IGCSE Economics Revision Guide

Table of contents

1. Basic Economic Problem.................................................................................................................3

1.2 Factors of Production.....................................................................................................5
1.3 Opportunity Cost .............................................................................................................8
1.4 Production Possibility Frontier ..................................................................................9
2. The allocation of resources......................................................................................................... 13
2.2 The role of markets in allocating resources ......................................................... 13
2.3 Demand........................................................................................................................... 16
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2.4 Supply .............................................................................................................................. 18

2.5 Price determination .................................................................................................... 20
2.6 Price changes................................................................................................................. 24
2.7 Elasticity of demand .................................................................................................... 27
2.8 Price Elasticity of Supply (PES) ................................................................................ 32
2.9 Market economic system ........................................................................................... 34
2.10 Market failure ............................................................................................................. 35
2.11 Mixed Economic system ........................................................................................... 37
3 Microeconomic decision makers................................................................................................ 41
3.1 Money and banking ..................................................................................................... 41
3.2 Households .................................................................................................................... 42
3.3. Workers ......................................................................................................................... 44
3.4 Trade unions ................................................................................................................. 50
3.5 Firms ................................................................................................................................ 53
3.6 Firms and production ................................................................................................. 58
3.7 Firms’ costs, revenue and objectives ...................................................................... 60
3.8 Market structure .......................................................................................................... 64
4. Government and the macroeconomy ...................................................................................... 67
4.2 Economic Objectives of the government ............................................................... 67
4.3 Fiscal policy ................................................................................................................... 69
4.4 Monetary Policy ............................................................................................................ 73
4.5 Supply-Side Policies..................................................................................................... 75
4.6 Economic growth.......................................................................................................... 77
4.7 Employment and Unemployment ............................................................................ 83
4.8 Inflation and deflation ................................................................................................ 89
5. Economic development ................................................................................................................. 95
5.1 Living Standards ........................................................................................................... 95
5.2 Poverty ............................................................................................................................ 98
5.3 Population ...................................................................................................................... 99
5.4 Differences in economic development ................................................................. 100
6. International trade and globalisation ................................................................................. 101
6.2 Globalisation and Free trade.................................................................................. 101
6.3 Exchange Rates ........................................................................................................... 105
6.4 Balance of payments ................................................................................................. 107
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1. Basic Economic Problem

• The fundamental economic problem is the issue of scarcity and how best to produce
and distribute scare resources.
• Scarcity means there is a finite supply of goods and raw materials.
• Finite resources means they are limited and can run out
• Unlimited wants mean that there is no end to the quantity of goods and services
people would like to consume.
• Because of unlimited wants - People would like to consume more than it is possible to
produce (scarcity)
• Therefore because of scarcity, economics is concerned with:

o What to produce?
o How to produce?
o For whom?

• Needs – an economic need is a good or service considered essential to maintaining a

basic living standard. Needs will include food, shelter, clothes and access to basic
health care.
• Wants – An economic want is a good or service that a consumer would like to have.
If they had sufficient money, then then would purchase these good that they want.

Examples of the economic problem

Consumers

Households have limited income and they need to decide how to spend their finite
income.

• For example, with an annual income of £20,000, a household may need to

spend £10,000 a year on rent, council tax and utility bills.
• This leaves £10,000 for deciding which other food, clothes, transport and other
goods to purchase.

Workers

Householders will also face decisions on how much to work.

• For example, working overtime at the weekend will give them extra income to
spend, but less leisure time to enjoy it.
• A worker may also wish to spend more time in learning new skills and
qualifications. This may limit their earning power in the short-term, but enable
a greater earning power in the long-term.

Producers
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A producer needs to remain profitable (revenue higher than costs).

• It will need to produce the goods which are in high demand and respond to
changing demands and buying habits of consumers - for example, switching to
online sales as the high street declines.
• Firms may also need to make long-term investment decisions to invest in new
products and new means of production.

Government

The government needs to decide how they collect tax and then they need to decide
whom they spend money on.

• For example, the government may wish to increase spending on health care, but
this will require higher taxes.

Economic good
• Economic goods have a degree of scarcity and therefore an opportunity cost.
• An economic good also is a good or service that has a benefit (utility) to society.

Free good
• A free good is a good needed by society but available with no opportunity cost. It is a
good without scarcity.
• For example, air is a free good, because we can breathe it as much as we want. By
breathing, we do not diminish the available resource for other people.

Example of difference between free and economic good

• If we live by a river, taking a drink of water is a free good – because there is an

unlimited supply of water.
• However, if we want a bottled mineral water, then it is an economic good. There is a
limit to the amount of plastic that we can produce. Also, producing a plastic bottle and
mineral water has an alternative – we could have used the same resources to produce
other goods.
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1.2 Factors of Production

These are different elements that are needed to produce goods. The main factors of
production are:

1. Land – Raw materials taken directly from the earth, land or sea. This includes wood,
oil, water, and fish. They are resources that can be taken from the natural
environment.
Ownership of land enables the landlord to earn rent or sell the land to others.
2. Labour – Workers who help to produce goods and services.
Labour will earn wages/salary.
3. Capital – Man-made inputs used in the productive process. For example, machines
used to convert natural resources into manufactured goods.
The value of capital is the production of goods, that can be sold from using the
capital
4. Entrepreneur. People who set up a business. You could think of people like Richard
Branson who set up companies like Virgin.
Entrepreneurs can pay themselves a salary, but the main reward is profit from
a successful business.

Another possible factor of production

• Knowledge/human capital - the skills and ability of workers. For example, a doctor
who spent 15 years studying medicine is more productive than non-skilled workers.
o Human capital can enable workers to get a better paid job.
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Examples of factors of production

Land - raw materials

• Oil, Coal, metals Fish

• Agricultural produce - fruit, vegetables, meat
• Commercial real estate - land to build factories

Labour (human resources)

• Workers - full time, part-time, temporary, permanent

• Management

Capital (man-made resources)

• Machines, tractors, spades

• Computers, Phone
• Office block, factory, assembly line
• Public infrastructure - communication and roads needed to transport goods across the
country.

Entrepreneurs (individuals who bring factors of production together

• Self-employed
• People who start up businesses - Anita Roddick, Bill Gates, Richard Branson
• Finance - Entrepreneurs needs access to money - either savings or loans from banks to
get started.

Combination of factors of production

Examples of how different goods and factors of production are inter-related.

Example - Coffee

• The Entrepreneur purchases land to grow coffee plants. In this industry land is an
important factor - it needs to have the right climate and soil to grow the coffee.
• The company then need to employ workers to look after tea and at harvest time pick
the coffee beans.
• The entrepreneur (farmer) will also need to invest in some capital - farming tools,
baskets and vehicle to deliver the crop to the market.
• This is a relatively labour intensive industry because labour costs will incur a high %
of total production costs.

Example – Car production

• The firm will need land for a factory.

• They will need to invest significantly in sufficient capital – machines, robots and
tools to build cars.
• With a large factory, the firm will then need to employ skilled labour to work and
operate the machinery.
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• The industry is relatively complex and will require a degree of specialisation - with
workers concentrating on a range of tasks from technological innovation to marketing
and design.
• This industry will be relatively capital intensive. (Capital is a high % of total costs)

Mobility of factors of production

Mobility refers to how easily factors of production can be used and transferred between
different economic uses.

Land. Land has often considerable immobilities. If a business owns a piece of land, it can be
time-consuming to sell the land to another business.
In the production of raw materials like coal and gas, the geographical location cannot be
changed. The mobility of land depends on:
• How easy it is to buy and sell land and raw materials.
• The geographical location.

Labour. Labour can display different levels of mobility. For example, a labourer could move
between different building jobs. They could also take work picking crops in the field.
However, labour can also show immobilities. If new jobs are created in high-tech industries,
then it may take time for an unskilled worker to become skilled in the new type of
employment.

• Better education and training can increase labour mobility

• Also, a good housing market – with flexible and low-cost renting enables workers to
move more easily around the country to where jobs are available.

Capital. This refers to how easy it is for firms to employ different machines and capital
equipment. The mobility of capital depends on:
• Ability of firms to borrow and invest in new machines
• A second hand market for buying and selling different capital goods
• Availability of technology, such as 3D printing which makes it easier to produce
different types of capital.

Entrepreneurs. In some countries, we see more entrepreneurship. Factors which encourage

people to set up business include:
• Availability of finance
• Absence of regulations which impinge on firms ability to set up business
• A Stable economic environment. (e.g. low inflation)

Quantity and quality of factors of production

Factors which determine quality and quantity of factors of production.

Land
• Discovering more raw materials.
• Planning permission to build on land
• New technology which enables mineral extraction
• Climate changes which influences productivity of agricultural land.
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Labour
• Education and training increase labour productivity
• Immigration – higher birth rate, increases labour force
• Better childcare enables more women to work.
• Industrial relations – influence worker motivation

Capital
• Better technology
• Easier to borrow to finance investment
• State of technology

Entrepreneurs
• Low tax regime encourages innovation.
• Quality of infrastructure – roads, railways.

1.3 Opportunity Cost

Key words : 1) Cost 成本
2)2 Cho i ce （Res t Home ; Orphanage 养⽼院；孤⼉院)
3)Cho i ce t he bes t one
4)G i ve up t he second bes t

• Opportunity cost is the cost expressed according to the next best alternative/choice foregone.
• If you choose one option, the opportunity cost is what you can’t benefit from.
• Economic choices refer to decisions that involve an opportunity cost. For example,
spending money on food or rent.
• Examples of opportunity cost:

o The opportunity cost of buying a CD for £10 is a book you now can’t buy.
o If the government spend £1 billion on health care, this £1 billion can’t be spent
on building a new road.
o If you spend 10 hours revising at the weekend, this is 10 hours that you cannot
use for leisure.
o If you spend money on employing an extra 10 workers, the opportunity cost is
that the firm cannot use this money for investing in new capital.
o If the government builds a new coal-fired power station the benefit is
increased electricity production, the opportunity cost includes damage to the
air quality and extra pollution.

• Opportunity cost is faced by consumers, firms and governments. There are always
alternative uses of scarce resources
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1.4 Production Possibility Frontier

A production possibility frontier (PPF) shows the maximum output that an economy can
produce if the economy is maximising the use of its resources and operating efficiently.

Points on PPF Curve

• D = inefficient (Within PPF)

• A or B = It is impossible to choose more
of consumer goods or environment units
without an opportunity cost.
• C = impossible (without economic
growth)

• If we move from point A to B, we gain an extra 3 units of the environment. However,

the opportunity cost is we have to forego 4 units of consumer goods.

Trade off between health care and military spending

• Increasing output of military (A to B) has an opportunity cost of less health care.

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Economic growth

• Economic growth enables the PPF curve to shift to the right, enabling point A2 and
B2 (more consumer goods and services).
• Economic growth increases the productive capacity of the economy.

Causes of economic growth

• Discovering more raw materials (e.g. discovering oil fields)

• Increase in the size of work force (e.g. immigration)
• Increase in capital stock (e.g. investment in new machines, factories)
• Increase in labour productivity (e.g. due to better technology)

Production possibility frontier and efficiency

• We say that any point on the PPF curve is productively efficient.
• This is because on the PPF curve it is not possible to produce more of one unit,
without producing less of another unit.
• However, productive efficiency is not the only criteria.
• Allocative efficiency is concerned with choosing the best combination of
goods/services – capital goods/consumer goods.
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PPF consumer and capital goods

• In this example, there is a choice between consumer goods (goods we use, e.g. food)
and capital goods (e.g. machines used to manufacturer goods)
• If the economy increases capital goods, in the short-term there is an opportunity cost
of fewer consumer goods. However, by increasing capital goods – there is investment
and in the long-term there is an increase in the production potential of the economy.

Economic growth and sustainability

Environmental sustainability is concerned with whether environmental resources will be

protected and maintained for future generations.

A big debate is the extent to which economic growth conflicts with environmental
sustainability.

• On the one hand - rising output leads to the higher consumption of resources, greater
pollution and greater demand on natural resources.
• However, certain types of economic growth can still be compatible with
environmental sustainability. For example, technological development has meant
that in theory, we could generate power from renewable resources.
• Therefore, it may not be necessary to stop economic growth, but change economic
growth, focusing on environmentally sustainable types of economic growth.
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• This simple production possibility frontier PPF shows a trade-off between consumer
goods and the environment (non-renewable resources).
• If we increase our consumption of consumer goods (non-renewable resources) then
there is an opportunity cost of reducing the available non-renewable resources and it
can reduce the long-term sustainability of the environment.
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2. The allocation of resources

Microeconomics
Microeconomics is the study of particular markets, and segments of the economy.
Microeconomics looks at issues such as:

• Consumer behaviour and consumer choice

• Different product markets
• Individual labour markets – labour supply and demand
• Whether markets are competitive or monopolies.
• In microeconomics the main decision makers are: Workers, firms, entrepreneurs

Macroeconomics
• Macro economics is the study of the whole economy.
• Macroeconomics looks at ‘aggregate’ variables, such as aggregate demand, national
output and inflation.
• Macroeconomics is also concerned with international trade and how different national
economies interact with each other.
• It is concerned with the choices of governments who decide how much to tax and
where and for whom to spend money
• Macroeconomics also examines the decisions of Central banks who set interest rates
to try and control inflation.

2.2 The role of markets in allocating resources

• A market is a place where buyers and sellers meet to trade goods and services.
• It can be a physical place – like a farmers market or it can refer to a collection of
different outlets selling similar goods.
• A product market refers to a place where goods and services are bought and sold
• A factor market refers to the employment of factors of production, such as labour,
capital and land.

Key resources allocation decisions

• The economic problem creates questions about
• What to produce, how to produce and for whom to produce
• The market is a mechanism for allowing these questions to be decided by market
forces.
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Product markets
• Demand for product markets comes primarily from households
• The main sellers of goods are different kinds of firms.
• Demand for goods is a direct demand. The good is bought for its intrinsic use.
• The market facilitates the exchange of goods and services in the economy. It is based
on a voluntary transaction across a wide range of places.
• Product markets rely on the operation of supply and demand to determine prices

Effect of an increase in demand

• In this case, an increase in demand can lead to an increase in the price of the product.

Examples of Product markets

• Farmer's market selling vegetables direct to the public

• Fish market
• Supermarkets selling a range of goods in a convenient place.
• Amazon.com - Offering the direct sale of goods, and marketplaces for intermediaries
• Ebay.com - Offering individuals the opportunity to sell goods.
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2.2.3 Price mechanism

• The price mechanism refers to how in free markets, resource allocation is determined
by ‘market forces’ – the price mechanism.
• For example, if there is a shortage of a good, this will cause a rise in the price. As the
price rises this creates an incentive for other firms to try and produce.
• If there is a surplus of the good, this will cause lower prices and firms will cut back on
production.

Interaction between markets

The price mechanism can also influence related markets.

1. Increase in demand for product leads to increased demand for factors of production.
For example, if there is a rise in demand for cars, there will be increased demand for
petrol and indirectly for oil.

In this case, the rise in demand for mobile phones and other mobile devices has led to a
strong rise in demand for lithium. Lithium is used in the batteries.
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2.3 Demand
The individual demand curve illustrates the price people are willing to pay for a particular
quantity of a good.

The market demand curve illustrates the price all consumers in the whole economy are
willing to pay.

Movement along the demand curve

A change in price causes a movement along the demand curve.

• A higher price reduces demand.

• A lower price increases demand.
An increase in price from $12 to $16 causes a movement along the demand curve, and
quantity demand falls from 80 to 60.
A change in price doesn’t shift the demand curve – we merely move from one point of the
demand curve to another.
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Shift in the Demand Curve

A shift in the demand curve occurs when the whole demand curve moves to the right or left.
For example, an increase in income would mean people can afford to buy more widgets even
at the same price.
The demand curve could shift to the right for the following reasons:

• An increase in disposable income, such as higher wages and lower taxes giving
consumers more spending power.
• An increase in the quality of the good. For example, mobile phones are now more
versatile and powerful, making them more attractive.
• Advertising can increase brand loyalty to goods and increase demand.
• An increase in the price of substitutes. For example, if the price of O2 Mobile phone
calls goes up, the demand for Vodafone mobiles will increase.
• A fall in the price of complements. For example, a lower price for Apple apps will
increase demand for Apple iPhones.
• Weather. Cold weather increases demand for heating.
• Seasonal factors.
Evaluation

• It depends on the type of good. A rise in income will not have any effect on demand
for salt, but it will have a bigger effect on demand for luxury cars.
• Some goods will vary due to seasonal factors like the weather and time of year (e.g.
scarves and air conditioners).
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2.4 Supply
The supply curve refers to the quantity of a good that the producer plans to sell in the market.

• As price increases, firms have an incentive to supply more because they get extra
revenue (income) from selling the goods.
• If price changes, there is a movement along the supply curve.
• E.g. an increase in the price from £40 to £50 causes an increase from 30 to 33.

Joint supply

Joint supply occurs when two goods are supplied together from the same source.

For example, the supply of beef and leather are linked because both come from the cow. With
an increase in the supply of beef, you also get more leather.
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Shifts in the supply curve

An increase in supply occurs when more is supplied at each price, e.g. a shift in supply from
S1 to S2. This could occur for the following reasons:

• A decrease in the costs of production. This means that business can supply more at
each price. Lower costs could be due to lower wages or lower raw material costs.
• An increase in the number of producers will cause an increase in supply. For example,
a new firm, like Tesco diversifying into mobile phone production.
• Expansion in the capacity of existing firms, e.g. investment to extend the size of a
factory.
• An increase in the supply of a complementary good, e.g. beef and leather.
• Favourable climatic conditions, which are very important for agricultural products,
e.g. good weather will give a good harvest.
• Improvements in technology, e.g. computers and the Internet enables more to be
produced for a lower cost.
• Lower taxes on the good, e.g. lower petrol tax.
• Government subsidies on the good (government paying part of the cost).
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2.5 Price determination

Market equilibrium occurs where supply = demand and there is no tendency for the price to
change.

Market equilibrium
The price mechanism refers to how supply and demand interact to set the market price and
the amount of goods sold.

The equilibrium price is at P1, Q1.

Excess demand
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If the price is below equilibrium (p2), demand is greater than supply (Q2 – Q1) – causing a
shortage.

• Therefore, with consumers wanting to buy more firms will put up prices and supply
more.
• As price rises, there will be a movement along the demand curve and less will be
demanded.
• Prices will rise until supply equals demand.

Excess supply

• If the price is above equilibrium (p2), supply is greater than demand (Q2-Q1) –
causing a surplus.
• To sell the unsold goods, firms reduce the price and reduce supply (movement along
supply curve). The lower price also encourages more demand.
• The price falls to P1 where supply equals demand.
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Impact of an increase in demand

• If consumers saw an increase in income, we would see an increase in demand for
goods like TV’s; the demand curve would shift to the right.
• Initially, there would be a shortage, but the higher demand would cause the price to
rise and suppliers to supply more.

The increase in demand causes an increase in price (P1 to P2) and an increase in quantity
(Q1 to Q2).

In the long-term, the higher prices may encourage more firms to enter the market and the
supply curve will shift to the right.

For example, in the past two decades, there has been a rise in demand for mobile phones.
This has encouraged new firms to enter the market and increase the available supply.
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2.5.2 Market disequilibrium

• A disequilibrium occurs when there is a shortage or surplus of the good.

• Disequilibrium will occur if the price is above or below the point where demand and
supply meet.

• For example, if the price is set below the equilibrium, the demand will be greater than
the supply. This will lead to queues as consumers wait to be able to buy the product.

• For example, in this case, there is a football stadium with a capacity of 55,000. The
price of tickets is set at £40.
• However, at this price, potential demand is 65,000.
• Therefore, there is a shortage and 10,000 spectators will not be able to buy tickets,
even though they would be willing to pay the price of £40.
• Prices would need to rise to £77 to regain equilibrium.
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Price above the equilibrium

At a price of P2, the supply is greater than demand, meaning firms have excess stock they
cannot sell. There is a surplus of Q3-Q2.

This might occur, if the government or trade council placed a minimum price for a particular
good, for example agricultural produce.

For example, if there is a very good harvest of potatoes, the supply will increase, but if a
minimum price for potatoes is maintained then there will be an unsold surplus

In a free market, you would expect the market price to fall to P1, where demand = supply.

2.6 Price changes

• A change in market supply or demand will cause a change in price and quantity. For
example, rising demand will tend to raise prices. An excess supply (glut) will tend to
lower prices in a market mechanism.
• Changes in price help firms respond to signals and changes in demand.
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Fall in supply
If the availability of oil decreased, we would see a fall in supply.

The fall in the supply of oil causes the price to rise and a small fall in demand. Since
demand for oil is inelastic, we see a relatively bigger increase in the price.

• The producer revenue was 9 million * $110 = $990

• After the price rise, the revenue is 8 million * $190 = $1,520
• Revenue has increased by $530.

Impact of fall in supply in long term

• If the price of oil increased, it may start to make it profitable to produce oil from
new places, such as Alaska and Antarctic.
• Previously it was too costly to produce oil from here, but the higher price may
make it worthwhile.
• If the price of oil rises, in the long-term people may respond to higher prices by
switching to other forms of transport which don’t use petrol.
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Factors that could explain a fall in the price of a good

• The price of a good, such as coffee, would fall if there was a fall in demand and/or an
increase in supply.

Fall in the price from P1 to P2

The demand for coffee could fall for various reasons such as:

• Lower incomes mean that consumers cannot afford to buy as much.

• Coffee becomes less fashionable.
• A fall in the number of coffee shops.
• Health concerns about caffeine.

The supply of coffee could increase for various reasons such as:

• An increase in the number of suppliers or countries producing coffee.

• Lower costs of production, e.g. lower wage rates in coffee-producing countries.
• Government subsidies, e.g. Latin American countries may wish to subsidies the coffee
farmers.
• Higher labour productivity in producing coffee, which will decrease the costs of
production.
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2.7 Elasticity of demand

• Price Elasticity of Demand (PED) measures the responsiveness of demand to a
change in price.

• For example, if the price of coffee increases 10% and the demand falls 2%, then
the PED = 2/10 = -0.2
• If price of iPhone falls from £600 to £450 and
Q.D increases from 5,000 to 6,000. What is PED?
o % change in Q.D = 1,000/5000 = 0.2 or 20%
o % change in Price = -150/600 = -0.25 or - 25%
o PED = 20/25 = -0.8
Elastic Demand
• Demand is price elastic if a change in price leads to a bigger percentage change in
demand.
• The PED will therefore be greater than 1. E.g. PED = -2.5
• An example might be Lipton tea. If Lipton Tea increases in price 10%, demand may
fall 17%. PED = -1.7
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Characteristics of Elastic Goods

1. Luxury goods (e.g. organic food)

2. They are expensive and a big % of income (e.g. sports cars and holidays)
3. Goods with many substitutes, e.g. if the price of Volvic water increased, there are
many alternative types of mineral water.
4. Goods in a competitive market. For example, if Tesco put up the price of its bread
there are many alternatives, so people would be price sensitive and people would buy
alternatives.
5. Goods which are bought frequently.

Inelastic Demand
• Demand is inelastic if a change in price leads to a smaller percentage change in Q.D.
• PED will be less than -1 e.g. -0.5

Example of inelastic demand

• Petrol – few alternatives

• Coffee – people like coffee and there are few close substitutes
• Apple Mac – for keen buyers, they don’t think substitutes are as good.
• Electricity – A necessity for most people.
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Example of inelastic demand

• In this example, the price of tobacco increases 40% and demand falls 10%.
• Therefore the PED of tobacco = -0.25
• This is inelastic as it is less than 1

Total revenue spent on the good:

• Initially, the revenue was 88 *$10 = $880
• After the price rise, the revenue is 80*$14= $1,120

Characteristics of Inelastic Goods

• They have few or no close substitutes, e.g. diamonds have few substitutes.
• They are necessities, e.g. petrol to drive a car and get to work.
• They are addictive, e.g. smokers keep buying cigarettes, even if the price goes up.
• They cost a small % of income or are bought infrequently, e.g. salt.

• In the short-term, demand is usually more inelastic because it takes time to find
alternatives. But, over time, demand may become more elastic.
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Significance of Elasticity

1. Revenue and elasticity

If demand is inelastic then increasing the price can lead to an increase in revenue.

In this example, the price of oil rises from $110 a barrel to $190, and the quantity falls from 9
million to 8 million.

• Revenue was $110 × 9 = $990 million

• Revenue is now $190 × 8 = $1,520 million
• An increase in revenue of $530 million
This is why OPEC tries to increase the price of oil, because higher oil prices are more
profitable.

What is the PED of oil in this example?

• % change in Q.D 1/9 = -0.11 (-11.1%)

• % change in price 80/110 = 0.727 (72.7%)
Therefore, PED of oil = -11.1 / 72.7 = -0.15 (inelastic)
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If demand was price elastic

• Price rises from £110 to £130 – (20/110) = 18%

• Quantity falls from 9 to 4 (5/9) = -55.5%
• Revenue was 110 × 9 = £990
• Revenue has now fallen to 4 × £130 = £520
• A fall of £470
PED of this example -55/18 = - 3.05 (elastic demand)

Importance of inelastic demand to firms

1. If demand is inelastic then increasing the price can lead to an increase in revenue.
2. In the example below, the supply of oil is reduced from S1 to S2. This causes the
price to increase from $15 to $30. However, because demand is inelastic, there is only
a small fall in demand.
3. Firms will try and make demand more inelastic if they can, e.g. brand loyalty.
Monopolies have an inelastic demand curve because consumers have no alternatives,
therefore, they can charge higher prices.
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2.8 Price Elasticity of Supply (PES)

• Price elasticity of supply measures the % change in quantity supplied after a change in
price.
• Price elasticity of supply measures the responsiveness of quantity supplied to a
change in price.

Inelastic Supply
• This means that an increase in price leads to a smaller % change in supply.
• Therefore PES <1

Supply could be inelastic for the following reasons

1. Firms operating close to full capacity.
2. Firms have low levels of stocks; therefore there are no surplus goods to sell.
3. In the short term capital is fixed, therefore firms do not have time to build a bigger
factory.
4. If it is difficult to employ factors of production, e.g. if skilled labour is needed.
5. With agricultural products supply is inelastic in the short run because it takes at least
6 months to grow crops.
 33

Elastic Supply

• This occurs when an increase in price leads to a bigger % increase in supply, therefore
PES >1
• This means that an increase in price leads to a smaller % change in supply. Therefore
PES <1

Supply could be elastic for the following reasons:

1. If there is spare capacity in the factory
2. If there are stocks available
3. In the long run supply will be more elastic because capital can be varied.
4. If it is easy to employ more factors of production.
5. In competitive markets supply is more likely to be elastic. As price increases, firms
can easily enter into the market and supply more.

Implications of Price Elasticity of Supply

• If supply is inelastic, it means firms will struggle to increase supply in response to a
change in price. However, it means that an increase in demand will cause a big
increase in price and make the good more profitable.
• If supply is elastic, it means an increase in demand will lead to only a small increase
in price. But, the firm can easily supply more in response to higher demand.
• The best combination would be for the industry supply to be inelastic, but for an
individual firm to be able to increase its own supply when price goes up.
 34

2.9 Market economic system

A market economic system is an economy based on the principles of free market enterprise. It
means the majority of goods and services are provided by private individuals and firms. In a
market economic system
• Firms decide what to produce and how to produce. Firms are influenced by the price
mechanism. For example, if there is a shortage of a good, the price will rise, making it
more profitable to produce.
• To stay in business, firms will need to cut costs and remain efficient, so they will be
seeking to produce it in a more efficient way.
• In a free market, prices are determined by the ‘invisible hand’ of the market
mechanism. Governments do not set prices, but they are determined by the market
equilibrium price
• Consumers are sovereign to decide what to purchase.
• Households will also look for work and seek employment.

Role of government in market economic system

• In a market economic system the role of the government is limited. The main function
of the government will be
• Secure law and order and the protection of private property.
• Provide public goods, such as national defence, sewage and other amenities, not
provided in a free market.

Advantages of market economic system

• Incentives to be efficient. Most business and industry can be managed by private
firms. Private firms tend to be more efficient than government controlled firms
because they have a profit incentive to cut costs and be innovative.
• Limits government interference. Market economic economies can reduce the
amount of government regulation and intervention prevalent in a command economy.
• Macroeconomic stability. Governments can pursue policies to provide
macroeconomic stability, e.g. expansionary fiscal policy in times of a recession.
• Even libertarians who dislike government intervention believe there needs to be a
legal support for private property and government provision of law and order.

Disadavantages of market economy

• Market failure. In a free market economy, there may be cases where the free market
fail to provide an efficient allocation of resources. This can include:
o The abuse of monopoly power, e.g. firms with monopoly power set higher
prices for consumers
o Goods which create negative externalities, e.g. burning fossil fuels create
pollution,
o The under-consumed/under production of goods with positive externalities.
This can include merit goods like education and healthcare and public goods,
like police and national defence.
• Inequality. The wealthy will tend to be able to accumulate greater wealth in a free
market. This is due to:
o The ability to inherit wealth
 35

o People with wealth and assets can use profit and dividend to purchase more
assets. The rich can accumulate more.
o The wealthy are likely to be able to create monopoly power, which
exacerbates inequality.
o In a free market, there will be periods of unemployment, leaving some people
with no income.
• Under-provision of public goods (e.g. defence and law and order – goods which are
non-rivalry and non-excludable)
• Under-provision of merit goods like health and education – goods with positive
externalities and services where people may under-estimate benefits of a good.
• Information failure – a lack of information about the best way to use resources, e.g.
moral hazard in insurance.
• Instability of free markets. John Maynard Keynes argued capitalism has a tendency
to boom and bust economic cycles – which leads to periods of mass unemployment.
• Over-production of negative externalities e.g. environmental pollution and
congestion, which lower living standards.
• Over-consumption of demerit goods – goods where people may ignore or under-
estimate costs, e.g. smoking, alcohol.
• Unsustainability. Free markets are concerned with the present moment but ignore
implications for long-term ecological stability. For example, free markets may lead to
the over-use of raw materials.

2.10 Market failure

• Definition of Market Failure – Market failure occurs when there is an inefficient
allocation of resources in a free market.

Causes of market failure

• Externalities – costs/benefits to third parties EG: K12 教育
• Monopoly – when firms have market power and can set higher prices
• Factor immobility. Geographical and occupational immobilities – e.g. when there are
jobs in the south, but it is difficult for the unemployed to move to the north.
• Public goods – e.g. law and order EG: Road Light
• Merit goods – good people tend to under-value, e.g. education
• Demerit goods – goods people tend to over-value, e.g. drugs, smoking.

Externalities
• Externalities: These occur when a third party is affected by the decisions and actions
of others. For example, producing electricity can cause carbon emissions and
pollutions.
• External cost – the cost imposed on third parties, e.g. pollution or effects of passive
smoking
• External benefit – benefit given to third parties, e.g. if you gain education – others
will benefit from your knowledge
• Social benefit is the total benefit to society = private benefits + external benefits.
• Social costs – is the total cost to society = private costs + external costs.
 36

Merit Good
A merit good is usually under-consumed in a free market. This is because:
o People do not realise the true benefit of consuming the good.
o These goods have positive externalities

Examples include:
• Health (people ignore benefits of getting a vaccination),
• Education (people may ignore benefits of studying for exams).

Demerit good
A demerit good is usually over-consumed in a free market. This is because:
• People don’t realise or ignore the costs of consuming the good.
• Usually these goods have negative externalities.
• Examples include:
o alcohol, fatty foods,
o smoking, and drugs.

Public goods

Public goods are goods with two characteristics:

• Non-rivalry: When a good is consumed it doesn’t reduce the amount available
for others. E.g. street lighting.
• Non- excludability: This occurs when it is not possible to provide a good without
it being possible for others to enjoy. For example, if you pay for the police and
provide law and order, that service (law and order) is available for everyone.
• Public goods are often not provided at all because once provided, you can’t stop
people using them for free.
• Examples include: law and order, national defence, street lighting and public
gardens. Public goods have two characteristics.

Positive externalities

• Positive externalities occur when the consumption or production of a good causes a

benefit to a third party.
• When you consume education you get a private benefit. But there are also benefits to
the rest of society. For example, you are able to educate other people and therefore
they benefit as a result.
• Therefore with positive externalities the benefit to society is greater than your
personal benefit. The Social Benefit is greater than the Private Benefit.
• Goods with positive externalities tend to be under-consumed in a free market.
 37

Negative Externalities
• Negative externalities occur when the consumption or production of a good causes a
harmful effect to a third party.
• For example, if you play loud music at night your neighbour may not be able to
sleep.
• If you produce chemicals but cause pollution then local fishermen will not be able
to catch fish. This loss of income will be the negative externality.
• With negative externalities the social cost is greater than the private cost.
• Goods with negative externalities tend to be over-consumed in a free market.

2.11 Mixed Economic system

• A mixed economy means that part of the economy is left to the free market, and part
of it is managed by the government.
• Mixed economies start from the basis of allowing private enterprise to run most
businesses.
• In addition, the governments intervene in certain areas of the economy, such as
providing public services (health, education, waste management) and the regulation or
private business (e.g. legal right to private property, and abuse of monopoly power)
• In reality, most economies are mixed, with varying degrees of state intervention.

2.11.2 Government intervention to correct market failure

• Tax – to reduce demand for demerit goods/negative externalities
• Subsidies – to increase demand for merit goods/positive externalities
• Regulations – to limit/prohibit demand for demerit goods
• Direct provision – government provide public goods.
• Minimum prices – guarantee minimum price for goods, e.g. to increase revenue for
farmers
• Maximum prices – prevent excess prices, e.g. if landlords have monopoly power in
setting rents
• Nationalisation – when government takes ownership of large company, e.g. gas,
water, electricity to run directly.
 38

1. Taxes on Negative Externalities

A tax on oil.

• A tax shifts the supply curve to the left. It causes price to rise to $190 and demand to
fall from 9 to 8.
• Therefore a tax can reduce demand for goods with negative externalities.
• A tax also raises government revenue. This can be used for reducing the impact of the
negative externality.

Problems of using tax

• If demand is inelastic then taxes will be ineffective in reducing demand.
• If the government places taxes on goods, it may encourage people to try and evade
paying. (e.g. smuggling cigarettes from another country)
• There may be high administration costs in collecting the tax.
• Taxes may be regressive (take a higher % of income from people with low income).
 39

Subsidies for Positive Externalities

• A subsidy involves the government paying part of the cost to the firm.
• This causes supply to shift to the right.
• The government is effectively paying for part of the good.
• The consumer benefits from lower prices

Subsidy for positive externality

• A subsidy shifts supply to the right. The price falls (from $350 to $200) and
quantity increases. (from 20 to 22)

• Subsidies can encourage consumption of goods with positive externalities (e.g.

trains, education, and health care).
 40

Problems of Subsidies
1. Subsidies are expensive and the government will have to increase taxes.
2. Difficult to estimate the benefits of the positive externality and therefore it is
difficult for the government to know how much subsidy to give.
3. Giving subsidies to firms may encourage inefficiency as the firms can rely on
government aid.
4. If demand is price inelastic, then a subsidy will only have a small effect in
increasing demand.
State Provision

For some services and goods, the government (state) provide them directly.

• For example, the NHS is a government body which provides health care in the UK.
• The maintenance of roads is provided by state bodies.
• Law and order (courts, police and judicial system is provided directly out of general
taxation.

Benefits of Government providing Public Services

1. People may not realise or underestimate the benefits of public services like education.
Free provision encourages people to be educated.
2. Positive externalities. The consumption of health care services has benefits to the rest
of society. A healthy population helps increase labour productivity. They will be
underprovided in the private sector.
3. Economies of scale in providing a national service.
4. Providing a universal service leads to greater equality of distribution.
In a free market, some would be unable to afford to pay.
5. Minimum service standards: important for public services such as health. The private
sector may cut costs by cutting quality of products / service.

Government Failure

This occurs when government intervention leads to an inefficient allocation of resources. E.g.
it could fail to overcome market failure and / or lead to an inefficient allocation of resources.
Government failure can occur for various reasons:
1. Poor information. The govt may have poor info about the type of service to provide.
2. Political interference, e.g. politicians may take the short-term view rather than
considering long-term effects.
3. Administration costs of government bureaucracy in running public services.
4. Lack of incentives: There is no profit motive working in the public sector and this can
lead to inefficiency. For example there could be overstaffing because there is no
incentive to make redundancies.
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3 Microeconomic decision makers

3.1 Money and banking
Definition of Money
• Money is an object used as a medium of exchange between two parties.

There are also different potential definitions of money

• Narrow money is seen as cash - the basic amount of notes and coins in circulation
• Broad money includes notes and coins but also saving accounts and deposits in a
savings account. You can access this money, but it might take longer to get and spend

Functions of money
Without money, we would need a barter economy, which makes specialisation harder.
(e.g. a pig farmer is unlikely to sell me some pork in return for a few hours of economics
tuition) The functions of money include:

• A medium of exchange. Money is a way of paying for goods and services. This
could be gold and silver or notes and coins. It needs to be readily acceptable.
• Store of value. Money can be used to store wealth and easily converted into a form
which can be used for medium of exchange. Though inflation may reduce the value of
money
• Deferred payment. The agreed monetary terms for repaying a debt.
• Unit of account. A standard numerical measurement for valuing goods and services.

3.1.2 Banking

The function of commercial banks/building societies includes:

• Keep money safe for customers

• Offer customers interest on deposits, helping to protect against money losing value
against inflation.
• Lending money to firms, customers and homebuyers.
• If firms wish to invest in increasing capacity, they need to take out a bank loan to
afford the investment.
• Provide services such as cash points and debit cards.
• Offering financial advice and related financial services, such as insurance.

Evaluation of the importance of banking services

• Loans essentials to enable firms to invest and expand. However, banks are not the
only source of finance. Firms may turn to private investors, the stockmarket,
government grants or personal savings.
 42

• In times of recession or shortage of funds, banks may not be willing to lend when
firms need it most.
• Bank lending is profitable for banks and can incur significant costs for the firm.
• Consumers increasingly need banks to pay for bills electronically.
• Bank loans and mortgages provide an opportunity to purchase very expensive items
and pay back over a long period – e.g. house, car.
• The poorest consumers often don’t have access to bank account and bank loans,
causing the poorest to look outside traditional banking to more exploitative loans,
such as pay day loans and money sharks.
• If banks go bankrupt it may cause a loss of confidence in the banking system so the
government may feel the need to ‘bailout banks’ – give them loans so they don’t go
out of business.

Functions of a Central Bank

A Central Bank, e.g. Bank of England (UK), Federal Reserve (US) are responsible for
providing economic and financial stability. They are involved in:

• Money Supply. The Central bank is responsible for issuing bank notes and coins.
They need to print enough to meet demand, without causing excess inflation.
• Lender of Last Resort. A Central bank is also the lender of last resort. This means
that if commercial banks suffer a shortfall of cash then they can always borrow money
from the Central bank.
o This is an important function has it helps maintain liquidity and confidence in
the banking system.
o In 2007 in the UK, a bank Northern Rock couldn’t raise enough funds on the
money markets and were forced to borrow from the Bank of England with
government acting as guarantor.
• Setting Interest Rates. The Central Bank usually have an inflation target of CPI 2%
+/-1. The Bank produces an inflation forecast and set interest rates according to
predictions of future inflation. The Central Bank set the base rate – which influences
all the main interest rates of the commercial banks.

3.2 Households
When households receive income, they can use it to purchase goods or they can save it. For
example, with an income of £20,000, the individual may spend £18,000 on goods and
services but save the rest. Households may wish to save because

• Survive a period of unemployment/low income

• They don’t know what to spend all their money on
• Save for retirement
• Save for purchasing expensive item, like deposit on a house

Households may also borrow to be able to purchase certain items, e.g. taking out a personal
loan to buy a car. Taking out a mortgage to be able to buy a house. Those on low-income
may need to borrow – just to keep up with basic bills.
 43

Factors that influence spending, saving and borrowing

• Interest rates – higher interest rates make it more attractive to save and less attractive
to borrow.
• Income – rising income means consumers have more disposable income to spend on
goods. It also means they can save for the future, e.g. retirement. Those on low-
incomes rarely have the luxury to save. Those on high-incomes will be able to save
considerable sums.
• Confidence – In times of high confidence, consumers more likely to spend and even
borrow. If consumers are fearful of the future (e.g. expect to lose jobs) they will tend
to cut back on spending and save more.
• Life cycle – Young people, who are studying are more likely to borrow and have
negative savings. People in the 40s, are in a position to save for retirement.
Interest rates
• Interest rates determine the amount of interest payments that savers will receive on
their deposits.
• An increase in interest rates will make saving more attractive and should encourage
saving.
• A cut in interest rates will reduce the rewards of saving and will tend to discourage
saving.

Examples of different interest rates

Example of interest rate changes

• £20,000 Loan at interest rate of 7%
• Annual interest rate payment will be 0.07 * 20,000 = £1,400

• If interest rates rise to 9%

• Annual interest rate payment will rise to 0.09 * 20,000 = £1,800
• The rise in interest rates will cost households an extra £400 a year. This will
discourage borrowing.
 44

Example of saving rate changes

• £7,000 savings at 4%.
• Annual interest payments received will be 0.04 * 7,000 = £280
• If interest rates rise to 6%
• Annual interest payments received will be 0.06 * 7,000 = £420
• With higher interest rates, it is more attractive to save money in a bank

Evaluation of interest rate changes

• Interest rates are not the only factor which determine demand for saving and
spending.
• In a recession/high unemployment, low interest rates may be insufficient to encourage
borrowing.
• Some households may want to borrow, but banks may refuse to give a loan because
they don’t have confidence in their ability to repay.

3.3. Workers
The labour market refers to the supply and demand of workers in a particular industry. For
example, firms need people to work in shops. The supply and demand for shop workers will
determine their wage.

Definitions in the Labour Market

• Gross income – This is the income before tax is deducted.

• Net income – this is the income the worker receives after the deduction of taxes and
other compulsory contributions. (e.g. pensions)

• Nominal income – This is the monetary level of income (unadjusted for inflation)
• Real Income – This is the level of income after adjusting for inflation.
• For example, if your actual wage increases 7%, but inflation is 2%, then your real
wage has increased by 5%.
• If wages increased by 8%, but inflation was 8%. It would mean your wages would
still buy the same amount of goods. Therefore, your real income has stayed the same.

Factors affecting choice of occupation

Individuals choice of job/career/occupation will depend on how attractive the job is compared
to the alternatives. Several factors will influence the choice of occupation.

• Wages. All things being equal, higher wages, will make a particular occupation more
desirable. Students are more likely to choose a high paying profession than low-
paying profession
• Non-wage factors. However, wages is not the only factor that will influence choice
of occupation, there are also non-wage factors, such as:
 45

• Qualifications and skills required. Often the highest paying jobs require challenging
qualifications. A lawyer is highly paid, but the long period of training and
qualification will put some people off.
• Cultural expectations. Sometimes the choice of occupations may be influenced by
social and cultural factors. For example, in coal-mining/ship-building areas, young
people may wish to follow their parent's career.

• Non-wage satisfaction from a job. Many individuals will choose a job which
enables them to gain a high utility/satisfaction from doing the job. For example, a job
like becoming a nurse or teacher may be relatively low paid, but it gives value to the
worker.
• Different types of non-wage benefits. There are many factors that influence how
much individuals will appreciate their career. Non-wage benefits of jobs include:
o Do they enjoy working in that particular environment? e.g. some may wish to
work as gardener - rather than in an office.
o Is there a chance for individual responsibility and taking the initiative in
particular areas of the job?
o Does it afford flexible working hours? e.g. suitable for parents who need to
look after children
o Is the job creative or is it dull and repetitive?

3.3.2 Wage determination

Wages are determined by supply and demand

• In the diagram on the left, supply and demand are both elastic. This could be an
unskilled job such as a cleaner. Therefore, wages are relatively low.
• On the right, supply and demand are inelastic leading to a higher wage. This could be
a lawyer where supply and demand are inelastic.
 46

Demand for Labour depends upon:

• Productivity of workers – higher productivity of labour = higher demand.
• Demand for good – labour is a derived demand. E.g. if there is high demand for
watching football, clubs will be willing to pay higher wages to footballers because
there is substantial money in the sport.
• Wages. Higher wages cause a movement along the demand curve.
• Non-wage costs include paying national insurance, health insurance, and potential
redundancy pay.

Elasticity of Demand for Labour

The elasticity of demand for labour measures how responsive demand for labour is after a
change in wages. Elasticity of demand for labour depends on:

• How essential is the worker? If there are no substitutes for labour, demand will be
inelastic
• Number of people with qualifications and skills. If a small number of workers have
qualifications, demand will be more inelastic.
• Time Period. In the short term, demand for labour will be inelastic. However, other
time it becomes easier to substitute labour for capital.
• Proportion of wage costs. If labour is a high % of total wage costs, the firm will be
more sensitive to a rise in wages.

Workers with inelastic demand are hard to replace. Therefore they tend to have greater
bargaining strength and can demand higher wages.

3.3.3 Reasons for differences in earnings

Why do some workers get paid more?
Wage Differentials between different Occupations
• Skills Required. Jobs that are highly skilled will generally have higher wages. This is
because fewer people can supply their labour.

• Profitability of Industry. In some occupations, there is more money in the industry.

Therefore, wages will be higher. For example, the influx of TV money into football
increased the wages of footballers.

• Trades Union activity. Trades unions can bargain for higher wages. Occupations
with strong trade unions may get higher wages than jobs with little union activity.

• Popularity of job. If a job is a popular because of non-monetary benefits, more will

be willing to supply their labour, pushing down wages.

• Government sector. If a job has wages set by the government (nursing, doctors), then
wages may be lower than the private sector as the government tries to reduce
spending.
 47

Wage Differentials within the same Occupation

In a labour market, such as lawyers, different lawyers will gain different wages for doing a
similar job. Reasons for wage differences include:

• Experience and Qualifications. Workers who have more qualifications and

experience will be able to command a higher salary. Typically older workers gain a
higher wage because of more experience.
• Productivity. If a worker is more productive, he can get a higher wage. For example,
a job such as picking strawberries is likely to depend on quantity of strawberries
picked. However, in a job like teacher or lawyer, it is harder to measure productivity.
But, if a lawyer is more successful in acquitting clients, he should get paid more.
• Discrimination. It is possible some workers may be paid less because of age / sex /
race. In theory, this is outlawed by equal pay legislation, but in practise it can be
difficult to implement.
• Trades Unions. In some industries, members of unions may get a higher wage. But,
part-time temporary staff may get a lower wage.
• Region. Workers in London may expect a London bonus to account for the higher
living costs in London.

Impact of increase in supply of labour on wages

In this example, there has been an increase in the supply of labour. (S1 to S2) This
increase in the supply of labour has led to a fall in wages from W2 to W1.

For example, if there was an increase in net migration, there may be more workers
available to work and this could push down wages for some occupations.
 48

Wage differentials due to geography

In this case, wages in London are higher than wages in Sunderland. This is because of
different local economies and geographical immobilities. Firms in London are more
profitable and so can pay higher wages, but with more expensive housing costs, the
supply of labour is more limited. This causes wages to be higher.

Impact of increase in demand for labour

In this case, workers become more productive and so firms are willing and able to pay a
higher wage, workers add more revenue to the firm. Demand increases to W2 and this causes
wages to rise to W2
 49

3.3.4 Division of Labour/Specialisation

• This occurs when workers concentrate on different tasks with a certain firm.
• Rather than try to master all aspects of production, some workers will specialise in
various aspects of work.
• For example, in a car building firm, some workers will concentrate on design, some
on testing cars and some workers will just do unskilled jobs such as painting the car.
• This means workers don’t need to be trained in all aspects of building a car, but can
become highly skilled in certain areas.

Benefits of division of labour

• Workers only need to be trained for their area of expertise.
• Workers can become expert in their area of work.
• It enables higher productivity and higher wages.
• Workers can make use of their specific skills or qualifications.

Potential costs of division of labour

• If production is highly specialised, production could grind to a halt, if one segment

gets stuck – it is hard for workers to perform different tasks
• Highly repetitive jobs can become boring and workers may feel alienated – which can
be damaging to labour productivity.
• It only works for large scale production

Specialisation of Firms

• Firms will specialise in producing certain goods. This enables them to benefit from
economies of scale (lower cost of production with higher output.)
• Specialisation also enables them to maximise their knowledge and information about
certain practices.
• Firms may even specialise in producing an aspect of a finished good. For example,
some firms just specialise in producing tyres which are then used by other car
companies.

Advantages of Specialisation
• Firms can concentrate on producing goods where they are relatively most efficient.
• It means countries don’t have to produce every good they need, but can trade to
increase overall economic welfare.
• By specialising in production, firms can benefit from economies of scale. This means
with increased output they benefit from lower average costs. This is important for
industries with high fixed costs.
• Workers can be more efficient and need less training to do jobs.
 50

Problems of Specialisation
• Concentrating on producing a small number of goods can make an economy
vulnerable. For example, Cuba specialises in producing sugar. If the sugar price falls,
the Cuban economy suffers.
• Division of labour can make jobs on assembly lines highly specialised, leading to
boredom and demotivation of workers; this can cause diseconomies of scale.
• If firms specialise in a small specific sector, they can lose out if that product becomes
unfashionable. If they diversify, they are less at risk.

Evaluation

• Specialisation is necessary to achieve economies of scale. This is very important in

the global market where firms can sell all around the world, and there are greater
competitive pressures.
• As well as specialising in some aspects of production, it makes sense for firms to have
some diversification into related products, so they are not so dependent on one
product.
• It depends on the product and industry. If there are high fixed costs (e.g. mining) it
makes sense to specialise. But, in other industries (e.g. clothing) it is more important
to market unique products with a high selling value.

3.4 Trade unions

Trade unions provide an organisation for workers to have joint representation with their
employers. Trade unions have several functions:

• Represent workers with regard to pay and working conditions.

• Bargain for higher wages with the possibility of going on strike to target higher
wages.
• Co-ordinate with firms to implement new working practises and negotiations with
workers
• Represent workers who are disciplined/sacked by the firm
 51

Effect of Trades Unions in a Competitive Labour Market

• In a competitive labour market, wages were W1. If a trade union successfully

bargains for a higher wage of W2, then employment falls to Q2

• This is why economists who believe labour markets are generally competitive argue
that trade unions can cause inefficiency and unemployment.

• Therefore, trade unions can increase wages for members – but those outside the union
may be more likely to experience unemployment.

• However, if firms have monopoly power, they may be able to exploit workers and pay
low wages and make very high profit. In this case, the trade union may be able to
increase wages without causing any fall in employment levels.

• Also, trade unions may be able to help increase wages in return for increasing labour
productivity. For example, introducing new working practises. If labour productivity
increases, firms can afford to pay higher wages without reducing employment.
 52

What determines the success of trades unions?

• The density (% of the workforce in the trade union)

• Bargaining power of workers, e.g. power plant workers have more economic leverage
than supermarket shelf stackers.
• Economic climate – is the firm highly profitable or struggling to survive? If the firm
is highly profitable, there is room for getting wage increases.
• Government legislation. e.g. since the 1970s, UK government has reduced the power
of trades unions, e.g. abolishing closed shops, outlawing secondary picketing.
• Nature of the labour market and industry – is the market competitive or does the firm
have market power?

Benefits of trade unions

• Trade unions can provide counter-balance to very profitable firms with market power
– increasing wages and employment for their members.
• Trade unions can provide greater coordination between firms and employers, e.g.
introducing productivity deals – which benefits both firms and workers.
• Trade unions can develop co-operation between workers and firms.
• Trade unions can represent workers in disputes over health and safety and disciplinary
matters. They can help promote workplace safety and reduce stress.
• Trade unions can increase wages – which leads to increased spending in the economy.

Potential costs of trade unions

• Trade unions can push wages above the equilibrium. Therefore fewer people are
employed by the firm – this leads to a loss of earnings to those outside the trade
unions. This can cause unemployment, which is a problem for the government and
whole economy
• Time lost due to strike action. This can lead to lower economic growth
• Trade unions bargaining for higher wages can cause cost-push inflation. In the 1970s,
union activity was responsible for some of the cost-push inflation of that period.
Though unions were also trying to protect wages against the higher inflation.
• Trade unions can increase incomes of union members, but this is only a limited
approach to reducing inequality. Lowest income groups are often unemployed or not
employed in a union job.
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3.5 Firms
• In an economy, firms or companies play a role in using inputs (different factors of
production) and producing goods and services (output).
• Firms play a key role in deciding what to produce and how to produce.

Different types of firms 所有权+规模+信息透明度

• Individual entrepreneurs – self-employed individuals 个体户，⾃⼰是⽼版 100% owne r
• Private companies – often small/mid-sized companies who are owned by a small
number of individuals. 私企：100% 私⼈拥有 但不是所有⼈都是⽼板
• Public limited companies – generally large companies who are listed on the stock
market. The public can buy shares in the company and share in their profits. 上市
公司。信息必须公开；不同的股东持有份额，失去所有权
• Co-operatives/social ventures. Firms which are not targeting profit maximisation but
exist to further particular social and economic goals. 合作 不只是为利润MAX；
• Government-owned companies – In some industries, the largest firms are state-owned
companies. For example, British Steel, British Coal. 国企 State Grid
The role of firms in an economy
Firms play a crucial role in the circular flow of income within an economy

• Firms employ different factors of production, such as land, labour and capital F4 LLCE.
• Developing new products. In the pursuit of profit, firms will try to respond to
consumer preferences and develop new goods and services.
• Investing in capital and new technology. This will involve developing new technology
and working practices to improve productivity in the economy. Eg. 5G
• Providing goods and services for the consumer. Firms which produce a range of
goods and services enable greater specialisation in the economy. 专业的 ⼈专
业的事情，提⾼Produc t i v i t y

3.5.2 Small firms

Benefits of being a small firm

• Concentrate on niche markets - Small niche markets may have less competition and
therefore be more profitable. Moving into a mass market may make competition more
intense.
• Small can be a selling point - In some goods like clothes, there could be an
advantage to small firms selling top end clothes ranges.
• Local profile - Small local firms can take advantage of their local knowledge and
local profile. Consumers gain utility from supporting ‘local small businesses.
• Economies of scale are limited in some industries. In the car industry, there are a
small number of relatively big firms as economies of scale are very significant. But, in
some industries like coffee shops, economies of scale are relatively insignificant.
• Different business objectives. Not all firms aim at profit maximisation and
increasing market share. If people work in small firms, they may get more joy
because they feel in control and have a close connection with customers.
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• Tax advantages - In the UK there is a VAT threshold of £83,000. Once firms

increase turnover above this, they are liable to paying VAT and filing in VAT returns.
This can be a disincentive for a firm to grow.
• Individuality. Multinationals tend to standardise service and types of goods. This is
more efficient and cost-effective but can lead to feelings of similarity.
• New ideas. New innovative ideas often start with small businesses just beginning to
start.
Disadvantages of small firms
• Less efficient than big firms. Big firms can benefit from economies of scale in
production and sell at lower cost
• Lack of resources. Small firms do not have resources to invest in research and
development and bring to market
• Small firms may lack access to supply chains and retail outlets. For example, big
supermarkets may not want to deal with small suppliers.
• Lack brand awareness. Consumers may prefer to use a well-known brand as they
can be sure of the quality and not worry about getting an unexpected experience

3.5.3 Causes and forms of growth of firms

How firms grow
1. Internal expansion – When firm increases size through increasing sales. Internal
expansion can include:
• Using profit to fund investment to expand productive capacity.
• Reaching into new markets – e.g. overseas markets
• Product diversification – introducing new models and types of service
• Economies of scale. In an industry with high fixed costs - as a firm expands output -
it gets lower average costs and greater efficiency. This means it can cut prices as it
expands – helping to increase sales
• Offering free services – e.g. a free delivery service can attract a more loyal long-term
customer base.

2. External expansion – When the firm grows through a merger with another firm.
This could involve a takeover of another firm. A takeover is where one firms buys shares in
another firm and gains control.

Why do firms wish to grow?

• Greater sales lead to greater profit, making the firm more attractive to shareholders
• Successful, growing firms are likely to increase salaries/pay bonuses to managers.
• Increasing output enables economies of scale, greater efficiency and lower average
costs.
• Increased prestige for managers seeing the firm become more influential and
powerful.
• Greater risk diversification, e.g. when growth comes from product diversification.
• Growing in size enables growth in market share and monopoly power, enabling even
greater profitability.
• Owners having a passion for their product and wanting to see it do well.
• Globalisation has enabled firms to sell product in global market.
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3.5.4 Mergers
• A merger is when two firms join to become one firm.

Horizontal merger occurs when there is a merger between two firms in the same industry
operating at the same stage of production.
• For example, if two supermarkets (e.g. Tesco/Sainsburys) merge
• Or if two newspapers (NY Times and Washington Post)

Vertical merger occurs when a firm controls different stages of production. For example if a
coffee retailer purchases a grower of coffee beans.

For example, in the coffee retail industry, you have

1. Production – Growing of coffee beans

2. Distribution – Coffee beans transported to local markets.
3. Retail – Coffee sold in cafes.

Conglomerate merger occurs when two firms merge – they may not have any direct
relation. For example, a firm in the film industry merging with an internet provider
(AOL/Time Warner) This was an attempt to bring an established industry together with a new
industry.

Benefits of Mergers

• In industries with high fixed costs, horizontal merger enables firms to benefit from
greater economies of scale, greater efficiency, lower costs and lower prices for
consumers.
• As well as sharing fixed costs, the firm may benefit from marketing economies of
scale and access to a more efficient distribution network.
• For a vertical merger the scope for economies of scale are less, but they may exist in
terms of finance and marketing.
• More profit and resources for investment in research and development. This is
important for industry like pharmaceuticals and aeroplane manufacture.
• Struggling firms can benefit from new management.

Potential Problems of Mergers

• Horizontal integration could lead to an increase in market share and monopoly power.
(If the firm has more than 25% of Market share). This could lead to all the problems
of monopoly power, such as higher prices for consumers.
• A vertical merger could also increase monopoly power. For example, if a brewery
owns the majority of pubs it can make it difficult for small scale brewers to sell their
beer.
• Diseconomies of scale. If the firm gets too big, it may become harder to co-ordinate
and communicate between different sections of the firm. It may become easier for
workers to slack off because no one notices if you take it easy.
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3.5.5 Economies of Scale

Definition of Economies of Scale – this occurs in the long run when increased output
leads to lower average costs and increased efficiency.

• For example, by increasing output from Q1 to Q2, the firm is able to reduce average
costs from P1 to P2.
• Internal economies of scale occur when the firm gets lower average costs from
increasing its own output
• External economies occur when the firm benefits from an increase in the size of the
total industry.
Types of Economies of Scale

1. Specialization and division of labour: In large scale operations workers can do more
specific tasks. With little training they can become very proficient in their task; this
enables greater efficiency. A good example is an assembly line with many different
jobs.
2. Bulk buying: If you buy a large quantity of raw materials then the average costs will
be lower.
3. Technical. When a firm benefits from increased scale of production. For example, a
large machine (e.g. blast furnace/combine harvester) would be inefficient for small
scale production; for higher rates of production, the firm gains a better rate of return
from this initial investment.
4. Financial economies. A bigger firm can get a better rate of interest from a bank than
small firms.
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5. Marketing. A national TV advertising campaign is more efficient for a large firm.

Large firms get lower average costs for marketing.
6. Risk Bearing. Bigger firms are able to diversify into different areas. This gives them
a greater ability to avoid an economic downturn.

External economies of scale:

• This occurs when firms benefit from the whole industry getting bigger. For example.
If the industry gets bigger all firms will benefit from better infrastructure, access to
specialized labour and good supply networks.
• External economies of scale encourage firms to set up in areas where an industry is
already developed. For example, a car firm may set up in the East Midlands where
there is already a well-established infrastructure.
• Silicon Valley is an example of concentration in the micro-computer industry.

Diseconomies of Scale

This occurs when increased output leads to higher average costs. This can occur due to
factors such as:
• Difficulty of controlling and monitoring workers in a big firm. It is easier for workers
to be lazy and ‘slack off’
• In a big firm, with highly specialised work, workers may become alienated and bored
with little motivation to work hard.
• A larger firm may experience difficulties communicating across the different aspects
of the business.
• Higher administration costs. With a bigger firm, it is harder to control the firm.
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3.6 Firms and production

3.6.1 Demand for factors of production
Factors of production, such as land, labour and capital are needed in different quantities for
the production of goods and services. The demand for these factors of production will depend
on:
• Price – A rise in wages will encourage firms to try and minimise the number of
workers they need. They may invest in more capital to try and autonomies production
• Availability. For some industries, it may be difficult to employ certain skilled
workers – they may not be enough qualified doctors for certain jobs. Alternatively, a
firm may wish to produce agricultural goods, but in bad weather, there is nothing they
can do if the crop is destroyed by frost.
• Productivity of a factor. If workers are demotivated and disruptive, the firm may try
to shift to more capital intensive methods of production.
• Demand for product. If wages rise, but there is increase in demand for the product,
then a firm may be able to afford to employ more workers

Combination of factors of production

Example - Coffee

• The Entrepreneur purchases land to grow coffee plants. In this industry land is an
important factor - it needs to have the right climate and soil to grow the coffee.
• The company then need to employ workers to look after tea and at harvest time pick
the coffee beans.
• The entrepreneur (farmer) will also need to invest in some capital - farming tools,
baskets and vehicle to deliver the crop to the market.
• This is a relatively labour intensive industry because labour costs will incur a high %
of total production costs.

Example – Car production

• The firm will need land for a factory.

• They will need to invest significantly in sufficient capital – machines, robots and
tools to build cars.
• With a large factory, the firm will then need to employ skilled labour to work and
operate the machinery.
• The industry is relatively complex and will require a degree of specialisation - with
workers concentrating on a range of tasks from technological innovation to marketing
and design.
• This industry will be relatively capital intensive. (Capital is a high % of total costs)

New Tech industries

• In new high tech industries such as software development. The most important factor
is human capital - the experience, education and skills of the workers.
• There is scope for the individual or small team to set up a business to focus on a small
aspect of developing new software.
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3.6.2 Labour intensive/Capital intensive

Labour intensive refers to a production process where labour costs are the largest
component. Labour intensive implies that capital (machines/factories) are a small percentage
of the final cost.

Certain industries tend to be more labour intensive. These include:

• Nursing – difficult to replace with machinery.

• Fruit picking- Certain types of fruit need picking by hand. It is difficult to get
machines to pick strawberries and apples from trees.
• Retail staff – Retail assistants at shops or bar staff selling drinks.

Capital intensive

• Capital intensive refers to a productive process that requires a high percentage of

investment in fixed assets (machines, capital, plant) to produce.
• A capital-intensive production process will have a relatively low ratio of labour inputs
and will have higher labour productivity (output per worker).

3.6.3 Production and productivity

• Productivity means the output per factor in a certain period of time.

• Labour productivity means the output per worker in a period of time.
• Production This is the total output produced. Total production doesn’t measure how
many inputs (workers) were required; it only measures how many goods are actually
produced.

Productivity
• Labour productivity measures the output per worker in a period of time.
• If productivity rises, firms can produce more with the same number of workers. This
enables
• Higher wages for workers
• Increased output for the economy
• A reduction in costs. A firm can produce the same quantity with fewer workers,
leading to lower average costs. This can lead to lower prices or at least keep prices
low.
How to increase Productivity
Firms can increase productivity through the following measures:

• Better Technology. New technology enables more to be produced for lower costs.
For example, computers and the internet have enabled greater efficiency.
• Training of Workers. If workers gain better education and training they will be more
productive in working on specialised tasks.
• Increased Capital. Investing in capital (e.g. machines) can enable fewer workers to
be needed, which helps reduce wage costs.
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• Specialisation and division of labour. This occurs when workers concentrate on

specific tasks to produce more.
• Better motivation for workers. Performance related pay might make workers more
motivated to work hard.
• More competitive markets. If firms face competitive pressures they will have greater
incentives to cut costs and increase productivity.

Evaluation of labour productivity

• Increasing productivity is only part of the equation. There must be demand for the
product.
• Increasing labour productivity might require expensive investment in capital. The cost
savings from higher productivity need to be higher than the capital investment.
• If real wages rise, it becomes more important to increase labour productivity.
• If wages are low and capital is expensive, firms may place less emphasis on labour
productivity.

3.7 Firms’ costs, revenue and objectives

Business Costs

• Fixed Costs. - Costs that do not vary with output; e.g. cost of a factory.
• Variable Costs (VC) - Costs that do vary with output; e.g. electricity, materials.
• Total Costs (TC) - Fixed + variable costs
• Average Total Cost (ATC)= TC / Q
• Average Variable Cost (AVC) = VC / Q
• Average Foxed Costs (AFC)= FC / Q

Example of Costs

Q FC TC VC ATC
0 1000 1000
1 1000 1200 200 1200
2 1000 1300 300 650
3 1000 1550 550 516.67
4 1000 1900 900 475

A rise in costs will shift the supply curve to the left

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Graph showing TC (total costs) VC (Variable costs) and FC (Fixed Costs)

Profit and Revenue

• Total Revenue (TR): This is the total income a firm receives.

This will equal Price * Quantity
• Average Revenue (AR): TR / Q

• Profit = Total revenue (TR) – Total Costs (TC) or (AR – AC)* Q

Price (P) Quantity (Q) Total Revenue (TR) Average Revenue

(AR)
10 1 10 10
9 2 18 9
8 3 24 8
7 4 28 7
6 5 30 6
5 6 30 5
4 7 28 4

Average revenue (AR) = the price

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Total Revenue and Average Revenue

• Graph showing AR and Total Revenue. In this example total revenue is maximised at
an output of 6, with total revenue of £30.

Importance of cost, revenue and profit for producers

• Firms often seek to maximise profits. This enables higher dividends for shareholders.
It also gives the firm more resources to invest in increased production.
• Not all firms may seek to maximise profits – other may seek to maximise market
share. In this case, they will seek to maximise revenue and not just cut costs.
• For example, companies like Amazon and Walmart have been through periods of
reinvesting most of their profit into expansion.
• If costs rise, supply will shift to the left, and there will be a movement along the
demand curve, firms may become unprofitable and even leave the industry.
• If demand rises, then firms will see a rise in revenue and profit. In the long-term, this
may encourage more firms to enter the market.
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Objectives of firms

Firms may exist for different reasons. They may have different objectives. Some of the
common objectives include
1. Profit maximisation
In economics, we often assume firms aim to maximise total profits. Benefits of maximising
profit can include:
• Higher salaries for managers and workers.
• Higher dividends for shareholders.
• Encourages firm to be efficient and to keep looking at cutting costs.
• Higher profit enables more resources to invest in future projects and safeguards the
long-term success of the firm.

2. Sales growth
Firms may seek to increase their sales and revenue growth, even if it means less profit. This
could involve:
• Sales revenue maximisation – maximising total revenue
• Sales volume maximisation – selling as many units as possible – probably selling
goods as cheap as possible without making a loss.
• Increasing market share – trying to gain a bigger share of the total market.

A firm may pursue sales maximisation for various reasons:

• Increased market share increases their monopoly power and may enable them to put
up prices and make more profit in the long run.
• Managers prefer to work for bigger companies, as it tends to lead to greater prestige
and higher salaries.

3. Social welfare
• Some businesses may be set up with aim of promoting social welfare. For example,
housing trusts and co-operatives.
• A firm may incur extra expenses to choose products which don’t harm the
environment, or choose products not tested on animals.
• Organisations like the Co-op have a different structure to share profits amongst
consumers and workers.
• Corporate social responsibility (CSR) is a business model where the main
stakeholders in a business are considered – beyond the usual profit maximisation
aims.

Factors which influence choice of objectives

• Aims of owners. Some owners may be motivated by the prospect of profit. Others
may be more concerned with ideas of social welfare.
• Public opinion. Adverse publicity can encourage firms to take social
welfare/environment more importantly.
• Social concern could increase profit. It could be argued that making statements of
social can enhance a firm’s long-term reputation and become a good marketing
strategy.
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3.8 Market structure

Market structure refers to the nature of a particular industry. Some industries are dominated
by a small number of firms or even one firm. Other industries are more competitive and have
many firms in the industry.

• Competitive markets – Many firms, freedom of entry, homogeneous product, low

profit.
• Monopoly – One firm dominates the market, barriers to entry, possibly supernormal
profit.
• Oligopoly – An industry dominated by a few firms, e.g. the five largest firms having a
combined market share of over 50%.

3.8.1 Competitive Markets

In a market economy, companies are usually free to compete for business. This means there
is:

• Freedom of entry into markets

• Firms try to attract customers through offering cheaper prices, better quality, more
convenient location

A competitive market is characterised by:

• Many firms in the market.

• Freedom of entry and exit. This means it is relatively easy for new firms to enter the
market. There must be low barriers to entry.
• Low profits made by firms. If firms made very high profits, in a competitive market,
this would encourage new firms to enter and reduce their profitability. If a market is
competitive, firms will tend to make low profit.
• Prices relatively low for consumers. The competition helps keep prices low.

How Competitive Markets affect business

• Firms face the threat of competition, therefore they must remain efficient and develop
better quality products and services, and otherwise they will go out of business.
• In competitive markets, it is difficult to increase prices because consumers will buy
from cheaper competitors. Therefore, in competitive markets prices stay low.
• Competition means that profits are likely to be lower. This may make it more difficult
to invest in new products.

Benefits of Competitive Markets for Firms

• Forces it to be efficient and offer the best products

• If it becomes the best firm it can attract more custom.
• It will need to identify its strengths and weaknesses and encourages firm to be
innovative
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Problems of Competitive Markets for Firms

• Difficult to make high profits because other firms will enter into market. This makes
the firm less attractive to shareholders
• Need to spend a lot of money on advertising to attract customers.
• You can easily lose customers to rival firms and new firms who just enter the market.
• Easier to go out of business. This uncertainty may discourage investment.

Benefits of Competitive Markets for Consumers

• Consumers are likely to pay lower prices than in markets with monopoly power.
• Consumers face a greater choice of goods and services
• Firms will try hard to win consumers therefore; they are likely to get better consumer
service.
• If firms are inefficient or unsatisfactory, consumers can choose another firm.

Limitations of competitive Markets for Consumers

• Firms may make insufficient profit to invest in research and development. Therefore,
they may be less improvement in products.
• If there are many small firms, they will not be able to benefit from economies of
scale.

3.8.2 Monopoly markets

• This is a market structure with one dominant firm.

• Monopoly power occurs when a firm controls over 25% of the market.
• Examples of monopoly include: Regional tap water companies (100% of tap Water
market), Railtrack (100% control of rail tracks), Google (80% of search engine
market)

For a monopoly to occur there needs to be barriers to entry, these are conditions which
make it more difficult for a firm to enter a market.

Barriers to Entry
1. Economies of scale. A new firm would find it difficult to compete because its
average costs would be much higher than the incumbent who has a higher output and
lower average costs. Examples include electricity generation.
2. Natural / Geographical barriers. Only a few countries can produce diamonds
because they only occur in small parts of the world.
3. Brand Loyalty. Through advertising firms can differentiate their brand and
encourage consumers to be loyal to the product. It makes it more difficult for new
firms to enter.
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4. Control Supplies. By controlling supplies, firms can deter entry. E.g. oil companies
can limit supply of petrol to new petrol stations.
5. Legal Barriers. This prevents competition by law. For example a patent or
government monopoly (like Royal Mail used to be)

Disadvantages of Monopolies

1. Higher prices. Consumers have only a limited choice, therefore demand is inelastic.
This enables the firm to increase prices, thereby causing a fall in consumer surplus.
2. Allocative inefficiency. Firms don’t respond to consumer needs and preferences.
Therefore monopolies tend to be allocatively inefficient.
3. Productive inefficiency. Because competition is limited firms have less incentive to
cut costs and therefore could be productively inefficient.
4. Monopolies can pay lower prices to suppliers E.g. car companies with monopoly
power can pay lower prices to suppliers.
5. Diseconomies of scale. If a firm gets too big and unwieldy, average costs will start to
rise.

Advantages of Monopolies

1. Economies of Scale. If there are high fixed costs in the industry the firm will be able
to benefit from economies of scale and lower average costs as output increases. This
enables lower prices for consumers.
2. Research and Development. A firm can use its supernormal profits to invest in new
products which will benefit the consumer. This is important for many industries such
as pharmaceuticals.
3. Some firms may gain monopoly power because they are efficient and innovative.
E.g. Google is considered an innovative company; this gave it monopoly power in
search engines.
4. International competition. A domestic monopoly may face competition from
abroad.