Theme 1 Flashcards
Economics
Economics is the study of how individuals, households, businesses and governments with scarce resources make choices in an attempt to satisfy their needs.
Microeconomics
when we study the behaviour of individuals and businesses up to the level of individual industries
The Basic Economic Problem
the central purpose of economic activity is the production of goods and services to satisfy our changing needs and wants. The Basic Economic problem is that resources as scarce relative to the purposes to of which they could be put. As a result choices have to be made about how to use resources. Thus frequently referred to as ‘scarcity and choice’.
Need
something you must have in order to survive
Want
something that you desire that is not essential for human survival
Opportunity Cost
In decision making, is the value of the next best alternative forgone
Scarcity and Choice
Unlimited wants and scarce resources leads to choices. The issue that irises from scarcity is that is forces people to make choices.
Economic Agents
All economic agents ( producers, consumers and governments) have to make choices and look at opportunity costs i.e.
Consumers have to decide what they buy, where they work
Governments have to decide where to invest funds and raise taxes
Firms have to decide what price to sell at and how to produce
Factors of Production
Economics is concerned about converting inputs into outputs. Inputs are known as Factors of Production.
Capital- man made goods to supply other products such as factories and machinery.
Enterprise-human skill needed to organise the other factors of production and take risks associated with setting up and running a business.
Land-stock of natural resources available for production I.e. land and natural resources
Labour-quantity and quality of human input available for the production process.
Non Renewable resources
Finite in supply- for many there is no mechanism to replenish them
E.g. oil, gas and coal
Renewable Resources
Replaceable if rate of extraction is less than natural rate at which resource renews. If not managed appropriately they may be exhausted. Over extraction may threaten long term supply.
E.g. Solar, wind, Tidal, fish stock and Timber
Model
In order for economists to cope with the complexity of the real world it is essential to simplify reality. Therefore economists work with Models. These are simplified versions of reality allowing economists to focus on key aspects of the world often focussing on just one thing at a time.
How to form a model
Start with an assumption
In order to isolate one factor it is assumed all other factors remain the same.
This is known through the latin phrase ‘Ceteris paribus’ meaning ‘other things being equal’.
It is used in economics when we focus on changes to one variable while holding other influences constant. Models help economists understand complex decisions and predict future behaviour and therefor hold a value but sometimes they may seem remote from reality.
Positive Statement
A positive statement is a statement of fact that can be tested , amended or rejected. Often this might involve cause and effect
Normative Statment
A normative statement is about what “ought” to be- they are subjective and involve value judgement ( a statement based on opinion or beliefs rather than facts)
Productive possibility frontier (PPF)
The nations productive capacity reflects the potential output of an economy. A productive possibility frontier shows the maximum combination of goods that can be produced in a given period with a given set of resources. When considering opportunity cost of this, it is useful to simplify the concept and consider the maximum combination of two types of goods using a diagram.
PPF Graph
PPFs show the maximum production potential of an economy using a combination of two costs or services when resources are fully and efficiently employed. Any point on the frontier shows a point that all resources are being fully utilised so an efficient use of resources.
If point is under the graph it means it isn’t a efficient use of resources( factors of production) for example may have unemployment or not using land properly.
If a point is above the line them it is unattainable with current resources so to reach it you would need more resources- improvement in technology.
If more good x is produced then less of good y produced- opportunity cost.
Scarcity- PPF
The PPF demonstrates the concept of scarcity which refers to the limited availability of resources ( such as labour, capital and land) in relation to the unlimited ( and often growing) wants and needs of society
Trade offs- PPF
The PPF reflects the idea that an economy must make trade-offs when allocating its resources. Producing more of one good necessitates producing less of another. The shape of a PPF highlights, the trade offs required when reallocating resources between two goods.
Opportunity Cost- PPF
The opportunity cost of producing more of one good is the amount of the other good that must be given up. The slope of the PPF represents the opportunity cost of switching from producing one good to producing the other.
Efficiency- PPF
Points along the PPF represent an efficient use of resources where the economy is fully utilising all available resources to produce goods and services. Points inside, the PPF are inefficient, indicating that resources are not fully employed.
Marginal analysis
an approach to decision making based on considering the additional (marginal) benefit and cost of a change in behaviour. Firms will consider the cost of producing an additional unit of output compared to the benefit (marginal return) of selling it.
Shape of PPF- why it curves
The shape of a PPF is commonly drawn as an arc that is concave to the origin. If the law of diminishing returns holds true then the opportunity cost of expanding output of X measured in terms of lost units of Y is increasing. Resources such as land, capital and labour used in producing wheat might not be equally suited to producing beef. If the marginal productivity of resources is declining then the opportunity cost will increase. We are sacrificing more to get a little extra of something.
PPF shift outwards
A PPF shifts outwards when there is an increase in an economy potential to produce goods and services. This outwards shift represents economic growth (macro) which allows the economy to produce more of both goods or to improve its production capabilities. For a business it means they are able to produce more of both goods. For the PPF to shift outwards there needs to be either an increase in the factor inputs available or an increase in the efficiency of supply.
Q2CELL- Quantity, Quality, Capital, enterprise, labour, land.
Inward shift of PPF
It is possible for the productive capacity to shift inwards. e.g. net loss of ppl due to migration, low birth rate, pandemics, natural disaster, war + conflict
PPF- Economic efficiency
The PPF diagram is a useful toll in economics to illustrate different types of economic efficiency. It helps demonstrate the concept of efficiency in resource allocation and provides insight into how an economy can achieve optimal production levels given its available resources. 3 types of economic efficiency are: Productive efficiency, Allocative efficiency and Dynamic efficiency.
Productive efficiency
Occurs when an economy is producing goods and services at the lowest possible cost given its existing technology and resources.
On a PPF diagram, productive efficiency is achieved when the economy is operating on the PPF curve. Points on the PPF represent the max output attainable with given inputs, and any point inside the PPF indicates underutilisation of resources. If the economy operates inside the PPF, it is not reaching productive efficiency because resources are being wasted.
Allocative efficiency
Occurs when an economy is producing a mix of goods and services that best aligns with consumer preferences and social needs. It represents the ideal distribution of resources among different goods to maximise overall satisfaction.
On the PPF diagram allocative efficiency is achieved when the economy is producing at a point on the PPF that matches society’s preferences. If the economy is producing at a point inside the PPF it is not achieving allocative efficiency because it can produce more of one good without sacrificing the production of another good. A point outside the PPF, it is not feasible and achieving such a point would require additional resources or technological advancements.
Dynamic efficiency
Refers to an economy’s ability to grow and expand its production possibilities over time. This involves shifting the PPF outward through technological advancements, investments and innovations.
An outward shift on the PPF indicates that the economy has achieved dynamic efficiency allowing it to produce more goods + services than before with same resources. This might have been achieved through process innovations such as lean manufacturing used in car making or innovation in farming that increases yields of particular crops each year.
Specialisation
Refers to producing what a worker, firm or country is most efficient at.
Adv + DisAdv of Specialising in a narrow product range.
Adv- allows company to specialise effectively
-produce efficiently by building up skills and increasing quality
-charge higher prices (better quality, or charge same/lower price due to lower cost)
-Increased output
DisAdv- changing demand
-Labour- boring
-finite resources
-over reliance
Division of labour
Refers to production process being broken down into separate specialised tasks/ sequences of stage. By focusing on a particular stage workers can become highly adept and thus more efficient at carrying out that task.
Division of Labour Adv & DisAdv
ADV
-By focusing on one task that they perform well, workers become more productive
-This is likely to lower costs and increase profit margins OR allow the firm to reduce the price. Lower prices are likely to increase standards of living
-Training can be more cost effective as only focusing on a narrow range of skills.
-Working as a team may allow more overall output to be produced.
DISADV
-Monotonous - this may mean workers become bored and de-motivated.
* This may mean they become less productive and take less pride in their work.
* Over-specialisation may lead to a lack of flexibility. Workers may find it difficult to move to other jobs.
Therefore it may be difficult to cover for absent workers or find alternative employment.
* More produced standardised goods may mean less choice for consumers.
Potential gains from specialisation
-Higher labour productivity and rising business profits
>learning by doing increases output per hour worked
>higher productivity lowers costs and supply of goods +services
>increased productivity =higher profits for businesses
-Specialisation creates a surplus output that can be traded for mutual benefits
>Businesses/ countries specialise in areas of relative advantage
>trade increases the range of products we can consume
-Lower Prices cause higher real incomes and GDP growth
>Lower prices gives consumers greater real purchasing power.
>higher productivity allows businesses to pay increased wages
>successful specialisation is a key cause of economic growth
Batered
Before money people bartered, swapped a good for another of similar value, however there had to be a double coincidence of choice for this to happen.
In the economic system nowadays this would be impossible as economy/businesses many workers and households do not make a good/ service in its entirety. So nothing to barter with. Therefore another medium exchange is required. Money is anything that is generally accepted in the settlement of debt. These days for most economies this includes notes, coins and electronic money.
Main functions of money
-Medium of exchange
-Store of value
-Unit of account
-Standard of deferred payment
Main functions of money: Medium of exchange
Money serves as a standard unit of account that facilitates transactions by allowing goods and services to be exchanged for a common and widely accepted medium of exchange.
Main functions of money: Store of value
Money allows individuals to save for future consumption by maintaining its purchasing power over time.
Main functions of money: Unit of account
Money serves as a standard unit of measurement for the value of goods, services, and financial assets, enabling individuals and businesses to compare prices and make informed decisions.
Main functions of money: Standard of deferred payment
Money enables individuals and businesses to make deferred payments, such as loans, mortgages, and insurance contracts, by providing a means of transferable credit.
the 3 economic questions
What goods should be produced?
How? How should the productive resources of the economy be used to produce various goods and services
For whom? Once produced how should they be allocated among the population for consumption
3 types of economies
-Free market
-command
-mixed
Free Market economy
Free market economy allows market forces to guide the allocation of resources through the price mechanism. In a free market there is a very limited role for the government. Adam Smith argued that in such a system resources would be allocated effectively through the operations of an ’Invisible hand’. For example: Singapore, Switzerland, Luxembourg. Price is dependent on the interaction between demand and supply components of a market. Benefits of a market economy includes increased efficiency, production and innovation. Greater economic freedom from lower government size increases inequality.
Approach to ownership of assets, incentives for employees and entrepreneur’s- Free market economy
The factors of production are all owned by individuals and free for them to allocate the resources how they want without government intervention
Entrepreneurs use profit as an incentive as they’re in control of how they operate to gain a profit. Employees can have higher incomes when the business decides but also if their productivity leads to growth it would likely increase more.
Advantages of free market economy
-An efficient allocation of scarce resources factor resources tend to go where the expected profit is highest.
-Competitive prices for consumers as suppliers look to increase and then protect market share.
-Competition drives innovation & invention bringing higher profits for businesses and better products for consumers.
-The profit motive stimulates investment which encourages economies of scale and lower prices for consumers.
-Competition through trade in goods and services helps to reduce domestic monopoly power and increases choice.
disadvantages of free market economy
-Free markets can fail to achieve an economically and socially efficient and equitable allocation of resources- there are numerous potential causes of market failure that may require government intervention
-Free market activity can lead to a rise in the scale of income and wealth inequality as shown by rise in the Gini coefficient
-Businesses can develop monopoly power which leads to higher prices and damage to consumer welfare
-Under or non-provision of pure public goods (e.g. defence – goods which are non-rival and non-excludable)
-Under-provision of merit goods such as health and education – which many cannot afford – leading to lower social welfare
-Free markets may fail to address negative externalities from production and consumption – unsustainable growth
-Deregulated financial markets often prone to bouts of instability – the fall out from which affects millions not directly involved
Command economics
Where the government undertakes the coordination role, planning and directing the allocation of resources. The government is likely to own most of the countries scarce resources. They will tell businesses what to produce, how much to produce and who to sell to and at what price. The government regulates economy completely. For example Russia, Cuba and North Korea. Command economies were often associated with the political system of Communism. It was Karl Marx, in the Communist manifesto who argued for ‘common ownership of the means of production.’ Prices in the economy must be set by government officials, so they cant arise naturally. Because a command economy is centrally planned, its pros theoretical equality between citizens(lack of inequality),
Approach to ownership of assets, incentives for employees and entrepreneur’s- Command economics
Command economy approach to ownership - requires that the central government own and control the factors of production.
Incentives for employees and entrepreneurs - wades are set centrally for employees and profits are eliminated. This leads to no incentive to increase production or be more efficient. Factors of production being centrally owned leads to a lack of incentive too
Outcomes of an Command economy
Production in command economies is notoriously inefficientas the government feels no pressure from competitors or price-conscious consumers to cut costs or streamline operations. They also may be slower to respond—or are even completely non-responsive—to consumer needs or changing tastes.
Advantages of command economics
-Supporters of command economies argue that it enables the government to overcome market failure, inequality and create a society that maximises social welfare rather than maximises profit
-Command economies can prevent abuse of monopoly power
-Command economies can prevent high unemployment, sometimes a feature of capitalist economies
-Command economies could produce goods which benefit society and ensure everyone has access to basic necessities
-Command economies may be more equitable
Disadvantages of command economics
-Government agencies usually have poor information about what to produce. Centralisation means that decisions are taken by people who may have no access to what is actually happening. This may mean over or underproduction of goods and services and a waste of scarce resources
-Unable to respond to consumer preferences
-Lack of incentives for both workers and businesses ie no incentive to earn more profit/wages set therefore no incentives to work harder
-Inefficient firms are protected and kept going; making it harder for resources to move to dynamic and efficient firms
-Bureaucratic: Command economies tend to be very bureaucratic with decisions help up by planning and committees.
-Price controls invariably lead to shortages and surpluses
Adam Smith
Famous for his book, “The wealth of Nations” (1776).
Seen as an advocate of free market economics and laissez-faire government (leaving markets to regulate themselves wherever possible).
He explained how the “invisible hand” would allocate resources everyone’s advantage. He argued that individuals would act in their own self interest and that this would lead to an economy that maximised benefits.
However, he also recognised that the state also had a part to play.
To be wary about businesses that become too large and have too much power (over prices.).
* The state needed to provide goods and services which the free market would otherwise not provide (roads, bridges, defence etc).
The role of government to regulate financial markets.
There needed to be law enforcement of property law, patents and copyright (to protect
invention).
Despite recognising the need for some government intervention, Smith is regarded as the founder of free market economics.
Friedrich Hayek
Best known as a proponent of the 20th century Austrian School of economics in which there is a strong belief in the role and importance of the individual in the economy rather than any collective group or government. Hayek believed in the liberty and freedom of the individual.
Hayek disagreed with Smith in terms of financial markets, seeing Iess of a role of government. The only role of government was for law and order.
He also argued against command economies citing the problem of economic calculation. He saw that a small group of central planners was responsible for determining how much of every product should be produced and delivered. In his view it would be impossible for them to ever have enough information to properly meet people’s needs.
Hayek believed that markets alone would have the information needed to make these decisions.
What might a rational consumer consider
-Price of product/ service
-Price of other products/ services (opportunity costs)
-Your income- how much can you afford
-Preferences
Utility
In a nutshell you make decision to get maximum satisfaction. Economists refer to satisfaction in this context as Utility. The assumption economists make is that rational customers set out to maximise their utility. The corresponding assumption for firms is that they aim to make as much profit as possible. Maximise profits.
Making a rational decision
- Identify problem
-Outline pros and cons of choices
-Weigh up pros and cons
-Any other alternatives?
-Evaluate all options
-Select the best options
Not always best or most realistic way for firms to make decisions, takes significantly longer to decide which is not practical in a firm with strict time constraints.
Assumptions - rationality
Assumptions are necessary in order to analyse how consumers or firms will act. Economists assume that firms and individuals will behave rationally when making decisions. If we know consumer sets out to maximise satisfaction, then economists can build a model to show under what conditions they would achieve this. It helps economists understand human and business behaviour and to identify situation in which people or firms depart from rationality.
Diminishing marginal utility
Describes a situation where an individual gains less additional utility from consuming a product the more of it is consumed. The margin is one additional unit.
Concept of demand and supply rooted in:
-Individuals maximising their satisfaction- utility
-Firms maximising satisfaction/ reward- profit
Demand
defined as the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period.
effective demand
this is the combination of desire for a product or service with the ability and readiness to pay.
Consumer sovereignty
this suggests that consumers control resources by deciding what to buy
Law of inverse demand
states that there is an inverse relationship between price and quantity.
Law of demand
States that the demand curve is downward sloping, 2 types of changes in demand:
-movement along the demand curve
-shifts in the demand curve( any other factor leading to an increase or decrease in demand)
Movement along the demand curve
A change in price of the product will cause a movement along the demand curve. Other factors remaining constant (ceteris paribus) there is an inverse relationship between the price of a good and demand therefore: A fall in price of the good results in an extension of demand (quantity demanded will increase). Whilst an increase in price causes a contraction in demand (quantity demanded will decrease)
Complementary goods
Products which are bought and used together. A fall in good x will lead to an extension in quantity demanded for x. And this might lead to higher demand for the complement Good Y. Complements are said to be in joint demand. The cross price elasticity of demand for 2 complements is negative. Examples include, fish and chips, pasta sauce and pasta, shoes and polish and flights and taxi services.
Substitutes
Substitute goods are two alternative goods that could be used for the same purpose. They are goods that are in competitive demand. A rise in Price of Good x will lead to a contraction in demand for Good x. This might then cause some consumers to switch to a rival product Good y. This is because the relative price of Good y has fallen. The cross price elasticity for 2 substitutes is positive. Examples include: tea and coffee, smartphone brands, supermarket chains, cereal brands.
Normal goods
Goods that experience an increase in demand due to an increase in consumer income, e.g. clothing, holidays, electronics.
Inferior goods
A good whose demand decreases when peoples income rises when real incomes rise during economic growth, demand for inferior goods will fall curing an inward shift of demand curve. Examples include, own label discounters, economy class travel, public transport, cigarettes.
Shift in demand curve
Shift in demand curve is caused by a change in any factor other than price. The curve can shift to the right(increase) or left(decrease) . These are known as the conditions/ determinants of demand.
Determinants of Demand:
-price of substitutes
-price of complements
-taste and preferences
-advertising
-income
-population- changes in size/ age distribution
PPP.TAI
Supply
defined as the quantity of a product that a producer is willing and able to supply into the market at a given price in a given time period.
Changes In supply
2 types of changes in supply:
- Movement along the supply curve
- Shifts in the supply curve
Law of supply
Positive relationship between price and quantity supplied. As price rises, quantity supplied rises.
Movement along the supply curve
Causes by a change in price of the good or service. An increase in the price of the good results in an extension of supply (quantity supplied will increase). A decrease in price causes a contraction of supply (quantity supplied will decrease)
Shifts in Supply curve
Shifts in supply curve caused by a change in any non price determinant of supply. Curve can shift right or left- Demand curve must also be included. Determinants of Supply:
-technology
-legislation
-taxes placed by government on products/ services
-subsidies
-weather/natural disaster
-changes to number of firms in an industry
-cost of production
Karl Marx
A 19th Century German thinker and writer, his most famous book is Das Capital (1867).
He developed many of Adam Smith’s ideas on capitalism/free market economics, but mostly considered the negative consequences.
He saw that there was a great gulf between the economic fortunes of the owners of property and workers in 19 century Europe
Marx believed that the drive for profit in the capitalist system would push workers wages to the bare minimum. He said that exploited workers, would come together and overthrow capitalism, being replaced by socialism. A new democratic society would arise which would lead to equality and where property would be owned by everyone collectively. The distribution of the goods made would be to each according to contribution.
The Price Mechanism
This is the mechanism through which price is determined in a market system. Basically, the price will adjust until supply equals demand, at which point we have the equilibrium price. Price mechanism refers to the system where the forces of demand and supply determine the prices of commodities and the changes there in. It is the buyers and sellers who actually determine the price of a commodity. Its responsible fro the allocation of resources in a free market economy. The decisions of consumers and producers are all responsible for how the price mechanism work through demand and supply.
Equilibrium
Equilibrium basically means ‘a state of rest’. In a D & S diagrams the market is at rest when supply = demand - the point where the 2 points meet. This is the point where amount consumers demand at a given price is exactly the same as the amount businesses are prepared to supply at a given price
Market disequilibrium
when the market does not clear/ when there is excess demand or excess supply.
Excess demand
when demand for product is higher than the amount firms wish to supply. Stock will be sold very easily. The price could possibly be raised on a good like this given the popularity. This could be done until demand equaled supply. Can occur when a ceiling price (or max price) is placed on an item so it’s more affordable for everyone. Usually done as part of government intervention- ie in housing market that might impose a rent cap. When price is too low
Excess supply
Excess supply is when price is above market rate, when price is too high. Excess supply can occur when a min price is placed on a product. It is usually done by the government to reduce consumption of a particular item. One recent example is the min price for alcohol is Scotland.
Shift in demand
*How do shifts in demand affect equilibrium price?
The original equilibrium price is lower p1 and at this point q1 is demanded and supplied. Say a business increases its advertising this is likely to increase demand shown by the shift in the demand curve right to D2. If the price remains at PI there is excess demand.
* As before this is likely to cause the price to go upwards and this will keep going until we reach the new equilibrium price where the new demand curve crosses the supply curve (at higher Q2/P2).
* Note that there has been a shift in the demand curve, but only a movement along the supply curve (to reflect the increase in price). None of the determinants of supply have changed.
shift in supply
Suppose that a new pasta-making machine is produced, enabling dried pasta makers to produce at a lower cost than before. This is likely to reduce a firms costs and incentivise them to supply more pasta. The supply curve will shift to the right.
* If the price remained at P(higher) there would be excess supply. However the market is likely to adjust to a new equilibrium price of PI(lower).
* Not there has been a movement along the demand curve as the price has changed an extension of demand.
Main functions of price mechanism
A- allocate scarce resources
R- rationing excess
S- signals sent
I- incentive
The market will allocate scarce resources as effectively as possible at equilibrium. By rationing away excess demand/ supply. This is through signals that are sent to the producer to lower or increase price. This is because there is an incentive to increase profit.
Price mechanism - Rationing
Due to scarcity not everyone is able to buy everything they want, when demand is greater than supply, prices will rise so that the good/service is rationed out only to those who can afford to pay for the items
Price mechanism - Incentive
When the price of a product rises it creates an incentive for firms to shift production towards products that help generate higher profits. Likewise falling prices may create an incentive for firms to move away from the production of a product.
Price mechanism- Signalling
When the price of a product rises it signals to producers that the demand for that product is probably high and firms should increase production. Prices are helping to determine where and how resources should be allocated.
Consumer surplus
The value consumers gain from consuming a good or service over and above the price paid. It is the difference between the maximum consumers are willing and able to pay for a good or service and the total amount they actually do pay. In most markets all consumers face the same prices for goods and services. Some may just be willing to pay the market price ( the marginal customer). However some may be willing to pay more and some significantly more. Consumer surplus is derived whenever the price a consumer actually pays is less than they are prepared to pay. It is below the demand curve but above the price line.
Marginal Utility
An economic concept measuring the amount of satisfaction gained from consuming an extra unit of a good or service ; generally the level of marginal utility declines as additional units of a product are consumed.
Producer Surplus
Difference between price the producer is willing to charge and the price they actually receive. It is above the supply curve and below the price line.
Economic welfare
the economy is made up of producers, consumers and government. We can see both the producers and consumers benefit when demanding and selling goods. Economic welfare is the total benefit received from an economic transaction. It is calculated by the area of producer surplus and consumer surplus added together. it is important when considering the effects of government policies which could affect either producer or consumer surplus.
Price elasticity of demand
The responsiveness of demand to a change in price. When price rises demand falls but by how much? Elasticity is measuring the extent to which demand will change.
Elastic demand
Demand is responsive or sensitive to a change in price. A change in price will lead to a more than proportional change in quantity demanded.
Inelastic demand
Demand is not very responsive to a change in price. A change in price leads to a less than proportionate change in quantity demanded
Unitary elasticity
The percentage change in quantity demanded is equal to the percentage change in price.
Perfectly elastic
Consumer demand is unlimited at that price. No firm has an incentive to drop price, however an increase in price by even a penny would mean demand drops to zero. Rare and usually occurs in markets where producers can instantly and costlessly adjust production. The coefficient is infinity. E.g. Suppose there are many farmers selling an identical type of wheat. If one farmer raises the price of their wheat by even a small amount, consumers will immediately buy from other farmers who are offering the wheat at the original price. As a result, the demand for the higher-priced wheat falls to zero. An extreme that in reality doesn’t exist.
Perfectly inelastic
In the case of perfect inelasticity, quantity supplied does not respond to price changes. Producers are unable or unwilling to adjust supply in response to price fluctuations. The coefficient is zero. E.g. Life-saving medications may have perfectly inelastic supply; their production cannot be immediately increased, regardless of price changes. An extreme that in reality doesn’t exist.
Calculating PED
the formula used to calculate PED is
% change in quantity demanded (QD) / % change in price (P)
to work out % change - difference / original x 100
using PED to find relationship
If answer <1 the relationship in inelastic ( consumers do not react much to a change in price) perefectly inelastic = 0
If answer >1 the relationship is elastic (consumers do react to a change in price) perfectly elastic = infinity
If value is 1 then it is unitary
Sales revenue
Income received from selling goods and services = P x Q
Impact of price on elasticity - Elastic
Response to a rise in price- % change in QD is larger than % change in price
PED coefficient - >1
Impact on total revenue if price Increases/ decreases -
Increase in price = decrease in revenue
decrease in price = increase in revenue
Impact of price on elasticity - Unitary elasticity
Response to a rise in price- % change in QD is same as % change in price
PED coefficient - 1
Impact on total revenue if price Increases/ decreases -
Increase in price = no change in revenue
decrease in price = no change in revenue
Impact of price on elasticity - Inelastic
Response to a rise in price- % change in QD is less than % change in price
PED coefficient - <1
Impact on total revenue if price Increases/ decreases -
Increase in price = increase in revenue
decrease in price = decrease in revenue
Revenue vs Profit
Firms who have products that are price elastic would benefit from a price cut to increase their revenue. However it is important to note that this does not mean there will be an increase in profit. Where there are extra sales, there is likely to be an increase in costs, therefore total costs will rise as well as total revenue. If costs actually rise more than revenue , profits will fall
Products which are price elastic
( Demand will fall if prise rises )
-Goods with close substitutes ( e.g. spaghetti )
-Luxuries
-Longer time period
Products which are price inelastic
( Demand won’t fall despite price rise)
-Shorter time period
-Necessities
-Addictive goods - cigarettes, alcohol
-Goods with no clear alternative - e.g apple iPhone
Factors Influencing PED
S- substitutes
P- proportion of income
L- luxury or necessity
A- addiction
T- time
Factors Influencing PED - Substitutes
- Existence of close alternatives or substitutes, will increase PED (become more elastic). Where there are close substitutes including other brands it is important for firms to differentiate their products to make their products less price responsive because substitutes become less attractive in comparison.
Income Elasticity of Demand
Income elasticity of demand (YED) is the responsiveness of quantity demanded to changes in income. The basic formula for calculating the coefficient of income elasticity is:
% change in quantity demanded / % change in income
Normal good
Have a positive income elasticity of demand. As consumer income rises, more is demanded at each price level. I.e there is a right shift of the demand curve.
Normal goods can be separated into 2 groups:
-(Normal) Necessities. Coefficient = 0 -> 1. E.g. Fruit and veg
-(Normal) Luxuries. Coefficient = 1-> infinity. E.g. holidays, sports car, designer clothes.
Inferior goods
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. Typically inferior goods or services tend to be products where there are superior goods available if the consumer has the money to be able to buy it. However in a recession the demand for inferior goods may actually increase. Coefficient = -infinity -> 0. Examples include tinned food and public transport
Significance of YED
Inferior goods can benefit from an increase in sales during a recession as consumers tend to consider their spending. In a boom producers of inferior goods will feel the need to diversify. They need to increase their range of products to include some with growing markets. They may need to find new ways of adding value to their products. Whereas producers of luxury products tend to see the sales of their products fall significantly during a period of recession. Finally when interpreting YED not all consumers will view goods in the same way. A good that is regarded as a luxury to one person might be viewed very differently by someone else who has a higher level of income/ wealth
Income elasticity and co- efficient
Below -1 = Income elastic inferior good
Below -1 and 0 + income inelastic inferior good
0 = No relationship between income and QD
0 and +1 = Income inelastic normal good/necessity
Greater than +1 = Income elastic normal good/ luxury
Cross Elasticity of Demand
(XED) : Measures the responsiveness of a change in demand of one good to a change in price of another good.
The Factors:
- Substitutes
-Complements
-No correlation
% change in quantity demanded X / % change in Price of Good Y
Co efficient of Substitutes
Co- efficient
Strong substitutes: +1 -> infinity
Weak substitutes: 0 -> +1
Explanation of change in price for one good on the demand for the other:
Increase in price causes an increase in demand for the other
Decrease in price causes an decrease in demand for the other
( significant change for strong)
Co efficient of Complements
Co- efficient
Strong Complements: -1 -> -infinity
Weak Complements: 0 -> -1
Explanation of change in price for one good on the demand for the other:
Increase in price causes an decrease in demand for the other
Decrease in price causes an increase in demand for the other
( significant change for strong)
Co efficient if no correlation between goods
Co- efficient- 0
Explanation of change in price for one good on the demand for the other:
If there is an increase or decrease in price there is no change
Using Elasticities
PED will help firms judge the impact of a change in price. YED will help to forecast changing demands if real incomes are increasing / decreasing. XED helps anticipate changes in demand based on changes in prices of other products. From the prospective of Government, knowing the PED will help inform them of the impact of imposing/ increasing indirect taxes on the revenue received. Similarly the impact of introducing a subsidy can be estimated.
Price elasticity of supply
PES measures the responsiveness of QS of a good or services to a change in price of that good/ service
% change in quantity supplied / % change in price
Supply curve - PES
The supply curve is upward sloping - price elasticity of is positive
An increase in the market price is likely to encourage firms to supply more
If PES is between 0 and 1 then supply is inelastic
If PES is more than 1 then supply is elastic
When = 1 it is unitary
inelastic supply
A change in price causes a smaller proportionate change in quantity supply
Firms can’t increase supply easily, it can be expensive and/or take a long time
Grapes- Harvest is once a year, so in short term, supply would be very inelastic
elastic supply
A change in price causes a bigger proportionate change in supply
Firms can increase supply at little cost
Taxi Services- easy for people to work as taxi drivers, licence and car.
unitary elastic supply
A unitary elastic supply has a change in supply which is equal to the change in price
E.g. 10% change in price leads to a 10% change in supply.
Perfectly inelastic supply
-Supply fixed, so if there is a change in demand, it can’t be met, not straight away anyways
PES = 0, supply is perfectly price inelastic
What affects Price elasticity of supply
- How willing and able firms are to respond to a change in price
-Spare production capacity: if there is plenty of spare capacity, a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. - Stocks of finished products and components and perishability. If stocks of raw material and finished products are high, then a firm can respond to a change in demand - supply will be elastic - perishable goods are often harder / more expensive to store - this makes supply less elastic.
-Ease and costs of factor substitution / factor mobility : if capital and labour are occupationally mobile then the elasticity of supply is higher as resources can be mobilised to supply extra output e.g. reallocation of workers to new tasks
-Time period and production speed : supply is more price elastic the longer the time that a firm is given to adjust their production levels.
What affects Price elasticity of supply
P- production lag
S- stock
S- spare capacity
S- substitutability of factors of production (CELL)
T- time
B- carries to entry
Supply could be elastic for the following reasons
- If there is spare capacity in the factory
- If there are stocks available
- In the long run, supply will be more elastic, because capital can be varied
-If it is easy to employ more factors of production
Supply could be inelastic for the following reasons
-In the short term, capital is fixed in the short term .e.g. firms do not have time to build a bigger factory
-It is difficult to employ factors of production e.g. if highly skilled labour is needed
-With agricultural products, supply is inelastic in the short run, because it takes at least 6 months to grow new crops. In September the farmers cannot suddenly produce more potatoes if the price goes up.
- Firms operating close to full capacity
What affects price elasticity of supply
- How willing and able firms are to respond to a change in prices
- A firm that has high levels of stock / running at below capacity is likely to be able to respond very quickly to a change in price - Where as a firm who will need to pay overtime / rent new buildings or machinery may be less responsive to a change in price
Tax
A charge or fee that a government imposes on a citizen or business is called a tax
Government intervention - taxes
Governments may intervene in markets to influence demand/ supply of particular goods
An indirect tax is put on expenditure for goods and services- it is imposed on producers. An element of this is likely to be passed on to the consumer (as opposed to a direct tax which is charged directly on an element of income / wealth or profit. It is paid directly by a business or individual to government)
Indirect taxes are imposed by the government and they increase production costs for producers.
Main indirect taxes in the UK
-VAT
-Cigarettes, alcohol, fuel and sugar levy (excise duty)
-Landfill
-Insurance premium tax
Types of Indirect tax
- Ad valorem taxes- are percentages ,such as VAT, which adds 20% of the unit price. This is the main indirect tax in the UK
-Specific tax - a set tax per unit, such as the 58p per litre fuel duty on unleaded petrol
Specific tax - graph
Shifts the supply curve to the left.
Incidence and burden of tax
Who pays tax?
Although the seller is responsible for the mechanics of paying the tax, it is effectively divided between the buyer and the seller. Part of the tax can be passed on the buyer in the turn of a higher price.
This is called incidence of tax
The price elasticity of demand determines the incidence of tax.
If the co-efficient of price elasticity of demand >1 (elastic) , then most of the burden of an indirect tax will be absorbed by the supplier
If the co-efficient of price elasticity of demand <1 (inelastic), most of an indirect tax can be passed on to the final consumer
Ad valorem tax
An Ad Valorem tax is a % of the price. Value added tax (VAT) (standard rate in UK is 20%) is an example of an Ad Valorem tax. The effect of an ad valorem tax is to cause a pivotal shift in the supply curve. This is because the tax is a % of the unit cost of supplying the product. So a good that could be supplied for a cost of £50 will now cost £60 when VAT of 20% is applied. A different good that cost £400 to supply will now cost £470 when same rate of VAT is applied.
VAT
Value Added Tax is an Ad Valorem indirect tax which is charged on the purchase of many goods and services. It is levied at each stage if the supply chain where value is added from initial production to the point of sale.
Standard rate of VAT is 20%
Reduced rate of VAT is 5%, reduced rate VAT is on goods that the government wish to encourage the consumption of, for example, Children car seats, home energy saving materials, smoking cessation products such as nicotine patches and gum.
Zero rated VAT is on certain foods and beverages, exported goods, donated goods sold by charity shops, equipment for disabled, prescription medicine, water, child clothing.
Subsidies
The government may wish to encourage production of a particular good or service. A subsidy is a form of government intervention, it usually involves a payment by the government to suppliers that reduce their costs of production and encourages them to increase output of a good or service.
Reasons for Subsidies
-Encourage infant industries/ prop up industries that are struggling to compete
-Strategic industries ie foods or defence
-Encourage consumers to buy products and services that have positive benefits for individuals/ society .i.e.
~Fresh fuit and Veg
~Solar panels
~Electric Cars
Impact of a Subsidy
-Shift in the supply curve to the right
-Fall in Price
-The Price fall is less than the total subsidy
Subsidy on a graph
- Size of Subsidy is the vertical distance between the 2 supply curves
- A subsidy per unit of output causes an outward shift of the market supply curve leading to a lower equilibrium price
-Benefit of subsidy to consumer is bottom area- consumer now paying less
-Benefit of subsidy to producer given by top area and represents the fact they earn more revenue per item
-Total cost of subsidy to government will be sum of the benefits to both consumers and producers or the total areas of the 2 rectangles
Effects of PED on subsidy
-If demand is price inelastic, the subsidy will have a large effect on the equilibrium price. This gives a greater consumer gain than when demand is elastic
-If demand is price elastic, the subsidy will have a large effect on quantity and therefore benefit producers more
Reasons for Irrational decision making- Habitual Behaviour
-Habitual Behaviour- Always done it e.g. buying Heinz, smoking- addictive even though we know it’s bad for us. This could also be due to inertia ie in the last 6 months I have watches 2 films but still keep paying as I cant be bothered to go unsubscribe.
Reasons for Irrational decision making - other people
- Other People can influence how the consumer acts (how they behave and their choices)
Reasons for Irrational decision making - Consumer weakness at consumption
Self control can be difficult with some decisions. The law of diminishing marginal utility suggests that every extra unit consumed provides a smaller benefit to the consumer. Consumers may consume past the optimal benefit point because of their weakness in identifying optimal benefit or self control.
Reasons for Irrational decision making -Bias
Biases stop individuals acting in a rational way due to:
-rule of thumb- mental shortcut. Given range of prices we take the one in the middle.
-Anchoring- the tendency to rely too much on a single piece of information, frequently the 1st piece of information when making decisions.
-Availability of bias- people make judgements about the probability of events by how easy it is to recall examples of such events for example due to recent occurrences.
-A social norm is a belief that is held by the group or groups of people with whom we associate about how we should behave in a given situation
-Habitual behaviour- refers to a rigid pattern of behaviour followed by a person
Reasons for Irrational decision making - Bounded rationality
A term that means that people ability to make rational is severely restricted. It’s why consumers don’t act rationally and why people tend to satisfy rather than spend ages trying to make a rational decision that maximises utility. Three main reasons are often identified:
-The human mind has limited ability to process and evaluate information
-The information available is invariably incomplete and often unreliable
-The time available in which to make decisions is limited.
Reasons for Irrational decision making - Nudge Theory
Suggests consumer behaviour can be influenced by small suggestions and positive reinforcement. Proponents of nudge theory suggests that well placed nudges can reduce market failure, save the government money, encourage desirable actions and help increase the efficiency of resources used.
Rational decision making
Rational behaviour is the cornerstone of rational choice theory,a theory of economics that assumes that individuals always make decisions that provide them with the highest amount of personal utility. These decisions provide people with the greatest benefit or satisfaction given the choices available.
Irrational Decision making
Irrational behaviour happens when people make choices and decisions that go against the assumption of rational utility-maximisingbehaviour.
