All countries are economic systems.
These economic systems decide:
- What goods are services are produced
- How they are produced
- Who gets to consume them
There are 3 types of system:
- Free market/capatalist: The markets decide what gets produced and the price mechanism decides who gets what.
- Mixed: Public & Private sectors.
- Command/communist: State intervention. Government controls all economic activity.
Stages of Development
The stages of development are:
- Surplus and Trade
- Division of Labour
- People only proving for themselves from their own land.
Surplus and Trade:
- Successfull subsistence leads to surplus output that can then be traded with other groups.
- Trade allows more goods to be available: --> Standard of living increases
- Markets are created where people meet to trade
Scarcity and Opportunity Cost
The basic economic problem is scarcity. Demand is infinite whereas supply is finite.
There are insufficient resources to provide for everyone's wants.
This means that we must make choices over how to use our limited resources.
Once a decision has been made over how to use a resource, an oppertunity cost arrises.
This refers to the value of the next best alternative forgone.
E.g.1: I have £20 to spend. I can either spend it on shoes or on Lunch, i cannot have both. If i decide to buy Lunch then the oppertunity cost is forgoing the new shoes.
E.g.2: A firm has £50,000 to invest either in a new machine or in a new training programme. If the firm decides to do the training prgramme, the oppertunity cost is forgoing the training programme.
Factors of Production
These are inputs used in the production of goods and services. They are finite and can be grouped into four types.
The 3 Main Functions of Price
- The signalling function: Prices signal what is available, it allows all firms in the market to plan their economic activities.
Prices signalling wrong or misleading information can lead to market failure.
- The incentive function: Prices provide an incentive to economic agents to behave and make decisions that are consistent with pursuing and achieving the fulfillment of their personal satisfaction.
- The allocation function: Resources are scarce which means that the goods produced from them are also scare. The price mechanism allocates these goods to those who are prepared to pay the most fot them.
A PPF or Production Possibility Frontier shows the potential level of output for two goods. The line indicates the maximum potential of that economy.
I.e. When all resources are being utilised- 100% enployment for example- the resources are being used efficiently.
A point within the line indicates that there is spare capacity within the economy, not all resources are being utilised. An ineffiecent allocation of resources.
A point outside of the line is unobtainable. The economy must grow in order for us to be able to reach that point.
A shift from consumer goods to capitcal goods would increase the rate of growth- Captical goods are crucial for increasing production.
Economic Growth is shows as an outward shift of the PPF.
A drop in consumer goods would result in a drop in living standards, however this will allow a faster increase in the future.
Specialisation and Division of Labour
- Trade ad markets remove need for subsistence living
- Individuals specialise in producing what they are best at producing (e.g. One may specialise in producing pottery).
- Leads to increases in efficiency and productivity- More is produced.
Division of Labour:
- Within specialisation, production can be split into small tasks.
- Skills and productivity increase further as everything is streamlined to be as eficient as possible.
- Wealth created is used for the benefit of society.
- Contributes to the economic welfare of the country.
- Can lead to a higher turnover of staff as people get bored.
- Easier to replace workers with machines = more structural unemployment
There are three types of economic agent:
- Demand Side- Spend incomes on the consumption of goods and services
- Supply Side- Sell their labour to firms for income.
- Economic objective- To maximise their satisfaction or well being. E.g. getting a bargain.
- Opperate on the supply side
- Organises the factors of production
- Economic Objective- To make profit
- Influences what is produced, consumed and the prices through intervention in the markets.
- Economic objective- To maximise the economic welfare of its citizens.
A demand curve is the quantity of a good or service that households plan to consume over a range of different price levels in a given period of time.
The substitution effect:
When the price of a good falls, it becomes cheaper relative to its substitutes and some consumers will swap which good they consume.
The income effect:
When the price of a good falls, the real income of a consumer may rise. This means that their purchasing power increases and so they can consumer more.
Movement along a demand Curve:
There is a movement along a demand curve for a good only when there is a change in its price.
- A fall in its price will cause an extentsion in demand
- A rise in its price will cause a contraction in demand.
Shifts in demand
An increase in demand refers to the whole demand curve shifting outwards to the right at every price level.
A decrease in demand refers to the whole demand curve shifting inwards to the left at every price level.
Factors which can shift the demand curve (e.g. for a playstation):
- Price of alternative goods (e.g. if the Xbox's price increased)
- Price of complementary goods (e.g. if fifa's price decreased)
- Change in fashion and tastes (e.g. if gaming became fashionable)
- Increase in advertising
- Increase in real incomes (the PS becomes more affordable)
- decrease in income tax
- Increase in the population or change in the age structure (more teenager likely to buy a ps3)
- increase in credit facilities which makes it easier to obtain funds
A supply curve is the quantity of a good or service that firms are silling to sell to a market over a range of different price levels.
It slopes upwards from left to right for 2 reasons:
- As the price rises, it encourages firms to supply more of a good
- As firms raise output in the short run, they face rising production costs. To cover the rising costs, firms need to be able to charge higher prices.
A rise in Price will cause an extention in supply whereas a fall in price will cause a contraction.
Shifts in Supply
An increase in supply refers to the whole supply curve shifting outwards to the right at every price level.
Factors which can shift the supply curve (e.g. for a crude oil):
- Improvements in technology (e.g. the extraction of oil frommore difficult places)
- A reduction in labour costs (e.g. lower wages for workers on oil rigs)
- A reduction in capital goods (e.g. oil rigs become cheaper to build and run)
- A reduction in transport costs (e.g. an increase in the size of oil tankers)
- discovery of new oil fields
- Increase in the number of firms in the market
- Decrease in the influence of trade bodies (e.g. OPEC)
- reduction in taxes on oil
- Increase in government subsidies to oil producers
If a 5% change in price = 10% change in Qs: Supply is elastic
If a 5% change in price = 3% change in Qs: Supply is in-elastic
If a 5% change in price = 5% change in Qs: Unit elasticity of Supply
Price Elasticity of Demand
This measures consumers' responsiveness to a change in a good's price.
The factors that influence it are:
- Substitutability. If there are many alternatives to the good, demand will be elastic. If the price increases, people will just swap to an alternative. If there are no alternatives and it is a necessity, demand will be inelastic as people have no choice but to continue demanding it.
- Percentage Income: Goods or services that a large % of the household's income is spend on tend to be more elastic (things such as a car) whereas cheaper items tend to be more inelastic (things such as pasta or newspapers).
- The 'width' of the market definition: the demand for one particular type of a good is more elastic than the demand for the good overall. e.g. demand for shell petrol is more elastic than demand for petrol from all companies.
- Time: Demand is more elastic in the short run as it takes time for the market to respond to changes.
- Luxury and necesity goods- items such as designer clothing will be more elastic than necesesities such as loo role.
- Addictive goods: will be inelastic.
Income Elasticity of Demand
This measures how demand responds to a change in real income.
In most circumstances, YED is +ve. This means that a rise in income causes a rise in demand and vice versa.
In come cases, YED is negative. This means that as income increases, demand decreases and vice versa. This is because people demand better quality goods as their income increases. For exampe, sainsburys own brand vodka is an inferior good because as people's income increase, they will buy smirnoff instead- their demand for sainsburys own will drop.
If YED is +ve, the good is Normal. If YED is -ve, the good is inferior.
Cross Elasticity of Demand
This measures the responsiveness of demand for one commodity to changes in the price of another good.
The XED between two goods or servies indicates the nature of the demand relationship between them.
Negative XED = Joint Demand: A fall in the price of tennis rackets will cause an increase in demand for tennis balls. The gradient of the graph is -ve.
Positive XED = Competing Demand (substitute goods): As the price of coffee rises, so does demand for tea. The gradient of the graph is +ve.
Price Elasticity of Supply
This measures the extent to which firms are prepared to increase output in response to a change in price.
- If PES >1, the good is price elastic. The % change in Qs > % change in P.
- If PES <1, the good is price inelastic. The % change in Qs < % change in P.
- If PES =1, the good is unit elastic. The % change in Qs = % change in P.
- If PES =0, the good is perfectly inelastic. A change in price has no effect on Qs.
- If PES is infinite, the good is perfectly elastic.
Determinants of Price Elasticity of Supply
- Length of the production period: If it only takes a matter of days to produce a good, it is going to be more elastic than if it takes months to produce. (i.e. a PS3 will be more elastic than a food crop).
- Exictence of spare capacity: If a firm has a lot of space capacity, it is possible to increase the Qs quickly. It is elastic. If a firm is opperating at full capacity, it will take time to increase the Qs. It is inelastic.
- Ease of accumulating stocks/Perishability of the product: if it is possible to stockpile a good, it tends to be elastic as firms can respond to a price change either by stockpiling more or by releasing some stock. Goods that cannot be storred, such as fruit, tend to be inelastic.
- Ease of factor substitution: supply tends to be elastic if firms can use different combinations of labour and capital to produce a good.
- Number of firms in the market: The more firms in a market, the more elastic the market is.
- State of the economy: In a recession there are many unemployed resources and so there is more spare capacity. Changes in price can be met with changes in supply if needed.
- Easy of entry into the market: if it is very hard for a new firm to enter a market, supply will be inelastic.
Definition: A tax is a compulsory charge made by the government on goods, services, incomes or capital. The purpose is to raise funds to pay for government spending programes.
- Levied directly on an individual or organisation. Direct taxes are normally paid on incomes. E.g. Income tax or corporation tax.
- Usually levied on the purchase of goods and services. It is a tax on expenditure. There are two types, Specific tax and Ad Valorem Tax.
- The imposition of an indirect tax raises the price of a good or service.
- The tax is added to the supply price, effectively causing the supply curve to shift vetically upwards and to the left.
Indirect Taxes- More info
A specific tax is charged as a fixed amount per unit of a good, such as a litre of wine or a packet of cigarettes.
A specific tax causes a parallel shift of the supply curve to the left.
Ad Valorem Tax:
An Ad Valorem tax is charges as a percentage of the pruce of a good. E.g. VAT
An Ad Valorem tax causes a pivitol rotation of the supply curve to the left.
Usually falls partly on the consumer and partly on the producer- It depends of the relative price elasticities of demand and supply for the good/service.
PED Inelastic + PES Elastic = more of the tax burden is on the consumer.
Addictive goods such as cigarettes tend to be price inelastic in demand and so firms usually pass on most of the tax burden to the consumer.
Definition: A subsidy is a grant, usually provided by the government to encourage suppliers to increase production of a good, leading to a fall in price.
Public transport is heavily subsidised to increase the number of services that are made available.
A subsidy is often paid directly to producers, however as they respond by increasing output, the price falls which benefits the consumers.
If PED is elastic, the market price will fall by a relatively small amount and so the consumer gains less.
In a competitive labour market, the wage rate is determined by the interaction of supply and demand.
The demand for labour is undertaken by firms.
The supply of labour comes from the general population- the workforce.
In practice, there are many different types of labour market: Shop assistants, chefs, lawyers etc.
Demand for Labour
The demand for labour is a derived demand. It is derived from the demand for the goods and services that it makes.
E.g. The demand for building workers is derived from the demand for new houses.
Determinants of the Demand for Labour
- Demand for the final product: An increase in demand for a good will result in an increase in the demand for the labour involved in making it.
- The wage rate: A fall in the wage rate means that labour becomes more affordable and so firms will demand more labour.
- Other labour costs: E.g. a fall in the employers' national insurance contributions on behalf of their staff results in an increase in the Qd.
- Price of other factors of production: An increase in the price of capital goods encourages firms to employ more labour and cut back on the use of machinery.
- Productivity of Labour: An increase in output per worker may lead to higher revenue/profits, firms will demand more labour.
- Government employment regulations: The fewer the number of regulations, the greater the damnd for labour is likely to be.
The Supply of Labour
The factors that determine the supply of labour:
- The Wage Rate: An increase in the wage rate will encourage more people to offer their services for work.
- Other net Advantages of Work: Improvements in working conditions tend to increase the supply of labour.
- Net Migration: Over recent years the UK has experienced a significant increase in immigration.
- Income Tax: A reduction in income tax will increase disposable income and so there will be a greater incentive for people to work.
- Benefit Reform: A recution in benefits will provide a greater incentive for people to work.
- Trade Unions: Trade unions act to increase wage rates and imporve other working conditions. This may increase the supply of Labour.
- Social Trends: There has been a significant increase in the number of women in the workforce over the past 40 years.
National Minimum Wage
- The NMW is the lowest rate of pay that a firm can pay its workers.
- Is the NMW is set above the free-market equilibrium then it may cause unemployment.
Advantages of Increasing the NMW:
- A reduction in exploitation of labour and poverty
- A reduction in wage inequality between men and women.
- A reduction in voluntary unemployment since there is more incentive to take low paid work.
- An increase in labour productivity. Workers are more satisfied in their jobs.
- To keep up with an increase in teh cost of living due to inflation.
Disadvantages of Increasing the NMW:
- Increases in unemployment since firms find it too expensive to employ labour.
- Increase in inflationary pressure as firms pass on the extra costs to consumers.
- Ineffective means of reducing poverrty since many poor people no not work- e.g. unemployed, sick and elderly.
- Increase in red-tape for firms leading to higher costs and less flexibility in the labour market- government failure.
Market Failure occures when the price mechanism causes an inefficient allocation of resources; Supply and Demand lead to a net welfare loss in society. Resources are not allocated to their optimum use.
- These costs or benefits which are external to an exchange.
- They are 3rd party costs that are ignored by the price mechanism.
- Also knows as indirect costs and benefits
- External costs are negative externalities
- External benefits are positive externalities.
External, Private and Social Costs
- E.g (poduction). A chemical firm pollutes a river while producing a good.
- This causes an external cost to the fishing and water supply industries.
- Fish catches may be reduced- It may become more expensive to treat water.
- E.g. (consumption). A person smoking tobacco, they pollute the air for others.
- Non smokers may suffer from smoking relating illnesses.
- In a free market, producers are only concerned with the private costs of production.
- There are costs that it pays for that are neccesary to keep the business running such as wages, rent, payment for raw materials, machinery, elictricity etc
- Private costs may also refer to the market price that a consumer pays for a good.
- Private costs + External costs = social costs (external costs are the difference between priceate and social costs).
- External costs are disproportionate with output (the lines diverge).
External, private and social Benefits
- E.g (production). The recycling of waste materials such as newpaper or plastic.
- Benefit of reducing the amount of waste disposal- helps to promote sustainable eonomic growth.
- E.g. (consumption). The vaccination of individuals against diseases.
- Reduces the possibility of people catching a disease from someone who they have contact with.
- Consumers are only concerned with the pricate benefits from consuming a good.
- We assume that this can be measured by the price that is payed for a good/service.
- Private benefits may also refer to the revenue that a firm makes.
- External benefits + private benefits = social benefits
- Difference beteern pricate and social benefits is the external benefit
Free market equilibrium:
- Supply curve for a firm is the marginal private cost curve.
- The addition of all the MPC curves will form the market supply curve.
- Demand curve for consumers is the marginal private benefit curve.
- As an individual consumers more units of a good, the marginal benefit will fall.
- Market equilibrium occurs where MPB = MPC
Social optimum equilibrium:
- Occurs when MSC = MSB
- The social cost of producing the last unit of output equals the social benefit from consuming it.
External costs and triangle of welfare loss
The free market ignores negative externalities.
Adding external costs on to the production of a good/serivce causes the supply surve to shift to the left and become the MSC curve.
When external costs are ignored, there is under pricing and over production.
The triangle that is produced when an externality diagram is drawn (between the MSC and MPC curves) is the welfare loss to society.
Some goods are not produced at all through the markets, despite offering significant benefits to society. This is called a missing market and the goods are called Public Goods.
Public goods are non excludable and non rivalrous:
- Non-excludability means that once a good has been produced for the benefit of one person, it is impossible to stop others from benefiting from them.
- Non-rivaly means that as more people consume a good and enjoy its benefits, it does not reduce the amount available to others.
- E.g. Street lights, light houses, public parks
The under-provision of public goods
The free rider problem:
- Once a public good has been provided, it is not possible to widthhold the good from those who have not payed for it. E.g. National defence, street lighting, the NHS
- The 'Non excludability' characteristic means that the price mechanism cannot develop. People wait for others to pay and then benefit from the good for free instead of paying for it themselves.
The valuation problem:
- It is difficult to measure the value obtained by consumers from public goods and so it is hard to establish a market price.
- It is in the interests of consumers to under-value the benefit gained so that they can pay less for it.