Economics of the Market

Scarcity is the basic economic problem.

Too much demand for too few goods as a result of human greed and competing wants. As a result, not all wants can be satisfied.

Human wants are unlimited, but resources (land, labour, capital and enterprise) are finite.

This is a permanent and universal problem, as it affects both developed and developing countries.

Because of this problem, choices have to be made, leading to opportunity cost.

Needs are things that are required for basic human survival e.g. food, shelter and water.

Wants are things that aren't required for survival, but we would still like to have as they give us satisfaction e.g. phones, newest clothes, TV, and video games.

In order to produce these needs and wants, the world's scarce resource need to be used up.

The factors of productions are resources that are used to produce goods and services.

Land- the natural resources available for production e.g. oil, trees. The return for land is rent.

Labour- the human input into the production process e.g. engineers. The return for labour is wages.

Capital- man-made goods used in the production of other man-made goods e.g. computers, hammers. The return for capital is interest.

Enterprise- the entrepreneur who combines the other three resources to provide a good or service e.g. Alan Sugar. The return for enterprise is profits.

Opportunity cost arises because there are insufficient resources to supply consumers with everything they want, forcing them to make choices. For example, trees can be used to make paper or provide timber, meaning a choice must be made for its use.

Opportunity cost is the sacrifice of the next best alternative in your scale of preference as a consequence of our unlimited wants and finite resources.

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A free good does not require any economic resources to produce it and so it is abundantly supplied at no cost. They are unlimited in supply and have no opportunity cost. An example is air.

Economic goods do require economic resources to produce it so they are sold at a cost. Since they require scarce resources to produce them, they are finite and do have opportunity costs. An example is a car.

Consumers have to make choices because they are limited by the amount of disposable income which they have. A choice for them is going to the cinema instead of buying a DVD, meaning the opportunity cost is the DVD. They chose the option which maximises utility.

Businesses make choices because they have limited sales revenue. A choice for them is making an advert instead of renovating their shop, meaning the opportunity cost is the renovation. They chose the option which maximises their profits.

Governments make choices because they have limited taxation revenue. An opportunity cost of building a school could be not building a hospital. They choose the option which maximises social welfare.

Scarcity arises as there are insufficient resources to supply consumers, businesses and governments with everything they want forcing them to make choices. This is the basic economic problem. It refers to human wants being infinite yet resources are finite. This means human wants will never be fully satisfied. This is a permanent problem.

A shortage is that there are insufficient goods to supply consumers with what they demand at a particular time (what they are willing and able to pay for it). They can be controlled through price movements. The market mechanism can resolve this through an increase in price. This is only temporary.

Economic efficiency is an economic state in which every resource is optimally allocated to serve each person in the best way. It maximises the most wants in society while minimising waste and inefficiency.

Productive efficiency: all products are produced at the minimum unit cost i.e. when the fewest resources are used to produce each product.

Allocative efficiency: all resources are allocated to produce only the goods and services that consumers actually want, at the price that reflects the value of the resources used up in the production of the foods and services.

Full employment: when all resources are being used and there are no idle resources which result in lost output.

This is desirable because: an efficient allocation of resources would reduce the rate at which scarce resources are being used up. The economy could grow at a sustainable rate and resources would be available for future generations. Only goods/services demanded would be produced- no resources would be wasted on things that don't maximise utility. More cost-effective, less wastage of resources in lower average costs and greater profits.

Unemployed resources represent inefficiency in an economy and result in fewer products being produced. To fix this, resources must be mobile.

Resource mobility refers to how easy it is to move resources geographically or occupationally.

Geographical mobility: the movement of a factor of production from area to area e.g. a construction worker moving from Edinburgh to London.

Occupational mobility: the movement of a factor of production between one job and another e.g. a construction worker retraining to be a plumber to gain more work opportunities.

Resource substitution refers to the extent which one factor can be exchanged for another to increase efficiency and productivity (amount of output you get from every unit of input e.g. output per worker or machine).

Productive efficiency is when all products are produced at the minimum unit cost i.e. fewest resources are needed. On the curve, this is represented by points A, B and C. All of these points lie on the curve, so they all represent an economy which efficiently uses all of its resources, they are producing the maximum number of goods at the minimum cost. However, point D is not on the curve, so it isn't productively efficient, as resources are being wasted.

The PPC shows the maximum combination or goods and services which can be produced given the present level of resources available in the current time period. The maximum output is the country's potential output.

Moving from point A to point B involves an opportunity cost as both are on the line meaning all resources are already employed, so to produce more consumer goods, less capital goods must be produced. However, moving from point C to point B doesn't incur an opportunity cost as the economy will only be using more resources which aren't being used, not sacrificing anything, increasing their economic activity.

Economic growth is an increase in the value of all goods and services produced in an economy in one year. This is shown as a movement from point A to point B, as more capital and consumer goods are now being produced, due to investments in labour, capital or new resources being discovered.

However, economic activity is a step up in the output of an economy as they have started using resources which weren't in use before. Moving from point C to point A is an increase in economic activity. This is because point C illustrates unemployed resources, which are only now being used on the production of goods, signifying a step up in activity in the economy.

In order for this to occur, the production potential of a country must have suffered.

The damaging effects of severe natural disasters such as a tsunami, floods, persistent droughts and other extreme weather effects. These can destroy resources and damage key infrastructure.

The economic damage caused by war and other types of conflict for example in failing states.

Large scale net migration of people out of a country e.g. when there's high unemployment or economic instability. This results in a loss of resources, meaning less can be produced,

A fall in productivity of labour.

Productivity refers to output per worker or output per machine (output per unit of input).

Increased productivity can lead to increased output as each unit of input can produce more.

Production, however, is a measure of the total output.

To maximise production, productivity should be at its highest level.

High productivity which leads to high production levels can result in lower average costs i.e. productive efficiency.

A worker's productivity can be influenced by:

Levels of capital investment enabling workers to use more advanced, efficient machinery.

Investment in human capital i.e. training courses for workers.

Financial rewards i.e. bonuses.

Levels of demand in economy, each business has to work to its full capacity.

Demand refers to the willingness and ability to buy a product. It also refers to the amount of goods and services that will be bought at any period of time.

Demand is different from wants, as it is influenced by our income levels, prices, needs and what gives us satisfaction.

Ceteris paribus- the condition of what would happen to a good's demand if everything stayed the same and one demand influencer changes.

Veblen Goods: goods which people buy to show off their wealth. As the good drops in price, the consumer gets less utility from the purchase as it is less luxurious and demand falls. Examples include Gucci, Rollies, Prada, Ferrari and Lambos.

Consumers associating a link between quality and price: when presented with a choice, we may select the more expensive item as we believe it will last longer, taste better or look better. An example is people preferring private healthcare to NHS treatments.

Expectations of further price rises: this causes speculative buying in times of rising prices. This leads to increased demand as the buyer is either motivated by owning a valuable asset or fear that the price will rise beyond a level which they can afford in the future. Examples include oil prices, antiques, stocks and shares and collectables.

Giffen Goods: during times of severe economic hardship, demand for basic stable foods such as potatoes, maize and rice may actually rise as their price rises as luxuries become less affordable. An example is potatoes being a big part of the Irish diet. During hard times, the price of potatoes rose, but so did demand as families weren't able to afford meat, so they bought potatoes which were more affordable.

Demand curves show how the amount of goods and services which will be purchased at a given price.

They slope downwards because of the income effect. This is that as the price of a good rises, people's real income will fall, meaning they will no longer be able to buy the same quantity as before, so demand falls at higher prices.

Another reason is the substitution effect. As the price rises, rational consumers would switch consumption to a substitute good which offers greater utility at lower prices, offering better value for money. Therefore, at high prices we switch to substitutes and at low prices we switch from substitutes.

Also, the law of diminishing marginal utility states that the satisfaction gained from consuming one more of a good declines as more of it is consumed. This means the more we buy, the less we are willing to pay for one more. Therefore, we will only buy one more when prices fall. If the price falls, we will get the same amount of utility for less money. We can now increase our total utility by purchasing more of this good and less of other goods. A demand curve slopes downwards showing more is demanded as prices fall, reflecting the fact that we are only willing to consume more if we pay a lower price. Therefore, a demand curve is a curve that plots marginal utility.

An increase in price of that good causes a contraction in demand, while a decrease in price of that good causes an extension in demand.

The demand curve can also shift to the left or right if people's incomes changes, the good becomes of better quality, the price of substitute or complementary goods change, the weather, the population increases or people expect future price rises so they buy the good now.

If consumers are demanding more at every price than before, demand will shift to the right. If they are demanding less, demand will shift to the left.

Supply is the willingness and ability to sell a good or service at every price level.

The supply curve shows how much is being supplied at every price.

The supply curve slopes upwards because firms are driven by profit. Therefore, when the market price rises, it becomes more profitable for businesses to increase their output.

It also slopes upwards because when a firm increases their output, their costs of production will also rise, meaning a higher price is needed to justify the extra output and cover the extra costs.

An increase in price motivates suppliers to supply more, so there will be an extension in supply. A decrease in price motivates them to supply less as it is less profitable, so there will be a contraction in supply.

An increase in supply means producers are willing to sell more than before at each price. A decrease means that they are willing to sell less than before at each price.

The supply curve can shift to the left or right if levels of productivity changes, indirect taxes (VAT) changes, the number of firms in the market changes, technology becomes better, firms receive subsidies, extreme weather or costs of production changes.

An increase in tax will increase costs of productions, giving the firms two choices: pass the cost onto consumers through higher prices, but they may become less competitive and lose customers; or they can absorb the cost, though they may have to supply less or they may not make enough profit to stay in business.

Subsidies lower costs of productions for a firm, meaning they can supply more at the same price to make more profit, or lower prices to attract more demand.

The price mechanism helps the economy allocate resources more efficiently. This is desirable as resources are scarce. Scarcity drives up prices, sending a signal to the economy, giving firms an incentive to produce more and households the motivation to ration consumption. The price mechanism is that supply or demand of a good responds to its price.

Signalling function- prices rise due to scarce resources. If it rises, a signal is sent out to new suppliers to enter the market and allocate resources to produce that good, as they can make a profit from a high price, meaning that more of that good will be available in the market.

Incentive function- when price rise, existing suppliers will be enticed by a higher profit margin and more revenue to allocate more of their resources to the production of the goods which had their prices increased.

Rationing function- an increase in demand for a good will cause a shortage of it. This shortage will push up its price, meaning less people will be able to afford the good, so they ration their consumption of it.

(No place for government)

Only what is wanted will be produced as the signal and incentive functions will inform suppliers about what consumers want, wasting less resources on what people don't want.

More allocative efficiency when allocating resources.

Consumers get what they want at the lowest possible price.

Firms choose what to produce, whom to produce for and how much to produce. They are driven by profit so have an incentive to be more efficient and competitive.

Firms can invest more in innovation as they don't have to pay corporation tax, meaning they can keep all of their profits. Results in better quality goods and lower prices.

Market not distorted by maximum and minimum prices.

Shortages don't last long- changes in demand bring changes in supply.

A market is the place where buyers and suppliers meet to determine an equilibrium price of the product. It is made up of producers and consumers of a particular product. E.g. the market for CDs consists of all the people willing to produce and sell CDs and all the people willing to buy CDs.

Excess demand- when quantity demanded is greater than quantity supplied at a given price. This causes a shortage, which will cause price to rise to the equilibrium because of the supplier's price motive.

Excess supply (glut)- when quantity supplied is greater than quantity demanded at a given price. This causes a surplus in supply, which will cause price to fall to the equilibrium so that the supplier isn't left with unsold stock, which is a waste of resources.

Equilibrium price- when quantity demanded is equal to quantity supplied, known as the market clearing price. The price will remain constant as this is the price at which there is no unsold stock or excess in demand.

Derived demand- the demand for a good/service which is a consequence of the demand for something else e.g. labour market.

In the free market, there is no role for the government and all scarce resources are owned by private individuals. Resources are allocated based only upon the price mechanism.

Benefits: consumers can purchase whatever they like as there is no income tax; suppliers can produce whatever they like; as there is no corporation tax, firms are free to keep profits to use for better innovation and efficiency; what to produce, whom to produce for and how much to produce determined by market forces; allocative efficiency- producing what people want at the price they are prepared to pay; can lead to complete efficiency as resources can be optimally distributed.

Drawbacks: prices are never at equilibrium; harms people below poverty line, can't pay high prices; under-consumption of merit goods (education, health and housing), poor suffer but not the rich; no public goods (bus stips, army, police, street lights) provided; overconsumption of demerit goods; social costs ignored; wasted resources, social injustice and increases in inequality; economic instability.

Reasons for government intervention: correct market failure; subsidies mean lower prices and more supply; minimum wage encourage people to work and prevent exploitation of people; quotas help sustainability; narrow gap between rich and poor (higher wages, lower prices); taxes deter consumption and supply of demerit goods; quotas can ensure future generations still have enough resources e.g. fish and trees; no abuses of monopoly power.

Consequences: consumers can't choose what's subsidised; using subsidies can lead to higher taxes to pay for it; using taxes could lead to higher prices, may lead to workers being made redundant and loss of international competitiveness; maximum prices can lead to excess demand, businesses aren't profitable and black markets may form as supply may fall as it isn't profitable; minimum prices could lead to excess supply and wasted resources; a quota may result in more imports.

Tax- government influences market price through VAT, customs and excise duties. Increase in COPs. Shift supply to the left and may result in some suppliers leaving if they can't pass on higher costs.

Subsidy- grants paid by the government to suppliers, reduces COPs allowing more to be produced. Shifts supply to the right.

Minimum price- price is not allowed to fall below a certain level e.g. minimum wage. Can lead to excess supply labour or the product.

Maximum price- price is not allowed to rise above a certain level e.g. bus fares on countryside routes. Can lead to excess demand.

Quota- limit on the amount that can be supplied in the market. Fixed supply means the supply curve becomes inelastic, resulting in a new equilibrium at lower quantity and higher price.

Price elasticity of demand measure the responsiveness of demand to a change in price.

Elastic- demand for a product is very responsive to changes in price. More than proportionate change in demand i.e. price increases by 10%, demand decreases by more than 10% e.g. Pepsi.

Inelastic- demand for a product is not very responsive to changes in price. Less than proportionate change in demand i.e. price increases by 10%, demand decreases by less than 10% e.g. petrol.

To calculate PED:

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Ignore negative sign, it is always negative.

Between 0 and 1- inelastic, % fall in demand less than % fall in price.

>1- elastic, % fall in demand is greater than % fall in price.

=1- unitary elastic, % fall in demand is equal to % fall in price.

Inelastic: 1- revenue gained when price is increased.

               2- revenue lost when price is increased.

Revenue gained is greater than revenue lost so price increases are beneficial when product is price inelastic.

Elastic: 3- revenue lost when price is decreased.

             4- revenue gained when price is decreased.

Revenue gained is greater than revenue lost so price decreases are beneficial when product is price elastic.

Perfect inelastic: Q doesn't change when P does e.g. water.

Perfect elastic: any Q demanded at a certain price but none will be demanded above that e.g. good with thousands of direct substitutes.

Availability of close substitutes.

How widely defined a good is e.g. food is a loose term, Coke is specific.

If it is a habit-forming or addictive good.

If it is something bought regularly out of necessity e.g. milk or bread.

If it has to be bought now or if the purchase can be postponed.

Proportion of disposable income involved in buying the good.

Petrol- necessity for driving, weak substitute for driving e.g. train, inelastic good.

Salt- no real substitutes, small % of income, not bought regularly, inelastic.

Good produced by monopoly- no other substitute, inelastic.

Apple iPhone- strong brand, inelastic. Dell- not a well-known brand, elastic.

Fixed costs- the COP that does not vary directly with output e.g. rent, insurance, advertising.

Variable costs- the COP that does vary directly with output e.g. raw materials, packaging, components.

Total cost=TFC+TVC

TFC= sum of all fixed costs

TVC= variable cost per unit x output

Total profit= total revenue-total cost

Marginal cost/revenue is the increase in total cost/revenue as a result of increasing total output/selling one unit more.

Any average cost or revenue= total cost or revenue divided by output.

Average costs:

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Total costs:

Short run- period of time when at least one factor of production is fixed e.g. fixed number of machines, skilled workers or size of building. All other costs are variable.

Long run- period of time when the capacity of the firm can be increased or decreased. No factors of production are fixed.

The short run law of diminishing returns:

In the short run, increasing returns occur as each variable factor was able to specialise using capital. This efficient use of fixed and variable factors led to increased output and falling AC. Increasing returns occurred until each worker was unable to specialise and output peaked at optimum output (where AC is lowest).

Decreasing returns occurred as with each marginal worker it became less possible to specialise. It is possible that workers got in each others' way so much that output fell. However, cost of wages and raw materials have to be paid for so AVC continues to rise even though AFC falls continuously. This means AC begins to rise.

When marginal costs are less than average costs, average costs are falling.

When marginal costs are greater than average costs, average costs are rising.

At the point where ATC are neither rising nor falling, MC must be equal to ATC. Hence graphically, MC intersects ATC at its lowest point.

Therefore, the production of one more (marginal) unit impacts on the SRAC curve in a positive or negative way depending upon whether the increase in MC is greater or less than the SRAC curve.

The law of increasing returns to scale:

In the long run, ATC falls as output increases because of economies of scale (increasing returns to scale)- % increase in input is less than % increase in output.

Optimum size- where ATC is lowest.

However, diseconomies of scale lead to rising ATC as output increases- % increase in input is greater than % increase in output.

Economies of scale- output increases faster than the size of the firm, indicates improved efficiency and leads to lower average costs.

Diseconomies of scale- output increases slower than the size of the firm, indicates inefficiency and leads to higher average costs.

In the long run all factors can change, increasing the scale (size) of businesses. The long run is made up of successive short runs and each time the firm becomes inefficient in the SR, they change the ratio of fixed to variable costs and start a new SR curve.

Financial- cheaper loans given to larger businesses than to smaller competitors which helps to reduce costs.

Managerial- large businesses are able to afford managerial experts who can increase efficiency and reduce costs, whereas small businesses have employee staff to complete a range of jobs.

Purchasing- large businesses can negotiate bulk buying discounts to reduce costs paid per unit.

Technical- larger businesses have more money to spend on research and development, allowing them access to the best technology which can improve efficiency and lower costs.

Marketing- large businesses can afford to spend more on advertising so they get more exposure.

Management problems- more difficult to keep control of activities in larger business, so inefficiencies may not be spotted.

Communication problems- more time taken to make decisions as there is a longer chain of command and errors are more likely to be made when passing on instructions.

Alienation- workers in highly specialised assembly lines may feel like they are a small part of a large machine and can lose motivation. Demotivated workers are less efficient so they generate less output so costs rise.

Internal economies of scale refer to the changing efficiency of production within a firm. The firm can control it e.g. financial, managerial.

External economies of scale happen outside the control of a firm caused by growth in the industry they operate in, reduces costs and increases productivity for all firms in the industry.

External economies: greater cooperation between firms, lower training costs as universities provide the necessary skills rather than firms training them, better transportation links, ancillary services which provide materials for firms locating themselves near firms which they supply materials to which lower costs of raw materials for all these firms.

External diseconomies: labour shortage, raw material shortage, congestion leading to higher transport costs.

Normal profit: minimum level of profit required as an incentive for a firm to stay in business, AR=AC, because we assume the entrepreneur is a cost of production so their income is included in the costs.

Supernormal profit: price charged is greater than costs of production- occurs when costs fall or prices rise. They are eliminated in the long run due to the freedom of entry/exit into the industry. AR>AC.

Subnormal profits= price charged is lower than costs of production- occurs when costs rise or prices fall. AR<AC, in this situation firms will leave the industry.

In the short run, if firms are still able to pay AVC even if they can't pay AFC they will remain in business as: it allows them to keep the goodwill of their workforce, maintain the loyalty of customers, keep machinery working, maintain the profile of their products in the market, avoid possible difficulty of restarting production afterwards, don't lose sunk costs e.g. adverts or R&D, gives them time to restructure.

However, in the long run normal profits are required as an incentive to keep trading.

Market failure: where resources are inefficiently allocated due to imperfections in the working of the market mechanism e.g:

Externalities- third party spill over effects arising from production and consumption of goods/services no compensation is paid (cost to society not included in selling price).

Overprovision of demerit goods- market mechanism informs suppliers to supply more of it e.g. cigarettes, alcohol.

Information failure- suppliers or consumers don't have complete information about goods e.g. may purchase something of bad quality due to bad information.

Public goods- private sector doesn't supply public goods because of free-rider problem e.g. streetlights.

Monopoly- higher prices and under-production damages consumer welfare.

Factor immobility- unemployment, loss of productive efficiency.

Tax goods/services which have negative externalities.

Subsidise goods/services which have positive externalities e.g. sports centres.

Set quotas to limit over-production that causes pollution or shortages.

Ban activities e.g. smoking in bars and restaurants.

Provide goods deemed necessary to wellbeing of society such as public/merit goods.

Minimum prices e.g. cheap alcohol.

Maximum prices e.g. electricity.

Competition and Markets Authority to investigate abuses of market power e.g. monopoly.

Extend property rights so if there is a negative externality, the government knows who is responsible, allowing them to tax the offender. This make the private cost equal to the social cost, eliminating the externality.

No. of firms: 1 dominant firm.

Product type: unique- high barriers to entry prevent substitute firms from entering market.

Price taker/setter: setter- no competition, set price at what suits them due to total market control and high barriers to entry.

Shape of demand curve: inelastic- only firm so even at high prices people have to purchase from them.

Barriers to entry: high- new firms would find it hard to compete with the already established firm which can use low prices to get them out. High set-up costs. E.g. well-known brand, legal rights (Royal Mail), established firm with economies of scale.

Type of profit: supernormal- no competition, choose their own price.

Types of efficiency: none- only firm, no competition, don't have to worry about other firms lowering prices to steal demand, so can produce what they want at the price they want.

No. of firms: many.

Product type: homogenous- consumers can choose between many sellers selling identical products.

Price taker/setter: taker- no firm has total market control, lots of competition so can't have higher prices, must take market price.

Shape of demand curve: perfect elastic- if one firm raises prices, there are perfect substitutes to switch to.

Barriers to entry: low- low set-up costs which new firms can afford, no high prices.

Type of profit: normal- can't raise prices so must be as low as possible (equal to AC).

Types of efficiency: productive and allocative- one way to get an advantage is to be efficient, spread costs over more output so they can lower their price.