Section 2 - The Role of Markets and Money

What is demand?

The willingness and ability to purchase a good or service at a given price in a given time period

What is the law of demand?

As price rises quantity demanded falls — as price falls quantity demanded rises — price and quantity demanded vary inversely

What is individual demand?

The demand for a good or service by a single individual consumer — each consumer has their own demand schedule

What is market demand?

The total demand for a good or service in a market — found by adding together all individual consumers' demand schedules

What does a demand curve look like?

A downward sloping curve from left to right showing the inverse relationship between price and quantity demanded [DRAW: downward sloping demand curve axes labelled P (price) and Q (quantity demanded)]

What is a shift of the demand curve?

When the whole curve moves rightward (increase in demand) or leftward (decrease in demand) due to a non-price factor

What is a movement along the demand curve?

When price changes causing quantity demanded to change — the curve itself does not move only the point on it does

What are the causes of shifts in the demand curve?

Increase in income (right) — increase in marketing/advertising (right) — change in taste/fashion (either direction) — price of substitute rises (right) — price of complement falls (right) — expectation of price rise (right) — population increase (right) — government policy e.g. tax cut (right)

What is a substitute good?

A good that can be used in place of another — if the price of one rises demand for its substitute increases (e.g. butter and margarine)

What is a complementary good?

A good consumed alongside another — if the price of one rises demand for both falls (e.g. petrol and cars)

What is price elasticity of demand (PED)?

The responsiveness of quantity demanded to a change in the price of a product

What is the formula for PED?

PED = % change in quantity demanded ÷ % change in price

What does elastic demand mean?

When the % change in quantity demanded is greater than the % change in price — PED greater than 1

What does inelastic demand mean?

When the % change in quantity demanded is less than the % change in price — PED less than 1

Why is PED important for consumers?

If demand is inelastic consumers face higher prices when supply falls — if demand is elastic consumers have more choice as substitutes are available — allows informed choices about substitutes

Why is PED important for producers?

Allows producers to maximise total revenue — can charge different prices to different groups for the same product — affects decisions about whether to supply the product

What is supply?

The willingness and ability of producers to provide goods and services at each price in a given time period

What does a supply curve look like?

An upward sloping curve from left to right showing the positive relationship between price and quantity supplied [DRAW: upward sloping supply curve axes labelled P (price) and Q (quantity supplied)]

What is a shift of the supply curve?

When the whole curve moves rightward (increase in supply) or leftward (decrease in supply) due to a non-price factor

What is a movement along the supply curve?

When price changes causing quantity supplied to change — the curve itself does not move only the point on it does

What are the causes of shifts in the supply curve?

Increase in costs of production (left) — increase in taxes/decrease in subsidies (left) — new technology (right) — climate change (variable) — increase in number of producers (right) — government regulation e.g. health and safety laws (left)

What is a subsidy?

An amount of money a government gives directly to firms to encourage production and consumption — has the opposite effect of a tax on supply

What is price elasticity of supply (PES)?

The responsiveness of quantity supplied to a change in the price of a product

What is the formula for PES?

PES = % change in quantity supplied ÷ % change in price

What does elastic supply mean?

When the % change in quantity supplied is greater than the % change in price — PES greater than 1 — firms can respond quickly to price changes

What does inelastic supply mean?

When the % change in quantity supplied is less than the % change in price — PES less than 1 — firms cannot respond quickly to price changes

Why is PES important for consumers?

If supply is inelastic consumers may face high prices when demand rises as firms can't increase output quickly — if supply is elastic price changes are smaller as firms respond easily

Why is PES important for producers?

Elastic supply allows firms to be more flexible and respond to market changes — firms prefer elastic supply as it allows them to adapt to what the market offers

What is equilibrium price and quantity?

The price at which quantity demanded equals quantity supplied — the market clears with no surplus or shortage [DRAW: supply and demand diagram showing intersection at equilibrium price P* and quantity Q*]

What happens if price is above equilibrium?

Quantity supplied exceeds quantity demanded creating excess supply (surplus) — price falls back toward equilibrium [DRAW: supply and demand diagram with price above equilibrium showing excess supply]

What happens if price is below equilibrium?

Quantity demanded exceeds quantity supplied creating excess demand (shortage) — price rises back toward equilibrium [DRAW: supply and demand diagram with price below equilibrium showing excess demand]

What are market forces?

The factors that determine price levels and availability of goods and services in an economy without government intervention — demand and supply pushing prices toward equilibrium

What is price as a reflection of worth?

Price is used to indicate worth — worth is how much you value something — worth varies depending on fashion and differences between people — individuals may be prepared to pay a different price for the same product — price and worth may be very similar where you are willing to pay a high price to get something you really want

What is the role of price in signalling?

Prices signal where resources are needed — if price rises in an area more resources are directed there

What is the role of price in transmitting preferences?

Higher prices encourage producers to supply more — price reflects what consumers want and signals producers to respond

What is the role of price in rationing?

When resources are scarce price rises so that demand equals supply — price rations scarce goods among competing consumers

What is competition?

Where different firms try to sell a similar product to a consumer — they compete on price and/or non-price factors

What is price competition?

When firms compete by cutting prices to attract more consumers and gain greater market share — those who cannot cut price may go out of business — selling below cost of supplying may lead to disaster

What is non-price competition?

Any way of competing other than cutting prices — e.g. advertising, offering a specialist service, better consumer experience, better quality product

Why do producers compete?

To enter a new market — to survive in a market — to make a profit (needed to survive and grow)

What is a competitive market?

A market with a large number of sellers all competing to satisfy consumers — prices are set by demand and supply and no single firm controls the market

What is a monopoly?

A sole producer — legally a monopoly is where one producer has 25% or more of the market — able to set its own price but cannot control the quantity

What is an oligopoly?

A small number of firms controlling the majority of the market — technically exists if the five largest firms control 50% or more — can influence price but restrained by reaction of rivals

How do monopoly, oligopoly and competitive markets differ?

Size: monopoly usually very large — oligopoly can be large or small — competitive normally relatively small — Number of firms: monopoly one — oligopoly a few — competitive many — Price control: monopoly sets price but not quantity — oligopoly can influence price but restrained by rivals — competitive price set purely by market forces — Efficiency: monopoly not efficient in theory but can use economies of scale — oligopoly usually not economically efficient — competitive markets normally lead to economic efficiency

What are the positive effects of competition on consumers?

Cheaper prices means consumers can buy more leading to a rise in living standards — improved quality of goods and services — innovation gives consumers more choice — increased consumer sovereignty

What are the negative effects of competition on consumers?

Innovations may be harmful e.g. use of pesticides on food crops — quality may fall if producers cut corners — marketing may persuade consumers to buy what they do not want

What are the positive effects of competition on producers?

Increased efficiency by cutting costs to maintain profits — motivating firms to innovate and keep supplying consumers with new products — improving productivity

What are the negative effects of competition on producers?

May lose consumers and possibly go out of business — may have to replace workers with technology which costs money and harms workers

What is production?

The total output of goods and services produced by a firm or an industry in a period of time — involves the use of the factors of production

What are the advantages of an increase in production?

Increase in employment — rise in standard of living as more goods available to buy — increase in profits — larger economies of scale — individual firm gains greater market share — country will have economic growth

What are the disadvantages of an increase in production?

Increase may result from new technology meaning workers replaced by machines — workers replaced by machines have lower standard of living — average costs may rise leading to diseconomies of scale — other firms lose market share — could lead to environmental problems

What is total cost (TC)?

All the costs of a firm added together — TC = total fixed cost (TFC) + total variable cost (TVC)

What is total fixed cost (TFC)?

Costs that do not change with output — e.g. rent, marketing

What is total variable cost (TVC)?

Costs that change directly with output — e.g. raw materials

What is average cost (AC)?

The cost of producing one unit of output — AC = total cost (TC) ÷ quantity (Q) — a fall in AC as output rises shows the firm is becoming more efficient

What is total revenue (TR)?

The total amount of money received from selling goods or services — TR = price (P) × quantity (Q)

What is average revenue (AR)?

The revenue received per unit sold — equal to the price — AR = total revenue (TR) ÷ quantity (Q)

What is profit?

When total revenue is greater than total cost — TR > TC — Profit = TR − TC

What is a loss?

When total revenue is less than total cost — TR < TC — a continuous loss will lead to a firm closing down — acts as a signal to resources to move away from the firm

What are economies of scale?

When an increase in the scale of production results in a fall in average costs of production — internal economies are benefits from belonging to an industry (all firms gain)

Name the 6 types of internal economies of scale

Division of labour (splitting work into specialist areas speeds production) — Financial (larger firms borrow at lower interest rates) — Increased dimensions (volume increases faster than costs) — Managerial (larger firms employ more specialists) — Marketing (larger firms promote more products within same budget) — Purchasing/bulk-buying (buying large quantities leads to discounts)

What is productivity?

A measure of how efficiently the factors of production are used — measured as output per unit of input

What is the difference between production and productivity?

Production is about total output — productivity is output per unit of input — they are not the same thing

How can productivity increase?

Workers specialising and developing skills — improving skills through education and training — greater investment in new technology — increasing the amount of capital equipment used

Why is increased productivity important?

Lower average costs and increased economies of scale (firms more competitive at home and in world markets) — increased profits leading to better training and more investment — increased total output increases employment wages and tax revenue — more exports leading to greater economic growth

What is the labour market?

A market consisting of the supply of labour by households and the demand for labour by firms — the wage rate is influenced by government and trade unions

What is the role of the labour market?

To enable workers willing and able to work to sell their labour to firms — enables firms to find workers — determines the wage rate or salary

How does the labour market operate?

Operates on a local, national and international basis — some jobs require specific qualifications while others are geographically fixed — depends on exchange of information between employers and employees on wage rates, conditions and competition — lacks perfect mobility so workers cannot move to any job that is available

What are the four reasons for lack of labour mobility?

Lack of necessary skills (skills in different jobs are not interchangeable) — unable/unwilling to relocate (e.g. restricted to English-speaking countries) — personal factors (family ties or preference to live in certain areas) — information failure (not aware of what jobs are available)

What are the factors affecting the demand for labour?

Demand for the product labour helps produce — productivity of labour — profitability of the firm — state of the economy

What are the factors affecting the supply of labour?

Wage rate (higher wage more people willing to work) — other monetary factors (overtime/productivity pay) — non-monetary factors (working conditions/promotion) — education and training — barriers to entry (qualifications/discrimination) — size of working population (migration/retirement age)

What is gross pay?

The actual amount an employer pays a worker before any deductions are made

What is net pay?

The amount an employee takes home after deductions — net pay = gross pay − income tax − national insurance − pension contributions

What is income tax?

A direct tax levied on a person's wages

What is National Insurance (NI)?

A contribution paid by workers and employers toward the cost of state benefits (e.g. NHS, state pension)

What is a trade union?

An organisation that represents workers' interests — negotiates wages and conditions with employers through collective bargaining

What is individual bargaining?

When a worker deals directly with their employer about pay and conditions without union involvement

What is collective bargaining?

When a trade union negotiates on behalf of all its members with an employer about wages, hours and working conditions

What is money?

Anything that is generally acceptable as a means of payment for goods and services

What are the four functions of money?

Medium of exchange (enables buying and selling without bartering) — Store of value (money can be saved and spent later) — Unit of account (used to measure and compare value of goods) — Standard of deferred payment (used to set value of a loan to be repaid later)

What is a medium of exchange?

Anything that enables people to exchange goods and services without bartering — removes the need for a double coincidence of wants

What are the roles of commercial banks?

Accept deposits and pay interest — make payments by mobile phone/card/bank transfer — make payments by accepting cheques — issue loans to firms and individuals — provide foreign currencies — offer safe deposit boxes

What are the roles of the Bank of England (central bank)?

Issue bank notes and supervise money supply — control monetary policy by setting the bank rate which determines all other interest rates — provide financial stability — manage the country's foreign reserves — act as bank for commercial banks — act as bank for the government

What are investment banks?

Banks that help firms with specialist needs — examples include Goldman Sachs, Morgan Stanley, Rothschilds, UBS — they assist with mergers and takeovers — underwrite share issues (guaranteeing all shares will be sold) — assist with international trade including financial conditions in new markets

What is the difference between banks and building societies?

Banks: public limited companies (PLCs) owned by shareholders — wide range of services — can borrow widely on the money market — Building societies: mutual organisations owned by members who save with them — limited range of services mainly savings and mortgages — limited as to how much they can borrow from the money market

What is the role of insurance companies?

Financial institutions that guarantee compensation for specified loss, damage, illness or death in return for regular payments — pools clients' risks to make payments more affordable — examples include Aviva, Legal and General, Prudential, Zurich

What is life insurance?

Pays out money to the surviving family to replace lost income due to death — also used for long-term savings, pensions and annuities for retirement

What is general insurance?

Covers all non-life aspects including property, contents, motor, health and pets

What is saving?

The part of an individual's income not spent on consumption — money set aside for future use

What is borrowing?

Receiving money with an obligation to pay it back at a specified time in the future usually with interest added

What is investment?

The purchase of capital goods used to produce future goods and services — also an asset purchased to provide income in the future or to be sold for profit

How do interest rates affect saving?

When interest rates rise saving becomes more attractive as the return increases — when interest rates fall saving is less attractive and quantity saved falls [DRAW: upward sloping savings curve with rate of interest on vertical axis and quantity on horizontal axis]

How do interest rates affect borrowing?

When interest rates rise borrowing becomes more expensive and quantity borrowed falls — when interest rates fall borrowing is cheaper and quantity borrowed rises [DRAW: downward sloping demand for money curve with rate of interest on vertical axis and quantity on horizontal axis]

How do interest rates affect investment?

Level of investment is inversely related to the rate of interest — as interest rates fall investment increases as borrowing to finance capital is cheaper — as interest rates rise investment falls as opportunity cost of investing rises [DRAW: downward sloping demand for investment curve with rate of interest on vertical axis and quantity of money on horizontal axis]

What is the importance of the financial sector for consumers?

Credit provision (can buy now pay later increasing consumption) — liquidity provision (can borrow against assets e.g. a house to pay later) — risk management (insurance allows spreading risk across companies rather than just one)

What is the importance of the financial sector for producers?

Credit provision (can borrow money to expand) — liquidity provision (banks provide overdraft facilities so firms can continue trading while waiting for payments) — risk management (reduces risk of not receiving payment especially when exporting)

What is the importance of the financial sector for the government?

Credit provision (can run a budget deficit and spend before taxes are collected) — liquidity provision (can borrow to cover expenditure when revenue is uncertain) — risk management (allows for vital expenditure even when revenue is uncertain)