Economics. Microeconomics, The UK Economy and The International Economy [INTERMEDIATE 2; HIGHER] Martin Duguid. abc

Transcription

1 Economics Microeconomics, The UK Economy and The International Economy [INTERMEDIATE 2; HIGHER] Martin Duguid abc

2 The Scottish Qualifications Authority regularly reviews the arrangements for National Qualifications. Users of all NQ support materials, whether published by LT Scotland or others, are reminded that it is their responsibility to check that the support materials correspond to the requirements of the current arrangements. Acknowledgement Learning and Teaching Scotland gratefully acknowledge this contribution to the National Qualifications support programme for Economics. First published This publication may be reproduced in whole or in part for educational purposes by educational establishments in Scotland provided that no profit accrues at any stage. ISBN

3 CONTENTS Introduction: Student Induction Pack 5 Unit 1: Microeconomics Topic 1: The basic economic problem 23 Topic 2: Demand 32 Topic 3: Supply 44 Topic 4: The operation of markets 70 Topic 5: Types of market (for Higher only) 79 Unit 2: The UK Economy Topic 1: National income 85 Topic 2: Inflation and unemployment 104 Topic 3: The role of government in the economy 122 Topic 4: Government economic policies (for Higher only) 143 Unit 3: The International Economy Topic 1: International trade and payments 179 Topic 2: The international economic environment 206 INTERMEDIATE 2/HIGHER ECONOMICS 3

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5 INTRODUCTION STUDENT INDUCTION PACK Introduction The aim of this pack is to provide information which will help you during your Economics course at Intermediate 2 or Higher level. Rationale All societies, organisations and individuals face the economic problem of allocating scarce resources among competing uses. Economics is the social science which provides the knowledge and skills required to make decisions about the production and consumption of goods and services. This course is concerned with the ways in which such decisions are made and the implications which these decisions have for individuals, organisations and society. The course will help you to build up knowledge of economic principles. You will develop skills in interpreting and analysing economic information as well as evaluating the costs and benefits of decisions. This economics course looks at both the world of business and the economic environment in which business is set. It will benefit anyone thinking of a career in central or local government, commerce, finance or industry. Course aims The course aims to develop: a knowledge and understanding of the basic economic problem of allocating scarce resources among alternative uses an understanding of the economic roles and responsibilities of the individual as a consumer, employee, producer and citizen an understanding of the economic roles and responsibilities of firms and governments in the use of resources an understanding of the environmental and social costs involved in economic decisions an understanding of the economic relationships between countries an ability to explain and analyse economic problems and to suggest possible solutions an ability to communicate economic ideas in a logical and effective manner. INTERMEDIATE 2/HIGHER ECONOMICS 5

6 STUDENT INDUCTION PACK Course details The course is made up of three units: Microeconomics The UK Economy The International Economy Each unit is divided into topics. It will help you to organise your notes if you have a ring binder for each unit with a separate section for each topic. The topics are: Unit 1: Microeconomics 1. The Basic Economic Problem 2. Demand 3. Supply 4. The Operation of Markets 5. Types of Market Unit 2: The UK Economy 1. National Income 2. Inflation and Unemployment 3. The Role of Government in the Economy 4. Government Economic Policies Unit 3: The International Economy 1. International Trade and Payments 2. The International Economic Environment Methods of teaching and learning Different methods of teaching and learning will be used during your course but emphasis will be placed on examining, explaining and analysing current economic events and issues in the UK, European and world economies. You will be using articles from newspapers, magazines and journals and programmes recorded from TV or radio. The Internet is a very valuable source of material. You may also use computer simulations of the economy and economic statistics drawn from a variety of sources. It is important that you keep up with economic events and you should regularly listen to or watch news bulletins. You will also find 6 INTERMEDIATE 2/HIGHER ECONOMICS

7 STUDENT INDUCTION PACK it useful to scan radio/tv listings to look for and record relevant programmes. Reading a newspaper and compiling a file of articles will also be of great benefit to you. Homework Your teacher will give you homework. This may consist of written exercises, completing work started in class or researching information. Study is also important and you should spend time as soon as possible after each lesson reading and learning your notes and textbook. It is important that you identify any problems of understanding as soon as possible and ask your teacher for help. Do not let problems drift they will not go away by themselves. Keeping up with events (as outlined above in Methods of Teaching and Learning) should also be considered as part of your homework. It follows that planning, setting deadlines and sticking to them is vital for homework and study. This will contribute greatly to your success. Absence If you know in advance that you are going to be absent, inform your teacher and ask for any work which will be covered in your absence. In the case of sickness or other unavoidable absence, ensure that you obtain a copy of all notes, homework, etc. before the next class. It is your responsibility to catch up on the work that you have missed. Because part of your assessment is continuous, it is important that your attendance is good. Poor attendance, together with a failure to cover any work which has been missed, will inevitably result in lack of success. Assessment You will be assessed on your performance in two main ways internal assessment and external assessment. Internal assessment There are three internal assessments, one for each unit. Each assessment will be one hour long. INTERMEDIATE 2/HIGHER ECONOMICS 7

8 STUDENT INDUCTION PACK External assessment At the end of the course you will sit an examination. This assessment will be set and marked by the Scottish Qualifications Authority. If you pass you will awarded a grade A C. You must pass all the internal assessments and the final examination to pass the course. Intermediate 2 The examination will be a written paper and you will be allowed 1 hour 45 minutes. Part 1 Two data response items. 40 marks Part 2 One question from a choice of five. Each question will be normally divided up into three sections. You will have to write extended answers. 20 marks TOTAL 60 marks Higher The examination will be a written paper and you will be allowed 2 hours 30 minutes. Section A Two data response items. 50 marks Section B Two questions from a choice of six. Each question will require you to write extended answers. 50 marks TOTAL 100 marks Prelim examination You will also be given an examination in the spring which will be of the same type as your final examination. The prelim exam is to give you practice and may be used for an appeal if you fail to reach the grade your school expects. This exam is not part of your assessment for the course. 8 INTERMEDIATE 2/HIGHER ECONOMICS

9 STUDENT INDUCTION PACK Learning outcomes The following pages provide you with a checklist for revision purposes. You should tick each learning outcome when you have revised it in preparation for (1) an internal assessment, (2) your prelim exam, (3) your final exam. You will also find it useful to compare your performance in internal assessments and in your prelim exam with these learning outcomes. INTERMEDIATE 2/HIGHER ECONOMICS 9

10 STUDENT INDUCTION PACK Unit 1: Microeconomics Topic 1 The Basic Economic Problem For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam explain the basic economic problem. explain the meaning of scarcity. explain with examples the meaning of opportunity cost as it is faced by individuals, firms and governments. describe the choices (what, how, for whom) faced by different economic systems. describe three different types of economic system (see also Topic 3 in Unit 2: The Role of Government in the Economy). classify resources/factors of production and describe their characteristics. explain the meaning of economic efficiency and why countries seek to achieve it. explain the meaning of substitution of resources. explain the meaning of geographical and occupational mobility of resources. describe measures to increase the substitution and mobility of resources. and in addition for Higher, you should be able to: explain how substitution of resources and mobility of resources may contribute to improved economic efficiency. explain the term potential output. draw production possibility curves. calculate opportunity costs from production possibility figures or curves. explain the factors which may shift a production possibility curve. explain the term equity. 10 INTERMEDIATE 2/HIGHER ECONOMICS

11 STUDENT INDUCTION PACK Unit 1: Microeconomics Topic 2 Demand For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam define the term effective demand. distinguish between individual and market demand. distinguish between total and marginal utility. draw a demand curve and explain its shape in terms of marginal utility. define the law of demand in words and in graph form. describe factors which influence demand and explain the effects of changes in these factors on demand. distinguish between movements along and shifts of demand curves. outline the economic objectives of consumers in terms of marginal utility. and in addition for Higher, you should be able to: describe price elasticity of demand in words and in graph form. calculate price elasticity of demand. describe the effects of price changes on revenue for different price elasticities. explain the factors which may influence price elasticity of demand. describe and calculate income elasticity of demand. explain the significance of positive and negative income elasticity. outline the significance of price and income elasticities of demand for firms and governments. INTERMEDIATE 2/HIGHER ECONOMICS 11

12 STUDENT INDUCTION PACK Unit 1: Microeconomics Topic 3 Supply For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam define the law of supply and draw a supply curve. explain the factors which influence supply. describe the effects on supply of changes in these influencing factors. distinguish between movements along and shifts of supply curves. and in addition for Higher, you should be able to: explain and calculate elasticity of supply. analyse the importance of time in influencing elasticity of supply. 12 INTERMEDIATE 2/HIGHER ECONOMICS

13 STUDENT INDUCTION PACK Unit 1: Microeconomics Topic 3 Supply Cost, Revenue and Profit For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam explain the meanings of specialisation and division of labour by product and by process. describe the advantages and disadvantages of specialisation to employees, employers and consumers. distinguish between the short and the long run period of time. define the law of diminishing marginal and average returns. explain why varying a factor of production eventually leads to diminishing returns. define fixed and variable costs of production. calculate total, average costs and marginal costs from a given set of figures. draw fully labelled graphs of total, average and marginal costs as they vary with output in the short run. explain the shape of the short run average cost curve in terms of increasing and diminishing returns. define optimum output. explain the shape of the supply curve in terms of the marginal cost curve. define economies of scale; internal and external. describe the different internal economies of scale. explain diseconomies of scale. describe the trends and motives towards globalisation amongst multi-national enterprises. describe the process and motives for downsizing. INTERMEDIATE 2/HIGHER ECONOMICS 13

14 STUDENT INDUCTION PACK Unit 1: Microeconomics Topic 3 Supply Cost, Revenue and Profit (contd.) Internal Assessment Prelim Exam Final Exam explain the relationship between long run output (returns to scale) and average cost. draw a fully labelled graph showing the behaviour of average cost in the long run. define optimum size. define and calculate total, average and marginal revenue. define and calculate profit. describe the role of profit for a firm. 14 INTERMEDIATE 2/HIGHER ECONOMICS

15 STUDENT INDUCTION PACK Unit 1: Microeconomics Topic 4 The Operation of Markets For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam define what a market is, and give examples. describe and explain, both in diagrams and in words, how equilibrium or market-clearing price is arrived at in a free competitive market. describe and explain the effects on equilibrium price and output of changes in demand and supply. define what is meant by market intervention and describe the types of such intervention. explain why intervention in free markets may take place. and in addition for Higher, you should be able to: explain the meaning of ceteris paribus. show on a diagram the effects of intervention such as maximum price, minimum price, tax, subsidy. analyse data, in textual, numerical or graphical form, of given market situations. INTERMEDIATE 2/HIGHER ECONOMICS 15

16 STUDENT INDUCTION PACK Unit 1: Microeconomics Topic 5 Types of Market This is for Higher level only, and you should be able to: Internal assessment Prelim exam Final exam distinguish between a perfect and an imperfect market. describe and analyse the different types of competition in markets, i.e. competitive, oligopolistic, monopolistic and monopsonistic in terms of the number and size of firms in the market. describe how firms may differentiate their products. outline the possible barriers to entry to a market and the effects of such barriers explain and analyse how prices are determined in perfect and imperfect markets 16 INTERMEDIATE 2/HIGHER ECONOMICS

17 STUDENT INDUCTION PACK Unit 2: The UK Economy Topic 1 National Income For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam explain the term national income. describe the relationship between national output, income and expenditure. describe what national income statistics are used for. identify the problems of measuring national income. describe the circular flow of income. explain the meaning of injections and withdrawals and their effects on output, employment and income. and in addition for Higher, you should be able to: distinguish between GDP, GNP and national income. explain the difference between nominal and real measurement. describe the difficulties in using national income statistics for making comparisons over time, or between countries. describe aggregate demand and its components. describe aggregate supply (including potential/full employment supply). explain how equilibrium national income is arrived at, using an aggregate demand and supply diagram. explain reasons for change in equilibrium national income. describe and explain, using the circular flow of income diagram, how the multiplier process works. calculate the multiplier and its effect on national income. describe the phases of the business cycle. INTERMEDIATE 2/HIGHER ECONOMICS 17

18 STUDENT INDUCTION PACK Unit 2: The UK Economy Topic 2 Inflation and Unemployment For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam define inflation. explain how the rate of inflation is measured in terms of the Retail Price Index (headline rate) and the Consumer Price Index (underlying rate). list and describe the factors which can cause inflation. explain the difference between measuring prices and incomes in money terms and in real terms. explain the effects of inflation on individuals, firms, government and the economy. and in addition for Higher, you should be able to: describe what is meant by money. explain the quantity theory of money and the role of money in inflation. describe and explain the main trends in inflation in recent years. For Intermediate 2 and Higher, you should be able to: define unemployment in terms of unused resources. describe how unemployment may be measured using the claimant count and labour force survey. list and explain the demand side causes of unemployment. list and explain the supply side causes of unemployment. explain the effects of unemployment on individuals, firms, government and the economy. and in addition for Higher, you should be able to: explain patterns and trends of unemployment from given statistics. 18 INTERMEDIATE 2/HIGHER ECONOMICS

19 STUDENT INDUCTION PACK Unit 2: The UK Economy Topic 3 The Role of Government in the Economy For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam describe the characteristics of different economic systems, namely free market, planned, mixed. describe the economic objectives of government. describe the main types of government expenditure in terms of programme and type, i.e. capital or current. explain the reasons for government expenditure on nonmarketable goods (public and merit) and transfer payments. describe the changes in recent years in government provision of goods and services. list the main sources and types of government income. explain direct, indirect, progressive and regressive taxes. describe the change in balance between direct and indirect taxation in recent years. explain the Budget and its role. explain the effects of changes in the Budget on individuals and the economy. state the meaning of economic growth. describe how economic growth is measured. describe the sources of economic growth. distinguish between private and external costs and benefits. In addition for Higher, you should be able to: distinguish between macroeconomic and microeconomic objectives. list government macroeconomic objectives and identify the possible conflicts between them. list government microeconomic objectives. INTERMEDIATE 2/HIGHER ECONOMICS 19

20 STUDENT INDUCTION PACK Unit 2: The UK Economy Topic 4 Government Economic Policies This is for Higher only and, you should be able to: Internal assessment Prelim exam Final exam explain fiscal policy and how it may be used to achieve a government s macroeconomic objectives. explain monetary policy and the role played by the Bank of England in attempting to achieve a government s macroeconomic objectives. explain supply-side policies and their impact on workers and firms. explain the meaning of and give examples of market failure. explain the reasons for market failure. describe and explain the policies which a government may use to address failings of the market mechanism. 20 INTERMEDIATE 2/HIGHER ECONOMICS

21 STUDENT INDUCTION PACK Unit 3: The International Economy Topic 1 International Trade and Payments For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam describe and explain the gains from trade in terms of absolute advantage and comparative advantage. describe the benefits of international trade to countries and consumers. analyse patterns and trends in trade from given statistics. outline the main trends in recent years in the pattern and direction of UK trade. describe the barriers to free trade. describe the purpose and structure of the current account of the balance of payments. explain what is meant by an exchange rate and how it is determined. explain the effects of changes in an exchange rate for visitors and travellers and on prices of exports and imports. describe the progress towards and features of European Monetary Union. In addition for Higher, you should be able to: explain the reasons for governments imposing barriers to free trade. explain the effects of trade barriers on consumers, firms and the economy. describe the purpose and structure of the capital account of the balance of payments. explain the factors which influence the capital account. explain the relationship between exchange rates and interest rates, and capital movements. distinguish between fixed, floating and managed exchange-rate systems. outline the advantages and disadvantages of fixed, floating and managed exchange rate systems. INTERMEDIATE 2/HIGHER ECONOMICS 21

22 STUDENT INDUCTION PACK Unit 3: The International Economy Topic 2 The International Economic Environment For Intermediate 2 and Higher, you should be able to: Internal assessment Prelim exam Final exam describe the main economic features of the European Union. describe the main characteristics of developing countries. describe the main characteristics of newly industrialised countries. In addition for Higher, you should be able to: list and explain the advantages and disadvantages of monetary union. explain the economic problems of developing countries. explain the role of developed countries in promoting development. describe the work of the World Trade Organisation and its recent achievements. explain the role of international trading and monetary organisations in the world economy. 22 INTERMEDIATE 2/HIGHER ECONOMICS

23 UNIT 1 MICROECONOMICS Topic 1: The Basic Economic Problem 1 Scarcity 1.1 The basic economic problem is scarcity. In economics scarcity means that there are not enough resources to produce all the goods and services which consumers want. Scarcity arises because human wants for goods and services are unlimited but the resources required to produce them are limited. 1.2 Scarce goods and free goods. Scarce goods, also called economic goods, are those which have a price, i.e. something has to be sacrificed to obtain them. Free goods are those goods of which there is enough to satisfy everyone s wants, e.g. fresh air, sea water. Free goods have no price. All scarce goods have an opportunity cost whereas free goods do not. 1.3 Scarcity is not the same as shortage. A shortage is when the demand for a product is greater than its supply. Scarcity is when wants for a product are greater than its supply. Demand means what consumers want and can afford to buy. Therefore if there is enough of a product to meet the demand of those consumers who want and can afford to pay the prevailing price there is no shortage. However the product will remain scarce because of all those consumers who want the product but cannot afford to pay the price. 2 Choice and opportunity cost 2.1 Because of the problem of scarcity it follows that choices have to be made. Consumers must choose what to buy out of their limited incomes. Producers must choose what to produce with their limited resources. Governments must choose what services to provide out of their limited tax revenues. 2.2 Every choice involves a sacrifice and this sacrifice is called opportunity cost. Opportunity cost is the sacrifice of the next best INTERMEDIATE 2/HIGHER ECONOMICS 23

24 MICROECONOMICS alternative choice. For a consumer the opportunity cost of choosing a product is the next item on his/her scale of preference. For a producer the opportunity cost of producing a good is the next most profitable product which could have been produced with the resources used. For a government the opportunity cost of providing a service is the next best service which it could have provided with the resources used. 2.3 In economics we assume that people are rational, i.e. when faced with a choice they will always choose the alternative that will give them the greatest satisfaction. This involves weighing up all the alternatives and then choosing the one that has the lowest opportunity cost. 3 Resources: factors of production 3.1 Resources may be classified as natural, human or man-made. They are sometimes called factors of production and are then classified as land, labour, capital and enterprise. 3.2 Land refers to all the gifts of nature and includes not only land itself, but also all the minerals in and on the land, the sea and everything in the sea, the air, sunlight, etc. 3.3 Labour refers to any human effort (manual or mental), which is directed to the production of goods or services. 3.4 Capital refers to those man-made resources which are used to produce goods or services. Capital may be categorised as industrial, social, private or financial. Industrial capital is used by firms, e.g. factories, offices, plant and machinery, tools, vehicles. Social capital belongs to the whole community, e.g. schools, hospitals, roads. Private capital belongs to individuals, e.g. houses. Financial capital is money waiting to be used to buy capital goods. When capital goods are bought this is called investment. (Note the difference between saving and investment!) 3.5 Enterprise refers to the decision making and risk taking of entrepreneurs. The entrepreneur decides how many of each factor is to be used, how they are to be combined to make the most profit and how the work should be done. He or she also bears the risks 24 INTERMEDIATE 2/HIGHER ECONOMICS

25 MICROECONOMICS caused by business uncertainties. An entrepreneur is an organiser and a risk taker. 4 Mobility of resources 4.1 Modern industrial economies are dynamic. This means that they are in a continual state of change. Changing consumer demands and changing production methods mean that some industries will be growing, e.g. electronics, finance while others are declining, e.g. coal, shipbuilding. In such a world there is a need for resources to be mobile to be able to change their location or their use. Resources which cannot change either their location or their use run the risk of becoming unemployed. 4.2 Factor or resource mobility is the speed and ease with which a resource can move from place to place (geographical mobility) or can change use (occupational mobility). 4.3 In practice there are obstacles to factor mobility and to ensure that resources are used efficiently these obstacles need to reduced. 4.4 Land tends to be geographically immobile. Its mineral wealth and the crops it produces are commonly transported from one area to another but the great majority of land is used where it is. For this reason, attention is focused not so much on where it might be used as on how. 4.5 People may become geographically and occupationally immobile. Many factors influence people s mobility. Willingness to move elsewhere is determined largely by age and by family and cultural ties. Willingness and ability to do another type of job is closely linked to age, education and training. 4.6 Capital has varying degrees of mobility. Some capital is highly specialised. As a result it is difficult to adapt it to other uses. Power stations and swimming pools are examples, as also are screwdrivers and staplers. The geographical mobility of capital is determined largely by its size and weight. Money capital is much more mobile. It can be moved about the world quickly and cheaply by electronic means. INTERMEDIATE 2/HIGHER ECONOMICS 25

26 MICROECONOMICS 5 Economic efficiency 5.1 All countries have the problem of scarce resources and so should find ways of making best use of them. Best use of resources is called economic efficiency. 5.2 Economic efficiency in the use of a country s resources is achieved when the following three conditions are met: (a) when technical efficiency is achieved, i.e. when products are produced at minimum unit cost, in other words when the fewest necessary resources are used to produce each product. Example In building a bridge, using the least amount of steel while ensuring the bridge will not collapse. Building a bridge strong enough to take 1000-ton lorries would be wasting steel, which could be used for making other products. (b) when allocative efficiency is achieved, i.e. when resources are allocated (used) to produce those goods and services which consumers most want. Example One hundred bridges could be built over the River Don in Aberdeen in a technically efficient way, but this would be a wasteful use of resources if consumers don t want 100 bridges. The resources could have been used to make products which consumers want more. (c) when all resources are employed. Idle resources will result in lost output. 6 Equity Equity concerns social justice or fairness. The aim of economic efficiency can conflict with the aim of equity, e.g. a country with a free-market economy could be achieving economic efficiency by satisfying many of the wants of a few rich people at the expense of a large number of poor people. 26 INTERMEDIATE 2/HIGHER ECONOMICS

27 MICROECONOMICS 7 Economic systems 7.1 All nations face the problem of scarcity, i.e. they have insufficient resources to produce all the goods and services which their citizens need and want. Three basic questions have to be addressed: What goods and services will be produced? How will these goods and services be produced? This means who will do the production and which methods of production will be used. To whom will the goods and services be distributed? This means who will consume the goods and services after they been produced how will it be decided who receives them. 7.2 To address these questions a nation needs an economic system. There are three different economic systems: the command or planned economy, the market economy, and the mixed economy. Each has different ways of allocating resources and of distributing goods and services to consumers. 8 The command or planned economy 8.1 All decisions about resource allocation are made by government. The government owns the resources and directs them into the production of the goods and services decided on. This system is based on the principle of equity. This was the type of economic system which used to exist in the communist countries of Eastern Europe. 8.2 A command economy answers the three questions in the following ways: What to produce? government planners estimate what their population need. They fix the quantity of each good to be produced. How to produce? government sets quotas for each factory and decides how many resources should be employed in producing the goods. For whom to produce? prices and incomes are controlled so that each citizen has an almost equal entitlement to what has been produced. INTERMEDIATE 2/HIGHER ECONOMICS 27

28 MICROECONOMICS 9 Free-market economy 9.1 The features of a market economy are: Resources are owned by private individuals. Producers are free to produce what they wish. Consumers have consumer sovereignty (literally meaning the consumer is king) and rule the market, i.e. the freedom of consumers to decide what to buy influences what producers produce. Decisions are made on the basis of self-interest. Producers aim to maximise profit. Consumers aim to maximise value for money. Competition exists between producers and between consumers. Resources are allocated by the price mechanism. Price acts as a signal to producers. Products which consumers demand will rise in price thus encouraging producers to supply them. Producers will need more resources. They will attract them by offering higher incomes to those who own them. Falling demand for products will result in lower prices and lower rewards to owners of resources so that they will then be encouraged to move their resources to where the rewards are greater. 9.2 A market economy answers the three questions as follows: What to produce is decided by consumers. How to produce is decided by producers using the most efficient methods of production in order to keep down cost so that they can compete and maximise profit. To whom products is distributed is decided by the buying power of those consumers who earn the highest incomes from the resources which they own. 10 The mixed economy In this system there is a private sector and a public sector. In the private sector the price mechanism allocates resources but the public sector, i.e. government, intervenes when the private sector fails to produce in an efficient way the goods and services which consumers want. In practice, all economies are mixed what varies is the degree of mix. Some are planned rather than free, e.g. North Korea, while others are more free than planned, e.g. the UK. Please note that Economic Systems is dealt with in more detail in Topic 3, The Role of Government in the Economy of Unit 2, The UK Economy. 28 INTERMEDIATE 2/HIGHER ECONOMICS

29 MICROECONOMICS Higher only 11 Production Possibility Curves (PPC) 11.1 Production possibility curves can be drawn (in theory) for a country or firm to show the possible combinations of goods that can be produced Capital goods Consumer goods On the diagram above, A is the maximum amount of consumer goods that a country could produce if all resources were devoted to their production. B is the maximum amount of capital goods that could be produced. The production possibility curve joins all the possible maximum combinations of consumer and capital goods. This maximum output is called the country s potential output Points on the curve are possible if all existing resources are being fully and efficiently employed, i.e. if resources are being used in a technically efficient way. If the economy is producing at a point inside the curve then it is producing less than it could. This could be because some resources are unemployed, or because some resources are being used inefficiently. Points outside the curve are not possible because the economy does not have the productive capacity. Given that any point on the curve represents a technically efficient use of resources, an economy still has to make the decision about which combination of goods to produce. Remember that to use resources in an economically efficient way, the combination chosen must be that which satisfies most wants. INTERMEDIATE 2/HIGHER ECONOMICS 29

30 MICROECONOMICS 11.4 A production possibility curve can be used to show the opportunity cost of producing a product, e.g. the opportunity cost of producing OD consumer goods is EB capital goods. The resources required to produce OD could have been used to produce more capital goods, i.e. EB. Capital goods Consumer goods 11.5 A production possibility curve (PPC) can also show the opportunity cost of a change in production, e.g. the opportunity cost of increasing the production of consumer goods from OD to OF is EG capital goods. Capital goods Consumer goods 30 INTERMEDIATE 2/HIGHER ECONOMICS

31 MICROECONOMICS 11.6 The usual PPC curves outwards from the origin because the opportunity cost of producing one good usually increases as more of it is produced. This is because more resources are required to produce each extra unit. Notice that as more consumer goods are produced the opportunity cost in terms of lost capital goods increases. Capital goods Consumer goods 11.7 If an economy s productive capacity increases, the PPC will move outwards and more of both goods can be produced. This is known as economic growth This would result from an increase in the quantity of a country s resources, e.g. discovery of North Sea oil; an advance in technology, e.g. the invention of the microchip; or an increase in the efficiency of resources, e.g. training of workers. Capital goods Consumer goods INTERMEDIATE 2/HIGHER ECONOMICS 31

32 MICROECONOMICS Topic 2: Demand 1 Consumer behaviour 1.1 Consumers gain satisfaction from consuming goods and services. Economists call this satisfaction utility. The utility gained from consuming a product is difficult to measure accurately but three possible ways of measuring it are by noting: how people react when they are consuming how much of the product people consume the price that people are willing to pay for it. Note that none of these measures is totally reliable, but the third is the most commonly used. 1.2 Total utility is the total satisfaction gained from consuming a product in a period of time. Marginal utility is the satisfaction gained from consuming an extra unit of a product. Total utility, then, is the total of the marginal utilities gained from each unit consumed. 1.3 Diminishing marginal utility. As a person consumes more of a good or service in a certain period of time, the utility gained from each extra unit (the marginal utility (MU)) decreases. Total utility will continue to increase, although at a decreasing rate, until a maximum is reached. At this point there is no further satisfaction to be gained from consuming more of the product. Marginal utility will be zero. Example Using the price the consumer is prepared to pay as a measure of utility: Pints of beer (per night) Marginal utility Total utility First 2.00s worth 2.00s worth Second 1.80s worth 3.80s worth Third 1.50s worth 5.30s worth Fourth 1.10s worth 6.40s worth 32 INTERMEDIATE 2/HIGHER ECONOMICS

33 MICROECONOMICS This is the same as saying that: if price were 2.00 the consumer would be willing to buy 1 pint because he gets 2 worth of utility if price were 1.80 the consumer would be willing to buy 2 pints because he gets 2 worth of utility from the first pint and 1.80 s worth from the second if price were 1.50 the consumer would be willing to buy 3 pints if price were 1.10 the consumer would be willing to buy 4 pints. Marginal utility of pints of beer Total utility of beer consumed 1.4 The information in 1.3 can be converted into a demand schedule: Price Quantity demanded per night (in pints) INTERMEDIATE 2/HIGHER ECONOMICS 33

34 MICROECONOMICS 1.5 The same information can be shown on a graph as a demand curve. Demand for beer Note that the demand curve and the marginal utility curve you drew in para. 1.3 are the same curve. 1.6 Consumer surplus is the difference between how much a consumer would be prepared to pay and what is actually paid, e.g. if beer were 1.80 per pint, 2 pints would be bought. The consumer was prepared to pay 2 for the first pint so he gets 20p of utility free i.e. he gets a consumer surplus of 20p. If the price were 1.50, he would gain consumer surplus of 80p (50p + 30p) of utility free. 1.7 Rational consumer behaviour. Economists assume that consumers act in a rational way i.e. they spend their money in the way that gains them maximum utility or, in plain English, best value for money. Of course, in practice, this does not always happen. Several factors may prevent this, e.g.: imperfect knowledge of the product or of rival products the actions of other people (both positive and negative) lack of self-control the consumption of some addictive products may be involuntary. 34 INTERMEDIATE 2/HIGHER ECONOMICS

35 MICROECONOMICS Assuming rational behaviour, a consumer will achieve maximum utility in the spending of their income when the marginal utility (MU) per p, spent on the last unit of each good is equal, i.e. when: MU of last unit of good A MU of last unit of B MU of last unit of C = = Price of A Price of B Price of C Example A student has 10 to spend one day on her lunch. There is only beer and sandwiches available. She gives a score out of 100 for the utility she thinks she would gain from each pint and each sandwich. Beer costs 1 per pint and sandwiches cost 1 each. How should she spend her 10 in order to gain maximum satisfaction? See the following table. Beer Marginal Marginal Sandwiches Marginal Marginal (pints) utility utility per p utility utility per p At 7 pints of beer and 3 sandwiches, satisfaction is maximised. If she were to buy an eighth pint of beer she would gain 0.3 units of utility per p, but this would have an opportunity cost of 0.4 units of utility per p from the third sandwich given up. If a fourth sandwich were bought, 0.35 units of utility would be gained but at an opportunity cost of 0.4 units of utility from the seventh pint of beer given up. INTERMEDIATE 2/HIGHER ECONOMICS 35

36 MICROECONOMICS 2 Demand 2.1 Definition. Demand (sometimes called effective demand) is the quantity of a good or service which consumers are willing and able to buy at a particular price in a certain period of time. 2.2 Individual demand and market demand. Individual demand refers to the demand of an individual consumer for a product. Market demand is the sum of all individual consumers demand for a product, i.e. total demand. 2.3 The Law of Demand states that the demand for a product varies inversely with its price. 2.4 As the price of a commodity goes up then there is a fall in the quantity which consumers are willing and able to buy. This happens for two main reasons: The income effect. As the price of a good rises then a person s real income (i.e. their buying power) falls. They are not able to buy the same quantity. The substitution effect. As the price rises then the marginal utility per p of the last unit(s) consumed falls. The rational consumer would switch to substitutes which would give a higher marginal utility per (better value for money). They are less willing to buy. Remember from para 1.7 that a consumer will arrange his spending until: MU of last unit of good A MU of last unit of B MU of last unit of C = = Price of A Price of B Price of C If the price of apples were to rise then the MU per p gained from the last apple would fall. The consumer would switch that spending to bananas or chocolate until equality of MU per p was restored. By consuming fewer apples the MU per p from the last apple will rise and by consuming more bananas or chocolate the MU per p from the last unit of these will fall. 36 INTERMEDIATE 2/HIGHER ECONOMICS

37 MICROECONOMICS 2.5 Exceptions to the Law of Demand Goods of prestige or ostentation, e.g. the demand for certain brands of jeans, training shoes or cars may rise as their price rises. Assumption of link between price and quality consumers may equate a rise in the price of a product as meaning that its quality has improved. Expectation of future price rises, e.g. speculators may react to a rise in the price of shares by buying more, expecting them to rise even further. Giffen goods Giffen, a nineteenth-century economist, observed that during the Irish potato famine, the demand for potatoes rose as their price rose. This was because living standards were so low that most people spent nearly all their income on potatoes, a filling food, so that when the price rose they had so little money to buy meat, etc., that they bought more potatoes. This effect can apply to any basic foodstuff in conditions of poverty. The demand curve in any of the above situations will slope upwards but note that above a certain price it will resume its normal shape, as the income effect will reduce people s ability to buy the product. INTERMEDIATE 2/HIGHER ECONOMICS 37

38 MICROECONOMICS 3 Changes in conditions of demand 3.1 Ceteris paribus. One difficulty in economics is predicting the effect of a change in a variable because there may be a number of different causal factors. The economist s way round this is to assume ceteris paribus. Ceteris paribus is a Latin phrase meaning other things remaining the same. Ceteris paribus is assumed so that the effect of one changing variable can be predicted. Example Price is only one of many factors which determines the demand for a product others include changes in income, prices of other goods, population, etc. With all these conditions affecting demand, one cannot predict a fall in demand as price rises unless these other conditions remain the same. Ceteris paribus is therefore assumed in the Law of Demand, i.e. the only changing influence is price, and all other conditions which could cause demand to change have not changed. Of course, in real life things are not so simple! 3.2 What are the conditions of demand? These are the factors, other than the price of the product, which may cause demand to change. They include: number of consumers (think of the effects of a change in total population and of a change in age distribution) disposable income (think of the effect on normal goods and on inferior goods) prices of other goods (think of complementary goods e.g. central heating and gas, and of substitute goods, e.g. gas and electricity) tastes and preferences, e.g. the influence of fashion and advertising. 38 INTERMEDIATE 2/HIGHER ECONOMICS

39 MICROECONOMICS 3.3 Note the different ways of showing the effect of a change in price on a demand curve and the effect of a change in a ceteris paribus condition. A change in price is shown by a movement along the demand curve, whereas a change in a condition is shown by a shift in the curve. Change in price Change in a demand condition INTERMEDIATE 2/HIGHER ECONOMICS 39

40 MICROECONOMICS Higher only 4 Elasticity of demand You need to know about two types: price elasticity income elasticity. Note that when writing or talking about elasticity of demand you should state what kind of elasticity of demand it is, i.e. price or income. 4.1 Price elasticity of demand (PED). This is a measure of the responsiveness of demand to a change in price. Price elasticity measures the reaction of consumers to a change in the price of a product. It is measured by comparing the percentage change of demand to the percentage change in price, i.e. Price elasticity of demand = % change in demand % change in price If PED is greater than 1, i.e. if the % change in demand is greater than the % change in price, then demand has been very responsive to the change in price. Demand is said to be price elastic. If PED is less than 1, then demand is price inelastic. If PED is 0, then demand has not changed at all. Demand is perfectly inelastic. If PED is equal to infinity (meaning that demand changed without a price change) then demand is perfectly elastic. If PED =1, then demand has unitary elasticity. This means that the % change in demand and the % change in price are the same. Note that the value of PED will usually be negative because an increase in price will cause a decrease in demand and vice versa. PED would only be positive in cases where demand does not follow the normal law of demand. This would be when demand increases as price rises (see para. 2.5). 40 INTERMEDIATE 2/HIGHER ECONOMICS

41 MICROECONOMICS 4.2 Effects of price elasticity on sales revenue Graph A Graph B Revenue gain Revenue gain Revenue loss Revenue loss Graph A shows that demand is price inelastic. A rise in price from P to P 1 leads to a fall in demand from Q to Q 1. The % fall in demand is less than the % rise in price. The revenue gained as a result of the rise in price is greater than the revenue lost as a result of the drop in demand so that revenue rises. You should also be able to say what would happen to revenue if price fell. Graph B shows that demand is price elastic. A rise in price from P to P 1 leads to a fall in demand from Q to Q 1. The % fall in demand is greater than the % rise in price. The revenue gained as a result of the rise in price is less than the revenue lost as a result of the drop in demand so that revenue falls. You should be able to explain what would happen to revenue if price fell. 4.3 Factors affecting price elasticity of demand Availability of substitutes. The closer the substitute the more elastic is demand (the more responsive are consumers). Price relative to total spending. If low then consumers take little notice of a change in price, e.g. the demand for a box of matches will tend to be price inelastic consumers will take little notice of a 10% (1p or 2p) change in price. INTERMEDIATE 2/HIGHER ECONOMICS 41

42 MICROECONOMICS Habit. The more a commodity is considered to be a necessity then the more demand will be price inelastic, e.g. petrol, cigarettes, a newspaper. Fashion. Products which are in fashion will tend to have a price inelastic demand, e.g. certain brands of jeans, toys, hairstyles. Frequency of purchase. Products that have to be bought frequently have price inelastic demands, e.g. fresh milk. Where purchase can be postponed, e.g. consumer durables (TVs) demand tends to be price elastic, in the short run at least. 4.4 The importance of price elasticity of demand (a) Businesses will want to know the effects on sales revenue if they change their prices. raising the prices of goods that have an inelastic demand will raise revenue lowering the prices of goods that have an elastic demand will raise revenue. Note that firms cannot predict exactly what will happen to revenue since they cannot predict accurately the response of consumers to a change in price, and of course ceteris paribus does not exist in the real world. (b) Government will want to know the effect on tax revenue if they change an expenditure tax. An increase in an expenditure tax increases the price of a good. Whether revenue increases depends on demand for the taxed product being price inelastic. 4.5 Income elasticity of demand Income elasticity of demand measures the responsiveness of demand to a change in income. It is calculated by: % change in demand % change in income 42 INTERMEDIATE 2/HIGHER ECONOMICS

43 MICROECONOMICS If a person s income rises by 10%, it does not follow that he will buy 10% more of all that he was previously buying. (a) (b) (c) (d) (e) Some commodities will still be out of his reach 0 income elasticity. Some commodities he will buy no more or no less of, e.g. a newspaper 0 income elasticity. Some commodities he may buy only a little more of, e.g. food income inelastic demand. The demand for necessities in a high-income economy such as the UK tends to be income inelastic. Some he may buy significantly more of, e.g. meals out, entertainment income elastic demand. Luxury goods/ services tend to have an income elasticity of demand greater than 1. Some he may buy less of, i.e. inferior goods such as bread, cheap brands of clothing negative income elasticity. 4.6 The importance of income elasticity (a) (b) If sellers know the income elasticity of demand for their products they will be able to predict what will happen to their total revenue in times of changing incomes, e.g. if demand for a product is income elastic then in times of rising incomes sellers can expect a significant rise in demand and in revenue. For products which have an income inelastic demand then the rise in incomes will increase demand but not by much sellers can expect a small rise in revenue. For inferior products which have negative income elasticity demand then demand would fall and so would revenue. On the other hand in a period of falling incomes, say in a recession, the demand for inferior goods and services should rise. The Government would also be able to predict changes in revenue from taxes on products. INTERMEDIATE 2/HIGHER ECONOMICS 43