farmer can grow more potatoes and cabbages because of the fall in the
cost of land.
• The supply of cabbages will fall.
• Factors affecting supply are market prices, costs of production, cost and
availability of resources, productivity of resources and weather conditions.
4
Activity 2.11 Finding the market price

Price of chocolate bars (cents)
50 D S
40
30
20
10
D S
0
100 200 300 400 500
Quantity (thousands) per month

1 30 cents.
2 a Market price is found where the market demand curve crosses the market
supply curve.
b
200,000 per month.
3 a There is excess demand at 5, 10 and 20 cents per unit.
b
There is excess supply at 40 and 50 cents per unit.
4 a Market price should rise.
b
Market prices should fall.
c
There will be no excess demand or supply when the price is 30 cents
per unit.
Activity 2.12 A fall in demand and market price
300 D S
Price per pen (cents)
250 D1
200
P
150
P1
100
S D1 D
50
0
100 200 300 400 500
Q1 Q
Quantity (thousands) per week
5 Supply has contracted from 300 pens per week to 200 per week.
6 Fountain and felt-tipped pens fall in price; consumer tastes change to favour
pencils; unemployment rises; income taxes rise.
5
Activity 2.13 A fall in supply and market price

Price per tonne ($)
600
S1 S
D
500
400
P1
300
P
200
S1
100 S D
0
100 200 300 400 500
Q1 Q
Quantity (thousands of tonnes) per year
4 Market demand has contracted from 300,000 tonnes per year to 200,000
tonnes per year.
5 Poor weather conditions cause crops to fail; farmers grow other crops because
their prices rise and they become profitable; wages and other production
costs rise; the government withdraws farm subsidies; there are labour and
land shortages.
Activity 2.14 A flat-out market

1 Demand increased.
2 Market demand for smaller televisions fell and supply contracted.
3 Market supply increased and market prices fell.
4 Quantity traded will rise.
5 Original equilibrium (P,Q)
D D1
Price of large screen TVs ($)
S
S1
P1
P2
S
S1 D D1
0
Q Q1 Q2 Quantity of TVs per period
6
Activity 2.15 A problem to ‘stretch’ you

Product Small or large change in Price elastic or Why?
quantity demanded? inelastic?
Electricity Small Inelastic Essential, few substitutes
Luxury holiday Large Elastic Expensive, non-essential item
Bread Small Inelastic Essential
A Toyota car Large Elastic Luxury, expensive item with many close substitutes
A newspaper Small Inelastic Low-cost item
Activity 2.16 Using the formula

1 PED = (500/1000)/(10/40) × 100 = 2
2 Demand is relatively price elastic.
3 The demand curve will be gently downward sloping, as shown below.
Price
40
30
0
1000 1500
Quantity per period
Activity 2.17 Elastic brands

1 Flu vaccinations help to prevent a dangerous virus that makes people ill and can cause deaths. Demand
for flu vaccinations is therefore likely to be highly price inelastic, i.e. PED will be much below 1. In
contrast, although meat is a basic foodstuff for many people we do not need to eat meat to survive.
That is, not only does each type of meat have many close substitutes because there are many different
types of meat from different animals, we can also choose to eat vegetarian foodstuffs instead. Demand
for each type of meat is therefore likely to be price elastic, i.e. PED will be greater than 1.
2 The existence of close substitutes in consumer demand means several products can satisfy a similar
want. If the price of beef rises, consumers may choose to buy lamb instead to satisfy their want for
meat.
3 PED for Toyota cars = 41%/10% = 4.1. Demand is price elastic because cars are a luxury item, are
expensive so their cost will account for a significant percentage of many people’s incomes, and Toyota
cars have many close substitutes, such as cars made by Ford, Hyundai, Peugeot and Volkswagen.
PED for a newspaper = 0.27%/50% = 0.0054. Demand is highly price inelastic. Newspapers are a low-cost
item and many consumers remain loyal to one or more daily newspapers even when their relative prices
change.
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Activity 2.18 What happens to total revenue?

(500 ÷ 10,000)
1 Loaf of bread: PED = = 0.25
(5 ÷ 25)
(800 ÷ 1,000)
Airline ticket: PED = =4
(100 ÷ 500)
2
Price per loaf (cents) Quantity demanded per month Total revenue ($)
25 10,000 $2,500
20 10,500 $2,100
Price per airline ticket ($) Quantity demanded per month Total revenue ($)
500 1,000 $500,000
400 1,800 $720,000

3 a No, because revenue will fall. The cut in the price of bread is
proportionately more than the increase in demand.
b
Yes, because revenue will rise. The increase in demand for tickets is
proportionately greater than the cut in price.
4 a Demand is price elastic when the percentage change in quantity demanded
is more than the percentage change in price. A fall in price will cause a
large extension in quantity demanded so that total sales revenue rises. If
price is increased, total revenue would fall.
b
Demand is price inelastic when quantity demanded changes by a smaller
percentage than price. A fall in price will cause a small extension in
quantity demanded so that total sales revenue falls. A rise in price therefore
causes total revenue to rise.
Activity 2.19 Stretching supply

(100 ÷ 1,000)
1 PES for natural rubber = = 0.4
(20 ÷ 80)
(800 ÷ 2,000)
PES for man-made rubber = = 1.6
(20 ÷ 80)
2 Natural rubber takes a long time to grow. Supply will therefore be price
inelastic in the short run. In contrast, the supply of man-made rubber is
more responsive to price because production of the synthetic material can
be increased relatively quickly by firms using their existing capital, labour
and materials.
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Activity 2.20 Free failings

Article What do the articles suggest or allege are failures and disadvantages of
the market system
By 2050, there will be more waste plastic in Firms are not taking account of what happens to the plastic they use in the
the world’s oceans than fish manufacture of products and in packaging and containers after they have
been used and discarded. Consumers and firms that discard plastic are not
taking account of the costs of polluting seas and rivers, harming marine life
and the negative effects it could have on fishing and tourism industries – or
the cost of clearing up the plastic waste.
Tortured for greed and profit Animals may suffer significant cruelty and their welfare is overlooked by
some people and organisations seeking to make a profit, because treating
animals more humanely may increase their costs.
Ready meals and designer shoes fuelling Rainforests are being cleared to farm cows to meet an increasing demand
destruction of the rainforest for meat and leather goods. Private firms supplying these products care only
about their own costs and profits and not about the long-term damage or
loss of wildlife habitats being caused by destruction of rainforests.
Canadian drugs firm accused of overcharging Some private firms may exploit consumers by charging high prices for
essential products in order to maximize their profits.
Customers warned energy bills are to stay high… The profit motives of private sector firms may result in high prices,
especially if consumers have few substitutes to choose from.
Car manufacturing ends in Australia Private firms will only employ people if it is profitable to do so and will
often relocate their factories and other operations to countries where wages
and other costs of production are low.
Toxic pollutants from oil and gas companies… Production decisions by oil and gas companies are imposing costs on others
by creating pollutants that are damaging to people’s health.
Lack of affordable housing Many private firms will only supply goods and services to consumers with
the greatest ability to pay in order to maximize their profits. Essential goods
and services required by people on low incomes may be underprovided.
Activity 2.21 Smoking

1 Private costs will include wages, purchase of tobacco and other materials,
insurance premiums, any loan repayments, rents, electricity and telephone
charges, etc.
2 The total revenue is calculated by multiplying the number of packets sold by
the price per packet.
3 They will have to breathe in his smoke. This could damage their health. The
smoke will also make their clothes and hair smell.
4 The government would have to pay for inspectors, police and the legal system.
5 a The opportunity cost is lower taxes or the benefit of other public
expenditures foregone, for example a new school, more police, higher
welfare payments or more farm subsidies.
b
The cost will be met by taxpayers or the beneficiaries of other public
expenditures which are subsequently cut to pay for the increased cost of
health care.
6 a The volume of cigarettes consumed is likely to fall.
b
Revenue may fall but this will depend on how responsive demand is to
price. Cigarette smoking for many people is habitual so a rise in price may
9
only produce a very small fall in demand. Overall revenues will rise but
some of that revenue has to be paid in tax to the government. After tax,
therefore, cigarette producers may still suffer a small fall in revenue.
c
If consumers start buying fewer packets of cigarettes, producers may cut
their output and the size of their workforces. Some workers in cigarette
factories may lose their jobs.
Activity 2.22 Not painting a pretty picture

1 The company only takes into account its own private costs, such as wages and
rents, and its private benefits, namely revenues from the sale of its paints.
2 From society’s point of view the firm should take into account the external
costs paint production could give rise to, including air and water pollution,
noise and visual intrusion, and the negative impact these could have on
people’s health. For example, the activity suggests increased health-care costs
will be $4 million a year.
Activity 2.23 Ringing the price changes

1
Price per unit
D S
EXCESS
SUPPLY
50p
40p
S D
0 qd Q qs
Units of alcohol
2
Price per litre
D S1
A$1.40 $0.40 tax

S
pe
A$1.00
S1
S D$
0 Qe Q
Diesel (litres)
10
Many governments have imposed indirect taxes on diesel and other

petroleum products in an attempt to reduce their consumption because their
use creates significant external costs.
The burning of diesel and petrol in cars and other vehicles releases harmful
emissions that cause air pollution and that are contributing to climate change.
In turn, poor air quality is damaging to people’s health. Indirect taxes will
increase the market prices of these products and demand for them should
contract thereby reducing the external costs of their consumption.
The taxes may also be used to encourage consumers to switch their demand
to electric vehicles instead when they purchase new vehicles. This could help
to boost jobs in electric vehicle manufacturing in these economies.
Activity 2.24 Mixing it up

Article Problems with government interventions in a mixed economic system
Corporate tax on the profits of local Taxes can distort markets and reduce incentives.
businesses is too high
French consumers can expect a three-fold Policy aims can conflict. Producers of solar energy panels and power will
increase in tax on electricity benefit. Cleaner energy will also benefit the environment and reduce health
problems – but consumers will have to pay more for the energy they use.
This may especially hurt those on low incomes.
New employment regulations and taxes will Laws and regulations to correct market failures can increase production
impose costs on business costs, reduce the supply of goods and services and increase prices
consumers must pay.
Government policies failing the poor Firms will only supply products to consumers who are able to pay for them
but public sector organizations may also be inefficient and produce poor-
quality goods and services.
Turks and Caicos PM quits after corruption Some governments may take actions that are for political or personal gain.
inquiry
Inefficient public hospitals ‘wasting billions of Public sector organizations may be badly run and fail to adequately
pounds every year’ control their costs if they have no profit motive. Product or service quality
may also be poor because of a lack of competition. As a result, some
public expenditures may result in an inefficient allocation of resources
and be wasted.
Additional tax measures Government interventions can result in conflicts because they create
‘winners’ and ‘losers’. Public sector workers benefit from increased pay;
people on welfare will receive more support – but taxpayers will have to pay
more to finance these measures.
Microsoft threatens to move jobs overseas Taxes on company profits may result in higher unemployment if companies
relocate their production to countries with lower or no taxes on profits.
11
Activity 2.25 Public or private provision?

1 Privatization is the transfer of public sector activities to private firms because
it is thought they will be able to provide them more efficiently than public
sector organizations.
2 Lee will pay a private company to supply water and sewerage services.
3 Arguments for privatization: a private company will have a profit motive and
will therefore do more than a public sector organization to reduce costs and
improve services to earn additional revenue and profits. Arguments against
privatization: workers may lose their jobs as the private company will want
to reduce costs; the private firm may also cut service levels and reduce health
and safety to save costs to improve its profits.
4 If privatization improves efficiency and service levels, local taxpayers will
benefit because the public sector will save money providing water and
sewerage services through the private supplier and local customers will also
benefit from lower prices and improved services. However, some former
public employees may lose their jobs as the private firm seeks to cut its costs.
It may also cut pensions and other benefits for those employees it retains.
5 (This is your own research on examples of privatization in your country.)
12

Assessment: Model answers goods in a free market economy because
they are not profitable. A government may
1 (a)
The basic problem in economics is scarcity also intervene in markets to regulate the
of resources relative to human wants. That pricing and resource allocation decisions of
is, there are just not enough productive private sector firms.
resources in the world to produce
everything humans want. This is because (c)
Because resources are finite and scarce
human wants are limitless. relative to human wants, we must
choose how best to use them. Devoting
(b)
In a market economy, the interaction of more resources to the production of
consumer demand for different products one particular good or service therefore
and producers’ decisions to supply them means fewer resources remain available
will determine the prices at which they are to produce others. That is, every resource
exchanged and the quantities exchanged. allocation decision involves an opportunity
Because private sector firms are motivated cost measured by what is given up or
by profit, they will choose to supply the most foregone as a result.
profitable products depending on what goods
and services consumers want and what they
For example, the diagram below shows
are able and willing to pay for them. the production possibility curve (PPC) for
an economy. If it uses its scarce resources

If consumer demand for a product is rising, as fully and efficiently as possible, it will
firms will be able to charge them a higher be able to produce any combination of
price for the product and earn more profits. quantities of consumer goods and capital
A rising price therefore acts as a signal goods along its PPC. At point A, it can
to other producers that the product is produce 200 units of consumer goods
becoming more popular and more profitable. each period and 100 units of capital goods.
As a result, they will allocate more resources However, if it wants to produce more capital
to the production of the product. goods each period, it will need to move or

In contrast, if consumer demand for a reallocate resources from the production
product is falling, firms will have to cut of consumer goods into the production
their prices or will risk being left with of capital goods. The PPC shows that it
unsold stock. A falling price therefore will have to give up producing 80 units of
signals falling profitability. As a result, consumer goods in order to produce an
producers are likely to reduce their additional 50 units of capital goods. The
production of the product and reallocate opportunity cost of 50 more units of capital
the resources they had used to produce to goods is therefore the benefit of 80 units of
other, more profitable uses. consumer goods given up.

It is this price mechanism and the profit
motives of firms that therefore determine
the allocation of resources in a free market B
150
Capital goods
economy and also in many markets within

a mixed economy. However, in a mixed A
100
economy a system of government will also
make some resource allocation decisions.
These may include decisions to provide
public goods, such as street lighting, and
merit goods including public healthcare and 0 120 200
education. Private firms will under supply Consumer goods
these socially and economically desirable
1
(d) An increase in resources allocated to the 2 (a)

The equilibrium price of a product is the price
provision of healthcare could benefit an at which the quantity supplied exactly equals
economy in a number of ways. The most or satisfies the quantity consumers are willing
direct benefits will be the creation of and able to buy. The equilibrium price will
additional jobs in the healthcare sector. therefore remain unchanged over time unless
Increased spending on medical equipment the quantity demanded by consumers and/or
and medicines will also boost the sales the quantity supplied by producers changes.
and profits of firms making and supplying
(b)
The market supply curve of a product
these products. In response, they are likely
shows how much producers are willing
to increase output thereby creating more
and able to supply of that product at every
employment opportunities. They may also
possible price. The amount of profit made
reinvest some of their increased profits
from the sale of each item will rise as the
in the research and development of more
price of the product rises so producers will
advanced equipment and medicines.
expand its supply as price increases.

It is also likely to improve the health of

If, however, producers increase the amount
many workers in other sectors, reducing
they are willing and able to supply at each
lost production during days off work
price then the market supply curve for
due to sickness and boosting their levels
the product will shift to the right. This
of productivity; both of which should
will happen if there is a fall in the cost of
contribute to increased output or GDP. In
producing the product, for example, due
turn, this will help to raise living standards
to technical progress or a fall in the cost of
as well as overall life expectancy.
materials. A fall in the costs of production

However, devoting more resources to means that firms can produce more at the
healthcare has an opportunity cost. For same price.
example, public spending on education or

Seasonal factors may also increase the
roads may have to be cut to pay for it. Or it
market supply of some natural products.
may have to be financed by higher taxes or
For example, good weather can boost the
higher health insurance payments, both of
amount of fruit, flowers, vegetables and
which will reduce the disposable incomes
arable crops grown and supplied to market.
of consumers.

(Other reasons include a reduction in indirect

Better healthcare may also reduce the
taxes; an increase in government subsidies;
death rate and increase the number of
a fall in the prices and profitability of other
people living longer into retirement. This
products; an increase in business optimism and
in turn will increase the cost of providing
expectations of profit; an increase in resources, for
pensions.
example, an increase in capital equipment.)

Further, there may be very few benefits
(c)
All other things unchanged, a fall in
from expanding healthcare provision if the
product price will reduce the amount of
population is increasing at a faster rate.
profit from each item sold. Total profits will,
As a result, the quality of the service may
however, depend on how many units of the
actually fall, for example, if people have
product are sold at the new lower price.
to wait longer to see a doctor or undergo
surgery and medicines have to be rationed.
The fall in price may increase sales of the
product significantly if demand for it is

If, in addition, hospitals and healthcare
price elastic. If so, the quantity demanded
practices in the public sector are badly
will increase by proportionately more
managed and run, then there is a risk that
than the fall in price. As a result, the total
additional resources may be wasted or
revenue and total amount of profit from
misallocated.
the sale of the product will increase even if

Whether or not increased provision the profit per item sold is lower than it was
of healthcare will benefit an economy before. If the farm is able to expand output
therefore depends on a large number of in response, it may also be able to reduce
factors. However, if the benefits of doing the average cost of each item produced
so outweigh the costs then it will be because it is able to use its land and
worthwhile. machinery more intensively than before.
2

However, if demand for the product is costs of equipment, fertilisers and seeds. As
price inelastic, the fall in price may have costs fall, food production becomes more
little effect on the amount consumers are profitable and will attract more resources.
willing and able to buy. As a result, their An increase in government subsidies may
total spending on the product will fall as also encourage increased food production.
price falls. Total revenue and therefore total

However, reductions in subsidies and
profit will be lower than before.
increasing wages and other costs will have
(d) It is difficult to predict what will happen the opposite effect, causing a reduction
to food prices in the future because it in food supply and forcing up food prices.
depends on a large number of factors, some Similarly, increasing demand for land for
of which will affect the demand for food housing and to grow crops for biofuels
products and others that will affect their could reduce the amount of land available
total supply. Any increase in demand for for agriculture if it is less profitable than
food not matched by an increase in supply these alternative uses.
will cause prices to rise.
3 (a)
Demand is the willingness and ability of

For example, the demand for food is likely consumers to buy a product. Consumers
to continue to rise as the global population demand different products to satisfy their
expands. All other factors unchanged, the needs and wants.
increasing demand for food will cause food
(b)
Bicycles are used by people as a form of
prices to rise. Rising incomes will have a
transport, for example as a substitute for
similar effect.
bus travel and also for leisure and exercise

However, rising incomes may also be to keep fit. The demand for bicycles may
accompanied by variations in the pattern therefore increase if there is an increase
of demand for different foods and also food in the price of other forms of transport,
prices. Demand for some basic foods, such for example if bus fares rise or if the price
as bread and potatoes, may fall as demand of petrol rises making travel by car more
for other ‘superior’ items and also many expensive. If a greater number of people
processed food items increases. take up exercise and want to keep fit, then
there may also be an increase in demand

Diets may also change over time due
for bicycles.
to health and other concerns, and this
may also cause variations in the prices of
(Other reasons include rising incomes, if bicycles
different food products. For example, more are a normal good; a rise in disposable incomes
people are giving up highly processed foods due to a reduction in income taxes; increased
and meat in favour of healthier vegetarian advertising of bicycles; an increase in the
or vegan diets, and also because of population; a government ban on the use of
increasing concerns over the mistreatment cars in certain areas; the provision of dedicated
and killing of animals. cycling paths and good weather may encourage
more people to take up cycling.)

The supply of food products is also likely
to change over time, both in response to (c)
The article suggests that the demand for
changes in the pattern of demand for food bicycles is quite low or price inelastic
and their effect on food prices, but also due in Asia Pacific countries compared to
to other factors. countries in other regions. When demand
for a product is price inelastic, a small

For example, advances in technology have
change in its price will have relatively
helped to improve crop yields by making
little impact on the quantity demanded.
many more resistant to damage from
For example, in some countries a bicycle
drought and insects. This means more
may be essential for many people for travel
can be grown per area of farmland than
because they cannot afford to buy a car or
previously. The increase in supply will
travel by bus or rail. Or perhaps there are
help to reduce prices but not if demand
very few bus or rail services provided. The
continues to rise at a faster rate.
absence of these alternatives or substitutes

Similarly, advances in technology may for cycling therefore makes demand for
also improve productivity and reduce the bicycles relatively price inelastic.
3

However, in other countries the demand inelastic. The tax will therefore have
for bicycles may be price elastic whereby to increase significantly before it has a
a small percentage change in their price big impact on demand. If this can be
will result in a larger percentage change in achieved, then it should reduce public
quantity demanded. This is likely to be the spending on healthcare. It will also help to
case in countries where there are many bus boost labour productivity and total output.
and rail services to choose from and fares This is because as cigarette consumption
are relative cheap. Any increase in the price falls, fewer people smoke, fewer workers
of bicycles may therefore result in many will suffer smoking-related health
consumers switching their demand to these problems and time taken off work due to
transport alternatives instead. sickness should fall. Life expectancy should
also improve.

Demand for bicycles may also be
relatively price elastic in countries where
However, if many of the cigarettes
they are considered luxury items because consumed by people in the economy
average incomes are low and many are manufactured in the economy then
people cannot afford to buy them. Any discouraging their consumption could force
increase in the price of bicycles will make those firms to cut their production and their
them even less affordable and could cause workforces. Unemployment will rise unless
demand for them to fall sharply. This will there are jobs in other sectors into which
especially be the case if bicycle prices are the displaced workers could easily move.
already very high.

The domestic industry may also be harmed

In contrast, in countries where average if the increase in tax on cigarettes results
incomes are relatively high and the prices in consumers switching their demand to
of bicycles are relatively low, demand for cheaper imported cigarettes. This will have
them may be price inelastic because many a negative impact on the balance of trade. It
people can afford to buy them even if they may also encourage the smuggling of cheap
are considered a non-essential item used cigarettes from other countries.
mainly for leisure. If so, an increase in

Because indirect taxes are regressive, the
bicycle prices is unlikely to cause a dramatic
increase in tax on cigarettes will have a
fall in demand because the proportion of
disproportionate effect on people with low
average income spent on them is low for
incomes. However, they could easily avoid
many households.
the tax if they were to stop smoking.
(d) Whether or not a government should
4 (a)
Price elasticity of supply measures the
increase the tax on cigarettes depends on
responsiveness of quantity supplied to
what it wants to achieve and how effective
small changes in the price of the product.
any increase will be.
If the percentage change in price exceeds

For example, if the aim is to raise the percentage change it causes in quantity
additional revenues to finance higher supplied, the price elasticity of supply is
public expenditures on, say, expanding relatively price inelastic.
the provision of education or building new
(b)
The supply of apples may decrease because
public hospitals, then increasing the tax will
of poor weather or disease. These factors
help. This is because cigarettes are addictive
will destroy crops and reduce the quantity
and this makes demand for them relatively
harvested. Their supply will also decrease
price inelastic. Increasing the tax will raise
if some of the land used to grow pears is
their price but is likely to have relatively
reallocated to more profitable uses, for
little impact on demand for them. As a
example, to grow other crops or to build
result, total spending on them, and therefore
new homes or factories.
tax revenues from their sale, will increase.

A rise in the costs of producing pears may

However, if the aim is to discourage their
also reduce their profitability relative
consumption because of their negative
to other crops or activities resulting in
impact on health and air quality, then
a transfer of resources from banana
a small increase in the tax is unlikely
production to those other uses.
to achieve this while demand is price
4
(Other reasons include a reduction in resources an increase in demand in the market for
available to banana growers, for example, due pears, shown in the diagram below as the
to a shortage of labour; technical failures, such outward movement in the market demand
as mechanical breakdowns when harvesting curve from DD to D1D1. As result, the
the fruits; poor expectations of future prices and market price of pears will rise to P1 because
profits; a reduction in or removal of subsidies their supply will be fixed or price inelastic
paid to banana growers; the imposition of an in the short run at Q.
indirect tax on pears making their production

However, the rise in market price will
less profitable; any other relevant factors, such as
encourage more banana trees to be planted
wars and natural disasters.)
so that over time the supply of pears
(c)
If apples are a close substitute for pears, and, therefore, the quantity traded in the
then an increase in the price of apples market, will expand from Q to Q1 at the
could result in consumers switching their new long run equilibrium price (Pe).
demand from apples to pears. There will be
Short-run Long-run
S
D D1 D D1
S
P1
Price
Price
Pe
P P
D D1 S D D1
0 Q 0 Q Q1
Pears Pears
(d) Whether or not a government should only price elastic unless they are set so very high
impose indirect taxes on products with on products with price inelastic demand
price inelastic demand very much depends that people simply cannot afford to buy
on its objectives. If the main objective is them anymore.
to raise public revenues, then it may be a

Raising indirect taxes may conflict with
sensible thing to do. An indirect tax will
a government aim to keep price inflation
raise the market price of the product but
in the economy low and stable. This is
the impact on demand may be relatively
because indirect taxes increase the prices
minor. This is because when demand is
of the goods and services on which they
price inelastic, any increase in price will
are imposed. They are also regressive
cause a smaller percentage contraction
in nature. This means that payment of
in the quantity demanded. As a result,
indirect taxes takes proportionately more
total spending on the product, including
out of a low income than it does a higher
payment of the tax, will increase.
income. Imposing indirect taxes on goods

However, imposing indirect taxes on may therefore conflict with an aim to
products with price inelastic demand is reduce poverty. As many products with
unlikely to be a very successful policy if the price inelastic demand also tend to essential
aim is to discourage consumption of these items such as electricity and many basic
products because they are imported or they foods, imposing indirect taxes specifically
are considered harmful or demerit goods. on these products will additionally affect
The indirect taxes will only reduce total those on low incomes the most.
spending on products for which demand is
5
5 (a)
Regulations are legal rules introduced by a
Conversely, private firms will under-
government to control the way something provide some socially and economically
is done or the way people or firms behave beneficial goods and services because it
to achieve more socially or economically is not profitable for them to do so. For
desirable outcomes. example, private sector firms are unlikely
to supply public goods such as street
(b)
In a free market economy, all productive
lighting or national parks. This is because
resources are privately owned and market
it will be impossible for them to charge
interactions between consumer demand
individual consumers a price according
and producer supply determine how they
to how much they ‘consume’ and benefit
are used.
from them.

Consumers will buy those products that

Similarly, private firms will only supply
give them the most satisfaction while
merit goods such as education and
producers will allocate resources to the
healthcare to those consumers able to pay
production of those products that earn
a profitable price for them. Many will not
them the most profit. In this way, those
and so consumption of these goods will be
consumers willing and able to pay the
less than what is socially and economically
highest prices will get the products they
desirable.
want. The prices and profitability of
different products therefore determine the
Other goods with significant external
allocation of resources in a free market benefits, such as vaccinations against
economy. infectious diseases, will also be under-
consumed if people have to pay the full

If consumer demand for a product is rising,
market price for them because private firms
firms will be able to charge them a higher
will only supply these goods if they can sell
price for the product and earn more profit.
them at a profit.
A rising price therefore acts as a signal to
other producers that consumers want more
In contrast, the provision and consumption
of the product and are willing and able of harmful demerit goods, such as guns,
to pay more for it. This will increase their cigarettes and alcohol, is likely to exceed
profits and as a result they will allocate what is socially and economically desirable
more resources to the production of the because they can be produced cheaply and
product. because consumers are not always aware of
the harm their use can cause to themselves

In contrast, a falling price signals falling
or others. The prices of such products need
consumer demand and profitability. As
to be much higher to reduce demand for
a result, producers are likely to cut their
them.
production of the product and reallocate
their resources to other, more profitable uses.
The desire to maximise profit among firms
may also result in the creation of large
(c)
Market failures occur when free markets
monopolies able to restrict the market
fail to produce socially and economically
supply of the goods or services so they are
desirable market outcomes. Market failures
able to charge high prices for them. Many
therefore reduce social and economic
of these products may be essential items
welfare. This means alternative resource
such as water and electricity supplies. In
allocations will be more efficient and
the absence of any alternatives, consumers
desirable.
will therefore have no choice but to pay

Because private sector firms want to high prices for them.
maximize their profits, they will only
(d) A decision to cut down forests will benefit
be concerned with the private costs and
an economy only if the social benefits
benefits of their activities and not the
of doing so exceed the social costs of the
external costs or benefits they impose on
decision.
others. For example, products that create
pollution, cause damage to the natural
A number of firms and employees may
environment and wildlife and result in benefit from the decision in terms of higher
other external costs will be over produced if profits and wages. These will include firms
it is profitable to do so. and their employees hired to cut down the
6
trees and firms who will benefit from a fall

The act of cutting down trees may cause
in the price of wood due to the increase significant noise and dust pollution. This
in its supply. Manufacturers of wooden may be a short-term cost but clearing
furniture, paper and other wood-based the forests will destroy the natural
products will benefit from falling production environment and wildlife habitats forever.
costs and will expand their production. This in turn could reduce tourism to
Their prices can be lowered without a loss these areas and reduce the trade and
of profit margin and this should encourage profits of firms that provide services
higher sales. The balance of trade will to tourists. Conserving the forests will
improve if many of these additional sales enable future generations to enjoy
are to consumers in other countries. them and benefit from the income they
generate, including from the sale of

In turn, the cleared land could be used
wood. If the forests are cut down and not
for housing or to build factories. This will
replanted, then there will be no future
help to create additional business and
domestic supply of wood. This will increase
employment opportunities, increasing
both the price of wood and the need to
total profits and wages further. These
import it in future thereby worsening the
will contribute to higher GDP and living
balance of trade.
standards.

On the plus side, clearing of the forests

However, the additional sales, profits
may release land for farming to grow much
and wages of private sector firms and
needed food and may also make travel
individuals will reflect only their private
easier. Trees also soak up a significant
costs and benefits. Cutting down forests
amount of groundwater that could instead
may also give rise to external costs and
be used to irrigate crops for food if the trees
benefits that should also be taken into
were cleared.
account before a final decision is made.
7
Part 3 Microeconomic decision makers

Activity 3.1 How specialization began
Frame 1 shows that Og the caveman is clearly very disappointed with his effort
to produce spears and pots. He is not very good at making these items and should
specialize in the production of something he is good at.
Frame 2 shows that Og has planted some seeds and is watering them to help
them grow.
In frame 3 the plants have matured and have produced fruits.
Frame 4 suggests Og has produced more fruit that he needs or wants.
In frame 5 he exchanges his surplus fruit for a spear.
Frame 6 shows a happy Og because he now has good collection of pots and spears.
By specializing in fruit growing and producing surpluses Og has been able to
engage in trade with producers of other items he needs and wants but is unable to
produce efficiently himself.
Activity 3.2 Ye olde swap shop

1 There must be a double coincidence of wants for exchange to take place, i.e.
the ruler-maker must want to exchange rulers for pencils. The exchange rate
between pencils and rulers – i.e. how many pencils are needed to obtain one
ruler – must also be agreed.
2 If the pencil-maker does not want erasers then the eraser-maker must
persuade the ruler-maker to exchange some of the pencils it has acquired in
the first trade in return for erasers. Again, there must be a double coincidence
of wants between the ruler-maker and the eraser-maker and they must agree
a rate of exchange between pencils and erasers.
3 Milk, cheese and eggs are perishable items. They will go off – i.e. lose their
value – if people are unable to trade them.
Activity 3.3 Funny money

1 Due to hyperinflation the Brazilian currency, the cruzeiro, failed as a good
store of value. People lost confidence in the currency and so it had to be
replaced with a new currency, the Real.
2 The cruzeiro was failing to perform all three functions before it was replaced.
Because the rate of inflation was so high the currency lost value rapidly
so people did not want to accept it as medium of exchange. Because the
purchasing power of the currency was being eroded so quickly by rapid
inflation it also failed to provide a stable measure of value. The article states
that a product priced at $1 one day had risen to $2 a month later, and to
$1,000 by the end of the year.
1
Activity 3.4 What is a ‘good’ money?

Mountains are scarce but too big to be a good money. They are not portable.
Cheese is perishable and will not be a very good store of value.
Cigarettes are portable, relatively scarce and durable unless they are consumed.
However, they may be easily damaged and unlikely to be generally acceptable to all.
Gold is scarce, durable, divisible, a good measure of value and store of value. Gold
rings and pieces are likely to be generally acceptable mediums of exchange.
Activity 3.5 Mrs Mint’s money

1 Notes, coins and instant access savings.
2 Long-term savings, savings bonds, jewellery.
Activity 3.6 Why do we need banks?

1 If there were no banks Digital Dreams would need to use a generally
acceptable medium of exchange or exchange goods or services of equal value
to make payments.
2 In a safe of its own. Bank accounts provide a much safer way to store money.
3 Borrowing money from friends, relatives or other people. The business is
unlikely to raise very much from these sources. The money supply in the
economy will be far more limited. This is because banks create deposit money
from their lending activities.
4 Because Digital Dreams would have to organize making payments to all its
employees and suppliers and would have to collect cash or other acceptable
forms of payments from all its customers, its running costs would be much
higher. There would be no credit or debit cards to make online payments.
Activity 3.7 You can bank on it!

Central bank Commercial bank
1 Main functions To maintain the stability of the national currency The provision of financial services to
and the money supply individuals and businesses
2 Services issuing notes and coins • accepting deposits of money and savings
managing payments to and from the government’s • helping customers make and receive
account payments
managing the national debt • making personal and commercial loans
supervising and regulating the banking system • buying and selling shares for their customers
acting as lender of last resort to the banking system • providing insurance
managing the nation’s gold and foreign • operating pension funds
currency reserves • financial and tax planning advice
operating monetary policy • exchanging foreign currencies
3 Organization, In most countries, the central bank is owned by the These banks are usually limited companies
control and government and run by a public corporation owned and financed by their shareholders
finance
4 Relationships The central bank in a country supervises the banking Commercial banks are regulated by the
with other system, regulates the conduct of banks, holds their central bank; they lend money to other
organizations deposits and transfers funds between them businesses and to government
2
Activity 3.8 Spending patterns

1 Households with the highest incomes spent proportionally more of their
total weekly expenditure on restaurants and hotels, recreation and cultural
activities and transport than low-income households. In contrast, low-income
households spent a larger proportion of their weekly expenditure on food and
non-alcoholic drinks, housing, fuel and power, and alcohol and tobacco, than
high-income households.
2 All households will have to spend money on essential products such as food,
housing and power, but these costs will account for a far greater proportion
of the weekly budget of a low-income household than a household with a
much larger income. High-income households can afford to spend more on
satisfying their wants and the purchase of luxury items, hence the larger
proportion of their total expenditure they spend on recreation and culture,
eating out at restaurants and travel.
Activity 3.9 Shop ’til they drop

Consumer trends Reasons
Rising sales of new cars Increase in real disposable incomes and availability of motor vehicles in many
developed and especially rapidly developing economies such as China; increase in
availability of credit to buy cars; increase in demand for travel and leisure activities
as incomes have increased and tastes have changed; growing pressure to reduce
vehicle use to cut harmful emissions and increasing taxes on petrol may reduce
demand for cars and vans and travel in future. However, new low-emissions and
electric vehicles are being developed and becoming more affordable as their scale of
production is increased
Increased consumption of healthy Increasing health conscious diets; demand is likely to rise further as concerns about
foods and drinks diet and obesity grow
Increasing household ownership of Rise in real household disposable incomes; increased availability and falling prices of
consumer durables many consumer durables; changes in lifestyles have increased demand for labour-
saving products such as washing machines and microwaves; many products have
reached saturation point so demand is likely to fall, requiring manufacturers to
develop extension strategies and new technologies and products
Increase in mobile telephone and Increasing demand for fast Internet access and communications while on the move;
broadband subscriptions; falling fixed increasing competition between broadband service providers has reduced charges;
telephone line subscriptions falling cost of mobile communications relative to cost of fixed lines and likely to see
continuation of these trends; also cheaper for phone companies to supply mobile
telecommunications instead of investing in the fixed-line network and physically
having to visit buildings to connect telephones to the network
Changes in global pattern of cigarette Increased taxation of tobacco products and increasing awareness of negative impact
consumption of smoking on health has reduced consumption in many developed economies.
This trend is likely to continue. However, the reverse is true in many developing
economies in Asia, Africa and especially in China, where rising incomes have
increased cigarette consumption.
Changes in dietary patterns in Rising incomes (reduction in demand for some basic ‘inferior’ foods such as
America potatoes) and increased awareness of food related health issues has reduced the
consumption of some high fat, high carbohydrate, dairy and sugary foodstuffs
over time. These have been replaced in the average per capita diet with lower
fat, healthier alternatives including chicken, rice and yogurt. However, cheese
consumption per person has also increased, possibly due to the income effect and
related changes in tastes.
3
Activity 3.10 ‘If I owe you a pound, I have a problem; but if I

owe you a million, the problem is yours’
1 Increased consumer spending and low interest rates. Both factors have
increased borrowing and therefore consumer debt.
2 Many UK households have total debts exceeding their annual income.
Many loans are short term and have variable interest rates. An increase in
interest rates will therefore increase the cost of interest charges on loans
and will therefore take a larger proportion of household income. This will
reduce disposable income available for spending on consumer goods and
services and, if significant, could create an economic recession, increase
unemployment and reduce economic growth.
3 A government could reduce consumer demand for borrowing by increasing
interest rates and by increasing taxes on incomes.
4 A young, unmarried university graduate will have a relatively low income
and is likely to spend most of his or her income on food and rented
accommodation, but also on fashionable clothes, music and going out
with friends.
A married couple with a young family will spend a larger proportion of
their income of housing costs, for example paying off a mortgage, and
on household goods and services for their home. Children’s clothes and
education costs are also likely to account for a significant proportion of
total expenditure.
A retired couple are likely to have a relatively stable income from a pension.
They will tend to spend a larger proportion of their income on heating their
homes during winter, medical care and recreational activities because they are
not working.
5 As debt rises, loan repayments and interest charges will take a larger
percentage of total income. Households will have less to spend on other goods
and services. If consumer spending falls, firms may be forced to cut back
output and employment. They may also delay plans to invest in new plant
and equipment that could expand their productive potential.
Activity 3.11 Why do people work?

1 Wages and salary levels will depend on the labour demand supply
conditions for each job. Some jobs require people with high levels of skills
and qualifications. However, the supply of labour with specific skills and
qualifications may be relatively low compared to the supply of unskilled
labour. So, for example, jobs for economists may offer high wages or salaries
to attract a supply of suitably qualified labour. Similarly, jobs that require
people to work long and unsociable hours or involve dangerous work may
need to offer attractive wages to encourage a supply of labour willing to work
in these jobs.
2 The job advertised for an economist is likely to offer the higher salary
because the supply of skilled economists may be limited. This is because
good economists may have studied for many years at university to obtain the
qualifications they need. In contrast, general labouring may offer the lowest
wages because there is a ready supply of semi-skilled and unskilled labour
willing to undertake the work.
4
3 The economist job is likely to attract the least number of applicants. This is
because economist skills are in short supply. The cost of long periods of study
at college and the opportunity cost of foregone earnings during these periods
will restrict the number of people wishing to become economists.
4 Your choice of job will depend not just on your skills and interests but also the
net advantages of the positions, including the wage or salary, hours of work,
the cost and time it takes to travel to and from your workplace, promotion
prospects and many other factors.
5 This task requires you to investigate different jobs and the monetary and non-
monetary benefits they offer.
Activity 3.12 The rise and fall of labour

What has changed? Impact on labour demand? Impact on labour supply? Impact on market
wage rate?
• Nurses are offered new contracts Increase in the supply of nurses Fall
with shorter working weeks
• Consumer spending on flat-screen Increase in the demand for Rise
televisions increases significantly factory workers to make
flat-screen televisions
• The government raises the retirement Increase in the supply of people Fall
age of public sector workers seeking public sector jobs
• Overtime payments for airline Fall in the supply of airline Rise
employees are to be scrapped industry workers
• Computerized assembly lines boost Increase in the demand for Rise
labour productivity in car plants car assembly line workers
• A major retail chain announces it Fall in the supply of retail Rise
will remain open 24 hours each day workers
• Assaults on police increase Fall in the supply of police Rise
• The government announces it will Fall in the supply of restaurant Rise
tax tips received by restaurant and and hotel workers
hotel staff from next April
• A survey finds more people are Increase in the supply of Fall
working part-time and flexible hours part-time workers and others
seeking more flexible working
arrangements
• Statutory maternity leave and pay Fall in the demand for Increase in the supply of Fall
are to be increased female workers female labour
• New technology allows more office Increase in the supply of labour Fall
workers to work from home to office-based occupations
5
Activity 3.13 How’s your differential?

1 Labour demand and supply conditions for different occupations will explain
differentials in earnings and between males and females. For example,
managerial and professional occupations, such as lawyers and doctors, tend
to pay higher salaries than less skilled occupations because the supply of
professional and managerial skills is more limited. Average female earnings in
the same occupations tend to be lower than average male earnings because
many women may take career breaks to raise families and may work reduced
hours. However, it is also possible that workplace discrimination may hold
back the pay and career prospects of some females.
2 This task requires you to find examples of jobs in different occupational
groups in your country, state whether their wage rates or earnings follow the
same pattern given in the bar chart in the activity based on the UK, and use
your knowledge of factors that may affect labour market conditions to explain
the pattern of wage of earnings differentials.
Activity 3.14 The minimum wage debate

1 Arguments for a minimum wage: to lift people on low incomes out of
poverty; to boost productivity.
Arguments against a minimum wage: it raises employment costs and will
reduce the demand for labour.
If the minimum wage (MW) for an occupation is set below the market wage
rate (W) it will have no effect. If the minimum wage (MW) is set above the
market wage rate (W) there will be an excess supply of labour, equal to n1 to
n2 in the diagram below. Employment will fall from N to n1.
Dn Sn
Wage
MW
Sn Dn
0 n1 N n1
Quantity of labour employed
2 By observing changes in employment and levels of productivity in low wage

occupations.
3 a There us an excess supply of labour at W1
b
W2 is below the equilibrium wage rate and will therefore have no effect
4 Wage elasticity of demand for teenage labour = % change in quantity of
labour demanded / % change in wage. Therefore the elasticity of demand is
0.3. This suggests labour demand is relatively wage inelastic.
6
Activity 3.15 Why I’m part of the union!

1 Negotiating wages and other non-wage benefits with employers; defending
employees’ rights and jobs; improving working conditions, such as better
hours of work and health and safety; improving pay and other benefits,
including holiday entitlement, sick pay and pensions; encouraging firms
to increase workers’ participation in business decision making; supporting
members who have been dismissed or who are taking industrial action;
developing the skills of union members, by providing training and education
courses; providing social and recreational amenities for their members;
influencing government policy and employment legislation.
2 Benefits might include time savings associated with negotiating with union
representatives rather than many individual workers; unions will maintain
the skill levels of their members through on- and off-the-job training; unions
can participate in business decision making and discuss ways to improve
productivity. Problems might include increased bargaining power of unions
in negotiations over pay and working conditions, especially if there is a closed
shop or single union agreement negotiations; unions may restrict the supply
of labour to put upward pressure on wages.
3 See answer to question 1 for possible benefits of union membership. There
are costs associated with union membership including membership fees but
also foregone wages if the union requires its members to take strike action.
Activity 3.16 A tough negotiation

This activity requires you to write a report and take part in a role-play exercise.
The outcome of the exercise will depend on your skills in negotiation.
The team playing the union will need to address the following questions in
its report.
• What is your pay claim? A 5% increase in the wage rate. However, you might
also seek improvements in overtime pay and performance-related payments.
You might be willing to accept changes in these to reduce your demand for a
5% pay increase.
• Why have you made this pay claim? Because your members will be required
to operate new machinery. The new equipment will increase productivity and
reduce costs. As a result, profits are likely to rise so the union wants to secure
a share of these by raising its members’ wages but also wants to protect the
jobs of its members.
• What has been the management response? Managers have not rejected the
demand outright but have stated that they are to avoid any increase in wage
costs that may make them uncompetitive. This means they might be willing
to improve pay if there are improvements in labour productivity.
• What forms of action could the union take if necessary? Initially the
union could ask its members to work to rule and reject overtime working.
Ultimately, the union could organize a strike.
• Why are both you and the management keen to avoid a strike? Union
members will lose wages while on strike and the union does not want to
jeopardize a big customer order that will help to keep its members in jobs.
Managers similarly do not want to lose output and put the new customer
order at risk. The strike may lose the company custom it cannot recover and
ultimately may force it to close down.
7
The team playing the managers will need to address the following questions in
their report.
• What wage claim has the union made? A 5% increase in the wage rate.
However, the union may also seek improvements in overtime pay and
performance-related payments. The union might be willing to accept changes
in these to reduce to its demand for a 5% pay increase.
• What are the implications of accepting or rejecting this claim? If the union
demand is rejected its members may take strike action but the union will
know this might place the new order and future of the business, and
therefore the jobs of their members, at risk. Accepting the demand without
any improvements in labour productivity will increase production costs and
may make the business uncompetitive.
• Why you are keen to avoid a strike? It will mean lost output and revenue during
the strike because the company will not be able to meet customers’ orders. The
reputation of the company as a reliable supplier will also be damaged and it may
continue to lose customers even when the dispute is resolved.
• What will be discussed with the union? The likely impact of any disruption
on the company and therefore the jobs of union members; reducing their
immediate pay demands; linking improved pay to improvements in productivity;
how best to minimize redundancies following the introduction of the new
equipment, for example by offering generous early redundancypackages
Activity 3.17 Which stage of production?

1
Primary Secondary Tertiary
Fishing Construction Television broadcasting
Forestry Furniture making Film making
Farming Engineering Decorating
Mining Shipbuilding Health service
Chemicals Banking
Manufacture of motor Hotels
vehicles Retailing
Advertising
Universities
Restaurants
Activity 3.18 Size matters

• The largest firm depends on the measure used. Toyota is the largest employer.
Exxon-Mobil is the largest by capital employed and value of total annual
output. Google has the largest market share of the four companies.
• As the answer to the first question illustrates, it is not sensible to use just one
measure of firms’ size.
• Focusing on just one measure ignores other measures of firms’ size. For
example, labour-intensive firms may have very little capital employed. High-
tech manufacturing firms may employ many billions of dollars worth of capital
equipment on automated production lines that require very little labour input.
Similarly, a small village shop may have a large market share of its local market
because it is the only shop for many miles, but a large global retailer may have
a smaller share of a huge global market worth many billions of dollars.
8
Activity 3.19 Staying small

Personal preference; the owner of a sole trader keeps all the profits; there is
preferential tax treatment of small firms to encourage enterprise; they lack
access to capital; they are able to work from home; there has been a fall in cost
of new technology; customers are attracted by more personalized service; the
market size is small.
Activity 3.20 What type of integration?

Merger or takeover Horizontal? Vertical? Lateral?
A chocolate maker takes over a cocoa plantation ✔
A travel insurer merges with a on-line holiday company ✔
A clothing retailer takes over a clothes manufacturer ✔
A bus manufacturer merges with a car maker ✔
An investment bank takes over an electronics producer ✔
An aircraft maker merges with an aero-engine company ✔
Activity 3.21 Big is beautiful

Case 1: Cleaning up their act
1,2 Larger firms tend to be more secure financially and banks are therefore more
willing to extend loans to them and at more attractive interest rates than they
would for smaller firms (financial economies); the fixed costs of new, more
efficient machinery and advertising can be spread over a much larger output
in a large firm (technical and marketing economies); larger firm produces a
range of soaps for different markets (risk-bearing economies)
Case 2: Blasting off!

1,2 The large firm was able to invest in large-scale blast furnace – the fixed cost
can be spread over a much larger output than smaller firms investing in
furnaces (technical economies); large firms are also able to invest in their
own vehicle fleet rather than using the services of road haulage providers and
paying the cost of their services and profit margins (technical economies);
large firms are able to buy in bulk from suppliers and receive discount
(purchasing economies); large firms are able to access new markets overseas
(risk-bearing economies).
Activity 3.22 Dough!

1 The chain of production for bread may be as follows.
3 Farms plant seeds to grow wheat
7 Wheat is harvested
8
Insurance firms provide insurance to protect farms from risk of damage
or theft
13
Commercial banks provide loans and payment services for farmers
5
Road haulage service providers transport harvested wheat and
finished breads
8
Insurance firms provide insurance to protect road haulage companies from
risk of damage or theft
9
13 Commercial banks provide loans and payment services for road

haulage companies
1
Wheat, water, yeast and other ingredients are mixed together to
produce dough
2 Coal and oil are used to power electricity stations for use by the bakery
8
Insurance firms provide insurance to protect the bakery from risk
of damage or theft
13
Commercial banks provide loans and payment services for the bakery
9 Dough is poured into baking pans and placed in ovens to cook
14 Food inspectors check the quality and hygiene of the breads and the
bakery
10 Sealed packets for the bread are produced and labelled in
printing machines
12
Finished loaves of bread are sealed in plastic packaging
5
Road haulage service providers transport harvested wheat and
finished breads
4 Supermarkets and other shop sell bread to consumers
2
Coal and oil are used to power electricity stations for use by firms
and households
8
Insurance firms provide insurance to protect supermarkets from risk of
damage or theft
13
Commercial banks provide loans and payment services for the bakery
6 Consumers buy bread
2
Coal and oil are used to power electricity stations for household
consumption
11
Consumers make sandwiches or toast to consume
13
Commercial banks provide loans and payment services for households
2 The task is your own research into the chain of productive activities in the
production and sale of six different products.
Activity 3.23 Passport to success

1
Year Total output achieved No. of workers Average annual labour
(*forecast) productivity
1 100,000 5 20,000
2 210,000 10 21,000
3 330,000 15 22,000
4 460,000 20 23,000
5 570,000* 25 (Option 1) 22,800
5 540,000* 20 (Option 2 using 27,000
new machinery)
10
2 The addition of five extra workers increases total output to 570,000 units
per year, but average labour productivity falls from 23,000 units per worker
per year to 22,800 units per worker per year. In contrast, employing new
machinery instead increases total output to 540,000 but average labour
productivity increases to 27,000 units per worker per year. Based on these
figures, the company is wrong to consider just increasing the workforce.
3 The company should install the new machinery because:
•
average labour productivity is increased by 4,000 units per worker per year
(option 1 will result in it declining by 200 units per worker per year);
•
although total annual output is greater under option 1, the company may
not be able to sell the extra output without reducing prices and this will
reduce the profit margin per unit sold;
•
the cost of the machinery is $300,000 compared to an increase in labour
costs of $100,000 per year for five additional workers. However, the cost
of the machinery can be spread over a useful life of ten years: a cost of
$30,000 per year;
Existing workers may demand a wage increase to operate the new machinery
and may need training to operate it. This will increase costs.
4 The company could increase average labour productivity further by:
•
replacing old plant and machinery with new, more efficient machines and
equipment for workers to use;
•
training workers to operate the new machinery and to improve their skills;
•
introducing lean production processes and new working practices designed
to continually reduce waste, increase speed, improve quality and raise
output.
•
motivating workers to increase their effort and output, for example, by:
–
offering workers performance-related pay or bonuses;
–
offering workers non-financial rewards, including free gym membership
or additional days off if they improve their productivity;
–
increasing their job satisfaction, for example by improving the working
environment, making jobs more varied, introducing more team
working, involving workers in business decision making and giving
regular feedback on performance.
Activity 3.24 March of the robots

1 They can reduce labour requirements and costs; they can be used
continuously and increase productivity; average costs of production are
reduced; product quality can rise; firms will become more competitive.
2 Industrial robots can undertake tasks formerly carried out by employees. They
can therefore replace labour in production processes.
3 Workers may be made redundant if robots replace them. Productivity may
rise, thereby reducing business costs. Cost savings may be passed onto
consumers through lower prices. Product quality may also increase.
4 They can be expensive; business managers may not be aware of their benefits
workers may not have the skills to use them efficiently; trade unions may
resist their introduction if it means workers will lose their jobs.
11
Activity 3.25 Bear Necessities

1 They are costs that do not vary with output. Examples include rents, loan
repayments, insurance premiums, lease payments for equipment and
depreciation.
2 $200
3 $200
4 They are production costs that vary directly with the amount of output, for
example cost of materials and components, power to operate machinery and
piece rate payments to employees.
5 $800
6 $8,000
7 a $1,000 b $8,200
8 17
Bears produced Total fixed costs Total variable Total costs Average cost per
per week $ costs $ $ bear $
0 200 0 200 -
50 200 400 600 12.00
100 200 800 1,000 10.00
200 200 1,600 1,800 9.00
300 200 2,400 2,600 8.67
400 200 3,200 3,400 8.50
500 200 4,000 4,200 8.40
600 200 4,800 5,000 8.33
700 200 5,600 5,800 8.29
800 200 6,400 6,600 8.25
900 200 7,200 7,400 8.22
1,000 200 8,000 8,200 8.20
9
$
9,000
8,000 Total fixed costs

Total variable costs
7,000
Total costs
6,000
5,000
4,000
3,000
2,000
1,000
0 100 200 300 400 500 600 700 800 900 1000
Output of bears per week
12
10 $10
11 $10
12 $1,000
13 $10,000
14 16
Bears produced and Total revenue $ Total costs $ Profit or loss $

sold per week
0 0 200 -200
50 500 600 -100
100 1,000 1,000 0
200 2,000 1,800 200
300 3,000 2,600 400
400 4,000 3,400 600
500 5,000 4,200 800
600 6,000 5,000 1,000
700 7,000 5,800 1,200
800 8,000 6,600 1,400
900 9,000 7,400 1,600
1,000 10,000 8,200 1,800
15
$
12,000
Total fixed costs

10,000 Total variable costs
Total costs Profit
Total revenue
8,000
6,000
4,000
Loss
2,000
0 100 200 300 400 500 600 700 800 900 1000
13
18
12
10
Average cost per bear $
0 100 200 300 400 500 600 700 800 900 1000
Activity 3.26 A calculated issue

1
Magazines per Total fixed costs Total variable Total cost Average cost Total Revenue Profit or Loss
month costs
0 $4,000 0 $4,000 - 0 - $4,000
1,000 $4,000 $3,000 $7,000 7.00 $5,000 -$2,000
2,000 $4,000 $6,000 $10,000 5.00 $10,000 0
3,000 $4,000 $9,000 $13,000 4.33 $15,000 $2,000
4,000 $4,000 $12,000 $16,000 4.00 $20,000 $4,000
5,000 $4,000 $15,000 $19,000 3.80 $25,000 $6,000
6,000 $4,000 $18,000 $22,000 3.67 $30,000 $8,000
7,000 $4,000 $21,000 $25,000 3.57 $35,000 $10,000
8,000 $4,000 $24,000 $28,000 3.50 $40,000 $12,000
2 2,000 magazines per month

3
$
45,000
40,000 Total cost
35,000 Total revenue
30,000 Profit
25,000
20,000
15,000 Loss
10,000
5,000
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

Output of magazines per month
14
Activity 3.27 What’s the objective?

Firm Objectives
Large car manufacturer Survival
New small window cleaning firm Survival; market growth
Established low cost airline Market growth; long run profit maximization
Leading supermarket Market growth; long run profit maximization
Small manufacturing firm employing disabled Social welfare
people
Activity 3.28 All washed up

1 Price wars involve competing firms continually trying to undercut each
other’s prices, often to force rivals out of business. All firms involved in a price
war usually end up losing money by trying to out compete each other on
price.
2 P&G’s motives were recent price cuts and an aggressive new advertising
campaign for its main rival brand.
3 Profit margins fell.
4 HUL may have significant economies of scale. This means its average or unit
costs are likely to be lower than its rival. It can therefore afford to lower prices
and still earn a good margin for profit. Having a bigger range of well-known
products in its portfolio also means it will only have to cut the prices of those
that compete directly with those products offered by P&G, while having a
bigger market share also means it has more customers, many of whom may
be loyal to brands offered by HUL and therefore unlikely to switch easily to
rival products. It will also have a larger share of total sales revenue. This will
give the company greater financial strength to withstand a price war.
5 It is price elastic, because there are many close substitutes to choose from.
6 Price leadership could have been used to avoid a price war. Instead HUL and
P&G could charge very similar prices and could raise them or lower them
together at the same time to avoid price competition.
Activity 3.29 Creating barriers

Big Sell Supermarket plc: barriers might include the scale of the supermarket itself
and the product ranges it offers to customers allowing them the convenience of
shopping for many of the products they need and want ‘under one roof’; it could
prevent its wholesaler from supplying rival retailers by threatening to take its
custom elsewhere if the wholesaler does.
Flyhigh airlines: the airline may use predatory pricing to deter new competition
and heavily subsidize those routes under threat from competition with monopoly
profits from other routes.
Spreadwell Limited: it can threaten to withhold supplies of its popular margarine
from supermarkets that stock rival products.
15

Assessment: model answers current consumption and firms can borrow
money to finance new investment. They will
1 (a)
The size of an industry in an economy repay their loans with interest from their
could be measured in a number of future incomes; and (ii) to accept deposits of
ways. First, it could be measured by the money and savings. Banks provide a secure
total number of people it employs as a place for people and firms to save money
proportion of the total workforce. Secondly, and earn interest on their savings.
the size of an industry could be determined
by the contribution it makes to total (f)
Whether or not a government should
output, i.e. the value of its annual output protect the declining car industry depends
as a proportion of the total annual output on how the costs and benefits of doing so
of the economy. A third way to measure compare.
the size of an industry in a country is to
The benefits include saving jobs and
compare it with international rivals in preventing unemployment. In turn,
terms of its global market share. this will prevent a loss of tax revenues
(b)
Wages in the UK car industry fell because and increased public spending on
there was an economic recession. Demand unemployment benefits. If the car industry
for cars fell and as a result the demand is a major employer and producer in the
for labour decreased. Car makers reduced economy, as well as being a major customer
wages to help protect UK jobs and factories for parts and services supplied by other
from closures. domestic firms, it could also help to prevent
a dramatic fall in output, negative economic
(c)
A trade union is an organization of workers growth and declining living standards.
formed to promote and protect the rights
and interests of its members concerning
Protecting the industry may slow down the
wages and working conditions, including rate at which it declines but may not stop
reduced hours of work, increased holiday or reverse its decline. This, however, will
entitlements and improved health and give workers more time to find other jobs,
safety at work. to retrain in new skills to improve their
chances of finding alternative employment

Trade unions also aim to agree improved and for other industries to grow and to
sick pay, pensions and other benefits for provide more employment opportunities.
their members. Trade unions can often
secure these improvements for their However, using public money to subsidise
members because they have significant the industry may be an expensive and
bargaining power in negotiations with inefficient use of resources. The resources
employers. In the extract, trade unions may be better used in support of growing
have used their collective bargaining industries or for improving education and
strength to resist job cuts that would have healthcare. These uses will help to increase
made UK car workers unemployed during the rate of long-run economic growth in
and following an economic recession when the economy.
demand for cars was falling. Countries with major car industries may
(d) The article suggests a decrease in also retaliate by imposing trade restrictions,
employment may increase labour making it difficult for the car manufacturers
productivity as less skilled and less and many other firms to export their goods
productive workers lose their jobs and are to these countries. As a result, the car
replaced by more efficient and productive industry and many other firms may require
capital equipment. additional support from the government.
(e)
Two functions of commercial banks are: (g)
Large car manufacturers are likely to enjoy
(i) providing personal and commercial loans significant cost advantages in production,
so people can borrow money to fund their making the average cost of producing each
1
car much lower than that of their smaller 2 (a) Money is a generally accepted medium of
rivals. For example, they will be able to exchange.
receive bulk purchase discounts on the
(b)
Money functions as a unit of account
parts and materials they buy and have
because it allows the prices of all other
access to lower cost sources of finance
goods and services to be set or expressed in
which may enable them to purchase more
terms of units of one single, and generally
efficient capital equipment. In so doing, the
accepted, means of payment. Money
larger manufacturers will be able to capture
therefore allows buyers and sellers of
and keep a larger share of the market and
different goods and services to compare
encourage consumer loyalty towards their
all the prices or values placed on them in
car brands.
simple monetary terms.
As such, it will difficult for smaller car

Money provides a standard for deferred
manufacturers to compete with them head
payments because it allows goods and
on. They will not be able to produce the
services to be bought on credit, and for the
volume or range of models the large firms
amount owed or borrowed to be paid off at
do or compete with them on price. If they
a later date.
try, the larger firms may undercut their
prices to force them out of the market. (c)
The money supply in an economy is made
up of notes and coins in circulation and
Smaller car manufacturers are also unlikely
bank deposits. An increase in bank lending
to be able to be able to compete with the
will therefore increase the money supply in
larger manufacturers on levels of spending
the economy because it will increase bank
on advertising and on research and
deposits. A person who borrows money
development. However, smaller firms may
from a bank will have their bank account
be able to specialise in the production and
credited with the amount of the loan. They
marketing of more personalised, innovative
will then be able to make payments from
and luxury vehicles for small ‘niche’ markets
their bank account using the loan. People
and be able to price them at a premium.
who borrow from their banks will therefore
Further, because the larger car makers have more money to spend and this in turn
have often invested significant amounts of will increase total demand in the economy.
money in capital-intensive or automated This will drive up market prices and, in
production, they may find it more difficult response, firms are likely to expand their
to adapt their car designs quickly in output.
response to changes in consumer demand

Firms may also respond by increasing
compared to smaller firms.
their own borrowing to fund an increase
The smaller manufacturers may also receive in their scale of production, for example,
grants or subsidies from the government. through investment in new and additional
This will help to reduce their costs of plant and machinery. This will increase
production and allow them to charge prices the productive capacity of the economy
that can compete with larger firms so that and should also boost the rate of economic
they have a better chance of surviving and growth. Total output or GDP will increase
growing. and living standards will improve.
The cost advantages of large-scale However, more lending can result in
production may also disappear if the large rising inflation if total demand increases
car manufacturers grow too large and at a faster rate than total output in the
experience coordination problems and economy. Increased borrowing may also
labour and supply shortages. Deliveries be used to buy more imports, reducing a
of cars may be held up and quality may balance of trade surplus or worsening a
also suffer as a result. These diseconomies balance of trade deficit.
of scale will increase their average
(d) The interest rate charged by a bank on a
production costs relative to those of
loan is the cost of borrowing money. It
smaller manufacturers and, if significant,
follows that the higher the rate of interest
may give them a cost and also a quality
charged, the less money people will tend
advantage instead.
to borrow. A fall in the rate of interest is
2
therefore likely to encourage a rise in total with low disposable incomes may have to
borrowing. However, many other factors spend it all just to meet their basic needs for
can affect an individual’s decision to borrow food, clothing and shelter.
money from a bank.
People with relatively high disposable

A major determinant will be the ability incomes have the ability to save but may
of the individual to repay the loan plus choose not to, especially if interest rates on
interest charges. This will depend on both savings are low and especially if they are
their current income and their expectations below the current rate of price inflation.
of future income. If they expect their Interest is the reward for saving but the real
future income to rise, then repaying a loan value of savings will fall if the rate of price
will become easier over time. However, inflation exceeds the rate of interest.
if they expect their income to fall due to
(Other influences are propensities to spend or
possible illness or unemployment, then the
save from disposable incomes, which in turn
person may decide against borrowing any
may vary with age, social attitudes, family
money regardless of how low interest rates
circumstances; consumer confidence in the
currently are.
economy, for example, expectations of recession

The ability to repay a loan rises with and unemployment may persuade more people
income. People on high incomes are more to save more money as a precaution; desires to
able to repay loans than people with low save for future consumption, including for a
incomes, but they are likely to have less major purchase, such as a house, or to provide
need to borrow money to finance their a pension income in retirement; availability
current consumption than poorer people. of savings schemes; how wealthy a person is;
However, while people on low incomes whether interest income on savings is taxable
may have more need to borrow money, for and the rate at which it is taxed.)
example to meet unexpected bills, banks
(b)
Cash (notes and coins) is money because
may be less inclined to lend them money
it performs the functions of money. First
because of the risk they may not be able to
and foremost, it is generally accepted
repay their loans.
as a medium of exchange meaning it is
Whether or not the interest rate on a loan universally accepted as payment for other
is fixed or variable will also be an important goods and services. This also means that
consideration. If the interest rate is fixed, the prices of every good or service can be
then interest charges will be unchanged if set or expressed in cash because it provides
interest rates rise in the future. If, however, a single accepted and recognisable unit of
the interest rate is variable, any increase in account or measure of value.
interest rates will increase interest charges

Cash is reasonably durable and provides a
on existing loans making them more
good store of value, especially if inflation
expensive to repay.
is relatively low and stable. The face value

Expectations of future interest rates will printed on each note or coin will not
therefore also affect the decision to borrow change even if what they can buy may be
money now, as will expectations of future reduced over time as prices rise. As such,
price inflation. For example, if people think cash also provides a means of deferred
the prices of many goods will rise in future, payment. Because it is a good store of
they may borrow more money now to buy value and unit of account, an agreed
the goods they want before their prices rise. amount of cash can be borrowed and
repaid at a later date.
However, no matter how low interest rates
might be, some people simply do not like to (c)
Commercial banks help trade to take place
borrow and be in debt. in an economy by helping customers make
and receive payments quickly and easily.
3 (a)
Influences on the amount people save
They do this by enabling people and firms
include their ability to save. This will
to deposit money into current or checking
depend on their disposable income, i.e. the
accounts. These can then be used to make
amount of income they retain after any
payments or transfers to the bank accounts
income taxes have been deducted. People
of other customers using cheques and direct
3
debit instructions. Bank current accounts low incomes will not expect their incomes
can also therefore be used to receive to rise significantly in the future. On the
payments or transfers from other accounts. contrary, many might expect their incomes
to fall, especially in real terms if they are in
Commercial banks will also exchange
low paid jobs or expect to be unemployed in
foreign currencies thereby supporting
the future or receive fixed welfare payments
international trade and tourism.
or pensions from the government.
Banks also provide secure deposit or savings
Banks and other lenders are also unwilling
accounts in which people and firms can
to lend large sums of money to people with
keep their money. In return, banks will
low incomes and little or no collateral to
pay savers interest on their total savings
offer against their loans because of the risk
because the banks can use this money to
they may default on repayments. Lenders
make loans. These will include personal
are also likely to charge higher interest
loans people can use to buy a new car, for
rates on loans to those people who they
example, and commercial loans firms can
think are at greatest risk of not being able
use to invest in new capital equipment.
to pay off their loans in full. The higher
Mortgages are long-term loans used to buy
the interest charge, the more costly it is to
property. In contrast, overdrawing a current
borrow money.
account or making purchases using a bank
credit card are ways of borrowing money 4 (a) Specialization involves concentrating
from a bank for short periods. Commercial productive efforts on completing specific
banks therefore help to boost current tasks or products.
consumer spending and investment in an
Workers will normally specialise in those
economy by providing loans that people and
jobs or occupations they are most skilled
firms can repay in instalments, including
at or best qualified to perform. Similarly,
interest charges from their future incomes.
rather than producing a wide range of
(d) People with low incomes may have to different products, most firms concentrate
borrow money simply to help pay towards their resources on the production of
the cost of buying the basic goods and a single product or a narrow range of
services they need, such as food, housing products. This specialization enables firms
and electricity costs. They are unlikely to to combine resources in the most efficient
have any savings or other forms of wealth way possible to maximize their productivity
they can draw on to fund their day-to- and minimize their unit costs.
day expenditures or other more expensive
(b)
Fixed costs are production costs that do
items such as medical care, furniture,
not vary with the amount of output.
holidays or even books for their children’s
Because the production of aircraft is capital-
education. Borrowing may be the only way
intensive, the fixed costs of buying, hiring
they are able to afford these items.
and maintaining the machinery and other
Out of necessity rather than desire, capital equipment will be high in the
therefore, poorer people may be more aircraft manufacturing industry. Much of
inclined to borrow money than richer the machinery or equipment used may
people and the total amount of money have been purchased with borrowed money
they borrow is likely to be a much larger and, if so, interest payments on loans will
proportion of their low incomes than it is also be high and will have to paid even
for richer people. if no aircraft are produced. Similarly, the
manufacture of aircraft will require large
However, the total amount of money poor
factories and land space. Rental payments
people are willing and able to borrow may
are therefore also likely to be high.
be much less in absolute terms than richer
people who may borrow large amounts of (c)
The demand for capital goods by firms
money to buy luxury homes, new cars and is a derived demand. This means capital
exotic holidays. This is because people on goods are not wanted for themselves, but
lower incomes cannot afford to repay large are wanted because they are used in the
loans including interest payments from their production of other goods and services.
incomes if they remain low. Most people on The demand for capital goods will therefore
4
depend not only on their prices but also the quality. Any increased profits earned by
demand and profitability of the other goods the firm from higher sales of its improved
and services they are used to produce. product will soon be competed away. In
contrast, a monopoly can protect its profits
Like consumer demand for most other
from new competition through natural and
products, the higher the price of capital
artificial barriers to entry. Not only will it
goods the lower the quantity firms will be
be able to afford to invest in new product
willing and able to buy. If the capital goods
research and development, but it will also
are purchased with loans, then any increase
be able to retain any increase in profits
in interest rates is also likely to reduce
from sales of better quality products.
demand for them.
Because of its large scale, a monopoly is
However, government subsidies may be
also likely to enjoy many cost advantages
available to firms to encourage them to
over smaller firms, including technical
invest in new capital equipment. The
economies in research and development,
subsidies will reduce the cost of capital
making it cheaper on average for
goods and expand demand for them.
the monopoly to invest in product
Further, the more profitable the products improvements than smaller, competing
produced with the capital goods, the more firms.
firms are likely to demand to increase their
Finally, not all monopolies are able to
scale of production. Similarly, large firms
protect their markets and profits from new
are likely to need more capital goods over
competition. If there are low barriers to
time to replace old and worn out plant and
entry, their markets will be contestable.
machinery simply because of the large scale
This means the only way they will be able
of their production. However, advances
to retain control of their market will be
in technology may actually reduce the
to ensure they charge competitive prices
quantity of capital they need over time
and offer good quality products so that
because new machinery and equipment is
consumers do not switch their demand to
not only likely to be more productive than
other suppliers.
the old ones they replace, but may also
last longer. That said, the more productive 5 (a) Labour and enterprise.
capital equipment becomes, the more likely
(b)
Two influences on what factors of
firms may substitute new capital for labour.
production a firm uses are their relative
(d) A pure monopoly controls the total market prices and productivity. For example, as
supply of its product and can therefore wages rise and labour becomes relatively
determine the market price that will more expensive then a firm may replace
maximize its profits. In the absence of close labour with capital. Alternatively, a
substitutes, consumers will have no option firm may employ more labour intensive
but to continue to buy the product of the methods of production as labour becomes
monopoly even if the monopoly reduces its more highly skilled and its productivity
quality to reduce its costs of production and improves. Alternatively, labour may be
boost its profits further. Additionally, there replaced by new, more advanced machinery
is no competitive pressure on the monopoly and other capital equipment because it is
to improve its product. more productive and profitable to use.
Therefore, it is argued that market price (Others influences may include the type of product
will be higher and total supply and quality the firm produces, for example, passenger aircraft
lower in a monopoly than under conditions manufacturing and nuclear power generation
of perfect competition where many firms are capital intensive while fruit picking is often
compete to supply the product. However, labour intensive; the level of demand for the
there are many reasons why this may not product which, if significant, will allow firms to
be the case. mass produce the product using capital-intensive
methods; the availability of different factors
Competing firms may have no incentive
of production, for example, a firm may have
to spend more improving the quality of
to employ more capital-intensive methods of
their product if rival firms will all be able
production is there are labour shortages.)
to produce identical products of the same
5
(c)
Many workers are motivated by money and advanced machinery and equipment.
will tend to choose between occupations As a large firm, it may additionally be
depending on how much they are likely to offered lower cost loans to purchase new
earn from each one. In general, the higher equipment because it will have more
the wage rate for an occupation, the greater assets it can offer as security against loans
the supply of labour is likely to be to that from banks and other lenders. As a larger
occupation. If the supply of labour to an company with a bigger market share and
occupation greatly exceeds the demand for more sales, it may also be more attractive to
that labour, then the market wage rate may investors who are willing to buy its shares.
be quite low; but even at a relatively low This will allow it to raise permanent capital
wage some workers would still supply their that does not have to be repaid. If the firm
labour to fill available jobs. Those workers was a small, sole trader it would be unable
will be relatively low skilled and would to sell shares and would have to rely on
be unable to command higher wages in loans to finance expansion, often at much
alternative occupations. higher rates of interest.
However, many other factors than potential Specialist staff may also be employed
earnings also affect labour supply decisions. because the high cost of their salaries can be
For example, people will compare such spread over a much higher output. Similarly,
factors as when and how long they are spending on advertising and research and
required to work each day or week, holiday development is more cost effective for items
entitlements, promotion prospects, job mass-produced in large quantities.
security, and any non-wage benefits such as
The industry in which the firm operates
free medical insurance, subsidized canteens,
may also be growing in size, enabling
or the provision of a company car or free
the firm to take advantage of external
travel. So, for example, a worker may
economies of scale.
choose a job that offers a relatively low
wage over another job with a much higher However, if the firm expands too far too
wage because it offers more holidays, fast, it may experience diseconomies of
greater job security, is closer to home and scale. Total costs may rise faster than
involves less travel cost and time, and output, such that the average cost of
provides other benefits which more than producing each item rises as scale is
offset the lower wage. increased. This is because controlling and
coordinating production in a large firm
Some people also work for relatively
can be difficult, especially if it produces
low pay in charities that help people
and sells a wide variety of products in
and animals in need, because of the job
many different locations. A large firm
satisfaction it gives them.
can have thousands of employees and
(d) A firm that increases its scale of production many different layers of management.
may experience economies of scale that This can cause communication problems
reduce the average cost of producing each and disagreements between managers at
item as output rises. different levels in different parts of a firm.
Economies of scale are cost advantages It is also harder for senior managers to stay
associated with large-scale production, for in day-to-day contact with employees in
example, because the firm is able to buy the large firms that employ many hundreds or
parts or materials it needs for production in thousands of workers. As a result, workers
bulk quantities and in return for doing so may feel their ideas and skills are not
may receive bulk price discounts from their valued. This can reduce their motivation
suppliers. Smaller firms will not be able to with potentially damaging consequences
buy or store items in bulk and so will not for output and product quality. Production
be offered similar price discounts. may be disrupted by industrial actions, such
as strikes, if workers feel they are not being
The firm may also experience technical
consulted or treated fairly, or if they feel
economies of scale, because its large scale
their jobs are at risk of being substituted for
of production enables it to use more
capital equipment.
and larger cost efficient technologically
6
Some very large firms may also need vast of resources while at any point of production
quantities of materials, components or inside the curve there will be inefficiency and
power for production. They may have less than full factor employment.
to pay much more to obtain the supplies
• Economic growth: actual growth is shown by
they need and they may also experience
a movement closer to the PPC from a point of
shortages that can hold up production.
production inside the PPC and an increase
They may also be unable to attract enough
in productive potential will shift the PPC to
workers with the right skills and may have
the right.
to raise the wages they pay to attract them
away from rival firms or increase spending • Specialization in production: a PPC curve can
on training. All of these factors can push up be used to show how a firm uses its resources
the total and average costs of production in to specialize in the production of one good (a
large firms relative to smaller ones. point at either end of its PPC) or two goods (a
point of production along its PPC).
6 (a) An economic good is one that is limited in
supply because scarce resources must be (c)
Price elasticity of demand is the
used to produce it. This means there is an responsiveness of the demand for a product
opportunity cost involved in the production to a change in its price. If demand is price
of an economic good. elastic, a small percentage change in price
will result in a larger percentage change in
(b)
A production possibility curve shows the
quantity demanded each period.
maximum possible output that an economy
can produce with its factor resources. It There are a number of factors that will
therefore illustrates the economic concepts cause consumer demand for a product to
of scarcity of resources and opportunity cost. become more price elastic over time. For
example, in the short run the product may
A PPC shows there is a limit to what can be
have very few close substitutes. Consumers
produced with existing resources because
will therefore either have to continue
they are limited in supply and scarce
buying the product following an increase in
relative to unlimited human wants. All
its price or go without. However, over time
societies must therefore choose how best to
more substitutes may become available
use their resources. This involves deciding
if the product is profitable and new firms
what goods and services to produce with
enter the market offering alternatives.
them. That is, all societies must choose
which human wants will be satisfied and Demand will also tend to be more price
which ones will not. elastic the more time consumers have
to search or shop around for alternative
If more resources are devoted to the
suppliers or products, for example, if the
production of one type of product, fewer
product is not a necessity and it is possible
resources will remain to produce another
to delay its purchase.
product. This is shown by a movement
along the curve from one allocation of Demand also tends to become more
resources to another. Each movement price sensitive the higher the price of the
along the curve therefore shows what has product. Over time as price continues to
to be given up to produce more of the other rise, for example, due to inflation, the
good. So, for example, using more labour product will become less and less affordable
and capital to produce cars means less until eventually consumers are forced to
labour and capital is available to produce find cheaper alternatives or stop buying it
computers. The benefit given up from those altogether.
computers is therefore the opportunity cost Some products, such as telephone and
of the decision to allocate more resources to broadband services, electricity supplies, car
the production of cars. insurance and satellite television services,
Other concepts a PPC can be used to demonstrate are usually only supplied to consumers
are: who have agreed to long supply contracts.
These contracts will ‘lock’ a consumer into
• The efficient allocation of resources and full
an individual supplier for periods of 12,
employment: any point of production on the
18 or more months during which prices
curve represents a full and efficient allocation
7
may rise. Early exit fees can be expensive Large firms can pass on some of these
so consumers may have no choice but to cost savings to their customers as lower
pay the higher prices. However, after the prices, and because they can invest in
contract expires, consumers will able to developing new and improved products
shop around for alternative suppliers. and in improved customer service levels,
consumers can also gain from wider
(d) Through growth, a firm is able to enjoy a
product choice and quality.
number of cost advantages over smaller
firms. When a firm expands its scale of However, growth in the size of firms may
production, it has a chance to become not always benefit consumers or their
more efficient. Average or unit costs of owners. This is because some firms can
production can be reduced as a firm grows experience problems if they try to expand
in scale because it gives the management their size and scale of production too much
or owners a chance to reorganize the way and too quickly. As a result, productivity
the firm is run and financed. Cost savings may fall and average costs will rise. These
that result from increasing the scale of problems are caused by diseconomies of
production are called economies of scale scale. These occur because managing a
and will allow firms to increase their profits. large firm can be difficult, especially if the
firm has factories or offices spread over
For example, large firms are often able to
many different locations producing many
buy the materials, components and other
different types of products, and with many
supplies they need in bulk because of the
different layers of management. This can
large scale of their production. Suppliers
cause communication breakdowns and
will usually offer price discounts for bulk
disagreements between different managers
purchases because it is cheaper for them
in different parts of the organization and
to make one large delivery than several
at different levels in the management
smaller deliveries. Larger firms are also
hierarchy. Some large firms may also be
able to borrow more money and at lower
unable to attract enough workers with the
interest rates than smaller businesses.
right skills. Their costs may rise as they
Bank managers and other lenders often
have to spend more money on training
consider lending to big organizations as
their workers and increasing their wages
less risky than lending to smaller ones.
to ensure they do not leave to take jobs in
This is because large firms are often more
other firms.
financially secure and can offer more assets,
including property and other investments, If a large firm experiences significant
that they can use as collateral against loans. diseconomies of scale, it may attempt to
Larger firms may also be able to form a pass on these costs to consumers as higher
limited company and sell shares to raise prices. The mass production of standardized
non-repayable share capital. products by many large firms also reduces
product choice for consumers. Many
With more financial resources than smaller
consumers may prefer the personalized
firms, a large enterprise can invest in
service and products that smaller firms
specialized machinery and equipment, to
may offer.
train and recruit highly skilled workers,
and to research and develop new products Some large firms may also grow to
and processes to increase the efficiency of dominate the market supply of a product
their production. They can also diversify and may use this market power to restrict
into other products and markets. In this new competition so they are able to charge
way, a large firm is able to reduce the risk higher prices and earn abnormal profits.
to its business of losing a major customer, Consumers will suffer reduced choice
or a fall in demand for a product in one of and higher prices as a result of such anti-
its markets. competitive behaviour.
8
Exam preparation: model answers

Part 1 The basic economic so will require the firm moving some of its
resources out of the production of A and into
problem the production of B. The opportunity cost of
increasing output of B by 30 units each week is
1.1 therefore the loss of 40 units of A.
(a) Resources used to produce goods and services (Note: A and B can be any two products you wish to
are finite or limited compared to human wants. name)
These are infinite or without limit. The scarcity
(d) An increase in public expenditure on education
of resources relative to human wants means
is likely to increase both the quantity and
that many of our wants cannot be satisfied.
quality of education available. More people
Choices must therefore be made between what
will now be able to attend schools and colleges
goods and services to produce, how they are
because more places and more teachers will
produced and who they are produced for. That
be available. An increase in the quantity of
is, all societies must choose how best to use
education will help to increase the workforce
their scarce resources.
because more people will be able to learn
(b) Enterprise involves combining and organizing the basic skills and knowledge they need to
other factors of production into firms to get a job. An improvement in the quality
produce goods and services that consumers of education would also help people to
want and are willing to pay for. It therefore develop additional and higher-level skills and
requires taking risks and making decisions knowledge. This will increase the mobility and
necessary to make firms run successfully. The productivity of the future labour force and
reward for successful enterprise is profit. boost economic growth.
(c) Educated people are also more likely to be
(a) innovative and want to start up their own
X businesses. This can result in the creation of
100
more and better products, more employment
Product A
Y opportunities, improve living standards and

60
increase the rate of economic growth further.
As incomes rise, a government should also
benefit from increased tax revenues it can
use to invest in more schools, hospitals, roads
0 120 150 and other infrastructure to increase social and
(b)
economic development.
Product B
Higher education spending may also help to
The firm in the diagram can use its factor improve public health by teaching people how
resources to produce two products: A and B. At to look after their health, for example, through
point (a) all of its resources are used to produce better nutrition and improved cleanliness,
A. At point (b) all of its resources are used to In turn, this should reduce days lost at work
produce B. Alternatively, it can produce any through sickness and reduce government
one of the combination of quantities of A and spending on providing healthcare.
B shown by its production possibility curve. At
However, increased public spending on
every point along this curve, all of its resources
education has an opportunity cost. Because
are being used as fully and efficiently as possible
the government has limited resources, it will
to maximize production of A and/or B.
either have to reduce spending in other areas
For example, at point X, the firm produces of the economy or raise taxes. For example,
100 units of A and 120 units of B each week. spending on transport, defence, housing and
At point Y, it could produce 60 units of A and state pensions may have to be cut. This could
150 units of B each week. However, to do damage the productive capacity of the economy
1
and also result in higher unemployment as jobs buy these services from these companies or
are cut from these sectors. Higher taxes will go without. Similarly, many people have to
reduce the disposable incomes and spending of travel to work each day by buses or trains.
consumers. This in turn could result in firms If fares rise, they will still have to use them
cutting output and shedding labour. to travel to work because there are few
other ways of getting there, even if there are
These problems are likely to be more immediate
competing bus and train providers.
than any of the benefits from increased
spending on education if people spend more • Products like newspapers and matches do
years in education as a result. This will have not cost very much so even a relatively
the additional effect of reducing the supply of big increase in their prices may not cause
labour in the economy in the short term. demand to contract very much.
There is also a risk that many of the benefits In contrast, products for which demand
associated with higher levels of spending on is relatively price elastic tend to have the
education may be lost if, for example, those following characteristics.
receiving a better education move overseas if
• They are luxury items and expensive,
there is a lack of skilled jobs in their country
such as cars and holidays. An increase in
and if they can also earn more in jobs overseas.
their prices may cause demand for them to
Or their education may be wasted if they are
contract significantly.
taught the wrong skills or if they are not taught
for long enough so they do not develop the • They have many substitutes. For example,
range or level of skills and knowledge they a rise in the price of butter may cause an
need to succeed. increase in consumer demand for
margarine instead.
In conclusion, an increase in spending on
education will only be appropriate if the • Similarly, consumers can choose between
benefits of doing so clearly outweigh the many different makes of car. A rise
opportunity costs and risks involved. in the price of one make may cause a
big contraction in demand for them as
consumers turn to alternative makes. The
Part 2 The allocation of more time consumers have to shop around
resources to find lower-priced alternatives, the more
elastic demand is likely to be.
2.1 (c) There are two main reasons why many more
people travel by aeroplane today. First, real
(a) Price elasticity of demand measures the
incomes have risen in many countries so more
responsiveness of demand for a product to
people can afford to travel more by plane.
changes in its price. For example, if demand
The demand for air travel has increased. More
is price elastic, a small change in the price of
and more people want to go on holidays these
a product will cause a proportionately larger
days, and more often. Business air travel has
contraction in the quantity demanded of that
also increased.
product.
Secondly, increased supply and competition
(b) Goods and services for which consumer
in air travel has reduced airfares. There are
demand tends to be relatively price inelastic
many low-cost airlines around the world today
tend to have the following characteristics.
competing for air passengers with established
• They are necessities, such as many basic national airlines, and many more airport
foods, and gas or electricity for power and destinations to fly to and from than previously.
heating, which people cannot go without
We can use a diagram to show these changes
even if their prices rise.
in demand and supply in the air travel market.
• They have few substitutes. For example, The diagram below plots airfares against air
in some countries the market supplies of travel per period, measured in air passenger
electricity, postal services and passenger kilometers travelled between two countries. The
rail services are each controlled by a single total market demand for air travel between the
company. They are pure monopolies and two countries at every possible fare is plotted as
have no competitors. Consumers must either a downward sloping line or curve because the
2
demand for travel will tend to expand as fares nearer it gets the date to the day of departure,
reduce. The market supply is an upward sloping or during periods of relatively low demand at
line because airlines will tend to supply more the start and end of the holiday season when
flights and seats the higher the fare they can many children are at school and families are
charge passengers. The equilibrium fare (P) and unable to travel.
the quantity of air travel purchased from the
However, if demand for the tour is price
airline providers (Q) occurs where the market
inelastic then cutting price, even by a large
demand curve (DD) crosses the market supply
amount, is unlikely to create further bookings.
curve (SS).
In this case it may be worth charging consumers
more for the holiday, because overall sales
D D1 S S1 revenues will tend to rise if the price rise has
little effect on demand. For example, some rich
people like to go on very exclusive holidays,
P1
staying in luxury hotels and travelling on first-
P class tickets. They do not want lots of other
Air fare
P2 people on the same holiday and may be willing

to pay a very high price to ensure it remains
exclusive. Despite it being a luxury, rich people
S
can afford to pay for the holiday and increasing
S1
D D1 the price of it may have little impact on their
Q Q1 Q2 demand, so overall revenues will rise.
Air passenger km per period

2.2
Increased demand for air travel due to rising
(a) An economic system refers to the ways in
real incomes of consumers is shown as a
which people and organizations within an
rightward shift in the market demand curve
economy determine what goods and services
to D1. If nothing else had changed the impact
to produce with their scarce resources, how to
would be to push up the equilibrium airfare
produce them and who to distribute them to.
from P to P1, and the quantity of travel from
Q to Q1. (b) A mixed economic system combines a market
economic system with government planning to
The increased supply of air travel provided by
determine the allocation of resources.
airlines is shown as a rightward shift in the
market supply curve to S1. This has the effect In a free market system resources will be
of reducing the equilibrium airfare from P1 allocated by the owners of firms to their most
to P2 and increasing the quantity of air travel profitable uses dependent on what goods and
undertaken further from Q1 to Q2. services consumers want and what they are
willing to pay for them.
(d) A company selling holiday tours would find
it useful to know if its sales revenues would Changes in the market prices of different
rise or fall if it increased or reduced its holiday products provide signals to firms about what
prices. For example, if a specific holiday tour consumers are spending their money on.
is proving unpopular and pre-booked seats of A rising price indicates that consumers are
aircraft and hotel rooms will be left unfilled, buying more of the product and private sector
then the company could lower the holiday firms will respond by allocating more resources
price to attract more holidaymakers and fill to its production. This is because production
these vacant places. This will be especially of the product will become more profitable
important If the holiday company has already as its price rises. In contrast, falling product
paid air travel companies and hotels for these prices indicate consumer demand for those
places. To cover these costs and not make a products and their profitability is falling. Firms
loss it must book more people on the tour. If are likely to cut their production and move
demand is price elastic, cutting the holiday price their resources to the production of more
will expand demand and overall revenues will popular and profitable products. In these ways,
rise. This is why many holiday companies cut consumers get what they want and are willing
their prices to fill empty spaces on holidays the and able to pay for.
3
However, some people in a market economy can therefore also provide employment for
may not get the products they need and many people to produce goods and services.
want because they are unable to afford For example, in many countries water and
them or because they are not profitable electricity supplies are provided by government
enough for private sector firms to produce. organizations because they are essential for
In a mixed economy, a government can public and economic welfare. In this way a
intervene to correct these and other failures government can more easily regulate service
by regulating prices and the actions of private quality, provision and prices charged to
firms, producing and supplying socially and different groups in society than it would be able
economically desirable products that private to if these services were provided by profit-
firms undersupply including street lighting, seeking private firms.
national defence and public healthcare
(d) Governments may intervene in markets by
education, and supporting the incomes of poor
regulating the behaviours of producers to
households.
achieve more desirable economic outcomes.
(c) The government is a major employer, consumer Governments may use laws that outlaw certain
and producer of goods and services in many activities, such as the production and sale
countries. Governments will sometimes of dangerous drugs and weapons, and use
intervene in markets for different goods and selective subsidies and taxes to affect market
services if these markets produce outcomes that supply and demand conditions.
are undesirable and the decisions of producers
In a market economy private firms and
or consumers result in wasteful or harmful
individuals may fail to take account of the
activities. These market failures will reduce
impact their production and consumption
economic welfare. This means other resource
decisions can have on the natural environment.
allocations or market outcomes may be more
A government may therefore introduce laws
beneficial and economically worthwhile.
or regulations to protect the environment. For
For example, consumers with little or no example, anti-pollution and dumping laws
money, perhaps because they are too old or can make it illegal to burn waste or dump
disabled to work to earn money, may be unable untreated waste into rivers and seas. Similarly,
to afford many basic goods and services. Private competition laws can be used to outlaw anti-
sector firms are unlikely to produce many of competitive behaviours used by large powerful
the goods and services they may need, such as firms to restrict competition and force up
health care or products that aid mobility, simply market prices. Large firms found to be actively
because it is not profitable to do so. Similarly, restricting competition and acting against the
other goods or services such as street lighting, a public interest may be fined, be subject to price
legal system and defence may not be provided controls or, in the case of monopolies, broken
in free market economies because it will be up into smaller, competing firms. A government
difficult for private firms to identify and collect may also introduce price controls to stop
money from the individual consumers who monopolies from charging consumers excessive
will benefit from them. This is because once, prices in order to maximise their profits.
say, street lighting, is provided it is difficult Governments may often set legally binding
to exclude consumers from the benefit of it, maximum prices in markets for essential
whether they have paid for it or not. In all products such as rented accommodation, water
these cases a government can use resources supplies and food and energy products, to stop
to produce goods and services that are in the suppliers from overcharging consumers and
public and economic interest, and distribute to make these items more affordable to people
them to people in the most need regardless of with low incomes.
their ability to pay. A government can pay for
Similarly, a government may use indirect
the provision of such goods and services from
taxes and subsidies to influence consumer
the tax revenues it collects.
behaviour and in, so doing, the production
High levels of unemployment among decisions of firms. For example, indirect
workers can also be a big problem in many taxes may be imposed on demerit goods that
market economies. Resources may become create significant negative externalities such
unemployed if the products they produce are as cigarettes and alcohol. If they are profitable
no longer profitable. Government organizations to produce, private sector firms are likely to
4
supply far more of these goods than is socially would make holding money unacceptable; it must
or economically desirable. Indirect taxes on also be scarce otherwise it would not be of any value).
cigarettes and alcohol can reduce consumer
(c) Consumer price inflation will reduce the
demand for these products. Consumer demand
purchasing power or real value of the euro. For
for these products will tend to fall as their after-
example, if inflation is 1% a product exchanged
tax prices rise. Indirect taxes will also increase
for 1 euro last year will cost 1.01 euros this
the cost of producing demerit goods because it is
year. This means a euro will buy less than it did
unlikely that their producers will be able to pass
the previous year. Inflation therefore affects
on the full amount of the taxes to consumers
the ability of the currency to be a good store
in higher prices. As a result production of
of value. When inflation is low the real value
the taxed items becomes less profitable and
of the currency will fall only slowly over time.
producers are likely to reduce their output in
However, in a hyperinflation confidence in the
response. A government may also vary the
currency may be lost because it no longer holds
total amount of taxation in the economy to
its value and will also fail to provide a means
affect the total or aggregate demand of goods
of deferred payment. As a result, the currency
and services. If prices are rising rapidly in an
may no longer be a generally acceptable
economy because total demand is rising faster
medium of exchange.
than supply, a government may increase direct
taxes on personal incomes to reduce consumer (d) The central bank in a national economy has
spending. It may also raise interest rates to many functions including supervision of its
reduce borrowing and encourage saving. banking system. It does this by regulating the
conduct of banks. It also hold their deposits of
Selective subsidies can be used to influence
money and transfers funds between them to
production decisions by offsetting costs. For
settle the many millions of cheque, debit card
example, many governments are encouraging
and other payments made by their customers to
the development of new technologies such as
the bank accounts of other people and firms or
renewable energy generation, bio-fuels and
even to the government.
electric vehicles that will help to boost economic
growth but in a more sustainable way. By A central bank will also support the banking
reducing the costs of production, subsidies can system as its lender of last resort if banks run
increase output and employment, and help short of money. If this happens, depositors are
to reduce market prices, thereby expanding likely to lose confidence in their banks and
demand for new products and technologies. may want to withdraw their savings and other
deposits all at the same time. This will cause
the banking system and very possibly the entire
Part 3 Microeconomic economy to collapse unless the central bank
decision makers steps in to lend banks the money they need to
pay off their liabilities.
3.1 The central bank is also the government’s
bank, which means it holds tax and other
(a) Money is a good that is generally accepted as a
public revenues collected by the government
medium of exchange. This means all producers
and organises payments from them through
are willing to accept that good in payment
government departments and other public
for their goods and services, consumers are
sector organizations to pay private sector
willing to use the good to make payment and
suppliers, interest on the national debt and the
receive change, and employees will accept it in
wages of public sector employees.
payment for their labour in the form of wages
or salaries. The central bank will also normally have the
exclusive right to print and issue new notes and
(b) To be a good, money, euro notes and coins
coins and to issue and repay public sector debt
must be generally acceptable to be a medium
on behalf of the government.
of exchange. They must also be easy to carry
and divisible into smaller units without any It also manages the nation’s gold and foreign
loss of value to allow different amounts to be currency reserves. They are used to make
exchanged and change to be given. international payments and to stabilize the
value of the national currency on the foreign
(A good must also be durable otherwise it would lose
exchange market if necessary.
value if it wears our or perishes too quickly and this
5
The central bank will also operate the on meeting their needs, that is, spending
government’s monetary policy. This involves money on food and accommodation. They
changing the money supply or interest rate to will have little left over to save to fund future
influence the level of borrowing, saving and consumption. Young people tend to earn lower
spending by consumers, which in turn can help incomes and will spend more and save less than
to control total demand, employment and price middle-aged people. Older people may also
inflation in the economy. have low incomes and will fund their spending
from any savings they have made over time.
Middle-aged people are more likely to earn
3.2 more income but also save more to fund large
(a) Disposable income is that amount of income purchases in the future, such as a new car
a person or household has available to spend or home, and to fund their retirement or to
or save after any income or payroll taxes cover possible future medical bills or periods
have been deducted from their gross income. of unemployment.
Disposable income is therefore gross income less
As income taxes rise, disposable incomes
any income and payroll taxes payable.
available for spending or saving will tend to fall.
(b) The spending patterns of Neil and Natalia differ As a result, people may save less to maintain
will largely depend on their incomes, family lifestyles and their previous levels of spending.
circumstances and tastes. Relative disposable
Family circumstances will also influence saving
income after the deduction of any income taxes
– people with young families may spend a lot
will be a major factor. Because Natalia has been
of their income on bringing up and educating
working for some time and has been promoted
their children and have little left over for
to a senior position it is likely that she earns
saving. Economic conditions will also affect
more than Neil who is just starting his first job.
motives for saving. When people are confident
Natalia may therefore spend more in total than
that the economic situation is good and will
Neil, although the proportion of income spent
remain good in the future, they will feel more
may be less than the proportion Neil spends, as
secure in their jobs and may spend more and
he will have to spend all or most of his income
save less. If confidence in the economy is low,
meeting his basic needs for food, clothing and
people will save more and spend less in case
rent for accommodation.
they lose their jobs.
In contrast, Natalia may have her own home
The interest rate, relative to the inflation rate,
and spend more on household goods and
will also influence saving. If inflation is higher
mortgage repayments than Neil. Natalia may
than the interest rate, people will spend rather
also be married with young children and will
than save. If the interest rate is higher than the
therefore spend more on food, health care,
inflation rate, people will tend to save more.
children’s clothes, toys, family holidays and
education. Motoring and travel costs may also Finally, people have different tastes and habits
be higher in Natalia’s household than for Neil, that will influence their spending and saving
who may not be able to afford to own and run over time.
a car. If Neil is a single young man he may send (d) An increase in consumer spending can have
more on music, fashionable clothing and going widespread impacts on an economy. If, as a
out with his friends compared to Natalia. result of the increase in consumer spending,
(c) People have many different motives for saving aggregate demand for goods and services in
that will be influenced by their income, age, the economy increases, producers will tend to
family circumstances, economic conditions and increase their output and to do so may need
taste. Saving allows a person to delay spending to hire more labour. This will tend to reduce
and consumption, for example to purchase an unemployment and boost disposable incomes.
expensive product such as a car or to fund the Producers may also experience an increase in
person’s retirement from work. profits if the additional revenues exceed the
costs of expanding output.
Income is a major determinant in saving
decisions. People on higher incomes will tend As personal incomes and profits rise, the
to save a larger proportion of their incomes government will tend to collect more in
than people on lower incomes. People on low direct taxes. Revenues from indirect taxes on
incomes will tend to spend most of their income goods and services will also rise as consumer
6
sending increases. Government spending on Cutting the annual interest charge from 15%
unemployment and welfare supports may to 10% on credit cards is therefore likely to
decrease at the same time as employment rises. increase credit card borrowing to fund an
increase in current consumption. However,
However, if the increase in consumer spending
it will require people to devote more of their
is on imported goods and services domestic
future disposable income to paying off their
firms and employment may not benefit. The
credit card debts and interest charges. This, in
balance of trade may deteriorate and this could
turn, will require them to reduce either their
place downward pressure on the exchange rate
future consumer spending or saving or both.
of the currency of the economy. In turn this
However, it is unlikely to affect those people
will increase the prices of imported products.
who choose to pay off their credit card debts
Further, if total demand in the economy
in full each month and therefore avoid any
increases at a faster rate than total output or
interest charges.
supply can expand, there may be a demand-pull
inflation as the general level of prices rise. (d) The market or equilibrium wage rate for an
occupation will depend on labour demand
and supply conditions for that occupation.
3.3 Differences in labour demand and supply in
(a) An interest rate is a charge added by a lender different occupational markets will therefore
to a loan for the use of that money. That is, it is explain wage differentials. The same will apply
the cost of borrowing money and it is usually to service occupations.
set as a percentage of the total amount or value
Service occupations that require skills that are
of the loan made. Equally, an interest rate is
in short supply relative to demand will tend
also a reward for saving money in a bank or
to pay more than those service occupations
other financial institution. So, for example, an
for which there is abundant supply of labour.
annual interest rate of 5% means that $5 will
This will explain why, for example, doctors,
be added to every $100 borrowed or saved.
lawyers and accountants tend to earn far more
(b) People have many different motives for saving, than shop assistants. The supply of labour to
which will be influenced by their income, age, such professions also tends to be low because
family circumstances, economic conditions and of the amount of training people require before
taste. Saving allows a person to delay spending they can enter these service occupations.
and consumption, for example to purchase an For example, it takes doctors over six years
expensive product such as a car or to fund their to qualify to do their job and up to 15 years,
retirement. perhaps more, to become a skilled surgeon.
People will also save money to earn interest. The supply of labour to a service occupation
The higher the rate of interest on savings, will also depend on many non-wage factors.
the more people are likely to save from their For example, a service occupation that involves
disposable incomes. working unsociable hours or offers less annual
(Other motives may include saving as a precaution, leave days and fewer fringe benefits, such
for example, against possible future unemployment, as free medical care or a subsidized canteen,
large unexpected repair bills or medical costs; saving will tend to be less attractive than other
for a special occasion such as a wedding or family occupations. To attract a suitable supply of
holiday; saving gives people satisfaction because they labour, higher wages may have to be offered to
feel wealthier.) compensate.
(c) Using a credit card to make purchases is a Some service occupations may also be heavily
form of short-term borrowing since it allows unionized. If union membership in a workplace
the cardholder a month or more to pay for or occupation is high, the union will have
their purchases. Interest, usually at a high significant bargaining strength in negotiations
rate, however, is payable if the amount on the with employers over pay and working
credit card is not repaid in full in the specified conditions. This bargaining power may be
period. People who pay off their entire balance strengthened even more if the union’s members
each month will not normally be charged any provide an essential service, such as the fire or
interest. police service.
7
3.4 wages may be a loss of leisure time because

of the need to work longer hours or to travel
(a) A trade union is a group or association of
further to and from the place of work.
workers in the same industry, profession or
occupation, who join together to maintain and (d) The market or equilibrium wage rate for an
improve their wages and working conditions. occupation will depend on labour demand
and supply conditions for that occupation.
(b) People join trade unions because of the benefits
Differences in labour demand and supply in
they provide to their members. These include
different occupational markets will therefore
defending the right of employees in disputes
explain wage differentials.
with their employers, developing the skills
of their members by providing training and As wages rise the supply of labour will tend
education programmes and, in some cases, to expand. However, as it becomes more
providing social and recreational amenities for expensive to employ people, the demand for
their members. labour will contract. At the equilibrium wage
rate the demand for labour will equal the
Trade unions will also have greater bargaining
supply of labour. An increase in demand for
power than individual employees in
labour or a fall in its supply to an occupation
negotiations with employers to improve their
will therefore tend to push up the market wage.
wages and conditions of employment. Through
In contrast, if labour demand falls or supply
their collective bargaining unions may also
rises, the market wage rate will tend to fall.
secure better hours of work and improvements
in holiday entitlement, sick pay and pensions Highly skilled labour tends to be in relatively
for their members. short supply compared to unskilled workers
so the wage rates highly skilled employees can
Before trade unions existed, each worker had
earn will tend to be much higher. This explains
to negotiate on his or her own for increased
why, for example, doctors, lawyers and pilots
pay and better working conditions with his or
tend to earn far more than shop assistants and
her employer. With few rights, a worker could
farm labourers. The supply of labour to such
face being sacked for asking. Trade unions,
professions also tends to be low because of the
however, can negotiate with and put pressure
amount of training people require before they
on employers on behalf of all their members to
can enter these occupations. For example, it
secure these aims.
takes doctors over six years to qualify to do
(c) All the wage and non-wage factors that their job and up to 15 years, perhaps more, to
affect the attractiveness of a particular job become a skilled surgeon.
or occupation are called its net advantages.
Workers who are skilled and highly productive
A person will compare and select jobs or
will also tend to be in great demand compared
occupations by comparing their advantages and
to less-productive workers. This is because they
disadvantages.
will contribute more to output, revenue and
Wage factors will include the basic wage lowering average production costs than less-
rate each occupation pays, how they reward productive workers. As a result of demand for
overtime working and working unsociable their labour being high, they will tend to earn
hours, and other monetary rewards each higher wages.
occupation offers such as performance related
The demand for labour is a derived demand
payments and bonuses.
because firms want labour to produce goods
Many non-wage factors will also be important and services that consumers want and are
including diffrences in their hours of work, willing to pay for. It follows that the more goods
working conditions, promotion or career and services demanded, the higher their market
prospects and other costs and benefits price will be and therefore the more revenue
associated with each occupation including how is generated from their sale, so the more the
much it costs to travel to and from different demand for labour is likely to be.
places of work.
Trade unions with significant bargaining
Choosing between different occupations will strength and who insist on full membership
therefore involve trade offs. For example, the by all workers in a particular firm, industry or
opportunity cost of choosing a job with high occupation may also be able to secure higher
8
wages for their members. This is because a efficiency and market power of the new
powerful union can restrict labour supply and firm. Average costs tend to fall as the scale of
disrupt production through industrial action if production increases as a result of economies
employers fail to meet their wage demands. of scale. For example, the new firm can spread
its fixed costs over a much larger output and
may be able to borrow money more cheaply
3.5 from the banking system to buy more efficient
(a) A merger is an agreement between two or more machinery. In turn this may result in lower
firms (or companies) to combine their operations prices for consumers. However, there may be
into a single firm (or company). reduced choice and higher prices for consumers
(b) Factors of production are the inputs to if the merger significantly reduces competition
productive activity. The goods and services they and creates a powerful monopoly able to
produce are the outputs. Economists classify control market supply.
productive resources into land (all natural Lateral or conglomerate merger occurs between
resources), labour (physical or mental efforts firms producing different goods and services.
by people) and capital (man-made resources This diversification means the new firm can
like machinery and computers used to produce enjoy risk-bearing economies. This means it
other goods and services). Entrepreneurs will can continue in business if there is a sudden fall
combine and organize these resources into in the demand for one of its products because
firms to produce goods and services. Enterprise it produces different products for different
is therefore recognized as economists as another markets.
factor of production. Enterprise refers to the
Vertical merger occurs between firms at
business know-how entrepreneurs have that is
different stages of production. For example,
necessary to organize production successfully.
a car manufacturer may integrate with a tyre
Productive resources or factors of production
manufacturer and a car retailer so it can be
are scarce relative to human wants for goods
guaranteed a steady and secure supply of tyres,
and services.
and prime retail locations to sell its cars.
(c) Most small firms are one-person businesses
However, mergers to create much larger
called sole traders. Many may be new start-
enterprises can create less rather than more
ups and will start small. This is because they
efficient firms. They can experience problems
usually lack the finance or capital they need
if they try to expand their size and scale
to grow and operate a larger organization.
of production too much and too quickly.
Many, however, may prefer to remain small
Productivity may fall and average costs will rise
because growing large can often mean the
as a result of diseconomies of scale.
original owners lose control of their businesses.
To raise enough finance needed to invest in For example, managing a large firm can be
large-scale production a small firm may have difficult especially if the firm has factories or
to become a limited company and sell shares in offices spread over many different locations
the ownership of the company. However, the producing many different types of products
cost and capabilities of modern technologies, and has many different layers of management.
such as computers, mobile phones and other This can cause communication breakdowns
equipment, has allowed many firms to remain and disagreements between different managers
small in terms of the size of their premises and in different parts of the organization and at
workforce. different levels in the management hierarchy.
Decision-making will be slowed down, and it
Small firms also tend to serve local markets and
may take longer for decisions to be acted on by
can offer their customers personalized services,
employees at the bottom of the organization.
specialist or made-to-measure products that
larger firms would find too difficult or costly Similarly, a large firm can experience
to make. The size of their markets will also shortages of labour and materials that will
constrain the ability of small firms to grow. slow down production and increase costs.
Large firms may also find it difficult to
(d) Integration between two or more firms at the
continually attract new customers because
same stage of production and producing the
their products are too standardized and they
same products is called a horizontal merger.
have outgrown their market.
This can increase the scale of production,
9
3.6 salaries of flight crews and cabin staff would not

be saved as these will need to be paid whether
(a) Profit is a surplus of total revenue from the
or not flights were operated. Similarly, the
sale of products remaining after the total
disruption is unlikely to have affected other
cost of producing those same products has
fixed costs such as costs of operating offices and
been deducted. Most private sector firms aim
aircraft hangars, loan repayments and insurance
to maximize their profit by attempting to
premiums.
boost their revenues while minimizing their
production costs. Profit is the reward for risk However, some variable costs could increase,
taking in business. for example, costs of rebooking customers
onto different flights, costs of investigating and
(b) A fixed cost is one that does not vary with
correcting technical problems and increased
the volume of output produced by a firm.
marketing in an attempt to attract customers
For example, fixed costs will include rents,
back to using the airline following the
telephone bills, insurance premiums and
disruption.
equipment hire charges. Fixed costs may,
however, increase if a firm expands its scale of
production, for example, by moving to larger 3.8
premises and hiring more machinery.
(a) A horizontal merger is an agreement between
In contrast, variable costs, such as the purchase two or more firms (or companies) producing
of component parts and materials and piece- the same or a very similar good or service to
rate payments to workers, vary directly with combine their operations into one firm (or
the volume of output produced. company). Examples include mergers between
(c) The cancellation of flights over an extended two or more car manufacturers or between
period will clearly lose the airline a significant two or more supermarket chains. Most mergers
amount of revenue. If costs are unchanged, between firms are horizontal.
profits will fall. However, costs are unlikely to (b) A competitive market will often have numerous
have remained constant, but it is not clear if firms competing to attract consumers to buy
overall they will have fallen or increased. their products. As a result, there will usually be
Fixed costs of owning and operating aircraft are vigorous competition between these firms on
likely to be a major element in total cost and price and product quality.
will be largely unaffected by the disruption. Product features and brand images will
Likely savings in variable costs, such as on be highly differentiated and the range of
fuel, maintenance and crew overtime may product features and designs available, the
be significant but may be offset by increases quality of after-sales services and product
in variable costs associated with rebooking prices will all tend to change frequently as
customers onto alternative flights operated by competing firms develop new ones they hope
other airlines and increased marketing costs. will attract consumer demand away from
The outcome in terms of profits is therefore rival suppliers.
unclear but on balance one could expect there
However, vigorous price and non-price
to be a reasonably big drop in profits as the loss
competition may also be observed in markets
in ticket revenues is likely to far exceed any
controlled by a small number of large firms.
decrease in costs.
(Other characteristics: the market shares and
(d) If flights have been cancelled, Ryanair would
profits of competing firms will tend to vary over
lose significant revenue but may also be able
time; there are no or few barriers to entry – new
to save some costs. These will be mainly the
firms are able to enter the market easily and
variable costs of operating flights such as
inefficient firms will be forced to exit; if the
fuel costs, maintenance costs and any airport
market is perfectly competitive, products will be
charges for landing and handling flights.
identical and all firms will be price takers.)
If some of Ryanair’s aircraft were leased rather
(c) Through growth, a large firm is able to enjoy a
than owned outright the airline may also have
number of cost advantages over smaller firms.
been able to cancel some of its leases. Further, if
When a firm expands its scale of production, it
pilots refused to work overtime these payments
has a chance to become more efficient. Average
will also have been saved. However, the basic
10
or unit costs of production can be reduced of the organization and at different levels in the
as a firm grows in scale because it gives the management hierarchy.
management or owners a chance to reorganize
Some large firms may also be unable to attract
the way the firm is run and financed.
enough workers with the right skills. Their costs
Cost savings that result from increasing the may rise as they have to spend more money
scale of production are called economies of scale on training their workers and increasing their
and will allow firms to increase their profits. wages to ensure they do not leave to take
For example, large firms are often able to buy jobs in other firms. If a large firm experiences
the materials, components and other supplies significant diseconomies of scale, it may attempt
they need in bulk because of the large scale of to pass on these costs to consumers as higher
their production. Suppliers will usually offer prices.
price discounts for bulk purchases because it is
Some very large firms may also need vast
cheaper for them to make one large delivery
quantities of materials, components or power
than several smaller deliveries. Larger firms are
for production. They may have to pay much
also able to borrow more money and at lower
more to obtain the supplies they need and they
interest rates than smaller businesses. Bank
may also experience shortages that can hold up
managers and other lenders often consider
production.
lending to big organizations as less risky than
lending to smaller ones. This is because large Further, some firms may grow so large that
firms are often more financially secure and can smaller firms are unable to compete with
offer more assets, including property and other them. As a result, they can dominate the
investments, that they can use as collateral market supply of a product and control its
against loans. market price. Large firms with dominant
market positions in an economy may attract
With more financial resources than smaller
the attention of the government. It may
firms, a large enterprise can invest in specialized
introduce laws and regulations that control
machinery and equipment, to train and recruit
the prices charged by large firms and the
highly skilled workers, and to research and
quality of the services they provide. The need
develop new products and processes to increase
to understand and comply with government
the efficiency of their production. They can also
regulations will increase running costs in the
diversify into other products and markets. In
affected firms.
this way, a large firm is able to reduce the risk
to its business of losing a major customer, or a (d) A monopoly is a firm that has significant
fall in demand for one its products in one of its market power over the supply of a particular
markets. Large firms can pass on some of these product. For example, a pure monopoly has
cost savings to their customers as lower prices, no competitors and controls the total market
and because they can invest in developing supply of a product.
new and improved products and in improved A monopoly may therefore use its market
customer service levels, consumers can also power to restrict competition and market
gain from wider product choice and quality. supply in order to raise the market price and
However, growth in the size of firms may not earn excessive or abnormally large profits
always benefit consumers or their owners. over and above what it might expect to earn
This is because some firms can experience in a more competitive market. As a result,
problems if they try to expand their size and consumers will face higher prices, reduced
scale of production too much and too quickly. choice and possibly reduced service levels and
As a result, productivity may fall and average product quality if the monopoly cuts these to
costs will rise. These problems are caused by reduce its costs and boost its profits further.
diseconomies of scale. These occur because Many governments around the world have
managing a large firm can be difficult, especially therefore introduced laws and regulations to
if the firm has factories or offices spread over control monopolies in the private sector that
many different locations producing many act against the public interest, for example by
different types of products, and with many capping the prices they can charge and profits
different layers of management. This can cause they can earn. Governments must therefore
communication breakdowns and disagreements employ scarce resources paid for from tax
between different managers in different parts
11
revenues to monitor and regulate monopoly Part 4 Government and the

behaviour. These scarce resources could have
been put to other more productive uses instead. macroeconomy
In addition, because a monopoly faces little or
no competition and earns abnormal profits, it 4.1
may make less effort than a competitive firm
(a) Direct taxes are taxes on the incomes, profits and
to ensure its resources are used in the most
wealth of individuals and organizations.
efficient way.
Indirect taxes include tariffs and excise duties
However, because of its size, a monopoly can
added to the prices of goods and services. They
enjoy significant cost advantages or economies
are normally imposed on producers who will
of scale compared to smaller firms, such as
then pass on as much of the tax as they can to
the ability buy materials it needs in bulk at
their consumers in higher prices.
a discount and to attract low-cost finance.
Some of these cost advantages may be passed (b) A reduction in the general level of taxation in
on to consumers as lower prices. A monopoly an economy can help to expand the aggregate
may also invest more in the research and demand for goods and services. A cut in income
development of new products and processes taxes will increase disposable incomes and in
that can increase the availability and variety turn consumer spending may rise. As demand
of different types of products, and promote expands, firms may increase their output and
economic and possibly more sustainable employ additional resources, including labour.
growth. This is because a monopoly does not This will help to reduce unemployment.
face competition and therefore the profits it Boosting total demand in the economy
could earn from new developments will not be may also encourage firms to invest in new
competed away. production facilities and equipment. This will
Further, despite an absence of direct expand their productive scale and therefore the
competition, a monopoly may still face rate of growth in the economy. Cuts in taxes
competition from firms based in other countries on profits may especially encourage investment
or from firms selling products that can satisfy in new capital and new firms to be created.
similar consumer wants. For example, a Lowering income taxes can similarly motivate
monopoly provider of air or railway services more people to seek employment and increase
could still face competition on some routes motivation and productivity among those
from providers of bus, coach or boat services. already in work. These combined effects will
A monopoly may therefore still have to behave also help to grow the total output and size of
as if it does face competition and charge low the economy.
competitive prices because new firms could (c) Unemployment is a waste of resources. If more
otherwise be attracted by higher prices to people were in work more goods and services
enter the market it dominates and compete for could be produced to satisfy more consumer
its sales. A market is said to be a contestable needs and wants. Expanding employment
market if barriers to entry are low and new opportunities can therefore make better use of
firms can enter a market easily to compete. available scarce resources to boost output and
It is not clear therefore in all cases of monopoly increase economic welfare.
that the disadvantages of this market structure An increase in the number of people in
will outweigh its advantages. If a monopoly employment will also reduce hardship,
has significant economies of scale and/or its crime and cut public expenditure on welfare
market is contestable or heavily regulated by payments, allowing the government to either
government, then it could potentially be more reduce taxes or re-allocate public spending to
advantageous for consumers than a number other worthwhile projects.
of smaller firms competing to supply the same
market. However, it will be less advantageous The government may also increase in
for the owners of the monopoly because popularity if more people are in work and
its profits would be higher if the firm was prosperity is rising.
not regulated and if it was also protected by (d) Unemployment can have both economic and
significant barriers to market entry. emotional costs. People who lose their jobs
12
will lose their income and may have to rely on and unemployed. In this way, taxes, particularly
charity or government benefits. Unemployed those levied on incomes and wealth, can be
people can also lose their working skills if used to help alleviate poverty and reduce
they are unemployed for a long period of inequalities in wealth and incomes between
time and, without retraining, they may find it people.
even harder to find work. They may become
Government fiscal policy involves changing
depressed, possibly even ill, and it may also put
the overall level of tax collected and public
a strain on other family members and health-
expenditure to vary the total level of demand
care services. Some unemployed people may
in an economy. Raising taxes and lowering
lose their homes if they cannot meet their
public spending can help reduce a demand-
mortgage repayments and some may even be
pull inflation caused by an excess of aggregate
drawn into crime.
demand for goods and services in an economy.
Income and output in the economy will also In contrast, lowering taxes and increasing public
be lower than it could otherwise be if there is expenditure can help boost total demand during
a high level of unemployment. Government an economic recession when unemployment
spending may also have to rise or be diverted may be high and rising due to low demand for
from other areas to provide welfare benefits goods and services. Taxes can therefore be used
such as income support, low-cost housing and to influence the level of economic activity in an
health care for the unemployed. economy and help a government to achieve its
overall macroeconomic aims.
This means people in work will either have
to pay higher taxes to pay for the additional Individual taxes on specific goods or services
welfare payments and benefits, or government can also be used to influence the level of
spending on other public services or consumer demand for those products. For
investments, such as on new schools or roads, example, indirect taxes on tobacco products,
will have to be cut. such as cigarettes, can help to discourage
their consumption and therefore reduce the
incidence of health problems, lung cancers
4.2 and deaths that may be caused by smoking.
(a) A government could cut public expenditure Similarly, by helping to reduce demand for
and/or raise taxes to reduce a budget deficit. car use, excise duties on petroleum can help
(b) Public expenditure is money spent by a conserve oil and reduce harmful exhaust
government and public sector organizations. emissions that can pollute the natural
This may include current spending on wages to environment and contribute to harmful climate
employ public sector workers such as doctors, change.
police officers and civil servants, and capital (d) A government can finance its expenditure in a
expenditures on the building of new schools, number of ways but by far the most important
roads and electricity generators. is from direct taxes on personal and corporate
In contrast, private expenditure is money spent incomes and wealth, and indirect taxes on
by households and organizations in the private expenditures.
sector. It includes consumer expenditure on A government may also earn some rents from
consumer goods and services and investments publicly owned buildings and land rented to
by firms in new capital equipment, premises the private sector and admission charges, for
and research and development. example from public museums and national
(c) Government imposes direct and indirect taxes monuments. Some government agencies and
for many reasons. A primary reason is to raise public corporations will also earn revenue from
revenue to pay for government spending, the sale of the goods or services they supply,
such as wages of public sector workers and such as nationalized postal services, public
investments in infrastructure including new transport and electricity supplies.
schools and roads. In this way, a government Periodically a government may also be able to
can direct spending at goods and services sell off land and other assets it owns, including
that can help increase economic growth and nationalized industries. The sale of nationalized
economic welfare. For example, tax revenues industries to the private sector is known as
can finance welfare benefits paid to the old, sick privatization.
13
If, however, a government fails to raise businesses and working people. This will
sufficient revenue from all the above ways to reduce their incomes and spending on goods
finance its expenditure, it will need to borrow and services. High levels of employment
the shortfall from the private sector, from banks therefore help to increase output, incomes,
or through the sale of government loans stocks, consumer demand and living standards;
or from the governments of other countries.
• balance of payments stability. A favourable
balance of international trade and payments
4.3 provides opportunities for businesses to export
their goods and services overseas. It also
(a) A mixed economy combines a market
provides jobs and incomes and ensures the
economic system with government planning to
economy can afford to import a wide variety
determine the allocation of its scarce resources.
of goods and services to satisfy consumer
The government or public sector of a mixed
needs and wants. However, if a country spends
economy can intervene to correct failures of
more on imports than it receives from the sale
the market system, for example by banning the
of exports, its balance of international trade
sale of guns, taxing other harmful products to
will be in deficit. As a result, the country may
reduce their consumption, and providing goods
run out of foreign currency to buy imports
and services that people need and the economy
and may have to increase borrowing from
will benefit from although they are unprofitable
other countries. The national currency may
for private firms to supply.
also lose value against other foreign currencies
(b) Many governments aim to achieve low and making imported goods and services more
stable price inflation and economic growth in expensive to buy and pushing up the rate of
their macroeconomies. inflation. Firms that need to import materials
High inflation erodes the purchasing power of and parts from overseas to produce their own
incomes and causes people hardship, especially products will also face rising costs.
those on low fixed incomes. It also increases (c) (i) If a government increases tax or duty on
production costs for many firms and can a product, it may end up losing revenue
damage confidence in an economy as a good if demand for that product is price elastic
place to invest. because demand for it may fall significantly.
Governments also aim to grow the size of their However, if demand for a product is
economies over time. Fulfilling an objective to price inelastic the increased tax or duty
achieve long-term economic growth will help to on the product will raise revenue for the
expand employment opportunities, increase the government because demand is relatively
availability of goods and services, lower inflation unresponsive to changes in price. For
and improve living standards. Private and example, imagine demand for a product is
public investments in new products, processes, currently 1,000 units per week at a price
equipment, factories, education and training, and of $10 inclusive of a $2 tax. Revenues are
economic infrastructure can all help to boost the therefore split $8,000 for the producers
long-term productive potential of an economy. and $2,000 for the government. If the
government increases the tax to $3, this
Other macroeconomic aims are: will increase the after tax price to $11 – an
• high or full employment and low increase of 10%. If demand falls by only
unemployment. Unemployment is a waste of 5% to 950 units total, revenues will now
productive resources. Increasing employment be split $9,500 for producers and $2,850 for
will therefore help to boost output, incomes, the government (i.e. 950 × $3).
consumer demand and living standards. (ii) In the same way the government can
However, when unemployment is high, use its knowledge of the price elasticity
many people will suffer hardship from of demand for imported items to target
a loss of income and total output will increases in tariffs that will reduce overall
be lower than it could otherwise be. In spending on imports. Increasing tariffs
addition, a government may have to spend on those imported products for which
more on welfare payments to support the demand is price elastic will cause the largest
unemployed and their families. This means contraction in demand and therefore
the government may have to raise taxes on spending on imports.
14
(d) Governments will usually have four over the long term. It can also stabilize or
macroeconomic aims for their economies. improve the balance of international trade.
These are for low and stable price inflation,
Supply-side policy instruments are designed
a high level of employment, a healthy rate
to boost productivity and to improve the
of economic growth and a stable balance of
efficiency of different markets by removing
payments. However, achieving these policy aims
barriers to competition. By expanding the
at the same time can prove difficult and they
supply side of the economy, employment
can sometimes conflict. For example, during
an output will increase and this will help to
an economic boom unemployment will be
reduce inflationary pressures on prices caused
low but there may be inflationary pressures as
by rising demand. Keeping inflation low will
continued growth in consumer demand begins
also help to keep wage demands down and
to outstrip growth in the aggregate supply of
it reduces uncertainty for businesses seeking
goods and services. The growth in demand may
to invest in new capacity. It will also increase
also suck in many imports, causing the balance
the competitiveness of goods and services on
of international trade to deteriorate.
international markets.
To reduce inflationary pressures, the government
may cut its own expenditure and raise taxes. This
will have the effect of reducing aggregate demand 4.4
in the economy. The government may also raise (a) Economic growth involves an increase in the
interest rates to curb borrowing and increase total output or real GDP of a national economy,
the incentive for people to save. However, as generally measured as its real gross domestic
demand contracts, firms may cut back their product (GDP). A sustained growth in real GDP
output and demand for labour in response. means that each year the economy will have
Employment is likely to fall and more and more produced more goods and services than the
people may become unemployed over time as previous year.
demand and output continue to contract. Firms (b) Cyclical unemployment occurs when consumer
are also likely to cut back their investment plans demand for goods and services falls during an
in response to falling demand and rising interest economic recession. The reduction in demand
rates. If old and worn out plant and machinery leads to a cut in production and an increase in
are not replaced, then the productive potential unemployment. As people lose their jobs and
of the economy will also contract. However, incomes, demand falls further. In very serious
while the fall in consumer demand may be recessions, there can be a high proportion of
beneficial to the balance of international trade people unemployed with very few opportunities
as spending on imports falls, the deteriorating to get work and earn incomes. This type
economic conditions may reduce flows of inward of unemployment is a real concern for the
investment by overseas firms. government although economies will come out
In contrast, during an economic recession when of recession in time and the rise in consumer
aggregate demand is falling and unemployment demand will lead firms to increase their output
is high and rising, a government may attempt and demand more labour.
to reflate demand by boosting its own Structural unemployment is by far the most
spending and by cutting taxes and interest serious form and results from long-term
rates. However, these policies could prove to changes in the structure of the economy as
be inflationary if the rise in demand is not entire industries close down because of a lack
matched by an increase in the aggregate supply of demand for their goods and services. People
of goods and services in the economy. Cutting employed in these industries will not be able to
taxes on profits and cutting interest rates can, use their skills elsewhere and they can become
however, encourage firms to borrow money occupationally immobile and unemployed
to invest in additional productive capacity and for very long periods. This can have a serious
boost economic growth. impact on particular regions within a country
However, some economists argue there need with high levels of unemployment compared
not be any policy conflicts because sound fiscal with levels in other regions. Retraining
management combined with sensible supply- workers can help them move into other jobs
side policies can achieve low inflation high if they are available. In some cases, workers
employment and healthy economic growth will have to leave the region in order to seek
15
employment elsewhere. New industries will

also need to be encouraged to develop. In many
developed countries, structural unemployment
has occurred as the economies have moved
Consumer goods
economic growth
from labour-intensive production, such as in
agriculture or coal mining, to capital-intensive,
service-based industries.
(c) Investment involves the purchase or
development of productive assets. Investments
undertaken by private sector firms may
include the construction or purchase of new 0
factories and offices, new machinery, vehicles Capital goods
and computers to be used in the production
and sale of other goods and services. Public (d) Most governments have four main
sector investment is spending on fixed assets macroeconomic aims: low and stable inflation;
by government organizations. This may also high or full employment; economic growth and
include the construction of new factories a favourable and stable balance of payments.
and offices, new machinery, vehicles and These objectives can prove difficult to achieve
computers, but may also include investments all at once and policy aims may conflict. For
in new schools and colleges, hospitals, public example, measures to increase aggregate
transport, road networks and airports. demand during an economic recession to
reduce unemployment could create inflationary
Investment in new capital is vital for economic pressures and boost consumer demand for
growth. Investment is not only needed to imports making the balance of international
replace old and worn out productive assets payments less favourable. Faster economic
to maintain the same level of output in an growth in the national output may also create
economy, but also in new assets to expand more pollution and waste, possibly conflicting
the productive capacity of an economy. If old with any environmental objectives. Similarly,
and worn out assets are not replaced, then the raising taxes or interest rates, and cutting
productive capacity of an economy will shrink public expenditure to reduce price inflation by
and fewer goods and services will be produced. lowering total demand, may result in lower
The prices of many goods and services will growth and more unemployment.
tend to rise as their market supply falls relative
Failure to control inflation, lower
to demand. Employment, incomes and living
unemployment or achieve economic growth
standards will also fall.
can have costly implications for an economy.
Investments in new productive assets by How severe these are and the importance
firms will allow them to expand their scale people and a government attaches to them will
of production, lower their average costs and determine which problem the government will
produce more goods and services in the future. target with its policies.
Similarly, public sector investments in education
Unemployment is a waste of resources and
and health care can produce a more highly
if more people are in work more goods and
skilled workforce while investments in roads
services can be produced to satisfy more
and airports will reduce travel times and costs
consumer needs and wants. Expanding
for many private sector firms. Governments
employment opportunities can therefore
can also subsidize private sector investments
make better use of available scarce resources
in the research and development of new, more
to boost output and increase economic
efficient processes and products. Technical
welfare. An increase in the number of people
progress is a major driver of economic growth.
in employment will also reduce poverty and
Increased investment spending in an economy hardship, crime and cut public expenditure on
will have the effect of shifting its production welfare payments, allowing the government
possibility curve (PPC) out to the right. This either to reduce taxes or re-allocate public
is shown in the diagram below. It shows spending to other worthwhile projects.
the economy is now able to produce more However, high rates of inflation can also
consumer and capital goods than previously create significant problems. Inflation erodes
because it now has more resources. the purchasing power of incomes and causes
16
hardship, especially those on low fixed incomes. that every price will necessarily be rising. Some
It also increases production costs for many may be falling but overall, when taken together,
firms. If it becomes hyperinflation, it can destroy the general level of prices will be rising.
confidence in the currency and entire economy.
(b) Most governments aim to keep price
However, increasing taxes and/or interest inflation low and stable and will collect price
rates, and cutting public expenditure to information in order to measure progress.
control price inflation by reducing aggregate Clearly it will be difficult and expensive to
demand may result in lower growth and more collect information on all the prices of all
unemployment. goods and services in an economy
Economic growth is an important objective Government will therefore measure inflation in
because it involves expanding the total output their economies by collecting price information
of the economy. This means more goods and on a sample, or basket, of different goods
services, business and employment opportunities and services. The ones chosen will normally
and income, all of which raise living standards. be those a ‘typical’ family or household
If growth is slow, unemployment is likely to purchase. The prices of this typical ‘basket’ will
remain high and living standards will remain then be monitored at a selection of different
poor for many and fail to increase at the rate retail outlets and online retailers. This price
of economies experiencing faster growth rates. information will then be used to compile a
Worse still, if there is negative economic growth, consumer price index (CPI).
output, employment, incomes and living
The proportion of total household expenditure
standards will fall.
spent on each type of good or service is used
However, choosing which is the most to weight their prices to reflect the importance
important objective to target suggests there of each product in the basket. So, for example,
may be conflicts or trade-offs between the if on average households spend twice as much
achievement of different macroeconomic on food products as they do on clothes then
aims. This may not necessarily be the case. changes in food prices will be weighted twice
Indeed, some economists argue there need not as much as changes in the prices of clothes in
be any policy conflicts and that sound fiscal the index because an increase in the price of
management of public spending and taxes food by say 10% will have a bigger impact on
combined with sensible supply-side policies household costs than a 10% increase in the
can achieve low inflation, high employment price of clothes.
and healthy economic growth over the long
A price index expresses the change in the
term. It can also stabilize or improve the
weighted average price of the basket of goods
balance of international trade. This is because
and services as the movement in a single
expanding the supply side of the economy will
number. The weighted average price of the
increase employment opportunities, increase
basket in the first year of measurement, or base
output and reduce prices, also making goods
year, is given the index number 100. Then,
and services more competitive on international
if on average the prices of all the goods and
markets. Further, if people expect price
services in the same basket rise by 10% over
inflation to remain low and stable in the future
the following year, the price index at the end of
then they are less likely to push for big wage
the second year will be 110.
increases to compensate; if they did, it would
raise production costs and reduce profits. (c) Just because oil prices are high does not
Similarly, firms will tend to invest more in new necessarily mean they will be inflationary.
capital and product development because they Although oil prices are high they may be stable.
are more confident of making a good long- That is, they are not rising and therefore not
term return. putting additional pressure on price inflation.
Secondly, if oil prices are high consumers may
have to spend more of their income on oil
4.5 products such as petroleum and heating oils,
(a) Price inflation refers to a sustained or leaving them less to spend on other goods and
continuous increase in the prices of goods and services. The fall in demand for these other
services in an economy. This does not mean goods and services may help to reduce demand-
every price will be rising at the same rate, or push inflation.
17
Rising oil prices, however, may be inflationary Cost-push inflation can often be the result
if they add to the cost of producing oil products of rising import prices for materials and
and other goods and services that use oil, components purchased from other countries,
including the manufacture of plastics and but it can also be due to rising wage costs as
paints, and the provision of bus and other workers demand wage rises not matched by an
transport services. Producers faced with rising increase in their productivity. A government
costs of buying oil or oil products will attempt may react by holding down the wages of the
to pass these costs on to their consumers in workers it employs in the public sector. It may
higher prices for their goods and services. This also use deflationary fiscal and monetary policy
results in a cost-push inflation. Consumers because other workers will wish to spend their
may react to these rising prices by seeking higher wages on goods and services and this will
wage increases from their employers if they put upward pressure on prices. This can involve
are in work. This will also increase pressure on raising taxes on wages and/or raising interest
production costs and cost-push inflation. rates so workers with loans such as mortgages on
their homes will have to use their higher wages
(d) Price inflation may be the result of demand
to pay more in interest charges instead.
for goods and services rising faster than their
supply in an economy, increasing production A government can also try to control inflation
costs which producers pass on to consumers in by using supply-side policy instruments
higher prices, and/or from rising import prices. to increase the productive potential of the
In turn we refer to these types of inflation as economy. Increasing the aggregate supply of
demand-pull inflation, cost-push inflation and goods and services to meet increased levels of
imported inflation. total demand can reduce inflationary pressures
caused by rising demand. It can also help
A government that is concerned with
reduce production costs as the productivity
controlling a demand-pull inflation can use
of resources is increased. Supply-side policies
contractionary or deflationary fiscal policy. A
can be used by a government to stimulate
contractionary policy involves cutting public
incentives to work and enterprise and to
spending on goods and services and raising
remove barriers that restrict competition,
taxes to reduce total or aggregate demand
international trade and higher levels of
in the economy. However, this may in turn
productivity. For example, a government
cause an increase in unemployment and lower
may lower taxes on businesses to increase
growth in the real output of the economy.
incentives to enterprise. It may use competition
A deflationary monetary policy involves policy to regulate or break up monopolies that
raising interest rates, which raises the cost of might otherwise restrict the market supply of
borrowing money and also makes saving more their goods or services to force up prices. A
attractive. If people and firms borrow less government may also introduce laws to control
money to spend, and consumers save more the power of trade unions to strike and to force
of their incomes as a result of the increase in up wages. Improvements in education and
interest rates, then this will help reduce the training can also help teach workers new and
total demand for goods and services in an improved skills.
economy and reduce demand pressures on
prices. However, firms usually borrow money
to invest in new capital and therefore higher Part 5 Economic development
interest rates may reduce investment and the
potential for economic growth. 5.1
Higher interest rates can help increase the value (a) Absolute poverty is the inability to afford basic
of the exchange rate of the national currency necessities needed to live successfully, such as
against other currencies. An appreciation in the food, water, education, healthcare and shelter.
exchange rate will make imports cheaper to buy The extent of absolute poverty in a country
and reduce an imported inflation. However, is usually measured by the number of people
it will also make exports more expensive to living on or below a very low level of income.
overseas consumers. As a result, overseas
(b) Useful indicators of the standard of living
demand for exports may contract and could
in different economies may include average
result in rising unemployment as exporting
income or real GDP per capita. However,
firms cut back their production in response.
18
average income per person tells us very little revenue potential lower compared to locations
about how evenly incomes are distributed in more-developed economies.
or what and how much people can buy with
Instead many people in developing countries
their incomes, their access to health care and
work on small farms producing only enough
education, their security or the quality of their
food for themselves and their families to live
environment. Therefore a better measure
on. Farming methods are usually poor and they
is to look at the number of people living in
produce very little surplus to sell. Slow economic
poverty, for example, by measuring how
growth combined with high birth rates means
many people have to live on less than a few
the available output has to be shared between
dollars per day.
more and more people over time.
The human development index (HDI) provides
Unstable and corrupt governments, and wars
a much wider measure of living standards and
with neighbouring nations or between different
economic welfare than real GDP per capita. It
tribes or religious groups, have often blighted
combines three different measures into a single
the development of some less-developed
index with a value between 0 and 1. These
countries and therefore confined many people
measures are for living standards, measured by
in their populations to continued poverty.
the average gross national income (GNI) per
person adjusted for differences in exchange (d) The standard of living in a developing country
rates and prices in different countries; the level may be improved in a number of ways.
of education, measured by how many years Underemployment is a major cause of poverty
on average a person aged 25 will have spent in and may be tackled by improving education
education and how many years a young child and training so that more people can enter
entering school now can be expected to spend the workforce. By improving the quantity and
in education during his or her life; and health quality of education available to children from
measured by life expectancy. poor families it will increase their job prospects
and earning potential once they leave school or
(Other indicators may include percentage of
college. Better education about family planning
the workforce in agriculture, ownership of
may also help reduce birth rates and improve
consumer goods, access to safe drinking water,
living standards.
proportion of children who are underweight or
who die at birth.) A government may be able to fund these and
other programmes targeted to help the poor,
(c) Many people in the least-developed countries
including providing low-cost housing, free
can live in absolute poverty. This refers to their
health care and direct income support, by
inability to afford basic necessities needed to
increasing taxes on the richest households.
live successfully, such as food, water, education,
health care and shelter. The scale of absolute Increasing public spending on developing the
poverty can be measured by the number of economic infrastructure can also provide jobs
people living below a certain income threshold, but also support the development of industry
usually less than $2 a day. This is often the and trade. Extending road, communications
result of not enough jobs being available, and power networks, and the development of
low levels of education and skills, and a lack container ports and airports will assist economic
of capital to invest in industry, health care, development and overseas trade. Attracting
schools and infrastructure, such as roads, more foreign visitors and selling more goods
power grids and modern communications and services overseas will bring more money
networks. This holds back economic growth in into the economy and provide jobs.
these economies. However, governments in less-developed
Many less-developed countries lack basic economies will often lack the capital and other
industries and services. If incomes and resources they need to reduce poverty in their
therefore consumer demand are low there is countries. Increasing borrowing from overseas
little incentive for firms to set up factories and governments and banks can provide funds but
shops. If workers are uneducated and lack skills can be expensive. Some developing countries
then industry may be unable to employ them. have borrowed so much that they have been
These factors make production and trade more unable to meet loan repayments and interest
difficult. Costs of production will be higher and charges. Instead governments of developing
19
countries can seek to attract inward investment their incomes and slowing down their career
from overseas firms to develop industry and progression. Increasing female employment will
infrastructure, import new technologies, provide therefore tend to reduce birth rates.
jobs and teach employees new, more advanced
(Other reasons may include improvements
skills. Offering subsidies and tax incentives to
in healthcare reducing infant mortality rates
multinational firms may help to do this.
so that more babies survive; improvements
Similarly, governments can seek to attract in education; changes in social and religious
overseas aid from foreign governments and attitudes, for example, towards the use of
aid agencies. This aid can be in the form of contraception; a trend towards later marriage).
grants of money but can also take a number
(c) The populations of many developed countries
of other forms such as food, medicines, expert
are ageing. This means the average age of
advice and technical assistance, for example
their population is rising as both birth and
helping people to improve their farming
death rates have fallen and remain low. This
methods or teaching them how to start up and
means more people are living longer and fewer
run a small business. Aid can also take the
children are being born. These features are
form of debt relief. Because of the problems
associated with higher levels of development,
debt has caused in many less-developed
including modern health care, education
countries, a number of poor countries have
and high levels of female participation in the
received partial or full cancellation of their
workforce. In some developed countries birth
loans from foreign governments, the IMF
rates have fallen below death rates so their
and World Bank. This will release them from
populations are shrinking.
meeting future loan repayments and high
interest charges and they can use this money The age and sex distribution of a population
to fund economic development and poverty of a developed economy can be displayed on a
reduction projects instead. population pyramid. Along the bottom axis is
the number or percentage of males to the left of
the vertical axis, and to the right the number or
5.2 percentage of females. The vertical axis shows
(a) The birth rate in a country is measured by the age in ascending ranges. The pyramid for a
number of babies born each year for every developed country therefore tends to be narrow
1,000 people in the population. at the base as birth rates are low and it bulges in
the middle due an increasing number of people
(b) The birth rate of a country may fall as living
reaching middle age or above.
standards improve and as female participation
in the workforce increases. In contrast, the pyramid for a developing
country tends to be much wider at its base and
Improvements in living standards are normally
narrow at the top. This is because both birth
associated with increased incomes, high levels
and death rates are relatively high. This means
of economic development and therefore
there are more children and young adults than
increased access to food, safe drinking water,
older people. The average of the population will
better housing, education and medical care.
therefore be relatively low. High birth and death
As a result, more babies survive infancy and
rates are associated with low levels of economic
are able to go on to school and eventually
and human development in a country.
into paid employment. In some less developed
Developing countries also tend to lose people
economies, birth rates remain high simply
of working age to more developed countries
because parents want to be sure they will have
because they can earn more and enjoy a higher
enough surviving children who will be able
standard of living in more developed countries.
to go out to work to earn incomes to support
their families. Improvements in living standards (d) If governments of developing countries have
reduce these risks and the need to rely on large allocated large amounts of public expenditure
families to provide goods and incomes. to developing new hospitals and to providing
health education programmes this will reduce
Female participation in the workforce is high
the amount of money available to other public
in many developed countries and rising in
projects or result in higher taxes. If taxes have
many developing countries. Giving up work
to rise this could reduce aggregate demand in
to have and raise children means giving up
20
their economies and result in firms cutting back • Its global scale of production also means
their production and employment. Incomes that it can spread the cost of advertising
and living standards may fall further in these and other promotions across a large total
countries that already have a relatively low output and across international markets.
level of economic development and welfare. It may also employ its own transportation
Increasing direct taxes on people with low and distribution network to move its goods
incomes will also have the effect of creating within and between different countries
more hardship. rather than paying other companies to
provide this service.
Instead of spending more on hospitals and health
education programmes, the government could • It will be able to raise finance easily and
spend more on infrastructure developments, cheaply because of its size, either from bank
such as new roads, ports and airports, and on loans or from the sale of shares. It will be
programmes to develop workforce skills. These able to select loans from banks in countries
will help to expand the productive potential of offering the lowest interest rates and will also
the economy and increase employment. In turn, be able to sell its shares internationally.
higher standards of living and education among
• A multinational will also be able to enjoy
the population may reduce the spread of disease.
risk-bearing economies. Market risks are
The same governments could instead decide to reduced because it produces and sells its
cut taxes to boost consumer demand required products in different countries. As a result, its
to stimulate private sector investments in an business will be cushioned from the impact
industrial base and services sector to expand the of a fall in demand for its products in any
choice and availability of goods and services in one country.
their economies. Many people in developing
(c) There are a number of factors that may lead a
countries lack access to even basic and essential
multinational company to locate production
foodstuffs and other goods and services.
facilities in one or more particular countries.
A key factor is the ability to locate near to low
Part 6 International trade cost sources of natural materials and labour.
and specialization Locating in countries with low wages and low
material costs will reduce its costs or production
and help to boost its profits.
6.1 A multinational may also seek out countries
(a) A multinational company is a firm that has its with advanced technologies and skilled labour
headquarters in one country but has production that it wishes to gain access to.
and other facilities located in one or more other
Access to consumer markets will also be an
countries.
important consideration. A multinational will be
(b) Because of their size and scale multinationals able to expand its sales and scale of production
can enjoy many cost advantages or economies of by producing and selling its products in countries
scale (choose any two from the following). with large or expanding consumer markets.
• A multinational will be able to buy the Setting up in production facilities in different
materials, parts and equipment it needs in countries will also allow it to avoid any trade
bulk. It will also be able to place large contracts restrictions that would apply to its products
with other suppliers to provide it with various if they were instead exported to these
services it needs, from window cleaning to countries. Exports will also incur additional
equipment maintenance. As a result, suppliers transportation costs. A multinational will
will be willing to offer the company generous therefore seek to minimize its transport costs
discounts to attract and retain its custom. by locating plants in different countries to be
• Similarly, multinationals will be able to benefit near to sources of materials and key consumer
from technical economies because of its size markets.
and ability to finance, develop and install A multinational may also be attracted to
highly specialized and productive equipment countries with fewer laws and regulations and
and machinery and also to hire the most to those countries offering the most generous
technically skilled workers. subsidies to foreign companies.
21
(d) Multinational companies are global businesses benefits to a country. Governments should
that employ many thousands of people at therefore seek to attract multinationals but
different factory, office and retail locations only if they can ensure that they do not exploit
in more than one country. Their size and local laws and workers and can control any
scale allow them to benefit from significant potentially damaging impacts their activities
economies of scale and to invest in the latest could have on local businesses and the
technologies, production processes and product environment.
developments. Multinational companies can
therefore benefit a country in a number of
significant ways. 6.2
The construction and operation of new factories (a) An open economy is one that engages in free
and other business premises in a country or relatively unrestricted trade with other
by foreign firms can create many new jobs, countries.
reducing unemployment and boosting incomes (b) Trade restrictions or barriers can take a number
and living standards. They will also benefit local of forms. For example, tariffs are taxes placed
suppliers and their investments in advanced on the prices of imported goods to make them
technologies, processes and products will help more expensive for consumers to buy. This
to boost economic growth and can be used to should reduce demand for imports. Similarly, a
teach locally employed workers new skills and quota limits the volume of particular products
to improve their productivity. that can be imported. The limit on their supply
The location of new productive activities in will also tend to push up their price.
a country will also increase competition and Governments can also increase costs on
consumer choice in that country. Consumer exporters and slow down the flow of imports by
demand for imported products may fall in favour introducing complex and unreasonable quality
of buying the new, locally produced goods and controls, standards and licensing requirements.
services. Multinationals will also export many For example, a government may set arbitrary
of their products globally and this will help to and excessive quality standards on imported
improve the country’s balance of payments. goods so many fail and can be rejected. Or it
However, the presence of multinational may keep changing product labelling and other
operations in a country could also cause major regulations so that exporters are unable to keep
problems. For example, the construction and up with new requirements.
operation of many more factories and other (c) Reducing or removing trading restrictions
businesses may create significant negative between countries should help to increase
externalities, including the depletion of international trade by lowering the cost of trade
natural resources and the creation of air and and improving market access. A developing
noise pollution. Large powerful multinational country may immediately see an increase
corporations may also force local competitors in its visible exports to other countries and
out of business and exploit local workers by this will improve its balance of trade. Wages
forcing them to accept low wages and poor and salaries are still relatively low in many
working conditions, especially if they are also developing economies and this enables many
able to persuade the government to remove or of their firms to produce goods and services
weaken employment laws and regulations. far cheaper than those in more developed
Multinationals may also secure very generous economies. An increase in demand for their
subsidies and other financial incentives from products in international markets will therefore
the government of a host country. These will improve revenues and, as a result, exporting
need to be funded from higher taxes on local firms are likely to expand their production.
people and businesses. Output, employment and national income are
likely to rise, thereby helping to boost domestic
Finally, some multinationals may avoid paying consumer demand for goods and services.
taxes in their host countries and will instead However, some of the increase in consumer
move them overseas to countries where spending may be on imports. The lifting of trade
corporation taxes are lower or do not exist. restrictions will increase consumer choice in
Despite these downsides, the presence of developing countries and allow them to access
multinational companies can bring significant a wider variety of goods and services from
22
overseas. As imports of goods and services rise, individual and business consumers need and
the balance of payments on current account want in a country may also be risky. They
may deteriorate but the final outcome will may abuse this market power to restrict their
depend on by how much exports expand, the supply to force up prices and their profits.
degree of international competition, and which Problems with weather patterns or industrial
trade barriers were removed or reduced and disputes in other countries may also hold up
which ones remain in place. vital supplies bringing production to a halt in
that country.
Longer term, because the lowering of trade
restrictions allows consumers in developing The economic risks of overspecialization can
economies to import many more of the therefore be high and a country may therefore
products they need and want from overseas, try to encourage greater diversification in its
it will enable firms in these economies to industrial base. This may require it to use trade
specialize in the production of the goods and barriers against producers from other countries
services they are best able to produce. The that are more efficient in the production of
ability to re-allocate resources more efficiently these products in order to protect its domestic
in a developing economy should further expand firms and jobs. However, trade barriers will
output, employment and income and living restrict consumer choice and other countries
standards should rise. may also retaliate with trade barriers of their
own which can harm the industries the country
As the incomes and purchasing power of
is trying to protect.
consumers in developing countries expands it
also creates opportunities for foreign firms to It is therefore difficult to argue conclusively
increase their international sales. An increasing whether it is better for a country to produce
number of business organizations are already many products and protect its markets from
moving some or all of their business units to international trade or whether it is better to
these countries to benefit from their low wages try to achieve specialization in some products
and their growing consumer markets. This only. It will depend on which strategy secures
inward investment can bring new technologies, the most economic advantage and gains. Both
jobs and skills into developing countries and strategies involve potential gains but also losses
will help to expand the productive potential in terms of consumer choice, employment,
of their economies. However, the arrival of incomes and growth.
multinationals in a developing economy can
also create more competition for local firms.
6.3
(d) International trade enables economies to
(a) The foreign exchange rate of a currency is the
specialize in the production of those goods and
rate at which that currency can be exchanged
services their natural, human and man-made
for another on the global foreign exchange
resources are best able to produce because they
market. It is therefore the market price of one
have an absolute or comparative cost advantage
currency in terms of another currency, in this
over producers in other countries. They can
case, the price of the Japanese yen in terms of
then trade their surplus output with other
the US dollar.
countries to obtain the other goods and services
they need and want. Through specialization (b) The foreign exchange rate of one currency
and trade therefore, output, incomes and living in terms of another currency will depend on
standards will be much higher. market demand and supply conditions on the
global foreign exchange market.
However, a country can overspecialize by
producing too narrow a range of goods and An increase in the demand for a currency,
services. If there is a fall in demand for the for example because consumers are buying
products a country specializes in, or another more goods and services from the country or
country becomes more efficient in their countries trading in that currency, will increase
production, that country can lose significant its exchange rate against other currencies. A
trade. Many domestic firms may be forced to rise in the value of one currency against others
close and many jobs and incomes will be lost. is referred to as an appreciation in the exchange
rate. This is shown in the diagram below. As
An overdependence on foreign producers
demand for the Japanese yen rises (from DD to
to provide many of the goods and services
23
D1D1) the rate at which 1 yen exchanges for However, the outcome may be more complex
US dollars rises (from $ to $1). depending on the type and volume of goods
and services traded. For example, if Japanese
demand for US imports is price inelastic
Price of 1 yen in terms of $
D D1 S
then the fall off in demand for imports from
the USA may be relatively small. Further,
if US producers rely heavily on imports of
$1
components and materials from overseas to
make their products then their costs will fall.
$ This will boost their profits and may provide
them with an incentive to expand their scale
of production. The reduction in import costs
S D D1
may also be passed in part onto US consumers,
Q1 Q2 thereby expanding domestic demand.
Quantity of yen traded per period
(d) A country will have a deficit on its balance
In contrast, if the global market supply of the of payments on current account debits for
yen rises, for example because Japanese firms imports and the payment of incomes or current
are investing more overseas and therefore transfers to residents of other countries exceed
selling yen to buy overseas currencies, the its receipts or credits from its international
exchange rate of the yen will fall. This is transactions with other countries. This means
referred to as depreciation in the exchange rate. there will be a net loss of income from the
country and there will be less available for
(c) If a currency is ‘strengthening’, it means the residents to spend on domestic goods and
currency is appreciating in value against others. services. Domestic firms that experience a fall
This has a number of implications for an in demand for their products may cut back
economy. This is because a rise in the value of production and reduce their demand for labour,
a currency will increase the cost of its exports resulting in higher unemployment. To pay for
on international markets but lower the price of recurrent annual deficits a country may need
imported goods and services. to borrow money from overseas. Total debt will
For example, if 1 US dollar exchanges for 8 rise and more income will have to be used each
Japanese yen then a car exported from the year to pay interest charges. This will add to the
Japan to the US for 5,000 yen will cost $625 in amount of money flowing out of the economy
the US economy. If the US dollar appreciates and reduce over time the amount of money
to $1 = 10 yen then the same car will now cost it has to invest in new productive activities or
$500 on import to the USA. As a result, demand spend on domestically produced products. Not
for Japanese cars in the USA may rise. This surprisingly, the government of the country
may be at the expense of a fall in sales of US may seek to overturn a deficit. It may do this in
cars, which may result in a reduction in output a number of ways.
and employment in US car manufacturers. The For example, the government could introduce
increase in demand for imports from Japan will trade barriers to make overseas products
also cause the US balance of trade to deteriorate. more expensive and difficult to import, for
In contrast, a machine exported from the US to example by placing a tariff or excise duty
Japan priced at $1,000 will rise in price in Japan on their imported price or by restricting the
from 8,000 yen to 10,000 yen following the amount that can enter the country through a
appreciation in the US exchange rate against the quota or embargo. If demand for the imports
yen. If Japanese demand or US goods is price is price elastic, the increase in their prices will
elastic then demand for the US imports will fall. cause demand for them to fall significantly as
US exporters will suffer a decline in sales and, consumers switch their demand to domestic
if the fall in demand is prolonged, are likely to products. This will help to correct a deficit.
cut back their production and employment as However, trade barriers restrict consumer
a result. The fall in employment and incomes choice, will increase inflation and business costs
could cause a fall in demand for goods and and are likely to cause overseas trading partners
services in the USA that is more widespread, and to retaliate with trade restrictions of their own.
this could reduce economic growth.
24
Alternatively, the government could simply As a result, domestic demand for imports should
do nothing because the deficit should correct fall and overseas demand for exports should rise
itself over time as the exchange rate adjusts. If until the current account balance is restored at
there is a deficit more of the national currency a new lower equilibrium exchange rate.
is being supplied internationally to pay for
(Other measures may include contractionary
imports than is being demanded from overseas
fiscal and monetary policies to restrict demand
consumers to buy that country’s exports. The
for imports. However, these measures will also
value of the exchange rate will therefore fall
tend to reduce total demand in the economy
on the global foreign exchange market. This
including for domestically produce goods
will make imports more expensive to buy while
and services.)
reducing the prices of exports sold overseas.
25

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Part 1 The basic economic problem

Part 1 The basic economic problem

Activity 1.2 What do we need and what do we want?

Need Want Reason

Water Water is essential for human survival

Jewellery Jewellery is a luxury

Video and audio discs These satisfy wants for entertainment

Activity 1.3 What’s the big problem?

Activity 1.4 Classifying resources

Land Labour Capital

Land Labour Capital

Activity 1.5 Getting mobile

Activity 1.6 The next best thing

Activity 1.7 Free to choose?

Free to choose? Children in Bangladesh European children

2 Most people in European countries enjoy much higher standards of living

Activity 1.8 The cost of making choices

Activity 1.9 Shift it!

Part 1 The basic economic problem

if the country is overpopulated then a on involves giving up the opportunity to

emigration of people who have retired from PPC2

Part 2 The allocation of resources

Activity 2.2 Problem solving

Activity 2.3 An introduction to the workings

Activity 2.4 Food for thought

4 The prices and profitability of many organic food products is rising.

Activity 2.5 What is your individual demand?

Possible price of a chocolate bar (cents) Your demand per month

Activity 2.6 Market demand curve

2 a around 170,000 b around 300,000

Activity 2.7 What causes a shift in demand?

Article 1a Factor that has changed 1b Impact on demand

Quantity of cans per day

DD = market demand curve before hot weather; D1D1 = market demand

Activity 2.8 Competing or complementary?

Activity 2.9 The market supply curve

1 Supply extends as price rises and supply contracts as price falls.

Activity 2.10 What causes a shift in supply?

Activity 2.11 Finding the market price

Quantity (thousands) per month

Activity 2.12 A fall in demand and market price

Activity 2.13 A fall in supply and market price

Activity 2.14 A flat-out market

Activity 2.15 A problem to ‘stretch’ you

Activity 2.16 Using the formula

Activity 2.17 Elastic brands

Activity 2.18 What happens to total revenue?

Activity 2.19 Stretching supply

Activity 2.20 Free failings

Activity 2.21 Smoking

Activity 2.22 Not painting a pretty picture

Activity 2.23 Ringing the price changes

A$1.40 $0.40 tax

Many governments have imposed indirect taxes on diesel and other

Activity 2.24 Mixing it up

Activity 2.25 Public or private provision?

Part 2 The allocation of resources

economy and also in many markets within

(d) An increase in resources allocated to the 2 (a) 

trees and firms who will benefit from a fall 

Part 3 Microeconomic decision makers

Activity 3.2 Ye olde swap shop

Activity 3.3 Funny money

(d) An increase in resources allocated to the 2 (a)

trees and firms who will benefit from a fall

13 Commercial banks provide loans and payment services for road