Economics Theme 1 The Basic Economic Problem... 2 Economic Resources... 3 Positive and Normative Economics... 6 Economies of Scale... 7 Diseconomies of Scale... 8 Specialisation and Division of Labour... 9 THE DIVISION OF LABOUR... 10 Efficiency... 11 The Demand Curve... 12 Consumer surplus... 14 The Supply Curve... 14 Demand and Supply Diagrams... 17 PPF: Production Possibility Frontiers... 18 Elasticity of Demand... 20 Income elasticity of Demand... 24 Normal, Inferior and Giffen goods... 25 Cross Elasticity of Demand... 26 Price Elasticity of Supply ( PES)... 26 1
The Basic Economic Problem SPEC: Candidates should appreciate that the choices made to deal with the problem of scarcity affect the allocation of resources. They should understand the role of incentives in influencing choices. Candidates should know that the environment is an example of a scarce Resource which is affected by economic decisions. Wants are infinite but resources are limited. SCARCITY When there is a high demand for something that there is little quantity of. Over time as technology develops countries are able to produce morehowever, as wants increase scarcity will continue. For example, diamonds are low in quantity but there is high demand for them- therefore they can be sold for a higher price. NEEDS AND WANT Needs are things you require to survive- food, water, clothing, shelter, warmth. Needs are limited- there is a fixed amount of food, water or warmth an individual needs. Wants are unlimited- there is never a fixed value of things an individual desires. THE ECONOMIC PROBLEM FACED BY ALL COUNTRIES: What to make How to make it Who will get it o Planned economies- when the government decides how to distribute ALL resources (Communist Countries) o Capitalist economies- Government has little or no say in how resources are allocated. o Mixed economies- some resources and industries are owned by the Government whilst others remain private OPPURTUNITY COST When choices are made alternatives are considered. The next best alternative achieved in the same amount of time with the same amount of income or resources is called the opportunity cost. WHY ARE RESOURCES LIMITED? Sacrifices have to be made in order to produce more of one type of good. For example, if a store has retail space for clothes- it can not start selling food there. Therefore, it has to sacrifice selling the clothes. 2
Economic Resources SPEC: Economic Resources Candidates should understand the economists classification of economic resources into land, labour, capital and enterprise, which are the factors of production. Candidates should also understand the distinction between free goods and economic goods. 1. LABOUR Human effort- mental and physical Can be split in to different sectors: o Primary: extracting raw materials, e.g. agriculture, mining, fishing o Secondary: manufacturing e.g. publishing, chemicals, toys and housing. o Tertiary: industries that provide services e.g. banking, transport, education and retail The mobility of Labour This refers to how easy it is for workers to move from one occupation to another. Some workers may lack skills which make their work transferable meaning that changing jobs is virtually impossible. This is called occupational mobility of labour. Other workers may find it difficult to move from one location to another because of differences in house prices or lack of knowledge about opportunities elsewhere. This is called geographical mobility of Labour. Quantity and Quality of Labour At any one time there is only so much labour available in the countrythe supply is finite. Over time the quantity can change as immigration increases, a higher retirement age is imposed or an increased willingness to work occurs Quality can improve because of improvement in human capital- this is when workers are given better education and training and can therefore produce better and more goods and services. Human capital is the value of the worker. Factor reward: Wages 2. ENTERPRISE AND ENTREPREUNEURS Entrepreneurs take risks such as losing profits or economic downturns to make profits. They must take part in Organising labour capital and land and how they are to be effectively used. 3
The mobility of the Entrepreneur Most mobile of economics resources They have raw skills that can enable to recognise new opportunities and create new products or new businesses They are often more willing to move from one location to another Factor Reward: Profit 3. CAPITAL Refers to physical capital such as machinery, factories, railways, power stations etc. They are known as producer goods- they are only wanted for their ability to produce or provide other goods. The mobility of Capital Most machines and equipment are geographically mobile however things like factories and railways are not. Some capital goods can be used for more than one purpose and are therefore occupationally mobile. Financial capital is financial assets, shares, savings, loans For example: A office could be used by an accountant or an advertising agency however coal mines could only be used for one purpose and are therefore occupationally immobile. Quantity and quality of capital goods An increase in the quantity of capital goods could result in a short term opportunity cost for consumer goods because more resources will be used to create the capital goods. However in the long term this will then be used to produce more consumer goods. The quality of capital goods is improved by advances in technology. Factor Reward: Interest 4. LAND Land means all natural resources that can be used to produce goods and services. This includes everything in the sea, under the ground and things that occur naturally on the ground. These can be divided in to: o Renewable Resources Replaced automatically by nature so can be used continually. E.g. rivers, air, tidal power. o Non- Renewable Resources Are not automatically replaced by nature. E.g. coal, oil and natural gas 4
The mobility of land Land itself is geographically immobile- it is not possible to move land from Scotland to London because there is a shortage of space for offices and homes. Resources are immobile in their natural form Land is the most occupationally mobile it can be changed easily and quickly An area of land could be used for living, farming or recreation FACTOR REWARD: Rent Free goods: Economic goods: The objectives of economics actors: Candidates should understand that individuals, firms and governments may have a range of economic objectives. 1. Consumers/ Individuals: Maximise their own economic welfare (could be utility or satisfaction) they want to make the most out of their income. Make choices that will give them the most satisfaction 2. Workers: Maximise their income, working conditions and Job security. Other objectives such as obtaining company benefits may also come in to play. 3. Firms: Maximise Profit. However, some firms such as Oxfam work to help those who are less fortunate 4. Governments: Maximise welfare of citizens and act in their best interests. 5
Positive and Normative Economics SPEC: Candidates should be able to distinguish between positive and normative statements. They should understand how value judgements influence economic decision- making and policy. Positive statements: Also known as economic statements, these can be tested and proved right or wrong. For example The NHS employs over 1 million workers or Females perform better at A levels than Males These are either true or false Normative Statements: These are mostly opinions and can not be proven right or wrong. For example More aid should be given to developing countries or The state pension should increase There is no definite true or false answer for this, it tends to rely on personal opinions and judgments These normally involve words such as should or ought Value Judgments: These can influence economic policy making A government has to decide on its economic priorities- for example, should it increase spending on education or health care? These decisions are informed by positive economics- in the case of retirement age it can calculate the expected costs and expected future size of the labour force to make its decisions. 6
Economies of Scale SPEC: Candidates should be able to categorise and give examples of economies of scale, recognise that they lead to lower average costs and may underlie the development of monopolies. Candidates should be able to give examples of diseconomies of scale, and recognise that they lead to higher average costs and may discourage the growth of firms. Definition: When a firm increases in size so that the average cost per unit of production is greatly decreased. Types of economies of scale: 1. Technical More expensive, specialist equipment is invested in by larger companies as they can split the cost of the machinery with all of their store branches. They can use technology to mass produce the same product. It is not viable for a smaller company to do the same thing as there is little demand for the same product. It would also be more expensive as there are not many branches to split the cost over. If they did invest in this they would have to increase the individual price of the product. 2. Marketing Larger companies can afford better advertising campaigns such as celebrities. This is also when companies can negotiate cheaper prices with suppliers because of their reputation within an industry. (brand power) For example, Cadbury can normally negotiate a better price for cocoa beans from farmers because they are a reliable and trusted brand. 3. Financial Larger firms are given loans quicker and with less difficulty because they are trusted and successful. They are also given loans with less interest because they have more collateral. They are considered more credit worthy than smaller less known firms or businesses. 4. Specialisation The production process is split in to separate jobs in order to increase output Leads to improved productivity 7
Diseconomies of Scale INTERNAL DISECONOMIES OF SCALE Definition: A large firm may eventually experience a rise in the average cost of a product. Causes of diseconomies of scale: 1. Control o Monitoring thousands of employees in big firms can be more difficult so productivity of individual employees may fall. 2. Co-Operation o Workers in larger firms may feel alienated and may lose morale. o May lead to the productivity falling. 3. Costs o Firms may purchase large bulk orders which do not always get utilized and can sometimes go to waste. o Resources can also be mis-used more easily by employees in larger firms so this could result in money being wasted. EXTERNAL DISECONOMIES OF SCALE Definition: When one area of a country becomes very specialised in a certain field that they begin to rely on it too much. When other parts of the country or world become specialised in the same field and offer it much cheaper the area can not do anything else and therefore the factories and manufacturing plants are closed down, this has a negative impact on the overall economy. 8
Specialisation and Division of Labour SPEC: Candidates should understand the benefits of specialisation and why specialisation necessitates an efficient means of exchanging goods and services such as the use of money as a medium of exchange. SPECIALISATION Definition When we concentrate on one particular product or task. For example it can be when certain countries produce a certain goodfor example Honduras produce bananas because their climate allows them to. Regional specialisation can also take place for example, Stoke-on- Trent specialises in pottery whilst London specialises in financial services. Benefits of specialisation: 1. Higher output: Total output of goods and services is raised and the quality can be improved. A higher output at lower costs mean more wants and needs might be satisfied with a given amount of scarce resources. 2. Variety: Consumers have improved access to a greater variety of higher quality products Better choice both from within their own economies and the production of other countries. 3. A bigger market Specialisation and international trade increases the size of the market offering opportunities for economies of scale. 4. Competition and lower prices Increased competition for domestic producers acts as incentive to reduce costs to remain competitive. 9
THE DIVISION OF LABOUR Definition: Where the production of a good is broken up in to many separate tasks. Each task is performed by one person or a small group of people. Benefits of division of labour: Firm: Output per worker increases Profits will increase as the average cost falls Profits are maximised so price can decrease Reduces cost per unit because time is saved as the worker is not constantly changing tasks. Low unit costs allow firms to remain competitive in the market in which they operate. Individual: Each worker can concentrate on what they are good at and build up their expertise. Possibility of higher pay for specialised jobs. Disadvantages/limitations of division of labour: May eventually reduce efficiency and increase unit costs because the work can become unrewarding and repetitive. This lowers worker s motivation. Workers may begin to take less pride in their work and quality will suffer. Runs the risk that if one machine or level in the process breaks down then the entire production line could stop functioning. Workers who receive narrow training may not be able to find alternative jobs if they find themselves out of work. (occupationally immobile) Mass produced standardised goods tend to lack variety. (no unique qualities) 10
Efficiency SPEC: Candidates should understand the meaning of productive efficiency. They should be able to illustrate the concept both on a production possibility diagram, and on an average cost curve diagram. Definition: Relates to how well a market or economy allocates scarce resources to satisfy consumer needs. Static Efficiency: In the short run (exists at one point in time) Dynamic Efficiency: In the long run Productive Efficiency (static efficiency): Refers to a firm s cost of production Productive efficiency exists when production is achieved at the lowest possible cost. When a firm s output is produced at the lowest average cost. Efficiency on a PPF Diagram Point A: Productively Inefficient Point B: Productively Efficient This is because all the resources in at point B are fully utilised. Productive Efficiency via Cost Curve Diagram Point A: Productively Efficient as it is the lowest average cost point. Point B: Productively Inefficient as it is a high average cost. B A 11
The Demand Curve SPEC: Candidates should know that the demand curve shows the relationship between price and quantity demanded, and understand the causes of shifts in the demand curve. Definition: The quantity of goods or services that will be bought at any given price over a period of time. Demand and Price: When the price of a product or service is decreased, the demand for this good or service is normally increased. The demand curve shows the quantity that is demanded at any given price. There is an inverse or negative relationship. Key terms: Extension of demand: When quantity that is demanded rises. Contraction of demand: When quantity demanded falls. At the price of 0.50 the quantity demanded is 100, however once that price is decreased to 0.20 then the demand rapidly increases to 400. The curve shows Effective demand (how much people would like to buy with their given amount of resources) not how much they would like to buy with unlimited resources. Shifts in the Demand Curve: An increase in demand is shown by a shift in the demand curve. The curve will shift to the LEFT. A decrease in the demand is shown by the curve shifting to the RIGHT. A decrease in demand takes place in this diagram, as D1 shifts to D2. 12
Factors which effect Demand: 1. Demand and Income This is another factor which effects demand- a rise in income leads to an increased demand for luxury goods such as better or faster cars. The demand curve would shift to the right. 2. The price of other goods The price of another good or service could affect the demand for another product. For example, if a drought leads to a rise in the price of potatoes, this may lead to a rise in the demand for a substitute product like rice, bread or pasta. A rise in the price of a tennis racket may result in a decrease in demand for tennis balls as this is a complimentary good. It may instead lead to a rise in badminton rackets as an alternative sport. 3. Changes in population An increase in population would lead to an increase in demand of certain products, and vice versa. 4. Changes in fashion Changes in fashion may mean that certain types of clothing have reduced demand. 5. Changes in legislation Government may release new legislation resulting in an increased demand for certain products such as seat belts or infant car seats. 6. Advertising Powerful advertising can influence consumer demand. 13
Consumer surplus Definition: This occurs when people are able to buy a good for less than they would be willing to pay. For example, if somebody was going to buy a can of soup and were willing to spend a maximum of 2 on it, and the shop is selling it for 1.50 instead, the consumer surplus is 0.50p, because this is how much they have extra, or they have saved. The Supply Curve SPEC: Candidates should be aware that, other things being equal, higher prices imply higher profits and that this will provide the incentive to expand production. They should understand the causes of shifts in the supply curve. Definition: The quantity of a good or service that a producer is willing and able to provide the market at a given price at a given time. The supply curve: An increase in price means an increase in the quantity supplied. There is a positive correlation. BECAUSE: As the market price of a particular good or service increases, producers expand supply in order to take advantage of potential profits. Limitations of the supply curve: Firms are not always motivated by profit. E.g. Oxfam The cost of producing a unit does not take in to account for economies of scale. 14
Price changes lead to a MOVEMENT along the curve: As show in the diagram, if the price rises, the quantity being produced moves from position X to position Y so the quantity being produced increases. This is because as the price rises there is more profit to be made and therefore firms will want to take advantage of this. This is called an EXTENSION of supply. If prices decreased the supply would also decrease, this is called a CONTRACTION of supply. THEREFORE: 1. If prices of a good increase how do producers respond? Ceteris Parabus, producers will expand production to take advantage of the higher prices and the potential higher profits they can now make. 2. If prices of a good fall how will producers react? A price fall will cause a contraction in supply because at lower prices production becomes relatively less profitable hence firms will cutback or even stop production. SHIFTS IN SUPPLY: Any other factor other than price causes a SHIFT in the supply curve. A shift in supply to the LEFT means that the amount producer offer for sale at every price will be LOW. A shift in supply to the RIGHT means that the amount producers offer for sale at every price will be MORE. From s1 to s3 supply will decrease. From s1 to s2 supply will increase. 15
FACTORS THAT COULD CAUSE A SHIFT IN THE SUPPLY CURVE: 1. Costs of production If the costs of production increase, the supply curve will shift to the left this is because higher cots in production mean that suppliers are unable to produce at the same rate as before. If costs of production decrease, the supply curve will shift to the right as they are able to produce more with the same amount of resources. 2. Technology New technology can lead to a fall in costs of production which means more supply. HOWEVER: sometimes with war and natural disasters technology can become less efficient and therefore supply could fall. Allow more products to be produced with less resources. 3. The price of other goods If price of beef increases, there will be an increase in the quantity supplied. More cows will be reared to be slaughtered as a result there will be an increase in the amount of leather supplied. However, increase in the price of beef means that farmers will stop supplying goods like cotton or wheat. 4. The goal of sellers If there is a change in profit levels there will be a change in supply. 5. Government legislation Anti air- pollution control raise costs of production which can lead to decrease in supply. If extra tax is added on the production of a good, the supply could decrease. For example, alcohol, tobacco, petrol (demerit goods) Direct tax- tax upon your income (income tax) Indirect tax- tax upon your spending (VAT at 20%) 6. Expectations of future events If firms expect prices in the future to be higher they may increase supply. 7. The weather In agriculture bad weather may reduce supply and good weather may increase supply. 16
8. Producer cartels In some markets, firms and producing countries may restrict supply which allows them to raise prices and increase profits. E.g. OPEC which restricts supply of oil. 9. Changes in productivity of Labour If worker s productivity increases they can produce more. Greater productivity is a result of an increase in human capital. More can be produced with existing Labour resources. Cost of production per unit will FALL. 10. Subsidies These have the opposite effect to taxes; this reduces the cost of producing an additional unit and causes the supply curve to shift outwards. E.g. scrappage subsidy scheme 11. Price of substitutes If apples are selling for a higher price than pears, you would produce more apples. 12. Industrial relations If relations are poor between workers and management it can result in industrial action which can decrease the supply of goods and services. 13. Unexpected Events These can not be predicted so can have an impact on supply. For example, the volcanic ash could lead to widespread disruption in the aviation industry. Demand and Supply Diagrams This is a demand AND supply diagram, the point where the two curves meet is called the Equilibrium or the market clearing price. This is the exact price when the demand will meet exactly with the supply. 17
PPF: Production Possibility Frontiers SPEC: Candidates should understand production possibility diagrams and be able to use them to illustrate different features of the fundamental economic problem, such as opportunity cost, under- use and the full use of economic resources, together with trade- offs and conflicting objectives. Definition: Diagram which illustrates the maximum output of a combination of two types of products than economy, are, firm or individual can produce with its current resources and technology. It assumes maximum production level Explaining the shape of PPF: Concave to origin Linked to the idea of opportunity cost. Resources are not mobile between industries. At point A: under utilisation of resources occurs, the economy is not producing at its maximum ability. At point B: the economy is producing at its maximum efficiency, all resources are fully utilised. At point C: This is currently unattainable in the SHORT RUN. However it may be possible in the LONG RUN. Short run- A period when all factors of production are FIXED Long run- Factors of production are variable Factors that may result in under- utilisation- (point a) Resources are not being used to full potential. For example, industrial action may take place, machines may have broken down, or workers may be sick. 18
Factors that may allow the PPF to shift OUTWARDS- QQT! Quantity of resources may increase. Improved technology- new ways are found to produce goods and services. Economy may require an increase in productive potential (economic growth) Increase in the quality of resources- e.g. better training for workers (increase in human capital) Factors which can cause a country s PPF to shift INWARDS Impact of a deep recession- firms may close down, people being made permanently unemployed or redundant. External shocks which destroy factor resources. E.g. natural disasters RECESSION- two successive quarters of negative economic growth PPF and opportunity cost Illustrates the opportunity cost of increasing the production of one type of product in terms of another type For example, at point B, the firm decides to produce 30 million pizzas and 30 million sodas; however, if they then decide to increase the amount of pizza being produced to 40 million, they sacrifice the production of 10 million sodas. This is the opportunity cost. 19
Elasticity of Demand SPEC: Candidates should be able to calculate price, income and cross elasticities of demand and understand the factors that influence these elasticities of demand. They should understand the relationships between price elasticity of demand and firms total revenue (total expenditure), and between income elasticity of demand and normal and inferior goods. Definition: The proportionate response of changes in quantity demanded to a proportionate change in price, measure by the formula: P * the change in quantity Q the change in price. Extreme Price Elasticities of demand This is an example of a perfectly elastic demand curve, even if the price is increase by 1p there will be no demand for that particular product or service. This is because there are plenty of substitutes for the same product, for example, a sack potato has lots of competition and therefore consumers have more choice. This is an example of a perfectly inelastic demand. The price can be raised to any amount and it will still meet a demand. Consumers are willing to pay more because it is something that they NEED. For example, petrol, it can also apply to goods to which somebody can be addicted, e.g. alcohol or cigarettes. 20
Demand for the good is price elastic. (Consumers are sensitive to price changes) Demand for the good is price inelastic (consumer are not so sensitive to price changes) This curve is price inelastic; people are less sensitive to price changes because they need the good. Another example could be brand loyalty. People are willing to pay more to get the product or service from particular brand. Or there could be few substitutes for this good and therefore consumers would still purchase it. The good has unitary price elasticity of demand. This is when the quantity demanded responds to a price change by the SAME or EQUAL proportion. 21
Calculating Price Elasticity of Demand PED= Percentage change in quantity demanded Percentage change in price Percentage change in quantity demanded can be calculated by: 1. Dividing the change in quantity demanded BY original quantity demanded 2. Multiply this value by 100 Percentage change in price can be calculated by: 1. Dividing change in price by original price 2. Multiply this value by 100 EXAMPLE: If price of a product rises from 20 to 24 and demand falls from 400 to 300 the PED will be: -25% = -1.25 20% Degrees of Price elasticity of demand: The relationship between price and demand is normally INVERSE The PED is usually negative Elastic demand is when a given percentage change in price causes a greater percentage change in demand, when the PED is greater than 1 and less than infinity. Elastic demand is illustrated by a SHALLOW downward sloping demand curve. Inelastic demand is when a given change in price causes a SMALLER percentage change in demand; the product will have INELASTIC demand. The coefficient of PED in this case will be greater than 0 and less than 1. This is illustrated by a steep downward sloping demand curve. Unitary price elasticity of demand occurs when a percentage change in price results in an EQUAL percentage change in demand. The numerical coefficient is 1. Perfectly elastic demand is when a change in price will cause an infinite change in the quantity demanded. The numerical value is infinity. This is when consumers are VERY sensitive to price changes and substitutes are readily available. Perfectly inelastic demand is when a change in price causes NO change on the quantity demanded. The numerical value is 0. For instance, a person with an addiction to cigarettes will always be willing to buy them, no matter the price. 22
Determinants of price elasticity of demand: The original price of the product o If the price of one packet of sugar was increase by 10% it would have little effect on the consumer as it takes little away from their income, however, if the price of more expensive product, such as a car, was increased by 10% it would make more of an impact. o Consumers would be likely to find alternatives to that particular car so it would have high PED. o Consumers are not likely to stop buying sugar because of a small increase in price and therefore there is low PED. Width of market definition o Products which are widely defined have little or no substitutes and demand is INELASTIC. For example, spaghetti has lots of substitutes but food as a whole has no substitutes so would appear to be inelastic. Time o Demand can become more elastic over time, for example if the prices of petrol increased the demand would not change very much because petrol is needed to get to work etc. However, over time they may decide to use public transport or cycle to work instead. Amount of substitutes o Products which have many substitutes will have ELASTIC demand because people are more willing to switch to other brands or products. Habit forming products o If the price of all brands of cigarettes increased it would not have an effect on demand because smokers find it hard to give up smoking. Luxuries o These have elastic demand because they are not essential purchases. For example, strawberries and jewellery are likely to suffer from less demand. o However, products like soap or toilet paper have inelastic demand because they do not have close substitutes and consumers are therefore willing to pay more. 23
Total revenue and price Elasticity of Demand TOTAL REVENUE= price * quantity Total revenue- total cost = Profit 1. On an elastic curve it is worth decreasing the price because the total revenue will increase. On an elastic demand curve it is not worth increasing the price because the total revenue will decrease. 2. On an inelastic curve it is not worth decreasing the price because more revenue is lost than gained. On an inelastic demand curve it is worth increasing the price because the totally revenue is increased as there are less substitutes for this particular good. 3. On a unitary demand curve it does not matter whether the price is increased or decreased as the totally revenue remains the same. Income elasticity of Demand SPEC: Candidates should be able to calculate income and c understand the factors that influence this elasticity of demand. They should understand the relationship between income elasticity of demand and normal and inferior goods. Definition: Measure of the change in demand of a good if the consumer s income changed. Formula for income elasticity of demand: Percentage change in quantity demanded Percentage change in income A fall in demand for a good when income rises gives a NEGATIVE value to income elasticity of demand. Items which have low income elasticity of demand would be items like washing up liquid or super market branded products. A rise in demand for a good when income rises gives a POSITIVE value to income elasticity of demand. Items which have a high income elasticity of demand would be holidays or new cars. 24
Normal, Inferior and Giffen goods Normal Goods These have a positive income elasticity- more is demanded if income increases. Demand curve shifts outwards. Normal necessities have an income elasticity of demand between 0 and +1. For example: if income increases by 10% and demand for fresh fruit increases by 4% then the income elasticity would be +0.4. Luxury goods and services have an income elasticity of demand as more than +1. Demand rises more than proportionately to a change in income- 8% increase in income may lead to a 10% increase in demand for a holiday. The income elasticity of demand is +1.25 Inferior Goods These have a negative income elasticity of demand As income increase, demand falls. Superior goods are bought instead. E.g. supermarket own brand cola may be replace with Cocoa Cola or council owned properties. Giffen Goods As price increases the demand also increases. Bread is a staple food for many people, especially the poor; the poorer parts of society would rely on it to fill up their stomachs. If prices of bread went up, poorer people would abandon demand for meat or vegetables all together and buy up more bread instead. Therefore as price of bread increased, so did demand for bread. o Substitution effect If the price of a good rises, consumers will buy less of that good and more of others because it is now relatively more expensive. o Income effect If the price of a good rises, the real income of consumers will fall. They will be unable to buy the same goods as before, or the same quantity of goods or services as before. If the good is a normal good they will buy less, if the good is an inferior good they will buy more. Other goods that would have upward sloping demand curves: Goods with snob appeal- also known as VEBLEN GOODS; these are goods which make the buyers look wealthier and confer status upon the buyer- e.g. diamonds or cars. Speculative goods- as the price of a commodity or valuable good increase, the quantity being bought also increase because the overall trend shows that the price will increase further so they can then sell them on and make a profit. Quality goods- some people may automatically assume that goods with a higher price will be of better quality and therefore choose to spend more money on branded products 25
Cross Elasticity of Demand SPEC: Candidates should be able to calculate cross elasticities of demand and understand the factors that influence these elasticities of demand. Definition: This measures the proportionate response to the quantity demanded of one good to the proportional change in the price of another For example, if beef increased in price, the demand for pork may increase because it is a substitute- cross elasticity measures the extent to which this demand increases. Formula: Percentage change in the quantity demanded of good X Percentage change in price of another good (Y) Two goods which are substitutes have a positive cross elasticity for example if the price of pasta rises by 10% then the demand for a substitute good such as bread may increase by 2%. The cross elasticity for this would be 0.2 Two goods which are complementary will have a negative cross elasticity For example, if the price of air travel increase, there could be a fall in demand for foreign holidays. Another example could be that if the price of paper decreases by 20% then the demand for pens could increase by 5%. The cross elasticity of demand for this would be -0.25. Two goods that have little or no relationship with another have 0 cross elasticity. For example, a 10% increase in the price of cheese will have no affect on the demand for bicycles. So the cross elasticity of demand would be at 0%. Price Elasticity of Supply ( PES) SPEC: Candidates should be able to calculate price elasticity of 1supply and understand the factors that influence price elasticity of supply. Definition: The responsiveness of quantity supplied to a change in price Price Elasticity of Supply equation: Percentage change in Quantity Supplied Percentage change in Price 26
Interpretations of PES Supply curve is always upward sloping PES will always be positive Top and bottom of PES inputs will either both be positive or negative values. Size The size of the number tells us the degree of response Perfectly inelastic if PES=0 No response to quantity supplied if there is a change in price. Very little quantity response in price change PES= Between 0 and 1 Percentage change in Quantity supplied is equal to price change. PES= 1 27
Larger response in quantity compared to the price change. PES= between 1 and infinity Producers are willing to supply any amount at any given price. PES= infinity 28
Determinants of PES 1. Time period involved in production process In the short term the supply is likely to be more price inelastic than in the long term, this is because: o Some items take a long time to make, for example if there is a crop failure for hazelnuts then it will take time for the next growing season to come round again halting supply. 2. Capacity If there is plenty of spare capacity then a firm can increase its output without a rise in cost as the resources are not being fully utilised. Therefore, supply is ELASTIC in response to a change in price (they can begin to supply more if prices rise) However, if firms are already at full capacity already then the supply curve will be INELASTIC. 3. Levels of stock Some firms hold large amounts of stock They can then respond to changes in price. For example, wheat can be stored around the world to be released if price rises, however, some products can not be stored for a long time. 4. The ease and cost of factor substitution If both capital and labour are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour can not easily be switched. A good example for this is a printing press which can easily switch between printing magazines and greeting cards. 29