IGCSE AND GCSE Economics Units 1 and 2 Notes - markets and the allocation of resources.

by venky1998 (student)

UNIT 1 – Basic Economic Problem: choice and the allocation of resources

1 – Define the nature of the economic problem (finite resources and unlimited wants)

The resources we have (land, labour, capital and enterprise) are in limited quantities

However, the needs and wants we have are unlimited in nature

This leads to a scarcity of resources

So, all goods and services demanded cannot be produced, so there arises the need for choice since resources can be used in alternative ways

2 – Define the factors of production (land, labour, capital and enterprise)

Land – all the natural resources used in the production process, such as soil, farmland, coal, oil etc.

Labour – all human contribution, both mental and physical, to the production process, such as miner, mason, carpenter, clerk, accountant etc.

Capital – all the man-made resources that go into the production process, such as machinery, tools, vehicles etc.

Enterprise – the risk-taking ability of an entrepreneur who brings al the other factors of production together to produce goods and services

3 – Define opportunity cost and analyse particular circumstances to illustrate the concept

Opportunity cost is the next-best alternative foregone when a choice is made

If one chooses to do ABC with a resource (s)he cannot do DEF with it

Time/money is scarce in day-to-day life

Buying an expensive pen may be your decision, but you, in the process, might have sacrificed the opportunity to buy the MP3 player you always wanted, because money is a scarce resource, and we need to make a choice about how we need to spend it

Opportunity cost is always there whenever an economic decision/choice is made

4 – Demonstrate how production possibility curves can be used to illustrate choice and resource allocation

A, B and C are points on the PPC which show the different possible combinations in which Product A and product B can be produced simultaneously by the resources currently present in the economy

X is a point inside the curve and it shows a sate in which there is inefficiency in the economy since it is not operating at its maximum production potential (on the curve)

Y is a point outside the curve and it shows a point currently unachievable (with the current state of resources in the economy)

The PPC can be shifted outwards when economic growth takes place, due to technological advancements or an increase in the quality or quantity of resources in the economy

Once it has shifted outwards, the point Y becomes achievable (and thus the total output of the economy increases, the reason for economic growth)

If an economy decides to move from point A to point B, an opportunity cost is involved

While more of Product B is being produced the economy is ‘sacrificing’ the opportunity to produce some units of Product A, the opportunity cost

Thus, the PPC is also sometimes called an opportunity cost curve

5 – Evaluate the implications of particular courses of action in terms of opportunity cost

Look at it from these perspectives –

Individual

Producer

Government

An individual A might decide to purchase a car, but the opportunity cost to this decision could be the long holiday with his family that he had been wanting for quite some while now

A jam producer might decide to move a few of its resources from producing apricot jam to the production of mixed fruit jam, in which case, while the output of mixed fruit jam will increase, the opportunity cost will be the loss in the production of apricot jam

A government might decide to move some of its revenue from subsidising university students to healthcare, in which case, the healthcare facilities will probably become better, but the opportunity cost to the government of this choice will be the loss in subsidy to university students

UNIT 2 – The allocation of resources: how the market work; market failure

1 – Describe the allocation of resources in market and mixed economic systems

There are three questions which every economy needs to answer –

What to produce?

How to produce?

For whom to produce?

In a market economic system, goods and services are freely exchanged

The three questions are answered by the buyers and sellers when they trade in different goods and services

All the resources are privately owned by firms or people

All these private firms aim for profit

What to produce – Since firms aim to make profits, they will move the scarce resources from the production of goods and services which consumers do not demand, into the production of those goods and services which they do demand

Therefore, only those goods and services will be produced which are demanded for by the consumer.

How to produce – Goods and services will be produced in the cheapest possible method, either labour-intensive (in countries with large populations) or capital intensive (in countries where capital is easily available)

For whom to produce – Goods and services will be produced for those who can afford to pay for them

In a mixed economic system, there are two sectors – the private sector, consisting of privately owned firms (as in a pure market system), and the public sector which is run by the government

The private sector looks to make the greatest possible profits while the public sector utilises the scarce resources to benefit society in general

Resources are owned both by the government and by private individuals and organisations

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2 – Demonstrate the principle of equilibrium price and analyse such changes to show effects in the market

Equilibrium price is the price level at which the market is cleared

This means that the quantity supplied is equal to and satisfies the quantity demanded

Thus, there is no surplus demand or supply (no consumers unsatisfied and no extra goods in warehouses)

This can be shown on a demand and supply graph, since where these two graphs meet is the equilibrium price and equilibrium quantity

When this condition is not met, the market is said to be in disequilibrium, ...

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2 – Demonstrate the principle of equilibrium price and analyse such changes to show effects in the market

Equilibrium price is the price level at which the market is cleared

This means that the quantity supplied is equal to and satisfies the quantity demanded

Thus, there is no surplus demand or supply (no consumers unsatisfied and no extra goods in warehouses)

This can be shown on a demand and supply graph, since where these two graphs meet is the equilibrium price and equilibrium quantity

When this condition is not met, the market is said to be in disequilibrium, however, eventually the market will move back into equilibrium

If the price is set above the equilibrium price, producers will supply more than what the consumers demand and to clear their stock, producers will be forced to lower their price, and thus move the market back into equilibrium

If the price is set below the equilibrium price, the consumers will deman d more than the producers are willing to supply, so producers will raise the price of the product, in hope for a greater profit margin, and the market will eventually move back into equilibrium.

An extension in demand refers to the way in which demand changes with a fall in price, with no change in any other factor that could affect demand (ceteris paribus – all other factors constant)

A contraction in demand refers to the way in which demand changes with an increase in price, ceteris paribus

An extension in supply refers to the way in which supply changes with a rise in price, with no change in any other factor that could affect supply (ceteris paribus – all other factors constant)

A contraction in supply refers to the way in which supply changes with a decrease in price, ceteris paribus

An increase in demand means that consumers now demand more of a product at each and every price than they did before

A fall in demand means that consumers now demand less of a product at each and every price than they did before

An increase in demand is shown by a rightward shift in the demand curve and causes the equilibrium price as well as the equilibrium quantity to rise, given that supply stays the same

A fall in demand is shown by a leftward shift in the demand curve and causes the equilibrium price as well as equilibrium quantity to fall, given that supply stays the same

An increase in supply means that producers are now more willing and able to supply a product than they were before at all possible prices

A fall in supply means that producers are now less willing and able to supply a product than they were before at all possible prices

An increase in supply is shown by a rightward shift in the supply curve and causes the equilibrium price to decrease, but the equilibrium quantity to rise, given that demand stays the same

A decrease in supply is shown by a leftward shift in the supply curve and causes the equilibrium price to rise, but the equilibrium quantity to fall, given that demand stays the same

3 – Describe the causes of change in demand and supply conditions and analyse such changes to show effects in the market

Demand shifts are caused due to various reasons

1. Changes in consumers’ incomes – A rise in incomes will cause an increase in demand whereas a fall in incomes will cause the demand to fall. The precise nature of the relationship between incomes and demand will depend upon the product considered and the levels of consumer income spent on the product. A rise in incomes might not increase a demand for necessities such as salt or a cheap product such as newspapers. However, it will cause an increase in the demand for products such as air travel or taxis. Moreover, some goods are inferior in nature, which means that as incomes go up, the demand for these goods decreases. For example, as incomes increase the demand for matchsticks might decrease as more people are now able to afford the more expensive option, which is, a lighter.

2. Changes in taxes on incomes – Disposable income refer to the amount of income a consumer has left to spend or save after taxes have been deducted from it. An increase in taxation rates will mean people have less disposable income, so the demand will fall. A decrease in taxation rates means higher disposable incomes, and thus a greater demand.

3. The price and availability of other goods and services – Some goods are complementary in nature since they are in joint demand, that is, to gain utility out of one of them, the other is required as well. For example, car and petrol or bread and butter. If the price of a complement of a product falls, the demand for the complement will rise, and this in turn, will cause the demand for the actual good to rise as well. Some goods are said to be substitutes, since the purchase of one can replace the want for the other good or service, in other words, they give the same utility to consumers. For example, butter is a close substitute of margarine, and the same can be said for tea and coffee. If the price of the substitute of a good falls, the demand for the substitute will rise, and this in turn, will cause the demand for the actual good to fall, as consumers who previously bought the actual good will switch over to the substitute, since it is available to them cheaper, and yet, serves the same purpose as the actual good.

4. Changes in tastes, habits and fashions – Consumer tastes and fashion keep changing, since they may get bored of the old products, and demand for newer, more innovative products. For example, clothing fashion changes in a small period of time, and so does hairstyle fashions and so on. A successful advertising campaign may also increase the demand for the advertised good and shift its demand outwards.

5. Population Changes – An increase in population will increase the demand for almost all goods and services since the consumer base of the economy is increasing (so market or aggregate demand is increasing). Change in the structure of the population will also change demand of certain goods and services. For example, if the Birth Rate increases and there are more young infants the demand for formula milk, diapers, nappies etc. will increase, while at the same time, if the elderly population increases, the demand for walking sticks, healthcare, spectacles etc. will increase.

6. Other factors such as weather (more demand for ice creams in the summer, woollen clothes in the winter), advertising etc. to name a few.

There are various factors that affect supply as well

1. Changes in the cost of factors of production – This is the biggest determinant of supply since it includes wages for labour, rent for land, interest for capital and so on. A rise in the cost of production will cause the profit margins of the business to decrease, causing a decrease in profits for the company. For example, the labourers could demand a higher wage, or the raw materials could become more expensive. Producers in such a situation will tend to cut back their spending on labour and raw materials, and thus will be less willing to supply as much of the particular product as they did previously. Taxes and subsidies by the government can also increase or decrease the cost of production, and thus affect supply.

2. Changes in the price of other goods and services – Price acts as a signal for producers to move their factors of production to and from production of different goods and services. In a free market, resources will be allocated to the production of those goods and services which are the most profitable to produce. So, if the price of a product falls, profits reduce, and producers move their resources from producing this good (thus, causing a fall in supply) to other, more profitable goods (thus, causing an increase in supply).

3. Technological advancements – This could mean improvement in the performance of machines, labour force or better production methods, better management, quality control etc. Technological advancements, generally, reduce the cost of production of goods and services, and thus producers become more willing to produce larger quantities of such goods and services. Moreover, with technological advancements, efficiency increases, and thus the output increases, increasing supply of the good.

4. Business optimism and expectations – If producers fear that an economic downturn might be around the bend, they will move their resources to the production of those goods and services which they believe are going to be least affected by the recession. For example, expensive cars and holidays often fare badly during recessions whereas necessities such as bread and butter do not get affected by much. However, if an economy is recovering, producers will move their resources into new markets, such as cars, theme parks and so on, causing an increase in supply for these goods and services.

5. Global factors such as sudden climatic changes, trade sanctions, wars, political instability, natural disasters etc. can all affect supply.

4 – Define price elasticity of demand and supply and perform simple calculations

PED is the responsiveness of demand to a change in price of a particular good or service.

PES is the responsiveness of supply to a change in the price of a particular good or service.

PED and PES can be perfectly inelastic (PED = 0), perfectly elastic (infinity), relatively inelastic (<1), relatively elastic (>1), or unitary elastic (1)

PED – PES –

5 – Demonstrate the usefulness of price elasticity in particular situations, such as in relation to revenue changes, consumer expenditure

There are various factors that affect PED

1. The number of substitutes – If there are many substitutes for a certain product, the demand for it is likely to be price elastic, since with even a small change in price, many consumers will prefer to purchase one of the other substitutes (and thus, there is big fall in quantity demanded). If there are not many substitutes, the demand is likely to be price inelastic.

2. The period of time – If the price of a good or service increases, consumers will start searching for cheaper substitutes. The longer the time they have, the more likely they are to find such substitutes. Thus, while in the short run demand for most products will be price inelastic, in the long run, demand will become price elastic in most cases.

3. The proportion of income spent on the good or service – Goods which cost very little, and form a small part of consumer expenditure, will be likely to have an inelastic demand since even if the price does rise by a large amount, it will only take a little bit extra out of a consumer's income, and thus the quantity demanded will fall only by a small margin. At the same time, if a product is very costly, it will have an elastic demand, since even a small rise in price will mean that consumers will have to spend a lot more, and thus they may cut their demand (so, quantity demanded falls by a lot)

There are various factors that affect PES

1. Time – The supply at any one moment will be fixed since it takes time for producers to increase their production and procur the required raw materials, labour etcetera. In this case, the supply will be a straight vertical line, showing it is perfectly inelastic. In the short run, the supply can be increased by some amount by employing more labour or by allowing overtime work. This will only increase the supply slightly since other factors such as capital and land are fixed in the short run, and thus will limit the increase in supply. The supply in this case will be relatively inelastic. In the long run, firms can obtain more of all factors of production and thus increase supply greatly (price elastic)

2. The availability of resources – A firm wishing to expand its output needs to employ more of the factors of production, such as land, labour and enterprise. If an economy is already operating at its peak efficiency and no resources are unemployed, firms will find it hard to increase their output. Thus, the supply of most goods and services in such an economy will be price inelastic. However, if there is widespresd unemployment of resources such as land or labour, firms can easily employ more factors of production and increase their output, making supply of most products in such an economy price elastic.

Effect of PED on total revenue – For a product with inelastic demand, an increase in price will cause a much smaller decrease in quanity demanded. Total revenue is the price times the quantity, so the total ervenue will increase. For a product with elastic demand, with an increase in price there will be a much larger decrease in quantity demanded. Once again, since total revenue is price into quantity, the total revenue of the firm will fall. Thus, with the knowledge of the PED of the products they sell, firms can decide whether to raise or reduce their prices. If the product they sell has an inelastic demand, they should probably increase the price, whereas if the demand is price elastic, they should reduce the price as far as possible.

Effect of PED on consumer expenditure – Same effect as total revenue since consumer expenditure too is price into quantity. For example, if an individual purchases 20 bars of Mars chocolate at SGD 2.00 each, his/her expenditure will be 20 x 2 = SGD 40

6 – Evaluate the merits of the market system

There are many adavantages to the free market system

1. The free market system encourages comepetition and thus, many firms operate at the same time trying to fulfil consumer wants and gaining a profit at the same time. With more firms, producing varying products, consumers have a wide variety of goods and services to choose from to meet their demands. The quality if these goods and services will also be very good since firms know that if they compromise on the quality of their product, consumers will simply move to their competitors, and they will be left without any business.

2. All firms in the market are trying to make profits and thus they will all try and get a wider consumer base than the other competitors. To do this, firms will try and sell their product at the cheapest possible price and thus, gain consumer support and create a brand name. A firm knows that if it charges too highly, the consumers will not but their products and instead move over to their competitors products, leaving them without any business.

3. Firms are all looking to maximise profits, so they will not only try and increase revenue, but also decrease costs as far as possible. To do so, they will use the most cost-effective method of production, with more machinery and newer technology, thus resources get used to the fullest. In other words, the immense competition in a free market economy ensures maximum efficiency and productivity.

4. A free market responds quickly to consumer's wants and demands since it is completely controlled by the market forces of demand and supply. A high demand for a certain good or service, increases its price, which is a signal for producers to move their scarce resources into the production of this good, increasing supply, and thus meeting the demands of the consumers.

7 – Describe the concept of market failure and explain the reasons for its occurrence

Market failure takes place when the allocation of resources by a free market economy is not efficient, that is, an economy is not operating at Pareto optimal, and there is some amount of allocative inefficiency. The community surplus is not maximisesd, and from societal point-of-view producer surplus is not equal to community surplus.

There are various ways in which market failure can take place

1. Can lead to widespread unemployment – Since profit is the man aim of firms in a market economy, they will only employ factors of production if it is profitable to do so. If a profitable use cannot be found, the factor of production will be unemployed. Labour is just another factor of production, so if, a firm decides that some labour is not required or that capital-intensive technology is more profitable, they will make labour redundant. This can cause widespread unemployment in the economy. Widespread unemployment in an economy can mean that more people are living in relative or absolute poverty, so the disparity in income between the upper classes and the less well-to-do is increases, another sign of market failure.

2. The free market can fail to provide certain goods and services – Certain goods, such as public goods, may not be provided by the firms in a free market since these goods are enjoyed by all, but no one is ready to pay for them, such as street lighting, defence, army etcetera. Since it is not profitable to produce suchgoods the firms in a free market will not.

3. The free market can tend to under-produce certain important products – Merit goods are those which provide positive externalities such as healthcare and education. Such goods have to be produces in bulk, since everyone should have acess to them, but the profit motive of firms may mean that they do not produce such goods altogether or they produce in such little quantities, that the price of them are so high, that the less well-to-do cannot afford them. However, this is wrong since everyone should have access to such goods.

4. The free market may encourage the consumption of harmful goods – Demerit goods are those which produce negative externalities when consumed such as drugs. Thus, they should either be banned or their production and consumption restricted. Some consumers may, however, wish to purchase such goods and have the ability to pay for them, and firms in the free market will supply them since it is profitable to do so. Such drugs ar eharmful not only for the consumer, but also for society in general.

5. The social effects of production may be ignored – Since private firms have the main aim of making profits they only look at the private costs and benefits. Many a times, the social costs are neglected. The main social cost of production is pollution – air pollution as well as noise pollution. Air pollution can cause problems such as respiratory ailness for members of society and also destroy the natural environment, while noise pollution can be quite irritating.

6. The market system allcates more goods and services to those consumers who have more money than others – The upper classes, who have more money, will demand for more goods and services than those less well-to-do, and will have the ability to pay for them (money). While for them there is a wide variety of choice, the unemployed or the elderly will have much less freedom of choice, since firms will not produce for those who are poor, and incur loss on such production.

7. Formation of natural monopolies – Markets may be unable to control a monopoly from abusing its powers. If a producer manages to become the biggest or perhaps, the only producer in the entire industry, it becomes a monopoly. A monopoly can charge consumers exorbitant prices since it is, after all, the only producer and there is no competition to worry about. It can also ensure that no newcomers enter the industry by undercutting them, that is, charging prices that are lower than what the new firm can hope to charge, and then, once the firm has exited the market, hiking prices greatly once again. Monopolies, due to the lack of competition, have no incentive to be efficient, and thus, allocatie and productive ineffiency will exist in a monopoly, another big sign of a market failure.

8. Information asymmetry – This occurs when one party in a transaction has more or better information than the other. Such a situation can create an imbalance in power between the parties in a transaction causing transactions to go awry, a market failure in its worst form.

8 – Define private and social costs and benefits, and discuss conflicts of interest in relation to these costs and benefits in the short term and long term through studies of the following issues: conserving resources versus using resources; public expenditure versus private expenditure

Private Costs – The costs of setting up and running a business as well as the costs to the consumers of purchasing goods and services to satisfy wants

Private Benefits – The monetary benefits (such as profits) for firms when they sell their products, and the benefits a consumer gets from purchasing goods and services

External Costs – The costs that the external stakeholders (society, in general) have to bear due to the firm’s activity

External Benefits – The benefits to the external stakeholders (society, in general) due to the activity of firm

Social Costs – The total cost paid for by the society due to the activities of a firm

Social Benefits – The total benefit arising due to the production of goods and services by a firm

Social Costs = Private Costs + Social Costs

Social Benefits = Private Benefits + Social Benefits

If the social costs of an economic activity are greater than the social benefits, then the activity is harming society more than benefiting it. On the other hand, if the social benefits are greater than the social costs, the economic activity is benefiting society, and should go on to do so.