AQA gcse

economics

Topic Companion
How Markets
Work

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Contents
Chapter 1 Economic Foundations
1 Economic Activity 3
2 The Factors of Production 5
3 Making Choices 6

Chapter 2 Markets and Allocation of Resources

1 Markets 9
2 The difference between Factor and Product Markets 11
3 Economic Sectors 12
4 Specialisation, division of labour and exchange 14

Chapter 3 How Prices are Determined

1 Demand 19
2 Supply 23
3 Equilibrium Price and Quantity 26
4 Elasticities 32

Chapter 4 Production, Costs, Revenue and Profit

1 Business Objectives 40
2 Costs and Revenue 42
3 Profit 44
4 Production and Productivity 45
5 Economies of Scale 48

Chapter 5 Competitive and Non-Competitive Markets

1 Competitive markets 52
2 Non-competitive markets 54

Chapter 6 The Labour Market

1 The Role and Operation of the Labour Market 59
2 How are Workers Paid? 60
3 Gross and Net Pay 64

Chapter 7 Market Failure

1 Market Failure 67
2 Externalities 69
3 Consumption and Production Externalities 71

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Chapter 1 Economic Foundations

1 Economic Activity
What is economics?
Economics is the study of the allocation of scarce resources. A starting point for understanding the subject is
to consider the economic problem:

The Basic Economic Problem = People have an unlimited set of wants and needs but we have a
limited amount of resources (factors of production).
h The purpose of economic activity is the production of goods and services to satisfy the ever-
changing needs of society.

The Difference between a Need and a Want

A need is any good or service that we require or that is necessary for our survival such as food and water.
A want is any good or service that is desired but is not necessary. For example, we need clothing to survive
but we may want branded cloths to be fashionable.

Activity 1
Separate these goods and services into what you may consider as needs and wants:
Smartphone, Bread, Shoes, Car, Vacuum Cleaner, Vaccinations

Needs Wants

The key economic decisions

What are the key economic decisions?

uu what to produce? – which of the many goods and services that are wanted and needed should be
produced (e.g. should we produce more corn or farm more cows for beef)?

uu how to produce? – what methods are we going to use to produce our goods and services
(e.g. do we use more labour or do we use more machinery)?

uu who is to benefit from the goods and services produced? – how do we distribute the things that we
have produced so that people can access them and use them (e.g. how do we ensure that poorer people
still receive food and shelter)?

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The main economic groups

What are the main economic groups?

uu Consumers – those who demand the goods and services. Most people are consumers! Being a
consumer does not always mean that you have to pay. For example, you may the visit the doctor to
discuss a medical condition. In the UK, there is a good chance that you will not actually pay for this
consultation but you have ‘consumed’ the medical service.

uu Producers – those who supply the goods and services. In the UK, most produces are private businesses
but some organisations are provided by the Government (such as schools).

uu Government – the organisation who decides who should benefit and how to distribute the goods and
services produced. In the UK, the government is controlled by ‘elected representatives’ – people who are
in a position of power because they have been voted in to place. However, most government activity is
conducted by employed individuals.

Consumers

Need and Wants Government

Producers

Activity 2
Have a short discussion with someone in your class to answer the following question:
“There is a limited amount of space that has become available in the local town centre.
Would you build a new factory or a new hospital in this space?”

Did you and your friend agree? If you disagreed with your friend did you understand why they had
the alternative suggestion? This is a common dilemma that we face when making decisions – who
has the greater need? Sometimes, we have to rely on th e government to make that decision on our
behalf – hopefully they have the best information available that allows them to make that decision.

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2 The Factors of Production

All the scarce resources we have mentioned can be put into the four categories; land, labour, capital and
enterprise (or entrepreneurship). Each ‘factor of production’ brings a benefit or ‘reward’ to its owner.

Land
Land includes all natural physical resources – e.g. fertile farmland, the benefits from a temperate climate
or the harnessing of wind power and solar power and other forms of renewable energy. The reward for
land is called rent.
Labour
Labour is the human input into production e.g. the supply of workers available and their productivity.
The reward to labour is the wages that they receive.
Capital
Capital goods are used to produce other consumer goods and services in the future. The reward for
capital is called interest.
Enterprise
Regarded by some as a specialised form of labour input, enterprise (or an entrepreneur) is an individual
who supplies products or services. Their main reward is the profit made from running the business.

Activity 3
Match the factor of production to the example:

Land Accountant

Labour Digger

Capital Gold Nugget

Enterprise Market Stall Owner

Activity 4
Research these 3 famous entrepreneurs and find out what was the first product
or service that they sold?

Lord Alan Sugar Martha Lane Fox Deborah Meadon

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3 Making Choices
As we saw in Activity 2, one of the issues with having limited resources (but unlimited wants and needs) is that
eventually we must make a choice between which product or service gets produced.

The government will make some of those choices. Sometimes the choices are made by consumers
themselves. For example, if a product does not generate sufficient demand to reward the entrepreneur with
enough profit, it will not be produced.

How we make decisions on a daily basis is often down to the price of a product or service. The price acts as a
signal to consumers who will compare the value of one product and service to another.

Opportunity Cost
When we are making choices we often consider what is called the ‘opportunity cost’ of the decision.

Opportunity cost = the cost of any possible alternative when making a choice.

For example, if you bought a car this year you may not be able to afford to go away on holiday.
h So, the opportunity cost of purchasing the car is the missed holiday.

When we are making such a choice we will attempt to consider the costs and benefits with both
options.

Activity 5
List 3 possible benefits of purchasing a car (e.g. a small family saloon) and 3 further benefits of
taking a holiday (e.g. a family holiday to a Spanish resort)

Car Holiday

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Multi-choice questions
1 Which of the following is an example of a ‘capital’ factor of production?

A A cow

B A printer for a computer

C A coffee-shop barista

D A train driver

2 Which of the following is an example of a ‘need’ rather than a ‘want’?

A Apple juice

B Lemonade

C Energy drink

D Water

3 Which of these best describes opportunity cost?

A The next best product that is given up when we make

a consumption choice

B The cost of purchasing a house

C The price of two different chocolate bars

D Considering the price of earphones when purchasing a phone

4 Which of these is not considered an economic group?

A Consumers

B Producers

C Government

D Labour

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5 Which of these is considered as the ‘reward’ for the Capital factor of production

A Rent

B Wages

C Interest

D Profit

Short answer questions

6 State one example for each of the following types of factor of production:

Labour

Land
2 Marks

7 Explain one possible opportunity cost for a consumer when considering the purchase of new tablet computer
(such as an ‘Ipad’).

2 Marks

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Chapter 2 The role of the markets

1 Markets
What is a market?

In its simplest form, a market is an opportunity for buyers and sellers to meet and determine the price of
h a good or service.

What we might call a ‘market stall’ is a good example of this – a small outlet where there is a direct meeting
between the market stall owner and their customers. Although prices may have been decided before this
meeting, previous customers may have indicated what price they were prepared to pay and there may be some
form of discussion during the meeting.

The modern term ‘Market’ has come to mean all the different ways that buyers and sellers meet. Now, we have
internet interactions (e.g. purchasing from Amazon, booking a taxi via Uber), markets for complex goods (e.g.
a currency like the GB pound) and genuine price discussions (e.g. bids through Ebay). Markets can be local,
regional, national or even global.

The role of markets in determining allocation of resources

We know that economic resources are scarce but demand for them is unlimited. Markets are one method of
determining how these scarce resources get allocated among all those unlimited demands.

Many people may want a fast sports car or a luxury yacht. However, there are not enough resources to ensure
that everyone can have these goods so they can only be purchased by people with sufficient wealth. In this
way, ‘price’ determines who is able to consume the car or yacht. The ‘markets’ for cars and yachts have
determined the relative desire for these products and then matched this against the cost of producing them. If
enough buyers say they are willing and able to purchase the products and the amount of money that they offer
is acceptable to the supplier an interaction will take place.

Activity 1
Rank these products in terms of their relative price:
Standard loaf of bread, umbrella, Mars bar, Ipad mini, pint of semi-skimmed milk, Packet of four
AA batteries

Most expensive 2 3 4 5 Least expensive

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What do you think determines the price of the Ipad mini and why is it more expensive
than a loaf of bread?

The function of price

So, price acts as a way of sending a message between the seller and buyer. Price has three ‘functions’:

uu Rationing – it allows some people to afford the product/services but prevents others from being able
to make the purchase. This will depend on the individual’s relative wealth and the value of that product
compared to others (i.e. the opportunity cost of what must be given up).

uu Signalling – the price signals something about the good/service that is important to potential buyers.
A price rise may signal an increase in the cost of production. A price fall (for example, during a sale)
may indicate that the seller will no longer continue to provide the good or service. In the UK, the price
of healthcare is often ‘free’ (e.g. prescriptions for medicines for anyone under the age of 16) as the
government wants to encourage consumption of health care.

uu Incentive – the price of a good or service can act as an incentive for a supplier to provide it.As prices
rise, the supplier may make more profits and therefore receive a greater reward for investing in the supply
of the product or service.

Activity 2
In October 2015, a 5p charge for plastic bags supplied by stores (such as supermarkets)
was introduced UK wide for stores with more than 250 employees. Previously, many of the stores
would have given the bags away for free as a method of attracting people to purchase goods
within the stores. However, there was concern that an overuse of the bags was having a negative
environmental impact. The introduction of the 5p charge (which is not collected by the government
as a tax) was made to make people change their use of these bags.

It was estimated that by October 2016, 500m less plastic bags were being used in the UK – a
reduction of almost 85% compared to before the charge was introduced. Do you think the 5p
charge on plastic bags was using price as a rationing, signalling or incentive function (explain your
answer)?

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2 The difference between Factor and Product Markets

uu Factor market – this is a market for factors of production (land, labour, capital and enterprise).
For example, a livestock market may trade in sheep or cows. Markets exist for the trade in metals
(e.g. aluminium). A fish market may trade in fish caught daily in local seas and may be attended by fish
mongers (to sell the purchased fish at retail) or by restaurants using the fish to make meals.

uu Product market – this is a market concentrating on the sale of the final product or service. For example,
if you wished to purchase a burger you may go to McDonald’s or Burger King. If you wished to purchase a
fence panel you may go to a DIY store or a timber merchant. If you wished to purchase a smartphone you
may go to a network provider (e.g. Vodafone), a retailer (e.g. Argos) or the phone manufacturer themselves
(e.g. Samsung).

Activity 3
Separate the following into Factor and Product markets:
Bricks, coal, coffee beans, cappuccinos, laptop, leather, light bulb, trees,

Factor Market Product Market

The difference between a product and a service

uu Products are physical objects or products that have been farmed, mined or created by a production
process.

uu Products can be transferred and delivered from buyer to seller.

uu A service cannot be weighed or measured. A service is an activity of performing work for customers. At
the end of the interaction, the service should provide satisfaction of the wants of the customer.

uu At the end of a transaction the ownership of the product passes from the seller to the buyer. At the end of
the process, the ownership of the service remains with its provider.

uu After transaction, a product can be returned or exchanged. Services, however, cannot be returned.

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Activity 4
Separate the following into products and services:
Cash machine, insurance, car maintenance, packet of crisps, milkshake purchased from coffee shop, train
journey, cinema visit to watch a movie, family picture taken at a photographer’s studio

Products Services

3 Economic Sectors
The economy can be separated into 3 sectors:

uu Primary – this is any part of the economy that is involved with acquiring the land economic resources
(agriculture or mining). For example, coal must be mined, oil has to be extracted, maize has to be farmed.

uu Secondary – this is any part of the economy that is involved with the manufacturing or assembly of
products. The UK manufactures cars, aeroplanes and pharmaceuticals.

uu Tertiary – this is any part of the economy that is involved in the provision of services that support the
primary and secondary sectors. In the UK, we are successful at financial services such as banking and
insurance. Many people work in the retailing sector (the selling of produce).

A chain exists between the three sectors showing an interdependence – i.e. that each sector has a dependence
on the other.

Primary Secondary Tertiary Tertiary

h h h
Cattle raised Beef converted Burger transported to Restaurant serves
on farm to burger restaurant burger to customer

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Primary, Secondary and Tertiary Sectors in the UK

For many decades now, the tertiary sector has been the largest as a proportion of the total economy of the UK.
Compare this to…

Country (2016 stats) Primary Secondary Tertiary

UK 1% 19% 80%

Nepal 32% 14% 54%

Poland 3% 38% 59%

Activity 5
Suggest a disadvantage for the UK with such a large reliance on the tertiary sector.

Suggest a disadvantage for Nepal with such a large reliance on the primary sector.

Suggest an advantage for Poland with a relatively large secondary sector.

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4 Specialisation, division of labour and exchange

For an economy to become more effective at meeting the unlimited wants of its inhabitants it will need to ensure
that it organises itself in such a way as to encourage greater efficiency.

Specialisation
Specialisation is the concept of how an economy will start to concentrate on the production of goods or provide
services at which it is the most efficient. It will start to reduce the production of goods or provision of services
where it is less efficient.

For example, because of its climate, it would be very inefficient for the UK to mass produce bananas (it would
require a great deal of cost in the provision of greenhouses). However, the climate in the UK allows the country
to produce certain types of apple very efficiently – at relatively low cost and of good quality.

During the industrial revolution, Great Britain increased its production of products as it had large reserves of coal
to fuel furnaces. However, now that many of those coal reserves have gone (or have become too expensive to
mine) the UK is less efficient at producing energy to run large factories.

Likewise, regions can specialise. For example, for many years the West Midlands region of England specialised
in the production of cars allowing each car manufacturer to benefit from the skills of the local labour force and for
the government to invest in infrastructure (e.g. motorways) to allow greater transport of finished goods.

What are the possible gains from specialisation?

uu Higher output: Total production of goods and services is raised and quality can be improved
uu Variety: Consumers have access to a greater variety of higher quality products
uu Lower prices: Increased competition acts as an incentive to minimise costs and keep prices down.
Just as an economy can benefit from specialisation, a firm can benefit from allowing its workers to specialise
in one or just a few parts of the business process. As such, a firm may separate its workforce so that many
separate tasks are undertaken by specific individuals – this is called division of labour.

For example, in a restaurant, the owner may ask some employees to concentrate on cooking the food and
others to serve the food to customers. In this way, it may be more effective to employ a trained chef who
concentrates on a high-quality output of food and allow others to concentrate on customer service.

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In factories, this division of labour may go even further where individuals concentrate on a small task that is part
of the whole process.

Advantages and disadvantages of division of labour

Advantages:

uu An individual worker becomes more competent at a task that they repeat many times. Their output
should therefore increase.

uu This increase in productivity per worker reduces the overall production cost per unit.
uu The employer is more able to afford specific training for individuals as their output will increase and justify
that investment.

uu Workers can repeatedly use a single tool, making it more cost effective for a firm to purchase that tool.
This may reduce the cost of production or increase productivity for that worker.

Disadvantages:

uu When an individual repeats tasks many times, they may start to become bored with the job they are
doing. This may lead to lower levels of morale which, in turn can lead to lower levels of output and quality
of production.

uu If a job becomes more boring, an individual is more likely to look for another job. This can lead to high
levels of staff turnover (the rate at which employees leave a workplace).

uu An increase in mass-produced standardised goods may reduce choice for consumers.

Exchange

For specialisation and division of labour to be a valuable method for improving efficiency in an economy, there
must be a method of ‘exchange’. For example, if the UK does specialise in the production of apples, it would
benefit from a system where it can exchange some of these apples for bananas or other foodstuffs it has not
produced.

Likewise, if an individual specialises in one part of a production process that individual needs to be able to buy
other goods and services that they are not able to provide for themselves.

Economies have developed methods of exchange so that they can benefit fully from the advantages of
specialisation and division of labour.

The primary method of exchange, of course, is ‘money’. The UK can directly swap apples for bananas from
another country but it is more likely to sell the apples first. Individuals are now more likely to be paid in wages
which they use to purchase products and services from other firms.

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Activity 6
Consider this image of a pit stop at a Formula One
race. Individual drivers need to replace the tyres
on their cars at least once (often twice or three
times) per race. Each wheel has three people
allocated to it. There is one person at the back of
the car and one person at the front using ‘jacks’
to temporarily lift the car to enable the tyres to be
replaced and another person holding a board to
indicate to the driver when it is safe for them to
continue with the race.

Why do you think the Formula One driving teams use so many people to change the tyres
in the middle of a race?

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Multi-choice questions
1 Which one of the following is determined in a factor market?

A The amount of fish sold

B The output of cars

C The quantity of teachers trained

D The quantity of houses sold

2 Which of the following is an example of a service?

A Building a shed

B The production of a lawn mower

C A packet of seeds

D Removal of garden waste

3 Which of these occupations exists in the secondary sector of the economy?

A A farmer

B A ship builder

C An actor

D A painter and decorator

4 Which of these is an advantage of division of labour?

A Lower levels of morale

B Higher levels of output

C A reduction in choice for consumers

D Lower levels of training

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5 Which of these products has the UK economy not specialised in?

A Pharmaceutical production

B Electrical appliances

C Car manufacturing

D Sugar cane growing

Short answer questions

6 State one example for each of the following types of market:

Factor Market

Product Market
2 Marks

7 Explain one possible reason why a pint of milk may be more expensive than a pint of tap water.

2 Marks

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Chapter 3 HOW PRICES ARE DETERMINED

1 Demand
Demand refers to the quantity of a good or service that consumers are willing and able to buy at given prices
over a given period of time. A household may demand goods and services; however, in order for the demand to
become effective, the household must be able to pay for the goods and services. This is referred to as effective
demand, where the demand for a good or service is backed by an ability to pay.

A demand curve for a good

An individual demand curve for a normal good slopes downwards from left to right; i.e. there is an inverse
relationship between price and quantity demanded. As the price of a normal good falls, the quantity demanded
rises, and vice-versa.

N.B. There are some goods for which demand falls as the price falls. Such goods are referred to as inferior
goods and are commonplace, particularly with today’s rapid pace of technological advancement; e.g. as
updated models of the IPhone are brought to the market, consumers stop buying the older models, in spite of
the fact that they are cheaper.

How to construct an individual demand curve

It is possible to collect data for a specific good relating to its quantity demanded and price. The data can be
used to construct a demand curve, as shown below:

Price (£) Demand (million per year)

4000 4.0

6000 3.2

8000 2.8

10000 2

The corresponding demand curve is illustrated below:

Price (£)

10000

8000 A
expansion
$
6000 B

4000

Demand

2 2.8 3.4 4 Quantity

(million per year)

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The factors which determine the demand for a good or service

A change in price
The demand curve is downward sloping and shows that the lower the price, the higher will be the quantity
demanded. If the price falls from £8,000 to £6,000, quantity demanded increases from 2.8 million to 3.4 million.
This movement along the demand curve (away from the origin), from point A to point B, is referred to as an
expansion/extension of demand. If the price increased from £8,000 to £10,000, quantity demanded would
fall from 3.2 million to 2.8 million. This movement along the demand curve (towards the origin), from point B
to point A, is referred to as a contraction of demand. A change in price is the only factor which can cause a
movement along the demand curve.

Changes in the conditions of demand

There are other factors which can alter the level of demand for a good or service. When we draw a demand
curve in isolation, we assume that these ‘other factors’ are constant. This is referred to as the ceteris paribus
assumption; i.e. all other factors remaining equal. A change in these other factors is referred to as a change in
the conditions of demand, and, a change in one or more of these conditions of demand will cause the demand
curve to shift to the right or left.

An increase in demand is illustrated by a rightward shift of the demand curve; i.e. the demand curve moves
further away from the origin. A decrease in demand is illustrated by a leftward shift of the demand curve; i.e. the
demand curve moves towards the origin. The shift of the demand curve is illustrated in the diagram below.

Price

decrease increase

P*

D1

D3 D2

Q3 Q* Q2 Quantity

The main conditions of demand are:

uu The price of substitute goods; e.g. an IPhone and a Samsung phone;

uu The price of complementary goods; e.g. DVD players and DVDs;
uu Personal disposable income; i.e. an individual’s post-tax income;
uu Interest rates; i.e. the reward for saving and the cost of borrowing;
uu Tastes and preferences; and
uu Population size.

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A rightward shift of a demand curve may be caused by:

uu An increase in the price of a substitute good (a substitute is a good which can be replaced by another
good); e.g. if the price of an IPhone increases, the demand for Samsung phones will increase;

uu A fall in the price of a complementary good (a complementary good is a good which is demanded
because it is used with another good); e.g. if the price of DVD players rises, the demand for DVDs will fall;

uu An increase in personal disposable income; e.g. if an individual’s personal disposable income

rises, there will be an increase in demand for normal goods (Note: the demand for an inferior good would
decrease);

uu A reduction in interest rates; e.g. the cost of borrowing money falls then individuals are more inclined
to borrow in order to finance the purchase of a new car or other luxury items. Similarly, individuals are less
inclined to save as the reward for saving, in terms of the interest rate, has been reduced hence, individuals
are more inclined to spend;

uu A successful advertising campaign

uu An increase in population size

Working these changes in the conditions of demand in the opposite direction will cause the demand curve to
shift to the left.

How to construct a market demand curve

The market demand is the total demand for a good or service. Market demand is the sum total of the individual
demand for a particular good or service. Consider the following example where we assume that the total market
consists of only two customers:

Price (£) Jack’s Demand Jennifer’s Demand Market Demand

100 3 2 5

80 6 4 10

60 12 8 20

40 24 16 40

20 48 32 80

In the diagrams below, you can see the two individual demand curves for Jack and Jennifer.

Market Jack Jennifer

P P P

DM DJK DJN

Q Q Q

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Activity 1
Use the information in the table below to construct a market demand curve for chocolate bars
(remember to fully label your diagram).

Price (£) Demand (000s per year)

0.20 4

0.30 3

0.40 2

0.50 1

Explain what would happen to the demand for chocolate bars in the following instances:

uu An increase in advertising spending by the chocolate manufacturer

uu A television campaign outlining the dangers associated with eating too many sugary foods; and
uu A reduction in consumers’ disposable income.

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2 Supply
Supply refers to the quantity of a good or service that firms or producers are willing and able to supply at a given
price over a given period of time.

A supply curve for a good

The supply curve for a good slopes upwards from left to right; i.e. firms will supply more of a good at a higher
price. This stems from the firms’ desire to maximise their profits. As a firm’s profits are the difference between a
good’s selling price and its cost of production, firms will increase supply in order to take advantage of the higher
prices, and potentially higher profits.

How to construct an individual supply curve

It is possible to collect data for a specific good relating to its quantity supplied and price. The data can be used
to construct a supply curve, as shown below:

Price (£) Supply (million units per year per year)

5 5

10 8

15 11

20 14

25 17

The corresponding supply curve is illustrated below:

Price (£)
Supply

25

Expansion B
15
Contraction
A

5 11 17 Quantity

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The factors which determine the supply of a good or service

A change in price
The supply curve is upward sloping and shows that the higher the price, the higher will be the quantity supplied.
If the price rises from £15 to £20, quantity supplied increases from 11 million units per year to 14 million units per
year. This movement along the supply curve (away from the origin), from point A to point B, is referred to as an
expansion/extension of supply. If the price decreased from £20 to £15, quantity supplied would fall from 14
million units per year to 11 million units per year. This movement along the supply curve (towards the origin),
from point B to point A, is referred to as a contraction of supply. A change in price is the only factor which
can cause a movement along the supply curve.

Changes in the conditions of supply

There are other factors which can alter the level of supply for a good or service. When we draw a supply
curve in isolation, we assume that these ‘other factors’ are constant. This is referred to as the ceteris paribus
assumption; i.e. all other factors remaining equal. A change in these other factors is referred to as a change
in the conditions of supply, and, a change in one or more of these conditions of supply will cause the supply
curve to shift to the right or left.

An increase in supply is illustrated by a rightward shift of the supply curve; i.e. the supply curve moves further
away from the origin. A decrease in supply is illustrated by a leftward shift of the supply curve; i.e. the supply
curve moves towards the origin. The shift of the supply curve is illustrated in the diagram below.

Price (£) S3 S1 S2

Decrease Increase
P*

Q3 Q1 Q2 Quantity

The main conditions of supply are:

uu The costs of production;

uu Technology;
uu Taxes;
uu Subsidies;
uu Weather;
uu The prices of other goods; and
uu The number of firms in an industry.

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A rightward shift of the supply curve may be caused by:

uu The costs of production; e.g. a reduction in raw material costs, perhaps caused by a change in the
exchange rate, will enable firms to supply more at each and every price. The same principle can be
applied to wage costs and energy costs;

uu Technology; e.g. technological progress enables firms to become more productive and hence they are
able to increase the supply of goods and/or services;

uu Taxes; e.g. if the government reduces fuel excise duty, this reduces a logistics firm’s costs of production
and enables it to supply more goods and/or services;

uu Subsidies; i.e. a sum of money given by the government to producers. Subsidies lower firms’ costs of
production and enable them to supply more goods and/or services;

uu Weather; e.g. farmers are particularly reliant on the weather for their harvests. Favourable weather
conditions will boost harvests and consequently increase the supply of crops;

uu The prices of other goods; e.g. changes in the price of substitute goods may encourage producers to
switch production. If the price of a good rises, producers will see a potential profit making opportunity and
may reallocate resources to the production of this good. Consequently, supply of the good will increase;

uu The number of firms in an industry; e.g. an increase in the number of firms in an industry will increase
the supply of goods and/or services.

Working these changes in the conditions of supply in the opposite direction will cause the supply curve to shift to
the left.

How to construct a market supply curve

The market supply is the total supply of a good or service. Market supply is the sum total of the individual
supply for a particular good or service. Consider the following example where we assume that there are only
two firms in the industry:

Price (£) Firm A Firm B Market Supply

100 48 32 80

80 24 16 40

60 12 8 20

40 6 4 10

20 3 2 5

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Activity 2
Use the information in the table below to construct a market supply curve for chocolate bars
(remember to fully label your diagram).

Price (£) Demand (000s per year)

0.20 2
0.30 4
0.40 6
0.50 8
Explain what would happen to the supply of chocolate bars in the following instances:

uu An increase in the number of firms in the industry;

uu An increase in the national minimum wage; and
uu An increase in the rate of VAT.

3 Equilibrium Price and Quantity

How equilibrium price is determined by supply and demand
A market brings buyers into contact with sellers. In other words, firms which supply goods and/or services are able
to trade with the buyers who demand the goods and/or services. The point at which demand is equal to supply is
referred to as the market-clearing price or the equilibrium price. In the diagram below, the equilibrium price is £6.
Price S1

D1

10 Quantity

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Why excess demand and excess supply can lead to changes in price
Any point where demand does not equal supply is referred to as disequilibrium. It is often the case that markets
do not clear and remain in disequilibrium. At any price above the equilibrium price, there is excess supply, and,
at any price below the equilibrium price, there is excess demand. This is illustrated in the diagram below.

Price S1
Excess Supply

P1

P2

D1
Excess Demand

Quantity

In theory, an excess supply of goods and/or services should encourage producers to lower their prices in order
to clear the market. Consequently, price should fall until the market clears at its equilibrium level.
Excess demand for a good and/or service should cause the price to rise in order to ration the good and/or
service. Consequently, price should increase until the market clears at its equilibrium level.

How to use supply and demand diagrams to understand the impact of changes in equilibrium
market prices
We have considered how changes in the conditions of demand and supply can cause the demand and supply
curves to shift. Shifts in demand and/or supply will affect the equilibrium price, quantity demanded and quantity
supplied. Consider the diagram below where the demand curve has shifted to the right, caused by an increase
in personal disposable incomes.

Price S1

B
PB
A
P*

D2

D1

Q* QB Quantity

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Initial equilibrium is at point A where price is P* and quantity demanded and supplied is at Q*. An increase in
personal disposable incomes causes the demand curve to shift to the right and a new equilibrium is formed
where the market clears at point B. As a result of the demand curve shifting to the right, price rises to PB and
quantity demand and supplied increase to QB. The demand curve has shifted and there has been an expansion
of supply.

Consider the diagram below where the supply curve has shifted to the left, caused by an increase in wage costs.
S2
Price
S1

B
PB

A
P*

D1

QB Q* Quantity

Initial equilibrium is at point A where price is P* and quantity demanded and supplied is at Q*. An increase
in wage costs causes the supply curve to shift to the left and a new equilibrium is formed where the market
clears at point B. As a result of the supply curve shifting to the left, price rises to PB and quantity demand and
supplied decreases to QB. The supply curve has shifted and there has been a contraction of demand.

In some instances, the demand and supply curves may both shift. Consider our first example where the
demand curve shifted to the right, caused by an increase in personal disposable incomes. We could further
develop this model from equilibrium point B. At point B, price has increased from P* to PB, and this increase in
price may attract more firms into the industry as they see a potential profit-making opportunity. Consequently,
the supply curve shifts to the right and a new equilibrium is formed at C. As a result of new firms entering the
industry, the supply curve shifts to the right and there is an expansion of demand.

S1
Price
S1

B
PB
A C
P*

D1 D2

Q* QC Quantity

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Activity 3
Use the information in the table below to construct a demand and supply diagram:

Price (£) Demand (000s per year) Supply (000s per year)

0.20 4 2

0.30 3 4

0.40 2 6

0.50 1 8

Identify the equilibrium price and quantity.

Explain what would happen to the equilibrium price, quantity demanded, and quantity supplied, if there
was an increase in the population.

How to demonstrate revenue on a demand and supply diagram

Revenue is the amount of money a producer earns from selling a good or service. It is calculated by multiplying
the number of units sold by the price per unit.

uu Total Revenue = Selling Price x Quantity Sold

uu TR = P x Q
If you buy 5 DVDs priced at £10 each, the shopkeeper’s revenue from the sale is £50. A firm’s revenue can be
identified as the shaded area on the diagram below where price is £10 and quantity demanded and supplied is
equal to 5.

Price
S1

Total
Revenue

10

D1

5 Quantity

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Shifts of the demand and/or supply curves will shift the market equilibrium price and quantity. Consequently, the
revenue, as identified by the shaded area, will also change. A shift of the supply curve to the right will cause the
price of CDs to fall to £8 each, and the quantity demanded and supplied to increase to 6 units. Total revenue
decreases from £50 to £48 as shown in the diagram below.

S1
Price

S2

10

Total
Revenue
D1

5 6 Quantity

Activity 4
Using the data in the table below, construct a demand curve and use the diagram to illustrate how
total revenue changes if the equilibrium price falls from £0.40 to £0.30.

Price (£) Demand (000s per year)

0.20 4

0.30 3

0.40 2

0.50 1

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Intermarket Relationships

Complements and substitutes

You will recall that a complementary good is a good which is demanded because it is used with another good
and a substitute is a good which can be replaced by another good. When we considered changes in the
conditions of demand, we used the following example; if the price of an IPhone increases, the demand for
Samsung phones will increase. Demand and supply diagrams can be used to model the impact on the market
for IPhone and Samsung phones.

Iphone Samsung Phone

Price S2 Price
S1 S1

P2
P2
P1
P1

D1 D2
D1

Q2 Q1 Quantity Q1 Q2 Quantity

An increase in the costs of production in the IPhone market cause the supply curve to shift to the left. As a
consequence, the equilibrium price rises and the quantity demanded and supplied falls. The supply curve shifts
to the left and there is a contraction of demand. However, as Samsung phones are substitutes for IPhones,
there will be an increase in demand for Samsung phones. As a consequence, the equilibrium price of Samsung
phones rises and quantity demanded and supplied increases. The demand curve shifts to the right and there is
an expansion of supply.

When we considered changes in the conditions of demand, we also used the following example; if the price
of DVD players rises, the demand for DVDs will fall. Demand and supply diagrams can be used to model the
impact on the market for DVD players and DVDs.

DVD Players DVDs

Price S2 Price
S1 S1

P2
P1
P1
P2

D1 D1
D2

Q2 Q1 Quantity Q2 Q1 Quantity

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4 Elasticities
Price Elasticity of Demand
So far, we have assumed that quantity demanded changes as price changes; however, we have not considered
the extent to which quantity demanded changes in response to a change in price. For example, consider the
demand for petrol; drivers do not significantly reduce their petrol consumption as the price of petrol increases. In
this instance, quantity demanded is very insensitive to changes in price. On the other hand, during the summer
months, small reductions in the price of foreign holidays lead to very significant increases in demand. In this
instance, quantity demanded is very sensitive to changes in price. In economics, we describe this sensitivity
as a good’s price elasticity of demand.

Price elasticity of demand (PED) is defined as the responsiveness of quantity demanded

h to a change in price.

The factors that affect price elasticity of demand

uu Substitutability; i.e. if the price of a good rises and it is possible to switch consumption to a cheaper
substitute good, then demand will be sensitive to price changes. Conversely, if there are no substitute
goods available, demand will be insensitive to price changes;

uu Percentage of income; i.e. if the purchase of a good accounts for a very small percentage of an
individual’s income and the price of the good increases, individuals are unlikely to change their purchasing
decisions, consequently demand will be insensitive to price changes. The opposite is true if the purchase
of a good already accounts for a significant proportion of income;

uu Necessities or luxuries; i.e. if a good is considered to be a necessity, individuals will continue to buy it in
spite of price rises, in which case demand will be insensitive to price changes. On the other hand,
individuals will be much more swayed by changes in the price of luxuries which will account for a greater
proportion of an individual’s income;

uu Habit-forming/addictive goods; i.e. some individuals are dependent upon goods such as alcohol and
tobacco, and, as such will be indifferent to price changes. Demand will be insensitive to price changes; and

uu Time; i.e. demand is more sensitive in the long-run as it takes time for individuals to adjust their spending patterns.
Measuring price elasticity of demand
PED is measured by the equation:
Percentage change in quantity demanded / Percentage change in price

Using the equation to measure PED will always result in a negative answer, hence the need for the minus sign before
the equation. The reason for this is that the demand curve slopes downwards from left to right creating an inverse
relationship between price and quantity demanded. Consequently, using the equation always results in dividing a
negative value by a positive value, or, a positive value by a negative value. Either way, the outcome is negative.

N.B. when interpreting elasticity values, you ignore the minus sign.

If the outcome of a PED calculation is greater than 1, demand is said to be price elastic; i.e. demand is
sensitive to price changes;

If the outcome of a PED calculation is less than 1, demand is said to be price inelastic; i.e. demand is
insensitive to price changes; and

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If PED is elastic, a small change in price results in a large change in quantity demanded. As a result, the demand
curve will be relatively flat. This is illustrated in the diagram below where the change in quantity demanded is
greater than the change in price.
Price

P1 Total
Revenue
P2

D1

Q1 Q2 Quantity

If PED is inelastic, a large change in price results in a small change in quantity demanded. As a result, the
demand curve will be relatively steep. This is illustrated in the diagram below where the change in quantity
demanded is less than the change in price.

Price

P2
Total
Revenue

P1

D1

Q1 Q2 Quantity

The implications of price elasticity of demand for producers

If a firm knows that the PED for its good is elastic, it should reduce the price of its good in order to increase
total revenue. As a consequence of a small reduction in price, quantity demanded will rise significantly, thus
increasing total revenue.

As previously discussed, the revenue a firm earns from selling its good is shown by the area under the demand
curve. Therefore, if a firm knows that the PED for its good is inelastic, it should increase the price of its good
in order to increase total revenue. As a consequence of a large increase in price, quantity demanded will fall
marginally, thus increasing total revenue.

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Activity 5
Consider whether the price elasticity of demand for the following goods is elastic or inelastic.
Give reasons for your answers.

Price Elastic/Inelastic? Reason?

Bread

Coal

Baked Beans

Sky TV Subscription

Perform calculations from given data

If a firm reduces the price of its good by 10% and quantity demanded rises by 20%, using the PED formula: -
Percentage change in quantity demanded / Percentage change in price, we get:

+20%/-10% = -2 (ignoring the minus sign) this reads as 2. The PED for this good is therefore said to be elastic
as the value is greater than 1.

If a firm reduces the price of its good by 10% and quantity demanded rises by 5%, using the PED formula:
Percentage change in quantity demanded / Percentage change in price, we get:

+5%/-10% = -0.5 (ignoring the minus sign) this reads as 0.5. The PED for this good is therefore said to be
inelastic as the value is greater less than 1.

Activity 6
Using the information below, calculate the price elasticity of demand if:

uu Price falls by 20% and quantity demanded rises by 10%;

uu Price falls by 5% and quantity demanded rises by 10%.
In both instances, explain whether price elasticity of demand is elastic or inelastic.

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Price elasticity of supply

So far, we have assumed that quantity supplied changes as price changes; however, we have not considered
the extent to which quantity supplied changes in response to a change in price. For example, consider the
supply of goods on supermarket shelves; stocks on supermarket shelves can very quickly be replenished by
bringing goods onto the shop floor from the stockroom. In this instance, as stocks can be refreshed almost
instantaneously, quantity supplied responds very quickly to changes in price; i.e. quantity supplied is very
sensitive to changes in price. On the other hand, at times of heightened demand, such as bank holidays and
Christmas holidays, when even stockrooms and warehouses are emptied, large changes in price do not bring
about significant changes in quantity supplied because the supplies are simply not there. In this instance,
quantity supplied is very insensitive to changes in price. In economics, we describe this sensitivity as a good’s
price elasticity of supply.

Price elasticity of supply (PES) is defined as the responsiveness of quantity supplied to a

h change in price.

The factors that affect price elasticity of supply

uu The availability of stocks; i.e. as considered in the introduction above, supply will be very sensitive to
changes in price if significant stocks are available. If stocks are scarce, supply cannot respond quickly to
changes in price and hence quantity supplied is very insensitive to changes in price;

uu Spare production capacity; i.e. if a firm is operating well below full capacity, it can very quickly respond
to an increase in demand by increasing its supply. In this instance, as supply responds immediately,
quantity supplied will be very sensitive to a change in price. On the other hand, if a firm is operating close
to full capacity, it cannot immediately respond to an increase in demand by increasing its supply. In this
instance, as supply adjusts very slowly, quantity supplied will be very insensitive to a change in price;

uu The ease of switching between alternative methods of production; i.e. if a firm can quickly and
effectively switch between the use of capital and labour in production, it can very quickly respond to an
increase in demand by increasing its supply. In this instance, as supply responds immediately, quantity
supplied will be very sensitive to a change in price. On the other hand, if a firm has no choice but to use a
specific factor of production, and all factors of production are employed, it cannot immediately respond to
an increase in demand by employing a substitute factor of production. In this instance, as supply adjusts
very slowly, quantity supplied will be very insensitive to a change in price;

uu Time; i.e. it takes time for firms to respond to changes in demand. The speed with which a firm can
meet changes in demand with changes in supply depends upon the industry in which the firm is
operating. In agricultural crop markets, it is not possible to miraculously produce crops out of nowhere
as a certain lead time is required for planting and harvesting. In this instance, as supply adjusts very
slowly, quantity supplied will be very insensitive to a change in price. On the other hand, if farmers are
made aware that next year’s demand for crops will be much higher, farmers can plan ahead and meet
the additional demand with additional supply. In this instance, as supply responds immediately, quantity
supplied will be very sensitive to a change in price.

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Measuring price elasticity of supply

PES is measured by the equation:

h Percentage change in quantity supplied / Percentage change in price

If the outcome of a PES calculation is greater than 1, supply is said to be price elastic; i.e. supply is sensitive
to price changes;

If the outcome of a PES calculation is less than 1, supply is said to be price inelastic; i.e. supply is insensitive
to price changes; and

If PES is elastic, a small change in price results in a large change in quantity supplied. As a result, the supply
curve will be relatively flat. This is illustrated in the diagram below where the change in quantity supplied is
greater than the change in price.

Price

S1

P2

P1

D1

Q1 Q2 Quantity

If PES is inelastic, a large change in price results in a small change in quantity supplied. As a result, the supply
curve will be relatively steep. This is illustrated in the diagram below where the change in quantity supplied is less
than the change in price.

Price
S1

P2

P1

Q1 Q2 Quantity

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Perform calculations from given data

If a firm increases the price of its good by 10% and quantity supplied rises by 20%, using the PES formula: -
Percentage change in quantity supplied / Percentage change in price, we get:

+20%/+10% = 2. The PES for this good is therefore said to be elastic as the value is greater than 1.

If a firm reduces the price of its good by 10% and quantity supplied falls by 5%, using the PES formula:

Percentage change in quantity supplied / Percentage change in price, we get:

-5%/-10% = 0.5. The PES for this good is therefore said to be inelastic as the value is greater less than 1.

Activity 7
Using the information below, calculate the price elasticity of supply if:

uu Price rises by 10% and quantity supplied rises by 20%;

uu Price rises by 10% and quantity supplied rises by 5%.
In both instances, explain whether price elasticity of supply is elastic or inelastic.

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Multi-choice questions
1 Which of the following could lead to a reduction in the quantity demanded of a product?

A A fall in price of a substitute product

B A fall in the price of the product

C A fall in the price of a complementary product

D An increase in the cost of production

2 Which of the following would lead to a leftward shift of the supply curve for TVs?

A A fall in the price of raw materials

B A fall in income tax

C The introduction of new technology to make the production

process more efficient.

D An increase in the cost of labour manufacturing the TVs

3 A 6% increase in the price of apples leads to a 3% decrease in the quantity demanded.

What is the price elasticity of demand of apples in this case?

A -2.0

B +2.0

C -0.5

D -5.0

4 The demand for a product is more elastic

A The higher its price is as a proportion of income

B The higher the degree of habit there is when consuming

the product

C The more substitutes exist for the product

D In a short period of time

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5 Which of the following would lead to a leftward shift of the demand curve for a packet of crisps?

A A rise in general income levels

B An increase in the price of potatoes

C More advertising for the crisps

D A fall in the price of a packet of peanuts

Short answer questions

6 Suggest two possible factors that could lead to a rightward shift in the supply curve for replica
Premier League leather footballs:

2
2 Marks

7 Explain how and why a fall in the price of fish will change the demand for chips (from a takeaway).

2 Marks

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Chapter 4 Production, Costs, Revenue and Profit

1 Business Objectives
How a business manages its operations will depend on a number of internal and external factors. One such
factor is its own objectives as a business. Although the obvious reason for a business to exist is to ‘make
money’ there are several potential objectives that can be identified:

uu Profit (maximisation). Many firms exist in order to maximise the return to the business owners. Starting
and running a business is both risky (in terms of losing income) and hard work so many business owners
seek to maximise the profit made as their reward. Profit can be defined as ‘sales revenue minus the cost
of production (or running of the business)’.

uu Sales growth. Some firms may wish to maximise the number of units of their products or services that
they sell. Some business owners and managers will gain personal satisfaction from having as large an
operation as they can (without making a loss). This does not always mean that they are maximising profits
– to achieve sales growth firms may have to reduce the price of their goods and services.

uu Increasing market share. A firm may also take the view that a short-term goal may be to improve the
proportion of the market share that they have. This means that they will need to take customers off their
competition or start to sell a higher proportion of goods than their competitors. The firm may hope that
they gain more customer loyalty and maintain profits over an extended period of time.

uu Social enterprises. Some firms may not wish to make large profits at all but want their business to
provide a social purpose. For example, supermarkets may sell Fair Trade foodstuffs at high prices and
with low profit margins but will be content that they are supporting farmers in poorer communities.

Activity 1
Consider the table below on market share for supermarkets in the UK.

Grocery Market Shares April 2016 Market Share (%)

Tesco 28

Asda 17

Sainsburys 16

Morrisons 11

Co-Op 6

Aldi 6

Waitrose 5

Lidl 4

Iceland 2

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Although they have been established since 1913 in Germany, the first Aldi store in the UK was only opened
in 1990. Now it has over 300 stores nationwide and its market share continues to increase – over-taking
the long-established UK brand Waitrose.

Suggest two possible advantages for Aldi from growing its market share in the UK:

2 Costs and Revenue

Costs:
To determine if a firm is meeting its objectives it will need to calculate the revenue that it brings in from sales and
the costs of production or providing services.

uu Fixed Cost Any cost that does not change with output, e.g. rent
uu Variable Cost Any cost that does change with output, e.g. raw materials
uu Total Cost The total cost of all goods/services produced (fixed costs plus variable costs)
uu Average Cost Total cost of goods and services divided by the number of units produced

Activity 2
The list below shows some costs for a T-shirt manufacturer. Separate the costs into those that you
think are fixed and those that are variable.
Delivery charges, lighting, rolls of fabric, trade magazine advertising, fabric dye, sewing machines

Fixed Costs Variable Costs

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Calculating costs
Look at this table for a small business selling cakes at a market stall:

Fixed costs £2,500

Variable cost per cake £0.50

Current output of cakes 1,000

What is the average cost per cake?

We know that the business is selling 1000 cakes. The total variable cost must be:
Output x variable cost per cake
1,000 x £0.50 = £500

The total cost adds the total fixed and variable costs together. So:
Total Cost = £2,500 + £500 = £3,000

The average cost is the total cost divided by the number of cakes:
£3,000/1000 = £3.00

Activity 3
Look at this table for a small business selling printer cartridges:

Fixed costs £8,000

Variable cost per cartridge £2.50

Current output of cartridges 2,000

What is the average cost per cartridge?

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Revenues:

Total Revenue All revenues generated by sales of goods

Average Revenue Total revenue divided by the number of units sold

Profit Total revenue – total costs

Remember, from your demand and supply analysis, sometimes the only way that a business can increase sales
is by reducing prices. This means that as output and sales increases the business is likely to see a decrease in
average revenue – what they receive in sales receipts will fall per item sold.

Look at this table for a small business manufacturing and selling boxes of gloves to retailers (figures in £):

Total variable Average

Output Total fixed cost Total cost Average cost Total Revenue
cost Revenue
0 70 0 70 - - -

1 70 15 85 85 100 100

2 70 30 100 50 180 90

Total cost = Total Fixed Cost + Total Variable Cost

Average Cost = Total cost/Output

Average Revenue = Total Revenue/Output

Activity 4
Complete the table for a small business manufacturing and selling boxes of gloves to retailers
(figures in £):

Total Total Total Average Total Average

Output
fixed cost variable cost cost cost Revenue Revenue

0 70 0 70 - - -

1 70 15 85 85 100 100

2 70 30 100 50 180 90

3 240

4 280

5 300

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3 Profit
Profit is the difference between our costs and sales revenues. So,

h Profit = Total Sales Revenue – Total Costs

Continuing with our example of the small business above (figures in £)

Total Total Total Average

Output Total cost Average cost Profit
fixed cost variable cost Revenue Revenue

1 70 15 85 85 100 100 15

2 70 30 100 50 180 90 80

Activity 5
Complete the table for a small business manufacturing and selling boxes of lettuces
at local markets (figures in £):
Total fixed Total variable Total Average Total Average
Output Profit
cost cost cost cost Revenue Revenue

0 100 0 - - - -

1 20 180

2 40 320

3 420

4 480

5 500

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The importance of cost, revenue and profit for producers

If profit is the most likely objective for many businesses the ability to calculate and predict a figure is very
important. In order to do this, the businesses must be aware of their costs and potential revenue – including
being aware that average revenue is likely to decrease as sales increase.
Often the easiest costs to alter are the variables ones – although all costs can be altered over a period of time,
including such things as rent on factory space.

Ethical and Moral Considerations

‘Ethics’ is the concept that someone or an organisation should do the ‘right thing’ by society’s standards.
‘Moral considerations’ are referring to actions that contravene an individual’s or a group of people’s principles.
Although profit will often be the most significant objective, businesses may still be under considerable pressure
to ensure that they operate in an ethical or moral way, even if this may mean increasing average costs. Such
issues may include:

uu Ensuring sufficient business taxes are paid to central governments. Some firms are able to reduce
their tax payments by operating under favourable international conditions (e.g. Starbucks only paid £8.4m
in corporation tax to the UK between 1998 and 2012). If a business pays low levels of tax compared
to individuals paying income tax, some people will argue that the company is not fulfilling its moral
obligations.

uu Equality of pay for staff. Businesses are under pressure to ensure that the difference in income between
the lowest paid and highest paid workers is fair.

uu Environmental impact. The impact on the environment either from production processes or from use of
manufactured products needs to be considered.

uu Exploitation of workers living in relative poverty.

Some businesses reduce costs by using relatively
cheap labour from developing nations. The business needs to be seen to pay such workers a fair pay and
ensure that they work in a safe environment.

Failure to consider these ethical and moral objections can lead to bad publicity and a reduction in sales for
the business.

4 Production and Productivity

Production’ refers to the process of manufacturing a product. ‘Productivity’ refers to the level of efficiency
throughout the production process. Productivity is often quoted as ‘output per person’ or ‘output per hour’.
For many businesses, a key method of reducing costs is to improve the level of productivity. For example, if a
firm pays one worker a fixed wage of £200 a week and that worker produces 10 products the fixed cost per
unit is (200/10) £20. However, if the same worker could produce 12 units per week for the same wage then the
fixed cost per unit reduces to (200/12) £16.67. This would be classed as an ‘increase in productivity’.

Let’s say a worker for a business produces 100 units per week. The business purchases a machine for the
same worker and they now produce 200 units per week thanks to the machine. In this instance, the productivity
of the worker has clearly improved (in fact, its doubled!) but the cost of the machine has to be taken into
account. Machinery can be very expensive and whilst it may improve productivity it may take months or years
before the cost of the machine starts to bring improved profits for the business.

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Methods of improving productivity:

Division of labour (see previous chapter)

uuUse of technology and machinery to improve speed and accuracy of output. For example, the
development of digital scanners that read bar codes at supermarket tills means that more customers can
be served in any one hour.

uu Training of workers. A worker will become more effective at their job if trained. For example, a young
person fulfilling an apprenticeship at a building site (requiring them to attend school or college one day a
week) may become more effective.

uu Improving morale at the workplace. Some workers will react positively to their work conditions which
may improve their effectiveness. An obvious way to improve morale is to offer more wages (or an output-
based bonus) although this increases costs. Another method may be to make the workplace cleaner,
safer or generally more pleasant.

uu More effective management. A good manager is one that can ensure that their sub-ordinates are
working as effectively as possible.

Activity 6
Google have several offices around the world to house their employees and have plans
to build a new one in London. A common theme throughout their offices are a series of resources
to help its workers. These include swimming pools and saunas, ‘nap’ rooms for staff
to have short sleep breaks, games rooms and zones that resemble children’s play areas.

Why would Google include these types of resources for their workers when they come at
such a large cost?

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The benefits of increased productivity:

uu It should increase output leading to higher sales

uu It can lower costs leading to higher possible profit levels
uu Lowering costs could be passed on to a reduction in price, making the business more competitive
uu It could improve the quality of the products which, again, improves competitiveness.
uu Higher productivity could lead to higher wages for workers (particularly if they are paid commission
or by output).

Activity 7
A factory making golf balls employs 5 people and produces 1,000 golf balls a week.
The factory purchases a new machine to help the manufacturing process and the number
of golf balls produced increases to 1,500 per week. What is the increase in output per worker?

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5 Economies of scale
One way a firm may be able to reduce unit costs is if it can benefit from economies of scale.

‘Economies of scale’ is any financial advantage that comes from increasing output or production and
h which leads to a fall in average unit costs. Mass production of goods should start to reduce the average
cost of production per unit.

Types of economies of scale:

uu Technical economies – these may arrive through the use of technology. Use of a machine, robot or
computers can increase the speed and accuracy of production. However, the machinery may be expensive
and its cost can only be justified if output increases significantly.

uu Purchasing economies – businesses may be able to buy raw materials or components cheaper if they
purchase them in bulk. The reduction in price may be achieved due to a fall in the average cost of transport
if the raw materials are moved in larger quantities or due to a fall in administration costs.

uu Marketing economies – a firm which is selling on a large scale may be able to afford more effective
advertising. For example, a TV advert will have a much wider reach than a magazine advert. However, the
business can only afford the cost of TV advertising if producing and selling in large enough numbers.

uu Financial economies – businesses making larger loans can often do so at a reduced interest rate
(reducing the cost of repayments). Larger firms may be able to raise more money through other methods
such as selling shares.

uu Managerial economies – larger firms can afford to employ more managers which can lead to an increase
in efficiency of workers.

uu Risk-bearing economies – larger firms are more able to increase the range of different products that
they produce. In this way, the business is more able to cope with a fall in demand for one or more of its
products.

The existence of economies of scale means that businesses are more likely to want to grow and increase their
output. The reduction in average cost should lead to an increase in profits and improve the potential for gaining
market share from competitors.

However, business growth does not come without some costs. Any factor which starts to lead to an increase in
average cost is called a ‘diseconomy of scale’.

Types of diseconomies of scale:

uu Communication problems – with an increase in the number of managers and workers, effective
communication between them can become more difficult. Some staff may not know all the information that
they need or it may take a longer time to inform everyone. This will make the workers less effective and
increase average costs.

uu Co-ordination and control problems – the more staff that are employed the more likely people will
operate in different ways. This may make it more difficult to manage people.

uu Morale – workers in organisations with a large number of people may start to feel as if they are less
important as their view will count for less. This can lead to lower morale and less efficient work practices.

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Activity 8
Identify the types of economies of scale occurring in these case studies:

Type of economy of scale:

Paperworks paper manufacturing company

was set up to offer good employment to people
with registered disabilities and has just opened
a much larger factory with state-of-the-art
machinery. They now hope to supply paper
to newspaper companies as well as stationery
firms.

Gordon Construction have grown so large they

have been floated on the stock market. Now
that they are completing massive building
projects they are able to buy raw materials in
large quantities at a discount.

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Multi-choice questions
1 Which of these is an example of a variable cost in a car maintenance garage?

A Manager’s monthly wage

B Rent for the garage

C Advertising in local newspaper

D Replacement tyres

2 Which of these is a formula that could be used to calculate profit?

A Output x sales price

B Average revenue x sales

C Total revenue – total costs

D Total revenue/output

3 Which of the following is the most likely to lead to an increase in

productivity for a shoe manufacturing firm?

A An increase in effective training

B An increase in demand for shoes

An increase in the price of shoes

C

D An increase in the number of workers employed

4 A business decided to restructure its workforce and create a number of supervisory roles.
This lead to a fall in average prices. This is an example of:

A Technical economies

B Purchasing economies

C Managerial economies

D Financial economies

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5 A car manufacturer opened a new factory to produce small components for their cars instead of importing
those components from abroad. However, this lead to an increase in average costs per car. This is an
example of:

A Lower productivity

B Fall in output

C An ethical impact on production

D Diseconomies of scale

Short answer questions

6 A business makes wire baskets used in supermarkets. Give two ways the business could improve productivity:

2
2 Marks

7 Explain why average revenue tends to decrease as output and sales increase.

2 Marks

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Chapter 5 Competitive and Non-Competitive Markets

1 Competitive Markets
What is a competitive market?
A market is where buyers and sellers meet. A competitive market is a market that has many buyers and sellers.
In order for the market to work efficiently, producers should face no barriers to entry into the market and
consumers should have perfect information.

Activity 1
Have a short discussion with someone in your class about what barriers to entry there might
be in different markets. If you are struggling for markets to discuss, use these: Pharmaceutical
market, car manufacturing, newspaper publishing and the high street bank market.

How many did you and your friend come up with? Were there barriers to entry that were
specific to a particular industry or were there general barriers to entry?

Profit maximisation
In a free market economy, it is assumed that all firms want to maximise their profits. Therefore, in order to be
profitable in a competitive market, firms have to find ways of lowering their costs of production and this in turn
means they can lower their prices.

Remember that in an elastic market where there are many substitutes (which there should be in a competitive
market) a firm would have to lower its price in order to increase revenue. By increasing revenue, they should be
able to boost profits, assuming they can keep costs the same or lower them.

Competition
The most obvious way that firms compete is through price competition. However, there is a limit to how low
prices can go before producers start making a loss and therefore they have to come up with other ways of
enticing the consumer.

Activity 2
Think of all the different ways that producers try to make you part with your money. Can you break them
down into price and non-price competition (i.e. factors not relating to the price of the product/service)?

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Demand and Supply

A competitive market means that there are many buyers and sellers within the market.

As new firms enter a market, supply shifts to the right and this causes a reduction in price due to the increased
competition leading to increased efficiency, which lowers the cost of production. Draw this in the activity
below.

As there are more firms in the market, individual firms demand curves are likely to shift to the left as there are
more substitutes. Draw this in the activity below.

Activity 3
Many firms entering the market: Availability of more substitutes in market

Price Price

Quanitiy Quanitiy

Make sure that you draw the equilibrium price and output levels for both the original market
position and the new one. You should be able to see, price falls in both cases, which is normally
bad for the producers.

The economic impact of competition

How does competition impact the main economic groups?

uu Consumers – those who demand goods and services should benefit from competitive markets, as they
should pay lower prices and have more choice. Also, they may receive improved quality of products
as firms innovate to survive. However, it’s not all good news for consumers as sometimes the good or
service might be of poor quality due to a producer trying to cut costs in order to compete. They might
also be faced with higher prices as firms spend money advertising their goods and services and this is an
additional cost that could increase the price.

uu Producers – those who supply goods and services will have to become more efficient to survive. If
they do not, then they could easily go out of business. As a producer in a competitive market, it should be
impossible to make large profits as firms would be incentivised to enter the market if they could see large profits
were being made and this would compete away profit. A producer would also have to think carefully about
how to spend their profit. Would they use it to advertise in order to boost market share in the short term or
invest into research and development in order to create innovative products in the long run?

uu Government – the government normally encourages competitive markets as it leads to increased well-
being for consumers through lower prices and greater choice. However, as producers receive lower
profits, it means tax revenue will not be as high for the government.

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Activity 4
Rank the order of competitiveness in the following markets:
Railways, Glasses, Fruit and vegetables, Computers, Fast food

1 2 3 4 5

Justify your rankings with a partner and discuss where you have differentiated.

2 Non-competitive Markets
What is a non-competitive market?
A non-competitive market is a market that has few sellers. A market where there is only one seller is called
a monopoly and where there are just a few sellers it is called an oligopoly.

As well as the number of sellers, a non-competitive market will have the following characteristics:

uu Barriers to entry – there may be a number of reasons which prevent other businesses entering the
market. The existing business may benefit from customer loyalty or economies of scale. It may be that the
cost of setting a business in the market is so large many private individuals do not have (or even borrow)
sufficient funds to start.

uu Product - The firms will ensure that their products are slightly different (called differentiated) to set them
aside from their competitors. These differences are more likely to be important than differences in prices.
For example, petrol forecourts in any one town may charge very similar prices for their fuel but may use
opening times, offers or availability of groceries as a means of attracting customers.

uu Prices - Non-competitive firms have a much greater say over the price that they charge. A lack of
competition means that the firms are not having to drive their prices down to attract customers.

uu Profits – most non-competitive firms will attempt to profit maximise. They may be so large that they suffer
from diseconomies of scale.

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Activity 5
Conduct some research into the supermarkets below. Find one example of a branded product (e.g. Heinz
Beans) and find out the difference in price charged by the supermarkets. Find one example of how the
supermarkets offer something different to their competitors.

Tesco Asda Sainsburys

Price of branded product: Price of branded product: Price of branded product:

One way the supermarket One way the supermarket One way the supermarket
differentiates: differentiates: differentiates:

The economic impact of a non-competitive market

How does a lack of competition impact the main economic groups?

uu Consumers – a lack of competition will mean that the price charged to customers is likely to be higher
than a competitive market. Alongside this, there is less of a drive for the businesses to ensure as high
quality as possible or to innovate and improve the functionality of the product. There may also be very
little choice for consumers. As such, consumers often lose out in markets with few competitors.

uu Producers – Businesses in non-competitive markets are able to make large profits. There is less drive for
businesses to be highly efficient. However, those large profits may mean that the business has more
funds to innovate. For example, Apple exist in a market for tablets with few genuine competitors.
However, they use their huge profits to continually improve the quality of their Ipad. Likewise, whilst many
competitors can produce cheaper, possibly better value tablets than Apple, brand loyalty means that the
Ipad remains the most popular tablet on the market.

uu Government – because there is a potential for consumers to lose out in non-competitive markets, the
government are more likely to intervene on their behalf. For example, the UK government has discussed
the possibility of setting an upper price limit on energy suppliers so that consumers are not paying higher
and higher amounts. The government may prevent two firms merging if it will make the market less
competitive. In some cases, the government can even force businesses to break into two separate firms
so that more competition is created. The large profits made by non-competitive firms may bring in large
taxation revenues for government.

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Activity 6
The government has insisted that the arm of BT known as Openreach be legally separated from its
parent company and should operate as an independent business. Openreach provides the cabling to
almost every household and business in the UK allowing them access to data and the internet. They
act as a ‘monopoly’ in the supply of cabling and have been accused of giving preferential treatment to
businesses that use BT for other services (such as their telephone and mobile phone services). Another
concern was that Openreach was not acting quickly enough to ensure that customers had the best
quality of broadband fibre cables installed in their homes or offices.

Identify two issues that have arisen because Openreach operate in a non-competitive market:

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Multi-choice questions
1 Which of the following would be described as a competitive market?

A Bus services

B Mobile phones

C Window cleaning

D Search engines

2 Which of these is a type of non-price competition?

A BOGOF (Buy One Get One Free)

B Promotional pricing on new products

C Flyers through the door

D 3 for 2 deals

3 In a competitive market, what is most likely?

A Elastic demand curve and inelastic supply curve

B Inelastic demand curve and elastic supply curve

C Elastic demand curve and elastic supply curve

D Inelastic demand and inelastic supply curve

4 Which of these is not needed for a competitive market?

A Many buyers

B Perfect information

C Many sellers

D Barriers to entry

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5 How can producers use their profits to be more competitive?

A Reduce prices

B Pay their workers more

C Invest into Research & Development

D Advertise

Short answer questions

6 State one example for each of the two methods of competition::

Pricing

Non-pricing
2 Marks

7 Explain one possible impact of more firms entering a market on a producer already in the market:

2 Marks

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Chapter 6 The Labour Market

1 The role and operation of the labour market
What is the labour market?
The labour market is where the supply of labour offered by households interacts with the demand for labour by
firms. This interaction gives us the price of labour (in other words the wage rate).

The demand for labour is said to be ‘derived’. This means that the demand for labour is dependent on the
demand for the products and services for which the labour is required.

The Labour market is where workers sell their labour and employers buy their labour. The market is made up of
household’s supply of labour and firms demand for labour.

How are wages determined?

In a free market economy wages are determined by the interaction of demand and supply. However, in reality the
government and trade unions will exert influence on the actual wage level.

The labour market offers a meeting place for workers and employers to determine pay and the number of
workers who will be employed. A shortage of workers leads to higher pay; this in turn sends a signal to the
labour market that more workers are needed.

Activity 1
Sam is 17 and works at his father’s fish and chip shop. He is working part-time for eight hours
a week. The money he earns is used to run his second-hand car.
He doesn’t expect to work in his current job for long as he is going to university in September.
Why does Sam choose to work only 8 hours per week?

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2 How are workers paid?

Some workers are paid a salary where their annual pay is divided into 12 equal parts and paid monthly. Other
workers are paid an hourly rate and this is known as their wage. Economists often use the term ’wage’ to cover
both salary and wages.

Activity 2
There are a number of labour markets which depend on location and nature of skills involved.
Can you list three of each type?

Location

Skills involved

There are some factors that may cause the labour market to not operate perfectly. These could include:

Workers lacking the skills required;

uu Workers are unwilling to move to another part of the country or indeed to another country. We often use
the term ‘geographical immobility’ to describe this feature of the labour market.

uu Personal factors such as family ties may be an issue

uu Information failure is a form of market failure where economic agents lack full information. Some people
will be unaware of all of the job opportunities that exist.

Activity 3
Using the internet or local newspapers find a job that you would like to do for work experience.
What are the pay and conditions for this job?

What are the best and worst aspects of the job that you have chosen?

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How can we use demand and supply to determine wages?

Previously, we have used demand and supply diagrams to show how price and quantity is determined in the
market place. We can use a similar process in the labour market.

The factors affecting the demand and supply of labour

Demand factors
uu
The performance of the economy – if the economy is performing well and demand is growing,
businesses are more likely to demand labour to make products or provide services.

uu Changing demand in specific markets – if a particular market is growing, businesses within that market
are likely to demand more labour

uu Wage rates – if wage demands are relatively low, businesses are more likely to demand more labour
uu Productivity of labour – the more efficient an individual is, the more likely to they are to be employed.
However, as workers become more and more efficient, fewer people will be needed to perform a task

uu Profitability of firms – the more profit a firm is making the more likely they are to increase employment.

Supply factors
uuWage rate – the higher the wages offered, the more likely people are to offer their services to employers

uu Other monetary benefits – these could include bonuses or pension contributions from employers.
Offering these means an individual is more likely to seek employment

uu Structure of the population – if the population is aging (i.e. the proportion of older people is growing and
the proportion of younger people is falling) there is a smaller supply of labour.

uu Fringe benefits – these could include company cars, healthcare insurance or extended holidays.
The more fringe benefits offered the more likely people are to seek employment with a particular business.

uu Education and training – the more educated and trained people are the more likely they are to offer their
services.

We can use a modified demand and supply diagram to illustrate the impact of changing conditions to the supply
and demand of labour.

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For example, what happens to the supply and demand for labour if the economy sees growth?

Wages SL

W2

W1

DL2
DL1

Q1 Q2 Quantity of Labour

Note: the different labels for the axes and curves compared to demand and supply diagrams we used before.
Here, the improvement in the economy has resulted in an increase in demand for labour. This causes a rightward
shift in the Labour demand curve.

What if there is a decrease in the cost of nursery or creche facilities?

Wages
SL1

SL2

W1

W2

DL1

Q1 Q2 Quantity of Labour

Here, as childcare facilities have become cheaper, more people are willing to supply their labour.

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How big will the above changes in the labour market be?

At this stage, it is worth recapping your knowledge of Price Elasticities of Demand and Supply. Both of these will
have an impact on the size of any change.

It is the interaction of the two that is important. For example, when demand is low and elastic and the supply is
high and inelastic, the wage will be low e.g. cleaners.

There are cases where supply may be perfectly inelastic, for example a footballer with very rare talents, such as
Premier League footballer will receive very high wages.

Activity 4
Draw a demand and supply of labour diagram to show what might happen to the wages
of a Premier League Footballer after they have got their first call up for their international team.

Wages

Quanitiy of labour

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3 Gross and Net pay

Gross pay is the wage that you receive before any deductions are made. Net Pay is the amount of money that
you have to spend or save after all deductions such as income tax have been made. This is often referred to as
take-home pay.

Activity 5
Complete the tables below to show gross pay

Monthly wage £

Basic wage 22,500

Commission 1500

Gross Pay:

Income tax 4,000

National insurance 1900

Pension contribution 1200

Net pay:

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Multi-choice questions
1 Which of these factors reduce the level of mobility of labour within an economy?

A Highly qualified workforce

B Highly skilled workforce

C Family ties

D Internet job recruitment services

2 Which of the following would make the supply of labour to a particular job more elastic?

A Low levels of skill required for job

B High levels of risk to personal safety when undertaking the job

C High levels of skill required for job

D Job requires unsocial working hours commitment

3 Which of these best describes factors affecting the supply of labour?

A The next best alternative job

B The cost of purchasing a house

The weather
C

D The wage rate

4 Which of these is not considered a factor affecting the demand for labour?

A Increased demand

B Fashion

C Wage rate

D Profitability of firms

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5 Which of these would appear as a deduction from Gross Pay on a pay slip when calculating Net Pay?

A Rent

B Wages

C Income tax

D Profit

Short answer questions

6 State two examples of factors that may cause labour markets to lack perfect mobility:

2
2 Marks

7 Explain what is meant by the term Demand for labour?

2 Marks

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Chapter 7 Market Failure

1 Market Failure
Up until this point, we have been considering how markets determine prices and how demand and supply
impact on output. The use of demand and supply curves to determine prices and quantities can often ensure
that allocation of scarce resources is at its most efficient. However, there are examples of how these ‘market
forces’ can sometimes lead to ‘market failure’.

Examples of market failure

uu Public goods – for some goods the normal demand and supply rules can not apply. There are some
where it is difficult to stop people consuming them for free. For example, if someone puts a street sign up
to indicate location, it would be very difficult to stop someone else reading it without cost. Such goods
are called ‘public goods’ and there is a danger that no-one will supply them as everyone will wait for
someone else to supply the good first.

uu Merit goods – some goods have really positive effects on society which can be under-appreciated.
As such, they may be under-consumed. Education is a good example what is called a ‘merit good’.
Education gives people knowledge and skills that are not only valuable to them but to the rest of society.
However, if you allowed people to make a simple choice about whether they pay and go to school or do
not, many would choose not to go.

uu De-merit goods – likewise, some goods may be consumed that have a negative impact on society as
well as for those who consume it. For example, the negative health implications for someone who
smokes a cigarette are well known but the process of smoking may well pass on harmful diseases to
others who accidentally inhale cigarette fumes. The over-consumption of foods with high fat-content
such as crisps contribute to high levels of obesity in the UK – this in turn places pressure on health care
services. Such goods are called ‘De-merit’ goods.

uu Information failure – for a market to work effectively consumers need perfect information access. This is
difficult to ensure so can lead to consumers making decisions which are not optimal. For example, if a car
manufacturer does not fully inform customers of the full environmental impact of their product before it is
bought, a consumer may make a decision which does not match their objectives.

uu Market structure – the existence of non-competitive markets such as monopolies may lead to higher
prices and poorer quality goods.

What are the costs of market failure?

Market failure can have several costs:

uuCosts to society – market failure may require actions to counteract their impact which have cost
implications. For example, if we consume food and do not dispose of the wrapping appropriately, loose
litter will have to be picked up (at a cost). If our roads do not work effectively because they do not have
signage or traffic management systems then traffic will not run smoothly and businesses can not operate
effectively. If people do not fully consume education or healthcare because they do not value its long-term
benefit then our ability to run an effective and growing economy may be reduced.

uu Impact on quality of life – market failure can ultimately impact on people’s quality of life.For example,
environmental issues such as global warming could eventually lead to falling living standards through a
reduction in availability of resources.

uu Inequality – if market forces are applied without any intervention and price is used as the only mechanism
for rationing there will, by nature, be winners and losers (those who can and those who can’t afford some
goods and services). This will mean that not all people will have the same equality of access to resources.

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Methods of Government Intervention to counter market failure

uu Regulation – the government can introduce rules to control some markets and make them more
competitive or act as if they are competitive. For example, the UK government attempts to prevent some
markets being dominated by just a few firms (e.g. the energy market). In these instances, the government
may cap prices or insist on firms operating in the public interest (rather than just to maximise their own
profits).

uu Indirect taxation – some goods and services that have negative impacts may also receive an extra level
of taxation (other than VAT) on top of their market price. For example, cigarettes and alcohol both have an
additional ‘indirect’ tax on top of their normal market price. This tax will increase the price of the good or
service and should, therefore, reduce the demand for the product.

uu Subsidies – the government can give funds directly to producers to allow them to reduce their prices to
consumers. For example, the government may wish to subsidise farmers to ensure that they maintain
the environment of their farms or subsidise solar panel manufacturers to help reduce the price of their
products.

uu Government provision – if a product or service will not exist or will not be provided in sufficient quantities
the government can provide it themselves. For example, the UK government ensures that there is free
provision of primary and secondary schools for all children in the UK. Also, most traffic management
systems in the UK are provided by local governments.

uu Information – the government may also implement policies to ensure that consumers are better informed.
For example, most food products bought from supermarkets clearly indicate the levels of sugar and salt
content so that consumers can make an informed decision before they purchase.

Activity 1
You may need to do some research to undertake this task. Which of the following products have
0% VAT charged upon them, which have 5% charged upon them and which have the full standard
rate VAT charged upon them:
Alcohol, Bicycle Helmets, Books, Child car seats, Domestic Gas, Sweets,

0% VAT 5% VAT Standard rate VAT

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2 Externalities
‘Externalities’ refers to the impact of economic activity on a ‘third’ party who did not take part in the initial
economic transaction. Externalities are the spill over effects of economic activity.

If you imagine that the buyer and seller are the first two parties in any economic activity, at times their actions
impact on someone else who may be left with either a positive or negative impact. For example, if I buy a car
from a showroom then I have benefitted from having a new car (to get me from A to B) and the showroom have
made revenue (and possibly a profit). However, my car may create noise and other pollution for houses and
other groups who had no say in the transaction between me and the showroom. These other groups are the
‘third party’.

Positive and Negative Externalities

Pollution is the most common example of an ‘externality’ as environmental concerns grow and appear to be
so far reaching. Pollution is seen as a ‘negative externality’. However, some externalities may be positive. For
example, if a new school opens in my neighbourhood and it is deemed to be a very good school, there is a
chance that the value of my house will increase as people want to move to my neighbourhood to allow their
children to attend that school.

So, externalities can be both positive and negative.

Activity 2
Separate the following into positive and negative externalities:
Fumes from a nearby chemical factory, job opportunities in a nearby chemical factory, noise from a late-night
music venue, methane emissions from cattle, creation of an apple orchard near a beekeeping farm, opening of
cycle lanes in cities

Positive externalities Negative externalities

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Some key terminology:

Private cost This is any cost to a private individual from economic activity. For
example, if you purchase a tube of toothpaste for 90p, the private
cost of the purchase is the 90p (plus any transport costs to the
shops). The private cost to the shop who sold you the toothpaste
might be the rent for the shop and wages for staff.

Private benefit This is any benefit gained by private individuals from the economic
activity. So, purchasing the toothpaste will bring the benefit of
more healthy teeth and potentially the reduced cost of possible
dental treatment in the future. The toothpaste seller may well have
made profit from the sale.

Social cost This is the cost of any economic interactions to society. This
includes all private costs plus any negative externality that may
have occurred. So, the social cost of the toothpaste transaction
may be the private costs to you and the retailer plus the cost of
disposing of the toothpaste tube for the local council (and the
environmental damage of the toothpaste when it is sent through
sewage processes).

Social benefit This is the benefit to wider society from any economic interactions.
So, as well as the private benefits it will include any positive
externalities. The social benefits of the toothpaste transaction
include the private benefits described and the reduction of
government costs from having to provide less dental care.

Activity 3
Separate the following into private costs and private benefits. Note: there are two examples of
externalities – do not include these in your lists:
£1.50 bottle of anti-bacterial spray, advertisement at a bus stop,view of a nearby factory, £10 donation to a
charity, £500 earned from selling an antique, Christmas tree planted in local town square

Private costs Private benefits

The two externalities were:

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Activity 4
Move the following phrases relating to the creation of a new solar farm to match the titles
in the two equations below:
labour costs, technology used can be exported, cost of land, cheaper electricity, cost of manufacturing
panels, congestion near farm, fewer harmful gases emitted, visual pollution

Private Costs Negative Externality

Social Cost = +

Private Benefits Positive Externality

Social Benefit = +

3 Consumption and Production Externalities

Externalities can occur either in the production stage of economic activity or in the consumption stage.

Production – many production techniques create externalities that are not ‘paid for’ by the business creating
them. For example, factories may use fossil fuel energies which can create global-warming gases which impact
on regions much further away than where the firm may be based. Some production techniques may also create
harmful by-products (such as chemical waste or toxic fumes) that the producer does not pay to remove (nor
pass on the cost of that removal to their customers) – either through using sewage systems, dumping in rivers or
other sites or by allowing fumes to escape into the atmosphere from chimneys.

As neither the producer nor buyer are paying for these external costs, the burden for clear-up may lie with the
wider society. Some emissions are so harmful they may cause healthcare issues and, again, these are often
paid for through the society’s healthcare system.

Consumption – consumption of a good or service may have a spill over effect on others. For example, litter that
is not carefully disposed of may have to be paid for by wider society. Cigarette fumes (and possibly fumes from
e-cigarettes) could have a harmful effect on third parties who inhale. Over-consumption of fatty-foods is leading
to increasing rates of obesity which may have a knock-on effect as it creates greater pressure on health care
systems at the expense of other medical treatments.

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Activity 5
Separate the following into externalities that may be occur because of production
and those caused by consumption.
discarded high-caffeine drinks cans, noise from traffic at building site, healthcare costs of alcohol
addiction, road congestion causing loss of working hours, increased use of gyms, depletion of rainforest
used for farming animals

Externalities from production Externalities from consumption

Multi-choice questions
1 Which of these may be considered a ‘merit’ good?

A Cigarettes

B Alcohol

C Museum

D Gambling

2 Which of these is the most appropriate government policy for dealing with a market where
two firms have a high market share?

A Regulation

B Use of income tax

C Use of interest rates

D Increase government spending

3 Which of these is a positive externality from immunisation of children from disease?

A Higher profits for pharmaceutical businesses

B Greater incidents of side-effects from immunisation medicines

Software to monitor patient health

C

D Fewer people contracting the disease

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4 A factory opened on the banks of a river 2 years ago. Biologists have recorded a reduced number of fish
living in a river since the factory opened. This could be an example of:

A Positive externalities from production

B Positive externalities from consumption

C Negative externalities from production

D Negative externalities from consumption

5 Which of these is a private cost?

A Healthcare issues caused by being over-exposed to

harmful sun rays

B Increase in rainfall

C Increase in tourism

D Wages paid to workers in tanning salon

Short answer questions

6 A large number of mobile phones have been discarded on landfill sites even though they still function adequately.
Many people discard the phones once they have upgraded to a new phone. The phones can create environmental
problems due to toxic chemicals that reside in their batteries. Give two suggestions for government policies that
could be introduced to reduce this issue:

2
2 Marks

7 Explain why an increase in obesity may lead to externalities.

2 Marks

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