MICROECONOMICS REVISION

GUIDE

Use this syllabus for exams in 2023, 2024 and 2025

Ms. Mira Zaky
Table of Contents
Unit 1 – Basic Economic Ideas and Resource Allocation ........................................................................................ 2
1.1 Scarcity, choice and opportunity cost .......................................................................................................... 2
Scarcity and Choice ............................................................................................................................................ 2
Economic Agents ................................................................................................................................................ 3
Opportunity Cost ................................................................................................................................................ 3
1.2 Economic methodology ................................................................................................................................ 4
Positive and normative statements ................................................................................................................... 4
Time periods in economics ................................................................................................................................. 5
1.3 Factors of production ................................................................................................................................... 5
Division of labor and Specialisation ................................................................................................................... 5
Specialisation & Trade ........................................................................................................................................ 5
Role of the entrepreneur ................................................................................................................................... 6
1.4 Resource allocation in different economic systems ..................................................................................... 6
1.5 Production possibility curves ....................................................................................................................... 8
1.6 Classification of goods and services ........................................................................................................... 11
Public Vs. Private goods ................................................................................................................................... 11
Merit Vs. Demerit goods .................................................................................................................................. 12
Unit 2 – The price system and the microeconomy ............................................................................................... 12
2.1 Demand and supply curves ........................................................................................................................ 12
2.2 Price elasticity, income elasticity and cross elasticity of demand .............................................................. 15
Price Elasticity of Demand (PED)....................................................................................................................... 16
Income Elasticity of Demand (YED) ................................................................................................................... 17
Cross Elasticity of Demand (XED) ...................................................................................................................... 18
2.3 Price elasticity of supply ............................................................................................................................. 18
2.4 The interaction of demand and supply ...................................................................................................... 20
2.5 Consumer and producer surplus ................................................................................................................ 22
Unit 3 – Government microeconomic intervention .............................................................................................. 23
3.2 Methods and effects of government intervention in markets ................................................................... 23
1. Indirect taxes ........................................................................................................................................... 23
2. Subsidies .................................................................................................................................................. 24
3. Government expenditure and state provision ......................................................................................... 24
4. Buffer Stock Systems ................................................................................................................................ 25
5. Price Controls ........................................................................................................................................... 25
6. Information provision .............................................................................................................................. 26
3.3 Addressing income and wealth inequality ................................................................................................. 27

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The Content
Unit 1 – Basic Economic Ideas and Resource Allocation

1.1 Scarcity, choice and opportunity cost

The Basic Economic Problem: ‘Economic resources are scarce whilst human wants are infinite.’

In other words, decisions need to be made about how to allocate scarce resources (economic goods)
among alternative uses:
• What should be produced?
• How should it be produced?
• Whom should we produce for?

In a question you usually need to apply this problem to a specific market. Here is an example for how
to apply the basic economic problem to the housing market:

There are insufficient houses (1) to meet (rising) demand (1). People on low incomes (scarce resource)
(1) have to decide whether they can afford to purchase/rent housing (1). Government has insufficient
finance (1) and must choose whether to finance housing or meet the other needs of the population (1).
There is a shortage of housing (1) and a growing population or growing number of households (1)

Wants are the goods and services that people desire, whereas needs are the goods and services
people require to survive. It seems that there is a clear distinction between wants and needs, but
these concepts change over time and depend on the level of economic development. For example, is
broadband a ‘need’ in the UK in 2015 – 16?

Scarcity and Choice

Scarcity is a situation that arises because people have limited resources with which to fulfil their
unlimited wants. In other words, they are unable to satisfy their all of their desires with the resources
that they have. Therefore, all economic decision makers face a choice about how to allocate their
resources in order to maximise their satisfaction. They have to prioritise their desires and fulfil the
ones they want the most.
Sustainability is starting to have an impact on the choices that people make in relation to allocating
their scarce resources. Using a large amount of oil now will increase its scarcity in the future.

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In contrast to economic goods, which are scarce, free goods are available in as great a quantity as
desired with zero opportunity cost to society.

Economic Goods Free Goods

Resources that are scarce and valuable. Resources that are available in as greater
Therefore decisions need to be made about how quantity as desired. Therefore, no decisions
to allocate these goods. Every time a decision is need to be made about how to allocate these
made about how to allocate the goods, an goods. In other words, free goods have zero
opportunity cost is incurred. opportunity cost.
Examples: land, labour and enterprise Examples: oxygen

Economic Agents
These are the three stakeholders in society that we consider when undertaking economic analysis.
These agents all have limited resources to fulfil their unlimited wants and therefore face choices in
how to allocate their resources. They all play an important role in the economy.

Agent Role
Households Households consume goods and services and provide labour for firms.
Firm Firms produce the goods and services demanded by households and exchange
wages for the labour provided by households.
Government Governments attempt to maximise the welfare of society through influencing and
regulating the economy.
Opportunity Cost
This is a key concept and is related to the choices that have to be made by the economic agents due
to the scarcity of economic resources (the fact that land, labour, capital and enterprise are limited).
You can’t have everything, so decisions have to be made about what to produce, how much to produce
and whom for.
Definition: The value of the next best alternative foregone.

In other words, if you didn’t allocate your scarce resources to doing X, what else could they be doing?
The opportunity cost is not zero because resources allocated to one task could always be doing
something else to add value.

All economic decision makers (economic agents) have scarce resources and need to make decisions,
hence they all face opportunity costs:

Economic Decision Maker Example of Opportunity Costs

Consumers / households Spend money or save it
Workers Work or leisure time
Firms Product X or product Y / invest in capital or training labour
Schools New textbooks or ICT equipment
Governments New hospitals or pay off national debt

Whenever a decision is made, an economic decision maker makes a trade-off. This is where they
compare the benefits gained from one choice to the benefits gained by making another decision. In
economics, all decision makers are considered rational so they will make the choice that leads to the
most benefits.

For example, a firm may have £100,000 which they could invest either in installing new computers or
running an advertising campaign.

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 Choice Install New Production Machinery Advertising Campaign
Benefits Increased production speed Increased consumer awareness
Higher quality goods Increased sales
Less wastage of raw materials Improved brand image
Estimated value £2m £1.8m

How useful is the concept of opportunity cost?

Benefits Drawbacks
• It allows for us to calculate the economic • Opportunity cost is difficult to calculate
cost of a choice. This reflects cost of a accurately – what should the breadth and
decision to society as a whole rather than depth of the calculation include? The cost
the individual – the accounting cost. this year? In 5 years? 30 years?
• We can achieve more efficient uses of scarce • Limits of rationality – is what we think is the
resources as opportunity cost forces us to best alternative actually the best alternative
consider alternatives
1.2 Economic methodology

Positive and normative statements

In economics we make both positive and normative statements. Positive statements are about what
is and can be proved to be true. I.e. they are facts. Normative statements tend to be based on facts,
but they cannot be proven. I.e. they are opinions.
Positive Statements Normative Statements
Definition A statement about what is, i.e. about A statement involving a value
facts. judgement, i.e. about what ought to
be.
Examples • The UK emitted 424.6m tonnes of • The UK should reduce
CO2 in Q1 2015 greenhouse gas emissions by 5%
• 14.6% of people in Hackney cycle • The government ought to
to work encourage more people to cycle
to work

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 • The UK has one of the highest • The government should enforce
levels of underage drinking minimum prices for alcohol to
activities in Europe reduce underage drinking

Time periods in economics

1.3 Factors of production

These are the inputs that are used in the production of goods or services in the attempt to make an
economic profit.

Factor Explanation Factor Payment

Land The natural resources in the production process. E.g. oil and Rent
water. These resources can be either renewable (such as energy
generated by wind turbines) or non-renewable (like oil).
Labour This is the human resource put into production, and includes Wages / salaries
both high and low skilled technical work, manual,
administrational and professional workers.
Capital These are man-made or produced items which are used to aid Profits
production. Examples include commercial properties (like
factories and offices), machinery, and computers.
Enterprise This is another human resource, and is considered the organising Profits
factor that brings together the other factors with the aim of
making a profit.

Division of labor and Specialisation

Definition: When there is a focus on producing of a limited number of products or processes in order
to gain a greater degree of productive efficiency.

A country specialises in the production of goods and services for which it has a natural abundance of
the factors of production necessary to produce those goods and services. For example, the UK has an
abundance of workers with the skills to produce financial services whereas islands in the Caribbean
have an abundance of natural resources required to grow bananas.

Specialisation & Trade

Specialisation leads to a situation where individuals, firms or countries become very good at producing
a small number of products. They produce a surplus of these products, i.e. more than they can use
themselves. However, because they only specialise in a small number of good or services they will
want to trade and exchange their surplus products for goods and services they cannot produce
themselves.

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Specialisation reduces the problems caused by scarcity because specialisation means that the factors
of production are used to maximise the output gained from converting scarce resources into the
maximum possible output.

Advantages of specialisation Disadvantages of specialisation

• Larger range of goods and services in a • Reliance on a narrow range of products –
country prices can fluctuate which would reduce
• Greater quantity and quality of goods ability to trade internationally
• Ability to trade surplus goods and services • Reliance on overseas trade to obtain certain
with overseas economies goods and services
• Increased output leading to economies of • Reliance on finite resources and depletion of
scale non – renewable resources
• An increase in living standards due to • Changing tastes and fashions
increased international trade • Emergence of international competition

Role of the entrepreneur

Risk taking, organising the other factors of production and receiving profit are clearly linked to the
factor enterprise.

1.4 Resource allocation in different economic systems

The economic system within a national economy is the way in which that society has chosen to
coordinate the way in which a country’s resources are allocated.

Economic Definition Description

System
Market Market forces guide the The prices of goods and services dictate how resources
economy allocation of resources are allocated. As consumers’ demand for a product
within a society via the increases so does its price and firms, who own the
price mechanism means of production (capital), respond to price rises by
producing more of these goods and services. The role
of government is to protect property rights for the
owners of capital. This is known as capitalism.
Centrally Decisions on resource This is where decisions about what and how much
planned allocation are guided by should be produced is taken by governments based on
economy the state their view of peoples’ wants. The government owns the
means of production. This is known as communism.

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Mixed Resources are allocated This is where some of society’s resources are owned by
economy partly by the price the government (public sector) and some of society’s
mechanism and partly resources are owned by individuals (private sector).
by the direction of The government tends to provide infrastructure and
government merit goods and attempts to maximise welfare. Most
of the world’s economies are mixed.

Pros of Market Economies Cons of Market Economies

• The profit motive means that firms • Monopoly power – firms are incentivised to
compete to be efficient. They find ways to beat their competition and become the
cut costs, reduce waste and improve only provider of that good or service. This
products. increases inefficiency.
• Incentives in this type of economy can lead • Social costs and benefits ignored. Firms
to rapid growth. Individuals who work often pursue profits at a cost to the wider
longer and harder get paid more. Firms society (i.e. pollution)
who produce more maximise profits. This • Inherited wealth and sometime huge
can raise GDP and living standards for all. divisions between rich and poor leading to
• Less need for government tends to mean social unrest
more freedom for citizens. • Economic cycles of boom and bust
• Greater competition leads to greater choice • No public goods are provided e.g. street
for consumers lights, roads etc
• Greater competition leads to more
innovations in the products and production
process

Pros of Centrally Planned Economies Cons of Centrally Planned Economies

• Equality of income and wealth between • Large governments can lead to corruption
people and a lack of freedom for citizens
• Everyone has access to education, • Less choice in terms of products and
healthcare and employment services
• Less chance of boom and bust as output is • Lack of innovation
dictated by government • More bureaucracy and ‘red tape’
• Lack of incentive to improve yourself or
society
• Ineffective workers / firms kept on to keep
employment high

Pros of Mixed Economies Cons of Mixed Economies

• Private firms run industry and business and • Deciding between government intervention
are more efficient than public sector and allowing market forces to operate (e.g.
organisations due to the profit motive should the government intervene to
• Governments intervene to prevent ‘market prevent coal miners becoming
failure’: unemployed?)
o Monopolies can be regulated to ensure • Inequality between rich and poor leading to
they do not exploit their dominant tension
market positions
o Industries that would be under
consumed in a market economy are
provided by government (e.g.
education / healthcare)

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 Pros of Mixed Economies Cons of Mixed Economies
o Taxes / regulations placed on products
/ industries that could be damaging
(cigarettes)
• Welfare for the poorest in society, whilst
rewarding entrepreneurship and hard work
• Government intervention to reduce boom /
bust
• Public goods are provided by government

1.5 Production possibility curves

A production possibility curve (PPC) (also referred to as production possibility frontier or PPF) is a
diagram that shows the maximum combinations of goods or services that can be produced in a set
period of time given the available resources.

They can be used to show the opportunity costs faced by all economic decision makers.

Ensure you know how to draw these and how they can be used to show scarcity, choice and
opportunity cost.

• Scarcity: The limit of the PPF demonstrates that limited resources cannot produce infinite
goods and services
• Choice: The axes of the PPF shows that choices need to be made in terms of how to allocate
resources
• Opportunity cost: moving from one point on the PPF to another shows that to produce more
of product X, production of product Y will need to fall (unless the PPF itself shifts)
• Productive efficiency: if production is taking place on the PPF it means that all resources are
being used to produce the maximum amount of output.
• Economic growth: if a PPC moves outwards (shifts to the right) it shows that there is an
increase in the quantity and / or quality of factors of production. Therefore the economy can
produce more goods and services without having to suffer an opportunity cost.

Showing scarcity on a PPF:

PPF1 (below) represents an economy that can produce either capital or consumer goods.

• Point A: is within the PPF and represents a point of productive inefficiency. A country or firm
producing within the PPF has unused of production (i.e. unused labour or unemployment) and

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 is not producing the maximum number of goods and services that it could were all factors of
production fully utilised.
• Point B: is on the PPF and represents a point where all factors of production are being fully
utilised to produce the greatest possible output at the minimum average total cost.
• Point C: is outside the PPF and represents a combination of output that is not possible given
the current factors of production.

Showing choice and opportunity cost on a PPF:

PPF1 below shows the opportunity cost to a farm of producing 100 extra tonnes of carrots.

The diagram above shows a shift in production from Point A to Point B. To produce 100 extra tonnes
of carrots, the farm gives up 200 tonnes of tomatoes. We can use a formula to calculate the
opportunity cost of producing each extra unit of carrots.

Opportunity cost Opportunity cost = Economic loss / economic gain

calculation

In this case, the economic loss is 200 tonnes of tomatoes and the economic gain is 100 tonnes of
carrots.

Opportunity cost = Economic loss / economic gain

= 200 / 100
=2
Therefore the opportunity cost of producing an extra
tonne of carrots is two tonnes of tomatoes.

Showing economic growth on a PPF:

The diagram below shows a country experiencing
economic growth and moving from PPF1 to PPF2.
The economy has gone from producing at Point A to
Point B. This shows an increase in the production of both
capital and consumer goods, and has been made possible
by an increase in the productive capacity (the total
amount of production possible given the current level of
factors of production) of the economy from PPF1 to
PPF2. This is called an outward shift.

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An outward shift of the PPF shows an increase in quality or quantity of the factors of production:
• Land (the discovery of raw materials)
• Labour (inward migration, training and education)
• Capital (investment or improvements in technology)
• Enterprise (training or tax breaks for entrepreneurs)

PPCs can also experience inward shifts if the quantity or quality of factors of production fall. For
example, wars, a decline in the birth rate and emigration can all have an impact on the quantity and
quality of factors of production.

Question:
Discuss the differences between the constant opportunity cost and the increasing opportunity cost in
terms of Production Possibility Curve. ie.) the shapes of PPC and the main assumption behind these
two.

Difference Between The constant opportunity cost and increasing opportunity cost:

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1.6 Classification of goods and services

Public Vs. Private goods

• Private goods are goods which firms are able to provide to generate profits. They can generate
profits as these goods are excludable and rivalrous
o The firm is able to exclude certain customers from purchasing their goods through use of
the price mechanism. If customers cannot afford to buy them, then they are excluded
o Customers can also compete for these goods which are limited in supply and
this rivalry helps to generate profits for firms

• Public goods are goods that are beneficial to society but which will not be provided by private
firms due to the principles of non-excludability and non-rivalry
o Non-excludability refers to the inability of private firms to exclude certain customers from
using their products. In effect, the price mechanism cannot be used to exclude customers
e.g. street lighting
o Non-rivalry refers to the inability of the product to be used up, so there is no competitive
rivalry in consumption to drive up prices and generate profits for firms
o Therefore, governments will often provide these beneficial goods themselves, and so they
are called public goods

• If firms decided to provide

these goods anyway, it
would give rise to what is
called the ‘free rider’
problem

This is a situation where

customers realise that they
can still access the goods,
even without paying for
them. If they are paying, they
stop and continue to enjoy
the benefits. They are ‘free-
riding’ on the backs of other
paying customers. Over time,
any customers who are paying
for the goods will stop. At
some point firms will cease to
provide these goods.

Exam Tip
• Make sure that you know the difference between public goods and merit goods. The key idea is
that private firms will not provide public goods, so under-provision (or no provision) occurs in
society. On the other hand, private firms will provide some merit goods as they are able to make
a profit on them. However, due to the profit incentive and high prices that firms charge, not all
members of society will be able to afford these goods. So merit goods are also under-provided,
but there is some provision of them.

• MAKE SURE TO REFER TO FREE RIDER PROBLEM WITH ANY QUESTION THAT HAS TO DO WITH
PUBLIC GOODS.

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Merit Vs. Demerit goods
Merit Goods Demerit Goods
• A merit good is a good which is under-provided • A demerit good is a good which is over-provided
in a free market due to an information failure on in a free market due to an information failure
the part of consumers. on the part of consumers.
• the good is better than consumers realise so the • Namely, the good is worse than consumers
true benefit is larger than the perceived benefit. realise so the true benefit is smaller than the
• Examples: healthcare- museums- education- perceived benefit.
healthy food. • Examples of demerit goods include junk food,
alcohol, tobacco, etc.

Unit 2 – The price system and the microeconomy

2.1 Demand and supply curves

Market: a set of arrangements that allows buyers and sellers to come together in order for economic
transactions to take place.

A market is a place where buyers and sellers come together for the purpose of exchanging goods and
services. This does not necessarily mean a physical place, in fact the Internet provides a ‘place’ for
buyers and sellers to exchange products without the need to even be on the same continent. The
buyers in a market determine the demand for a good, while the sellers determine its supply. The price
of products, in free markets, are determined by the quantity of products demanded compared to their
supply.

Demand: the quantity of a good or service that consumers are willing and able to buy at any possible
price in a given period.

Assuming all other things remain equal (ceteris paribus), there is an inverse relationship between the
price of a good and demand. In other words, if prices fall people demand a greater quantity of goods
and if prices rise they demand fewer goods. This is known as the law of demand.

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Ceteris paribus is a very important concept in economics as it helps to simplify the real world. It means
that we focus on one variable changing at a time. In this case we assume that the only variable
changing is the price while other factors that could affect demand, like consumers’ incomes and prices
of other goods, remain the same.

An individual’s demand is the total quantity of goods and services that an individual demands at a
given price while market demand is the total quantity of goods and services demanded by all of the
consumers in a market.

Types of demand:

Definition Examples
Derived demand When the demand for one good is • Transport
determined by the demand for another. • Labour
Joint demand When two products are used together – • DVDs / DVD players
complementary goods • Strawberries and cream
Composite When one good is demanded for more • Sand (play, glass, cement)
than one distinct purpose • Water (shower, drink, clean)
Competitive When the goods are demanded by the • Fast food – Chinese vs Indian
same people for the same purpose • Coach vs train

The Demand Curve: a graph showing how much

of a good will be demanded by consumers at any
given price.

• As prices fall, we see an expansion of

demand.
• If price rises, there will be a contraction of
demand.

Shifts in the demand curve (to the left or the right)

occur when there is a change in a non – price
factor that determines demand. Non Price
Determinants of Demand (PICSA):
• P – Population size
• I – Income
• C – Price and/or availability of complements
• S – Price and/or availability of substitutes
• A – Advertising / fashion / trends

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Basically a change in one of these factors will mean that the quantity demanded at a given price
changes:

• An increase in demand shifts the curve right

• A decrease in demand shifts the curve left

The movement from D1 to D2 shows that there has

been a change in a non – price determinant of demand
increasing the quantity demanded from Q1 to Q2,
despite the fact that the price has remained the same
at P1. Perhaps the population has increased.

The movement from D1 to D3 shows that demand at all

prices has fallen. This could be caused by a fall in the income of consumers that means that at P1
demand for that product falls from Q1 to Q3.

Questions will often ask you to explain how non – price determinants of demand could apply to a
particular market.

For example:

• State and explain two likely determinants of an increase in the demand for houses in the UK.
(6 marks) Jan 2013

Incomes are rising (1 mark) which means that couples can afford to a deposit on a house (1 mark)
leading to more people buying a house (1 mark).

Supply: the number of producers who are willing and able to produce a product at any given price.
As prices increase firms will be willing and able to supply more of a product. This is because firms have
more ability to maximise profits if products are selling for a higher price. This positive relationship
between price and quantity supplied leads to an upward sloping supply curve.

Individual supply comes from the total quantity of goods and services that a firms can produce at a
given price while market supply is the total quantity of goods and services supplied by all of the
producers in a market.

Types of Supply:

Definition Examples
Joint supply* Where the supply of one good results in a Beef and leather
valuable by product Zoos and manure
Composite When the product produced by a firm Screws – households and
supply serves more than one market businesses
Competitive When two or more goods are produced Crops vs animal production
supply* using the same resources iPhones vs iMacs

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An extension in supply occurs when prices rise from P1 to
P2. Suppliers respond to increased prices by raising output
from P1 to P2. A contraction in supply occurs when prices
fall from P1 to P3. Producers are less incentivised to
produce a good or service, so the supply of it falls from Q1
to Q3.

Shifts in the supply curve (to the left or the right) occur
when there is a change in a non – price factor that
determines supply. Non Price Determinants of Supply
(iTecs):
• I – Indirect taxes
• T – Technology
• E – Expected future prices
• C – Costs of production
• S – Subsidies

The movement from S1 to S2 shows that there has been a

change in a non – price determinant of supply increasing
the quantity supplied from Q1 to Q2, despite the fact that
the price has remained the same at P1. Perhaps
production technology has improved.
The movement from S1 to S3 shows that supply at all
prices has fallen. This could be caused by an increase in the costs of production that means that at P1
supply of that product falls from Q1 to Q3.

Questions will often ask you to explain how non – price determinants of supply could apply to a
particular market.
For example:

• Using information in the case study, identify and explain two reasons for the decrease in the
supply of flights. (6 marks) June 2013

A sharp rise in the cost of fuel (1) has increased production costs (1) and therefore firms are less
willing to supply flights as it is more difficult to make a profit (1).

2.2 Price elasticity, income elasticity and cross elasticity of demand

Elasticity measures how responsive one variable is in response to another. For example, how much
will demand fall if the price of a product goes up? How much will demand rise if the price of a
complementary good goes down?

Elasticities come up every year. Some hints:

• Ensure you know how to calculate and interpret all elasticities
• Ensure you know why knowledge of each elasticity is relevant to a business and government
• Look at previous mark schemes to see how you pick up marks on these questions
• Be precise when you are discussing each elasticity. For example, when discussing PED a phrase
like ‘petrol is inelastic’ gets zero marks. It is better to say ‘Demand for petrol is price inelastic.’

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Price Elasticity of Demand (PED)
Definition The responsiveness of quantity demanded to a change in price.
Formula % change in quantity demanded / % change in price
Factors • Number of close substitutes – a lack of substitutes = inelastic PED
affecting PED • Luxury vs necessity = necessities tend to have inelastic PED
• Habitual goods = inelastic PED
• % of income spent = the greater the proportion of total income = more
elastic PED
• Time = over time more substitutes can be found, hence greater PED
Interpretation • Because there is an inverse relationship between them, as price goes up
the quantity demanded will fall. Therefore the calculation is always
negative. You can ignore the minus sign.
• 1 > PED > 0 = demand is price inelastic. Demand is not very responsive to
changes in price.
• 1 = demand has unitary elasticity. The change in demand is proportional to
price.
• 1 < = demand is price elastic. Demand is highly responsive to changes in
price.
• Infinity = perfectly elastic demand – any change increase in price will lead
to 0 demand
• 0 = perfectly inelastic demand – demand does not change, regardless of
price
Relevance to • Understanding PED will allow the government to estimate the effectiveness
Government of taxes in reducing demand for demerit goods
• Understanding PED will allow the government to estimate the effectiveness
of subsidies in increasing demand for merit goods
• Helps the government set prices for public goods, i.e. public transport
Business • Businesses will want to know the impact a change in price will have on
relevance revenues
• Total Revenue = Price x Quantity. (TR = P x Q)
• An increase in the price of an inelastic product will raise revenue, while a
fall in the price of an elastic good will raise revenue.
• Businesses can calculate if a change in price will increase or decrease
revenue, so it helps them make decisions
Evaluation • Allows a business to estimate impact on revenue, but need information on
how costs change to analyse impact on profit
• PED calculations are estimates (1) which may be inaccurate/unreliable (1)
• PED is based on historical data (1) which may not hold true over time (1)
• Other factors affect demand (1) meaning final change in revenue / demand
uncertain (1)
• One market may have different sub-sections of consumers with different
PEDs
• PED of a firms product can change over time

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 Price elastic demand: Perfectly elastic demand Price inelastic demand:

When price falls from P1 to P2, This occurs in perfectly When price falls from P1 to
there is a greater proportional competitive markets, like the P2, there is a less
change in Q. Therefore, to foreign exchange market. proportional response in
increase revenue a business Because there are so many quantity. Therefore to
should drop their price. suppliers selling homogenous increase revenue, a firm
goods, if any seller tries to sell needs to raise their price.
for above P1 they will lose all of
their customers.

The link between PED and revenue:

The diagram demonstrates the impact of changing

PED on revenue. When PED is elastic, a falling
price leads to a proportionally greater increase in
quantity sold, thereby increasing revenue. When
PED becomes inelastic, as you cut the price there
is less of an impact on quantity so total revenue
begins to fall.

PED Price Increase Price

Decrease
Elastic Total revenue Total revenue
falls rises
Unit elastic No change in No change in
revenue revenue
Inelastic Total revenue Total revenue
rises falls

Income Elasticity of Demand (YED)

Definition The responsiveness of demand to a change in income.

Formula % change in quantity demanded / % change in income
Interpretation • A minus figure indicates that as incomes increase, demand falls. This is
known as an inferior good. E.g. bus journeys, white bread
• Positive 1 > YED > 0 indicates that as incomes increase, demand goes up
proportionally. This is known as a normal good. E.g. food, toothpaste

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 • Positive 1< indicates that as incomes increase, demand goes up more than
proportionately. This is known as a luxury good. E.g. holidays abroad
Business • It shows a firm how demand for their products is likely to respond to
relevance changes in the economy.
• It can help a firm predict future revenues if there are changes in average
incomes
• It may indicate that firms should develop new products to cope with
changes in incomes (for example, developing a luxury product if incomes
are likely to increase)
Evaluation • YED calculations are estimates and may change in the future
• It is better to sell luxury goods in a boom, but inferior goods in a recession.
Demand for normal goods is unresponsive to changes in income.
• Ceteris paribus is assumed so there are other factors that may affect the
estimates (for example, demand is also determined by changes in price of
substitute goods)
Cross Elasticity of Demand (XED)
Definition The responsiveness of demand of one product to a change in the price of
another product.
Formula % change in price product A / % change in price product B
Interpretation A minus figure means the products are complementary goods
• -1 <XED<0 are weak complements
• -1< are strong complements
A positive figure means the products are substitute goods
• 1> XED >0 are weak substitutes
• 1< are strong substitutes
Business • Allows companies to estimate how the actions of competitors may affect
relevance them (how will a fall in price of a substitute good impact on revenue)
• If businesses sell complementary goods, how will changing the price of one
product affect the demand for the other
Evaluation • the data are estimates (1) and could change over time (1)
• it assumes only the price of product B changes
• The degree to which products are complements / substitutes tends to
depend on how great the change in price is. For example, a large increase
in price will encourage more customers to look for substitute goods.
• Closeness of substitutes may depend on the amount of branding and
advertising in the industry as this affects consumers perceptions of
substitutability
• Governments / competition authorities can use XED to determine the level
of competition in a market by seeing if products can be seen as substitutes
for each other.

2.3 Price elasticity of supply

Definition The responsiveness of quantity supplied to a change in price.
Formula % change in quantity supplied / % change in price
Factors • Time period: For example, it takes time to grow produce like fruit,
affecting PES therefore supply of fruit is inelastic because changes in quantity supplied
take time to respond to a change in price.
• Fixed supply: like at football stadiums. Means supply cannot change
regardless of price = perfectly inelastic PES

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 • Spare production capacity: If there is plenty of spare capacity then a
business can increase output without a rise in costs and supply will be
elastic in response to a change in demand
• Stocks of finished products and components: If stocks of raw materials and
finished products are at a high level then a firm is able to respond to a
change in demand - supply will be elastic.
Interpretation • When PES > 1, then supply is price elastic
• When PES < 1, then supply is price inelastic
• When PES = 0, supply is perfectly inelastic
• When PES = ∞, supply is perfectly elastic
Business • Businesses do not usually consider PES
relevance
Evaluation • Supply tends to be price inelastic in the short term where it is difficult to
switch production and more elastic in the long run
• The data are estimates (1) and could change over time (1)
• Be prepared to question a negative PES figure – it is likely to be wrong as it
implies that firms have responded to an increase in price by cutting supply.
• Depends on the product i.e. agricultural vs manufactured

Price elastic Supply: Perfectly elastic supply Price inelastic supply:

This diagram shows that supply is This diagram shows that This diagram shows perfectly
highly responsive to changes in supply is not very responsive inelastic supply, when
price. In other words, when price to changes in price. In other producers are unable to
increases from P1 to P2, there is a words, suppliers find it respond to changes in price.
large change in quantity supplied. difficult to respond to an This occurs when supply is
increase in price from P1 to fixed at Q1, for example at
P2. sports stadiums or parking
• spaces in car parks.

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2.4 The interaction of demand and supply
A market comes into equilibrium at the market clearing
price. This is the price at which the quantity demanded is
the same as the quantity supplied and there is not tendency
to change. This is a standard market equilibrium diagram,
and is the starting point for answering demand and supply
questions. You need to be able to draw and label it neatly,
quickly and accurately.

The diagram on the right shows what happens when price

moves away from the equilibrium:
• This market is in equilibrium when 200 units are
produced and sold for £20.
• When the price increases to £30, producers
increase supply to 300 units, but there is only
demand for 100 units. Therefore there is excess
supply of 200 units.
• When the price falls to £10, 300 units are demanded
by consumers but producers are only willing to
supply 100 units. Therefore there is excess demand
of 200 units.

Types of Market Equilibrium Questions:

Determination of Price Questions – 3 marks

Any question asking you to demonstrate how
the price of anything is determined simply
requires you to draw a basic supply and demand
diagram in equilibrium.
• Use a demand and supply diagram to
show how the price of private dental
implants is determined. (3 marks)

Explain / Analyse the Impact on Market – 6 marks

1. Draw the standard supply and demand diagram
2. Decide if you need to change the supply curve, the
demand curve, or both
3. Draw the new supply and demand curves and new
equilibrium
4. Describe what happened to price and quantity of the
product in your diagram, using the terms P1 / P2, Q1
/ Q2
• Using one diagram, explain the likely impact of these
changes on the market equilibrium. (6 marks)

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‘Comment on’ Evaluation Questions – 6 to 8 marks

1. Draw and label supply and demand diagram

(1 mark)
2. Decide which curve is affected – and shift left
/ right (1 mark)
3. Label new equilibrium (1 mark)
4. Explain impact on price and quantity (1 mark)
5. Comment / evaluation (2 marks)

• Using a demand and supply diagram,

comment on the likely impact on the
market for new houses of relaxing
planning regulations (6 marks)

Market Equilibrium – Evaluation Points

The signpost ‘comment on’ tells you that you
need to evaluate the extent to which market
equilibrium (i.e. price and quantity) is likely to
change. Make sure you are familiar with the
phrases you can use to pick up these marks.

• Impact on P / Q depends on the extent of the shift in S / D

• Impact on P / Q depends on elasticity of S / D
• Assumes ceteris paribus – all other S / D factors remain unchanged

For example:

• The extent of the impact on price and quantity depends on the magnitude of the change
in supply. A larger change in supply will have a greater impact on price and quantity.

• The extent of the impact on price and quantity depends on the price elasticity of demand
for X. If demand for X is highly price inelastic, a change in supply will have a proportionally
greater impact on price than quantity.

• The extent of the impact on price and quantity assumes ceteris paribus. If people’s
incomes increase at the same time then the size of the shift in the demand curve will be
even greater, leading to a bigger impact on price and quantity.

What are the main functions of the price mechanism?

1. Signalling function
Prices perform a signalling function – i.e. they adjust to demonstrate where resources are required.
Prices rise and fall to reflect scarcities and surpluses. If prices are rising because of high demand from
consumers, this is a signal to suppliers to expand production to meet the higher demand. If there is
excess supply in a market, the price mechanism will help to eliminate a surplus of a good by allowing
the market price to fall.

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2. Incentive function
Through choices consumers send information to producers about their changing nature of needs and
wants. One important feature of a free-market system is that decision-making is decentralised, i.e.
there is no single body responsible for deciding what to produce and in what quantities. This is in
contrast to a planned (state-controlled) economic system where there is significant intervention in
market prices and state-ownership of key industries.

3. Rationing function
Prices ration scarce resources when demand outstrips supply. When there is a shortage, price is bid
up – leaving only those with willingness and ability to pay to buy.

2.5 Consumer and producer surplus

Consumer surplus is the difference between the amount

the consumer is willing to pay for a product and the price they
have actually paid. For example, if a consumer is willing to pay
£18 to watch a movie and the price is £15, their consumer
surplus is £3

Producer surplus is the difference between the amount that the

producer is willing to sell a product for and the price they actually
do. For example, if a producer is willing to sell a laptop for £450
and the price is £595, their producer surplus is £145

When the market is at equilibrium the producer and consumer surplus are
maximised

How Market Changes Affect Producer & Consumer Surplus

Any change to the condition of supply or demand will cause a shift in the relevant curve. This shift will
change the consumer and producer surplus in the market

The condition of supply has changed and the diagram on

the left shows the resulting change to consumer surplus
while the diagram on the right shows the change to
producer surplus

Prior to the change in the condition of supply: Consumer surplus

was equivalent to ACE and producer surplus was equivalent to
ACF

After the change; supply increased S1→S2. Consumer surplus was

equivalent to BED and producer surplus was equivalent to BDG

Both the consumer surplus and producer surplus have increased as a

result of the increased supply in the market

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Unit 3 – Government microeconomic intervention

3.2 Methods and effects of government intervention in markets

Government Intervention: Governments will often intervene to correct incidences of market failure.

Type of Market Failure Intervention

Negative externalities & demerit • Indirect taxes
goods • Regulations (including complete ban)
• Information provision
• Tradable pollution permits
• Subsidise a substitute
Positive externalities & merit goods • Subsidies
• Legislation (e.g. school leaving age)
• Information provision
• Direct provision
• Tax a substitute
Information Failure • Information provision
Public goods • Government provision

1. Indirect taxes
Definition: compulsory charges imposed by the government on the sale of goods and services. For
example, VAT or duties.
Explanation:
• The supply curve shifts to the left because
indirect taxes increase producer costs. The
diagram above shows an ad – valorem tax
(like VAT, which is currently 20%), meaning
that the amount of tax charged on each unit
increases as the price rises
• This leads to an increase in price from P1 to
P2
• There is a fall in quantity from Q1 to Q2
which could solve the issue of over
production / over consumption
• Reduces the volume of output and consumption so reduces negative externalities
• If taxes move production closer to the socially optimum level of output it increases allocative
efficiency
Evaluation:
• If demand is price inelastic then the quantity demanded may not be affected by an increase
in price
• The correct value of the tax is difficult to determine
• There are costs of policing and collecting taxes
• Can be absorbed by firms rather than causing output to reduce

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2. Subsidies
Definition: A subsidy is a payment by the
government to suppliers that reduce their costs
of production and encourages them to increase
output

Explanation:
• Supply shifts from S1 to S + subsidies
because subsidies reduce producer
costs
• Price falls from P1 to P2 and quantity
increases from Q1 to Q2
• This solves / reduces under production
• Consumer surplus increases

Advantages of subsidies Disadvantages of subsidies

• Keep prices down and control inflation • Subsidies can keep inefficient businesses
• Encourage consumption of merit goods going which is artificial and unfair.
which generate positive externalities • May be kept for profits and not passed on
• Reduce the cost of capital investment to consumers
projects which stimulate growth. • Lower prices for merit goods benefit the
rich just as much as the poor.
• Government deciding to subsidise a merit
good comes with an opportunity cost which
is paid for by taxpayers
• Difficult to know how much the subsidy
should be

3. Government expenditure and state provision

Definition: when the government uses revenue from
taxation to provide goods and services to consumers for no
cost.

State schools and some forms of NHS care (like accident and
emergency) are good examples of this. The government will
also fund public goods and infrastructure in order to allow
the economy to operate more efficiently and to remain
internationally competitive.

Evaluation:
• The necessary collection of tax revenue is costly and it can create inefficiencies.
• When goods and services are provided for free, consumers ignore the cost that they impose
on others in the form of a heavier tax burden, which results in an over-consumption (i.e.
tragedy of the commons).
• Because of the absence of competitive pressure and profit motive, the provision of such goods
and services may be less efficient compared to what the private sector would achieve.
• The government might be unable to identify the optimal level of provision.

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4. Buffer Stock Systems
Definition: a scheme that is intended to stabilise the price of
a commodity by buying excess supply in periods when supply
is high and selling stock when the price is low.

These schemes are often used in agricultural markets because

they are considered to be strategically important, and thus
worthy of protection, and prices in them can be highly
volatile.

Explanation:
• The target price is at price P1
• When there is a good harvest, supply increases to S2 and prices fall to P2. In this case the
buffer stock scheme will buy up excess stock Q1 – Q2 and prices will rise from P2 to P1.
• When there is a poor harvest, supply falls to S3 and prices increase to P1. The buffer stock
scheme releases stock Q1 – Q and prices fall from P1 to P.

Pros Cons
• Stable prices help producers’ incomes have • Commodity markets are huge, successful
a positive relationship with the quantity intervention requires massive financial
they supply and improves incentives to investment
grow legal crops • Government has imperfect information and
• Steady prices mean more incentive to so will not know exactly how much to buy
invest in capital, thus increasing or sell in any given period. They may buy
productivity and efficiency too much or too little and fail to stabilise
• The production and extraction of price.
commodities provide employment • Collection and storage costs are huge, and
• Stable prices benefit consumers and help to often agricultural products may go off
maximise welfare • Can lead to moral hazard & over production
as inefficient producers know they will have
a guaranteed buyer for what they produce
above Q
• Relies on having both good and bad
harvests. If there is no good harvest, there
is no buffer stock to stabilise poor harvest.

Evaluation:
• The success depends on setting a realistic target price. Too high and all of the scheme’s
resources will be required to buy excess stock and too low and there will be a lack of stock
with which to intervene in the market.
5. Price Controls
Price ceilings occur when the government sets a
maximum price that is below the market equilibrium.
This means that prices cannot rise above a specified
level.
This is often done with the intention of ensuring that
important goods are priced at a level that make them
affordable to consumers. For example, price ceilings
have been used to control the price of certain drugs in
India and price of rent in the UK.

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Explanation:
• The government sets the price at P max, which is below the equilibrium price (Pe)
• At P max, quantity Qd max is demanded as consumers are attracted by low prices
• At P max, quantity Qs max is supplied as producers reduce output due to low prices
• Therefore, there is excess demand equal to Q2 – Q1. In other words, some consumers will not
be able to consume the good at this price due to a shortage of supply.

Pros Cons
• Important goods and services remain • Black markets emerge to satisfy unmet
affordable demand
• Increased unhappiness as there are more
unsatisfied consumers

Price floors are used to ensure that producers get a set

price for their products.
This is often done to ensure that certain producers in
certain industries are guaranteed a price for their output
and will continue to produce it. An example is EU subsidies
for farmers. The minimum wage is also an example of a
price floor.

Explanation:
• The government sets the price at P min
• At P min, Qd min is demanded as consumers
reduce consumption due to high prices
• At P min, Qs min is supplied as producers increase output in response to high prices
• Therefore, there is excess supply equal to Qs min – Qd min

Pros Cons
• Producers are incentivised to produce • Higher prices for consumers
strategic goods like agricultural products • Encourages oversupply and inefficiency
• Black markets may emerge as people sell
surplus stock for below the minimum price
6. Information provision
Definition: supplying data to economic decision makers to help them make efficient choices about
how to allocate their scarce resources
Methods of providing information:
• Regulations regarding the labelling of products (i.e. food)
• Advertising campaigns to raise awareness (e.g. alcohol / smoking)
• Advertising standards to reduce misinformation
• Watchdogs / regulators to monitor particular industries (e.g. Ofsted)
These methods are used to increase demand for merit goods, which are more beneficial to consumers
than they realise, and reduce demand for demerit goods, which are more harmful to consumers than
they realise.

Evaluation:
• Consumers may ignore the information
• Advertising campaigns are very expensive and represent an opportunity cost to governments
• Advertising success may be limited as government budgets may not be a big as private sector
firms with conflicting messages

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3.3 Addressing income and wealth inequality
Income inequality and wealth inequality are related, but they are not the same thing.
Income inequality refers to the unequal distribution of income within a society. It measures how much
income different individuals or groups of people earn. It can be measured by looking at the income
distribution of a population, and it is often represented by the Gini coefficient, which ranges from 0
to 1, with 0 being perfect equality and 1 being perfect inequality.

Wealth inequality, on the other hand, refers to the unequal distribution of assets and resources within
a society. It measures how much wealth (assets such as cash, savings, investments, and property)
different individuals or groups of people own. Wealth inequality can be measured by looking at the
distribution of wealth across a population, and it is often represented by the concentration of wealth
among the top 1% of the population.

Lorenz curve and Gini coefficient

The Lorenz Curve illustrates the distribution of

income (or wealth). It shows the cumulative
share of income from different deciles of the
population. If there was perfect equality, then
the poorest 20% of the population would gain
20% of total income. The poorest 50% of the
population would get 50% of income. Income
would fall the line of perfect equality. Income
is skewed towards the richer deciles among
the population.

The Gini coefficient is a commonly used

measure of income inequality that condenses
the entire income distribution for a country
into a single number between 0 and 1: the
higher the number, the greater the degree of
income inequality.

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