economics a level

ceteris paribus

assumption that all other factors remain unchanged

positive economics

• concerned with objective statements of how a market or an economy works

• can be proven true or false

positive statements

statements that can be proven true or false with evidence

normative economics

focuses on value judgements

study of policy prescriptions about economics

normative statements

statements that cannot be supported or refuted

viewpoints/opinions

basic economic problem

finite resources available in relation to the infinite wants and needs

Economics is the

study of scarcity and its implications for resource allocation in society

scarcity impact on prices (in a free market)

the scarcer the resource, the higher the price

the less scarce the resource, the lower the price

Opportunity cost is the

loss of the next best alternative when making a decision

what is an economic model

simplified version of reality

Production Possibility Frontiers (PPF) model is

• shows the maximum possible combination of two goods or services that can be produced using all available resources

Many PPF (production possibility frontier) diagrams show

• capital goods (y axis)

• consumer goods (x axis)

• Capital goods are

• man-made aids to production

• examples such as machinery/tools

consumer goods

sold to individuals to satisfy their wants and needs and are not meant for further production

inward shift

economic decline

outward shift

economic growth

Economic growth occurs when there is

an increase in the productive potential of an economy

outward shift/ economic growth is caused by

increase in the quality or quantity of the available factors of production

Economic decline occurs when there is

any impact on an economy that reduces the quantity or quality of the available factors of production

division of labour is when

production process is broken down into stages and each worker focuses on a specific task

division of labour (hence specialisation leads to)

higher output per worker over a measured time period and so increases productivity

advantages of division of labor/specialisation in production

• creates many low skilled jobs

• increased productivity, as workers do not have to keep changing tools and become highly skilled at specific tasks. helps businesses produce more cheaply than competitors becoming more competitive

• lower cost/unit as each worker is able to produce more goods whilst receiving same pay, enabling businesses to lower prices or increase profit margins.

• Less training is required as workers will only need to be trained on one task

• businesses may be able to replace workers with machines saving on labour costs

disadvantages of division of labor/specialisation in production

• boredom and worker demotivation which may mean less productivity and lower quality

• may increase worker turnover rates

• may be hard for the worker to find a new job as theyre only specialised in one skill

• Mass produced products often lack variety

advantages of division of labor/specialisation in trade

• lower cost makes firm more competitive internationally (exports) (lower price than its foreign competitors, or at the same price with a higher profit margin)

• Increased exports can result in economic growth for the nation (mean that domestic firms must increase production to meet this foreign demand)

• Economic growth leads to higher income and a better standard of living

• income from exports can be used for imports, increases variety of goods available in a country

disadvantages of division of labor/specialisation in trade

• may create over-dependency on other countries' resources, may cause problems if conflict arises

• will increase the rate of resource depletion in a country

• Many firms in an entire industry may close, leading to structural unemployment

structural unemployment

unemployment caused by mixmatch between a workers skill and the available jobs in the economy

money functions as

• Medium of exchange

• Measure of value - money as a common unit helps in comparison and accounting

• Store of value - goods take up too much space or lose their value over time

• Means of deferred payment - consumers can buy on credit and pay later

in order to solve the basic economic problem of scarcity, ________ emerge or are created by different economic agents within the economy

economic systems

economic agents

• consumers

• producers

• government

• special interest groups

any economic system needs to decide how to answer the three fundamental economic questions

• what to produce

• who to produce for

• how to produce it

• A free-market economy is an

• economy that has no government intervention in the allocation of resources

• A command economy is

• an economy in which all of the resources are owned by the state and the government controls the distribution of goods/services

• A mixed economy is

• resources are allocated by price mechanism and the government

advantages of free market economy

• profit incentive to work hard/innovative for increase in incomes

• profit incentive firms to be efficient → likely to use profits to develop new processes to reduce costs and improve efficiency

• consumers are free to choose the goods and services they desire

• producers are free to create products to meet consumer needs

• Greater variety of goods/services  as a lot of firms would compete in the market →increased choice for consumers→ high living standards

• Competition leads to better quality and lower prices of goods/services

• Firms have economic freedom to set up business due to no regulation & no tax obligation→ more numbers of firms set up → PPC shifts out and economy grows

• no expensive central planning

• firms likely to use profits to develop new processes helping to reduce cost and improve efficiency

• Firms respond quickly to meet the demand of consumers due to high competition→ increase in consumer welfare

• maximise both producer surplus and consumer surplus (welfare maximisation) without and deadweight loss due to government intervention.

• Labour more incentive to work as no income tax→ less unemployment

• government failure avoided (surpluses and shortages resulting from price controls, unintended consenquences such as smuggling, excessive administrative costs)

• market forces helps to clear the market when there is disequilibrium

disadvantages of free market economy

• Wealth concentrated in the hands of few → able to keep buying up the scarce factors of production →increases inequality

• Public goods will not be produced/underprovided due to free rider problem, no incentive for profit motivated firms to provide, market failure

• product quality falls as firms lower quality standards in order to increase profits

• product quality may fall as firms (motivated by profit maximisation, risk minimisation) may want to reduce costs → information gap → reduction consumer welfare → misallocation of resources, loss of trust, market failure

• markets can be unstable (uncertainty created as market bubbles can emerge and burst) → created by herd behavior, irrational exuberance → bursting creates economic instability, uncertainty/reduced investment. harms long-term growth

• Monopolies develop as firms increase market power through mergers and acquisitions → firms with higher market power can charge higher prices (exploit) → high prices low choice for consumers → welfare loss allocative inefficiency

• depends on extent to which an economy acts as a free market

• Merit goods will be underproduced and underconsumed

• Demerit goods will be overproduced and over consumed

• Can increase unemployment as firms (profit-motivated) may employ machines if they are more profitable → structural unemployment

• Dangerous goods can be produced and sold if profits can be made

• Negative externalities exist: No control on pollution. can lead to resource depletion and environmental degradation

command economy advantages

• objective is social welfare and equality → resources/income distributed more evenly → lower inequality improves overall welfare as less poverty

• gov sets wages rather than allowing market forces to determine pay → equal/similar wages regardless of occupation → prevents wage inequality between high and low skilled workers

• jobs are allocated by government → less unemployment → stable incomes

• Resources of the nation can be directed towards urgent priorities quickly

• government owns monopoly businesses so consumer exploitation through high prices can be avoided

• Provision of public goods

• No under consumption of merit goods by the state

• No overproduction of demerit goods

command economy disadvantages

• Receiving the same wage → disincentives for people to acquire difficult skills → reduces economic efficency and productivity, limits growth

• lack of competition → less incentive to innovate, improve quality, or reduce costs → reduces long term economic growth

• central planning must estimate consumer demand without price signals → information failure → inflexible and unresponsive to changes in consumer demand → misallocation of resources, shortages and surpluses of goods/services

• Black markets in shortages

• opportunities for higher incomes are limited → restricts access to luxury goods and improved living standards → personal freedoms restricted

• Less motivation to work due to guaranteed employment, low productivity and poor economic growth

how does government intervention occur in mixed economies

taxation (to raise revenue)

spending the revenue to redistribute income and provide essential goods/services

different type of tax interventions

• personal income tax

• corporation tax

• value added tax

• tariff on imports

• inheritance tax

Income is redistributed through the creation of a

welfare system

• Consumers are assumed to act rationally. They do this by maximising their

satisfaction gained by a good/service

• Producers are assumed to act rationally. They do this by selling goods/services in a way that

• maximises their profits

• Workers are assumed to act rationally. They do this by

• balancing welfare at work with consideration of both pay and benefits

• Governments are assumed to act rationally. They do this by

• placing the interests of the people they serve first in order to maximise their welfare

Demand is the

amount of a good/service that a consumer is willing and able to purchase at a given price in a given time period

A demand curve is a graphical representation of the price and quantity demanded (QD) by consumers

• price in y axis

• quantity demanded in x axis

• downward slope

law of demand

price and quantity demanded are inversely proportional

Marginal utility is the

extra utility (satisfaction) gained from the consumption of an additional unit of a product

The Law of Diminishing Marginal Utility states that

• as a person increases consumption of a product

• there is a decline in the marginal utility that person derives from consuming each additional unit of that product

law of demand states that

when there is an increase in price, there will be a fall in quantity demanded

Price elasticity of demand is the

responsiveness of quantity demanded to a change in price

PED formula

% change in quality demanded / % change in price

The PED value will always be

negative

PED = 0

perfectly inelastic

QD is completely unresponsive to a change in price

Consumers are willing and able to pay ANY price for the same quantity of the good. Straight downward line

PED =infinity

perfectly elastic

QD will change to zero with any percentage change in price

Factors that influence the PED

availability of substitutes (high number of substitutes mean that as soon as prices increases, consumers switch to a cheaper substitute)

habits and addictions

time period

Percentage of total expenditure on the goods/services (goods with large expenditures are usually elastic, whilst small goods with a small expenditure are usually inelastic)

Durability of the good (if good is too durable like gadgets you can postpone consumption and it will be elastic. Perishable goods are more inelastic as consumption cannot be delayed)

Brand loyalty (when a consumer becomes more loyal to a brand the product becomes more inelastic)

Income elasticity of demand (YED) reveals

how responsive the change in quantity demanded is to a change in income

YED formula

%change in quantity demanded / % change in income

YED is influenced by

any factors in an economy which change the wages or salaries of workers

Cross price elasticity of demand (XED) reveals how

responsive the change in quantity demanded for good A is to a change in price of good B

XED formula

% change in quantity demanded for product A/ % change in price for product B

importance of PED for firms

• Helps make business decisions regarding setting prices as revenues at different price points can be estimated. Setting wages and salaries

• Helps a firm to do price discrimination (charge differently in different markets for the same product. High price in the inelastic market and low in the elastic market.

to firms if a product is inelastic

should raise their prices

to firms if a product is elastic

lower their prices

Importance of PED for government

• Make decision on amount of tax: high taxes on inelastic goods and low taxes on elastic goods (however  a high tax on inelastic goods can lead to negative impact on the poor in case they are necessities)

for governments if the tax price inelastic in demand products, they can

raise tax revenue without harming firms too much

how can XED help firms

• help them adjust pricing strategies for substitute and complementary products

• can help them understand the likely impact of competitors' pricing strategies on their sales

Knowledge of YED is important to firms as they seek to

maintain sales and maximise profits through periods of recession or economic growth

total revenue rule states that

in order to maximise revenue, firms should increase the price of products that are price inelastic in demand and

decrease prices on products that are price elastic in demand

sales revenue =

price of product x quantity sold

when prices increase and the product is price inelastic in demand, the quantity demanded

falls but it is less than proportionate fall than increase in price

Supply is the

Willingness and ability of a producer to sell goods and services at different prices over a period of time

supply curve

• upward slope

• positive relationship between price sold and quantity supplied

law of supply states that

when there is an increase in price, producers will increase the quantity supplied and vice versa

Price elasticity of supply (PES) reveals

how responsive the change in quantity supplied is to a change in price

Price elasticity of supply formula

% change in quantity supplied/ % change in price

The factors that determine the responsiveness are called the determinants of PES and include:

Availability of factors of production (If there is no difficulty in hiring factors of production (land, labour, capital & enterprise and they are easily available then producer will immediately be able to increase the quantity supplied when price Increases, making PES >1 elastic)

Longevity of goods and whether they can be stored easily for a long period of time (if stocks of raw materials and finished goods can be stored for a long duration of time then their stock can be produced in advance, the firm can then extend supply when price rises. So PES>1, elastic)

If production is already running on full capacity (if yes then PES will be perfectly inelastic as even though the price increases, the quantity supplied cannot be increased at all)

How long and complex is the production cycle or production process? (if production process is long and complex then quantity supplied cannot be changed more than proportionately of price making PES<1)

Time under consideration (short-term vs long-term, in the long run a firm can adjust its production capacity by hiring more factors of production and implement technology making PES>1)

Barriers to enter in the industry (if there are high barriers to entry such as licenses, copyrights, patents like in the pharmaceutical industry then there will be few suppliers in the market.

factors of production

land

labour

capital

enterprise

Short-run is

any period of time in which at least one factor of production is fixed and this is a limiting factor

Long-run is

any period of time in which all the factors of production are variable (it is also called the planning stage). Producers are able to vary all of their resources to respond to changing market conditions

market is

any place that brings buyers and sellers together

free market economy, prices are determined by the

interaction of demand and supply in a market/ price mechanism

consumer sovereignty

economic power exerted by consumers in a market, customers refusing to buy

Equilibrium in a market (market clearing price) occurs when

demand = supply

on a diagram it is when new quantity demanded and supplied are the same

Disequilibrium - excess demand occurs when

prices are too low or when demand is so high that supply cannot keep up with it

Disequilibrium - excess supply occurs when

prices are too high or when demand falls unexpectedly

leading to supply being greater than demand

dynamic markets

real world markets that are constantly changing

what will lead to market forces seeking to clear excess demand or supply

• Any change to a condition of demand or supply

contraction and extension in quantity that occurs on the demand and supply curves due to the change in

price

price mechanism is the

interaction of demand and supply in a free market

price mechanism determines prices which are the means by which

scarce resources are allocated between competing wants/needs

price mechanism fulfils three functions in the relationship between buyers and sellers

• rationing - prices allocate (ration) scarce resources. when resources become more scarce prices will rise. goods/services are rationed to those who are most able to pay. Price rise discourages demand, conserves resources and spreads out their use over time

• signalling - price rise and fall to reflect scarcities and surpluses. If prices are rising bc of high demand, it's a signal to the suppliers to expand production. If prices are falling due to lower demand then producers will get a signal to contract their production.

• incentive - high prices attract producers to the market, when prices are low it motivates firms to shut down and set up shop in another profitable industry. Firms may also extend supply for more profits

Consumer surplus is the

difference between the MAXIMUM amount that a consumer is willing to pay and the price that they actually pay

Producer surplus is the

difference between the market price and the price at which the suppliers are willing to sell

where is consumer surplus

area beneath the demand curve and above the market price. (½ bh)

where is producer surplus

shown by the area above the supply curve and below the market price

what happens to consumer and producer surplus when the market is at equilibrium

producer and consumer surplus are maximised

Consumer surplus + producer surplus =

social/community surplus

when is indirect tax paid

on consumption of goods/services

specific tax

fixed tax per unit of output