Edexcel Economics AS NOTE

7/30/2019 Edexcel Economics AS NOTE

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Unit 1

1.3.1 What is the nature of economics?

Q.Understand the problem of unlimited wants and finite resources.

Students should understand that the economic problem is faced by consumers,producers and the government.

SCARCITY

Peoples wants are infinite, but the resources with which they will fulfill these wants are limited. Hence,

economic agents such as individuals, firms and govt have to make choices and can only obtain a limited

amount of such economic goods at any moment in time, e.g. a family has to live on a fixed budget, it

cant have everything it wants. This concept of scarce resources and infinite wants is called Scarcity.

Q.Distinguish between renewable and non-renewable resources.

Students should understand the meaning of sustainable resources

Renewable resources are any desirable items found in nature that can be naturally replenished over

a useful period of time. E.g. water.

If a renewable resource is being economically exploited in such a way that it will not diminish or run

out, then that is given a special name- SUSTAINABLE RESOURCES, e.g. forests are a sustainable

resource as long as it survives and replenish itself over and over again despite economic activities such

as deforestation, farming. However, it will cease to be a sustainable resource if the rate of harvest is far

greater than the rate at which it is renewed, so that it gets depleted over time. e.g. if the whole forest

is cleared to make a runway.

Resources which are diminishing over time due to economic exploitation and are not replaced over time

are called NON-RENEWABLE RESOURCES/ NON-SUSTAINABLE RESOURCE. e.g. oil,coal,gas,gold,land.


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Q. Use production possibility frontiers to depict opportunity cost, economic growth andthe efficient allocation of resources.

Marginal analysis is required to depict opportunity cost. A basic definition of economic

growth is required along with knowledge of the factors which might cause theproduction possibility frontier to shift outwards or inwards.

Combinations of output of goods X and Y (e.g. Agricultural products vsMilitary products) lying inside the PPF occur when there are unemployedresources or when the economy uses resources inefficiently. In the diagramabove, point X is an example of this. We could increase total output bymoving towards the production possibility frontier and reaching any ofpoints C, A or B.

Point D is unattainable at the moment because it lies beyond the PPF. A country would requirean increase in factor resources, or an increase in the efficiency (or productivity) of factorresources or an improvement in technology to reach this combination of Good X and Good Y. If

we achieve this then output combination D may become attainable.

Producing more of both goods would represent an improvement in our economic welfareproviding that the products are giving consumers a positive satisfaction and therefore an

improvement in what is called allocative efficiency

Reallocating scarce resources from one product to another involves an opportunity cost, whichincreases as we move down the curve(for good Y).

Moving from point C to A,the MARGINAL COST(which means ADDITIONAL costs) of producing 5 moreunits of good X, e.g. 15 to 20 would be the fall in production of 10 units of good Y,e.g. 30 to 20 now.

All points on the PPF are at PRODUCTIVE AND ALLOCATIVE EFFICIENCY.


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PRODUCTIVE EFFICIENCY

Productive efficiency can be defined as producing goods and services for the lowest cost. Productive

efficiency is said to occur on the production possibility frontier. On the PPF curve, it is impossible to

produce more of one good without producing less of another ,i.e. it involves an opportunity cost as

production is happening using the least amount of resources.

Here, point X is productively inefficient because you can produce more goods Y or goods X without an

opportunity cost. Productive efficiency only exists if there is TECHNICAL EFFICIENCY, but not all

technically efficient outputs are productively efficient!

E.g. Uchchash employs 2 workers and a machine to make 10 shoes,paying altogether 1000TK,whereas

Nirjash makes 10 shoes using 5 workers but at a lower cost of 400TK.Hence Uchchash is techinically

efficient but productively inefficient.

ALLOCATIVE EFFICIENCY

Allocative efficiency occurs when there is an optimal distribution of goods and services. This involves

taking into account consumer's preferences. For example, there is no point in being productively

efficient if all resources are diverted to making guns. We could be producing on a productionpossibility frontier but, if it is all guns, society may not have enough food and health care.

That is, it occurs at an output level where the MARGINAL BENEFIT = MARGINAL COST.

This is because the price that consumers are willing to pay is equivalent to the marginal utility that they

get. Therefore the optimal distribution is achieved when the marginal utility of the good equals the

marginal cost.

If the opportunity cost for producing two products is constant, then we draw the PPF as a straight line.

The gradient of that line is a way of measuring the opportunity cost between two goods.


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With economies of scale, the PPF would appear inward, with opportunity costs falling as more is

produced of each respective product. Specialisation in producing successive units of a good determines

its opportunity cost (say from mass production methods or specialization of labor)

Explaining Shifts in the Production Possibility Frontier

OUTWARD SHIFTS :

1.

There are improvements in productivity and efficiency perhaps because of the introduction ofnew technology

2. Iincreased HUMAN CAPITAL of labor force due to better training and higher quality ofeducation, which leads to better quality of goods and services produced.

3. More factor resources are exploited perhaps due to an increase in the size of the workforce or arise in the amount of capital equipment available for businesses

INWARD SHIFTS:

e.g. by destruction of infrastructure during war, rapid fall in the number of workers in a population can

reduce potential output,global warming can have a devastating effect on agriculture which will affect all

production.

** In microeconomics, the PPF shows the options open to an individual, household, or firm in a two-good world. By definition, each point on the curve is productively efficient, but, given the nature of

market demand, some points will be more profitable than others. Equilibrium for a firm will be the

combination of outputs on the PPF that is most profitable.[17]

**From a macroeconomic perspective, the PPF illustrates the production possibilities available to a

nation or economy during a given period of time for broad categories of output. However, an economy

may achieve productive efficiency without necessarily being allocatively efficient. Market failure (such

as imperfect competition or externalities) and some institutions of social decision-making (such as

government and tradition) may lead to the wrong combination of goods being produced (hence the

wrong mix of resources being allocated between producing the two goods) compared to what

consumers would prefer, given what is feasible on the PPF.


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Q. Understand the advantages and disadvantages of specialisation and the division oflabour.

AS students are not expected to have an understanding of international specialisationand comparative advantage.

Specialization is a system of organization where economic units such as households or nations are notself-sufficient but concentrate on producing certain goods and services and trading the surplus with

others. Specialisation happens at all levels:

The specialization of tasks within extended families in many of the worlds poorest countries Within businesses and organizations In a country Bangladesh is a major producer and exporter of textiles; Norway is a leading oil

exporter. And Ghana is one of the biggest producers of cocoa in the world.

In a region of a country for many years the West Midlands has been a centre for motor carassembly, there has been huge investment in recent years in the Mini plant at Oxford

Advantages :1. Increase in LABOR PRODUCTIVITY AND CAPITAL PRODUCTIVITY- workers only need to gain

skills of a narrow range of tasks,which enable them to be far more productive than if they

were jack-of-all-traders.The increased productivity, meaning lower labor unit cost

decreases cost of production and saves time, which gets passed on to consumers with

lower market prices.

2. Saving Time: By devoting time to a single task, a person avoids the loss of time incurred inshifting from one job to another. Also, time is saved by not fumbling around with a task

that one is not trained to do.

3. Specialization makes use of differences in ability. - Workers are free to specialize in a jobbest suited to them. If a worker has some special natural ability, then he can choose a job

which utilizes this particular skill so that he may perform better.If Uchchash is

strong,athletic,he can choose a job in the sports industry, whilst if Nirjash is charismatic and

rational, then he may choose to be a lawyer.

4. A bigger market- Specialisation on an international scale increase the size of the marketoffering opportunities for economies of scale ,increases competition(hence control inflation

by keeping prices low).

Disadvantages:1. 1)Monotony- if jobs are divided too much,the work can become tedious and

boring.Workers then feel alienated from their work.This will result in poorer quality of

work and less output per person.Workers will do everything to avoid work-going to

toilet often,reporting for sick,taking frequent breaks during work,etc.

2. 2)Putting all the eggs in one basket- an over-specialised country will be in a great crisisif the demand of its product falls in the world market suddenly and it will have then few

options to switch production into a different product,at least in the short run. This

might lead to high structural unemployment and put the economy into recession. Over-

specialisation also means that a country needs to import goods and services which it

doesnt produce from abroad. Also,a breakdown in a part of the production chain can

cause chaos within the whole system,e.g Toyota stopped production of cars completely

when an ancillary firm, supplying brake parts was destroyed in a fire.


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Q. Understand the advantages and disadvantages of a free market economy and whythere are mixed economies.

Students are not expected to have an understanding of centrally planned economies

A free market economy is an economy where resources are allocated(to solve the basic economic

problem) by market forces and price mechanism, and there is no government ownership or

intervention.

A mixed economy is where resources are partly owned and allocated by the government(public sector)

and partly by individual economic agents(private sector).Both the free market mechanism and

government planning process allocate significant proportions of total resources.

The advantages of a free market economy

1. EFFICIENCY - Most of their industries are assumed to be perfectly competitive and soallocative and productive efficiency will occur. Consumers cast their SPENDING VOTES(expenditure)when they purchase goods and services. Firms receive these spending votes

and use them to buy factors of production, and in turn cast their spending vote(factor

rewards) which determines how much income each individual consumer has to spend.

Decisions about what to produce are made by the people who will actually consume the

goods. Planners are less likely to make the correct decisions across the whole economy.

2. Choice -Firms will produce whatever consumers are prepared to buy. The consumer issovereign. Due to the free enterprise factor, there are no restrictions on what the firms can

produce. However,the range of choice available varies with income levels.People belonging

to first decile groups have a great deal of choice than those of lower decile groups.

3. Innovation -Firms will always be looking to produce something new to get ahead of theircompetitors. Profits also provide an incentive to reduce costs and be innovative to improve

quality.Companies which fail to innovate and produce high quality goods are likely to be

driven out of business by more efficient firms. However,in practice,markets tend to be

OLIGOPOLISTIC in structure,which manipulate the market through advertising and other

forms of marketing to exploit consumers.

4. Higher economic growth rates-History tells us that countries which are more towards freemarket econmy,e.g.USA have the highest growth rates than those of centrally planned

economies,e.g. North Korea.

5.

Market economies can adjust to change easily

The disadvantages of a free market economy (for which govt intervenes and

mixed economies exist)

No incentive to provide public goods-Public goods cannot be provided privately because of theFREE RIDER PROBLEM,resulting due of their two characteristics, non-diminishability and non-

excludability. E.g. street ligting,police service,defence,judiciary.

Underproduction of Merit goods(MARKET FAILURE), like health and education,tend to beunder provided in a free market. Consumption of merit goods is POSITIVE EXTERNALITY , where

the social benefit from consumption exceeds the private benefit. The govt. intervenes to


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encourage consumption of such goods, keeping their prices low in the market through giving

subsidies and increasing demand through advertising social campaigns.

Unequal distribution of wealth- in a pure free market economy,resources are allocated tothose with spending power. Individuals with no source of income,e.g. handicapped,orphans,old

people,abandoned children pay the ultimate penalty for their economic failure-they die from

starvation,cold or disease.People can find support through charity,but it is unlikely that it would

be provided by individuals in sufficient amounts. Free market economy operates in self-interest

only,so there is no incentive to provide goods and services to these people in society. Govt

intervenes by providing old age homes, orphanages, providing welfare benefits, and charging

citizens in the form of taxes to pay these.Govt also tries to minimize the gap between rich and

poor by charging the rich with high direct tax and transferring the money through benefits to

the poor.

Overproduction of Demerit goods (MARKET FAILURE)- economic agents in a pure free marketeconomy do not take account the social costs affiliated in the production process,e.g. air

pollution.Also,market mechanism tends to overprovide demerit goods,e.g. drugs,alcohol.Thesebear large NEGATIVE EXTERNALITIES. Crimes increases, health costs rises, valuable human

economic resources are destroyed and family and relatives suffer distress. Consumers

themselves suffer and are unable to stop as they are addicted. Govt intervenes to correct this

market failure by banning drugs,strictly controlling supply of alcohol by regulations or decrease

demand by using the price system(charging high indirect tax to keep market price high),mass

advertising to raise awareness.


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Q. Distinguish between objective statements and value judgements on economicissues.

Students should know that value judgements influence economic decision making and

policy

Positive Statements

A positive statement is an economic statement about what is and contains no indication of approvalor disapproval. They can be proven true or false by objective use of evidence, reason and logic.

e.g. Unemployment in Bangladesh rose by 15% last year.

Normative Statements

A normative statement expresses a value judgment about whether a situation is desirable orundesirable. They cannot be supported or refuted.They are opinions of how economies and markets

should work. Statements that include indicator words such as: should, ought, or prefer are likely to be

normative rather than positive.

E.g. The Minimum Wage needs to be replaced with a Living Wage of 8 per hour.

Q. Understand how a change in price causes a movement along a demand curve.

Students are not expected to have an understanding of utility theory or indifferencecurve analysis.

Law of Demand- states that there is an inverse relationship between quantity demanded and theprice of a good or service ,certeris paribus.

An increase in demand is shown by a RIGHTWARD SHIFT in demand curve,an increase in QUANTITY DEMANDED refers to a

change in quantity demanded resulting from a change in price and would be shown as MOVEMENT ALONG THE DEMAND

CURVE!!Ceteris paribus,if PRICE FLUCTUATE(only),then quantity demanded is affected,movement ALONG demand curveoccur,NO SHIFTS! But if other factors,such as RISE IN INCOME,CHANGE IN PRICE OF

SUBST,COMPLEMENT,etc.,FASHION,SEASON,anything other than price itself,then SHIFTS OCCUR(more is demanded at each

price.)!


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There are two reasons why more might be demanded even when the price of a good or service is

increasing.

Ostentatious consumption:A higher price may be regarded as a reflection of product quality and some consumers are prepared topay this for the snob value effect. Examples might include diamonds, designer clothes, and sports

racing cars like lambourghani, porche, Ferrari.

Goods of ostentatious consumption are known as Veblen Goods and they have a high-income elasticity

of demand. That is, demand rises more than proportionately to an increase in income or an increase in

price.

Speculative Demand:With speculative demand, a buyer hopes for a rise in price leading to a profit

Speculative demand for housing and for shares comes into this category and we have also seen, in the

last few years, strong speculative demand for many of the worlds essential commodities.

Effective demandDemand is different to desire! Effective demand is when a desire to buy a product is backed up by anability to pay for it

Latent DemandLatent demand exists when there is willingness to buy among people for a good or service, but whereconsumers lack the purchasing power to be able to afford the product.

Derived DemandThe demand for a product X might be connected to the demand for a related product Y giving riseto the idea of a derived demand. For example, demand for steel is strongly linked to the demand for

new vehicles and other manufactured products, so that when an economy goes into a recession, so we

expect the demand for steel to decline likewise.

Steel is a cyclical industry which means that market demand for steel is affected by changes in the

economic cycle and also by fluctuations in the exchange rate.

Q. Understand factors which may cause a shift in the demand curve, for example,changes in the price of substitutes or complementary goods; changes in real incomeand tastes.

FACTORS THAT CAUSES SHIFTS IN DEMAND CURVE (MARKET DEMAND) :

Changing prices of a substitute goodSubstitutes are goods in COMPETITIVE DEMAND and act as replacements for another product,e.g. coca

cola and pepsi cola,gas and oil(in long run),beef and pork.

e.g. Price of Coffee ,then Demand for Tea


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Changing price of a complementTwo complements are in JOINT DEMAND e.g. DVD players and DVDs, iron ore and steel.

Price of DVDs Demand for Dvds,then demand for DVD players Changes in the REAL income of consumers

For NORMAL GOODS,

If Income then Purchasing Power,so Demand for Goods & Services

For INFERIOR GOODS,

If Income,then Demand for Goods & Services

**Discretionary income is disposable income less essential payments like electricity &

gas and mortgage repayments.So if cost of these utilities,then peoples discretionary

income level so that they can afford to buy less goods and services now.

Changes in PopulationPopulation size,then Aggregate Demand Changes in fashionDemand for items such as wigs,trousers,electronic products changes time to time as

they go in and out of fashion.

Changes in LEGISLATIONGovt. might change legislation, such as removing entry barriers, structural bottlenecks,

a particular good, e.g. seat belts,anti-pollution equipments,books to increase demand

for that good.

The govt. sometimes influence the housing market, by allowing TAX RELIEFS on interest

paid on mortgages when houses are bought ,to effectively lower the cost of monthlyrepayments,thus such intervention affects demand for housing significantly.

ADVERTISING & MARKETINGThis has a very powerful influence on consumer demand as it affects consumer choice,

aware them of what products are available to buy, and displays competition.

Changes in Interest RatesMany products, are bought on credit using borrowed money,thus the demand for

them may be sensitive to the rate of interest charged by the lender.Therefore if the

Bank of England decides to alter interest rates the demand for many goods and

services may change. Washing machines, Plasma TV, Car, House, Refrigerator are allINTEREST SENSITIVE items.

E.g HOUSING MARKET- most houses are bought with a mortgage. When potential

buyers look at the price of the house, they tend to focus on the monthly repayments on

the mortgage instead of the actual housing price.In the short term,the demand for

housing is influenced by interest rates rather than house prices.

Consumer ExpectationsA newly formed expectation of higher future prices may cause consumers to buy now in

order to beat he anticipated price rises, thus increasing current demand. That is

often what happens in so-called hot real estate markets.Buyers rush in because they

think the price of new homes will continue to escalate rapidly.


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Q. Explain price, income and cross elasticities of demand. Understand factors thatinfluence elasticities of demand and their significance to firms and government.

Students may have to calculate and interpret numerical values of price, income and crosselasticity of demand.

Understand the relationship between price elasticity of demand and total revenue.

Students should understand the significance of elasticity to firms and government in termsof the imposition of indirect taxes and subsidies; changes in real income and changes in theprice of substitute and complementary goods.

PRICE ELASTICITY OF DEMAND- measures the responsiveness of demand after a change in price,

under condition of ceteris paribus. Its measured by the formula :

Or,

** Since changes in price and quantity usually move in opposite directions, usually we do not bother to

put in the minus sign.Thus, the price-elasticity coefficient of demand PED will always be a negativenumber for normal goods. We are more concerned with the co-efficient of elasticity of demand.


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A decrease in the price of a good normally results in an increase in the quantity demanded by

consumers because of the law of demand, and conversely, quantity demanded decreases when price

rises. As summarized in the table above, the PED for a good or service is referred to by different

descriptive terms depending on whether the elasticity coefficient is greater than, equal to, or less than

1. That is, the demand for a good is called:

Perfectly inelastic (Ed = zero),there is no response in demand to a change in price.

relatively inelastic when the percentage change in quantity demanded is less than thepercentage change in price (so that Ed > - 1);

unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when the percentagechange in quantity demanded is equal to the percentage change in price (so that Ed = - 1);

relatively elastic when the percentage change in quantity demanded is greater than thepercentage change in price (so that Ed < - 1)


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perfectly elastic (Ed= infinite),consumers are prepared to buy all they can at a given price butnone at all at a higher price.

Factors affecting price elasticity of demand1.

The number of close substitutes the more close substitutes there are in the market, the moreelastic is demand because consumers find it easy to switch.

2. The cost of switching between products there may be costs involved in switching. In thiscase, demand tends to be inelastic. For example, mobile phone service providers may insist on a

12 month contract.

3. Luxury vs Necessity necessities tend to have an inelastic demand whereas luxuries tend tohave a more elastic demand.e.g. it means little to the average person if the price of a

lambourghini doubles, but affected seriously when the price of staple food such as rice has

increased.

4. The proportion of a consumers income allocated to spending on the good products thattake up a high % of income will have a more elastic demand .e,g the PED of marker pens is likely

to be relatively elastic to a teacher who buys it frequently compared with a normal housewife.

5. The time period allowed following a price change demand is more price elastic, the longerthat consumers have to respond to a price change. They have more time to search for cheaper

substitutes and switch their spending.e.g. the demand for oil is likely to be price inelastic in the

short-run,as consumers have little choice but to buy oil and run their cars,trains or heating

systems.But in the long run,it becomes less inelastic as consumers may have switched to other

forms of energy-coal,gas.

6. Whether the good is subject to habitual consumption consumers become less sensitive tothe price of the good of they buy something out of habit (it has become the default choice). E.g.

Computer games sold on DVDs tend to be price inelastic in the long run.

7. Peak and off-peak demand - demand is price inelastic at peak times , and more elastic at off-peak times this is particularly the case for transport services. e.g. price inelastic during school

hours early in the morning and price elastic during noon.

8. The breadth of definition of a good or service if a good is broadly defined, i.e. the demand forpetrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be

more elastic following a price change.


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PED and Total Revenue/Expenditure & its importance to firms & Govt

Total Revenue= P xQ

Note what happens to total revenue when price changes. If total revenue changes in the

opposite direction from price, demand is elastic. If total revenue changes in the same direction

as price, demand is inelastic. If total revenue does not change when price changes,demand is unit-elastic.

As you move right ,total

revenue(TR) rises. The

increase in quantity sold

more than compensate for

the fall in price. Here,

demand is ELASTIC.

However, when the mid-

point is reached and

demand becomes unit

elastic, TR stops rising and

is at its maximum point.

The remaining part isinelastic: the increase in

quantity demanded is no

longer sufficient to

compensate for the

decrease in price, and TR

falls. Thus, if a firm is aware

of the PED of its products ,it

can anticipate consumer

response to its price

changes, which may be apowerful strategic tool.


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PED importance for Govt.

Effect of PED on the incidence of VAT :

If Demand is ELASTIC, then most of the incidence of VAT falls upon the Producer :

Demand is elastic, ,so,SELLER BURDEN !

If Demand is INELASTIC,then most of the burden of tax falls upon the Consumer:


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INCOME ELASTICITY OF DEMAND

measures the responsiveness of quantity demanded to a change in price.Its calculated by

or :

Normal goodshave a positive income elasticity of demand so as consumers income rises more is

demanded at each price i.e. there is an outward shift of the demand curve

INCOME, Demand

Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income

increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4.Demand is rising less than proportionately to income.

Income,Demand (but not much)Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more thanproportionate to a change in income for example a 8% increase in income might lead to a 10% risein the demand for new kitchens. The income elasticity of demand in this example is +1.25.Income,Demand(VERY MUCH)

Inferior Goods

Inferior goods have a negative income elasticity of demandmeaning that demand falls as income rises.

Typically inferior goods or services exist where superior goods are available if the consumer has themoney to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in

supermarkets and the demand for council-owned properties.

The income elasticity of demand is usually strongly positive for

o Fine wines and spirits, high quality chocolates and luxury holidays overseas.o Sports carso Consumer durables - audio visual equipment, smart-phoneso Sports and leisure facilities (including gym membership and exclusive sports clubs).

In contrast, income elasticity of demand is lower for

o Staple food products such as bread, vegetables and frozen foods.o Mass transport (bus and rail).o Beer and takeaway pizza!o Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.

Giffen Good

a special type of inferior good where demand increases when price increases.e.g. Bread(staple food)Bread is a staple food for low income households.When its price rises,it would not deter people from

consuming less as it is a necessity.Poor people now have so little extra money to spend on other foods

such as beef,or luxury food that they would abandon their demand for these instead and buy more

bread to fill up their stomachs.The result is ,Price of Bread,Qt. Demanded!!


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Explanation:

INCOME EFFECT: If the price of a good rises, the real income of consumers will fall.They will notbe able to buy the same basket of goods and services as before. Consumers can react to this fall

in real income in one of 2 ways- buy less of that normal good; if its an inferior good, then buy

more of it.

SUBSTITUTION EFFECT: If the price of a good rises, consumers will buy less of that good andmore of others because it now relatively more expensive than other goods, and vice-versa.

**For a NORMAL GOOD,INCOME & SUBST. EFFECT BOTH WORK IN THE SAME DIRECTION.

For an INFERIOR GOOD,THEY WORK IN OPPOSITE DIRECTIONS.A rise in price leads to a fall in qt.

demanded because the relative price of this good has risen(SUBSTITUTION EFFECT).However,it leads to

a rise in qt. demanded as consumers real income level have fallen.The SUBST. EFFECT outweighs the

INCOME Effect,so that the overall result is QT. DemandedBut for GIFFEN GOOD,INCOME EFFECT outweighs SUBST. effect,and Qt. Demanded when Price

Type of Good Effect on Quantity Demanded when PRICE

SUBSTITUTION EFFECT INCOME EFFECT OVERALL EFFECT

NORMALgood

FALL FALL FALL

Inferior good FALL RISE FALL (subst >Income)

Giffen good FALL RISE RISE (Income >subst)

Product ranges and longer term trends

Income elasticity of demand will vary within a product range. For example the YED for own-label foods

in supermarkets is less for the high-value finest food ranges.

There is a general downward trend in the income elasticity of demand for many basic products,

particularly foodstuffs. One reason is that as a society becomes richer, there are changes in tastes and

preferences. What might have been considered a luxury good several years ago might now be regarded

as a necessity. e,g, in many western countries, Internet access is considered to be a necessity, whilst it

was a luxury a few years ago!

Income elasticity and the pattern of consumer demand As we become better off, we can afford to increase our spending on different goods and

services. The income elasticity of demand will also affect the pattern of demand over time.

For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, theproportion of a consumers income spent on that product will go up.

For normal necessities (income elasticity of demand is positive but less than 1) and for inferiorgoods (where the income elasticity of demand is negative) then as income rises, the share or

proportion of their budget on these products will fall

For inferior goods as income rise, demand will decline and so too will the share of income spenton inferior products.

Cross Elasticity of Demand(CPed)


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a measure of the responsiveness of quantity demanded of a good to a change in price ofanother related good.Its measured :

or,

Complements have ALWAYS VE CPed (Price of Good X,Demand for Good Y) dueto Joint Demand

Substitutes have ALWAYS +VE CPed (Price of Good X Demand for Good Y) due toCompetitive Demand

Unrelated goods have ZERO CPed The stronger the relationship between two products, the higher is the co-efficient of

cross-price elasticity of demand.When there is a strong complementary relationship

between two products, the cross-price elasticity will be highly negative.e.g. Computer

games and Graphics Hardware

Lower the XED, weaker the Substitute good


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Q. Understand the factors which may cause a shift in the supply curve, for example,changes in the costs of production, the introduction of new technology, indirect taxesand government subsidies.

Producer cartels may be a significant determinant of supply in some markets, for

example, oil.Students should be able to apply both specific and ad valorem taxes to a market.

FACTORS THAT SHIFTS THE SUPPLY CURVE

1.Changes in Costs of ProductionLower costs of production mean that a business can supply more at each price. For example a

magazine publishing company might see a reduction in the cost of its imported paper and inks.

These cost savings can then be passed through the supply chain to wholesalers and retailers

and may result in lower market prices for consumers.2.Technology

Production technologies can change quickly and in industries where technological change is

rapid we see increases in supply and lower prices for the consumer.

3. Prices of other goodsChanges in price of goods which are in JOINT SUPPLY affect the supply of a particular good.e.g.

Price of Beef,More Cows are Reared in farms, so Cow Supply,More cows slaughtered and

hence Supply of Leather(Joint supply good)

4.Government taxes and subsidies


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5.Expectation of future eventsIf firms expect future prices to rise,then they may restrict supply and stockpile goods to earn

high profits later.If they expect disruptions to their future production because of a strike,they

may stockpile raw materials, paying them with borrowed money,increasing production costs

and hence reducing supply.

6.WeatherWeather plays a crucial role in determining supply especially in the agricultural markets.Bad

weather reduces crop yield and supply;good weather might result in bumper harvest and

increased supply.


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7.Producer CartelsIn some markets, producing firms or producing countries band together, usually to restrict

supply, which allows them to raise prices and increase their profits or revenues. e.g. OPEC

which restricts oil supply onto world markets.

Q. Explain price elasticity of supply; understand factors that influence price elasticity ofsupply.

Students may have to calculate and interpret numerical values of price elasticity ofsupply.

Q. Distinguish between the short run and long run in economics and understand itssignificance to price elasticity of supply.

PRICE ELASTICITY OF SUPPLY

measures the responsiveness of quantity supplied to a change in price.

If supply is elastic, producers can increase output without a rise in cost or a time delay

If supply is inelastic, firms find it hard to change production in a given time period.

When Pes > 1, then supply is price elastic When Pes < 1, then supply is price inelastic When Pes = 0, supply is perfectly inelastic When Pes = infinity, supply is perfectly elastic following a change in demand

What factors affect the elasticity of supply?1. Spare production capacity: If there is plenty of spare capacity then a business can increase

output without a rise in costs and supply will be elastic in response to a change in demand. The

supply of goods and services is most elastic during a recession, when there is plenty of spare

labour and capital resources.

2. Stocks of finished products and components: If stocks of raw materials and finished productsare at a high level then a firm is able to respond to a change in demand - supply will be elastic.

Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in

the market.

3. The ease and cost of factor substitution: If both capital and labour are occupationally mobilethen the elasticity of supply for a product is higher than if capital and labour cannot easily be

switched. A good example might be a printing press which can switch easily between printingmagazines and greetings cards.


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4. Time period and production speed: Supply is more price elastic the longer the time period thata firm is allowed to adjust its production levels. In some agricultural markets the momentary

supply is fixed and is determined mainly by planting decisions made months before, and also

climatic conditions, which affect the production yield. In contrast the supply of milk is price

elastic because of a short time span from cows producing milk and products reaching themarket place.

Q.Explain equilibrium price and quantity and how they are determined.Students should understand that shifts in demand and supply curves will change theequilibrium price and quantity

At Equilibrium price,

PLANNED DEMAND

= PLANNED SUPPLY,

and there is no

tendency to change.

Q. Distinguishbetween

consumer andproducersurplus.


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Students should understand how changes in demand or supply might affect consumerand producer surplus.

Illustrate consumer and producer surplus on a demand and supply diagram.

Consumer Surplus

Consumer surplus is a measure of the welfare that people gain from consuminggoods and services

Consumer surplus is the difference between the total amount that consumersare willing and able to pay for a good or service (indicated by the demand

curve) and the total amount that they actually do pay (i.e. the market price).

Consumer surplus is shown by the area under the demand curve and above theequilibrium price as in the diagram below.

Consumer surplus and price elasticity of demand

When the demand for a good or service is perfectly elastic, consumer surplus is zero becausethe price that people pay matches what they are willing to pay.

In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does notrespond to a price change. Whatever the price, the quantity demanded remains the same.

The majority of demand curves are downward sloping. When demand is inelastic, there is agreater potential consumer surplus because there are some buyers willing to pay a high price to

continue consuming the product. This is shown in the next diagram.


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** Consumer surplus can be used frequently when analyzing the impact of government intervention in

any market for example the effects of indirect taxation on cigarettes consumers or the introducing of

road pricing schemes such as the London congestion charge or a rise in air passenger duty.


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PRODUCER SURPLUS

Producer surplus is a measure ofproducer welfare It is measured as the difference between what producers are willing and able to supply a

good for and the price they actually receive

The level of producer surplus is shown by the area above the supply curve and below themarket price and is illustrated in the diagram below

Pm is the minimum price that this producer requires to supply the product to the market As the price rises, there is a great incentive to supply production will expand as a business

moves up their supply curve

Assuming the the market has reached an equilibrium at quantity Q1 and price P1, then the levelof producer surplus is shown by the shaded/labelled area.

Total revenue = price per unit x quantity sold = P1 x Q1

Producer surplus and changes in demand and supply

We first consider the effects of a change in market supply for example caused by an improvement in production

technology or a fall in the cost of raw materials and components used in the production of a good or service


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When Demand,


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Q. Understand the rationing, incentive and signalling functions of the price mechanismfor allocating scarce resources.

The price mechanism may be considered in the context of product, commodity andlabour markets.

Functions of the Price Mechanism

**Adam Smiths Invisible Hand

Adam Smith, one of the Founding Fathers of economics described the invisible hand of the price mechanismin which the hidden-hand of the market operating in a competitive market through the pursuit of self-interest

allocated resources in societys best interest.

The price mechanism describes the means by which millions of decisions taken byconsumers and businesses interact to determine the allocation of scarce resources

between competing uses

The price mechanism plays three important functions in a market:

1/ Signalling function

Prices perform a signalling function they adjust to demonstrate where resources arerequired, and where they are not

Prices rise and fall to reflect scarcities and surpluses If prices are rising because of high demand from consumers, this is a signal to suppliers

to expand production to meet the higher demand

If there is excess supply in the market the price mechanism will help to eliminate asurplus of a good by allowing the market price to fall.


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2/ Transmission of preferences

Through their choices consumers send information to producers about the changingnature of needs and wants

Higher prices act as an incentive to raise output because the supplier stands to make abetter profit.

When demand is weaker in a recession then supply contracts as producers cut back onoutput.

3/ Rationing function

Prices serve to ration scarce resources when demand in a market outstrips supply. When there is a shortage, the price is bid up leaving only those with the willingness

and ability to pay to purchase the product.

4/Incentive

Higher prices tempt producers to expand their supply to maximize profits.For this,firmsmay have to take more workers, invest in new capital equipment to increase

production.On the demand side,such high prices discourage consumption as consumersget fewer goods per TK spent.

A prolong fall in prices may drive some firms out of the market as the business is nolonger profitable for them to supply.

Q. Apply the price mechanism in markets, such as goods, services, commodities orlabour

Students should be able to apply the determinants of demand and supply to variousmarkets, for example, price of stock market shares, oil, precious metals andagricultural commodities.

Markets in Action - Market for Oil

Oil is one of the most heavily traded commodities in the world. Fluctuating prices have important effects for oil

producers/exporters and the many countries that remain dependent on oil as a key input in their energy,

manufacturing and service industries.

Demand for Oil

Cyclical demand: When global economic growth is strong, the demand for crude oilincreases. There is a positive relationship between world GDP and total demand for

crude. Fast-growing emerging market countries,e.g. China have provided the bulk ofthe extra demand for crude in recent years although the worlds biggest economy

the United States has also added to total demand. More recently the global

recession caused a fall in demand for crude oil and a sharp fall in prices

Rising living standards: The sustained rise in living standards in many countries hascontributed to increasing demand for energy and other oil-related products.

Prices of substitutes: Demand for crude oil is affected by the relative prices of andavailability of economically viable oil substitutes such as bio fuel.

Changes in climate e.g. affecting the demand for heating oil. It is often said that ifthe winter in North America is fierce, then the price of crude rises as the USA and

Canadian economies raise their demand to fuel household heating systems andworkplaces


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Market speculation: There is always a speculative demand for oil. Indeed one of thefeatures of the most recent spike in oil prices has been the high level of demand by

hedge funds and other investors pouring into the international petroleum

exchanges to buy up surplus oil futures contracts. They hope that by the time the

contracts are ready to be fulfilled, they will have made a large profit. Speculationinvolves risk, prices can do down as well as up. The scale of speculative activity has

been open to question some of it has been encouraged by the depreciation in the

value of the US dollar. This is because oil is priced in dollars so overseas investors

holding other currencies can buy more barrels of oil as the dollar declines.

Nearly two thirds of global crude oil production is consumed by leading industrialised

nations i.e. the nations that make up the Organisation of Economic Cooperation and

Development (OECD). But a rising share of demand comes from emerging economies

including China, Brazil, Russia and India.

Derived demand for oil

Crude oil is bought not for its own sake but for its uses including:

Gasoline: used in motor spirit/petrol Middle Distillates e.g. diesel used in vehicles and other motors/engines and jet

fuel

Kerosene cooking/heating Heating Oil Fuel Oil: boiler fuel for industry, power and shipping Other: lubricants, bitumen etc

The supply of oil

Supply is a flow concept what matters for the oil market is how many barrels of oil per

day are being extracted from reserves and how much of that is able to be refined for

different uses.

In short, the short-run supply of crude oil is affected by a series of different factors

1. Profit motive: The production decisions of OPEC and Non-OPEC countries.2. Spare capacity: The level of spare production capacity in the oil sector.3. Stocks: The level of crude oil stocks available for immediate supply from the

refineries4. External shocks: The effects of production shocks e.g. loss of output from rig

closures or disruption of oil supplies due to war and terrorist attacks.

Taking a longer-term perspective, the long run world oil supply is linked to

a) Reserves: Depletion of proven oil reserves the faster that demand grows, thequicker the expected rate of depletion. Peak oil theory claims that the world has

long since past the peak of new discoveries of oil and that most oil producing

nations will see a long-term decline in crude oil output in the years ahead.

b) Exploration: Investment spending on exploring, finding and exploiting new oilreserves. When oil prices are high and are expected to stay strong, it makesfinancial sense to invest in exploring for new reserves, even though these may not

come on stream for some years.


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c) Technology: Technological change in oil extraction which affects the costs ofextraction and the profitability of extracting and then refining the oil.

The interaction between oil demand and supply in the short run

Higher oil demand matched against an inelastic short run supply invariably drives priceshigher this is shown in the diagram below. An increase in demand causes a fall in stocks at

refineries and pushes prices higher. This acts as a signal to suppliers to expand production.

However there are time lags between a change in price and extra supplies coming on

stream.

The demand for oil is also price inelastic at least in the short term. This combination of an

inelastic demand and supply helps to explain some of the volatility in world oil prices.

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Edexcel Economics AS NOTE