Microeconomics Igcse Economics

MICROECONOMICS
WORKBOOK
FOR EXAMINATION IN
MAY/JUNE 2020/21
CIE IGCSE Economics Prepared By Richard Ogutu 1|Page

CIE IGCSE Economics Prepared By Richard Ogutu 10 | P a g e
THE NATURE OF THE ECONOMIC PROBLEM
Definition of Economics
This is a social science that studies how to make choices on allocating scarce resources and putting them in
the best use possible to satisfy human wants.
NEEDS
Needs are requirements necessary for human being to function and live (survive). Some of these things are very
important for our existence and we cannot survive without them
Examples of needs
 Food,
 Clothing,
 Water,
 Shelter and
 Air.
WANTS
Wants are things which are needed by us but they are not important for our survival and we can live without them
For example:
 Going on an expensive holiday,

 Bugatti Veyron
 Owning an 84 Inch LG TV.

LIMITED RESOURCES/FINITE RESOURCES
Restricted amounts of inputs required by an individuals, businesses or economy. Almost everything on this planet
has some limits
FACTORS OF PRODUCTION
Factors of production refer to the resources that are available to produce goods and services.
1. LAND (NATURAL RESOURCES)
Land includes all natural physical resources (gifts of nature)
 Land include
 Fields
 Mineral wealth
 Fishing stocks
 Fertile farm land
 Climate
 Harnessing of wind power
The reward for landlords for allowing firms to use their property is rent
2. LABOUR (HUMAN RESOURCES)
Labour is the human input into production. It is also the physical and mental work of people whether by hand, by
brain, skilled or unskilled. The reward for workers giving up time to help create products is wages or salaries.
3. CAPITAL (MAN-MADE RESOURCES)
Man made goods used to produce other consumer goods and services in the future including factories (plant),
machines and roads. The reward for creditors lending money to firms to invest in buildings and capital equipment
is interest.

4. ENTREPRENEURSHIP (HUMAN RESOURCE)
Involves taking financial risk to bring together the factors of productions (Land, Labour, capital) to produces
goods and services. Entrepreneurs will usually invest their own financial capital in a business and take on the
risks. Their main reward is the profit made from running the business. Unsuccessful firms make losses.

MOBILITY OF FACTORS OF PRODUCTION
Causes of geographical immobility:

Mobility of capital
Mobility of enterprise

QUALITY AND QUANTITY OF FACTORS OF PRODUCTION

The quantity of labour
The quantity of CAPITAL

RENEWABLE AND FINITE RESOURCES
Renewable resources: Are resources that are inexhaustible or replaceable over time provided that the rate
of extraction of the resource is less than the natural rate at which the resource renews itself.
Examples
 Oxygen
 Biomass
 Fish stocks
 Forestry
 Solar energy
Non-renewable resources/Finite resources

These are resources that are exhaustible over a given period of time. They cannot be renewed because there is no
mechanism existing to replenish them.
For example
 Plastics
 Crude oil
 Coal
 Natural gas

UNLIMITED WANTS/INFINITE WANTS
The side of human nature that wants an endless number of things yet has a limited amount of resources to
achieve these wants.
Unlimited wants essentially mean that people never get enough, that there is always something else that they
would like to have. When combined with limited resources, unlimited wants result in the fundamental problem
of scarcity
ALTERNATIVE USES
 All the resources we have on this planet can be utilised in a number of way. They have alternative uses. For
example, a piece of land can be used for making a factory, or doing farming or constructing a school and so
on.
 Therefore, we have to choose what is best for us. If we talk from an economist point of view it means ‘making
the optimum use of resource available’.
OPPORTUNITY COST
Definition of opportunity cost: This is the next best alternative sacrificed/forgone while making an economic
decision
Scarcity means we all have to make choices i.e. there exist trade-offs and Choices. Making a choice normally
involves a trade-off - this means that choosing more of one thing can only be achieved by giving up something
else in exchange.
Though we have alternative uses, we have to select the best way to use these resources.

OPPORTUNITY COST AND CONSUMERS
OPPORTUNITY COST AND WORKERS

OPPORTUNITY COST AND PRODUCERS
OPPORTUNITY COST AND THE GOVERNMENT

THE ECONOMIC PROBLEM
There is only one fundamental problem from which all others arise: The unlimited wants exceeding finite
resources
As a result, choices have to be made about how to use resources. The basic economic problem is thus frequently
referred to as 'scarcity and choice'

MAJOR BRANCHES OF ECONOMICS
Microeconomics is a branch of economics that studies the behaviour of individual households and firms in
making decisions on the allocation of limited resources. It concerns itself with demand and supply of particular
goods and services.
Macroeconomics is a branch of economics that studies the behaviour of the whole economy.
Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate
of growth, gross domestic product, and inflation.

FREE GOODS AND ECONOMICS GOODS
FREE GOODS
Free goods are products which does not require resources to make and therefore they have no opportunity cost.
A free good is a good with zero opportunity cost. This means it can be produced by society in as much quantities
as needed with little or zero effort.
Free goods are what is needed by the society and is available without limits. The free good is a term used in
economics to describe a good that is not scarce. A free good is available in as great a quantity as desired with
zero opportunity cost to society e.g. air
ECONOMICS GOODS
Economics goods are products that require resources to produce and therefore they have opportunity cost. Are
consumable item that is useful to people but scarce in relation to its demand, so that human effort is required
to obtain it. They have opportunity cost

PRODUCTION POSSIBILITY FRONTIERS
A production possibility frontier (PPF) is a curve or a boundary which shows the maximum combinations of two goods
and services that a country or an economy can produce at full employment (using all of the available factor resources
efficiently). The curve is also called production possibility Curve (PPC) or production transformation curve (PTC)
Draw PPF curve using the following information
COMPUTERS TEXTBOOKS
0 70
1 69
2 68
3 65
4 60
5 55
6 48
7 39
8 24
9 0

DRAW PPF CURVE

Any point inside the curve (X): Shows the combinations of output of goods X and Y when there are unemployed
resources or when the economy uses resources inefficiently. We could increase total output by moving towards
the production possibility frontier and reaching any of points C, A or B.
Any point outside the curve: Shows combination of goods and services that are unattainable with the current
level of resources. Point D is an example. This point is impossible with the economy’s current scarce resources,
but it may be an objective for the future.

FURTHER INTERPRETATION OF PPC
Firstly, we can describe the opportunity cost of producing a given output of computers or textbooks. For example, if 3m
computers are produced; the opportunity cost is 5m textbooks.
This is the difference between the maximum output of textbooks that can be produced if no computers are produced
(which is 70m) and the number of textbooks that can be produced if 3m computers are produced (which is 65m).
PPFs can also illustrate the opportunity cost of a change in the quantity produced of one good. For example, suppose 3
million computers and 65m textbooks are currently produced.
We can calculate the opportunity cost if it decides to increase production from 3 million computers to 7 million, shown
on the PPF as a movement from point A to point B. and textbooks is shown here.
The result is a loss of output of 26 million textbooks (from 65 to 39m). Hence, the opportunity of this decision can be
expressed as 26m textbooks. In fact, this is the same as comparing the static opportunity cost of producing 3m computers
(5m textbooks) and 7m computers (31m textbooks).

ECONOMIC GROWTH AND PPF
Economic growth has two meanings:
 Firstly, and most commonly, growth is defined as an increase in the output that an economy produces over a
period of time.
 The second meaning of economic growth is an increase in what an economy can produce if it is using all its
scarce resources. An increase in an economy’s productive potential can be shown by an outward shift in the
economy’s production possibility frontier (PPF).
The simplest way to show economic growth is to bundle all goods into two basic categories, consumer and capital
goods.
An outward shift of a PPF means that an economy has increased its capacity to produce.

EXPLAINING SHIFTS IN THE PRODUCTION POSSIBILITY FRONTIER
What creates growth?

When using a PPF, growth is defined as an increase in potential output over time, and illustrated by an outward
shift in the curve.
An outward shift of a PPF means that an economy has increased its capacity to produce all goods. This can occur
when the economy undertakes some or all of the following:
Employs new technology

Investment in new technology increases potential output for all goods and services because new technology
is inevitably more efficient than old technology.
Employs a division of labour, allo

wing specialisation
A division of labour, and specialisation, can considerably improve productive capacity, and shift the PPF
outwards.
Increases its labour force

Growth in the size of the working population enables an economy to increase its potential output. This can be
achieved through natural growth, when the birth rate exceeds the death rate, or through net immigration, when
immigration is greater than emigration.
Discovers new raw materials

Discoveries of key resources, such as oil, increase an economy’s capacity to produce.

AN INWARD SHIFT OF A PPF
A PPF will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce resources. This
reduces an economy's productive potential.
A PPF will shift inwards if:
Resources run out: If key non-renewable resources, like oil, are exhausted the productive capacity of an
economy may be reduced.
Failure to invest: A failure to invest in human and real capital to compensate for depreciation will reduce an
economy's capacity. Real capital, such as machinery and equipment, wears out with use and its productivity
falls over time. As the output from real capital falls, the productivity of labour will also fall. The quality and
productivity of labour also depends on the acquisition of new skills. Therefore, if an economy does not invest
in people and technology its PPF will slowly move inwards.
Erosion of infrastructure: A military conflict is likely to destroy factories, people, communications, and
infrastructure.
Natural factors: earthquake, change of climate

MAIN TYPES OF ECONOMIC SYSTEM
The Economic Problem prompts the following question
What is to be produced? What goods and services should an economy produce? – should the emphasis be on
agriculture, manufacturing or services, should it be on sport and leisure or housing or to produce lots of
military hardware to improve our defences?
How will it be produced? This question arise from the basic economic problem that since resources are scarce
in relation to unlimited wants, an economy need to consider how should goods and services be produced? –
labour intensive, land intensive, capital intensive, slavery or forced labourer should genetically modified
plants be used?
Who will get what is produced? Who should get the goods and services produced? – Equal distribution? More
for the rich or the poor? For those who work hard?
These three fundamental questions have to be answered by any economy, whether it is a highly developed
economy, the poorest of countries, or a small group of people.
To answer these questions, different economic systems have developed. These systems revolve around how
people in those societies allocate scarce resources to satisfy competing wants and needs. In other words, an
economic system attempts to find ways of solving the basic economic problem.

WHAT IS AN ECONOMIC SYSTEM?
Economic system refers to the different mechanism for determining the allocation of scarce resources in the face
unlimited and competing human wants.
A command, or planned, economy

A market or free market economy or capitalist economies
A mixed economy
THE COMMAND, OR PLANNED ECONOMY

In a planned economy, the factors of production are owned and managed by the government. Thus the
Government decides what to produce, how much to produce and for whom to produce.
Features:
Central planning. All resources are owned, planned and managed by the government.
There is no Consumer or producer sovereignty.
Price controlled by the government. The market forces are not allowed to set the price of the goods and services.
Absence of the profit motive Profit is not the main objective, instead the government aims to provide goods and
services to everybody.
State control. Government decides what to produce, how much to produce and for whom to produce.

Advantages
Provision of public and merit goods. Since profit motive is not the main reason why production is undertaken,
public and merit goods can be produced in quantities that government think is best for the population.
Greater economic stability. Prices are kept under control and thus everybody can afford to consume goods
and services.
More equal distribution of income and wealth. There is less inequality of wealth.
There is no duplication as the allocation of resources is centrally planned.
Low level of unemployment as the government aims to provide employment to everybody.
Elimination of waste resulting from competition between firms.
Reduced external cost
Consumers protected from monopoly
Disadvantages
Loss of consumer freedom. Consumers cannot choose and only those goods and services are produced which
are decided by the government.
Lack of flexibility: once a plan has been implemented, it is difficult to change even if the range of goods and
services demanded by the consumer change
Inefficiency in production. Lack of profit motive may lead to firms being inefficient.
Lot of time and money is wasted in communicating instructions from the government to the firms.
Opportunity cost of the planners: Planning involves collecting and coordinating a great deal of information.
This intern involves the labour of thousands of people who could otherwise have been employed to produce
goods and services for consumption.
Existence of shortages and surpluses: Since the planning authority determine show much of each goods and
services to produce, many of these decisions are based on the estimates.
Lack of innovation: since there is no competition among the producers, there is little incentive for innovation
and technological progress.
Examples of Planned economies
North Korea
Cuba
Myanmar
Belarus
Laos
Libya
Iran
Iraq (until 2003)

THE MARKET ECONOMY/ THE FREE MARKET ECONOMY
All resources are owned, planned and allocate privately. The market system is based on the demand and supply
of products. A market economy answers the three questions that form the economic problem through a market
system. Demand and supply determine prices and prices act as signals to both producers (suppliers) and
consumers (who create demand).

Features
Private property: All resources are privately owned by people and firms.
Profit motive: Profit is the main motive of all businesses; hence they produce those products that offer them
high profit.
There is no government interference in the business activities.
Freedom of choice Consumers are free to choose what they want. Workers are free to choose which
occupations they will enter. Producers are free to produce what they want, how much they want and for whom
they want to produce.
Prices are decided by the Price mechanism/market mechanism, i.e. the demand and supply of the
good/service.
A very limited role of the government
Competition forces the firms to be efficient. This may result into production of quality good at cheaper price
Advantages
Consumer control: consumers have the power to influence what is produced. By purchasing more of some
goods and less of the others, they influence what producers supply.
Free market responds quickly to the people’s wants: Thus, firms will produce what people want because it
is more profitable whereas anything which is not demanded will be taken out of production.
Wide Variety of goods and services: That is available in the market to suit everybody’s taste.
Efficient use of resources encouraged: Profit being the sole motive, will drive the firms to produce goods
and services at lower cost and more efficiently. This will lead to firms using latest technology to produce at
lower costs.
Economic growth encouraged. This is because free-market system offers a reward-and penalty signalling
system to its participants. There is incentive to increase productivity because of the reward (profit). Because
of the penalty of losses or reduced profits, resources do not stay in areas where consumer demand no longer
exists.
Disadvantages
Unemployment: Businesses in the market economy will only employ those factors of production which will
be profitable and thus we may find a lot of unemployment as more machines and less labour will be used to
cut cost.
Certain goods and services may not be provided: Those which people might want to use but don’t want to
pay may not be available because the firms may not find it profitable to produce. For example, Public goods,
such as, street lighting and merit goods such healthcare and education may be under produced or consumed
Consumption of harmful goods may be encouraged: Free market economy might find it profitable to provide
goods which are in demand and ignore the fact that they might be harmful for the society.
Ignore Social cost: In the desire to maximise profits businesses might not consider the social effects of their
actions. As a result, an individual or firm making a decision does not have to pay the full cost of the decision.
Pollution created by firms due to production activities is an example of negative production externality.
Unequal distribution of income and wealth: in a market system few who own resources such as land and
capital might be very rich compared with majority of the people who would probably own just one resource
– their labour.
Economic instability: there exist cyclical pattern of booms and slumps. During periods of boom, output and
employment rises and vice versa during a slump
Existence of monopoly

THE MIXED ECONOMY
This usually means an economy that contains both privately-owned and state-owned enterprises or that
combines elements of market economy and planned economy characteristics. This system overcomes the
disadvantages of both the market and planned economic systems.
THE ROLE OF THE STATE IN A MIXED ECONOMY
Resources are owned both by the government as well as private individuals. I.e. co-existence of both public
sector and private sector.
 Market forces prevail but are closely monitored by the government.
Advantages
Producers and consumer have sovereignty to choose what to produce and what to consume but production
and consumption of harmful goods and services may be stopped by the government.
Social cost of business activities ma
y be reduced by carrying out cost-benefit analysis by the government.
As compared to Market economy, a mixed economy may have less income inequality due to the role played
by the government.
Monopolies may be existing but under close supervision of the government.

THE PRICE/MARKET SYSTEM
THE DEMAND CURVE

What is demand?
Demand is defined as the Quantity of products that the Purchasers/buyers are willing and able to buy at
various prices over a given period of time, all other things being equal.
Quantities. Numerical values of goods and services in terms of Prices.

Product. Goods and services
Purchasers. Consumers
Willing to buy. Purchasers must want the product
Able to buy. It must be backed up by purchasing power if the demand has to be effective demand.
At various Price. The consumers have to judge whether the price represent the value of his or her money.
Per period of time. Dictates whether the demand is too high or low
Other things being equal. Other than the price, there are numerous things that affect the demand. They have
to be kept constant, ceteris paribus assumption

What is effective demand?
Effective demand: This occurs when a consumers desire to buy a good can be backed up by his ability to afford
it. In economics willingness to buy goods and services should be accompanied by the ability to buy (purchasing
power) and is referred to as effective demand.
Effective demand refers to the willingness and ability of consumers to purchase goods at different prices. It
shows the amount of goods that consumers are actually buying – supported by their ability to pay.
Ceteris paribus is "all other things being equal." When using ceteris paribus in economics, assume all other
variables except those under immediate consideration are held constant.
The demand schedule
This is a table that shows the Quantity of products that the Purchasers are willing and able to buy at various
prices per period of time.
PRICES $ QUANTITY DEMANDED PER WEEK(in millions)
1000 8
2000 7
3000 6
4000 5
5000 4
6000 3

THE DEMAND CURVE
This is a curve that shows graphically the Quantity of products that the Purchasers are willing and able to buy
at various prices per period of time, other things being equal (ceteris paribus).
Law of demand
The law of demand is an economic law that states that:
It states that when price increases, the amount demanded will fall, while when prices fall, the amount
demanded will rise.

MOVEMENT ALONG THE DEMAND CURVE/CHANGE IN QUANTITY DEMANDED
Extension of demand-Extension of demand is the increase in quantity demanded due to the fall in price, all
other factors remaining constant.
Contraction of demand-Contraction of demand is the fall in quantity demanded due to the rise in price, all
other factors remaining constant.

THE MARKET DEMAND

SHIFT IN THE DEMAND CURVE/CHANGE IN DEMAND
Usually demand curves are drawn based on the assumption except for price all other factors remain the same. But
there might be instances when demand may be affected by factors other than price. This will result in the change
in demand although the price will remain the same. This change in demand may cause the demand curve to SHIFT
inwards or outwards.
Shift of demand curve OUTWARDS shows an increase in demand at the same price level.
Shift of demand curve INWARDS shows that less is demanded at the same price level.

DEMAND AND INCOME
Consumer income (Y) is a key determinant of consumer demand (Qd). The relationship between income and
demand can be both direct and inverse.
NORMAL AND INFERIOR GOODS
 Normal goods: In the case of normal goods, income and demand are directly related, meaning that an increase
in income will cause demand to rise and a decrease in income causes demand to fall. For example, luxuries
like cars and computers are normal goods for most people.
 Inferior goods: In the case of inferior goods income and demand are inversely related, which means that an
increase in income leads to a decrease in demand and a decrease in income leads to an increase in demand.
Diagram alongside shows a Summary

FACTORS AFFECTING DEMAND/DETERMINANTS OF DEMAND
Change in people’s income: More the people earn the more they will spend and thus the demand will rise. A
fall in income will see a fall in demand. This occurs when the product is a normal good. The products for
which the demand decrease as the income increases are called Inferior goods.
Changes in population: An increase in population will result in a rise in demand and vice versa.
Change in fashion and taste: Commodities or which the fashion is out are less in demand as compared to
commodities which are in fashion.
Income Tax: An increase in income tax will see a fall in demand as people will have less money left in their
pockets to spend whereas a decrease in income tax will result in increase of demand for products and services
because people now have more disposable income.
Change in prices of Substitute goods: Substitute goods or services are those which can replace the want of
another good or service. For example, margarine is a substitute for butter. Thus a rise in butter prices will see
a rise in demand for margarine and vice versa.
Change in price of Complementary goods: Complementary goods or services are demanded along with other
goods and services or jointly demanded with other goods or services. Demand for cars is affected the change
in price of petrol. Same way, demand for DVD players will rise if the prices of DVDs’ fall. Joint Demand
Advertising: A successful advertising campaign may affect the demand for a product or service.
Climate: Changes in climate affects the demand for certain goods and services e.g. ice-cream, gumboots
Interest rates: A fall in Interest rate will see a rise in demand for goods and services.
Quality. An increase in the quality of the good e.g. better quality digital cameras encourage people to buy one
Expectations of future price increases.

WHAT IS SUPPLY?
Supply refers to the amount of goods and services firms or producers are willing and able to sell in the market
at a possible price, at a particular point of time, other things being equal (ceteris paribus).
Supply schedules
A supply schedule shows the relationship between price and range of prices.
Law of Supply
Why do supply curves slope upwards?

The law states that when the price of a commodity rises, the supply for it also increases. The higher the price for
the good or service the more it will be supplied in the market.
The reason behind it is that more and more suppliers will be interested in supplying those good or service whose
prices are rising since it is becoming more profitable to produce those particular products

The higher the price, the greater the quantity supplied. A supply curve is derived from a supply schedule. The
upward slope of a supply curve illustrates the direct relationship between supply decisions and price.

CHANGES IN SUPPLY (MOVEMENT ALONG THE SUPPLY CURVE)
Extension of supply- It refers to the increase in quantity supplied of a commodity with the rise in price,
other factors remaining unchanged.
Contraction of supply- It refers to the fall in quantity supplied of a commodity when its prices fall, other
factors remaining unchanged.

THE MARKET SUPPLY

SHIFT IN SUPPLY CURVE
When factors other than price affect the supply it results in the shift of supply curve. The supply curve may
move inward or outward.
A shift of supply curve OUTWARDS to the right will mean an increase in supply at the same price level.
When the supply curve moves INWARDS to the left it means that less is being supplied at the same price level.
Factors affecting Supply
Price of the commodity: A rise in price will result in more of the commodity being supplied to the market
and vice versa.
Non-price factors
Generally, supply is affected by the changes in the cost of production: Increase in the cost of any factor of
production may result in the decrease in supply as reduced profits might see producers less willing to produce
that commodity. As well as price, there are several other underlying non-price determinants of supply, including:
Prices of other commodities: For example, if it is more profitable to produce LCD TVs then producers will
produce more LCD TVs as compared to PLASMA TVs. Thus the supply curve for PLASMA TVs will shift
inwards i.e. a fall in supply.
Technological advancement: Improvement in technology results in lowering of cost of production and more
profits for the producer and thus more supply of that commodity.
Climate: Climate and weather conditions affect the supply of commodities especially agricultural goods.
The availability of factors of production: The availability of factors of production, such as labour or raw
materials, can affect the amount that can be produced and supplied. For example, if a firm producing motor
vehicles experiences a shortage of steel for its body panels, then its ability to produce vehicles will be reduced.
New firms entering the market -In terms of total supply to a market, the number of firms in the market will
affect the total supply.

Subsidies-Subsidies are funds given to firms to enable them to increase their supply or to reduce the price of
their product to the consumer. Subsidies can alter the firm’s willingness and ability to produce and supply.
Government policies e.g. indirect taxes. An INDIRECT TAX is a tax imposed on goods or services. It
reduces supply of products
INDIRECT TAX
Indirect tax is a tax imposed on goods or services (Tax levied on spending). It reduces supply of products. It shifts
supply curve to the left.

SUMMARY

THE MARKET EQUILIBRIUM
Equilibrium is a state in market where quantity demanded and quantity supplied is equal. Market equilibrium,
for example, refers to a condition where a market price is established through competition such that the amount
of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price
is often called the equilibrium price. In the graph below the point at which the demand curve meets the supply
curve is the equilibrium price.
Market clearing
Equilibrium price is also called market clearing price because at this price the exact quantity that producers take
to market will be bought by consumers, and there will be nothing ‘left over’. This is efficient because there is
neither an excess of supply and wasted output, nor a shortage – the market clears efficiently. This is a central
feature of the price mechanism, and one of its significant benefits.

DISEQUILIBRIUM ESTABLISHED

QUIZ: Consider the following table and draw demand and supply curve to reflect the changes.
DEMAND SUPPLY EQUILIBRIUM PRICE EQUILIBRIUM QUANTITY
Increase Unchanged
Decrease Unchanged
Unchanged Increase
Unchanged Decrease

EFFECT OF CHANGE IN DEMAND ON EQUILIBRIUM
Summary of the causes of a price change

An increase in demand shifts the demand curve to the right, and raises price and output.
Demand shifts to the right

Demand shifts to the left
A decrease in demand shifts the demand curve to the left and reduces price and output.
Supply shifts to the right

An increase in supply shifts the supply curve to the right, which reduces price and increases output.

Supply shifts to the left
A decrease in supply shifts the supply curve to the left, which raises price but reduces output.
Equilibrium is a state in market where quantity demanded and quantity supplied is equal. Market equilibrium,

CHANGES IN DEMAND AND SUPPLY

PRICE ELASTICITY OF DEMAND(PED)
% 𝐂𝐇𝐀𝐍𝐆𝐄 𝐈𝐍 𝐐𝐓𝐘 𝐃𝐄𝐌𝐀𝐍𝐃𝐄𝐃

𝐏𝐄𝐃 +
% 𝐂𝐇𝐀𝐍𝐆𝐄 𝐈𝐍 𝐏𝐑𝐈𝐂𝐄
Negative sign-The mathematical value which is derived from the calculation is negative. A negative value
indicates an inverse relationship between price and the quantity demanded. However, the negative sign is ignored.

Exercise:

TYPES OF PRICE ELASTICITY
1. PRICE ELASTIC DEMAND
Demand for a product is said to be ELASTIC if the percentage change in demand is more than the percentage
change in price. The value of PED more than 1

2. PRICE INELASTIC DEMAND
When a product has a PED less than 1 and greater than 0, it is said to be have an inelastic demand. The percentage
change in demand is less than the percentage change in price of the product. The value of PED less than 1 and
greater than zero

3. UNITARY ELASTIC DEMAND
When the percentage change in demand is equal to the percentage change in price, the product is said to have
Unitary Elastic demand. In short, PED=1

4. PERFECTLY INELASTIC DEMAND
Demand is perfectly inelastic if any change in price will not have any effect on the demand of the product. In
other words, the percentage change in demand will be equal to zero irrespective of the price charged. In this case
the PED = 0

5. PERFECTLY ELASTIC DEMAND
Demand is perfectly elastic demand if the demand for a product changes infinitely at a particular price. PED =
infinity

FACTORS AFFECTING PRICE ELASTICITY OF DEMAND
There are several reasons why consumers may respond elastically or in elastically to a price change, including:
Availability of substitutes-The greater the number of alternative products and the more closely substitutable
those products are, the more we would expect consumers to switch away from a particular product when its
price goes up.
The relative expense of the product- a rise in price will reduce the purchasing power of a person’s income
especially when the proportion of income that the price represents is large e.g. increase in price of a bus trip
and a flight from Kenya to London.
Time-in short-term, perhaps weeks, months, people may find it hard to change their spending patterns.
However, over time people will find ways of adapting and adjusting, so the PED is likely to increase over
time
The degree of necessity of the good -A necessity like bread will be demanded inelastically with respect to
price.
Whether the good is habit forming -Consumers are also relatively insensitive to changes in the price of
habitually demanded products.
Whether consumers are loyal to the brand -Brand loyalty reduces sensitivity to price changes hence PED
inelastic.
Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak times – this
is particularly the case for transport services.

APPLICATIONS OF PRICE ELASTICITY OF DEMAND
FIRMS:
Knowing PED helps the firm decide whether to raise or lower price. product
Inelastic demand- A firm will be more willing to increase the price of a product which has a more inelastic
demand because it will lead to an overall increase in their revenue. With an increase in price of the product,
the demand will not fall in the same proportion and this end up in more revenue for the firm.
Elastic demand -On the other hand a firm seeking to increase its revenue and having elastic demand for its
product should not increase its prices because it will lead to a fall in their revenue. As the price increase there
will be a more than proportionate fall in sales, thus pulling down the overall revenue of the firm.
WHAT IS THE ROLE OF PED TO THE GOVERNMENT?
PED hold a lot of significance for government while deciding indirect taxes on goods and services. Government
uses taxes to reduce the use of demerit goods in the economy. For example, they might increase taxes on
cigarettes.
Cigarettes are habit forming or ‘addictive’ and have inelastic demand, thus, even a high increase in indirect taxes
will not lead to a fall in the consumption of cigarette smoking.
Thus overall revenue of government will increase without drastically harming the cigarette manufacturing
industry and employment. Moreover, it might lead to some fall in cigarette consumption due to increased prices.

PRICE ELASTICITY OF SUPPLY
% CHANGE IN QUANTITY SUPPLIED

PES =
% CHANGE IN PRICE
Example

Types of Price elasticity of Supply
While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to infinite, perfectly
elastic
1. Supply is Price Elastic when the percentage change in quantity supplied is more than the percentage change
in Price of the commodity. PES is more than 1.

2. Supply is Price Inelastic when the percentage change in quantity supplied is less than the percentage change
in Price of the commodity. PES is less than 1.

3. Unitary Price Elasticity of Supply. PES=1

4. Perfectly price inelasticity supply
Perfectly inelastic, where only one quantity can be supplied irrespective of the price. PES=0

5. Perfectly price elastic Supply
Perfectly elastic, where supply is infinite at any one price. PES = Infinity

FACTORS AFFECTING/DETERMINANTS OF PES
How firms respond to changes in market conditions, especially price is an important consideration for the firm
itself, and to an understanding of how markets work.
DETERMINANTS OF PES
Availability of resources: If the economy already using most of its scarce resources then firms will find it
difficult to employ more and so output will not be able to rise. The supply of most of goods and services will
therefore be price inelastic.
Number of producers: More producers mean that the output can be increased more easily. Thus supply is
more elastic.
Ease of storing stocks: If goods can be stocked with ease and have a long shelf life, the supply will be elastic,
otherwise inelastic. For example, perishable goods such as fresh flowers, vegetables have comparatively
inelastic supply because it is difficult to store them for longer periods.
Increase in cost of production as compared to output: In cases where there is a significant increase in cost
of production when output is increased, supply is inelastic. This is because suppliers will have to have to do
a significant investment in order to increase the output. It will take time and some suppliers may be hesitant
in doing so.
Improvement in Technology: In industries where there is a rapid improvement in technology, the PES of
such goods will be more elastic as compared to industries where there is not much improvement in technology.
Stock of finished goods: In industries where there are high inventories/stocks of finished goods, the suppliers
can easily supply more as the price rises. Thus, the PES for these goods will be elastic.
Time: In the short run firms will only be able to increase input of labour to increase supply of commodities
may not be able to increase the supply in response to the price change but the supply change will be little
because other factors of production may not be increased in the same proportion and may limit the supply.
However, in the long run a firm will increase the input of all factors of production and thus the supply becomes
more price elastic.
The key considerations are:

 Are resource inputs readily available?
 Are factors mobile - are workers prepared to move to where they are needed?
 Can finished products be easily stored, and are there existing stocks?
 Is production running at full capacity?
 How long and complex is the production cycle or production process?

PUBLIC AND PRIVATE SECTORS
THE PUBLIC SECTOR OWNERSHIP AND CONTROL
The public sector: this is a sector made up of organizations which are owned and controlled by local or central
government
 Most of the services listed below are funded from tax revenue.
 The government also borrows money and charges for some services directly (e.g. entrance fees into swimming
pools).
PUBLIC SECTOR INCLUDES
1. Central government departments: Controlled by government ministers e.g. Ministry of defense,

Department of health, Department of transport
2. Public corporations or state owned enterprises
3. Local authority services: Deals with Recreation services (e.g. libraries, swimming pools, etc.)
4. Other public sector organizations: are run by trust and board e.g. BBC-British Broadcasting Corporation,
Post offices
Public Sector Aims
Most of its services are provided free at the point of delivery. Most are funded from tax revenue.
1. Improving the quality of services: Performance indicators are used to measure the quality of services.
Performance indicators focus on reliability, professionalism, levels of customer service and speed of service.
2. Minimizing costs: this because government resources are scarce, so it is important that waste is minimized.
In the past, public sector organizations have been criticized for being inefficient. This is because, unlike
private sector firms, public sector firms are not profit-motivated.
3. Allow for social costs and benefits: when making decisions, they must take into account externalities.
Therefore, aim is not to make a profit. Instead they take into account the needs of a wide range of
stakeholders.
4. In some countries such as (UAE): United Arab Emirates, government own businesses that are profit
motive

THE PRIVATE SECTOR OWNERSHIP AND CONTROL
Goods and services are provided by businesses that are owned by individuals or groups of individuals.
 In most economies, most goods and services are provided by the private sector.
 Most businesses are small sole traders, partnerships and companies; a minority of businesses are large.
 Some are multinationals- this means that they have factories and other production facilities all over the world.
The private sector Includes:
Sole traders: Businesses owned and controlled by one person. Examples: taxi drivers, plumbers, electricians, etc.
Partnerships: Businesses owned and controlled by two or more people working together. Often found in the
professions. Examples: accountants, doctors, lawyers, estate agents, architects, solicitors, etc.
Companies: Owned by shareholders who elect a board to run the business on their behalf. They Vary in size and
some become Multinationals. Can be found in many different business sectors such as manufacturing,
construction, public transport, media, financial services, oil and gas, engineering, etc.

Private Sector Aims

1. Survival: This is the Initial and most basic aim for every firm. When a firm is first set up many owners will
not expect to make a profit immediately due to unexpected difficulties
2. Profit maximization: refers to firms making as much profit as they possibly can in a period of time
 Companies pay their shareholders dividends, which is a share of the profit.

 Many of these shareholders want dividends to be high as possible and therefore profit maximization is an
important objective.
3. Sales revenue maximization: refers to firms making largest amount of revenue as they possibly can in a
period of time
4. Growth: Many firms aim to expand because bigger businesses generally have more benefits, such as:
 Bigger firms can exploit economies of scale.

 Profits will be higher in the future.
 Growth will also benefit other stakeholders such as workers, managers and directors because job may be
more secure.
 However, a problem with growth is that profit is often used to fund it, so shareholders will not like this because
it lowers the dividends.
5. Social responsibility: In order to receive approval from the general public and become better 'citizens'
6. Profit satisficing: This means that firms make just enough profit to keep owners 'satisfied while pursuing
other objectives.
DIFFERENCES BETWEEN PRIVATE AND PUBLIC SECTOR
PRIVATE SECTOR PUBLIC SECTOR

1. Businesses owned by private individuals. 1. Business owned by state/ the government.
2. Main motive of owning business is to make 2. Main motive of owning business is to provide
profit. services at an affordable rate to citizens
3. Funds to start and own business provided by (improve welfare).
private individuals 3. Funds to start and own these businesses
4. Provide goods and resources that are mostly provided from taxes collected by government
demanded by consumers (consumer goods). 4. Provide public and merit goods.

EFFICIENT RESOURCE ALLOCATION
WHAT IS ECONOMIC EFFICIENCY?
Economic efficiency means the using of resources in such a way as to maximize the production of goods and
services.
TYPES OF ECONOMIC EFFICIENCY

1. PRODUCTIVE EFFICIENCY
Productive efficiency occurs when a firm is combining resources in such a way as to produce a given output at
the lowest possible average total cost. Costs will be minimised at the lowest point on a firm's short run average
total cost curve.
It is achieved when production of goods is achieved at the lowest cost possible. This occurs when the maximum
number of goods and services are produced with a given amount of inputs.
This occurs on the production possibility frontier. On the curve it is impossible to produce more goods without
producing fewer services. Productive efficiency will also occur at the lowest point on the firm’s average costs
curve.
Look at the PPC diagram below. Point X shows Productive inefficiency. This is because the output is not
optimum and there are still resources left unused. Whereas, Point Y shows productive efficiency, as this is the
maximum output which can be achieved through the utilizing all resources.

In long-run equilibrium for perfectly competitive markets, this is where average cost is at the base on the Average
Cost curve. (MC=AC). In the diagram below q is the point of productive efficiency.

2. ALLOCATIVE EFFICIENCY
Allocative efficiency is a situation in which the limited resources of a firm are allocated in accordance with the
wishes of consumers-when goods and services are distributed according to consumer preferences.
An allocatively efficient economy produces an "optimal mix" of commodities. In short, the products that are most
wanted must be produced. A competitive market can lead to Allocative efficiency because the firms are forced to
produce what the customers want.
An economy could be productively efficient but produce goods people don’t need this would be allocative
inefficient. Allocative efficiency occurs when the price of the good = the MC of production

3. DYNAMIC EFFICIENCY
Dynamic efficiency involves the introduction of new technology and working practices to reduce costs over time-
means technological progressiveness and innovation.
Economic theory suggests that when existing firms in an industry, the incumbents, are highly protected by barriers
to entry they will tend to be inefficient.
Firms can benefit from two types of innovation
 Process innovation occurs when new production techniques are applied to an existing product. For example,
this is common in the production of motor vehicles with firms constantly looking to develop new methods
and production processes.
 Product innovation occurs when firms generate new or improved products. For example, this is common in
many consumer product markets, including electronics and communications

CONCEPT OF MARKET FAILURE
WHAT IS MARKET FAILURE?
Market failure occurs whenever freely-functioning markets operating without government intervention, fail to
deliver economic efficiency and the result is a loss of economic and social welfare.
market failure can also be defined as spillover effects of production or consumption that adversely affect third
parties or benefits who are not directly involved in the transaction
CAUSES OF MARKET FAILURE
1. Existence of externalities
2. Missing markets-Due to lack of public goods, such as defence, street lighting, and highways. the free-rider
problem; non-provision of public goods
3. Incomplete markets- Under provision of merit goods such as education and healthcare. Overprovision of
demerit goods- like cigarettes and alcohol,
4. Environmental degradation
5. Immobility of factors of production
6. Problems of information-Information failure

Definition of key terms in market failure
a) Private Benefit (PB) is the benefit which is derived by private individuals in the consumption or production
of a good or service
Examples of Private Benefit
 Profit
 Salary
 Medical schemes
 Experience
 Job security
 Education allowance
 Retirement benefits
 Entertainment benefits
b) External benefit (EB)-the benefit from consumption or production of a good or service that people other
than the consumer enjoy
Examples of External Benefit
 A bee keeper produces honey, but as an external benefit, his bees help to fertilize nearby fruit trees.
 Vaccination against communicable diseases
 Cycling to work helps to reduce the level of pollution and congestion. Therefore, other road users have
quicker journey times
c) Social Benefit (SB) — the benefit enjoyed by the entire society, both by the consumer and by everyone else.
SB=PB+EB
d) Private Cost (PC) is the cost of producing a good or service that is paid by the producer
Examples of Private Cost
 Wages paid to workers, Salaries paid to workers

 Plant Machinery
 Transport
 Equipment, Vehicle
e) External cost (EC) - the cost of producing or consuming a good or service that falls on other people other
than the consumer or producer
Examples of external Cost
 Greater congestion and slower journey times for other drivers.

 Cause of death for pedestrians, cyclists and other road users.
 Pollution e.g. Noise and air pollution
 Health related problems.
f) Social Cost (SC) is the total cost to society as a whole for production of goods and services SC = PC + EC
EXTERNALITIES
Economic activity, such as building e new factory or transporting a tanker full of oil from Qatar to Japan, will
affect those inside the business. However, economic activity can also have an impact on the outside. There are
spillover effects that may be positive or negative.
Social cost
The production or consumption of a good will have costs. These are divided into private costs and externalities.
Private costs are met by those who consume or produce a good. Externalities are the spillover effects of production
or consumption. They affect others and can be positive or negative. Negative are the costs that are not met by
those who impose them. Social costs are the costs that the society as a whole has to meet and are the sum of both
private and external costs (negative externalities)
SOCIAL COST = PRIVATE COST + EXTERNAL COST
Social benefits
The production or consumption of a good will also have benefits. These are divided into private benefits and
positive externalities. Private benefits are enjoyed by those who produce consume a good. Positive externalities
include the removal of an eyesore and creation of employment. The benefits to the society as a whole of an
economic activity, the social benefits, are made up of private benefits and external benefits (positive externalities)
SOCIAL BENEFIT = PRIVATE BENEFIT + EXTERNAL BENEFIT

EXTERNALITIES
Traffic congestion
noise pollution
air pollution
water pollution
overcrowding
resource depletion
Social costs and social benefits of consumption
The consumption of a good can also result in externalities. For example, a college student who buys a small car
for $2,000. The social costs and benefits are;
1. PRIVATE COST = $ 2,000 + any other running costs such as fuel and insurance.
2. External cost = the pollution resulting from exhaust fumes and the contribution of congestion.
3. Private benefit = the convenience and flexibility which car – owning provides
4. External benefit = the possible free lifts given to friends and family in the car.
Types of Externalities
Externalities can result either from consumption activities or from production activities. There are four types of
Externalities
Negative externality
Positive externality

NEGATIVE EXTERNALITY
Negative spill-over effects of production or consumption that affect people or organizations that were not part of
decision making.
For example
Road congestion.-As individuals 'consume' road-space they reduce available road-space and deny this space
to others.
Smoking-by smoking in public places, the consumer is creating negative externalities, in the form of passive
smoking, for non-smokers.
Using fossil fuels that pollute atmosphere

Playing loud music and disturbing neighbors
Discarding garbage in public places
Also if individuals consume alcohol, get intoxicated and do harm to the property of innocent third parties, a
negative consumption externality has arisen

DEMERIT GOODS
Demerit goods are goods which are deemed to be socially undesirable, and which are likely to be over-produced
and over-consumed through the market mechanism.
Examples of demerit goods are
cigarettes,
alcohol and
all other addictive drugs such as heroin and cocaine.
The consumption of demerit goods imposes considerable negative externalities on society as a whole, such that
the private costs incurred by the individual consumer are less than the social costs experienced by society in
general:
For example,
Cigarette smokers not only damage their own health, but also impose a cost on society in terms of those who
involuntarily passively smoke and the additional cost to the National Health Service in dealing with smoking-
related diseases.

POSITIVE EXTERNALITIES
Positive spill-over effects of production or consumption that affect people or organizations that were not part of
decision making. Third-parties include any individual, organization, property owner, or resource that is indirectly
affected. While individuals who benefit from positive externalities without paying are considered to be free-riders,
it may be in the interests of society to encourage free-riders to consume goods which generate substantial external
benefits.
MERIT GOODS- INCOMPLETE MARKET
Most merit goods generate positive consumption externalities; which beneficiaries do not pay for. For example,
with healthcare, private treatment for contagious diseases provides a considerable benefit to others, for which
they do not pay. Similarly, with education, the skills acquired and knowledge learnt at university can benefit the
wider community in many ways. The market for merit goods is an example of an incomplete market.
Merit goods have two basic characteristics
Firstly, unlike a private good, the net private benefit to the consumer is not fully recognized at the time
of consumption. In the case education, which is widely considered to be a merit good, pupils and students
cannot possibly know the specific private benefit to them of getting good grades at school, college or
university. They will be well aware of the sacrifice required to study, but will not know the benefits to them
in terms of a future job, salary, status and skills. Therefore, with education, as with other merit goods, there
is a significant information failure in terms of expected benefits.

Secondly, while consumption of a merit good also generates an external benefit to others, from which
society gains, this is unlikely to be known or recognized at the point of consumption. Given that decisions
to consume are driven by self-interest, it is unlikely that this external benefit will be taken into account when
the consumer of a merit good evaluates its worth
For example, an individual student is generally not motivated to study hard in order to benefit others later in
life, although everyone associated with them will benefit from their education in some way. Beneficiaries
include future employers and all those who consume the products supplied their employer, their family, and
friends. The better job they obtain, the more tax they will pay, and the greater the benefit to those who receive
welfare benefits and transfers. However, putting a value on these external benefits is impossible, especially
at the point of learning.
Healthcare : Healthcare is also regarded as merit good. For example, although it is not possible to know exactly
when the benefit will arise, inoculation against a contagious disease clearly provides protection to the individual,
and yields a private benefit. There is also an external benefit to other individuals who are protected from catching
the disease from those who are inoculated! However, few would choose inoculation simply to protect others!

PRIVATE GOOD

NON-PROVISION PUBLIC GOODS (MISSING MARKETS)
When combined, these three characteristics deter potential suppliers because it would be impossible to charge
users at the point of use.

WHY PUBLIC GOODS MAY NOT BE PROVIDED BY THE PRIVATE SECTOR
Why will suppliers not be able to charge?
Suppliers cannot charge at the point of consumption or use because of the free-rider problem. No one would
pay because the first person to pay for supply creates a free supply for everyone else! No one can be excluded
from the market and prevented from consuming, and hence they are encouraged to become free-riders.
Because of this, suppliers are not able to generate any revenue, or make a profit, so a necessary condition for
the formation of a market is absent, namely the absence of a profit incentive. With no incentive, entry into the
market is deterred, resulting in a missing market.
Common examples
Defence,
Public fireworks,
Lighthouses,
Clean air,
Street light.

ABUSE OF MONOPOLY POWER
Monopoly power occurs when a firm has market dominance in an industry. (for example, more than 40% market
share). Abuse of monopoly power could involve setting higher prices or limiting output. Abuse of monopoly
power can lead to deadweight welfare loss, less choice, and problems for suppliers.
Evidence of Abusing Monopoly Power
 Charging excessively high prices. This might be difficult to judge, but if they are making high profits then
this is an indication that prices are higher than in a competitive situation
 Predatory Pricing. This involves cutting prices and selling below average cost to force rivals out of business.
o Exclusive distribution. Some retailers will only buy from some particular manufacturers
o Tie in sales. E.g. if you buy a printer the company will try and make you buy their own brand ink
The costs of monopoly
1. Less choice: Clearly, consumers have less choice if supply is controlled by a monopolist – for example, the
Post Office used to be monopoly supplier of letter collection and delivery services across the UK and
consumers had no alternative letter collection and delivery service.
2. High prices: Monopolies can exploit their position and charge high prices, because consumers have no
alternative. This is especially problematic if the product is a basic necessity, like water.
3. Restricted output: Monopolists can also restrict output onto the market to exploit its dominant position
over a period of time, or to drive up price.
4. Less consumer surplus: There is asymmetric information – the monopolist may know more than the
consumer and can exploit this knowledge to its own advantage.
5. Productive inefficiency: Monopolies may be productively inefficient because there are no direct
competitors a monopolist has no incentive to reduce average costs to a minimum, with the result that they are
likely to be productively inefficient.

Factor immobility occurs when it is difficult for factors of production (e.g. labour and capital) to move between
different areas of the economy. Factor immobility could involve:
 Geographical immobility – When it is difficult to move from one geographical area to another.
 Occupational immobility – difficult to move from one type of work to another.

GOVERNMENT POLICIES TO DEAL WITH EXTERNALITIES
A government will want to discourage economic activities that result in negative externalities and encourage
those that result in positive externalities. The government uses following measures to deal with negative
externalities,
1. TAXATION. If a tax is imposed on a firm that produces damaging emissions, production costs will increase
and the prices charged by the firm will rise. This should result in a fall in demand for the firm’s product and
therefore a reduction in pollution.

2. SUBSIDIES. The government can offer grants, tax allowances and other subsidies to firms as an incentive
to reduce externalities. For example, a firm may receive a subsidy if it builds a plastic recycling plant. This
might encourage households and firms to recycle their plastic waste instead of dumping it. The government
can also give subsidies to firms that generate positive externalities.
3. FINES. In some countries fines are imposed on those who damage the environment.
4. GOVERNMENT REGULATIONS. Pressure has grown on government in recent years to pass more
legislation to protect the environment. Much of the pressure has emerged due to growing concerns about
global warming. In UK, for example, the Environment Act 1995 was set up to monitor and control pollution.
It also laid down regulations relating to contaminated land, abandoned mines, national parks, air quality and
waste.

5. TRADABLE PERMITS. Tradable-permit system in which a greenhouse gases (carbon) emitter can
buy/sell permission to emit a certain amount of emissions from/to other emitters (who are below/above their
limit). Tradable permits provide an incentive to polluters to ‘internalize' the externality. Tradable permits to
pollute involve:
The government, or an appointed agency, selling the right to generate a given quantity of pollution to
firms in an industry
These can be bought, and traded, with the result being:
 The high polluters have to buy more permits, which increases their costs, and makes them less competitive
and less profitable.
 The low polluters receive extra revenue from selling their surplus permits, which makes them more
competitive and more profitable.
 There is clearly an incentive to be a non-polluter!

6. MAXIMUM AND MINIMUM PRICE
MAXIMUM PRICE OR PRICE CEILINGS
A maximum price occurs when a government sets a legal limit on the price of a good or service with the aim of reducing
prices below the market equilibrium price
In some markets, governments intervene to keep prices of certain items higher or lower than what would result from the
market finding its own equilibrium price
A price ceiling occurs when the government puts a legal limit on how high the price of a product can be. In order for a price
ceiling to be effective, it must be set below the natural market equilibrium. It is also known as maximum price. If the
maximum price is set above the equilibrium price, then it will have no effect.
For the price that the ceiling is set at, there is more demand (Q2) than there is at the equilibrium price. There is also less
supply (Q1) than there is at the equilibrium price, thus there is more quantity demanded than quantity supplied i.e. shortage.

REASONS FOR MAXIMUM PRICES
Maximum prices involve the government making a normative judgement that the market clearing price is too high, and
needs to be reduced. The government may impose a maximum price for a variety of reasons.
The good is essential for daily living – without a maximum price some people may be unable to afford the good. By
reducing the price, it can help reduce relative poverty.
Monopoly exploitation. If firms have monopoly power, they can charge high prices to consumers – higher than the
marginal cost of production and higher than in a competitive market.
However, if supply is very inelastic, then a maximum price will not reduce the supply of the good, therefore, there will be
no fall in the quantity supplied.
Examples of maximum prices
Maximum prices for train tickets. With monopoly power, train companies could increase the peak tickets, but
governments may impose a maximum price
Maximum price for rent. Governments have tried different types of rent control – keeping the cost of renting below a
certain level.
Maximum price for food. In some developing economies, there are maximum prices for certain foodstuffs to keep
them affordable.
Problems of maximum prices
Existence of black market: Due to demand exceeding the supply, there will be buyers who will be willing to purchase
the good at a higher price. This will lead to existence of black market.
Shortage. A maximum price distorts the market and leads to disequilibrium. The demand is greater than supply
meaning many consumers will be unable to get the product at all. Cheap rents are no good, if it leaves many people
homeless.
Queues. One consequence of a maximum price is that people will end up queuing to try and get the good before it
sells out. This will encourage people to spend longer and longer in queues before it runs out. This time spent queuing
represents a significant cost in terms of time.
The market will become less profitable for firms. In the long-term this may lead to less investment and also decrease
supply in the long-term. For example, rent controls may be a way to deal with the short-term problem of expensive
housing. But, reducing rents will discourage some landlords from letting out property. It may also discourage people
from building houses.

MINIMUM PRICES OR PRICE FLOOR
A price floor is a government imposed price limit on how low a price can be charged for a product. A price floor must be
higher than the equilibrium price in order to be effective
A minimum allowable price set above the equilibrium price is a price floor. With a price floor, the government forbids a
price below the minimum Price Floors are minimum prices set by the government for certain commodities and services
that it believes are being sold in an unfair market with too low of a price and thus their producers deserve some assistance.
Government might set Minimum prices
To raise incomes for producers such a farmers and protect them from frequent fluctuations in the commodity market.
To protect workers and ensure that they get a enough wages to sustain a reasonable standard of living.
Examples of price floors
In many countries governments assist farmers by setting price floors in agricultural markets.
Setting Minimum wages for certain occupations is also an example of price floors.

7. COMPETITION POLICY
Competition policy is the structures governments have in place for the regulation of markets and monopolies.
Competition policy generally aims to:
 Prevent growth of Monopoly power

 Prevent abuse of Monopoly power and restrictive trading practices
 Investigate suspected abuses of monopoly power and recommend policy decision.
 Reduce barriers to entry and keep markets contestable.
8. ENVIRONMENTAL AGENCIES: Environmental agencies are responsible for taking action against
companies who don’t abide by regulations pertaining to the benefit of the environment. They can help firms
by looking after wildlife, reducing waste, working with farmers and giving advice on how to protect the
environment
9. ROAD PRICING AND CHARGES: Causing congestions and pollution can result in charges to the road
user(s) causing it. For example, in London, Drivers were charged with a fixed rate for entering a designated
central London zone. 12 months later it was claimed that traffic had been cut by 18% and delays were down
30%

10. NATIONALIZATION AND PRIVATISATION
Privatization is the transfer of public sector resources to the private sector
Form of privatization
1. Sale of nationalized industries

 Nationalized industries: public corporations previously part of the private sector which were taken into state
ownership
 Natural monopolies (more efficient under state control) but sold off and owned by private shareholders
2. Contracting out
 Where private contractors are given a chance to offer for services previously supplied by the public sector
 Government and local authority have been ‘contracted out’ to private sector business
3. The sale of land and property
 Tenants have their own right to buy their own houses
WHY DOES PRIVATIZATION TAKE PLACE?
(i) To generate income

- Sale of state assets make income for the government
(ii) Nationalized industries/Public sector organization were inefficient
- Lack of incentive to make a profit and often made losses
- In private sector, would have to cut costs…improve services…return profits for shareholders
- In private sector it would also be more accountable
(iii)To reduce political interference
In private sector, the government could not use these firms for political aims. Firms would be free to determine
their own investment levels, prices, product ranges, growth rates…etc

Effects of privatization on Consumers
Higher competition means lower prices, increased quality and innovation. Prices have fallen (for example
telephone services, gas and electricity).
However, exploitation may occur. Prices have risen sharply too (for example rail travel and water)
Effects of privatization on Workers

More unemployment as focus on efficiency means introduction of machinery hence cutting back on staffing
levels
In effort to improve efficiency, workers may have been pressurized to raise their productivity (For example,
have been asked to adopt more flexible working practices)
Effects of privatization on Firms

Objectives have changed to maximize profit
- Profit increased after privatization
Increased investment levels

- For example, water companies after privatization raised investment level to fund new sewerage system and
purification plants
Effects of privatization on Government

No longer responsible for running the privatized firms - focus more sharply on the government business
Money earnt from privatization is huge. However, often governments sell them off too cheaply.
Increase in company profits means greater tax revenue
Privatized firms don't have to be subsidized
Governments no longer take profits from firm
Effects of privatization on The Economy/economy
Businesses in the economy will run more efficiently because of increased competition. Increase in efficiency
results to higher growth.
Privatization would lower costs, improve quality of services
However, Unemployment may rise.
However, Inflation may become unstable.
However, Negative externalities may increase
However, it is difficult to evaluate the overall effect of privatization on the economy

11. NATIONALIZATION
Advantages of nationalization

Disadvantages of nationalization

12. DIRECT PROVISION

GOVERNMENT FAILURE
Government failure is a situation where government intervention in the economy to correct a market failure
creates inefficiency and leads to a misallocation of scarce resources. Government failure’ as intervention that
results in a net welfare loss.
Government intervention to resolve market failures can also fail to achieve a socially efficient allocation of
resources. Government failure is a situation where government intervention in the economy to correct a market
failure creates inefficiency and leads to a misallocation of scarce resources.
Examples of government failure include:
1. Government can award subsidies to firms, but this may protect inefficient firms from competition and create
barriers to entry for new firms because prices are kept ‘artificially’ low. Subsidies, and other assistance, can
lead to the problem of moral hazard.
2. Taxes on goods and services can raise prices artificially and distort the efficient operation of the market. In
addition, taxes on incomes can create a disincentive effect and discourage individuals from working hard.
3. Governments can also fix prices, such as minimum and maximum prices, but this can create distortions which
lead to:
 Shortages, which may arise when government fixes price below the market rate. Because public healthcare
is providing free at the point of consumption there will be long waiting lists for treatment.
 Surpluses, which may arise when government fixes prices above the natural market rate, as supply will exceed
demand. For example, guaranteeing farmers a high price encourages over-production and wasteful surpluses.
Setting a ‘minimum wage’ is likely to create an excess of supply of labour in markets where the ‘market
clearing equilibrium’ is less than the minimum.
4. Information failure is also an issue for governments, given that government does not necessarily ‘know’
enough to enable it to make effective decisions about the best way to allocate scarce resources. Many
economists believe in the efficient market hypothesis, which assumes that the market will always contain
more information than any individual or government. The implication is that market prices and market
movements should be free from interference because markets cannot be improved upon by individuals or
governments.
5. Lack of incentives: In the public sector, there is limited or no profit motive. Because workers and managers
lack incentives to improve services and cut costs it can lead to inefficiency. For example, the public sector
may be more prone to over-staffing. The government may be reluctant to make people redundant because of
the political costs associated with unemployment.
6. Political interference e.g. politicians may take the short term view rather than considering long term effects
Overcoming government failure
There are various things the government can try and do to overcome government failure
Give performance targets / profit incentives

Competitive tendering – where public sector bodies face competition from the private sector for the right to
run a public service.
Employing outside private sector consultants to make decisions about how to cut costs

MONEY AND BANKING
WHAT IS BARTER SYSTEM?
Barter system involves direct exchange of one good or service for another. Without money, all transactions
would have to be conducted by barter. The difficulty with a barter system is that in order to obtain a particular
good or service from a supplier, one has to possess a good or service of equal value, which the supplier also
desires. In other words, in a barter system, exchange can take place only if there is a double coincidence of
wants between two transacting parties.
The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services
rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium
of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each other’s'
goods and services.
WHAT IS MONEY?
Money is anything that is generally accepted as payment for goods and services and repayment of debts.
Examples of money
Notes and coins

Credit card
Debit card
M-Pesa etc.

Functions of Money
Function refers to the purpose of money or what money actually does. They are as follows:
 Medium of Exchange-Money is used as a standard of exchange for goods and services. Money overcomes
the problem of needing a double coincidence of wants.
 A unit of account- Money provides a common measure of the value of goods and services being exchanged.
Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the
good to make decisions about how much of the good to supply and how much of the good to purchase.
 Thus different commodities can be expressed in terms of money uniformly. This simplifies the comparison
of the value of two products or services.
 A store of value- For money to function as medium of exchange, it must hold its value over time; that is, it
must be a store of value. Unlike barter system where the commodities (Raw materials) could not be saved
over time, money can be stored as it does not lose value overtime.
 A standard of deferred Payment-Money can be used to pay over time for commodities. Goods and services
can be paid for in instalments over a period of time e.g. hire purchase. This was much more difficult and
complicated in the barter system.
Qualities of Good Money
A quality refers to a characteristic of good money. They are as follows:
General acceptance-The essential quality of good money is that it should be acceptable to all, without any
hesitation in the exchange for goods and services.
Portability- money should be easily transferable from one place to another for doing business and making
payment. The paper money is easier to carry because it has minimum possible wait than metallic
Storability-Money should not be depreciate with time. If the money used is perishable it will lose its value in
few days. Paper money has this quality of storability.
Divisibility-Good money is that which could be divided into small units without losing any value.
Durability-Money should be durable. The gold and silver coins do not wear out quickly and quality of money
remains the same.
Economy-Money should be made economically. If there is heavy cost on issuing more money that is not good
money. Good money is that has low cost and more supply. Paper money has this quality of economy

THE BANKING SYSTEM
A bank is a financial institution which is involved in borrowing and lending money. Banks take customer deposits in return
for paying customers an annual interest payment. The bank then uses the majority of these deposits to lend to other customers
for a variety of loans.
MAIN PURPOSE OF BANKS
1. Keep money safe for customers. Banks are seen as a secure place to deposit money. It would be impractical
and risky to keep all your savings as cash under your bed.
2. Offer customers interest on deposits, helping to protect against money losing value against inflation.
Commercial banks pay interest on deposits. For current accounts, this may be very low, but for saving
accounts, the interest rate can be significant. In a period of inflation, interest rates on deposits are very
important for maintaining the real value of your savings. For example, if inflation is 4% then keeping cash
will see the value of savings decrease in value. However, if the bank is paying an interest rate of 6%, then the
real value of your savings will increase.
3. Offering financial advice and related financial services, such as insurance
4. Lending money to firms, customers and homebuyers. A bank can become more profitable by using a
percentage of its deposits to lend to other customers. If a bank pays 2% on bank deposits but lends money to
firms and consumers at 6%, then it can make a bigger profit on its deposits.
Personal loan – In this case, the bank may make a loan to be paid back over a few years. This loan may be
unsecured against any assets like a house. Personal loans could be for a big purchase like a car or specifically
to help fund a career or educational improvement.
Business loan – A loan for a firm to invest and expand their business.
Mortgage – This is a special type of loan, where the bank advances a loan to purchase a house.
Overdraft. A bank can agree on an overdraft with customers. This allows them to borrow money in the short
term quickly and conveniently. However, the amount allowed tends to be quite small.

What is the function of a Commercial Bank?
The primary functions of a commercial bank are as follows:
1. Accepting Deposits
Commercial banks accept deposits from people, businesses, and other entities in the form of:
 Savings deposits – The commercial bank accepts small deposits, from households or persons, in order to
encourage savings in the economy.
 Time deposits – The bank accepts deposits for a fixed time and carries a higher rate of interest as compared
to savings deposits.
 Current deposits – These accounts do not offer any interest. Further, most current accounts offer overdrafts
up to a pre-specified limit.
2. Lending of Funds
Another important activity is lending funds to customers in the form of loans and advances, cash credit, overdraft
Loans are advances that a bank extends to his customers with or without security for a specified time and at an
agreed rate of interest. Further, the bank credits the loan amount in the customers’ account which he withdraws
as per his needs.
Under the cash credit facility, the bank offers its customers a facility to borrow cash up to a certain limit against
the security of goods. Further, an overdraft is an arrangement that a bank offers to customers wherein a temporary
facility is offered to overdraw from the current account without any security.
3. Agency Functions
Commercial banks may serve as agents by collecting and paying checks, dividends, for their customers. They
could also pay rent, insurance premiums, on behalf of their customers.

4. Taking Deposits
Initially, banks used to charge customers a fee to accept deposits; however, as the banking system has evolved
and become more profitable, banks pay a small interest to the depositors who keep money with them. Many of
these accounts tend to charge an administrative fee if certain minimum deposit amounts are not met.
5. Other functions: Banks may also provide other products such as safety deposit boxes for customers to
safely store their valuables, or foreign currency exchange services.
6. Credit Creation: A unique function of the bank is to create credit. In fact, credit creation is the natural
outcome of the process of advancing loan as adopted by the banks. When a bank advances a loan to its
customer, it does not lend cash but opens an account in the borrower’s name and credits the amount of loan
to this account. Thus, whenever a bank grants a loan, it creates an equal amount of bank deposit. Creation of
such deposits is called credit creation which results in a net increase in the money stock of the economy.

What is the function of a Central Bank?
A Central Bank is an integral part of the financial and economic system. They are usually owned by the
government and given certain functions to fulfil. These include printing money, operating monetary policy,
lender of last resort and ensuring the stability of financial system.

HOUSEHOLDS
1. SPENDING/CONSUMPTION
Consumption is defined as the SPENDING on the final goods and services by household to satisfy their current
wants like food, clothes, personal care items, etc., but doesn’t include things like the purchase of a home (which
is considered part of investment).
The main influence on consumption is the level of disposable income. When income rises, total spending also
usually rises. Rich people spend more than the poor.
Disposable Income - Income actually available for spending is personal income less net taxes. Savings- The
difference between disposable income and consumption.
Average propensity to consume (APC) –Defined as the proportion of household income that is used for
consumption expenditures
Consumption (C)
APC =
Income (Y)
Average propensity to save (APS) -Defined as the proportion of household income that is saved
Savings (S)
APS =
Income (Y)
The rich tend to have a lower APC and a higher APS than the poor. APC + APS = 1

Factors Influencing spending/Consumption
Major factors that influence planned consumption are:
Disposable income. High income earners spend more hence consumption increases
Real interest rate. When the real interest rate decreases, consumption expenditure increases. When the real
interest rate increases, consumption expenditure decreases.
The buying power of money. When the buying power of money increases, consumption expenditure
increases. When the buying power of money decreases, consumption expenditure decreases.
Expected future disposable income. When the expected future income increases, consumption expenditure
increases. When the expected future income decreases, consumption expenditure decreases.
Availability of credit. If it becomes easier to obtain loans it is likely that the total spending will increase.
Future expectation. People are not likely to borrow when they are pessimistic about the future.
Consumer confidence
Culture
Wealth effects

WHAT IS SAVINGS?
Relationship between savings and consumption
Consumption and savings are opposite by nature. The term consumption denotes expenditure and by savings we
understand the act of preserving money for the future needs. Again, when it comes to giving priority, consumption
comes first. Most of us are in the habit of meeting the present needs from our income. After that, if there remains
anything, then only savings can be done. But in the long run, it is the savings that matters most.

REASONS FOR SAVINGS
Save money for an emergency
Save money for retirement
To finance children’s education
Target savings to buy a house or a car

INCOME AND SAVING

BORROWING
FACTORS INFLUENCING BORROWING

THE LABOUR MARKET FORCES
FACTORS INFLUENCING CHOICE OF OCCUPATION
Wage factors.
Wages are the price that workers receive for their labor in the form of salaries, bonuses, royalties, commissions,
and fringe benefits, such as paid vacations, health insurance, and pensions.
Wages. All things being equal, higher wages, will make a particular occupation more desirable. Students are
more likely to choose a high paying profession than low-paying profession

Others factors
job satisfaction
Type of work
Working conditions
Working hours
Holidays
Pension
Fringe benefits
Job security
Size of the firm
location

Example:
Children need education so teachers are required
The streets need cleaning, therefore street cleaners are employed

FACTORS AFFECTING DEMAND FOR LABOUR
THE WAGE RATE (MOVEMENT A LONG DEMAND FOR LABOUR)

The higher the wage rate, the lower the demand for labour. Hence, the demand for labour curve slopes downwards.
As in all markets, a downward sloping demand curve can be explained by reference to the income and substitution
effects. At higher wages, firms look to substitute capital for labour, or cheaper labour for the relatively expensive
labour. In addition, if firms carry on using the same quantity of labour, their labour costs will rise and their income
(profits) will fall. For both reasons, demand for labour will fall as wages rise.
NB: Factors other than wages will shift the demand curve to the left or right. These factors include:
The demand for the products: The demand for labour is a derived demand, which means it is ultimately based
on demand for the product that labour makes. If consumers want more of a particular good or service, more firms
will want the workers that make the product.
Productivity of labour: Productivity means output per worker, and if workers are more productive, they will
be in greater demand. Productivity is influenced by skill levels, education and training, and the use of technology.
Profitability of firms: If firms are profitable, they can afford to employ more workers. In contrast, falling
profitability is likely to reduce the demand for labour.
Substitutes: The extent to which labour is indispensable also affects the demand. If substitutes, such as capital
machinery, become cheaper or more expensive, the demand curve for labour will shift to the left or right. For
example, if the price of new technology falls there may be a reduction in demand for labour.
The number of ‘buyers’ of labour or Changes in the Number of Firms: The number of buyers in a market
can influence total demand in a given market. A single buyer in a market is called a monopsonist, and these are
relatively common in labour markets. In general, when a labour market is dominated by one employer the demand
for labour is less than if there are many employers.
Changes in Technology: Technological changes can increase the demand for some workers and reduce the
demand for others. The production of a more powerful computer chip, for example, may increase the demand for
software engineers. It may also allow other production processes to be computerized and thus reduce the demand
for workers who had been employed in those processes.

THE SUPPLY OF LABOUR
The supply of labour refers to the total number of hours that labour is able and willing to supply at a particular
wage rate.
SUPPLY OF LABOUR = TOTAL NUMBER OF WORKERS X HOURS THEY ARE WILLING AND ABLE TO WORK
FACTORS AFFECTING THE SUPPLY OF LABOUR
THE WAGE RATE (MOVEMENT A LONG SUPPLY CURVE OF LABOUR)

The higher the wage rate, the more labour is supplied, which means the supply curve of labour will slope
upwards. A worker's wage, along with any bonus, provides the main pecuniary (monetary) benefit from
working.
Changes in Income
An increase in income will increase the demand for leisure, reducing the supply of labour. We must be careful
here to distinguish movements along the supply curve from shifts of the supply curve itself. An income change
resulting from a change in wages is shown by a movement along the curve; it produces the income and substitution
effects we already discussed.
NB: Factors other than wages will shift the supply curve to the left or right. These factors include:

The size of the working population
The working population is the number of people of working age (16 – 60 for women and 16 – 65 for men) who
are willing and able to work.
Migration
Migration can have a considerable impact on the labour market. Migrants tend to be of working age, and while
the general effect is to increase the supply of labour at all wage rates, migration especially affects supply at lower
wage rates.
People’s preferences for work

If people prefer more work, the supply of labour increases. Preferences can be influenced by a range of factors
including changes in the ‘cost’ of working, such a subsidized childcare, and non-wage benefits (advantages) of
working.
Net advantages of work

These advantages can either be pecuniary advantages or Non-Pecuniary Advantages
 Pecuniary advantages-these are monetary advantages e.g.
Wages, salaries
Bonus payments
Overtime payments
Pension prospects
 Non-pecuniary advantages -these are non-monetary advantages e.g.
Hours of work
Job security
Holyday entitlement
Promotion prospects
changes in working conditions
Location of workplace
Work and leisure

For many, part-time work is an increasingly attractive option given the advantages of increased leisure. Early
retirement is also a factor affecting labour supply. An individual’s decision to supply labour is greatly affected
by the choice between work and leisure. Given that time is fixed, work and leisure are substitutes for each other.
The choice between work and leisure can be affected by a number of factors, including:
Age – older workers often gain more utility from leisure.

Direct taxes – higher income tax rates may increase the utility of leisure and reduce the labour supply.
Dependents – having children may increase the utility of work, and increase the labour supply.

Non-work income –Non-work income can come in the form of cash benefits, such as the Job Seeker's
Allowance, and benefits-in-kind, such as subsidised travel cards.
Changes in Expectations
One change in expectations that could have an effect on labour supply is life expectancy. Another is confidence
in the availability of Social Security. Suppose, for example, that people expect to live longer yet become less
optimistic about their likely benefits from Social Security. That could induce an increase in labour supply.
Length of training of workers

If workers need lengthy training, the effective supply of labour is less in the short run.
Trade Unions
A trade union is an organisation that aims to protect the interests of workers. Unions can affect the supply of
labour in three ways.
Firstly, unions can attract workers into the labour market because of the benefits of becoming a member.
This will shift the supply curve to the right.
Secondly, unions exert control over the labour supply and can withdraw labour by limiting working hours or
going on strike. A strike will shift the supply curve of labour to the left.
Thirdly, by influencing wages through collective bargaining the supply curve for unionised workers is more
inelastic than one for non-unionised workers.
Tax and benefit incentives and disincentives

Tax and benefit rates can lead to increases and decreases in the effective labour supply. When income taxes are
excessive and benefits too generous, a stay-at-home culture may be encouraged.

WAGE DETERMINATION UNDER FREE MARKET FORCES
Wage Determination and Employment in Perfect Competition. Wages are determined by the intersection
of demand and supply.
The wage W is determined by the intersection of demand and supply. Employment equals L units of labour per
period. An individual firm takes that wage as given; it is the supply curve s1 facing the firm.

CHANGES IN DEMAND AND SUPPLY OF LABOUR
If wages are determined by demand and supply, then changes in demand and supply should affect wages. An
increase in demand or a reduction in supply will raise wages; an increase in supply or a reduction in demand will
lower them.

REASONS FOR DIFFERENCES IN EARNINGS
Demand and supply
Relative bargaining power of employers and employees
Government policies
Public opinion
discrimination
1. DEMAND AND SUPPLY
2. RELATIVE BARGAINING POWER OF EMPLOYERS AND EMPLOYEES

3. GOVERNMENT POLICIES
ARGUMENTS IN FAVOUR OF MINIMUM WAGE LAWS
Increases the standard of living for the poorest and most vulnerable class in society and raises average.
Motivates and encourages employee to work harder.
Stimulates consumption, by putting more money in the hands of low-income people who spend their entire
paychecks.
Decreases the cost of government social welfare programs by increasing incomes for the lowest-paid.

ARGUMENTS AGAINST MINIMUM WAGE LAWS
Hurts small business more than large business.

Reduces quantity demanded of workers. This may manifest itself through a reduction in the number of hours
worked by individuals, or through a reduction in the number of jobs.
Reduces profit margins of business owners employing minimum wage workers, thus encouraging a move to
businesses that do not employ low-skill workers.
Businesses try to compensate for the decrease in profit by simply raising the prices of the goods being sold
thus causing inflation and increasing the costs of goods and services produced.

4. DISCRIMINATION

WHY EARNINGS OF OCCUPATIONS CHANGE OVER TIME
Reasons why earnings of occupations change over time:
Changes in the demand for labour

Changes in supply of labour
Changes in stages of production
Changes in bargaining power
Changes in government policy
Changes in public opinion
Changes in earnings over time
1. CHANGES IN THE DEMAND FOR LABOUR
Rise in demand for labour results into rise in wage rate
2. CHANGES IN SUPPLY OF LABOUR

3. CHANGES IN STAGES OF PRODUCTION
for primary sector workers usually declines
4. CHANGES IN BARGAINING POWER
5. CHANGES IN GOVERNMENT POLICY

6. CHANGES IN PUBLIC OPINION
7. CHANGES IN EARNINGS OVER TIME

THE EXTENT TO WHICH EARNINGS CHANGE

DIVISION OF LABOUR/SPECIALISATION
Because there are limited resources, we need to use them the most efficient way possible. Therefore, we now
use production methods that are as fast as possible and as efficient (costs less, earns more) as possible.
This is achieved through Specialisation and Division of Labour. This means every individual performs a specific
task only so that he can give in the best output.
SPECIALIZATION
Specialization is a process by which individuals, firm, regions and nations/economies concentrates on producing
those goods and services for which they have an advantage
Workers will require less training to be an efficient worker. Therefore this will lead to an increase in labour
productivity and firms will be able to benefit from economies of scale (lower average costs with increased
output) and increased efficiency.
Examples of specialisation and division of labour
In the process of producing cars, there will be a high degree of labour specialisation.
Some workers will design the cars

Some will work on testing cars
Some will work on marketing
Some workers will work on different sections of the assembly line. Their job may be highly specific such as
putting on tyres etc.
Levels of Specialisation
The specialization of tasks within extended families

Within businesses and organizations
In a country – Bangladesh is a major producer and exporter of textiles; Norway is a leading oil exporter. And
Ghana is one of the biggest producers of cocoa in the world
In a region of a country

DIVISION OF LABOUR
Division of labour can be defined as the separation of a work process into a number of tasks, with each task
performed by a separate person or group of persons.
Division of Labour occurs when the production process is split up (broken down) into different tasks and each
specialized worker/ machine performs one of these tasks.
Importance of Specialisation/Division of Labour
Specialisation results in greater efficiency and productivity. As the workers don’t have to move between jobs.
This leads to lower cost of production.
Time is saved as the workers become for efficient in performing a particular job.
By doing the same job repeatedly, the workers become ‘experts’, they commit less mistakes and hence leads
to less wastage.
Due to specialization production level increases which make it possible to carry out mass production.
Specialisation is good for workers too. They master the job and can bargain for better wages.
‘Practice makes perfect’ people who perform the same tasks everyday become very skilled at performing
them and are able to do them faster (specialist workers become quicker at producing goods).
There is saving in tools and implements. When a worker has to perform only a part of a job, he does not need
to be supplied with a complete set of tools.
Disadvantages of Division of Labour for the individual Worker
Boredom: Performing the same task over and over again may lead to boredom for the workers.
Greater risk of unemployment: in modern economies, the demands of the consumers are constantly
changing. New products become available and demand for older products declines. Where workers have
trained in only one skill, it might be difficult for them to find alternative employment if demand for the
product they produce falls.
Risks of overspecialization especially on agricultural products for example coffee, tea, cocoa due to poor
weather and fluctuating prices of these commodities
Lack of variety: Though the number of goods produced increases but they are identical or standardized.
Low motivation for worker: Repeatedly performing the same task may lead to low motivation level for the
worker. The worker might not have the sense of fulfilling a complete task as he is performing only a part of
the job.
Lack of mobility: Due to specialization workers might find it difficult to switch between occupations.
Lack of flexibility. Workers lose flexibility due to over specialisation on a particular job. If by any reason, that
particular skills become obsolete, the worker will become redundant and might end up losing her job.
The business will have to invest in training their workers in particular skills. This costs money which adds
up to the cost of production

ROLE OF TRADE UNIONS IN WAGE DETERMINATION
In many markets the demand and supply of labour are affected by the actions of the trade unions. Such
interventions produce ‘imperfections in the labour market’.
A trade union or labour union is an organization of workers who have banded together to achieve common
goals in key areas such as wages, hours, and working conditions.
The trade union, through its leadership, bargains with the employer on behalf of union members and
negotiates labour contracts with employers.
This may include the negotiation of wages, work rules, complaint procedures, rules governing hiring, firing
and promotion of workers, benefits, workplace safety and policies.
Through collective bargaining, where trade union representatives get together with employers, trade unions
aim to:
 Increase the wages of their members

 Improve working conditions
 Maintain pay differentials between skilled and unskilled workers
 Fight job losses
 Provide a safe working environment
 Secure additional working benefits
 Prevent unfair dismissals.

TYPES OF TRADE UNIONS

FACTORS INFLUENCING THE STRENGTH OF TRADE UNION
THE EFFECT OF A STRONG TRADE UNION IN A COMPETITIVE LABOUR MARKET
Looking at this graph, at the equilibrium wage, the quantity of labour employed is L. A strong trade union can
force up wages to Wu. Number of jobs offered by employers’ falls to Lu. At this wage the number of people
who would like to work is higher (Lc). This will lead to a shortfall between who can actually want to work and
those who can actually work.

THE CLASSIFICATION OF FIRMS
Firms can be classified according to the following:
1. The stages of production

2. Ownership of firms
3. The size of firms

SURVIVAL OF SMALL SCALE FIRMS:
Small scale production firms have the actual survival value side by side with large scale production. The reasons
are that small scale firms concerns enjoy certain advantages which are peculiar to their own. They are:
Reasons for Survival of Small Scale Firms:
Close supervision. When production is being carried on a small scale, the producer can easily supervise each
part of the work. The raw material is fully utilized by avoiding the waste. As the workers are closely supervised
they work efficiently. The machines are carefully handled. All this results in lowering of cost production.
Economic independence. In a small firm, the producer is generally the sole proprietor himself. When he
clearly knows that the whole profit will go to him and not to anybody else, he works untiringly.
Close contact with customers. As the, workers employed in a small firm are few in number they can have
good relationship with customers.
Greater adaptability to Changes. Another advantage claimed by a small firm is that it can easily adjust its
supply to the changed conditions in demand. As the small firm has not to consult the various share-holders of
the business, so it can easily arrive at quick decisions and these decisions can be promptly executed.
Limited Demand: The demand for certain products is local and seasonal. In such cases, large scale operations
are not economical and small firms are required.
Specialized Service: When an enterprise supplies specialized services, small scale firms are more suitable.
Beauty parlors, interior decorators, tailoring shops, are examples of this type.
Why some firms tend to remain small.
The reasons why so many small firms exist in a world where the economic power lies with large MNCs are as
follows:
There are economic activities where the size of the market is too small to support large firms.
There are particular obstacles to the growth of small firms. Probably the largest of these is access to
borrowed capital because of the perceived risk on the part of banks.
The entrepreneur may not want the firm to get bigger because extra profit is not the only objective and
growth might involve a loss of control over the running of the business.
Small businesses may receive financial help under government enterprise schemes because of their
employment and growth potential.
Because they are in a Niche-market
Benefits of staying small (financial support)

HOW DO FIRMS GROW?
Organic growth/Internal Business Growth
Organic growth is also known as internal growth and happens when a business expands its own operations
rather than relying on takeovers and mergers. To grow organically, a firm will need to retain sufficient profits to
enable it to purchase new assets, including new technology.
This is when the firm increases its own size by producing more under its existing structure of management and
control. This can be done by:
 borrowing money
 using retained profits
 obtaining funds from other financial institutions
 Issuing shares
Organic growth might come about from:

Expansion of existing production capacity through investment in new capital & technology
Developing & launch of new products
Finding new markets for example by exporting
Growing a customer base through marketing
NB: Over time, the total value of a firm’s assets will rise, which provides collateral to enable it to borrow to
fund further expansion.

EXTERNAL GROWTH OF A BUSINESS
The fastest route for growth is through external growth – through mergers or contested take-overs. There are
many potential advantages:
Firms can amalgamate or integrate in two ways:
Take-over: A take-over or acquisition occurs when one company buys all or at least 50% of the shares in the
ownership of another company. In this way, the firm being taken over by the other company loses its own
identity and becomes part of the other company.
A merger occurs when two or more firms agree to join to form a new enterprise where there is a mutual
agreement
Types of External growth of a business

External growth takes place through merger/integration as follows:
HORIZONTAL INTEGRATION:
When two businesses in the same industry at the same stage of production become one – for example a merger
between two car manufacturers or drinks suppliers. Horizontal integration is also referred to as lateral
integration.
The advantages of horizontal integration include the following:

It increases the size of the business and allows for more internal economies of scale – lower long run average
costs – improved profits and competitiveness
One large firm may need fewer workers, managers and premises than two –designed to achieve cost savings
Reduces competition by removing rivals – increases market share and pricing power
Increase market share

VERTICAL INTEGRATION
Vertical Integration involves acquiring a business in the same industry but at different stages stage of
production/supply chain. The supply chain describes the process by which production and distribution gets
products to the final customer.
Types of Vertical integration:
Forward vertical merger: merging with a business in the same business sector at a later stage of
production/towards tertiary level.
 Forward vertical: Closer to the consumers

 Assured outlet for products
 Prevent retailer from selling products of other businesses
 Market research on customers transferred directly to the manufacturer
Backward vertical merger: merging with a business in the same business sector at an earlier stage of
production/towards primary level.
 Backward vertical: Closer to the raw materials in the supply chain

 Constant supply of raw materials
 Prevent supplier from supplying other businesses
 Controlled cost of raw material

Examples of vertical integration might include the following:
Film distributors owning cinemas
Brewers owning/operating pubs (forward vertical)
Crude oil exploration all the way through to refined product sale
Drinks manufacturers integrating with bottling plants
Google - a software business - buying Motorola, a phone maker
Advantages of Vertical Integration

Greater control of the supply chain – this helps to reduce costs and improve quality of inputs.
Improved access to important raw materials used in manufacturing.
Better control over retail distribution channels e.g. pub companies who can ensure that their beers and wines
are sold in tenanted pubs and clubs.
Removing suppliers, and crucial information from competitors which helps to make a market less contestable

CONGLOMERATE INTEGRATION/MERGER
A merger between firms that are involved in totally unrelated business activities. There are many ways for this to
benefit the companies, such as sharing of assets and reducing business risk, but can also become a risk to the
company if the new company gets too large or if it isn't able to successfully blend the two businesses.
Advantages of conglomerate diversification
 Risk spreading
 High profit opportunities potentials
 Research and development cost shared. A merger enables the firm to be more profitable and have greater
funds for research and development. This is important in industries such as drug research.
Disadvantages of conglomerate diversification
 Failure in one business will drag down the rest

 Lack of management experience
 Lack of a common identity and purpose in a conglomerate organization
 Job Losses. A merger can lead to job losses. This is a particular cause for concern if it is an aggressive takeover
by an ‘asset stripping’ company
 Diseconomies of Scale.
THE ADVANTAGES OF MERGERS
Mergers can generate a number of advantages:
 Firms that merge can take advantage of a range of economies of scale, such as cost savings associated with
marketing and technology.
 Existence of synergies i.e. benefits that arise when firms merge or undertake a joint venture, such as when
two pharmaceutical companies merge, and create a new drug
 Rationalisation is the process of eliminating parts of a business that are inefficient or unprofitable, and is a
possible consequence of two or more firms merging.
 When firms merge, they can share knowledge with each firm benefitting from the knowledge and
experience acquired by the other. With vertical integration, information asymmetries can be reduced or
removed.
 International Competition. Mergers can help firms deal with the threat of multinationals and compete on an
international scale.
 Mergers may allow greater investment in R&D-This is because the new firm will have more profit which
can be used to finance risky investment. This can lead to a better quality of goods for consumers. This is
important for industries such as pharmaceuticals which require a lot of investment.

DISADVANTAGES OF MERGERS
 Increased concentration and reduced competition are obvious disadvantages of a merger between two
dominant firms. Higher Prices-A merger can reduce competition and give the new firm monopoly power
making products more inelastic. With less competition and greater market share, the new firm can usually
increase prices for consumers.
 Firms that merge may experience diseconomies of scale, such as difficulties with co-ordination and control.
This will increase average cost in the long run, and reduce profitability.
 There may be less output from the merged firm, compared with combined output of the two firms.
 Rationalisation is likely to lead to lost jobs as the merged firms attempt to increase profitability. For
example, two advertising agencies that merge could dispense with two design departments, and share one.
 Consumers are likely to suffer from reduced choice following a merger of two close competitors. This is a
common criticism of banking and supermarket mergers, and one reason why they are the subject of scrutiny

ECONOMIES OF SCALE AND LONG-RUN AVERAGE COST
INTERNAL AND EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE
MOVEMENTS ALONG THE LONG-RUN AVERAGE COST CURVE
Economies of scale: Economies of scale are the cost advantages exploited by expanding the scale of production
in the long run. The effect is to reduce long run average costs over a range of output.
These lower costs represent an improvement in productive efficiency and can feed through to consumers in lower
prices. But economies of scale also give a business a competitive advantage in the market-place. They lead to
lower prices and higher profits!
INTERNAL ECONOMIES OF SCALE:
The long run cost curve for most firms is assumed to be ‘U’ shaped, because of the impact of internal economies
and diseconomies of scale.

SOURCES/TYPES OF INTERNAL ECONOMY OF SCALE
1) Technical economies of scale:
Technical economies arise from the increased use of large scale mechanical processes and machinery in
production.
Large-scale businesses can afford expensive capital inputs

mass production techniques and benefit from specialization and a division of labour
2) Marketing economies of scale: A large firm can spread its advertising and marketing budget over a much
greater output. A large firm will enjoy this economy as is able to sell its products easily due to the fact that its
known, hence can introduce a new product and make big sale. At the same time a very large firm may find it
cost effective to operate its own fleet of delivery vehicles, which would be cheaper than paying a distributor
3) Financial economies of scale: Large firms enjoy advantages when they raise money. They have a large
variety of sources to choose from. They can borrow from banks, government institutions unlike small firms
which may not get such advantage easily. Large businesses can also sell shares to the general public
4) Purchasing economies. Big firms that buy large amounts of resources can get cheaper rates. Suppliers offer
discounts to firms that buy raw materials and components in bulk. This is similar to consumers buying multi-
packs in supermarkets. They are better value of money. Bulk buying in this way is a purchasing economy.
5) Managerial economies. As firms expand they can afford specialists managers. A small business may employ
a general manager responsible for finance, human resources, finance, marketing and production. The manager
may find this role demanding and may be weak in some fields. A large firm can employ specialists in these
fields. As a result, efficiency is likely to improve and average costs fall.
6) Risk – bearing economies. Larger firms are likely to have wider product ranges and sell into a wider variety
of markets. This reduces the risk in business. For example, a large firm sells variety of products in different
markets such that if one product or a market fails the others will help the affected unlike a small which has
invested in only one product or focuses in one market.

EXTERNAL ECONOMIES OF SCALE
These are the benefits that all firms in an industry enjoy because of their large size (When industry grow). They
are,
1) Skilled labor. If firms concentrate in a particular area, there is likely to be a buildup of labour which has the
skills and work experience required by that industry. As a result, training costs will be lower when workers
are recruited from the pool.
2) Infrastructure. If a particular industry dominates a region the roads, railways, ports, buildings and other
such facilities will be shaped to suit that industry’s needs.
3) Ancillary and commercial services. An established industry in a region will encourage supplier in that
industry to set up close by. Specialist marketing, cleaning, banking, insurance, waste disposal and distribution
are likely to be attracted to that area. All firms in the industry will be able to benefit from their services.
4) Co-operation. When firms in the same industry are located close to each other they are likely to co-o operate
so that they can all gain. For example, they might join forces to share the cost and benefits of research and
development Centre.
5) Research and development facilities in local universities that several businesses in an area can benefit from.
6) Relocation of component suppliers and other support businesses close to the Centre of manufacturing
7) Local authority might provide training facilities free of charge geared to the needs of a particular industry
INTERNAL DISECONOMIES OF SCALE
If a firm expands beyond the minimum efficient scale average costs start to rise. This is because the firm suffers
from diseconomies of scale. Average costs start to rise because aspects of production become inefficient. A firm
may experience this type for diseconomies of scale,
1) Bureaucracy. In a large firm things are done in accordance of set structure. This means any step taken must
be with consultation to the entire administration. In most cases, this affect the operation because of many
people to be consulted even in areas which need faster decision. This is because of too many managers to be
communicated to. This is a disadvantage.
2) Labor relations. If a firm becomes too big relations between workers and managers may worsen. There may
be lack of empathy for workers and they may become demotivated. As a result, there may be conflicts and
resources may be wasted resolving them.
3) Control and Co-ordination. A very large business may be difficult to control and co-ordinate. Thousands of
employees, billions of pounds and dozens of plants all over the world can make running a very large
organization demanding. There may be a need for more supervision which will raise costs.
4) Poor communication. Larger firms often suffer poor communication because they find it difficult to
maintain an effective flow of information between departments, divisions or between head office. Time lags
in the flow of information can also create problems in terms of the speed of response to changing market
conditions. For example, a large supermarket chain may be less responsive to changing tastes and fashions
than a much smaller, ‘local’ retailer.
4. Difficulty Controlling the firm – monitoring the productivity and the quality of output from thousands of
employees in big corporations is imperfect and costly.
5. Co-ordination - it can be difficult to co-ordinate complicated production processes across several business
branches in different locations and countries.
6. Larger firms often suffer poor communication because they find it difficult to maintain an effective flow of
information between departments, divisions or between head office and subsidiaries. Time lags in the flow of
information can also create problems in terms of the speed of response to changing market conditions. For
example, a large supermarket chain may be less responsive to changing tastes and fashions than a much
smaller, ‘local’ retailer.
7. Poor industrial relationship/Low motivation of workers in large firms is a potential diseconomy of scale
that results in lower productivity, as measured by output per worker.

SHIFTS IN THE LONG-RUN AVERAGE COST CURVE
The Long Run AC is a boundary. The upper part of the LRAC curve show areas that are attainable, while the
lower part is unattainable unless the LRAC curve shifts.
EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE
External economies and diseconomies of scale are the benefits and costs associated with the expansion of a whole
industry and result from external factors over which a single firm has little or no control.

EXTERNAL ECONOMIES OF SCALE
EXTERNAL DISECONOMIES OF SCALE

External diseconomies are costs which are outside the control of a single firm and result of the growth of a
specific industry. External diseconomies of scale shift LRAC curve of an individual firm upwards.
Example
 Negative externalities, such as road congestion, can result from the growth of an industry in a specific region.
 Resources may become exhausted and the price of resources may rise as demand outstrips supply. E.g. land
and skilled labour shortages.
 Taxation- Shifts LRAC curve of an individual firm upwards

HOMEWORK: DEMAND FOR FACTORS OF PRODUCTION PG 183

LABOUR AND CAPITAL INTENSIVE PRODUCTION
In a production unit a firm may use either more workers or capital.
Labor intensive production: When a firm used more of workers than the machine then this is referred to as
labor intensive technique
Capital intensive production: The one using more machine than workers will then be referred as capital
intensive technique.
What is meant by Productivity?

This is the amount of output that can be produced with a given quantity of resources per a given period of time.
If the firm becomes more productive, then it has become more efficient, since productivity is an efficiency
measure.
Illustrating Productivity with PPC curve

If an economy can improve productivity the country will become wealthier. This can be shown using a
production possibility curve
The above figure shows that improvements in productivity will shift the PPC out to the right from ppc1 to PPC2.
This means that the economy can produce more of both capital and consumer goods with its given level of
resource. Improvement in productivity means that a country is making better use of its resource.

LABOUR PRODUCTIVITY
Labor productivity is the output per worker. It can be calculated by dividing total output by the number of
workers employed
𝐓𝐨𝐭𝐚𝐥 𝐨𝐮𝐭𝐩𝐮𝐭 𝐢𝐧 𝐚 𝐠𝐢𝐯𝐞𝐧 𝐭𝐢𝐦𝐞 𝐩𝐞𝐫𝐢𝐨𝐝

𝐎𝐮𝐭𝐩𝐮𝐭 𝐩𝐞𝐫 𝐰𝐨𝐫𝐤𝐞𝐫 =
𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐥𝐚𝐛𝐨𝐮𝐫 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
If a car manufacturer produced 24,000 cars in a year with a workforce of 2,000, labor productivity would be 12
cars per worker (24,000/2,000)
𝐓𝐨𝐭𝐚𝐥 𝐨𝐮𝐭𝐩𝐮𝐭 𝐢𝐧 𝐚 𝐠𝐢𝐯𝐞𝐧 𝐭𝐢𝐦𝐞 𝐩𝐞𝐫𝐢𝐨𝐝

𝐎𝐮𝐭𝐩𝐮𝐭 𝐩𝐞𝐫 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐢𝐧𝐩𝐮𝐭 =
𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐫 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
Improvements in productivity often arise because of the introduction of new technology. Improvements may arise
because more capital is employed, possibly at the expense of labour, or because new technology is more efficient
than existing technology. Each sector has ways to improve productivity.

FIRMS’ COSTS, REVENUE AND OBJECTIVES
1. FIXED COST (INDIRECT COSTS OR OVERHEAD COSTS)
Total fixed cost will remain constant even though output changes. At zero output, any cost that a firm has must
be fixed.
Examples
Capital goods e.g. factories, offices, plant and machinery

Rent and rates
Advertising and promotion
Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost graph.

2. AVERAGE FIXED COST
𝑻𝑭𝑪
Average fixed costs are found by dividing total fixed costs by output. 𝐀𝐅𝐂 = . Average fixed cost will fall as
𝐐
output increases because total fixed costs are being spread over a higher level of production.
As fixed cost is divided by an increasing output, average fixed costs will continue to fall. The average fixed cost
(AFC) curve will slope down continuously, from left to right.

3. TOTAL VARIABLE COSTS (VC)
Variable costs are costs that vary directly with output.
Examples
Costs of raw materials and other components,

The wages of part-time staff or employees paid by the hour,
The costs of electricity and gas and
The depreciation of capital inputs due to wear and tear.

4. AVERAGE VARIABLE COST
This is the cost of producing a single unit of output. Average variable costs are found by dividing total fixed
variable costs by output
𝑻𝑽𝑪
𝐀𝐕𝐂 = .
𝐐

5. TOTAL COST (TC= VC+FC)
It is composed of all the fixed cost and variable cost put together. The total cost (TC) curve is found by adding
total fixed and total variable costs.
EXERCISE
Draw on the same graph
OUTPUT FC (£000) VC (£000) AFC (£000) AVC (£000) TC (£000) ATC
1 100 50
2 100 80
3 100 100
4 100 110
5 100 150
6 100 220
7 100 350
8 100 640

THE TOTAL REVENUE
Revenue is the income derived by a firm from selling its products, over a period of time.
Total revenue (TR): Total revenue is the total receipts of a firm from the sale of any given quantity of
output. Average revenue is the total revenue divided by total quantity sold. TR = P × Q
1. AVERAGE REVENUE IN A PERFECTLY COMPETITIVE MARKET
AR=TR/Q (in units): In a competitive market, each firm has to accept the ruling market price, and thus its
demand curve is horizontal at this level
EXAMPLE
SALE PRICE TR AR
1 5
2 5
3 5
4 5
5 5
6 5
7 5
8 5
(i) Draw TR curve

(ii) Draw AR

MARKET AND FIRM DEMAND CURVES IN A PERFECTLY COMPETITIVE MARKET
P=AR

REVENUE IN OTHER MARKETS
In any other market the firm will face a downward sloping demand curve for its product. If the firm chooses to
increase its output, the extra sale will depress the price.

THE RELATIONSHIP BETWEEN THE PRICE ELASTICITY OF DEMAND AND REVENUE
PRICE (P) QD TE/TR (P X Q) AR
10 0
9 1000
8 2000
7 3000
6 4000
5 5000
4 6000
3 7000
2 8000
1 9000
0 10000

1. Draw the curve of TR, and AR on the same graph
2. What do you notice about the TE/TR figures as the as the price is cut from $10 towards $5 per unit?
3. Why does this happen?
4. What do you notice about the TE/TR figures as the as the price is raised from $0 towards $5 per unit?
5. Why does this happen?

THE PROFIT
P=TR-TC
PROFIT MAXIMIZATION
Maximizing profits means refers to producing at output level where the difference between TR and TC is highest.
It also means achieving the highest possible profit for the risk taker. Profit maximization has long been assumed
to be the dominant goal of private enterprise. Involves market power and motivation to set a price and output that
maximizes profits in the short or long run.

OBJECTIVES OF FIRMS
Profit maximisation: Maximizing profits means achieving the highest possible profit for the risk taker. Profits
are achieved when a firm’s revenue is greater than its production costs. Profit maximization has long been
assumed to be the dominant goal of private enterprise.
Higher profit means:
Higher dividends for shareholders.

More profit can be used to finance research and development.
Higher profit makes the firm less vulnerable to takeover.
Higher profit enables higher salaries for workers
However, a business may depart from profit maximization because:
The firms with large shares may wish to avoid the attention of the government watchdog bodies
Large abnormal profits will attract new entrants into the industry
High profits may damage the relationship between the firm and its stakeholders
Growth. The growth of a business – usually measured in terms of sales or value of output – has many potential
benefits for the managers and owners. Larger firms will be less likely to be taken over and should be able to
benefit from economies of scale. Managers will be motivated by the desire to see the business achieve its full
potential, from which they may gain higher salaries and fringe benefits.
EXPLAIN WAYS OF INCREASING PROFITS

THE MARKET STRUCTURES
COMPETITION
Competitive markets
Not all markets are the same. In some markets lots of firms compete with each other to sell their goods to
customers. They use a variety of methods such as advertising, promotions and special offers to encourage
customers to buy their products. In other markets a firm may face very little competition. Competition is the
rivalry that exists between firms when trying to sell goods in a particular market. In some markets there is a lot
of competition. In a competitive market there are likely to be some common features,
Key characteristics/Features of Competition
1) A large number of buyers and sellers

2) The firms are usually small in size and with small market shares
3) The products sold by each firm are close substitutes for each other. Products sold are identical
4) Low barriers to entry. This means that it is fairly easy to break into the market. For example, it is not
technically difficult or it does not require too much capital.
5) Firms are price taker. Each firm has no control over the price charged. For example, if a firm tries to charge
more than its rivals it is likely to lose business.
6) There is perfect knowledge. There is a free flow of information about the nature of products, availability at
different outlets, prices, methods of production and the cost and availability of production factors.

Competition and the firm
Generally, firms do not welcome competition. Most firms would prefer to dominate the market and operate
without the threat of rivals, if there is no threat from competition, a firm can usually charge a higher price. There
is also les pressure to be efficient and innovative. This reduces the effort needed to survive and be successful.
When faced with competition, firms have to offer products that give consumers value for money. This involves:
Operating efficiently by keeping costs as low as possible.

Providing good quality products with high levels of customer service.
Charging prices which are acceptable to customers.
Innovating by constantly reviewing and improving the product.
The main disadvantage to a firm operating in a competitive market is that the amount of profit made will be lower
and will be limited. In markets where competition is fierce, prices are likely to be lower and the potential for
profit also lower. The total profit in the industry has to be shared between many firms.

Competition and the consumer.
Most consumers would argue that competition in business is desirable. This is because of the advantages that
consumers enjoy from healthy competition.
Lower prices. In a competitive market firms cannot overcharge consumers. If one firm tries to raise price it
will lose a lot of its business. This is because the market is full of good substitutes and consumers can easily
switch from one supplier to another.
More choice. Competition means there are many alternative suppliers to choose from. Where possible, each
supplier is likely to differentiate its product from those of rivals. This helps to widen choice even more.
Competitive markets will also have a constant stream of new entrants offering fresh ideas and even more
choice.
Better quality. Firms that offer ‘shoddy’ goods in a competitive market will lose business. Consumers are
rational and will look for value for money. This means they consider both the price and the quality of
products when deciding what to buy. Therefore, in a competitive market firms are under pressure to improve
quality.
There are also disadvantages to consumers of a highly competitive market
i) Market uncertainty. It could be argued that there may be some uncertainty or disruption in competitive
markets. This is because unprofitable firms eventually leave the market. This means that some consumers
might be inconvenienced. For example, a struggling hair stylist may have small number of regular and
satisfied customers. But if the business collapses, these customers would have to find an alternative. They
may have spent years developing a good relationship with the failed hair stylist. In competitive markets there
are always firms leaving the market, which can result in uncertainty.
ii) Lack of innovation. It could be argued that innovation in a competitive market might be lacking. This is
because firms make less profit in competitive markets. As a result, they may not have enough profit to invest
in product development.

Competition and the economy.
One of the main advantages of competitive markets is that resources will be allocated more effectively. This is
because firms have to operate efficiently to survive.
They are under pressure to keep their costs down so that their prices are lower. To do this they buy cheapest
resources available, choose the most efficient production method, operate from the most cost – effective location
and ensure they all factors are working as productively as possible. The economy will benefit from this resources
are less likely to be wasted.
It is also argued that firms in competitive markets are more innovative. This is because innovative firms can get
a competitive edge over their rivals.
This means that firms will develop new products, new production techniques, new technologies and new
materials. The economy will benefit from this because people will have a better standard of living.
One main disadvantages of a highly competitive market is that resources might be wasted. One of the reasons for
this is because some factors of production are immobile. When firms cease trading in a competitive market
resources are released for alternative uses. People are made redundant and resources like machines, tools.

WHAT IS A MONOPOLY?
Situation in which a single company or group owns all or nearly all of the market for a given type of product or
service.
TYPES OF MONOPOLY
A pure monopoly is a single supplier in a market.

Statutory Monopoly-Monopoly power exists when a single firm controls 25% or more of a particular. This
is done for the purposes of regulation
A complex monopoly is said to exist whenever firms collude, and act as if they are a single firm.
MONOPOLY – CHARACTERISTICS/FEATURES
There is only one seller in the market.

Monopolist is the price maker/has control over the price
Produce unique products
Monopolist is able to make huge profits since they do not have close substitutes
Barriers to entry.
BARRIERS TO ENTRY
Barriers to entry are designed to block potential entrants from entering a market profitably.
Examples of barriers to entry
legal barriers: e.g. Patents-Giving the firm the legal protection to produce a patented product for a number
of years
Limit Pricing-Firms lowering prices to a level that would force any new entrants to operate at a loss
Cost Advantages-Lower costs, perhaps through experience of being in the market for some time, allows the
existing monopolist to cut prices and win price wars
Advertising and Marketing-Developing consumer loyalty by establishing branded products can make
successful entry into the market by new firms much more expensive.
Research and Development Expenditure-Heavy spending on research and development makes the existing
firms more competitive in the market
Technology
High start-up cost
CAUSES OF MONOPOLIES
If a firm has exclusive ownership of a scarce resource, such as Microsoft owning the Windows operating
system brand
Governments may grant a firm monopoly status
Producers may have patents over designs, or copyright over ideas, characters, images, sounds or names,
giving them exclusive rights
A monopoly could be created following the merger of two or more firms.

ADVANTAGES OF MONOPOLY
Economies of scale costs. This reduces costs resulting in lower price and more goods and services being
produced
More research and development- Monopolist can use part of its high profits for R & D and investment.
This can lead to lower costs and quality products
International competiveness: strong domestic monopolies have the strength to compete with other firms
overseas.
THE DISADVANTAGES OF MONOPOLY
Restricting output for consumers by producing less

Charging a higher price than in a more competitive market. Hence exploiting Consumers
Restricting choice for consumers. This is because it is a single firm
May exploit workers by paying them lower wages.
Lack of innovation: monopolist may have less incentive to be efficient and innovate since they can pass
high costs production to consumers
Formation of monopolies
Monopolies can form for a variety of reasons, including the following:
If a firm has exclusive ownership of a scarce resource, such as Microsoft owning the Windows operating
system brand, it has monopoly power over this resource and is the only firm that can exploit it.
Governments may grant a firm monopoly status, such as with the Post Office
Producers may have patents over designs, or copyright over ideas, characters, images, sounds or names,
giving them exclusive rights to sell a good or service, such as a song writer having a monopoly over their own
material.
A monopoly could be created following the merger of two or more firms. Given that this will reduce
competition, such mergers are subject to close regulation and may be prevented if the two firms gain a
combined market share of 25% or more

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MICROECONOMICS

CIE IGCSE Economics Prepared By Richard Ogutu 1|Page

 Going on an expensive holiday,

CIE IGCSE Economics Prepared By Richard Ogutu 17 | P a g e

1. LAND (NATURAL RESOURCES)

Land includes all natural physical resources (gifts of nature)

2. LABOUR (HUMAN RESOURCES)

3. CAPITAL (MAN-MADE RESOURCES)

CIE IGCSE Economics Prepared By Richard Ogutu 18 | P a g e

CIE IGCSE Economics Prepared By Richard Ogutu 19 | P a g e

Causes of geographical immobility:

CIE IGCSE Economics Prepared By Richard Ogutu 20 | P a g e

CIE IGCSE Economics Prepared By Richard Ogutu 21 | P a g e

CIE IGCSE Economics Prepared By Richard Ogutu 22 | P a g e

The quantity of CAPITAL

CIE IGCSE Economics Prepared By Richard Ogutu 24 | P a g e

Non-renewable resources/Finite resources

CIE IGCSE Economics Prepared By Richard Ogutu 26 | P a g e

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OPPORTUNITY COST AND WORKERS

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OPPORTUNITY COST AND THE GOVERNMENT

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Draw PPF curve using the following information

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Economic growth has two meanings:

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What creates growth?

Employs new technology

Employs a division of labour, allo

Increases its labour force

Discovers new raw materials

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A PPF will shift inwards if:

Natural factors: earthquake, change of climate

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A command, or planned, economy

THE COMMAND, OR PLANNED ECONOMY

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Examples of Planned economies

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THE ROLE OF THE STATE IN A MIXED ECONOMY

 Market forces prevail but are closely monitored by the government.

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THE DEMAND CURVE

Quantities. Numerical values of goods and services in terms of Prices.

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The demand schedule

PRICES $ QUANTITY DEMANDED PER WEEK(in millions)

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The law of demand is an economic law that states that:

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