1.

The Basic Economic Problem

In this guide, we'll explain the basic economic problem with clear examples,
explainers, practice questions and exam tips, to ensure you're well-prepared for any
questions on this topic this summer. This is a summary. Make sure to stop by each
individual page in this unit to gain more depth and understanding.
What is the basic economic problem?
The basic economic problem is the problem of scarcity, which means that human
wants and needs are unlimited, but the resources to satisfy those wants and needs
are limited
This creates a situation where people must make choices about how to allocate their
scarce resources, such as time, money, and labour, to satisfy their most urgent
wants and needs

Three questions the basic economic problem forces

every society to answer
In response to the basic economic problem, societies must answer three
fundamental questions:

1. What to produce?
This question refers to the decision about what goods and services to produce given
the limited resources available. Societies must decide which goods and services are
most important to produce to meet the needs and wants of their people

2. How to produce?
This question refers to the decision about how to produce goods and services.
Societies must choose the most efficient and effective methods to produce the goods
and services they have decided to produce

3. For whom to produce?

This question refers to the decision about who should receive the goods and
services produced. In a free market this is decided by who can afford to pay for the

● Answering these questions requires societies to make trade-offs between

different goods and services and to prioritise their production and distribution
based on the needs and wants of their people
● The answers to these questions form the basis of a society's economic
system (free market, mixed or planned) and determine how resources are
allocated
○ They also determine how wealth and income are distributed within that
society

The basic economic problem and opportunity cost

● The basic economic problem of scarcity requires individuals and societies to
make choices about how to allocate their limited resources to satisfy their
unlimited wants and needs
 ● Whenever individuals or firms choose to use their resources to produce or
consume one thing, they are giving up the opportunity to use those resources
for something else
● This is known as a trade-off
○ If a farmer decides to use his limited land and resources to grow wheat,
he must give up the opportunity to use that land and those resources to
grow other crops, such as corn or soybeans. This is the trade-off he
must make in order to produce wheat
● The opportunity cost is the value of the next best alternative that must be
given up in order to choose a particular course of action. In the example of the
farmer, the opportunity cost of growing wheat is the value of the crops he
could have grown if he had used his land and resources differently, such as
corn or soybeans
● Opportunity cost is important because it helps individuals or firms make better
decisions by forcing them to consider the value of their choices in terms of
what they are giving up
● Whenever a choice is made, the benefits of that choice must be weighed up
against the costs of the next best alternative, in terms of both monetary costs
and opportunity costs

Opportunity cost and production possibility curves

● A production possibility curve is a graphical representation of the trade-offs
and opportunity costs faced by an economy that produces only two goods
● The curve shows the maximum possible combination of the two goods that
can be produced with the given resources and technology, assuming that all
resources are used efficiently
● The slope of the production possibility curve represents the opportunity cost of
producing one good in terms of the other
● A movement along the curve demonstrates that producing more of one good
requires sacrificing some of the production of the other good
● The production possibility curve demonstrates the concept of opportunity cost
by showing the trade-offs that must be made when producing two goods
● It shows that producing more of one good requires sacrificing some of the
production of the other good
○ The opportunity cost of producing one good is the value of the next
best alternative that must be given up

Moving along the curve or shifting the entire curve?

● The production possibility curve (PPC) represents the maximum amount of
two goods that can be produced with a given set of resources and technology
 ● A movement of the entire PPC can be caused by changes in factors such as
the availability of resources, improvements in technology, changes in the size
of the labour force, and changes in capital investment
● An increase in the availability of resources, such as more fertile land or a
larger labour force, can shift the entire PPC outward. This means that more of
both goods can be produced with the same level of technology and resources
● The invention of new farming techniques, such as the use of tractors or
genetically modified seeds, can increase agricultural productivity and shift the
PPC outward.
● Capital investment, such as building new factories or improving infrastructure,
can also shift the entire PPC outward by increasing the productive capacity of
an economy.
● Any factor that increases the availability or efficiency of resources, or
increases the productive capacity of an economy, can shift the entire PPC
outward, leading to an increase in the maximum amount of goods that can be
produced
● Conversely, any factor that reduces the availability or efficiency of resources
can shift the entire PPC inward, leading to a decrease in the maximum
amount of goods that can be produced

Basic Economic Problem Practice Questions

Recently a series of earthquakes in one country destroyed farming land, factories
and residential homes. Analyse, using a production possibility curve diagram (PPC),
the effect of the destruction of some of its resources on an economy. (6 marks)

A Nigerian oil monopoly is reallocating resources from producing oil to producing

more environmentally friendly liquid petroleum gas (LPG). Analyse, using a
production possibility curve (PPC) diagram, the effect of reallocating resources from
kerosene to LPG. (6 marks)

Basic Economic Problem Key Terms

● Scarcity
● Economic good
● Free good
● Wants and needs
● Resources
● Land, labour, capital and enterprise
● What to produce?
● How to produce?
● For whom to produce?
● Opportunity cost
● Trade off
 ● Production possibility curve

1.1The nature of the economic

problem
Finite Resources & Unlimited Wants
● The basic economic problem is that resources are scarce
○ In economics, these resources are called the factors of production

● There are finite resources available in relation to the infinite wants and needs
that humans have
○ Needs are essential to human life e.g. shelter, food, clothing
○ Wants are non-essential desires e.g. better housing, a yacht etc.

● Due to the problem of scarcity, choices have to be made by producers,

consumers, workers and governments about the best (most efficient) use of
these resources

● Economics is the study of scarcity and its implications for resource allocation
in society

All Stakeholders in an Economy Face The Basic Economic Problem

Consumers Producers Workers Government

● In a free market, ● Producers ● Workers ● Governme
scarcity has a selling may want a nts have
direct influence products more to decide
on prices made comfortable if they will
● The scarcer a from & safer provide
resource or scarce working certain
product, the resources environmen goods/ser
higher the price will find t but their vices or if
consumers will their costs employers they will
pay of may not allow
production have the private
are higher resources firms to
than if to create it provide
they were them
selling instead
products ● Their
made decision
from more influences
abundant the
resources allocation
of
resources
in society.
E.g. If
they
choose to
provide
national
healthcare
, fewer
Doctors
will be
available
to work in
private
healthcare

Economic & Free Goods

● Economic goods are scarce in relation to the demand for them
○ This makes them valuable
○ Due to their value, producers will attempt to supply them in order to
make a profit
 ○ Anything that has a price tag on it is an economic good e.g. oil, corn,
gold, trainers, watches and bicycles

● Free goods are abundant in supply

○ Due to this abundance, it is not possible to make a profit from
supplying free goods
○ Drinking water has been a free good for thousands of years, but as the
population increases & water sources become more polluted, it has
become an economic good
○ E.g. sunlight, the air we breathe, sea water

1.2 The factors of production

● Factors of production are the resources used to produce goods & services
○ Land, labour, capital & enterprise

● The production of any good/service requires the use of a combination of all

four factors of production
○ Goods are physical objects that can be touched (tangible) e.g. mobile
phone
○ Services are actions or activities that one person performs for another
(intangible) e.g manicure, car wash

The Four Factors of Production

Land Labour Capital Enterprise

 Non man-made The human Capital is any Enterprise involves
natural input into the man-made resource taking risks in setting
resources are production that is used to up or running a firm.
available for process. produce An entrepreneur
production. Labour goods/services e.g. decides on the
Some countries involves tools, buildings, combination of the
have a vast mental or machines & factors of production
amount of a physical effort. computers necessary to produce
particular natural Not all labour goods/services with
resource & so is of the same the aim of generating
are able to quality. It can profit
specialise in its be skilled or
production e.g. unskilled.
oil, wood, fish, Some workers
corn, iron ore are more
productive
than others
because of the
education,
training &
experience
they have

Some of the Factors of Production Required to Produce a Motor Car

Land Labour Capital Enterprise

 iron ore robotic arms
rubber car designer conveyor belt CEO
oil rolled steel
production director
sand computers
cows production line seats
staff dashboards
mirrors
supply chain staff leather

Rewards for the Factors of Production

● In a market economic system, the factors of production are privately owned by
households or firms (The terms 'market' & 'free market' are used
interchangeably)
○ They make these resources available to firms who use them to
produce goods/services
○ Firms purchase land, labour, & capital from households in factor
markets

● Households receive the following financial rewards for selling their factors of
production. This reward is called factor income
○ The factor income for land → rent
○ The factor income for labour → wages
○ The factor income for capital → interest
○ The factor income for entrepreneurship → profit

1.2.1 Changes to the Factors of

Production
The Mobility of the Factors of Production
● The mobility of the factors of production refers to how easily firms can switch
between different factors of production during the production process
○ The more mobile the factors, the more flexibility there will be in
production
 ○ E.g. if a firm can produce both cars & trucks on its production line &
switching from one to the other only requires a few simple changes to
some robotic arm extensions, then its capital is very mobile
○ This means that the firm can be very responsive to changes in demand
for cars & trucks & is likely to make more profit

● Labour is often one of the most expensive costs of production

○ If firms can substitute capital (machinery) for labour, productivity often
increases & costs decrease

● Many firms rely heavily on labour & ensuring labour mobility helps to lower
unemployment & reduce worker shortages in an economy

Two Factors That Cause Labour To Be Less Mobile

Geographical Immobility of Labour Occupational Immobility of Labour

● This occurs when workers find ● This refers to the ability of a

it difficult to move from one worker to change occupations
geographical area to another in when they lose a job
order to secure employment ● If their skill base is transferable
● Barriers to mobility may between different occupations,
include family ties, lack of then their occupational mobility
information about possible jobs is high
in different parts of the country, ● In reality, many workers are not
& the challenges in able to easily transfer between
securing/affording occupations & this is a
accommodation in an unknown particular issue when an
location economy is faced with
structural unemployment

Changes in the Quantity & Quality of the Various Factors

● If the quantity or quality of a country's factors of production change, then the
productive potential of the country also changes
 ○ If the quantity or quality increases, this corresponds to an outward shift
of the potential output of an economy as shown on a production
possibilities curve model (see Subtopic 1.4.1). The country is able to
produce more
○ If the quantity or quality decreases, this corresponds to an inward shift
of the potential output of an economy as shown on a production
possibilities curve model. The country now cannot produce as much as
it used to

Influences On The Quality Or Quantity Of Factors Of Production Available To An

Economy

Influence Explanation

Technological advances These can often improve the quality of the factors
of production

e.g. development of metal alloys

Changes in the costs of Changes in the costs of factors of production (for

production example, higher energy costs caused by the war
in the Ukraine) reduce the output of a nation as
the input prices are now more expensive

Changes in relative Process innovation often results in productivity

productivity improvement e.g. moving from labour intensive car
production to automated car production
 Changes in education Over time this increases the quality of labour in an
and skills economy

Changes in government These can improve the quantity of the factors of

regulations production. e.g. deregulation of fracking
(extracting oil from shale deposits) in the USA
increased useable oil reserves

Demographic changes A positive net birth rate or positive net migration

and migration rate will increase the quantity of labour available

Competition policy Preventing monopoly power results in more firms

supplying goods/services in an economy and this
increases the potential output of an economy

1.3 Opportunity cost

Definition of Opportunity Cost
● Opportunity cost is the loss of the next best alternative when making a
decision

● Due to the problem of scarcity, choices have to be made about how to best
allocate limited resources amongst competing wants and needs

● There is an opportunity cost in the allocation of resources

 ○ When a consumer chooses to purchase a new phone, they may be
unable to purchase new jeans. The jeans represent the loss of the next
best alternative (the opportunity cost)
○ When a producer decides to allocate all of their resources to producing
electric vehicles, they may be unable to produce petrol vehicles. The
petrol vehicles represent the loss of the next best alternative (the
opportunity cost)
○ When a government decides to provide free school meals to all primary
students in the country, they may be unable to fund some rural libraries
which may have to close. The libraries represent the loss of the next
best alternative (the opportunity cost)

The Influence of Opportunity Cost on Decision Making

● An understanding of opportunity cost may change many decisions made by
consumers, workers, firms & governments
● Factoring the opportunity cost into a decision often results in different
outcomes & so a different allocation of resources

Examples of How The Consideration of Opportunity Costs Can Change Decisions

Stakeholder Example

Consumer ● Ashika is wanting to visit her best friend in

Iceland
● She looks at flight prices from London to
Reykjavík
● On Friday night it costs £120 whereas
Thursday night is only £50
● She is about to book the Thursday flight but
then realises that the opportunity cost of saving
£60 on a flight is the inability to work on Friday
(loss of £130 income)
● Ashika books the more expensive flight. If she
had booked the cheaper flight, it would have
cost her the income from the missed day of
work (£130) + £50 for the ticket
Worker ● Ric has been offered two jobs & is deciding
which one to accept
● Job A offers £400 a month more in salary than
Job B, but Job B offers the flexibility of working
from home
● Most people would only consider the actual
cost of commuting before they make a
decision, which in Ric's case is £40 a week or
£160 a month
● Ric values his free time & decides that each
hour he can save in commuting is worth £20 to
him (£180 a week) - he is considering the
opportunity cost of commuting
● Ric decides to take Job B as the cost of
monthly travel (4 x £40) and value of the lost
hours spent commuting (4 x £180) adds up to
£880 a month

Firm ● A firm selling organic avocados is offered a

supply contract by a large supermarket who
wants to buy all of their stock each month, but
at a low price
● The supermarket is a prestigious customer
● The firm decides to not accept the contract as
the opportunity cost (loss of prestigious
customer) is worth less than the lost revenue to
existing customers
 Government ● The Australian Government has entered into a
contract with France to supply them with 8
submarines valued at $70bn
● The USA hears about it & pressurises Australia
to buy the submarines from them instead
● The Australian Government considers the
opportunity cost of denying the USA which
includes less preferential deals on other
military hardware & general trade agreements
● They decide to break the contract with France
& view this as the approach that carries the
lowest opportunity cost

1.4 PPC & Economic Growth

Production Possibility Curves (PPC)
● The Production Possibility Curve (PPC) is an economic model that considers
the maximum possible production (output) that a country can generate if it
uses all of its factors of production to produce only two goods/services

● Any two goods/services can be used to demonstrate this model

● Many PPC diagrams show capital goods & consumer goods on the axes
○ Capital goods are assets that help a firm or nation to produce output
(manufacturing). For example, a robotic arm in a car manufacturing
company is a capital good
○ Consumer goods are end products & have no future productive use.
For example, a watch
A PPC for an economy demonstrating the use of its resources to produce capital or
consumer goods

Diagram Explanation

● The use of PPC to depict the maximum productive potential of an economy

○ The curve demonstrates the possible combinations of the maximum
output this economy can produce using all of its resources (factors of
production)
○ At A, its resources are used to produce only consumer goods (300)
○ At B, its resources are used to produce only capital goods (200)
○ Points C & D both represent full (efficient) use of an economy's
resources as these points fall on the curve. At C, 150 capital goods and
120 consumer goods are produced

● The use of PPC to depict opportunity cost

○ To produce one more unit of capital goods, this economy must give up
production of some units of consumer goods (limited resources)
○ If this economy moves from point C (120, 150) to D (225, 100), the
opportunity cost of producing an additional 105 units of consumer
goods is 50 capital goods
○ A movement in the PPC occurs when there is any change in the
allocation of existing resources within an economy such as the
movement from point C to D

● The use of PPC to depict efficiency, inefficiency, attainable and unattainable

production
○ Producing at any point on the curve represents productive efficiency
○ Any point inside the curve represents inefficiency (point E)
 ○ Using the current level of resources available, attainable production is
any point on or inside the curve and any point outside the curve is
unattainable (point F)

Shifts in a PPC
● As opposed to a movement along the PPC described above, the entire PPC
of an economy can shift inwards or outwards

Outward shifts of a PPC show economic growth & inward shifts show economic
decline

Diagram Explanation

● Economic growth occurs when there is an increase in the productive potential

of an economy
○ This is demonstrated by an outward shift of the entire curve. More
consumer goods and more capital goods can now be produced using
all of the available resources
○ This shift is caused by an increase in the quality or quantity of the
available factors of production
■ One example of how the quality of a factor of production can be
improved is through the impact of training and education on
labour. An educated workforce is a more productive workforce
and the production possibilities increase
■ One example of how the quantity of a factor of production can
be increased is through a change in migration policies. If an
 economy allows more foreign workers to work productively in
the economy, then the production possibilities increase

● Economic decline occurs when there is any impact on an economy that

reduces the quantity or quality of the available factors of production
○ One example of how this may happen is to consider how the Japanese
tsunami of 2011 devastated the production possibilities of Japan for
many years. It shifted their PPC inwards and resulted in economic
decline.

2. The allocation of resources

2.5 Differences Between Micro
& Macro
Microeconomics & Macroeconomics
Some Of The Differences Between Micro- & Macroeconomics

Microeconomics Macroeconomics

Single market e.g. milk Entire economy e.g. Singapore

Price of a good/service Average price levels in an economy

(inflation/deflation)
 Individual/market demand Total demand in an economy

Individual firm/market supply Total supply in an economy

Government intervention in a market Government intervention in the

e.g. cigarettes economy e.g income tax

Reasons for differences in workers Unemployment & minimum wages

wages

● Microeconomics is the study of individual markets & sections of the economy,

rather than the economy as a whole
○ It examines the different choices individuals, households & firms
○ It examines what factors influence their choices
○ It examines how their decisions affect the price, demand & supply of
goods/services in a market
○ It examines how Governments influence consumption & production

● Macroeconomics is the study of economic behaviour & decision making in the

entire economy, rather than just an individual market

○ It examines the role of the government in achieving economic growth &

human development through the implementation of specific
government policies (fiscal, monetary & supply-side)
○ It examines the role of the government in achieving price stability, low
unemployment & a stable Current Account balance on the Balance of
Payments account
 ○ It examines the interaction of the economy with the rest of the world
through international trade

Decision Makers in Micro & Macro

Decision Makers & Their Choices In Microeconomics

Decision Maker Choices They Make

Consumers ● Which combination of goods/services do they value

the most
● How to respond to changes in markets they
consume in
● How much money to save, spend or borrow

Firms ● Which combination of goods/service to supply

● How to best produce goods/services in order to
meet their objective (usually profit maximisation)
● How to respond to changing market conditions

Government ● Which policies will be most effective in addressing

specific market failures
● Which industries/markets are essential & require
government support

Decision Makers & Their Choices In Macroeconomics

Decision Maker Choices They Make

 Consumers ● How to best respond to changing macroeconomic
conditions such as recessions or interest rate rises

Firms ● How to best respond to changing macroeconomic

conditions such as recessions, interest rate rises or
a low supply of labour
● Whether to sell their goods/services locally,
nationally or internationally

Government ● Determining the best combination of policies that

will help them to meet all of their macroeconomic
aims

Multi national ● Which countries to invest in

corporations ● How to best develop international advantages
(MNCs) ● How to engage with the government & local
workforce in a way that maximises profit without
harming the brand image

2.6 The role of markets in

allocating resources
Different Economic Systems
● In order to solve the basic economic problem of scarcity, economic systems
emerge or are created by different economic agents within the economy

○ These agents include consumers, producers, the government, &

special interest groups (e.g. environmental pressure groups or trade
unions)
○ Any economic system aims to allocate the scarce factors of production
 ● The three main economic systems are a (free) market system, mixed
economy, & planned economy

What Determines The Economic System Of A Country

How the three questions are answered determines the economic system of a country

● Economic decisions need to be made to answer three important questions

1. What to produce? As resources are limited in supply, decisions carry an
opportunity cost. Which goods/services should be produced e.g. better rail
services or more public hospitals?

2. How to produce it? Would it be better for the economy to have

labour-intensive production so that more people are employed, or should
goods/services be produced using machinery?

3. For whom are the goods and services to be produced? Should goods/services
only be made available to those who can afford them, or should they be freely
available to all?

How These Questions Are Answered Determines the Economic System

Type of System What to Produce? How to Produce? For Whom?

Market System Demand & supply Most efficient, Those who can
(the price profitable way afford it
mechanism) possible.

Mixed System Demand, supply & Some efficiency Those who can
the Government but also a focus on afford it, plus some
welfare/well-being provision to those
who cannot afford
it

Planned System The Government Ensure everyone Everyone

has a job

How a Market System Works

● A market system works to allocate scarce resources efficiently, purely through
the forces of demand & supply (the price mechanism)
○ There is no government intervention in a pure market system (no taxes
or government spending)
○ In reality, there is no economy which is a pure market system

● In a market system, prices for goods/services are determined by the

interaction of demand & supply
○ A market is any place that brings buyers & sellers together
○ Markets can be physical (e.g. McDonald's) or virtual (e.g. eBay)

● The price mechanism is the interaction of demand and supply in a free market
○ This interaction determines prices which are the means by which
scarce resources are allocated between competing wants/needs

● The price mechanism fulfils several functions in an economy

○ Prices allocate (ration) scarce resources. When resources become
scarcer the price will rise further. Only those who can afford to pay for
them will receive them. If there is a surplus then prices fall & more
consumers can afford them
○ Prices provide information to producers & consumers where resources
are required (in markets where prices increase) & where they are not
(in markets where prices fall)
○ When prices for a good/service rise, it incentivises producers to
reallocate resources from a less profitable market to this market in
 order to maximise their profits. Falling prices incentivise reallocation of
resources to new markets

Market Equilibrium & Disequilibrium

● Equilibrium in a market occurs when demand = supply

● At this point the price is called the market clearing price

○ This is the price at which sellers are clearing their stock at an
acceptable rate

A graph showing a market in equilibrium with a market clearing price at P and

quantity at Q

● Any price above or below P creates disequilibrium in this market

○ Disequilibrium occurs whenever there is excess demand or supply in a
market.

2.7 Demand, Price & Quantity

Introduction to Demand
● Demand is the amount of a good/service that a consumer is willing & able to
purchase at a given price in a given time period
○ If a consumer is willing to purchase a good, but cannot afford to, it is
not effective demand

● A demand curve is a graphical representation of the price & quantity

demanded (QD) by consumers
 ○ If data were plotted, it would be an actual curve. Economists, however,
use straight lines so as to make analysis easier

Individual & Market Demand

● Market demand is the combination of all the individual demand for a
good/service
○ It is calculated by adding up the individual demand at each price level

The Monthly Market Demand For Newspapers In A Small Village

Market
Customer 1 Customer 2 Customer 3 Customer 4
Demand

15 4 4 53

30

● Individual & market demand can also be represented graphically

Market demand for children's swimwear in July is the combination of boys & girls
demand
Diagram Analysis

● A shop sells both boys & girls swimwear

● In July, at a price of $10, the demand for boys swimwear is 500 units & girls is
400 units
● At a price of $10, the shops market demand during July is 900 units

Movements Along a Demand Curve

● If price is the only factor that changes (ceteris paribus), there will be a change
in the quantity demanded (QD)
○ This change is shown by a movement along the demand curve

A demand curve showing a contraction in quantity demanded (QD) as prices

increase & an extension in quantity demanded (QD) as prices decrease

Diagram Analysis

● An increase in price from £10 to £15 leads to a movement up the demand

curve from point A to B
○ Due to the increase in price, the QD has fallen from 10 to 7 units
○ This movement is called a contraction in QD
● A decrease in price from £10 to £5 leads to a movement down the demand
curve from point A to point C
○ Due to the decrease in price, the QD has increased from 10 to 15 units
○ This movement is called an extension in QD

● The law of demand captures this fundamental relationship between price and
QD
○ It states that there is an inverse relationship between price and QD
 ■ When the price rises the QD falls
■ When prices fall the QD rises

Conditions of Demand
Shifts of the Demand Curve
● There are numerous factors that will change the demand for a good/service,
irrespective of the price level. Collectively these factors are called the
conditions of demand

● Changes to each of the conditions of demand, shifts the entire demand curve
(as opposed to a movement along the demand curve)

A graph that shows how changes to any of the conditions of demand shifts the entire
demand curve left or right, irrespective of the price level

● For example, if a firm increases their Instagram advertising, there will be an

increase in demand as more consumers become aware of the product
○ This is a shift in demand from D to D1. The price remains unchanged at
£7 but the demand has increased from 15 to 25 units

An Explanation of How Each of the Conditions of Demand Shifts the Entire Demand
Curve at Every Price Level
 Explanation
Condition Conditi Shift Conditi Shift
on on

Changes ● Real Income determines Income D Income D

in Real how many Increas Increa Decrea Decre
Income goods/services can be es ses ses ases
enjoyed by consumers Shifts Shifts
● There is a direct Right Left
relationship between (D→D (D→D
income & demand for 1) 2)
goods/services

Changes ● If goods/services Good D Good D

in become more become Increa become Decre
taste/fashi fashionable then s more ses s less ases
on demand for them fashion Shifts fashion Shifts
increases able Right able Left
● There is a direct (D→D (D→D
relationship between 1) 2)
changes in taste/fashion
& demand

Advertising ● If more money is spent Adverti D Adverti D

/ on advertising or sing Increa sing Decre
branding branding, then demand Increas ses Decrea ases
for goods/services will es Shifts ses Shifts
increase as more Right Left
consumers are aware of (D→D (D→D
the product 1) 2)
● There is a direct
relationship between
branding/advertising &
demand
Changes ● Changes in the price of Price of D for Price of D for
in the substitute goods will Good A Good Good A Good
prices of influence the demand for Increas B Decrea B
substitute a product/service es Increa ses Decre
goods ● There is a direct ses ases
relationship between the Shifts Shifts
price of good A & Right Left
demand for good B (D→D (D→D
● For example, the price of 1) 2)
a Sony 60" TV increases
so the demand for LG
60" TV increases

Changes ● Changes in the price of Price of D for Price of D for

in the complementary goods Good A Good Good A Good
prices of will influence the Increas B Decrea B
compleme demand for a es Decre ses Increa
ntary product/service ases ses
goods ● There is an inverse Shifts Shifts
relationship between the Left Right
price of good A & (D→D (D→D
demand for good B 2) 1)
● For example, the price of
printer ink increases so
the demand for ink
printers decreases

Changes ● If the population size of a Populat D Populat D

in country changes over ion Increa ion Decre
population time, then the demand Increas ses Decrea ases
size/distrib for goods/services will es Shifts ses Shifts
ution also change Right Left
● There is a direct (D→D (D→D
relationship between the 1) 2)
changes in population
size & demand
● Demand will also change
if there is a change to
the age distribution in a
country as different ages
demand different
goods/services e.g an
 ageing population will
buy more hearing aids

2.8 Supply, Price & Quantity

Introduction to Supply
● Supply is the amount of a good/service that a producer is willing & able to
supply at a given price in a given time period

● A supply curve is a graphical representation of the price and quantity supplied

by producers
○ If data were plotted, it would be an actual curve. Economists, however,
use straight lines so as to make analysis easier

● The supply curve is sloping upward as there is a positive relationship between

the price and quantity supplied
○ Rational profit maximising producers would want to supply more as
prices increase in order to maximise their profits

Individual & Market Supply

● Market supply is the combination of all the individual supply for a good/service
○ It is calculated by adding up the individual supply at each price level

The Monthly Market Supply Of Bread From 4 Bakeries In A Small Town

Bakery 1 Bakery 2 Bakery 3 Bakery 4 Market Supply

600 180 320 1400 loaves

300
 ● Individual & market supply can also be represented graphically

Market supply for smart phones in December is predominantly the combination of

iPhone & Samsung supply

Diagram Analysis

● In New York City, the market supply for smart phones in December is
predominantly the combination of iPhone & Samsung supply
● At a price of $1000, the supply of iPhones is 300 units & the supply of
Samsung phones is 320 units
● At a price of $1,000, the market supply of smart phones in New York City
during December is 620 units

Movements Along a Supply Curve

● If price is the only factor that changes (ceteris paribus), there will be a change
in the quantity supplied (QS)
○ This change is shown by a movement along the supply curve
A supply curve showing an extension in quantity supplied (QS) as prices increase &
a contraction in quantity supplied (QS) as prices decrease

Diagram Analysis

● An increase in price from £7 to £9 leads to a movement up the supply curve

from point A to B
○ Due to the increase in price, the quantity supplied has increased from
10 to 14 units
○ This movement is called an extension in QS

● A decrease in price from £7 to £4 leads to a movement down the supply curve

from point A to C
○ Due to the decrease in price, the quantity supplied has decreased from
10 to 7 units
○ This movement is called a contraction in QS.

Conditions of Supply
Shifts of the Supply Curve
● There are several factors that will change the supply of a good/service,
irrespective of the price level. Collectively these factors are called the
conditions of supply

● Changes to any of the conditions of supply shifts the entire supply curve (as
opposed to a movement along the supply curve)
A graph that shows how changes to any of the conditions of supply shifts the entire
supply curve left or right, irrespective of the price level

● For example, if a firm's cost of production increases due to the increase in

price of a key resource, then there will be a decrease in supply as the firm can
now only afford to produce fewer products
○ This is a shift in supply from S to S1. The price remains unchanged at
£7 but the supply has decreased from 10 to 2 units

An Explanation of How Each of the Conditions of Supply Shifts the Entire Supply
Curve at Every Price Level

Conditio Conditio Conditio

Explanation Shift
n n n Shift

COP S
Costs of If the price of raw materials Increase decreas COP S
or other s es, increase
Producti Decreas s,
shifting
on costs of production change, es shifting
left
firms respond by changing right
(COP) (S→S1)
supply
(S→S2)
 Taxes
Indirect Any changes to indirect Increase S Taxes S
Taxes taxes change the cost of decreas Decreas increase
production for a firm & es, e s,
impact supply shifting shifting
left right

(S→S1) (S→S2)

Subsidy
Subsidie Changes to producer Increase S Subsidy S
s subsidies directly impact s increase Decreas decreas
the cost of production for s, es es,
the firm shifting shifting
right left

(S→S2) (S→S1)

Technolo Technolo
New New technology increases gy S gy S
Technolo productivity and lowers Increase increase Decreas decreas
gy costs of production. Ageing s s, es es,
technology can have the shifting shifting
opposite effect right left

(S→S2) (S→S1))

No. of No. of
Change The entry and exit of firms Firms S Firms S
in the into the market has a direct Increase increase Decreas decreas
number impact on the supply. If ten s s, es es,
of firms new firms start selling shifting shifting
in the building materials in Hanoi, right left
industry the supply of building
material will increase (S→S2) (S→S1)
 Drought Good
Weather Droughts or flooding can S Weather S
Events cause a supply shock in decreas increase
agricultural markets. A es, s,
drought will cause supply to shifting shifting
decrease. Unexpectedly left right
good growing conditions
can cause supply to (S→S1) (S→S2)
increase.

2.9 Price determination

Market Equilibrium
● In a market system, prices for goods/services are determined by the
interaction of demand & supply
○ A market is any place that brings buyers & sellers together
○ Markets can be physical (e.g. McDonald's) or virtual (e.g. eBay)

● Buyers and sellers meet to trade at an agreed price

○ Buyers agree the price by purchasing the good/service
○ If they do not agree on the price then they do not purchase the
good/service and are exercising their consumer sovereignty

● Based on this interaction with buyers, sellers will gradually adjust their prices
until there is an equilibrium price and quantity that works for both parties
○ At the equilibrium price, sellers will be satisfied with the rate/quantity of
sales
○ At the equilibrium price, buyers are satisfied that the product provides
benefits worth paying for

Equilibrium

● Equilibrium in a market occurs when demand = supply

● At this point the price is called the market clearing price

○ This is the price at which sellers are clearing (selling) their stock at an
acceptable rate
A graph showing a market in equilibrium with a market clearing price at P & quantity
at Q

● Any price above or below P creates disequilibrium in this market

○ Disequilibrium occurs whenever there is excess demand or excess
supply in a market

Market Disequilibrium
Disequilibrium - Excess Demand
● Excess demand occurs when the demand is greater than the supply
○ It can occur when prices are too low or when demand is so high that
supply cannot keep up with it
 A graph that depicts the condition of excess demand in the market for electric
scooters

Diagram Analysis
● At a price of P1, the quantity demanded of electric scooters (Qd) is greater
than the quantity supplied (Qs)
● There is a shortage in the market equivalent to QsQd

Market response
● This market is in disequilibrium
○ Sellers are frustrated that products are selling so quickly at a price that
is obviously too low
○ Some buyers are frustrated as they will not be able to purchase the
product
● Sellers realise they can increase prices & generate more revenue and profits
● Sellers gradually raise prices
○ This causes a contraction in QD as some buyers no longer desire the
good/service at a higher price
○ This causes an extension in QS as other sellers are more incentivised
to supply at higher prices
● In time, the market will have cleared the excess demand & arrive at a position
of equilibrium (PeQe)
○ Different markets take different lengths of time to resolve
disequilibrium. For example, retail clothing can do so in a few days.
Whereas the housing market may take several months, or even years
 Disequilibrium - Excess Supply
● Excess supply occurs when the supply is greater than the demand
○ It can occur when prices are too high or when demand falls
unexpectedly
● During the later stages of the pandemic the market for face masks was in
disequilibrium

A graph that depicts the condition of excess supply in the market for Covid-19 face
masks during the later stages of the pandemic

Diagram Analysis
● At a price of P1, the quantity supplied of face masks (Qs) is greater than the
quantity demanded (Qd)
● There is a surplus in the market equivalent to QdQs

Market Response
● This market is in disequilibrium
○ Sellers are frustrated that the masks are not selling and that the price is
obviously too high
○ Some buyers are frustrated as they want to purchase the masks but
are not willing to pay the high price
● Sellers will gradually lower prices in order to generate more revenue

○ This causes a contraction in QS as some sellers no longer desire to

supply masks
 ○ This causes an extension in QD as buyers are more willing to purchase
masks at lower prices
● In time, the market will have cleared the excess supply & arrive at a position
of equilibrium (PeQe)

Exam Tip
Memorise the rule that shortages arise when the price is below equilibrium whereas
surpluses arise when the price is above the equilibrium.
Equilibrium in Demand & Supply Schedules
● A demand & supply schedule shows the quantity demanded & the quantity
supplied of a product at different price levels
● Demand & supply schedules can be used to identify equilibrium &
disequilibrium

Demand & Supply Schedule Per Week For YEEZY Boost 700 Wave Runner Trainers

Quantity Demanded Quantity Supplied Excess

Price ($)
(QD) (QS) Demand/Supply

300 1200 500 Excess demand =

700

400 1000 650 Excess demand =

350

500 800 800 Equilibrium

600 600 950 Excess supply =

350

700 400 1100 Excess supply =

700
● At a price of $500, the market is in equilibrium
○ The QD = QS (800 units)

● At a price of $300 & $400, there is excess demand as the product is more
affordable for consumers
○ Producers supply less at lower prices as they make less profit per unit
○ Producers are incentivised to supply more when prices are higher
 ● At a price of $600 & $700, there is excess supply as the high price has
eliminated some buyers from the market
○ Producers would love to sell at this high price but in order to clear their
stock they have to lower the price & move towards the equilibrium.

2.10 Price changes

Causes & Consequences of Price Changes
● Real world markets are constantly changing & are referred to as dynamic
markets

● Market equilibrium can change every few minutes in some markets (e.g.
stocks and shares), or every few weeks or months in others (e.g clothing)

● Any change to a condition of demand or supply will temporarily create

disequilibrium & market forces will then seek to clear the excess demand or
supply

Real World Example: Changes to Demand That Increase Price

● During lock downs associated with the Covid-19 pandemic, furniture retailers
experienced unexpectedly high demand for their products (especially desks
and sofas)

Diagram showing an increase in demand for desks due to a temporary change in

tastes/fashions

Diagram Analysis
 ● Due to the Covid mandated change of working from home, consumers
experienced a temporary change in taste as they sought to set up comfortable
home offices
○ This led to an increase in demand for desks from D1→D2

● At the original market clearing price of P1, a condition of excess demand now
exists
○ The demand for desks is greater than the supply

● In response, suppliers raise prices

○ This causes a contraction of demand and an extension of supply
leading to a new market equilibrium at P2Q2
○ Both the equilibrium price (P2) and the equilibrium quantity (Q2) are
higher than before
○ The excess demand in the market has been cleared

Exam Tip
Be systematic in thinking through the order of changes in market conditions. E.g. An
increase in demand (shift in demand) will cause a rise in price. The higher price will
cause an extension of supply (not a shift of supply)

Real World Example: Changes to Supply That Increase Price

● In September 2022, Hurricane Fiona destroyed much of Puerto Rico's crop of
plantains (a necessity in the diet of local people)

Diagram showing a decrease in supply of plantains in Puerto Rico due to a supply

shock caused by Hurricane Fiona
Diagram Analysis
● Due to Hurricane Fiona, Puerto Rico is experiencing a supply shock in its
plantain market
○ This causes a decrease in supply of S1→S2

● At the original market clearing price of P1, a condition of excess demand now
exists (shortage)
○ The demand for plantain is greater than the supply

● In response, sellers in Puerto Rico raise prices

○ This causes a contraction of demand & an extension of supply leading
to a new market equilibrium at P2Q2
○ The equilibrium price (P2) is higher & the equilibrium quantity (Q2) is
lower than before
○ The excess demand in the market has been cleared

Real World Example: Changes to Demand That Decrease Price

● Demand for lobsters in Maine, USA has been falling steadily in recent months
● This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35
/pound on the 1st May

Diagram showing a decrease in demand for lobsters due to a decrease in real

income

Diagram Analysis
● In recent months the USA has been experiencing an increasing rate of
inflation
 ○ Inflation lowers the purchasing power of money in a consumer's pocket
& so effectively reduces their real income
○ With reduced real income fewer luxuries are consumed
○ This led to a decrease in demand for lobsters from D1→D2

● At the original market clearing price of P1, a condition of excess supply now
exists
○ The demand for lobsters is less than the supply

● In response, suppliers gradually reduce prices

○ This causes a contraction of supply & an extension of demand leading
to a new market equilibrium at P2Q2
○ Both the equilibrium price (P2) & the equilibrium quantity (Q2) are lower
than before
○ The excess supply in the market has been cleared

Real World Example: Changes to Supply That Decrease Price

● In order to help meet their climate targets & to lower energy costs for
households, the EU is providing subsidies for solar panels

Diagram showing an increase in supply of solar panels in the EU due to a per unit
subsidy

Diagram Analysis
● To help meet its climate change targets & lower household energy bills the EU
has provided a subsidy to solar panel retailers
 ○ This causes an increase in supply of S1→S2

● At the original market clearing price of P1, a condition of excess supply now
exists (surplus)
○ The supply of solar panels is greater than the demand

● In response, sellers in the EU lower prices

○ This causes an extension of demand & a contraction of supply leading
to a new market equilibrium at P2Q2
○ The equilibrium price (P2) is lower & the equilibrium quantity (Q2) is
higher than before
○ The excess supply in the market has been cleared

Exam Tip
MCQ frequently require you to identify the consequences of dynamic changes in
markets e.g. the new equilibrium point after a change in the market). Memorise the
conditions of demand and the conditions of supply - by doing so, you will save
valuable thinking time in the exam.

In structured questions, explaining the steps in the dynamic change is often referred
to as analysis & students frequently leave out some steps in the explanation

Here is a systematic process to help build your explanation:

Step 1: From the scenario, identify if the change in condition is on the demand side
or supply side

Step2: State which way the demand or supply curve moves and use notation e.g.
S1→S2

Step 3: State the disequilibrium that now exists at the original market price (excess
demand or excess supply)

Step 4: State if sellers raise or lower prices to clear the disequilibrium

Step 5: Explain the relevant contraction & extension that occurs on the demand &
supply curves due to the change in price

Step 6: State the new market equilibrium points e.g. P2Q2

Step 7: Explain the market outcome (is the new price/quantity higher/lower than the
original?)
2.11 Price elasticity of demand
The Definition & Calculation of PED
● The law of demand states that when there is an increase in price, there will be
a fall in quantity demanded
○ Economists are interested by how much the quantity demanded will fall
● Price elasticity of demand reveals how responsive the change in quantity
demanded is to a change in price
○ The responsiveness is different for different types of products

Calculation of PED
● PED can be calculated using the following formula

PED = % change in quantity demand/ % change in price = %△ in QD/ %△ in P

● To calculate a % change, use the following formula

% Change = New value-Old value/ Old value x 100

Interpreting PED Values

The Size of PED Varies From 0 To Infinity (∞) & Is Classified As Follows

Value Name Explanation Diagram

 0 Perfectly The QD is completely
Inelastic unresponsive to a
change in P (very
theoretical value e.g.
heart transplant is
extremely inelastic but
possibly not perfectly)

0→1 Relatively The %∆ in QD is less

Inelastic than proportional to the
%∆ in P (e.g. addictive
products)

1 Unitary The %∆ in QD is
Elasticity exactly equal to the %∆
in P

1→ ∞ Relatively The %∆ in QD is more

Elastic than proportional to the
%∆ in P (e.g. luxury
products)
∞ Perfectly The %∆ in QD will fall
Elastic to zero with any %∆ in
P (highly theoretical
elasticity)

The Determinants of PED

● Some products are more responsive to changes in prices than other products

● The factors that determine the responsiveness are called the determinants of
PED & include:
○ Availability of substitutes: good availability of substitutes results in a
higher value of PED (relatively elastic)
○ Addictiveness of the product: addictiveness turns products into
necessities resulting in a low value of PED (relatively inelastic)
○ Price of product as a proportion of income: the lower the proportion of
income the price represents, the lower the PED value will be.
Consumers are less responsive to price changes on cheap products
(relatively inelastic)
○ Time period: In the short term, consumers are less responsive to price
increases resulting in a low value of PED (relatively inelastic). Over a
longer time period consumers may feel the price increase more and will
then look for substitutes resulting in a higher value of PED (relatively
elastic)

The Significance of PED

PED & Total Revenue
● Revenue is the amount of money a firm receives from selling its
goods/services
○ Total revenue = price x quantity
● The total revenue rule states that in order to maximise revenue, firms should
increase the price of products that are inelastic in demand & decrease prices
on products that are elastic in demand
● This can be illustrated using a demand curve
 An illustration of price elastic demand where a small decrease in price from P1→P2
causes a large increase in quantity demanded from Q1→ Q2

Diagram Analysis

● The demand curve is very elastic in this market

● When a good/service is price elastic in demand, there is a greater than
proportional increase in the quantity demanded to a decrease in price
● Total revenue is higher once the price has been decreased
○ (P2xQ2) > (P1xQ1)
An illustration of price inelastic demand where a large increase in price from P1→P2
causes a small decrease in quantity demanded from Q1→ Q2

Diagram Analysis

● The demand curve is very inelastic in this market

● When a good/service is price inelastic in demand, there is a smaller than
proportional decrease in the quantity demanded to an increase in price
● Total revenue is higher once the price has been increased
○ (P2xQ2) > (P1xQ1)

The Implications of PED for Stakeholders

● Knowledge of PED is important to firms seeking to maximise their revenue
○ If their product is price inelastic in demand, they should raise their
prices
○ If price elastic in demand, then they should lower their prices
○ Firms can choose to use price discrimination to maximise their revenue
i.e. lower prices for certain segments & higher prices for others

● Knowledge of PED is important to Governments with regard to taxation and

subsidies
○ If they tax price inelastic in demand products, they can raise tax
revenue without harming firms too much
○ Consumers are less responsive to price changes so firms will pass on
the tax to the consumer
 ○ If Governments subsidise price elastic in demand products, there can
be a greater than proportional increase in demand.

2.12 Price elasticity of supply

The Definition & Calculation of PES
● The law of supply states that when there is an increase in price (ceteris
paribus), producers will increase the quantity supplied & vice versa
○ Economists are interested in how much the quantity supplied will
increase
● Price elasticity of supply (PES) reveals how responsive the change in quantity
supplied is to a change in price
○ The responsiveness is different for different types of products

Calculation of PES
● PES can be calculated using the following formula

PES = % change in quantity supplied/ % change in price = %△ in QD/ %△ in P

● To calculate a % change, use the following formula

% Change = New value-Old value/ Old value x 100

Interpreting PES Values

The Values of PES Vary From 0 To Infinity (∞) & They Are Classified As Follows

Value Name Explanation Diagram

 0

Perfectly The QS is completely

Inelastic unresponsive to a
change in P (e.g.
fixed number of seats
in a theatre)

0→1 Relatively The %∆ in QS is less

Inelastic than proportional to
the %∆ in P (e.g
agricultural products)

1→ ∞ Relatively The %∆ in QS is more

Elastic than proportional to
the %∆ in P (e.g
t-shirts)

∞ Perfectly The %∆ in QS will fall

Elastic to zero with any %∆ in
P. However, supply is
unlimited at a
particular price. This
is a very theoretical
scenario
 1 Unitary Any supply curve that
Elasticity starts at the origin
(e.g. S1, S2 or S3)
has a PES value
equal to 1. The %∆ in
P = %∆ in QS

The Determinants of PES

● Some products are more responsive to changes in prices than other products

● The factors that determine the responsiveness are called the determinants of
PES & include:
○ Mobility of the factors of production: if producers can quickly switch
their resources between products, then the PES will be more elastic.
For example, if prices of hiking boots increase & shoe manufacturers
can switch resources from producing trainers to boots, then boots will
be price elastic in supply
○ Availability of raw materials: if raw materials are scarce then PES will
be low (inelastic). If they are abundant, PES will be higher (elastic)
○ Ability to store goods: if products can be easily stored then PES will be
higher (elastic) as producers can quickly increase supply (for example,
tinned food products). An inability to store products results in lower
PES (inelastic)
○ Spare capacity: if prices increase for a product & there is capacity to
produce more in the factories that make those products, then supply
will be elastic. If there is no spare capacity to increase production, then
supply will be inelastic
○ Time period: In the short run, producers may find it harder to respond
to an increase in prices as it takes time to produce the product (e.g.,
avocados). However, in the long run they can change any of their
factors of production so as to produce more

Exam Tip
Many students confuse PES with PED and inadvertently answer questions using
knowledge from PED. When faced with PES questions, tell yourself to think like a
producer (and not a consumer!) and it will help you to stay focused on providing the
correct answer.
The Significance of PES for Stakeholders
● If producers have a high PES (elastic) then they are able to respond to
increases in price very quickly
 ○ This is desirable as it means producers can increase revenues &
profits if they can supply more
○ Firms can increase their PES by:
■ Creating more spare capacity on their production lines
■ Maintaining larger inventories
■ Using more modern technology

● If producers have a low PES (inelastic) then they are less able to respond to
increases in price
○ This shortage in supply will mean that prices continue to rise, possibly
causing inflation in the economy

● Governments are very interested in the PES of key markets in the economy
as they want to ensure that these markets can respond quickly to rising
demand
○ One e.g is the housing market. If the PES of housing is low (inelastic),
property prices will become unaffordable with any increase in demand
○ Another e.g. is the labour market. If the PES of labour is low (inelastic)
then production costs of firms will rise quickly during periods of
increasing demand when firms need to hire additional workers.

2.13 Market economic system

Definition & Characteristics
● A market economy is an economy that has no government intervention in the
allocation of resources & distribution of goods/services
○ This is also called a free market economy
○ There is no purely free market economy in the world but some
countries have less government intervention than others

● An economy can be considered to be a market, mixed or planned economy

○ The type of economy is determined by how the three economic
questions are answered (see: 2.2.1 The (Free) Market System).

○ This ultimately determines the amount of government intervention in an

economy
The spectrum of economic systems & where certain economies fall based on the
degree of government intervention

● North Korea is a planned economy

● The United States, Japan & Singapore are mixed economies but have less
government intervention than Norway, Germany or China

Characteristics of a Market System

Characteristic Explanation

Property ● Individuals have the right to purchase the factors of

Ownership production

Freedom of ● Individuals are free to start their own business

Choice ● Firms are free to decide what they are going to
produce, how, & for whom
● Workers are free to decide who they are going to
work for
● Consumers decided what goods/services best meet
their wants/needs
Self Interest ● Entrepreneurs maximise profits
● Workers maximise wages
● Consumers maximise their well-being/satisfaction

Limited ● A pure market economy has no government

Government intervention
Intervention ● Most free market economies have a low level of
intervention, usually in the form of taxation, provision
of defence, healthcare & education

Price ● Changes in prices allocate scarce resources

Mechanism ● Rising prices indicate a shortage of resources &
falling prices indicate a surplus of resources

Advantages & Disadvantages of a Market System

● Each economic system has numerous advantages and disadvantages

The Advantages & Disadvantages of Market Economies

Advantages Disadvantages
 ● Profit incentive motivates ● Wealth gets concentrated in
people to work or develop the hands of the few as they
entrepreneurial ideas are able to keep buying up the
● Greater variety of scarce factors of production
goods/services ● This increases inequality such
● Competition leads to better that the gap between the rich
quality of goods/services and the poor continues to grow
● Competition leads to lower ● Sometimes product quality falls
prices of goods/services as firms lower quality
● Competition encourages standards in order to increase
innovation and product profits
development ● Workers get exploited
● Profits, income and wealth are ● Resource depletion and
unlimited resulting in better environmental degradation are
standards of living often ignored
● More efficient use of scarce ● Monopolies develop as firms
resources increase market power through
mergers and acquisitions
● This leads to exploitation of
consumers and supply chains

2.14 Market Faliure

Market Failure Defined
● In a free market, the price mechanism determines the most efficient allocation
of scarce resources in response to the competing wants and needs in the
marketplace
○ Scarce resources are the factors of production (land, labour, capital,
enterprise)

● Free markets often work very well

● However, there is sometimes a less than optimum allocation of resources

from the point of view of society. This is called Market Failure
○ Sometimes there is an over-provision of goods/services which are
harmful (demerit goods) & therefore an over-allocation of the resources
(factors of production) used to make these goods/services e.g.
cigarettes
 ○ Sometimes there is an under-provision of the goods/services which are
beneficial (public goods & merit goods) & therefore an under-allocation
of the resources (factors of production) used to make these
goods/services e.g. schools
○ Sometimes the market causes a lack of equity (inequality) - the rich get
richer and the poor get relatively poorer
○ Sometimes, environmental damage occurs during the production or
consumption of a good/service

● In each of these cases, from society’s point of view there is a lack of efficiency
in the allocation of resources

Private, Social & External Costs

● Externalities occur when there is an external impact on a third party not
involved in the economic transaction between the buyer & seller
○ These impacts can be positive or negative & are often referred to as
spillover effects
○ These impacts can be on the production side of the market (producer
supply) or on the consumption side of the market (consumer demand)

● External costs occur when the social costs of an economic transaction are
greater than the private costs
○ A private cost for the producer, consumer or government is what they
actually pay to produce or consume a good/service e.g. a consumer
pays $9 for a McDonald's meal
○ An external cost is the damage not factored into the market transaction
e.g. the consumer throws their McDonalds packaging onto the street &
the Government has to hire cleaners to collect the litter

● The social cost includes both the private cost & the cost to society
○ It is a better reflection of the true cost of an economic transaction
○ Social cost = private cost + external cost

Private, Social & External Benefits

● External benefits occur when the social benefits of an economic transaction
are greater than the private benefits
○ A private benefit for a consumer, producer or government is what they
actually gain from producing or consuming a good/service e.g. a bee
farm gains the private benefit of the income from selling their honey
○ An external benefit (positive externality) is the benefit not factored in to
the market transaction e.g. The bees from the bee farm pollinate the
nearby apple orchards
 ● The social benefit includes both the private benefit & the external benefit to
society
○ It is a better reflection of the true benefit of an economic transaction
○ Social benefit = private benefit + external benefit.

Causes & Consequences

Causes & Consequences of Market Failure
● Market Failure occurs when free market activity results in a less than optimum
allocation of resources from the point of view of society

The Causes & Consequences of Market Failure

Cause Explanation Consequences

Demerit ● These are goods which have harmful ● They are

Goods impacts on consumers/society over-provided
● They are often addictive in a market and
● E.g. Gambling, alcohol, drugs, sugary their
foods/drinks consumption
often creates
external costs
● Governments
often have to
regulate these
goods in such
a way that they
raise the prices
and/or limit the
quantities
consumed
Merit ● These are goods that are beneficial to ● They are
Goods society but consumers under-consume under-provided
them as they do not fully recognise the in a market &
private or external benefits their
● E.g. Vaccinations, education, electric consumption
cars generates both
private and/or
external
benefits
● Governments
often have to
subsidise these
goods in order
to lower the
price and/or
increase the
quantities
consumed
Public ● Public goods are beneficial to society ● Non-excludabili
Goods but would be under-provided by a free ty refers to the
market as there is little opportunity for inability of
sellers to make profits from providing private firms to
these goods/services as they are exclude certain
non-excludable and non-rivalrous in customers from
consumption using their
● Good examples include national products. In
defence, parks, libraries and effect, the price
lighthouses mechanism
cannot be used
to exclude
customers e.g.
street lighting
● Non-rivalry
refers to the
inability of the
product to be
used up, so
there is no
competitive
rivalry in
consumption to
drive up prices
and generate
profits for firms
● Therefore,
governments
will often
provide these
beneficial
goods
themselves,
and so they are
called public
goods
Abuse of ● The development of monopoly markets ● The outcome is
Monopol is a natural outcome of a market that
y Power system goods/services
● Firms seek to eliminate competition by are purposely
buying out competitors & increasing under-provided
their ownership of factors of production in order to
● With less competition, firms can raise raise prices
prices, reduce the choice available to and profits
consumers, or limit the supply ● Governments
often intervene
to ensure that
there is healthy
competition in
markets &
sufficient
provision of
goods/services

● Factor immobility occurs when it is ● Factor

difficult for factors of production to immobility
Factor move or switch between different results an
Immobilit uses/locations inefficient
y ● The two main types of factor immobility allocation of
are the geographical & occupational resources in a
immobility of labour market (usually
under-provision
)
● Governments
often
implement
programs to
reduce the
factor
immobility in
order to raise
production &
output
External ● Externalities occur when there is an ● A positive
Costs & external cost or benefit on a third party externality of
Benefits not involved in the economic consumption
transaction occurs when
● These impacts can be positive or there is a
negative positive
● The price mechanism in a free market external benefit
ignores these externalities in
● If these external costs/benefits were consumption,
acknowledged, then the price and such as when
output in the market would be different electric
vehicles are
consumed
CO2 emissions
fall
● A positive
externality of
production
occurs when
there is a
positive
external benefit
in production,
such as when
managed pine
forests produce
timber but also
increase CO2
absorption
● A negative
externality of
consumption
occurs when
there is an
external cost in
consumption
such as when
the
consumption of
alcohol
increases anti
 social
behaviour
● A negative
externality of
production
occurs when
there is an
external cost in
production
such as when
the production
of electricity
increases air
pollution

Government Intervention to
Address Market Failure
Intervention to Address Market Failure
● Four of the most commonly used methods to address market failure in
markets are indirect taxation, subsidies, maximum prices, & minimum prices

● Additional methods of intervention include regulation, nationalisation,

privatisation, & State provision of public goods

Exam Tip
The material on this page is frequently examined in the Paper 2 structured
questions. You will be asked to evaluate the effectiveness of taxes, subsidies,
maximum & minimum prices. To do so:

1. Consider the advantages & disadvantages of each method of intervention

2. Explain that several methods of intervention are likely to be more effective than a
single method e.g. smoking is taxed & highly regulated (age restrictions, packaging
restrictions, display restrictions)

3. Consider different market segments & their responsiveness e.g. wealthy

consumers will less responsive (inelastic demand) to tax increases than poorer
consumers (elastic demand)
 Maximum Prices
● A maximum price is set by the government below the existing free market
equilibrium price & sellers cannot legally sell the good/service at a higher
price

● Governments will often use maximum prices in order to help consumers.

Sometimes they are used for long periods of time e.g. housing rental markets.
Other times they are short-term solutions to unusual price increases e.g.
petrol

The maximum price (Pmax) sits below the free market price (Pe) & creates a condition
of excess demand (shortage)

Diagram Analysis

● The initial market equilibrium is at PeQe

● A maximum price is imposed at Pmax
○ The lower price reduces the incentive to supply & there is a contraction
in QS from Qe → Qs
○ The lower price increases the incentive to consume & there is an
extension in QD from Qe → Qd
○ This creates a condition of excess demand QsQd

The Advantages & Disadvantages of Using Maximum Prices

 Advantages Disadvantages

● Some consumers benefit as ● Some consumers are unable

they purchase at lower prices to purchase due to the
● They can stabilise markets in shortage
the short-term during periods ● The unmet demand usually
of intense disruption e.g. Covid encourages the creation of
supplies at the start of the illegal markets (black/grey
pandemic markets) as desperate buyers
turn to illegal bidding
● Maximum prices distort market
forces & therefore can result in
an inefficient allocation of
scarce resources e.g.
maximum prices in rentals in
the property market create a
shortage

Minimum Prices
● A minimum price is set by the government above the existing free market
equilibrium price & sellers cannot legally sell the good/service at a lower price

● Governments will often use minimum prices in order to help producers or to

decrease consumption of a demerit good e.g. alcohol
The imposition of a minimum price (Pmin) above the free market price (Pe) creates a
condition of excess supply (surplus)

Diagram Analysis

● The initial market equilibrium is at PeQe

● A minimum price is imposed at Pmin
○ The higher price increases the incentive to supply & there is an
extension in QS from Qe → Qs
○ The higher price decreases the incentive to consume & there is a
contraction in QD from Qe → Qd
○ This creates a condition of excess supply QdQs

The Advantages & Disadvantages of Using Minimum Prices In Product Markets

Advantages Disadvantages
● In agricultural markets, ● It costs the government to
producers benefit as they purchase the excess supply &
receive a higher price an opportunity cost is involved
(Governments will often
purchase the excess supply & ● Farmers may become
store it or export it) over-dependent on the
Government's help
● When used in demerit markets,
output falls (Governments will ● Producers lower output which
not purchase the excess may result in an increase in
supply of a demerit good) unemployment in the industry

● Producers usually lower their

output in the market to match
the QD at the minimum price &
this helps to reduce the
external costs

Minimum Prices in Labour Markets

● Minimum prices are also used in the labour market to protect workers from
wage exploitation
○ These are called national minimum wages

● A national minimum wage (NMW) is a legally imposed wage level that

employers must pay their workers
○ It is set above the market rate
○ The minimum wage/hour varies based on age
 A national minimum wage (NMW1) is imposed above the market wage rate (We) at
W1

Diagram Analysis

● The demand for labour (DL) represents the demand for workers by firms
● The supply of labour (SL) represents the supply of labour by workers
● The market equilibrium wage & quantity for truck drivers in the UK is seen at
WeQe
● The UK government imposes a national minimum wage (NMW) at W1
● Incentivised by higher wages, the supply of labour increases from Qe to Qs
● Facing higher production costs, the demand for labour by firms decreases
from Qe to Qd
● This means that at a wage rate of W1 there is excess supply of labour & the
potential for unemployment equal to QdQs

The Advantages & Disadvantages of a Minimum Wage In Labour Markets

Advantages Disadvantages
● Guarantees a minimum ● Raises the costs of production
income for the lowest paid for firms who may respond by
workers raising the price of
● Higher income levels help to goods/services
increase consumption in the ● If firms are unable to raise their
economy prices, the introduction of a
● May incentivise workers to be minimum wage may force them
more productive to lay off some workers
(increase unemployment)

Indirect Taxation
● An indirect tax is paid on the consumption of goods/services
○ It is only paid if consumers make a purchase
○ It is usually levied by the government on demerit goods to reduce the
quantity demanded (QD) and/or to raise government revenue
○ Government revenue is used to fund government provision of
goods/services e.g education

● Indirect taxes are levied by the government on producers. This is why the
supply curve shifts

● Producers and consumers each pay a share (incidence) of the tax

 The impact of an indirect tax is split between the consumer (A) & the producer (B)

Diagram Analysis

● The government places a specific tax on a demerit good

○ The supply curve shifts left from S1→S2 by the amount of the tax
● The price the consumer pays has increased from P1 before the tax, to P2 after
the tax
● The price the producer receives has decreased from P1 before the tax to P3
after the tax
● The government receives tax revenue = (P2-P3) x Q2
○ The consumer incidence (share) of the tax is equal to area A: (P2-P1) x
Q2
○ The producer incidence (share) of the tax is equal to area B: (P1-P3) x
Q2
● The QD in this market has decreased from Q1→Q2
○ If the decrease in QD is significant enough, it may force producers to
lay off some workers

The Advantages & Disadvantages Of Indirect Taxes

Advantages Disadvantages

● Reduces the quantity ● The effectiveness of the tax in

demanded of demerit goods reducing the use of demerit
● Raises revenue for goods depends on the price
government programs elasticity of demand (PED)
○ Many consumers who
purchase products that
are price inelastic in
demand will continue to
do so
● It may help create illegal
markets as consumers seek to
avoid paying the taxes
● Producers may be forced to lay
off some workers as output
 falls due to the higher prices

Exam Tip
This further develops the exam tip mentioned above. When analysing the impact of
taxes on a market it is worth highlighting the elasticity of the product as it influences
who pays more of the tax (producer or consumer).

The more price inelastic the product, the greater the proportion of the tax will be
passed on to consumers by producers as the QD will fall less proportionately than
the price increase. The more price elastic the product, the smaller the proportion of
the tax will be passed on to consumers by producers as the QD will fall more
proportionately than the price increase. (See sub-topic 2.7.2 for more on PED)
Producer Subsidies
● A producer subsidy is a per unit amount of money given to a firm by the
government
○ To increase production
○ To increase the provision of a merit good

● The way a subsidy is shared between producers & consumers is determined

by the price elasticity of demand (PED) of the product

○ Producers keep some of the subsidy & pass the rest on to the
consumers in the form of lower prices

A diagram which demonstrates the cost of a subsidy to the government (A+B) and
the share received by the consumer (A) & producer (B)
Diagram Analysis

● The original equilibrium is at P1Q1

● The subsidy shifts the supply curve from S → S + subsidy:
○ This increases the QD in the market from Q1→Q2
○ The new market equilibrium is P2Q2
○ This is a lower price and higher QD in the market
● Producers receive P2 from the consumer PLUS the subsidy per unit from the
government
○ Producer revenue is therefore P3 x Q2
○ Producer share of the subsidy is marked B in the diagram
● The subsidy decreases the price that consumers pay from P1 → P2
○ Consumer share of the subsidy is marked A in the diagram
● The total cost to the government of the subsidy is (P3 - P2) x Q2 represented
by area A+B

The Advantages & Disadvantages Of Producer Subsidies

Advantages Disadvantages

● Can be targeted to helping ● Distorts the allocation of

specific industries resources in markets e.g. it
● Lowers prices & increases often results in excess supply
demand for merit goods when used in agricultural
● Helps to change destructive markets
consumer behaviour over a ● There is an opportunity cost
longer period of time e.g. associated with the
subsidising electric cars makes government expenditure -
them affordable and helps could the money have been
motorists to see them as an better used elsewhere?
option for the masses - & not ● Subsidies are prone to political
just the elite pressure & lobbying by
powerful business interests
e.g. most oil companies
receive subsidies from their
respective governments
 (despite making $billions in
profits each year)

Other Government Policy Measures to Address Market

Failure

Method Explanation Advantages Disadvantages

State ● Public goods are ● They are ● Paid for

Provision beneficial for usually through
of Public society & are not provided free general
Goods provided by private at the point taxation
firms due to the of ● There is an
free rider problem consumption opportunity
● Examples include ● Accessible cost
roads, parks, to everyone associated
lighthouses, regardless of with their
national defence income provision
● Usually ● Products
provide both which are
private & free may
external result in
benefits to excess
society demand &
long waiting
times e.g.
procedures
at Public
hospitals
Privatisati ● Privatisation ● Increases ● Government
on occurs when government assets are
governments revenue in often sold
transfer ownership the year the well below
& control of asset is sold their actual
firms/assets from ● Private firms market
the State (public may run the value
sector) to the business ● Private firms
private sector more often
(private firms) efficiently provide a
● Many State firms ● The sub
are monopolies. By government standard
privatising them it no longer good/service
encourages more needs to as they cut
competition in manage the quality to
those markets business or increase
● This should result hire people profits
in more efficiency to work for it ● The price of
& lower prices for - this the
consumers reduces good/service
government usually
expenditure increases as
firms seek to
maximise
their profit
e.g. energy
prices in the
UK market
● Many
privatised
companies
still maintain
considerable
market
power &
have to be
regulated,
e.g. water
companies
Nationalis ● Nationalisation ● This can ● Government
ation occurs when the generate firms can
Government takes efficiencies, often run
control & especially very
ownership of firms when inefficiently
which were in the delivering ● There is an
private sector utilities (gas, opportunity
water, cost
electricity) to associated
the national with the
population money
● It creates required to
more equity run it
in society as ● The
all citizens Government
have the may lack the
same access expertise to
to the same run the
resource at business
the same
price e.g.
Norway
nationalised
much of the
oil industry
when oil was
first
discovered
in 1972. The
profits
belong to the
citizens
● The
business can
generate
significant
revenue for
government
 Regulation ● Governments ● Individuals ● Enforcing
create rules to limit or firms may laws
harm from the be requires the
external costs of fined/impriso government
consumption/produ ned for to hire more
ction breaking the people to
● They often create rules e.g. work for the
regulatory selling regulatory
agencies to cigarettes to agencies
monitor that the minors is a ● Enforcing
rules are not punishable laws can be
broken offence difficult as it
● They help to is a complex
reduce the process to
external determine if
costs of firms/consu
demerit mers are
goods breaking the
● Fines can laws
generate ● The
extra regulation
government may create
revenue underground
(illegal)
markets
which could
generate
even higher
external
costs on
society

2.15 Mixed Economic System

Characteristics of a Mixed Economic System
● Any economic system needs to decide how to answer the three fundamental
economic questions (see: 2.2.1 The (Free) Market System)
○ What to produce? More weapons for the military or more schools to
educate the children?
 ○ Who to produce for? Only those who can afford to pay for it? Or for
everyone in society?
○ How to produce it? Should more labour be used or should the economy
focus on using technology instead?

● A mixed economic system is a blend of a market & planned economy

○ Individuals, firms & the government own factors of production &
distribute goods/services
○ In reality, almost every country in the world operates as a mixed
economic system
○ Some countries have more government intervention than others e.g.
China has more intervention than the USA
○ The higher the level of government intervention, the more the economy
will lean towards operating like a planned economy

● Governments intervention is necessary for several reasons

A diagram showing several reasons for government intervention in mixed economic

systems

● To correct market failure: in many markets there is a less than optimal

allocation of resources from society's point of view
○ In maximising their self-interest, firms & individuals will not self-correct
this misallocation of resources & there is a role for the government
 ○ Governments often achieve this by influencing the level of production
or consumption

● Earn government revenue: governments need money to provide essential

services, public and merit goods
○ Revenue is raised through intervention such as taxation, privatisation,
sale of licenses (e.g. 5G licenses), & the sale of goods/services

● Promote equity: to reduce the opportunity gap between the rich & poor

● Support firms: in a global economy, governments choose to support key

industries so as to help them remain competitive

● Support poorer households: poverty has multiple impacts on both the

individual & the economy
○ Intervention seeks to redistribute income (tax the rich & give to the
poor) so as to reduce the impact of poverty
● As we have seen in 2.10.3 Government Intervention to Address Market
Failure, four of the most commonly used methods to intervene in markets are
indirect taxation, subsidies, maximum prices, & minimum prices

● Additional methods of intervention include regulation, nationalisation,

privatisation, & the State provision of public goods

3. Microeconomics decision makers

3.16 Money and banking

The Meaning of Money

● Prior to the creation of money, individuals & firms had to accept other goods
or services as payment, or be self-sufficient by producing everything required
● Often lacking self-sufficiency or driven by the desire for a wider range of
goods/services, bartering became the norm but it too had problems
● As individuals & firms trade with each other in order to acquire goods or raw
materials, they require a means of exchange that is acceptable & easy to use

● Modern currency fulfils this purpose & money functions as a medium of

exchange, a measure of value, a store of value, and a method of deferred
payment

The Functions of Money

 The Four Functions of Money

A Medium of A Measure of A Store of Value A Method of

Exchange Value Deferred
Payment

● Without ● Money ● Money holds its ● Money is

money, it provides value over time (of an
becomes a means course inflation acceptab
necessary of means that is not le way to
for buyers ascribing always true!) arrange
& sellers to value to ● This means that terms of
barter different money can be credit
(exchange goods saved (loans) &
goods) and ● It remains valuable to settle
● Bartering is services in exchange over any
problematic ● Knowing long periods of future
as it the price time debts
requires of a ● This
two people good in allows
to want terms of producer
each money s&
other's allows consume
goods both rs to
(double consume acquire
co-incidenc rs and goods in
e of wants) producer the
● Money s to present
easily make & pay for
facilitates decision them in
the s in their the future
exchange best
of goods as interests
no double ● Without
co-incidenc this
e of wants measure
is it is
necessary difficult
for
buyers &
sellers to
 arrange
an
agreeabl
e
exchang
e

The Characteristics of Money

● Many items were used for centuries as a form of money such as gold, silver,
shells, beer, tobacco
● However, each one of these items had some characteristics that made the
less than ideal for exchange in certain circumstances
● Good money has a number of essential characteristics - and modern currency
fulfils them all

The six characteristics of good money

1. Divisibility: to be a valued medium of exchange, currency must be divisible.

€50 notes can be exchanged for €10 euro notes or €1 coins
2. Acceptability: the currency must be valued & widely accepted by society as a
valid way to pay for goods/services
3. Durability: the currency must be robust, not easily defaced/destroyed & last
for a long period of time
 4. Scarcity: the supply of the currency should be such that is remains desirable
& retains its value in the market. Oversupply would decrease its worth
5. Uniformity: in order to be a valid measure of value each denomination must
be exactly the same e.g. every $50 note must be exactly the same
6. Portability: good currency is easy to carry/conceal.

Central & Commercial Banks

The Functions of Central Banks
● Central Banks play a vital role in maintaining stability in the financial system.
Additionally, the policy tools at their disposal help to meet Government
economic objectives & create economic growth

Central Banks play four important roles in the economy

1. Implementation of monetary policy: This is more fully explained in Sub-topic

4.4.1

2. Banker to the government: The Government sets the annual budget but it is
the Central Bank that manages the tax receipts & payments. In 2022 there
were 5.7 million public sector workers in the UK who had to be paid by the
Central Bank each month

3. Banker to the banks – lender of last resort: Commercial banks are able to
borrow from the Central Bank when they run into short-term liquidity issues.
Without this help, they might go bankrupt leading to instability in the financial
 system - & a potential loss of savings for many households

4. Regulation of the banking industry: the high level of asymmetric information in

financial markets requires that commercial banks are regulated in order to
protect consumers

The Functions of Commercial Banks

● Financial markets are any place or system that provide buyers & sellers the
means to exchange goods/services & trade financial instruments
○ Financial instruments include loans, bonds, equities, & international
currencies

● Commercial Banks play a central role in financial markets

1. They facilitate saving: storing money for future use is essential for households
& firms. It also provides a pool of money that financial institutions can lend i.e.
one person's savings is another person's borrowing

2. They lend to businesses & individuals: access to credit is a key requirement

for economic growth & development. Being able to borrow money speeds up
consumption by households & investment by firms. It also allows households
or firms to purchase assets & pay them off over an extended period of time
e.g. mortgages on home purchases

3. They facilitate the exchange of goods & services: each purchase of

goods/services requires the movement of money between at least two parties.
Commercial Banks provide multiple ways for this exchange to happen
including phone apps (e.g. Google Pay), debit cards, credit cards & bank
transfers

4. They provide forward markets in currencies & commodities: forward markets

are also called futures markets. They provide some price stability in
commodity markets & enable investors to make a profit by speculating on
future prices

5. They provide a market for equities: equities are shares in public companies
that are listed on stock exchanges around the world. Commercial Banks
facilitate both long term investment & speculation by providing platforms
which connect buyers & sellers.
3.17 Households

Spending, Saving & Borrowing

The Influences on Spending
● Spending in an economy is also called consumption
● The level of consumption by households is heavily influenced by income,
interest rates & the level of confidence in the economy

The Influences On Household Spending & Consumption

Changes to Income Changes to Changes to Confidence Levels

Interest Rates

● Disposable ● Interest ● The stronger the economy, the

income is rates are higher consumer confidence.
the money set by the Consumers feel secure in their
that governme jobs & are confident of receiving
households nt's regular salary payments.
have left Central Therefore consumption increases
over from Bank ● In a weakening or recessionary
their ● Changes economy, consumer confidence
salary/wage to the falls. Consumers feel less secure
s after they base rate in their jobs & consumption
have paid cause decreases
their taxes & commerci
have al banks
received any to change
transfer the
payments/be lending
nefits from rates they
the offer
government customers
● Consumptio ● If interest
n increases rates
as increase
disposable then the
income cost of
increases & borrowing
decreases increases.
 as Higher
disposable borrowing
income costs =
decreases less
consumpti
on
● If interest
rates
increase,
the
monthly
repayment
on any
existing
loan
increases.
Higher
loan
repayment
s = less
consumpti
on

The Influences on Saving

● Disposable income can either be saved or spent on goods/services
(consumption)

The Influences On Household Saving

Changes to Income Changes to Interest Rates Changes to

Confidence Levels
● When disposable ● Changes to the base ● Households
income increases, rate cause tend to save
the proportion commercial banks to when they are
saved depends on change the savings more fearful of
the overall income rate they offer the future
level of the customers ● The stronger
household ● An increase in the the economy,
● Low income savings rate offered the higher the
households will by commercial consumer
spend any banks incentivises confidence &
additional income households to save the lower the
on necessities or more level of
a few basic ● An decrease in the household
luxuries - little savings rate offered saving
additional saving by commercial ● The weaker the
occurs banks economy, the
● Medium income disincentivises lower the
households will households from consumer
increase both saving & confidence &
consumption & encourages the higher the
savings consumption level of
● High income household
households will saving
usually increase
their savings (or
asset purchases)
significantly

The Influences on Borrowing

● Households borrow money from friends, relatives, money lenders &
commercial banks
● Commercial banks usually require security in order to extend a loan
○ The need for security often prevents low income households from
accessing bank loans at competitive rates

The Influences On Household Borrowing

Changes to Income Changes to Interest Changes to

Rates Confidence Levels
 ● When disposable income ● If interest rates ● When the
increases, household decrease, economy is
borrowing often increases medium & high booming,
due to the ability to make income confidence is
additional monthly households may high resulting
payments decide to borrow in more
● Low income households more money borrowing &
find it difficult to access from commercial consumption
commercial bank loans & if banks, as it is ● When the
they need to borrow now cheaper to economy
money, they face higher repay slows down
interest rate charges (e.g. ● There will likely or stagnates,
payday loans or "buy now, be an increase in confidence
pay later" schemes) - or personal loans to falls resulting
they turn to money lenders fund travel, car in less
● Medium income purchases & borrowing &
households will increase home consumption
borrowing as income rises improvements
● High income households ● Low income
often receive preferential households are
interest rates & obtain usually unable to
large loans to fund asset access
purchases e.g. luxury borrowing from
properties commercial
banks, even
when interest
rates fall &
continue to
borrow from
sources that
charge high
interest rates

3.18 Workers

Factors Affecting Choice of

Occupation
 Wage Factors
● The occupational choices of workers are influenced by a range of wage &
non-wage factors, which are often held in balance when making decisions
about where to work
● Wage factors are financial payments that workers receive for their labour
● Non-wage factors incorporate a range of influences that are meaningful to a
worker

A Summary of Wage Factors That Influence Occupational Choices

Factor Explanation

Wages ● An agreed amount of money/hour & is

calculated directly from the number of hours
worked
● E.g. If a student works in a restaurant for 6
hours, 5 days a week & she gets paid $10/hour,
her weekly wage is $300 (6x5x$10)

Salary ● Employment contracts often state the agreed

annual salary the employee will receive
● This is then divided by 12 & paid monthly (in the
USA it is divided by 24 & paid every 2 weeks)
● The hours worked monthly may vary but the pay
received is always the same

Commission ● Often used as payment to sales people

● It is typically a percentage of the value of the
transaction involved e.g. estate agents receive
3-7% of the selling price of any property they
sell
● This can motivate employees to maximise sales
 Bonus ● Money paid in addition to a salary & is usually
single annual payment
● Often paid when the company earns high levels
of profits, or as a reward for exceptional worker
performance

Piece rate pay ● A fixed amount paid to the employee for each
completed item produced e.g. 25 Rupees paid
to workers in India for each pair of socks they
produce

Performance related ● Payment based on how well the worker

pay (PRP) performs
● Workers doing exactly the same job may
receive different compensation based on
different outcomes they achieve

Share options ● Payment through the issuing of shares in the

company the employee works for
● This is usually in addition to a monthly salary
● The monetary value of the shares provided to
the employee can be calculated on any given
day as: number of shares x share price

Fringe benefits ● Benefits provided in addition to the normal

salary
● They can be significant in influencing
occupational choices
● Includes benefits such as such as childcare,
free lunches, gym membership, company car

Non-wage Factors
● Many different non-wage factors influence a workers choice of occupation

1. Length of training or level of education required: The longer the time period
required to study/train for a job, the fewer the number of people who seek
employment in that occupation e.g. it usually takes seven years to become a
 lawyer

2. Job security: Employment contracts in different industries have different time

periods attached to them. Some contracts are one to four years in length, so
provide high security e.g financial sector contracts. Others have a short notice
period & the employee can be dismissed with a very short notice period e.g.
30 days

3. Job satisfaction: Finding fulfilment in a job role & enjoying work is a significant
part of generating job satisfaction. Workers will often change their
jobs/careers so as to improve their job satisfaction

4. Career prospects: Jobs with a defined pathway for promotion (& salary
increases) are often more desirable

5. Level of challenge: Many workers step into an occupation due to the

challenge of the role e.g. firefighters

6. Status: Some jobs carry a higher recognition in society which workers find
appealing, for example doctors, surgeons & lawyers

Wage Determination
Factors That Influence The Demand for Labour
● The labour market is composed of sellers of labour (households) & buyers of
labour (firms)
○ Workers supply their labour & firms demand labour

● The demand for labour is a derived demand

○ This means that it depends on the demand for goods/services
■ If demand for goods/services increases then the demand for
labour will increase - and vice versa

Factors That Influence The Demand for Labour

The price of the product being

The demand for the final product
produced
● If the selling price of the ● As demand for labour is a
product increases, then the derived demand, when an
firm will be incentivised to economy is booming then
supply more & the firm's demand for most
demand for labour will increase goods/services will be high - &
the demand for labour will be
high
● Conversely, when an economy
is in a recession demand for
most goods/services will be
lower - & the demand for
labour will be lower

The ability to substitute capital

The productivity of labour
(machinery) for labour

● Firms will constantly evaluate if ● If the productivity of labour

it will be possible & more cost increases (possibly through
effective to switch production training) this will lower average
from using labour to capital costs & firms will likely demand
(machinery) more labour
● If it is more cost effective, then
demand for labour will fall

Factors Influencing the Supply of Labour

● There are numerous factors that influence the amount of labour supplied to a
particular industry

Factors Influencing The Supply Of Labour

Wages in other Changes in migration

Training period
occupations policy
Long training periods (& Comparative wage rates Policies that increase the
their cost) act as a in substitute labour net migration rate
barrier to entry & exclude markets strongly increase the supply of
many households from influence the supply of labour to certain
offering labour in certain labour e.g. it is getting industries e.g. in 2022,
markets harder to recruit 36% of Singapore's
economics teachers as labour force were
the private sector offers migrants
higher wages for their
skills

Income tax levels Working conditions Trade union power

At a certain level, income The working conditions & Trade unions can
taxes become a non-wage benefits can increase the supply of
disincentive to act as strong incentive in labour to certain
households offering their certain industries e.g. industries as workers
labour. The assumption tech companies are well consider the benefits of
is that as income tax known for their laid-back belonging to the union
increases, labour supply work environment & wide e.g higher wages & a
decreases - and vice range of benefits e.g. safer working
versa on-site childcare & environment
restaurants

Level of welfare benefits Social trends

 The higher the level of Social trends include any
welfare benefits, the major changes within
lower the incentive for society & can influence
low-skilled labour to offer the supply of labour to
their labour - and vice certain industries e.g.
versa work from home during
Covid resulted in
significant changes to
the labour market & not
all workers returned to
work when economies
opened up again

Diagrammatic Analysis of the Labour Market

● The labour market is a type of factor market

● Factor markets follow exactly the same rules as product markets

○ They are affected by changes to price, demand & supply
○ They are affected by the price elasticity of demand & supply.

● Labour market equilibrium occurs where the demand for labour (DL) is equal
to the supply of labour (SL)
○ The DL is the demand by firms for workers - firms demand more labour
as the wage rate decreases which results in a downward sloping
demand curve
○ The SL is the supply of labour by workers - workers supply more labour
as the wage rate increases which results in an upward sloping supply
curve

● Individual firms are price takers in the labour market as they have to accept
the wage rate that workers are being paid in the industry
○ If they offer a lower wage, they will likely struggle to recruit workers
○ If they offer a higher wage there will be a large number of workers
applying to work there
 In the labour market for graphic designers, the equilibrium wage rate is W and the
equilibrium quantity is Q. At this point the DL = SL

Diagram Analysis

● The market for graphic designers is in equilibrium where DL = SL

● The equilibrium wage is W and the quantity of labour is Q
● There is no excess supply of labour
● There is no excess demand for labour

Analysing the PED & PES of Labour

Price Inelastic Demand & Supply

● Consider the labour market for NBA basketball players

● In 2022, LeBron James received a salary of $45m
 Wage determination in highly skilled markets is price inelastic in both supply &
demand

Diagram Analysis

● DL is the demand for labour from the basketball clubs

● SL is the supply of labour by the basketball players
● The demand for highly skilled players is very price inelastic
○ Clubs want the very best players, almost irrespective of what they cost
● The supply of highly skilled players is also very price inelastic
○ A significant increase in price will have little impact on the quantity of
labour supplied in the market as it takes years to develop LeBron
James type skills
● The market equilibrium is found at W1Q1 - a high price & relatively low
quantity

Price Elastic Demand & Supply

● Consider the labour market for labourers on a building site

 Wage determination in unskilled markets is price elastic in both supply & demand

Diagram Analysis

● DL is the demand for labour from the building company for labourers
● SL is the supply of labour by people willing to work on a building site
● The demand for workers is very price elastic
○ If wages dropped a little, then firms would respond quickly by
employing more workers
● The supply of workers is also very price elastic
○ Due to it being an unskilled job, there would quickly be an increase in
the supply of labour if wages were to increase
● The market equilibrium is found at W1Q1 - a low price & relatively high
quantity

Relative Bargaining Power

● Workers have different degrees of bargaining power when it comes to
negotiating wage increases with their employers
● The following factors influence their bargaining power
1. Membership of a trade union: trade unions represent the interests of the
workers in negotiations with employers & members frequently enjoy higher
wages than non-union members

2. Age & experience: young, inexperienced workers have less bargaining power
then older, more experienced workers. As workers grow older their age often
begins to count against them & this reduces bargaining power

3. Level of education: education provides higher levels of skill & specialisation to

a worker. This increases their bargaining power relative to unskilled workers
 4. Current supply conditions: the supply of labour in many industries can change
due to socio-political conditions e.g prior to Brexit, workers in the hotel
industry had very little bargaining power. Brexit created a shortage of labour
willing to work in hotels & so the bargaining power of workers has increased,
resulting in higher wages in the industry

Government Policy: Minimum Wages

● Government's often intervene in the labour market by setting a minimum wage
​ They do this in order to improve equity & avoid the exploitation of
worker
● A minimum wage is a legally imposed wage level that employers must pay
their workers
■ It is set above the market rate
■ The minimum wage/hour often varies based on age

A national minimum wage (NMW1) is imposed above the market wage rate (We) at
W1

Diagram Analysis

● The market equilibrium wage & quantity for truck drivers in the UK is seen at
WeQe
● The government imposes a national minimum wage (NMW) at W1
● Incentivised by higher wages, the supply of labour increases from Qe to Qs
 ● Facing higher production costs, the demand for labour by firms decreases
from Qe to Qd
● This means that at a wage rate of W1 there is excess supply of labour & the
potential for unemployment equal to QdQs

Wage Differentials
Reasons for Differences in Pay
● Workers are paid different amounts (wage differentials) due to a number of
factors, including
○ Gender pay differences
○ Industrial sector pay differences
○ Private & public sector pay differences
○ Differences in pay between skilled & unskilled workers

Reasons for Wage Differentials Between Men & Women

1. Men usually work full-time whereas women often work part-time in order to
meet the demands of motherhood/childcare
2. Men usually have an uninterrupted career journey whereas women often take
time away from work (motherhood/family) & so miss opportunities for
advancement
3. Women are more likely to accept a job below their skill or quantification level if
it fits in with the needs of looking after their children
4. The gender pay gap is a form of discrimination & occurs when a women is
paid less than a man who is doing exactly the same job

Reasons for Wage Differentials in the Primary, Secondary & Tertiary Sectors
● Primary sector workers are usually paid low wages due to the unskilled nature
of the job & the fact that raw materials often generate the lowest profits in the
production chain
● Secondary sector workers add value to the raw materials & these products
sell for higher profits. Therefore wages tend to be higher than primary sector
wages
● Tertiary sector workers are paid the highest. Their jobs often require highly
valued skills that take years to acquire & the products they sell or services
they provide can be complex & expensive e.g. artificial intelligence coders

Reasons for Wage Differentials Between Private & Public Sector Workers
● Public sector organisations are owned & controlled by the Government
 ● Private sector organisations are owned & controlled by private individuals &
firms

Reasons for Wage Differentials Between Private & Public Sector Workers

Private Sector Workers Public Sector Workers

● Salaries can be extremely ● Wages will reach a maximum

high, especially if the value of ceiling that is often below what
goods or services offered is the private sector may offer
high & the workers are e.g. public school teachers are
productive paid less than private school
teachers
● Some salaries can also be
very low as firms seek to cut ● Wages often do not fall as low
costs & maximise profits e.g. as some private sector jobs as
garment sector worker in many public sector workers
Bangladesh get paid very little belong to trade unions
for the work they do
● Job security is high resulting in
● Many wage benefits tend to be long careers with defined
better than those provided by pathways for promotion
the public sector e.g. bonuses
or share options ● Pensions are often very good,
but are limited in comparison to
private sector pensions

Reasons for Wage Differentials Between Skilled & Unskilled Workers

● Many economies have a high supply of unskilled labour. This means that
employers can push wages down as there is always someone willing to work
for less (take it or leave it approach to wages)
● To become skilled takes time & money which means that there is a more
limited supply of specific skillsets. In recognition of these factors, wages for
skilled workers are higher.

Division of Labour &

Specialisation
An Introduction to The Division of Labour & Specialisation
● Based on observations made during a visit to a pin factory, famous economist
Adam Smith developed the ideas of specialisation & the division of labour
○ He noted that a single worker could not make more than 20 pins a day
as it involved around 18 different processes, such as cutting the wire,
sharpening the end, stamping the head etc.
○ However, if the labour was divided up into different tasks & workers
specialised in just that one task, Adam Smith estimated that just 10
workers could produce 48,000 pins per day

● The division of labour is when a task is broken up into several component

tasks

● This allows workers to specialise by focusing on one (or a few) of the

components that make up the production process & thereby gain significant
skill in doing it
○ This results in higher output per worker & so increases productivity

● Specialisation occurs on several different levels

○ On an individual level
○ On a business level. For example, one firm may only specialise in
manufacturing drill bits for concrete work
○ On a regional level. For example, Silicon Valley has specialised in the
tech industry
○ On a global level as countries seek to trade. E.g. Bangladesh
specialises in textiles & exports them to the world

Advantages & Disadvantages for Workers, Firms & The

Economy
Pros & Cons of the Division of Labour & Specialisation

Stakeholder Pros Cons

Worker ● Workers can acquire ● The work can be
the single skill required repetitive & boring
relatively quickly ● There is limited
● Workers gain opportunity to gain
recognition & status for additional skills
performing their skill ● If the firm replaces
well labour with capital, the
worker may find it
difficult to find
employment elsewhere
due to their limited skill
base

Firm ● Time spent training ● Worker productivity can

new workers is fall due to the
relatively short boredom/ decreased
● Increased output motivation experienced
allows firms to ● Staff turnover may be
generate more sales & high as workers seek
profit new, interesting
● Higher labour opportunities
productivity lowers elsewhere
cost/unit for firms, ● International trade is
which makes their beneficial for the firms
goods more that can compete
competitive globally. However,
internationally (exports) some firms will be
unable to compete and
will go out of business
● Entire industries may
close leading to
structural
unemployment
 Economy ● Increased exports can ● Specialisation may
result in economic create
growth for the nation over-dependency on
● Economic growth other countries'
usually leads to higher resources. This may
income and a better cause problems if
standard of living conflict arises (E.g,
● Income gained from Europe's reliance on
exports can be used to Russian natural gas
purchase other goods during the Ukraine
from around the world crisis)
(imports). This ● Specialisation using a
increases the variety of country's own
goods available in a resources will lead to
country resource depletion.
Specialisation
increases the rate of
resource depletion

3.19 Trade Unions

Types of Trade Unions

● A trade union is an organisation that represents the interests of its workers in
negotiations with a firm’s management or owners

● The interests of the worker include

○ Wage & non-wage benefits of employment
○ Health & safety in the working environment
○ The reduction of discrimination & worker exploitation

● Trade unions are usually formed by the members of specific industries

○ Airline pilots have a pilots' union
○ Rail & sea workers have a rail & maritime union

● If there is no specialist union for an industry, most economies have a number

of general unions which any worker can join e.g. In the UK, UNISON is the
largest trade union, & it represents workers from across the public sector
including those working in local government, education & health
 ● All trade unions can be classified into one of four categories

Types of Trade Unions

Type of Union Explanation

General Union These represents skilled & unskilled workers in any

industry e.g. truck drivers, football referees, musicians
& gardeners

Industrial Union These represents workers in the same industry. Anyone

in the industry can join, irrespective of skill level or
seniority e.g. The Fire Brigades Union in the United
Kingdom

Craft Union These represent skilled workers with a specific trade

e.g. painters, electricians

White Collar Union These represent professional office-based

(‘white-collar’) workers e.g. financial advisors, teachers,
architects, designers

The Role of Trade Unions

The Work of Trade Unions
● Workers pay a monthly fee to join a trade union
○ The fee is called a subscription
○ Their membership ends when they stop paying this fee

● Benefits of union membership include

○ Collective bargaining
○ Job-specific training
○ Legal representation in disputes
 ○ Discounts on a wide range of goods/services

● When collective bargaining fails & discussions break down, trade unions have
several methods of forcing employers/governments to continue engaging with
them
○ These methods are collectively referred to as industrial action & include
■ Strikes
■ Overtime bans
■ Work to rule
■ Go-slows

The Focus of Trade Union Efforts

1. Collective bargaining on wages, working conditions & contractual terms

● Negotiates for acceptable ● Negotiates for increased

wage levels - often well above wages when comparative
the minimum wage industries receive pay
increases

● Negotiates for inflation-linked ● Negotiates for higher wages

pay rises when firms are making higher
profits

● Negotiates standard weekly ● Negotiates for improvements to

working hours & any overtime working conditions &
payments equipment

2. Protecting the employment of their workers

● Negotiates for the retention & ● Negotiates resettlement
redeployment of workers when packages when firms relocate
machinery (capital) replaces from one region to another &
labour redundancy terms for those
unable to relocate

● Negotiates to minimise job ● Negotiates on a fair termination

losses when machinery process when firms are
(capital) replaces labour struggling in an economic
downturn

3. Influencing government policy

● Negotiates with government on ● Aims to influence policy

the creation/maintenance of through member action such
minimum wage levels as strikes

● Negotiates to minimise job ● Negotiates on a fair termination

losses when machinery process when firms are
(capital) replaces labour struggling in an economic
downturn

Factors Influencing the Strength of Trade Unions

● The higher the percentage of workers from a firm that belong to a trade union,
the greater the collective bargaining power of that union with the employer

● The higher the percentage of workers from an economy that belong to trade
unions, the greater the collective bargaining power of the unions with the
 government

● There are numerous other factors which influence the collective bargaining
power of specific unions at different periods of time

Factors which influence the collective bargaining power of trade unions

1. The unemployment level - the higher the unemployment level the weaker the
bargaining power as firms can more easily replace existing workers
2. Wage levels as proportion of total costs - the lower the percentage of total
costs that a firms's wages represent, the higher the bargaining power
3. Swapping labour for capital - the nearer the replacement cost of capital for
labour to meeting the increased costs demanded by the union, the weaker the
bargaining power
4. The level of profits - higher profits strengthen the unions demands for higher
wages
5. State of the economy - less bargaining power in a recession & more when the
economy is booming
6. Overall size of the trade union - the larger the union the stronger their
bargaining power
7. The productivity of labour - if the workers are extremely productive, generating
high levels of output from low levels of input, they are more valuable to the
firm & the union has stronger bargaining power
Advantages & Disadvantages
of Trade Unions
Pros & Cons for Workers, Firms & Governments
● Different economies have different views about the usefulness of trade
unions. Capitalists generally do not like them as the collective bargaining
increases costs for firms

● The European Union values trade union activity whereas Saudi Arabia bans
trade unions completely

● When considering the benefits of trade union activity, it is useful to analyse

the advantages & disadvantages for workers, firms & the Government

Pros & Cons of Trade Unions For Workers

pro con

● Workers no longer ● Industrial action is

need to negotiate stressful as it is a conflict
with management between workers &
on their own as they management
benefit from ● Workers do not get paid
collective bargaining while on strike
● Workers receive ● Strike action disrupts
better pay than economic activity & can
non-unionised upset other people in the
workers economy
● Workers enjoy ● Individual workers may
better working not agree with specific
conditions than demands made by the
non-unionised trade union on behalf of
workers all the workers, & yet
● Workers enjoy they are pressured to
better non-wage support the collective
benefits such as action
guaranteed lunch ● Some union members
breaks continue to work through
 ● Workers receive a strike (they may need
specialised job the money) & receive
training & free legal abuse & intimidation
advice from the from the other striking
union union members

Pros & Cons of Trade Unions For Firms

Pros Cons

● Training from the trade union ● Including unions in

increases worker productivity decision-making increases the
which decreases costs time period taken to implement
● Empowerment in the changes which can be
workplace improves employee detrimental to effective
motivation, which usually competition
results in fewer sick days, ● Management styles have to be
higher productivity & greater more inclusive & less
output for the firm authoritarian which some
managers find difficult to
accept
● Meeting union demands
increases costs of production,
which may reduce output &
profits

Pros & Cons of Trade Unions For Governments/Economy

Pro con
● Trade unions help create a more ● Industrial action reduces output,
equal & prosperous society lowers firms’ profits, thereby
● A prosperous society is the basis lowering the potential corporation
of strong consumption in an tax collected by the government
economy & this helps to drive ● Strike action is often very
economic growth disruptive to many people’s lives,
● If firms’ profits increase due to especially when it occurs in
increased productivity, essential industries such as rail
governments receive more networks
corporation tax ● Governments may find it harder
● Higher wages mean that the to attract multinational
workers pay more income tax to corporations (MNCs) to invest if
the government, which can be industrial action occurs regularly
used to further fund public & ● MNCs may be more reluctant to
merit goods invest in strongly unionised
economies as the costs of
production will be higher