Chapter 3 Microeconomic decision makers

3.1 money and banking

 Definition of Money
Money: an item which is generally acceptable as a means of payment

 Forms of money
Coins: used to make small purchases and are given in change. – legal tender
Notes: used to buy more expensive items. – legal tender
Bank account: for the largest proportion of payments (main form of money).
• Legal tender is any of payment which by law, has to be accepted in settlement
• Bank account is not legal tender
• Note: money does not need to have intrinsic value.

 Functions of money
1) Medium of exchange (the most important)
Money allow people to buy and sell products
2) Store of value
Has a value over time, enables saving to occur
3) Unit of account (measure of value)
Money can place a value on an item, enables the value of items to be compared
4) Standard of deferred payments
Money allow people to borrow and lend and pay it back at a future date
An agreement can be reached about the amount to be repaid in the future.

 Characteristics of money/Advantages of money

Acceptable Most important; accept money in exchange for products and to settle
debts
Limited in supply Relatively scarce if it is going to keep its value
Durable Will last some time
Portable Can be carried around easily
Divisible Can be divided into units of different values
Homogeneous Every note and coin of the same value should be exactly the same
Recognizable People can easily see that the item is money

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 Definition of commercial bank
Commercial bank: a financial institution which aims to make a profit by providing a range
of banking services to households and firms.
 The role and importance of commercial banks*
1) Accept deposits from customers/ allow people to save and earn interest rate on savings
Two types of bank account
• current account with low interest rate and can withdraw money at any time
• deposit or time account with high interest rate but need time to withdraw money
2) Lend money to customers
Overdraft; loan
3) Enable customers to receive and make payments
Acting as agents for payments and providing money transmission services
4) provide other services, such as foreign currency exchange and storage of value

 Definition of central bank

Central bank: A government-owned bank which provides banking services to the government
and commercial banks and operates monetary policy.
 Role and importance of a central bank *
1) Act as a banker to the government
Operates an account for the government which enables it to receive revenue and make
payments
2) Operates as a banker to the commercial banks
Commercial banks’ accounts at the central bank enable them to make and receive payments
between each other and to withdraw money.
3) Act as a lender of last resort
It will lend to commercial banks that find themselves in difficulty and ensure trust in the
banking system is maintained
4) Implements the government’s monetary policy
5) Manages the national debt
Issues government securities and pays interest on those securities
6) Holds the country’s reserves of foreign currency and gold
7) Issues bank notes and coins
8) The supervisor and regulator of the banking and financial system
9) Represents the government at meetings with other central banks and international
organizations such as the World Bank and the International Monetary Fund.

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Exercise

3.2 Households
Spending
 Definition of spending
Spending: people spend in order to buy goods and services and to maintain a given standard
of living.
• Among the main items involving expenditure are food, clothing and footwear, housing,
gas, electricity, water, consumer durables, transport, entertainment, and leisure goods and
services.
 Influences on spending
1) disposable income
Disposable income: income after income tax has been deducted and state benefits received
As income rises, people usually spend more in total, but less as a percentage of their income.
2) wealth
Wealth: a stock of assets including money held in bank accounts, shares in companies,
government bonds, cars and property.
• Wealth generates income, e.g. dividends from shares
• Wealth can be cashed in. e.g. withdraw money from bank or selling a car.
• People can use their wealth as security for loans.
• Wealth also affects confidence. More wealth more confidence.
3) confidence
If people feel more optimistic about their future career prospects and income, they are likely
to spend more.
If they become pessimistic about economic prospects, they will tend to spend less.
4) interest rate

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Interest rate: a charge for borrowing money and a payment for lending money.
Expenditure may fall if the rate of interest rises.
• It will make borrowing more expensive, encourage saving and reduce the amount spent
by people who have borrowed in the past.
• Those people who have savings will gain more income and consequently, they may
spend more.

5) Distribution of income
A more even distribution of income and transfer of income from rich to the poor, is likely to
increase expenditure in a country.

6) Advances in technology
Advances in technology may also increase expenditure. This is because new products, such as
plasma TVs, encourage people to replace existing products.

 Pattern of expenditure
1) Different patterns of expenditure between the poor and the rich
 The poor spend a higher proportion of their income, and total expenditure, on food and
clothing than the rich
 The rich spend more on food and clothing, but the amount they spend is usually a
smaller proportion of their income and total expenditure.
 The rich spend more, both in total and as a proportion, on luxury items, consumer
durables, entertainment and service.

2) Different patterns of expenditure between the countries

 The poor countries spend a larger proportion of disposable income and expenditure on
necessities than rich countries.
 The rich countries spend a larger proportion of disposable income and expenditure on
luxuries.

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Saving
 Definition of saving
Saving: income not spent/minus spending. Saving in the bank, investment in shares,
securities, houses and other assets are all included in saving.
 Reasons for saving
1. Purchase expensive items
2. For retirement
3. Finance their children’s education or to leave them an inheritance
4. Cope with emergencies and unexpected problems
5. Increase their current income
 bank interest
 a rise in the value of their assets

 Influences on saving
1) income
As disposable income rises, the total amount saved and the proportion saved increases.
2) wealth
The wealthier people are, the easier they will find it to save.
3) the rate of interest
A rise in the rate of interest may reduce some target saving as people can now attain their
target amounts by saving less. Overall, it is likely to increase non-contractual saving as it
pushes up the reward for saving.
4) the tax treatment of savings
Tax concessions on the income earned from saving will encourage people to save.
5) the range and quality of financial institutions.
The greater the variety of saving opportunities on offer, the more likely people will find a
schme that will suit them. Confidence in the ability of institutions to pay an interest and repay
the amount saved, is also important.
6) age structure
The young and the old tend to save less than middle-aged people. Then old, especially the
very old, draw on their savings to ensure reasonable living standard during retirement.
7) social attitudes
The attitude to saving varies between countries. In some it is held in high esteem, while in
others people prefer to spend most of their income when they receive it.

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Borrowing
 Definition of borrowing
borrowing: borrowing moves income from people who do not want to spend it now to those
who need more money than they currently have.
 Influences on borrowing
1) Availability of loans and overdrafts
The easier it is to borrow, the more likely people to borrow
2) Interest rate
Interest rate ↑ 》》 cost of borrowing ↑ 》》 reduce borrowing
3) Confidence
An increase in confidence about the future >> foresee an increase in income >> more
confidence that they will repay loans >> borrow more
4) Social attitudes
Some countries and some group within countries are more concerned about the risks of
people getting into debt by borrowing, than others.
5) Disposable income
A rise in disposable income >> may reduce the need to borrow >> borrow less
A fall in disposable income >> may need to borrow to meet the demand for necessities,

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especially for low-income groups >> may raise the need to borrow >> borrow more
6) Inflation rate
Expectations of future price rises or if inflation rate > interest rate 》》 the real value of what
they repay may falls 》》 borrows gain 》》 borrow more
7) Age
- Generally, young workers may borrow more
- Because they may be buying a car/house
- however, younger worker may be more difficult to obtain borrowing from the bank than the
old workers.
- Because young workers’ low ability to repay, banks may be more reluctant to lend to young
workers.

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3.3 Workers
 Factors affecting an individual’s choice of occupation
1. wage factors
Earnings: the total pay received by a worker, including basic wages/salaries, overtime
payments, bonuses and commissions.
1) Wages (basic wage)
Wage rate: a payment which an employer contracts to pay a worker. It is the basic wage a
worker receives per unit of time or unit of output.
Salary: an annual sum of money paid to a worker in exchange for their labor
Generally, the higher the wage rate on offer, the more a person would want to do the
job.
2) Overtime payment
Overtime payment may be paid to the workers who work in excess of the standard working
week. It is usually paid at a higher rate.
3) Bonuses
An extra payment for workers who have better performance than others.
4) Commission
It involves them receiving a proportion of the value of the sales they make.

2. non-wage factors
1) Job satisfaction
Some jobs can provide a high degree of job satisfaction. E.g. nursing, teaching
2) Type of work
Prefer non-manual rather than manual work.
 Non-manual work tends to be better paid
 Non-manual work tends to enjoy a high status
3) Working conditions
People like to work in pleasant surroundings, with friendly colleagues and enjoying regular
breaks.
4) Working hours
- The length of working hours
• People prefer a job with short working hours
• Because working hours ↑ → leisure time ↓
• This makes the job less attractive
- Part-time job (flexible working hours)
 May suit some employer
When they need workers to work longer hours when demand for the product is high
 May suit some employees
Part time job provide more opportunity for other activities for employees
- The time of working
 Working unsocial hours
To work at nights

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e.g. nurses, emergency plumbers and catering staff
 working in shifts
working at different periods of the day and night
e.g. some nurses and other workers
5) Holidays
Some people may prefer a job with long holiday, because having time off when their children
on holiday is an advantage for parents. E.g. teacher
6) Pensions
With people living longer in most countries, occupational pensions are becoming an
important influence.
Generally, pensions in public sector is higher than private sector.
7) Fringe benefits
Fringe benefits are the extra benefits provided to workers by their employers. E.g. free or
subsidized meals, health schemes, and social and leisure facilities.
8) Job security
A high degree of job security means that workers are unlikely to be made redundant.
 When there is a high demand for the product and workers are given long-term contracts.
• Civil servants, high degree of job security
• Casual workers, little job security.
9) Career prospects
People often accept low wages at the start of their careers, if they think there is a good
possibility that they will gain promotion to a well-paid and interesting post. E.g. trainee
accountants, barristers and doctors.
10) Size of the firms
People are often attracted to jobs in large firms and organizations.
 This is because such firms and organizations often pay more and offer better career
prospects, job securities and fringe benefits than smaller ones.
Some people prefer to work for smaller firms
 They believe that the atmosphere will be more friendly than in a large firm.
11) Locations
People may choose an occupation which is close to their home

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 Wage determination
1. demand and supply
The higher the demand for and the lower the supply of workers in an occupation, the higher
the pay is likely to be.

Causes of changes for labor demand

1) Wage factor:
Wage rate rises >>> a decrease in the quantity demanded for labor
Firms are only likely to employ additional workers if they add more value than they cost to
employ
2) Non-wage factors:
 Demand for labor is a derived demand for what the labor can produce
 To meet the increase of demand for the product >> To produce more >> To hire more
workers >> Increase the demand for the labor used to make the product
 The higher productivity of labor >> the lower unit cost of labor >> Higher profits >>
expand production >> Demand more labor
 Higher price or greater difference between revenue and costs >> Higher profits >>
Expand production >> Demand more labor

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 A rise in the price of capital >> labor in place of capital >> demand more labor

Causes of changes for labor supply

a fall in wage rate >> A decrease in the supply of labor
1) Wage rate: As the wage rate rises, the quantity supplied of labor will also rise
2) Non-wage factor:
 Size of labor force or population / size of labor force. Fewer workers >> difficult to
recruit workers >> an increase in wage rate
 Unemployment rate >> more people available to workers >> increase in supply of labor
 The number of qualified people
If one job needs high qualification or skills >> More time is needed for training >> The
supply of labor for this job is limited and even decreases
 Special characteristics of some jobs
For example, a job with bad working conditions or low security >> decrease in supply of
labor
 A reduction in the non-wage benefits of a job >> Fewer workers
 Social attitudes. A reduction in gender discrimination >> an increase in working women
>> Increase in supply of labor

2. Relative bargaining power of employers and workers

Strong bargaining power >> higher wage
 The elasticity of supply and demand for labor
 The strength of trade unions if belongs to a trade union

3. Government policies
How government policy influence wages
 Influences the wages in public sector
 Influence wages in the private sector
• Policies for promoting economic growth >> an increase in demand for labor >> an
increase in wage throughout the economy
• Policies to affect demand and supply of labor (shift demand and supply curves) e.g.
car driver test >> demand for driving instructors
• Policies directly affect wages. E.g. A national minimum wage (NMW)
 Raise the pay of low-paid workers and reduce poverty,
but cause unemployment
 but some argue that
 higher wage will raise workers’ motivation and
hence their productivity
 and higher demand for products (less poverty) will
increase demand for labors
• Government policy on immigration
• An increase in education >> an increase in the wages of skilled workers
• Introduction of government anti-discrimination laws
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4. Public opinion
Public opinion tends to consider that jobs which involve long periods of study and training
should be highly rewarded.
Different countries hold different public opinion on jobs

5. Discrimination
Discrimination occurs when a group of workers is treated unfavorably in terms of
employment, the wage rate, the training received and/ or promotional opportunities.

 Reasons for differences in earnings

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1. Skilled/unskilled workers
Skilled worker has higher wages?
1) The demand for skilled workers is likely to be higher
• Higher productivity / education >>> expectation of a higher rate of return
• Better quality goods and services produced >>> resulting in greater profits
2) The supply of skilled workers is likely to be lower and more inelastic
• Long training required to learn skills >> the shortage of people with skills /
qualifications
3) Demand and supply of skilled is likely to be more inelastic
• Harder to replace-demand
• Long training required to learn skills-supply
4) Skilled workers may have more bargaining power
• May belong to a trade union >>> may cause more disruption by taking industrial
action

Skilled worker does not have higher wages?

• May have less experience, e.g. fresh graduates from universities
• May be in declining industries >> lower demand
• May place more importance on non-wage factors
• Skilled workers in poorer countries may have lower wages than some unskilled
workers in richer countries.

2. Male/female workers
Women are (on average) still paid less than men. Why?
• Women tend to work for fewer hours than men.
• Women tend to be less well qualified than men, but this is changing in a number of
countries, with more women now going to university than men.
• They tend to be more heavily concentrated in low-paid occupations
• They are less likely to belong to trade unions and professional organizations
• They are still discriminated against.

3. Primary/secondary/ tertiary workers

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Stages of production
Primary sector: covers agriculture, fishing, forestry, mining and other industries which
extract natural resources
Secondary sector: covers manufacturing and construction industries
Tertiary sector: covers industries which provide services

Tertiary sector may be paid more

1) Higher demand
• Increase in demand for services >> increase in demand for labor >> increase in wages of
workers
• Profits in the services sector may be high
• Workers may be difficult to replace >> inelastic demand
• Worker may be very productive
2) Lower supply
• Need high qualifications
3) Higher bargaining power
• In some tertiary sector firms, workers are not easily replaced by capital
• May be in trade union
4) More favored by government policy
e.g. increased government spending on education/healthcare; may be covered by minimum
wage legislation

4. Young and old workers

High wage for old workers
 gained experience >> high productivity/more reliable /make fewer mistakes >> Higher
demand
 gained more qualifications and received more training >> have more choice of
occupation >> lower supply
 In some countries, the minimum wage may rise with age
 May have been with the same employer for some time >> better at doing the job >>
more bargaining power

High wage for Young workers

 Young workers may be more up to date with advances in technology / new methods/ new
ideas >> Higher demand
 Young workers may be more qualified/ educated >> Higher demand
 Young workers may be fitter in jobs requiring physical strength
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 Young workers may be more occupationally mobile and geographically mobile and
thereby move to gain higher wages
 Young workers may work more hours and less time off for illness.

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5. Private sector/public sector
Public sector is higher
• High level of education and professional training required to work in many public sector
occupations >> lower supply
• In some countries the public sector is expanding >> higher demand
• More likely to be members of trade unions >> more bargaining power
Private sector is higher
• Private sector firms may earn high profits >> high wages
• High supply of labor in public sector because of greater job security, longer holidays and
better pensions

 Division of labor/specialization
Definition
Specialization: the concentration on particular products or tasks
• Instead of making a wide range of products, a firm may specialize in manufacture of one
or a few products

Division of labor: workers specializing in particular tasks

• Instead of producing the whole good or service, a worker carries out one particular task.

Disadvantages and advantages

Advantages for workers Disadvantages for workers

Repeating the same task, the worker will The repetitive work may be boring
become more skilled

Workers may enjoy more job satisfaction if The boredom may lead to job dissatisfaction
they are highly skilled in a specialist task and affect motivation

Potential to get higher payment Repetitive tasks can have health implications
for workers

Employment: workers with well highly practice Unemployment: if the demand for particular
skills will be able to find employment easily skills of workers decreases, some workers may
find themselves unemployed

Advantages (Efficiency) for firms Disadvantages for firms

Increased productivity: Workers can perform Reduced productivity: if tasks are too repetitive
tasks more quickly and more accurately. There and boring, people become dissatisfied and
are fewer mistakes and productivity will rise. poorly motivated, which might result in poor-
Therefore efficiency is improved quality work, staff arriving at work late,
increased rates of absence and high staff
A greater use of specialist tools, machinery and

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 equipment is possible
turnover
Saving time: Workers do not have to waste time Dependency on others: if one stage breaks
moving from one task to another, so production down, all other stages may also have to be
time is reduced stopped

Specialist workers can fit more easily into a A loss of flexibility: if a highly skilled and
structured system of production, so the specialist worker is absent, and there is no one
organization of production becomes easier else with those skills, production may be
disrupted

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3.4 Trade unions
 Definition of a trade union
Trade union: an association which represents the interests of a group of workers and
improve their pay and working conditions.

 The role of trade union

 Engaging in collective bargaining on wages, working hours and working conditions
 Protecting employment
 Influencing government policy

 Factors affecting the strength of a trade union

1) level of economic activity
• A high economic growth >> higher profit and higher demand for labor >> competing for
workers >> more willing to agree to union requests >> more strength of trade union
2) Number of members
• Larger size of membership >> larger proportion of workers who are members >>
stronger collective bargaining power >> Unions have greater bargaining strength
• Larger size of membership >> More funds available >> unions have greater bargaining
strength
3) Level of skill
Workers with high skills are hard to replaced >> higher strength of trade union
 The advantages and disadvantages of trade union activity
4) Essentiality of the industry
If an industry is important, e.g. utilities >> Production of such an industry can not be
interrupted by industrial action >> Unions have greater bargaining strength
5) Favorable government legislation
Laws allow trade unions to take industrial action > stronger position of bargain.

 Advantages and disadvantages of trade union

Firms
Disadvantages
1) the amount of revenue lost and damage done to the reputation of a particular firm by a
strike will be influenced by the effect on rival firms and the length of the strike.
2) A firm’s costs and flexibility will be adversely affected by overtime bans and “work to
rule” action.
Advantages
1) it is less time consuming, less stressful and hence cheaper to negotiate with workers as a
group, than to negotiate with each worker individually.
2) unions also provide a useful channel of communication between employers and workers.
3) they encourage workers to engage in education and training which raises productivity and

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promotes improved health and safety.
4) they also provide an outlet to vent workers’ discontent and channel their grievances to the
employers, thereby reducing conflicts.

workers
Advantages
1) Can negotiate with employers for better pay and working conditions
2) Can provide greater strength in negotiations compared to individual workers
3) Provide additional support for members, such as education and training
4) A trade union may influence a government to increase a minimum wage

Disadvantages
1) Could cause unemployment among its members
• Prolonged strike action could force a firm to go out of business
2) May bring workers out on strike >> lose potential earnings
3) Worker will have to pay a fee to be a member

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3.5 firms
 Classification of firms
1. According to different industries
Industry: firms that produce the same product. for example, the car industry includes firms
such as Volvo, General Motors and Toyota.

2. According to stages of production

Primary sector – the first stage of production
It is the extraction of basic materials and goods from the land and sea. E.g. agriculture, coal
mining, fishing
Secondary sector – the second stage of production
This is the manufacturing or construction sector where raw materials are turned into goods.
e.g. car production, motorway construction
Tertiary sector – the third stage of production
This is the service sector of the economy. E.g. retailing, education, banking, tourism.
Quaternary sector (sub-section of the tertiary sector)
Covers those service industries which are involved with the collection, processing and
transmission of information – essentially information technology

3. According to ownership
Private sector: Firms owned by shareholders and individuals
Public sector: Part of the economy controlled by the government

4. According to relative size of firms

Three main measures of the size of a firm
1) the number of workers employed
2) the value of the output it produces
3) the value of the financial capital it employs

 Small firms
Reasons for small firms’ existence
• The small size of the market
• Preference of consumers
• Owner’s preference. Entrepreneurs want to work for themselves
• Greater flexibility. Small firms may survive because they may be able to adjust to
changes in market conditions more quickly
• Technical factors
• Lack of financial capital
• Location
• Cooperation between small firms
• Specialization

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• Government support

0455/21/O/N/22
Medan is the third largest city in Indonesia by population. It is sometimes known as the city
of a million shop-houses as many people start small firms at the street level of their homes.
This has led to an increase in the market supply of industries such as cafes and clothes shops.
Also, due to the growth in demand for food delivery, the unemployment rate has fallen.
However, mobility of labour is limited both within Medan and within Indonesia.
c) Analyse the reasons for the existence of small firms. [6]

 Causes and forms of the growth of firms

1. Internal growth
Definition: an increase in the size of a firm resulting from it enlarging existing plants or
opening new ones
Causes of internal growth
Greater market share; lower costs; Increased profits; reduced risk; More effective marketing

2. External growth
Definition: an increase in the size of a firm resulting from it merging or taking over another
firm
Methods of external growth
Merger: two seperate entities combine to create a new, joint organization.
Acquisition (take over): the takeover of one entity by another.

 Mergers
1. horizontal merger
Definition
Horizontal merger: the merger of two firms at the same stage of production, producing the
same production.
e.g. the merger of two car producers or two TV companies.
Advantages
• To take greater advantage of economies of scale.
• To increase the market share.
• Rationalization: eliminating unnecessary equipment and plant to make a firm more
efficient.
If the two firms had not been using all their resources fully, merging could enable them
to sell off the redundant resources, for instance, one office block.
• The new firm may also be able to save on managerial staff.
Disadvantages
• With a horizontal merger that the merged firm may experience diseconomies of scale.

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• A large firm can be difficult to control.
• It may be difficult to integrate the two firms if they initially had different management
structures or are located some distance apart.

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2. Vertical merger
Definition
Vertical merger: A vertical merger occurs when a firm merges with another firm involved
with the production of the same product, but at a different stage of production.
 Vertical merger backwards: a merger with a firm at an earlier stage of the supply
chain.
e.g. a supermarket chain may take over a bakery and a tyre manufacturer merge with a
producer of rubber.
Advantages:
To ensure an adequate supply of good quality raw materials at a reasonable price.
To restrict the access of the rival firms to the supplies.

 Vertical merger forwards: a merger with a firm at a later stage of the supply chain.
e.g. an oil company may buy a chain of petrol stations and an airline may merge with a tour
operator.
Advantages:
To ensure that there are sufficient outlets, and the products are stored and displayed well in
high quality outlets.
Such a merger may help in the development and marketing of new products.

Disadvantages of vertical merger

• There may be management problems. The managers of the merged firms may not be
familiar with running.
• The two firms may also have been of different sizes and this may require some
adjustment or the buying in of some supplies from other firms or the selling of supplies
to other firms.

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0455/22/F/M/18
South Africa has more than 700 state-owned enterprises, a number of which have engaged in
vertical integration and horizontal integration. Some of the state-owned enterprises are
monopolies, including a railway monopoly. A leading South African economist has argued
that more of the country’s resources should be devoted to building and operating new railway
lines and stations.
b) Explain the difference between vertical integration and
horizontal integration. Give an example of each. [4]

3. Conglomerate merger
Definition
Conglomerate merger: a merger between firms producing different products.
e.g. an electricity company may merge with a travel company and an insurance company may
merge with a chocolate producer.

Advantages:
Such a merger spreads a firm’s risks and may enable it to continue its growth, even if the
market of one of its products is declining.
Disadvantages:
Coordinating a firm producing a range of products prove to be very challenging.

4. the effect of a merger on consumers

Advantages:
• It leads to greater economies of scale, consumers may enjoy lower prices.
• They may also benefit from high quality products and innovation, if the merger increases
the efficiency of the firm.
Disadvantages:
• If the merger results in diseconomies of scale, consumers may experience higher prices
and poorer quality.
• There is also a risk, in the case of a horizontal merger, of reduced choice of consumers
and use of greater market power by the merged firm to push up prices.

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0455/21/M/J/23
In Greece, rich households spend more than the average household. The amount of spending
in an economy influences whether its production point is on or inside its production
possibility curve (PPC). In 2020, household spending in Greece fell. This affected some
firms’ plans to merge. It also increased unemployment. More than half of those unemployed
in Greece had been unemployed for more than a year.
d) Discuss whether or not a government should encourage firms
to merge. [8]

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 Economies and diseconomies of scale
Definition
Economies of scale: a fall in long-run average costs resulting from an increase in scale of
production
Diseconomies of scale: a rise in long-run average costs resulting from an increase in scale of
production

1. Internal economies of scale

Definition
Internal economies of scale: Lower long run average costs resulting from a firm growing in
size.
Types and reasons of internal economies of scale ***
1) Buying economies
This may be offered a discount price when buying raw materials in bulk. Leading to a lower
cost per unit.
2) Selling economies
The advertisement expenditure can be spread over a higher output
The expenditure on processing orders, packing the goods, and transporting can be spread over
a higher output.
3) Managerial economies
Specialist staff may be employed when output is high, and revenue is high
Expenditure on employment of specialist staff can be spread over a higher output
4) Labor economies
Larger firms can divide work into separate tasks so their workers become specialized.
5) Financial economies
• As output increases, it may be able to borrow with a lower interest rate.
• Public limited companies can sell to the general public. The larger and better known
the companies are, the more willing people are to buy their shares.
6) Technical economies
The larger the output of a firm, the more viable it becomes to use large, technologically
advanced machinery.

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7) Research and development economies
The R&D expenditure can be spread over a higher output.
• By developing more efficient methods of production
• Raise total revenue by developing new products
8) Risk bearing economies
Larger firms usually produce a range of products >> spread the risks of trading

2. Internal diseconomies of scale

Definition
Internal diseconomies of scale: higher long run average costs resulting from a firm growing
in size.
Reasons of internal diseconomies of scale
1) Difficulties controlling the firm
More layers of management in a large firm >> may make management complex and take
longer time to make decisions >> firm could become slower in responding to changes in
market conditions >> inefficiency in production and mismatch market demand >> Rise in
average cost
2) Communication problems
There are more layers of communication
• Messages may be misinterpreted
• Take time to reach recipients
3) Poor industrial relations
At a greater risk from a lack of motivation of workers, strikes and other industrial action >>
due to the longer time it takes to address workers’ grievances

3. External economies of scale

Definition
External economies of scale: lower long run average costs resulting from an industry
growing in size.
Reasons of external economies of scale
1) A skilled labor force
A firm can recruit workers who have been trained by other firms in the industry
2) A good reputation
An area can gain a reputation for a high quality production
3) Specialist suppliers of raw materials and capital goods
Ancillary industries may develop to support the large firms >> easy access to supply chain
and lower the costs of it.
4) Specialist services
A local university’s research and development facilities can provide help to firms in similar
areas.
5) Specialist markets (specialist selling places and arrangements)
Some large industries have specialist selling places and arrangements >> reduce the cost of
selling network
6) Improved infrastructure
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Investment in a better transport network servicing an industry will result in a decrease in costs
for a company working within that industry >> reduce the cost of transportation

4. External diseconomies of scale

Definition
External diseconomies of scale: higher long run average cost arising from an industry
growing too large.
Reasons of external diseconomies of scale
1) Pressure on infrastructure
May cause congestion >> Higher cost of transportation
2) Higher cost of factors of production
If an industry is concentrated in one area >> increased competition from other firms in the
industry >> increased competition for resources >> Pushing up prices of factor of
production
3) Pollution

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3.6 Firms and production
 Demand for factors of production
1. The availability of different factors of production
1) The availability of land
In some countries, there may be shortage of natural resources, e.g. oil
2) The availability of labor
In some countries there may be shortage of people of working age.
In some countries the labor available does not have the necessary skills.
3) The availability of capital
In some countries there may be shortage of capital due to the lag in technology

2. The type of product produced

If the complexity of product being made is high, e.g. producing nuclear power >> increase
in demand of capital
If producing hand-made products or goods that cannot be produced in mass or standardized
way >> Increase in demand of labor

3. The demand of the product

1) demand for product >> incentive to expand >> need to raise the output
• Demand for labor is a derived demand >> increase demand in labor
• Also, may increase the demand for capital
2) demand for product >> revenue/profit rises
• The expected return will be higher >> raise the incentive to spend on capital goods
• Raise the funds to reinvest on capital goods >> increase demand in capital

4. The productivity of different factors of production

1) Reasons for increase demand for labor
• If labor becomes more skilled >> raise the labor productivity >> increase the demand
for labor >> a firm might become more labor-intensive
• If the capital equipment becomes less reliable >> reduce the productivity of capital >>
more expensive to maintain >> reduce the demand for capital >> may raise the demand
for labor
2) reasons for increase in demand for capital
• If the productivity of capital is higher than labor >> capital could reduce the average cost
of production >> raise the demand for capital
• If advances in technology happens >> new capital equipment is likely to be more
productive >> raise the demand for capital
3) reasons for increase in demand for land
• Most fertile land >> higher productivity >> in highest demand and receive the highest
rent
• City centre sites are very productive as firms have the potential to attract a high number
of customers.

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5. The price of different factors of production
• If capital is relatively expensive than labor (a fall in wage rate or a rise in price of
capital) >> labor-intensive methods of production may be used >> increase in demand
for labor
• If labor is relatively expensive than capital (a rise in wage rate or a fall in price of
capital) >> capital-intensive methods of production may be used >> increase in demand
for capital

 Labor-intensive and capital-intensive production

1. Labor-intensive
Definition
Labor intensive: A production method that uses a large proportion of labor relative to capital
Advantages and disadvantages
Advantages
1) high labor availability and low cost
Labor may be in plentiful supply in the economy >> relatively cheap of labor
2) can meet different consumer’s demand
Labor may be more suitable for the production of specific goods or services for different
customers, which cannot be produced in mass or standardized way. E.g. car repairs as
opposed car production
The production of some goods and services requires personal attention. e.g. hairdressing
3) workers can be more flexible in terms of what they do and the size of the labor force can
be adjusted by small amount
4) labor can provide feedback on how to improve production methods and the quality of
products.
Disadvantages
1) High cost
 Because low productivity compared to capital
• Low productivity than capital and need for training >> in the long run with
technology advance labor can be more expensive then machinery
• Labor can be affected by personal issues, e.g. illness, and is more likely to make
mistakes than the capital.
 Because low supply in some economies
• In some economies there can be a shortage of the right type of labor (skills shortage)
>> demand exceeds supply >> high cost
2) Difficult to produce standardized products
Labor will not produce the same every time and its effort will vary
For example, it can be affected by personal issues
3) Bad labor relations will disrupt production
Workers go on strike or take other industrial action, but machinery will not.

2. Capital-intensive
Definition

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Capital intensive: A production method that uses a large proportion of capital relative to
labor.
In practice, firms tend to switch from labor-intensive production to capital-intensive
production. This is because advances in technology tend to make capital goods more
affordable and more productive.
Advantages
1) Higher productivity and greater output (production in mass)
Capital is more productive than labor >> more can be produced in a set time period at lower
cost (Technical economies of scale)
2) Reduction of costs
If short supply of labor or labor with certain skill
The labor costs become relatively higher than capital >> Use capital to replace labor >> May
reduce average costs >> may enable price to be lower >> if the demand is elastic >> revenue
will rise
Able to produce exactly the same product every time >> improve the quality of products >>
increase demand
Disadvantages
1) cost is high in some cases
Machines may be expensive, especially for small firms
>> initial set-up costs may be high
>> high training costs to train workers for using of some machines
2) Possible reliability problem
Machines may break down >> interruptions in production
3) Lack of flexibility
If consumers may prefer handmade/personalized products >> but machines can often only
perform one task >> products cannot easily be changed in line with changes in consumer
demand >> demand for products produced by machines may fall.
4) Not suitable for small scale of production
- to be efficient, machinery often needs to operate on a large scale
- small scale of production cannot enjoy from the technical economies of scale >> it means
the capital-intensive production it costly for small firms

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0455/22/F/M/23
In 2019 India became the world’s largest producer of sugar. Sugar cane is grown in the
country by a large number of mainly low-income farmers. They sell sugar cane to mills which
process the sugar cane into sugar. Processing the sugar cane is more capital intensive than
growing it. The Indian government sets a minimum price for sugar cane and subsidises the
export of sugar.b) Explain two advantages of capital intensive production. [4]

0455/22/M/J/21
Consumers in Uruguay are eating more processed foods. Factors of production, including
enterprise, have responded to this change. Firms in the processed food industry have become
more capital-intensive. All of Uruguay’s industries were affected by the rise in its inflation
rate, from 6.2% in 2017 to 7.7% in 2018.
c) Analyse why a firm may become more capital-intensive. [6]

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 Production and productivity
Definition
Productivity: productivity is the output produced per factor of production. E.g. per worker,
per period of time, e.g. per hour.
• It is a measure of efficiency
• It measures how quickly products are produced
Production: production is the total output in a period of time. E.g. per year.

Influences on production and productivity

Productivity:
Improvements in education and technology
Production:
Productivity and working hours

3.7 Firms’costs, revenue and objectives

 Definition and calculation of costs of production
Short run and long run
 short run: a period of time in which at least one factor of production is fixed.
 long run: a period of time in which all factors of production are variable, but the state of
technology is fixed.
Short-run costs of production
1. Total cost
Total cost: the total amount that has to be spent on the factors of production used
to produce a product.
Average total cost: total cost divided by output.

Total cost = Fixed cost + Variable cost

2. Fixed cost
Fixed cost (FC): costs that do not change with output in the short run.
e.g. interest paid to the bank, rents for the buildings
• rent: affected by landlord’s decision
• insurance: depends on the insurance companies

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• some capital goods: e.g. factories, some large machines (not all, exclude some semi-
products on parts): affected by the method of production and demand for capital
• interest on past loans: affected by the central bank
Fixed cost (FC) = a constant number
fixed costs are still existing when output is zero.
when output = 0, total costs = fixed costs

Average fixed cost (AFC): total fixed cost divided by output.

average ¿ cost ( AFC )=total ¿ cost ¿
total output

3. Variable cost
Variable cost (VC): costs that change with output
total variable cost: the aggregate amount of all variable costs in corresponding output.
e.g. wages, material costs, component parts cost, transport cost, utility bills for telephone, gas
and electricity services, taxes based on the value of company profits.

• Total variable costs will rise with output

• No output, no variable costs

Average variable cost (AVC): total variable cost divided by output

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 Total variable cost
average variable cost ( AVC )=
total output

4. diagram for total cost in the short run

Long run costs

In the long run, all costs are variable.
e.g. a firm can increase the size of its factory, office or farm. Therefore, its rent and business
rates would rise and it can hire more workers.
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 Definition and calculation of revenue
Total revenue: the total amount of money received from selling a product.
Total revenue (TR) =price*quantity
Average revenue: the total revenue divided by the quantity sold.
Average revenue (AR) = TR/quantity sold

In very competitive markets, each firm’s output may have no effect on price.
Total revenue rises consistently as more quantity is sold.

In most markets, firms are price makers and need to lower price to sell more.

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Profit: profit occurs when a firm’s total revenue is greater than its total cost.
Profit = total revenue – total cost = TR -TC
Loss: total costs exceed total revenue

0455/22/F/M/22
c) Analyse, using a diagram, the effect of an increase in output on
average fixed cost (AFC) and total fixed cost (TFC). [6]

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 Objectives of firms
1. survival
The aim may just be to stay in the market until demand increases in the future.
When
• During difficult times such as recession
• When a firm is first established
• When some firms are making a loss

2. profit satisficing
achieving enough profit to keep shareholders happy while following other objectives.

3. Growth/expansion
A firm may be trying to maximize sale revenue or do mergers
1) Growth may reduce competition >> a firm may grow by merging or taking over another
firm >> increase its market power >> to raise price
2) To take advantage of economies of scale >> reduce average cost of production. E.g.
buying, managerial, technical, risk bearing economies of scale >> if prices are unchanged
profits will be higher.
3) Growth can increase the reward to directors and managers.
4. social welfare
business organization operating in the public sector may e.g. be concerned about the
environment or charging a low price to help the poor.
This is more likely to be the aim of companies in public sector.

5. profit maximization
when a firm produces where the gap between total revenue and total cost is larges. This is
more likely to be the aim of companies in private sector.

Reasons
1) to provide an incentive/reward for entrepreneurs.
>> profit is a payment for bearing risks/organizing the other factors of production.
2) To provide finance for investment
>> investment will allow firms to grow
>> new capital equipment may reduce costs of production
3) To obtain external finance more easily
>> shareholders prefer shares in profitable firms and banks prefer to give them loans.
4) To compete with rival firms
>> the most profitable firms are likely to be able to gain a larger share of the market
5) To provide finance to pay dividends to shareholders
>> this may keep demand for shares high/raise price of shares.

Ways of increasing profit

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1) Reduce costs of production
- Reduce any wastages and inefficiency.
- Increase the productivity of factors of production.
- Increase the size of the firm through merger or takeover.

2) Raise the revenue

- Increase the demand for product, through improving the quality of products, diversify
- Change the price according to the price elasticity of demand for the product.

0455/22/F/M/24
b) Explain two ways a firm can increase its profit. [4]

0455/21/M/J/21
. d) Discuss whether or not a firm should have growth as its main objective. [8]

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3.8 Market structure
Market structure: the conditions which exist in a market including the number of firms.
 Competitive markets
Definition of competitive market
Competitive market: a market with a number of firms that compete with each other.
 Each firm will have a small share of the market.
 There is free entry into and exit from the market.

Behavior of competitive firms

Low Price
 If an individual firm charges a higher price, it runs the risk of losing all of its sales to its
rivals as the products are likely to be close substitute.
 A high level of competition >> promote efficiency, provides firms with an incentive to
produce at the lowest possible cost >> low price
High quality
 Firms may seek to gain a competitive advantage by improving their products, and
respond more quickly to consumers’ demands.
Profit
Normal profit: the minimum level of profit required to keep a firm in the industry in the long
run.
Supernormal profit: profit above that needed to keep a firm in the market in the long run.
 In the short run, firms may earn more, or less than normal profit. They can earn
supernormal profit or get loss when demand falls.
 In the long run, there is no barriers to entry and exist, firms can only earn normal profit.

 Monopoly markets
Definition
Monopoly: a market with a single supplier.

Characteristics
• The firm is the industry. It has a 100% share of the market.
• There are high barriers to entry and exit, making it difficult for other firms to enter the
market.
• A monopoly is a price maker. Its output is the industry’s output and so changes in its
supply affect the market price.

Effect of monopoly
Advantage

40
 A monopoly could be relatively efficient and actually benefit consumers. If it produces
on a large scale, its unit cost and price may be lower than that in a more competitive
market.
 In some cases, a monopoly would definitely be more efficient than competition. It
prevents the wasteful duplication of capital equipment.
 A monopoly’s high profits would enable it to spend on research and
development, and therefore, it may introduce new, improved
variations.
Disadvantage
 The absence of competition may lead to inefficiency.
 A monopoly may restrict the supply to push up prices and may produce a poor-
quality product.
 It may fail to respond to changes in consumer tastes and develop new products.

Exercise

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