Econ unit 1

2.7. Factors influencing price elasticity

- Close substitutes If there are close, reasonably priced substitutes available on the market, the demand for a product will be more price elastic than if no substitutes exist. This is because if the price of a product rises, consumers can change to a substitute and their reaction to the price change will be more than proportionate. If the price of petrol rises, some people may go to work via public transport rather than by car. Or consumers may switch between different brands of the same product, say from one brand of coffee to another. If no close substitutes exist, customers may be forced to continue buying the original product when its price rises and so their demand is more price inelastic. Two examples are popcorn in a cinema and bottled water in a railway station. Both products have substitutes in the market as a whole but not for customers in the particular locations as there are no accessible alternative suppliers. - Proportion of income If the proportion of income spent on the product is high, for example buying a car, the demand is likely to be more price elastic. If the price of a product rises, this makes a big difference to personal budgets and consumers are more likely to look for substitutes or buy a lot less. But if the money spent on the product takes up a relatively small part of someone's incomes, say salt, the demand will be more price inelastic as a rise in price equates to only a small amount of money. - Necessity or luxury The extent to which a product is seen to be essential (or not) is also important. If people think that a product is a luxury, such as a dishwasher, the demand will be relatively elastic as they can do without it. But if it is seen as a necessity, such as soap, they will have to buy it even if the price rises and the demand will be relatively inelastic. A product that is addictive, like cigarettes, is seen as a necessity by those who use it and the demand is relatively inelastic. This explains why many people continue to smoke even when the price of tobacco rises significantly. - Time Demand for most products will tend to be more elastic the longer the period of time considered. This is because it takes some time for people to become aware of price changes and to adjust their purchases. It is also because people develop shopping habits and brand loyalties that are slow to change. If the purchase of a product can be postponed, such as a new kitchen, the demand is relatively elastic and a price rise would cause many people to put off buying one until a future time. We looked at the above factors separately but in practice they all act together to determine the price elasticity for any particular product.

1. Which of the following would cause the demand curve for a product to shift to the right? 2. Which types of products have negative cross elasticity of demand? 3. A product rises in price and total revenue received from selling the product remains unchanged. What would this indicate?

1. A shift to the right of a demand curve indicates an increase in demand. If a complementary product becomes cheaper, demand for it would extend and demand for the product that goes with it would increase 2. A rise in the price of one product will cause demand for that product to contract and demand for its complement to decrease. This gives negative XED 3. If demand and price change by the same percentage, as is the case with unit elasticity of demand, total revenue will stay the same.

5.2. Command economies

A command economy (also known as a planned economy) is one where all resources are owned and controlled by the state. The government makes all the decisions on what should be produced and therefore what can be consumed. It draws up long-term plans and sets targets for production such as how many tons of steel must be produced over the next five years. In the Communist states of the past, such as the Soviet Union, the government gave greater importance to the production of capital goods, such as those supplied to the armed forces, rather than consumer goods, such as television sets or cars.

3.1. Advantages of the division of labour

A firm uses division of labour if it believes that it is a practice that will lower its average costs (total costs divided by output). It will do this for one of four main reasons: It saves time. It makes better use of workers' skills. It saves tools and equipment. Parts of the production process can be mechanised. It can save time in two ways. New workers can be trained quickly if there is only one task to learn, and workers will spend less time moving about from one task to another. It also makes better use of a worker's skills as workers can use skills on a job for which they are best suited. In addition, workers performing one task regularly will become more skillful at it.

5.5. The role of the state in a mixed economy

A mixed economy is one in which there is both a public and a private sector. Some forms of production are owned and operated by the state, while others are owned and operated by individuals or groups of individuals. Resources are allocated by means of the price mechanism but government decisions are made on top of this. The government intervenes in a mixed economy to correct market failure and on the grounds of equity or fairness. For instance, it may seek to promote competitive pressure in markets in order to prevent firms exploiting market power by pushing up prices. Many governments also think that everyone should have access to basic necessities and that income should not be too unevenly distributed. In a pure market economy, those people whose labour services are in high demand would earn very high wages while those who are unable to work or whose services are not in demand would receive no income. But in a mixed economy the government provides financial support for vulnerable groups which is financed by tax revenue. Providing cash benefits for those on lower incomes while taxing those on higher incomes helps to make income more evenly distributed. The UK government also supplies state education and health care free to users because it believes that these are vital services that should be available to all. These are known as merit goods. The extent to which a government intervenes depends on the degree to which the market is failing and on the extent to which the outcome of free-market forces is seen to be unfair. This in turn depends on the political views of a country's government over the years. It is a matter of balance between the private and public sectors. For example, government spending in the UK in 2013/14 was around 41.2% of gross domestic product (that is, the total amount produced by the country). This figure changes over time and also differs between countries. As there are no pure examples of command or market economies, all economies are really mixed economies. In recent years there has been an increase in the relative size of the private sector and a decline in state intervention, not only in the former planned economies but also in the 'western' or more market-oriented economies. However, the state still has a large and important role to play, as the UK statistic quoted above shows. In the UK the public sector is responsible for the provision of health, education and transport services, infrastructure investment, the provision of law and order and defence and many other services, some of which are provided at local level.

5. Different types of economy

As resources are limited, an economy has to decide what it will produce with them. As we saw earlier, it may decide to allocate most of its resources to producing consumer products and only a small proportion to producing capital goods. Or it may decide the opposite or it might choose from an infinite variety of possible combinations between these two extremes. An economy also has to decide how to make the products (the methods of production) and who is to receive the products produced (the distribution of income). The question is this: Who makes the economic decisions? The answer is that there are various ways in which an economy can organise itself in order to make these decisions. In a market economy it is the consumers who play the key role in determining what products are produced. In a command economy it is the government which owns the resources, apart from labour, and makes the economic decisions. Today, very few economies are command economies, although North Korea is an example of one. Although in the last four decades the relative importance of the market has increased, all economies are really mixed economies, which combine elements of both market and command economies. In mixed economies, decisions are made both by consumers and by government, the balance being different in different countries. Economic philosophers have written much about these different economic systems. Adam Smith, in his book The Wealth of Nations, wrote in favour of free markets. He said that the individual buying and selling decisions made by many people become collective economic decisions. He called this the 'invisible hand' of the market and believed that this ensures that firms produce and sell the goods and services that people want to buy. He was not in favour of government intervention in free markets. Karl Marx disagreed in his books (The Communist Manifesto and Das Kapital) written between 1848 and 1894. He thought that a free-market, or capitalist, system leads to exploitation of the working classes. He said that the owners of firms pay their workers less than the value they create. As firms grow larger, they exploit even more and he predicted that the struggle that results will lead to the collapse of capitalism. Friedrich Hayek defended capitalism. Writing over a long period between the 1920s and 1950s, he argued against government intervention, believing that the economy works more efficiently when people are free to choose.

The role of value judgements

As we have seen, economic relationships are not always clear and there is a limited number of positive statements. But humans have to make economic decisions: Individuals have to decide how many hours to work, what to spend their money on and how much to save for the future. Firms have to decide what and how much to produce, what price to charge for their products and how much to invest in new equipment. Governments have to decide how much they can raise in taxes and what they should spend it on. All these decisions are based on the understanding of economic concepts and relationships of the positive factual knowledge which exists. But humans also base their decisions on value judgements - on normative factors. Even though smoking is expensive and bad for health, some people still do it because they like it or because it is a habit they find hard to quit. Governments choose whether to spend more or less on a particular public service according to their political beliefs such as education, health or defence. Such decisions are based on value judgements and not necessarily on hard facts or robust research.

5.1.1. The role of the price mechanism

Changes in price affect the allocation of resources in a number of ways. Prices act as a signal, alerting producers to changes in the pattern of demand. High prices that lead to high profits also act as an incentive, encouraging producers to make those products which are in high demand. In addition to gaining high profits, firms are encouraged to use the most cost-efficient methods of production, and in order to gain the ability to buy a large quantity of goods and services, workers are encouraged to move to jobs offering high wages (high prices of labour). In other words, the price mechanism deals with scarcity by rationing goods and services via their prices.

Summary of Demand

Changes in price cause movements along the demand curve. Changes in other factors than price cause shifts in the demand curve. Price elasticity of demand measures the responsiveness of demand for a product to a change in its price. Price elasticity of demand influences the effects of a price change on a firm's total revenue. Income elasticity of demand measures the responsiveness of demand to a change in income. Cross elasticity of demand measures the responsiveness of the demand for one product is to a change in the price of another product.

Identify possible opportunity costs to Cuban citizens of the opening up of public services to the private sector.

Citizens may lose their free access to these services and may have to begin to pay for them so the opportunity cost is other goods and services which they will have to give up in order to pay for education and health.

2.10. Complements

Complements are separate products that are used together. Examples are cars and petrol or MP3 players and downloads. They have negative cross elasticity of demand. This is because a rise in the price of one product causes a decrease in the demand for that product and therefore also for the complement. A fall in the price of one product would cause a rise in demand for that product and therefore a rise in the demand for the complement. So, if there is a rise in the price of cars, the demand for cars would fall and so would the demand for petrol. If the price of cars rises by 6% and the demand for petrol falls by 0.5%, demand would be relatively cross inelastic: XED=−5% / 6%=−0.08 If the price of MP3 players falls by 10% and demand for downloads increases by 12%, demand is relatively cross elastic: XED=12% / −10%=−1.2 So a negative XED indicates that the two products are complements. A fall in the price of tea cups from P to P1 causes an increase in demand for saucers from Q to Q1. To measure the cross elasticity we need to know the proportions of the changes or we could compare the rectangles. Note that many of the relationships between complementary goods work in only one direction. For example, a change in the price of cars will affect the demand for petrol but it's less likely that a change in the price of petrol will affect demand for cars, in the short run at least. However, a sustained rise in petrol prices would cause many customers to purchase cars with more economical engines.

Cross elasticity of demand

Cross elasticity of demand (XED also known as XPEOD) measures the degree of responsiveness of the quantity demanded of one product to a change in price of another product. The formula for cross elasticity of demand is: XED=% change in quantity demanded for one product / % change in the price of another product=%ΔQD of product A / %ΔP of product B If a change in the price of one good provokes a more than proportionate reaction in the demand for another good, the demand is relatively cross elastic. If not, it is cross inelastic. Cross elasticity of demand may be negative or positive, depending on the relationship between the products. These relationships can be classified as substitutes, complements and unrelated goods.

Demand curves

Demand curves are often drawn as straight lines. Extending the demand curve until it touches the vertical axis will show when the item will price itself out of the market. Extending it to the horizontal axis shows how much could be given away free. (In practice the demand curve might never touch the horizontal axis as there could be unlimited demand for a free product.)

3.3. Disadvantages of the division of labour

Division of labour has its limitations, however, and several criticisms are made of it. Although the quantity of production may be increased, the quality may fall as workers become bored if they repeat the same task many times. This can be exacerbated if workers are paid according to the number of units they produce, as they will rush their work to produce more. This can all lead to errors and faulty products. As a result, quality supervisors may have to be employed to check their work, and this will increase a firm's costs. In addition, if each worker concentrates on one task, a skill in a different task may not be discovered. In recent decades, several firms have found that the output and the performance of their staff have improved when they have moved away from specialisation. Several offices have been reorganised so that staff deal with a complete order rather than just part of an order. The increased job satisfaction, involvement and knowledge they gain may well result in them doing a better job. A number of manufacturing firms have reorganised their production lines so that a small team of workers makes the whole product from start to finish. The workers take more pride in their work and make fewer mistakes, it is claimed.

3. Division of labour

Division of labour, as its name suggests, is concerned with workers specialising in a particular area of work or a specific job. Traditionally, this phrase was used to describe the way that manufacturing industry breaks down the production of a physical good into small tasks and assigns each task to a different worker or team of workers. This still applies today but the term can also be used to refer to the breakdown of work in a service sector, such as a hotel employing different staff for its various departments like reception, accounts, restaurant, cleaning, etc. The economist Adam Smith famously described the process of division of labour in his book The Wealth of Nations, published in 1776, as follows: The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity and judgement with which it is anywhere directed or applied seem to have been the effects of the division of labour. He described how the division of labour works by using the example of the trade of the pin-maker. He described how the making of pins can be divided up into around ten distinct operations and he concluded that, using this method, each worker could produce 4800 pins in a day. But if one man had to make complete pins from start to finish, Smith believed he could make no more than 20 in a day.

Inability to carry out scientific experiments

Economics is a social science because it seeks to gather knowledge about, to explain and to predict human behaviour in the economic sphere - in the production, distribution and consumption of goods and services. Because it is a science, it is the subject of much research. Some research is quantitative - it deals in numbers such as the number of people unemployed in a country. Some is qualitative - it deals in concepts that cannot be quantified such as people's opinions about their standard of living. In order to do this research, economists need information. The Office for National Statistics (ONS), government departments and many other organisations collect a wealth of data on all aspects of economic life. Companies also do research into their markets and academic economists carry out research programmes into areas which interest them. This data is processed mathematically and statistical relationships are established such as averages, indices, correlations, trends over time and probabilities. These statistics are used to explain the past and present and predict the future. However, economic data has to be used carefully. Human behaviour is being studied but it is not possible to put people into a laboratory and watch them while they behave. They must be studied in their natural environment but this is complex. As we said above, many different factors can explain a trend and it can be difficult to separate them or isolate one of them. In addition, people do not always behave in the same way, usually because circumstances have changed - and it is not always easy to identify these circumstances. Economic theory assumes that people behave rationally and always plan to spend their money to get the most satisfaction out of it. But in practice, people make irrational decisions and some make impulse purchases. The impossibility of carrying out controlled experiments in carefully controlled conditions means that different economists come to different conclusions. They therefore make different predictions and suggest different solutions. So you will find some economists who believe that interest rates should be reduced and others who believe that they should be increased. They cannot all be right but it is not possible to judge who won the argument until after the event and even then there is scope for disagreement. It is important for you to bear all of this in mind when studying economic concepts and you should always qualify your conclusions. But actually economic science does teach us a lot. There are a number of generally accepted theories and relationships and these help us to build up a picture of the overall economic world. Studying this course will give you a good insight into this world.

2.6. Price elasticity of demand

Elasticity of demand is an important concept for economists, business people and politicians who need to know the extent to which quantity demanded is likely to change as a result of a change in price, income or the prices of other goods. It is a concept that has many practical applications. Price elasticity of demand (PED or sometimes known as PEOD) measures the degree of responsiveness of the quantity demanded of a product to a change in price of that product. We expect that, in most cases, a rise in price will cause the quantity demanded to fall and that a fall in price will cause the quantity demanded to rise. But we need to know by how much the quantity will change in each case. Price elasticity of demand measures whether the change in quantity demanded is in proportion to the price change, whether it is disproportionately large or whether it is disproportionately small. Since we need to measure and compare proportions, we use percentage changes. To measure PED we compare the percentage change in price with the percentage change of quantity demanded which follows it. The formula is as follows: PED=% change in quantity demanded divided by % change in price=%ΔQD / %ΔP PED=% change in quantity demanded% change in price=%ΔQD%ΔP (Note that the symbol ∆ (uppercase delta) means change, QD means quantity demanded and P means price) If the price of an electric kettle fell from £20 to £15, the percentage change in price would be the change in price divided by the original price and multiplied by 100. %ΔP=−5 / 20×100=−25%%ΔP=−520×100=−25% If, as a result of the above change in price, demand for the kettle expanded from 60 to 90, the percentage change in demand would be the change in demand divided by the original demand and multiplied by 100. %ΔQD=30 / 60×100=50%%ΔQD=3060×100=50% In this case PED would be as follows: %ΔQD / %ΔP=50 / −25=−2%ΔQD%ΔP=50−25=−2 This figure is known as the coefficient of price elasticity of demand. The meaning of the figure given by the coefficient is explained below. PED is usually negative as, for most products, demand and price vary inversely.

5.1. Market economies

In a market economy the private sector decides which products are to be made. The factors of production (land, labour, capital and enterprise) are owned by individuals, small businesses and large business such as public limited companies. In a completely free-market economy, there would be no government interference and consumers would - at least in theory - be the sole determiners of what is produced. In practice, producers influence consumers' decisions by their advertising and marketing campaigns. This is still free-market activity since the government is not involved although firms do have to comply with the regulations on advertising. Consumers express their preferences by being willing to pay more for those products that are becoming more popular and less for those that are declining in popularity. As producers see the prices of some products rising while others are declining in relative terms, they switch some of their resources to making the popular products and use fewer resources to make the less popular ones. (This does not always happen immediately as there can be bottlenecks in supply.) People who are in control of those resources that are in high demand, such as workers with special skills or directors of factories producing popular products, will receive higher incomes and will be able to buy more themselves.

Renewable and non-renewable resources

In considering the use of resources, economists distinguish between renewable and non-renewable resources. Renewable resources are natural resources that are capable of being used and replaced. Trees can be cut down and made into furniture, and at the same time new trees can be planted to become wood in some years' time. Non-renewable resources, such as fossil fuels and minerals, are not replaced when they are used. When hydrocarbon oil is refined into petrol and used to power vehicles, oil supplies are reduced and eventually depleted. If economic growth is based on the use of non-renewable resources, it is unlikely to be sustainable. The ability of future generations to drive cars and use oil-powered heating will be threatened if the world supplies of oil are depleted too quickly now. Some renewable resources may also be put at risk if they are over-exploited and they may indeed be turned into non-renewable resources. For example, if too many cod are caught, there will not be a sufficient number to reproduce and maintain stocks. Some renewable resources are more sustainable than others. Solar power can be used extensively and will still be regenerated. In contrast, if forests are cut down at a rapid rate, there may not be sufficient time to replant them.

2.11. Unrelated goods

In many cases there is no direct relationship between products. They are neither substitutes for each other nor complements. These are known as unrelated goods. For instance, there is unlikely to be any relationship between the demand for televisions and the price of cucumbers. So a rise in the price of cucumbers of 10% would not affect demand for televisions. The cross elasticity of demand would be zero: XED=0% / −10%=0 To illustrate this, Figure 3.17 shows that a fall in the price of cat food from P to P1 has no effect on the demand for leather coats, which remains at Q. I I I----I I----I -----I------------ In practice, a change in the price of one product may affect demand for a wide variety of other products, many of which may appear to be unrelated. This is because a change in the price of one product will affect consumers' ability to buy other products. For instance, if the price of car insurance increases, car drivers will have less spare money and may reduce their expenditure on clothes, even though car insurance and clothes are not directly related products.

5.3.4. The disadvantages of a command economy

In practice, no group of bureaucrats can know what individuals would like to consume. Because there is no private enterprise, there is no incentive for firms to produce attractive and good-quality goods and services and consumers do not have much choice. Because wages and salaries are capped, there is little incentive for people to work harder or to be efficient.

5.3.2. The disavantages of a market economy

In practice, the price mechanism may not work in such an ideal way, and a number of disadvantages may be encountered: Advertising can distort consumer choice and create demand for products that consumers might not otherwise have wanted to buy. Persuasive advertising can create demand by encouraging consumers to buy goods that producers want to sell. Some producers may have considerable power and drive up prices. This is especially so in markets where competition is restricted because they are dominated by a few large firms. It may not be easy to switch certain resources from producing one product to another product. For instance, if workers have family ties, they may not be able to move from one part of the country to another to take up a new job. Income may become very unevenly distributed, with some people experiencing poverty and others being paid very high salaries and bonuses. Firms may concentrate on producing luxuries rather than necessities as the rich will have most say in what is produced. Some products may be over-produced, some under-produced and some not produced at all. Firms make products which they are willing to sell even if they have harmful effects on those consuming them, or on other people. Cigarettes are an example of this and are known as 'demerit goods'. Firms will not worry if people do not consume enough of a product that is good for them or good for society in general, such as health care or education. These are known as 'merit goods'. Private firms will also fail to make those products that people cannot pay for directly, such as law and order or defence, and these are known as 'public goods'. You will be studying these categories in Topics 7 and 8. The price mechanism does not take into account the effects of production and consumption on those not directly involved (third parties) or on society as a whole. These effects are called externalities or social costs and benefits. A firm generating the social cost of pollution may not compensate people living in the neighbourhood. You will be studying externalities in Section 3. There is a risk of unemployment as it is unlikely that a large number of individual and uncoordinated decisions will result in full employment.

5.4. Moving towards market economies

In the late 1980s and early 1990s a number of Eastern European countries, which were command economies, started to change their economic and political systems. Many industries have since been privatised, regulations reduced and the role of the price mechanism increased. This reduction in government intervention and the increased role of market forces is now being witnessed in some Asian and African countries too. India is currently carrying out a privatisation programme that involves selling off government-owned firms to the private sector. China is also undertaking a series of economic reforms, including the development of private rural enterprises, and is encouraging foreign firms to set up factories, offices and shops in the country (direct foreign investment). The move towards the market system occurred for a number of related reasons. State planning was not delivering the type, quantity and quality of products that people wanted. It proved difficult and time-consuming to gather accurate and up-to-date information. This resulted in unachievable and inappropriate targets being set for state-run firms. In seeking to achieve ambitious targets, firms often sacrificed quality and the environment. Problems were also experienced in coordinating inputs and outputs with the result that firms experienced shortages of raw materials. There was a lack of incentives with a resulting impact on effort and enterprise. Government officials also became concerned about the slow growth of their state-run economies and their lack of international competitiveness. At the same time, individual consumers did not have access to the range of goods and services they would have liked.

1. Economics as a social science Economic concepts and thought

In this course, you will be looking at the economic decisions made by individuals and by groups of individuals. These decisions are connected with the way people produce the goods and services we need and want, and with how they consume those goods and services. You will study how markets operate to allocate those resources and why it is that some people have access to more products than others. You will base your study on the concept that economics is the study of the allocation of limited resources between unlimited and competing wants. (This was first described by Professor Lionel Robbins in 1932.)

Summary to the nature of economics

In this topic you have been introduced to the meaning of economics and a number of important definitions, terms and concepts. The key points are as follows: Economics studies how scarce resources are allocated between competing human wants. Scarcity exists because wants exceed resources and this means people must make choices from among various alternatives. Opportunity cost is the cost of choice in terms of the alternative forgone.

Topic 2 - Production and specialisation

In this topic you will look at the amount and type of production a country can make and how specialisation can help to boost production. You will consider how economic decisions are taken in different types of economy.

1. Rational decision making

In this, and the first two topics of Section 2, you will see how prices are determined by the interaction of how much of a product people are prepared to buy (demand) and of how much they are prepared to sell (supply). Demand and supply are the result of decisions made by people on both sides of a market and we have to study those decisions. Economic theory makes an assumption here - that people behave rationally. This means that both consumers and producers take decisions to get the greatest benefit for themselves. Assuming this helps us to determine how people behave when prices change. Consumers have to decide how to spend their limited income and they have to choose between a wide range of goods and services. They will decide to buy some and to forgo others. In economics we say that consumers derive utility or satisfaction from buying and using a product. The more a product satisfies a need or gives pleasure or enjoyment, the more utility someone gets from it. So rational consumers make those choices that allow them to derive maximum utility. Producers too make decisions on what and how much to produce and sell. They too are assumed to behave rationally. This means that they do what is necessary so that they make as much profit as possible out of their business - we say that they aim to maximise profits. This assumes that rational behaviour enables us to come to conclusions about consumer and producer behaviour in markets. But in the real world people do not always behave rationally. Consumers often make impulse purchases and waste money on something that does not yield them much utility. And producers sometimes make bad business decisions - they may choose to make and sell a product because it is fashionable without doing enough market research. In what follows you are going to study demand and supply separately and then bring them together. When studying demand, be sure not to consider supply factors; and when studying supply, do not bring in demand factors.

1. Production possibility frontiers

Production possibility frontiers are a useful tool for economists. They can be used to illustrate and explain a number of concepts and events including scarcity, choice, opportunity cost and efficiency. A production possibility frontier is also called a production possibility curve, a production possibility boundary or an opportunity cost curve. It depicts the maximum amount of a wide range of combinations of two types of product that a country can produce from a fixed quantity of resources and existing technological knowledge. This is called the maximum productive potential. Note that it assumes that the country can produce only two types of product; this makes the model simple to understand and to work with. You will note that all the production possibility frontier curves in this topic are curved; your textbook shows both curved and straight-line curves. The shape of the curve is determined by the rate of the opportunity cost between the two products at different points, which depends in turn on the efficiency with which each product can be made (see the section that follows on efficiency). Figure 2.1 shows a production possibility frontier for a country that can produce goods and services. If a country devotes all its resources to producing physical goods such as cars, computers and tables, a maximum of quantity Y can be made. But if, alternatively, all resources are devoted to producing services, such as health, entertainment and banking, a maximum of quantity X can be made. When we draw a curve that connects the two maximums, that is of goods and of services, we have a 'frontier'. All the points on this frontier show the various alternative combinations that can be made if different proportions of the resources are devoted to the two types of product - if different mixes of goods and services are produced. For example, if the country produces at point W on the frontier, it means that Y1 amount of goods would be made and X1 amount of services. Alternatively, it may produce at point Z, which would give a lower quantity of goods, Y2, but a greater quantity of services, X2.

1.1.2. Choice and opportunity cost

Production possibility frontiers show that, because of scarcity, societies have to choose which combination of products they wish to produce. In Figure 2.5 a country can choose to produce at point A or point B but not both. Figure 2.5 If it is currently producing at its maximum level at point A, the country is making 80 million luxury goods and services and 30 million necessities. In order to increase its output of necessities to 60 million, it would have to switch 40 million worth of resources from making luxury goods and services to making necessities. The opportunity cost of producing the extra 30 million necessities is 40 million luxury goods and services. This is a case where marginal analysis can be used. We can work out how many units of X need to be sacrificed in order to produce one additional unit of Y, or vice versa. In the above example, since 30 million necessities cost 40 million luxuries, the marginal cost of producing one more necessity is 1.33 luxury. If a country is producing inside its production possibility frontier there is no opportunity cost from switching. In this case more of both types of product can be made by using previously unemployed resources. Figure 2.6 shows a movement from point Y to point Z which increases the output of both agricultural products and manufactured products.

2. The economic problem Scarcity

Scarcity has a special meaning in economics. It is based on the fact that human wants are unlimited, but the resources of our planet to satisfy those wants are limited. People always want more than can be provided with the available resources. Most of us would like a better car, more clothes and more evenings out. However, even if everyone were in employment, and all offices and factories were working at full capacity, it would not be possible to produce all the goods and services that the world's population would want to have. Scarcity leads to choice. Since resources are scarce we are all forced to make choices: Individuals in households have to decide what to buy with their limited incomes. Firms have to decide what to produce and how to produce it. Governments have to choose how to spend their tax revenues. These choices are being made all the time and are influenced by changes in the economic environment. An investment company may choose to switch its resources of workers, IT equipment and office space from trading in utility (electricity, gas and water) shares to trading in internet shares.

Demand

Since there is never enough of any resource for everyone to have as much as they would like, we need to answer the question: Who gets what and how much? This topic, together with the first two topics in Section 2, explains how a market economy resolves this problem of allocation via the price mechanism. The more scarce a product relative to demand, the higher the price and the fewer people who can afford to buy it. This means we have to study the factors that determine prices. A price in a market is determined by the interaction of demand and supply - how much people are willing and able to buy and how much they are willing and able to sell. These two sides of the market come together and a price results. This topic looks at the key influences that cause demand to rise or fall, and at the likely extent of the rise or fall. You will see how economists use diagrams to illustrate points and information. Economists are careful with the language they use as it is important that they convey information and analysis in a way that cannot be misinterpreted. In this topic you will learn, for example, the distinction between an increase or decrease in quantity demanded when price changes and an increase or decrease in demand at the same price and due to some other cause. You will also learn how, as an economist, you can make use of percentage change calculations to analyse the responsiveness of demand to key influences.

2. Specialisation and division of labour

Specialisation happens when a worker or machine concentrates on doing specific tasks or making specific products. A worker in an advertising agency may concentrate on designing TV advertisements for dog food, while an estate agency may specialise in selling luxury flats. Regions of countries tend to specialise in particular industries. As an example, Cambridge now specialises in education and high-technology industries (IT, telecommunications, biotechnology and e-commerce). While a country will produce a greater range of products than a region, it is also likely to concentrate on particular products. For example, Brazil's main industries are agriculture and mining and its main exports are metallic ore, transport equipment, metallurgical products, coffee and soya products. There are advantages to a country when it specialises in the production of goods and services that it can trade with other countries. Because it becomes proficient in these products, it gains a reputation and therefore can sell in international markets. This not only creates employment and growth within the country but it also earns foreign exchange and boosts the country's balance of payments. An example is the financial services sector in the UK and in the City of London in particular. The City is one of the world's major financial centres and it sells financial services all over the world - banking, insurance, fund management and many others. If a country specialises in non-tradable products (goods and services which are mainly sold within its domestic market), it does not earn foreign exchange and the non-tradable sector does not help it to pay for its imports. Examples of non-tradable sectors are health, education, the retail sector and construction. However, even these sectors can earn some foreign exchange for a country. UK hospitals and universities sell services to foreign patients and students, and retailers such as Tesco have opened supermarkets in other countries. Specialising in tradable products can also result in certain disadvantages for a country. One is that foreign markets may be given preference over domestic markets in terms of product quality. People who live in Mediterranean countries often complain that the best-quality fruit and vegetables are exported and are not available in their local shops. Too much specialisation can be a problem, as a country may rely on foreign markets for much of its income and if these markets are cut off by economic crises or war, it will not be able to sell its products. Again, it is relying on a narrow group of goods and services and has to import its other needs, again relying on others. Some people argue that it is safer for a country to seek a higher degree of self-sufficiency.

The ceteris paribus assumption

The answers to most economic questions are the result of many different factors which all come together to produce a result. A model which includes all the factors would be very complex and so there is a need to simplify. Suppose we are trying to establish why the demand for petrol has increased. We could find a number of possible reasons, such as the price of petrol may have fallen, people's incomes may have risen or they may be buying more cars. If we want to establish a relationship between the demand for petrol and its price, we must ignore the other factors - incomes and the demand for cars. We construct a model in which we say 'Other things being equal, a fall in the price of petrol leads to a rise in demand for petrol.' What we really mean is that there is probably a strong relationship between the price of petrol and its demand but there are also other factors that we have not taken into account. This practice of holding constant all factors except one in order to explain a relationship is used throughout economic theory and you will often see the phrase 'other things being equal'. You may also see 'ceteris paribus ', which is the Latin phrase meaning the same thing. You should use it yourself, in either language, in answers to questions where suitable.

Economic and free goods

The concepts of opportunity cost and scarcity help us to distinguish between economic goods and free goods. An economic good is one that is produced by using resources. It cannot be obtained without forgoing something else that could otherwise have been produced with the same resources. Economic goods, which can also be called scarce goods, have an opportunity cost. Most goods are economic goods. For example, the computer resources employed in the insurance industry could be put to use in the banking industry. In contrast, there are free goods that humans do not have to produce but which they can consume without having to give up the opportunity to produce another good. Free goods include sunshine and the air we breathe. They are freely available to all of us with no limit and there is no opportunity cost of using them. However, even a free good can become an economic good in certain circumstances such as if air pollution in a city is so bad that people pay to buy oxygen machines. It is important to recognise that a free good is not the same as a good that is provided free of charge. State education is provided free to families with children but it is not a free good. This is because it requires the resources of teachers, school buildings and so on to provide it.

2.6. Price elasticity of demand continued Degrees of price elasticity of demand

The degree of price elasticity of demand depends on how much quantity demanded changes as a result of a change in price. It is measured on a scale that ranges from zero (perfectly inelastic) to infinity (perfectly elastic). In the vast majority of cases it is somewhere between these two extremes. There is also the special case of unit elasticity. We will explain and draw graphs for all these degrees of PED below. Later in this topic you will use the same graphs to illustrate the effect of price elasticity of demand on a firm's total revenue. - Relatively elastic demand Demand is relatively elastic when a percentage change in price causes a greater percentage change in the quantity demanded. In this case the coefficient will be greater than 1 and less than infinity. The higher the figure of the coefficient, the more responsive or elastic demand is to a change in price. A product with a PED of 2.5 will respond by a greater percentage change in demand to a price change than will a product with a PED of 1.5. Figure 3.9 illustrates relatively elastic demand. The contraction in demand from 100 to 80 (-20%) is greater than the percentage rise in price from £10 to £11 (10%) that brought it about. - Relatively inelastic demand Demand is relatively inelastic when a percentage change in price results in a smaller percentage change in the quantity demanded. This means that elasticity of demand is less than 1 but greater than 0. The lower the figure of the coefficient, the inelastic or less responsive the demand is to a change in price. A product with a PED of 0.1 will respond by a smaller percentage change in demand to a price change than will a product with a PED of 0.6. Figure 3.10 illustrates relatively inelastic demand. The rise in price from £7 to £10 (43%) has led to a smaller contraction in demand from 120 to 100 (16.6%). - Perfectly elastic demand Demand is perfectly elastic when a change in price causes an infinite change in the quantity demanded. In this case the coefficient is infinity (∞). Any quantity may be demanded at the going price, but nothing at a higher price and an infinite amount at a lower price. Such an extreme reaction to a price change is clearly not realistic but it does define the upper limit of PED. Perfect elasticity is represented by a straight horizontal line and is the first of the three graphs illustrated in Figure 3.11. - Perfectly inelastic demand Demand is perfectly inelastic when a percentage change in price causes no change in the quantity demanded. In this case, the coefficient is 0. A change in price in either direction will have no effect on demand and consumers will buy exactly the same amount after the price change as they did before. - Perfect inelasticity (also known as zero elasticity) is represented by a straight vertical line and is the second of the three graphs illustrated in Figure 3.11. Section elasticity of demand When demand elasticity is unity, a change in price will result in a change in quantity demanded which is exactly the same percentage as the change in price. Unit elasticity is represented by a graph with a special shape known as a 'rectangular hyperbola' and is the third of the three graphs illustrated in Figure 3.11.

4.1. Medium of exchange

The medium of exchange is the most basic function of money as it allows exchange to take place easily. It replaced the old system of barter, whereby people exchanged goods for goods. Barter did not work very well as there had to be a coincidence of wants and some goods were indivisible and it was complicated to establish values between many different pairs of products. Money gets over these problems as every good or service is given a money value and payments are made in money, which is called 'the third commodity of exchange'. Money works because it is generally acceptable. Everyone is willing to give up products in exchange for money because they know that others will accept it from them in turn.

1.1 Production possibility frontiers and scarcity

The production possibility frontier shows that there is a limit to the amount that can be produced by an individual, firm or country. Figure 2.2 shows that a country can produce any quantity inside the frontier (such as at points A and B), any point on the frontier (such as points C, D and E), but not points outside the frontier. Points F and G are unattainable as there are currently insufficient resources.

3.2. Division of labour and the size of the market

The size of the market for the product (how many products are demanded) determines the extent to which advantage can be taken of division of labour. For example, a firm producing 300 handmade dolls houses a year may employ two workers. The extent to which these workers can specialise will be limited. However, Mattel, the firm that makes Barbie dolls, produces large numbers each year and employs hundreds of workers worldwide. Its workers specialise to a much greater extent. Improvements in communications and transport have increased the market for most products and so division of labour has increased in many industries.

5.3.3. The advantages of a command economy

The state in a command economy may act for the good of the people by providing services such as health and education free of charge. These services are seen as a type of investment, as discussed above in relation to economic growth. Cuba, for many years a command economy, is well known for its free health service. This means that nobody, however poor, has to worry about whether they can afford to buy health services or education for their families. In a command economy, the state can ensure that there is reasonable equality between people. It can cap wages and place limits on purchases of consumer goods or on the size of accommodation people are entitled to.

Economic models and assumptions

The world is very complex and changes in economic factors are the result of a large number of individual decisions. For example, the price of oil on world markets is the result of many millions of individuals' buying and selling decisions. So in order to explore economic relationships, economists create models of how they believe the world works. These models are necessarily a simplification of the real world but they are useful in coming to conclusions. They then test their conclusions by observing what happens in the real world. By doing this they are using the scientific method, which helps to validate economics as a science.Economists seek to find out what factors determine the number of goods and services we produce and consume and what prices these are bought and sold for. They try to discover what causes inflation and unemployment and suggest ways of dealing with these problems. Factors that change are known as 'variables' and they try to establish relationships between variables and to assess their nature and strength. For example, they want to know what consumers do when the price of a product rises. Do they buy more, less or the same? If they buy less, how much less? Throughout this course you will need to be aware of the relationships between variables. In order to simplify a situation, economists make assumptions. This means that they suppose something which may or may not be true. In studying people's spending patterns, economists assume that they behave rationally, always weighing up each piece of expenditure carefully before making it. This does not always happen and so the assumption may not be correct. A word of warning! Economic research may come up with two sets of figures that seem to fit each other, and from this we might assume that one of the sets is caused by the other. Suppose that UK weather statistics show that temperatures over the course of a particular summer were higher than usual, and that UK sales figures for ice creams show a higher than usual demand during that same period. It would be intuitively reasonable to suppose that people are eating more ice cream because of the warm weather and that one factor has caused the other. But the causal relationship is not proven and there could be other factors that explain the higher ice cream sales - a strong marketing campaign by ice cream producers. An important tool in economic models is the use of marginal analysis. A marginal item is an additional one. Suppose that a worker produces 10 units of a product in an hour and then, having discovered a more efficient method of production, is able to produce 11 units an hour. The extra unit produced is called the marginal unit of production. Marginal profit is the addition to total profit from producing one more unit - the marginal unit. Marginal analysis is useful because it allows us to measure the effects of changes.

1.2 Movements and shifts

There are two main ways in which changes can take place in a production possibility boundary. There can be a movement along the curve to a new point or a shift in the curve itself.

4.4. Standard of deferred payment

This is the opposite of a store of value and it is a complicated way of saying that people can use money to borrow and measure their debt - a deferred payment is one that is put off to the future. So money enables people to buy products now and pay for them later. To sum up, money enables people to buy goods and services, to measure their value, to save and to borrow.

2.5. Diminishing marginal utility

We assumed above that demand curves have a negative slope because people react to price increases by buying less, and vice versa. This sounds reasonable and it describes what can normally be observed as the result of empirical research. Economics uses empirical research to support its theories. Empirical research happens when economists do surveys to find out how people behave. The resulting data therefore originates from observations and measurements of these and so the results are based on actual experience rather than on abstract theory. Look out for empirical data in the topics as you work through this course. Empirical data can be contradictory and as economics is a science it must have a theoretical background. The body of theory that underpins the shape of the demand curve is known as marginal utility theory. This is quite a complex theory and here it is described in outline only as this is all that this qualification requires. Utility in economics means the amount of satisfaction a consumer derives from consuming a product. Marginal utility is the amount of satisfaction that person derives from consuming one more unit of that product. Diminishing marginal utility theory says that, as someone consumes an increasing number of units of a product, the amount of additional satisfaction (the marginal utility) that person gets from each extra unit consumed decreases. You might test this yourself. Imagine that you are hungry and you buy some cakes. The first cake gives you a lot of satisfaction and you might also enjoy the second one but, after that, you would begin to feel full and eventually, an extra cake might make you feel ill. This could apply to many products. So you might be willing to spend quite a lot on the first cake and perhaps on the second, but to entice you in buying more cakes than that, the cake seller would have to reduce the price. What we are really saying is that the only way to attract someone into purchasing more units of a product is to reduce its price. Here we have the basis of the normal demand curve. Second one but, after that, you would begin to feel full and eventually, an extra cake might make you feel ill. This could apply to many products. So you might be willing to spend quite a lot on the first cake and perhaps on the second, but to entice you in buying more cakes than that, the cake seller would have to reduce the price. What we are really saying is that the only way to attract someone into purchasing more units of a product is to reduce its price. Here we have the basis of the normal demand curve.

2.3. Shifts in a demand curve

We noted above that there are other factors apart from price that affect demand, but we kept these constant by saying that other things were equal. However, in practice, other factors change and they affect the quantity demanded, even though the price has not changed. When this happens, we have to draw new demand schedules and demand curves to show the new quantities being demanded at each and every price. These changes in demand cause the demand curve to shift. For example, an increase in demand causes the demand curve to shift to the right of the original curve. This is illustrated in Figure 3.7 with the increase in demand being shown by the shift in the demand curve outwards from DD to D1D1. The factors that cause a shift in the curve are called exogenous variables as they come from outside the model. As price increases along the vertical axis, the demand on D1D1 is higher than on DD. A decrease in demand causes the demand curve to shift to the left of the original curve. Figure 3.8 shows a shift in the demand curve backwards from DD to D1D1. As price decreases along the vertical axis, the demand on D1D1 is lower than on DD.

2.2. Movements along a demand curve

When drawing up a demand schedule, we look at how demand reacts only to changes in price. But there are other factors besides price that can cause the quantity demanded of a product to change. So we say that other things being equal, a fall in price will lead to a rise in quantity demanded, and this is an extension in demand. Conversely, a rise in price will lead to a fall in quantity demanded and this is a contraction in demand. Both of these are movements along a demand curve. Figure 3.5 illustrates an extension in demand (an increase in the quantity demanded) from Q to Q1 resulting from a fall in price from P to P1. Under normal circumstances, a rise in price will cause a fall in demand. This can be called a decrease in quantity demanded or a contraction in demand. The rise in price from P to P1, as shown in Figure 3.6, causes a contraction in demand from Q to Q1. The only factor that can cause an extension or contraction in demand, and therefore a movement along a demand curve, is a change in the price of the product. This is known as an endogenous variable, as it is a variable that comes from relationships within the model.

2. The economic problem Economic agents

'Economic agents' refers to the main groups in an economy - consumers, producers and governments. Everyone is a consumer in their private, individual capacity, whether they are ordinary members of the community, workers, employers or members of the government. Consumers need to buy a wide range of goods and services in order to have the lifestyle they want. Producers are firms of varying sizes, from small businesses run by one person or a few people to large public limited companies. Many base their production on what consumers want to buy, although some are product-oriented and try to persuade consumers to buy what they have made. Governments consist of those people elected (or at least appointed) to make laws, raise taxes and carry out government expenditure.

2.7. Factors influencing price elasticity continued

- Price elasticity of demand and total revenue: When a firm is considering increasing or decreasing the price of a product, it wants to know the likely effect of the price change on the amount of money it will receive from sales. This is called its total revenue. The change in total revenue resulting from a price change depends on the price elasticity of demand for the product. We can use graphs to calculate the total revenue change, as shown below. When demand is relatively elastic, the price of the product and the firm's total revenue from sales move in opposite directions. So a rise in price will cause the firm's total revenue to fall. This is because, although each unit of the product sold brings in more money, people have reacted strongly to the price rise and buy proportionately less. Conversely, a fall in price will cause total revenue to rise because, although each product sold brings in less revenue, people react by buying proportionately more. Look again at the relatively elastic demand curve in Figure 3.9. When the price was £10, 100 units were sold so the total revenue was £10 × 100 = £1000. After the price rises to £11, only 80 units are sold and the total revenue is now £11 × 80 = £880. You can use the rectangles on the graph to compare the two total revenues. When demand is relatively inelastic, price and total revenue move in the same direction. So a rise in price will cause a rise in total revenue because the demand falls by less than the proportionate amount and the price is higher. A fall in price will cause a fall in total revenue because the demand response is not strong enough to compensate for the fall in price. Look again at the relatively inelastic demand curve in Figure 3.10. When the price was £7, 120 units were purchased and total revenue was £7 × 120 = £840. When the price rises to £10, 100 units are purchased and total revenue is now £10 × 100 = £1000. Again, compare the rectangles. If price elasticity is unitary, 1, a change in price in either direction will have no effect on total revenue. It will remain the same. This is because the price and the quantity demanded change by the same percentage. The graphs in Figure 3.11 do not have any figures, but here is an example. If 6 units sell at £10 each, total revenue is £60 (£10 × 6). If the price rises by 50% to £15 and the quantity demanded falls by 50% to 3, the total revenue is still £60 (£15 × 3). - Income elasticity of demand: Income elasticity of demand (YED also known as YEOD) measures the degree of responsiveness of quantity demanded to changes in income. (Note that income is represented in economics by the letter Y). Just like price elasticity of demand, income elasticity is relative. It can be relatively elastic or relatively inelastic. The quantity of goods and services people buy depends heavily on their income, as income determines affordability. (This applies whether people pay cash for products or whether they buy them on credit, because access to credit also depends on income to a large extent.) When income changes, consumers change their spending habits and patterns and income elasticity measures the degree of this change in the case of specific products. YED is calculated by using the following formula: YED=% change in quantity demanded / % change in income=%ΔQD / %ΔY YED=% change in quantity demanded% change in income=%ΔQD%ΔY So, in the same way as with PED, if the change in quantity demanded is greater than the change in income, demand is relatively income elastic. If the change in quantity demanded is less than the change in income, demand is relatively income inelastic. The coefficient of income elasticity is interpreted in the same way - a figure between 0 and 1 denotes relative income inelasticity, and a figure of more than 1 denotes income elasticity. You will remember that PED is normally negative, as there is an inverse relationship between price and quantity demanded. Income elasticity of demand can be either positive or negative, depending on the type of goods in question. We are going to study three types of goods. - Normal goods: A normal good is one which people buy more of when their income rises, and they buy less when income falls. This covers most goods and services that people consume in the course of their lives, such as food, clothes, cars, houses and entertainment. Since income and quantity demanded move in the same direction, this type of income elasticity is positive. For instance, if income rises by 5%, demand for shirts may increase by 2%. So demand is relatively income inelastic, as shown in Figure 3.12. YED=2% / 5% = 0.4 Similarly, an 8% fall in income may result in a 10% fall in demand for fillet steak, so demand is relatively income elastic. YED=−10% / −8% = 1.25 - Luxury goods: Luxury goods are very high-price goods that can be purchased only by people with high or very high incomes. Examples are expensive jewellery, eating in top-class restaurants and luxury cars. Their income elasticity is positive because the change in income and the change in quantity demanded of luxury goods move in the same direction. If someone's income increases considerably, say as a result of promotion or a new job, that person is now able to buy products which were previously unavailable, and the demand will rise more than proportionately than the income rise. Conversely, a fall in income will force people to stop buying luxury products and the fall in demand will be more than proportionate. - Inferior goods: Inferior goods are the opposite of luxury goods. They are low-price, probably low-quality products that people buy when their income is low and they cannot afford better alternatives. Examples would be cheaper cuts of meat and cheap brands of toiletries or essential domestic products for the home. Their income elasticity is negative because there is an inverse relationship between the change in income and the change in demand for the inferior good. As someone's income falls, they are probably forced to abandon more expensive alternatives and switch to cheaper but less desirable substitutes. As income rises again, they switch from inferior goods to normal goods. Negative income elasticity is shown in Figure 3.14. For example, an 8% fall in income may result in a 10% rise in demand for cheap minced meat, so demand is relatively income elastic, but negative. YED=10% / −8%=−1.25 Some students make the mistake of thinking that the demand for luxury goods is relatively income elastic and the demand for inferior goods is relatively income inelastic. This is incorrect. The difference is that luxury goods have positive income elasticity and inferior goods have negative income elasticity. Income elasticity measures the degree of the change in each case, whether it is positive or negative. Unit income elasticity, perfect income inelasticity and perfect income elasticity are uncommon, but they may occur over certain income ranges. Perfect income inelasticity demand is the same as zero income elasticity (a change in income results in no change in demand).

Calculate the income elasticity of demand in each of the following cases. 1. Income falls by 4% and demand for chocolate decreases from 10,000 bars a week to 9700 bars. 2. Demand for beef falls by 23% following a 7% decline in income. 3. Income rises by 14% and demand for chiropody treatment increases by 1.5%.

1) −3% / −4%=0.75−3%−4% = 0.75 (note that you need to work out the percentage change in demand) 2) −23% / −7%=3.28−23%−7%=3.28 3) 1.5% / 14%=0.1

Explain what is meant by a planned economy.

A planned economy is one where the state owns all the means of production and the government takes economic decisions.

1.2.1. Movements along a production possibility curve

A movement along a production possibility curve is the result of a change in the proportion of production devoted to the two types of products depicted. It shows a different allocation of resources but it does not show an increase or decrease in the total production. Here are examples of how this could happen. Suppose that a woman is self-employed and has two main jobs. She is a mobile hairdresser and visits clients in their own homes, and she also makes novelty cushions that she sells in a local shop. The main limitation to the amount she can produce is her time. Suppose that the amount of time which she has decided to devote to work is 30 hours a week. In these hours, she can either produce ten cushions or she can do the hair of 20 clients. At first she decides to produce five cushions and to take on ten clients. But her cushions are popular and the shop can sell more so she now decides to produce six cushions per week and visit only eight clients. This is an example of a movement along the production possibility curve as a change in the mixture of products has occurred, but the same overall total is being produced in terms of time worked. We could describe a similar situation for a company or a country which is producing two products and which makes a decision to switch resources so that it produces a little more of the one and a little less of the other. Again this is a movement along the curve. There are several reasons why a country might make a switch of resources in this way: The market price of one of the products may have risen while the other remains constant. This would motivate the country to switch more resources to the product with the higher price and increase revenue from sales. This is an example of why the PPF curve might be curved, as resources transferred to another use might be less efficient in their new use. The country may have discovered a better method of production that will improve efficiency and reduce costs. More units of the one product can be made in the same time and so there is a switch to this product from the other. A country may be forced to change its product mix because of physical limitations. If one of the products is a raw material and this is becoming severely depleted, the country must switch its resources to another industry. Or perhaps the country's workforce becomes skilled in a certain area and the balance of production changes towards that area. An example of this is the development of IT services in India. A key choice that economies have to make is what proportion of their resources they should devote to making capital goods and what proportion to making consumer goods. Capital goods are human-made products used in the production of other goods and services. Machines, factory buildings and delivery vans are classified as capital goods. In contrast, consumer goods are products bought by consumers for their own use and enjoyment such as clothes, mobile phones and food. If a country, using all of its resources, decides to make more capital goods this will involve an opportunity cost of forgone consumer goods. Figure 2.7 below shows that to produce 10 million more capital goods, 20 million consumer goods have to be sacrificed. This reallocation of resources is likely to reduce living standards in the short term. This is because people do not gain immediate satisfaction as a result of more machines being made and more offices being built. But they do experience lower satisfaction as a result of the production of fewer clothes, TVs and meals out. In the long run, however, devoting more resources to capital goods can improve living standards. This is because the extra capital goods can be used to make more of both capital and consumer goods.

Summary of Product and specialisation

A production possibility frontier shows the possible combinations of two types of goods that can be produced from a given quantity of resources. Consumer goods are consumed now but capital goods are used to produce other goods. Specialisation is the concentration on particular tasks or products. Money performs four important functions: a medium of exchange, a measure of value, a store of value and a standard of deferred payments. In a market economy resources are owned and managed by private organisations and individuals. In a command economy they are owned and run by the state. A mixed economy contains elements of both.

2.4. Causes of change in demand

A number of factors besides price can cause a change in demand and therefore a shift in the demand curve. These factors are known as the conditions of demand and they are set out below. - Changes in incomes This is perhaps the most important factor. Demand for most products will increase if people's real incomes rise, as they are then able to buy more or even to buy products that were previously unavailable to them. These products are called normal goods and they are directly related to income. However, a rise in income will cause a decrease in demand for a few products. These are called inferior goods; they are products that are regarded as bad substitutes and people buy them only because they cannot afford anything more expensive. An example might be cheaper cuts of meat. As people's incomes rise, many switch to more expensive meat. A change in the distribution of income can also affect demand. If income becomes more evenly distributed, demand for some expensive luxury items may fall, but demand for cars and foreign holidays may increase. - Changes in the prices of related products A change in the price of one product can affect the demand for a related product, depending on the relationship between the two products. Related products may be either substitutes or complements. Substitutes are in competitive demand. A rise in the price of a substitute is likely to cause demand for the first product to contract and demand for the substitute to increase; and the opposite will happen if the price of the substitute falls. For example, if house prices rise and it becomes too expensive for many people to buy a house, the demand for rented accommodation will rise. This is happening in the UK housing market in 2015. Complements are in joint demand as they are consumed together. A rise in the price of one of the complements will cause demand for that product to contract and demand for the other product to decrease as well; and the opposite will happen if the price of the complement falls. For example, a fall in the price of package holidays will cause a rise in the demand for these holidays and also an increase in the demand for holiday insurance. - Expectations of future price changes Expectations are very important in economics and you will read about them in other parts of this course. The future is uncertain and people act on what they believe will happen. Sometimes these beliefs can be self-fulfilling. Expectations of changes in price can cause a change in demand (and therefore a shift in the demand curve) even though the price has not yet changed. People may buy large stocks of non-perishable goods if they anticipate that the price will rise in the future. If they think prices will fall, they will postpone their purchases. People often buy more cigarettes and alcohol before the budget because they fear that the price of these goods will rise. - Tastes, fashions, advertising and marketing Most consumers respond to changes in fashion and this in turn is influenced by advertising. Marketing campaigns, including advertising, aim to shift the demand curve for products to the right. They hope that people will buy more because the products are fashionable, even though the price has not fallen. Tastes and beliefs also change over time and affect what people buy. For instance, concerns about cruelty and the possible extinction of a number of species of animals have made it undesirable to wear fur coats. - Changes in the weather and seasonal changes Weather and the time of year influence the demand for a number of products. A period of hot and sunny weather increases demand for sunglasses and anti-sun cream, and before and during the Christmas period demand for certain seasonal foods increases. - Changes in population size and composition A rise in the size of the population is likely to increase total market demand for most products. A change in the age distribution of the population can also influence demand. For instance, an increase in the birth rate will result in an increase in demand for baby clothes and accessories, toys and children's fashions as the years pass. In countries like the UK, people are living longer and the increase in the average age of the population will lead to a higher demand for mobility aids and care for older people.

Discuss the advantages and disadvantages to Cuban workers if they are able to specialise more in their jobs.

Advantages are better training and knowledge of the jobs they do - better skills mean higher production and higher wages.Disadvantages are a lack of diversification and difficulty in finding work If unemployed. Work may be very specific and boring.

1.1.1 Efficiency

An economy is said to be efficient when it achieves the optimal (best) allocation of its scarce resources. This happens when these resources are distributed among consumers according to their preferences - firms produce what consumers need and want. When an economy is perfectly efficient, any attempt to make one person better off would result in someone else becoming worse off. This is a theoretical situation and it would not be possible to prove in practice that such a situation had been reached. Production possibility frontiers concern productive efficiency. This is a situation where goods are produced at their lowest possible cost, by using the least possible resources and time. The maximum amount of outputs is produced from a given amount of inputs. If all resources are employed and are used efficiently, production will occur at a point on the production possibility frontier and this is the maximum productive potential. At this maximum point, there is no way that the country can produce more of one good without producing less of the other. Figure 2.3 shows various efficient production points on the frontier and also an unattainable point beyond the frontier. But the economy can produce less than maximum if it does not use all its resources or if it does not use them well. So any point inside the frontier indicates inefficiency and/or unused resources such as unemployed workers. If not all the available resources are used, the country is not producing all that it is capable of making - the inefficient point in Figure 2.3.

Why may an unemployment benefit scheme be important in a market economy?

Because there is a risk of high unemployment in such an economic system.

Define cross elasticity of demand. (2 marks)

Cross elasticity of demand is a measure of the relationship between a change in the price of one product and the resulting change in demand for another product. The formula is: percentage change in quantity demanded of good X / percentage change in price of good Y

2.1. Relationship between demand and price

Demand for most products rises as their price falls. This is because they become more affordable relative to substitute products. People see them as better value and buy more of them. Conversely and for the same reason, demand will fall as prices rise because people either cannot afford to buy them or are able to buy a cheaper substitute. We say that quantity demanded and price vary inversely - they move in opposite directions. (Note that there are cases of exceptional demand, where demand rises as price rises and vice versa. One example of this is the demand for shares on the stock market. If the price of the shares of a successful company begin to rise and people think they are going to rise further, they will buy them even though the price is higher. The opposite happens when the price begins to fall as people try to sell them, expecting that the price will crash.) Using this inverse relationship we can construct a demand schedule for a product. Table 3.1 shows the number of units demanded at different prices. From the demand schedule we can draw a demand curve. This shows the demand pattern of an individual person with regard to the price of a product. For most products, the demand curve will slope downwards from left to right. This is called a negative slope, because when the one variable rises, the other falls. If we add up the demand curves of all the individual consumers in the market, we have the market demand curve. Study hint When describing relationships between variables, we use the following terminology. When a change in one variable causes a change in another variable in the same direction, we say that there is a direct relationship between them. A graph illustrating this relationship has a positive slope. When a change in one variable causes a change in another variable in the opposite direction, we say that there is an inverse relationship between them. A graph illustrating this relationship has a negative slope.

2. Demand for goods and services

In economics, demand for a good or service means not only that someone wants to buy it, but also that they can afford to buy it. As a result, demand is often referred to as effective demand. So, when an economist says that the demand for a particular model of car is 30,000 cars a year at a price of £14,000 per car, this means that people are willing and able to buy 30,000 cars at that price.

5.3. Characteristics of market and command economies

It is interesting to compare the advantages and disadvantages of market economies and command economies.

Explain one opportunity cost of moving towards a market economy.

It has reduced the government's control of the economy so the opportunity cost is the ability to influence the economy.

2.12. The significance of elasticity

Knowledge of price elasticity is helpful to a firm that is considering carrying out price changes. If it needs to raise its price to cover higher costs, it will hope that the demand for its product is relatively inelastic in order to increase its total revenue. If it decides to lower its price to gain customers from its competitors, it will hope that the demand for its product is relatively elastic, again in order to increase its total revenue. If a firm knows that the demand for its product is relatively elastic, it is advised to lower its price. If the demand is relatively inelastic, it is advised to raise the price. Another application of price elasticity of demand refers to the amount of foreign exchange earned by a country from selling exports. If the exchange rate of sterling rises, UK exports become more uncompetitive abroad. But if the demand for the exports is relatively inelastic in other countries, the demand will not fall by as much as the price has risen and UK exporters will gain revenue. Price elasticity also helps a government to make decisions about levying taxes on certain products. In the UK, special excise taxes are placed on products such as tobacco and alcohol. The main reason why these products are chosen is that the demand for them is relatively price inelastic. When a tax is increased, demand falls by a lower percentage than the increase in the price because of the tax, and government revenue rises. Knowledge of income elasticity is useful when a firm is considering the ability of its customers to afford its products. During the recession that followed the 2008 financial crisis, many people suffered a fall in real income (income after taking off the effect of inflation) or became unemployed. They therefore had to change their buying habits. They cut down their demand for luxury goods and reduced their demand for normal goods. At the same time, they increased their demand for inferior goods, as evidenced by the growth of budget shops and supermarkets. Firms had to estimate by how much their demand would change, according to the type of product they were selling. From 2014, the UK economy began to grow again and reverse trends were set in motion and firms selling inferior goods may now begin to lose revenue. The government also needs to know the degree of income elasticity of demand to estimate receipts of VAT and other expenditure taxes. In a period of growth when people can afford to spend more, income elasticity may be high and is positive for normal goods, many of which are taxed. Governments also subsidise certain basic products and need to know how the demand for these reacts to a change in real incomes. If people increase their demand for inferior goods during a recession, many of these are likely to be subsidised and the government may find that its expenditure increases. All firms need to keep up to date with changes in the economic environment and a knowledge of cross elasticity of demand is helpful. A firm must take into account the extent to which demand for its products responds to changes in the price of related products. Here is an example of substitutes. If Tesco reduces the prices of a wide range of products, Sainsbury needs to know the extent to which its own customers will react and shop at Tesco instead. If Sainsbury discovers that demand is relatively cross elastic and that a disproportionate number of customers are switching to its competitor, it must take action, either by reducing its own prices or by launching an aggressive marketing campaign. Again firms must be aware of what is happening to the prices of complementary products and must take action accordingly. For example, if the value of sterling rises and foreign holidays become cheaper, more holidays will be booked and this will be good for companies offering travel insurance. They need to consider the extent to which this demand will rise so that they can cope with the increased business.

2. The economic problem Opportunity cost and economic agents

Making a choice involves a cost. When we choose one option, we give up the other alternatives we decide against. If I have £50 left at the end of the month I can spend it either on having an evening out or on a new pair of shoes, but I cannot have both. If I decide to spend the money on the evening out, then I give up the shoes I did not buy. Economists call this cost 'opportunity cost'. Opportunity cost is the cost of the 'forgone alternative' - the choice given up. This applies to all economic agents as in the example above of an individual's spending choices, and it applies to producers and governments too. A firm with a profit at the end of the year can decide what to do with its surplus. It might have to choose between using it to pay for a new training programme for its employees, pay a dividend to its shareholders or save it in a reserve in case of a future emergency. Whichever it chooses, it gives up the others. Again, a government that decides to spend tax revenues on expanding a hospital might have had to forgo the alternative of increasing retirement pensions or reducing taxes.

4.3. Store of value

People do not always want to consume their income as soon as they have earned it. In a system of barter, people's income consisted of goods but it was not always practical to store those that were not immediately needed because they would perish or take up too much room. Money is easily stored in bank accounts and so its existence enables people to save. This means they can separate their transactions over time. They can earn money now and spend some of it later when they have saved up enough to buy what they want.

What steps should people take today to limit their consumption of resources? Can you think of a specific example? (3 marks)

People today should reduce their consumption levels and also develop better methods of generating energy via more renewable resources, such as more tidal and solar power.

4.2. Measure of value

Some textbooks refer to this as a 'unit of account'. Since every product has a money value, the values of different goods and services can easily be measured and then compared. In other words, money is a benchmark for the relative values of a wide range of products. Money allows people to keep accounts and make financial conclusions.

4. The functions of money

Specialisation gives rise to trade. As individuals, firms and countries produce only certain goods and services, so they have to fulfil their other needs and wants from other people, companies or countries. In order for trade to take place, they need money, and indeed money allows specialisation to work. So money systems have developed and have become very sophisticated. Nowadays money has no intrinsic value - it has no value in itself. It consists mostly of electronic bank deposits and also a small amount of almost valueless notes and coins. But it does perform some very important functions.

Identify one way in which Vietnam has moved towards a market economy.

State farms have been given to the private sector.

2.9. Substitutes

Substitutes are products in competitive demand - they both satisfy a similar need and, because consumers do not need both, they choose between them. They may be different products that do the same job, such as electricity or gas to heat people's homes, or they may be different brands of the same product such as different brands of toothpaste. Substitutes have positive cross elasticity of demand. This is because a rise in the price of one product will cause an increase in demand for the other and both variables move in the same direction. Similarly, a fall in the price of one product will cause a decrease in the demand for the other. Note that, like price and income elasticity, cross elasticity does not simply state the direction of the relationship between the variables, but it measures the degree of the response. The greater the degree of possible substitution between the products, the higher the cross elasticity will be. For instance, if the price of electricity rises by 20% and demand for gas rises by 5%, the rise in demand for gas is less than proportionate to the rise in price of electricity. The cross elasticity of demand is measured as shown and it is relatively cross inelastic with a coefficient between 0 and 1: XED=5% / 20%=0.25 If the price of butter falls by 10% and the demand for margarine decreases by 15%, demand is relatively cross elastic with a coefficient greater than 1: XED=15% / 10%=1.5XED=1.5 Figure 3.15 illustrates positive cross elasticity of demand. It shows that a fall in the price of beef from P to P1 causes a decrease in demand for lamb from Q to Q1. To measure the cross elasticity, we need to know the percentage changes or we could compare the areas of the rectangles.

Explain one way in which Vietnamese people have benefited from the move towards a market economy.

The Vietnamese people have benefited from a greater choice of products with both domestic and foreign firms operating in the country. The greater competition has also led to a rise in quality, as firms are seeking to attract customers by offering them the best products. Greater competition may also be taking the form of price competition with Vietnamese people benefiting from lower prices.

Identify two advantages to M & S of allowing its employees to specialise.

The advantages to M & S include: workers will develop expertise and become more productive. time will be saved in training staff.

Identify two advantages to the employees of specialising in particular units.

The advantages to employees include: the opportunity to work in an area of interest the opportunity to develop expertise in a particular area in a reduced training period.

5.3.1. The advantages of a market economy

The benefits claimed for a market economy include the following: Consumer sovereignty - consumers have the power to determine the types of product produced, by expressing their choices and preferences via the market. Efficiency - firms that do not produce what consumers want, or do not produce it cheaply, will be driven out of business by competitors. Quick response - firms respond quickly to changes in demand for products.

Explain the relationship between the concepts of sustainability and of opportunity cost. (2 marks)

The concept of sustainability sees the opportunity cost of present consumption in terms of what future generations will have to do without.

1.2.2. Shifts in a production possibility curve

The production possibility curve can shift, which happens when the overall productive capacity increases because of growth, or decreases because of shrinkage. If a country discovers more resources, or if it improves the quality of its resources by investing in more up-to-date technology and infrastructure, its ability to produce goods and services will increase. Figure 2.8 below shows economic growth occurring. This rise in productive potential can be illustrated by a shift to the right of the production possibility frontier from the red line at A to the blue line at B. The maximum number of resources that the country can produce of both types of products has increased, and so has any combination of these two. An example of a discovery of new resources is the development of the fracking (hydraulic fracturing) industry in the US, which has increased the country's production of oil by a large amount. Another example might be an improvement in the amount or number of goods and services that human labour can produce after extensive training programmes. Or it might simply be that the activity rate of the labour force has risen and more people are making themselves available for work. Economic growth occurs when a country produces more goods and services or when it has the potential to produce more. In the short run a country might grow because it is using previously unemployed resources. However, in the long run it will be because the country has more and better-quality resources. The key to economic growth is investment. This might be investment in new technology and in improved work methods so that the workforce is more efficient and can produce more per head. It may also be due to more investment in education and health, so that the workforce is better qualified and skilled and enjoys better health, taking fewer days off work. Figure 2.8 Conversely, a country can experience a fall in its productive potential. This could happen if the labour activity rate falls and those who were previously available for work withdraw from the workforce. In the longer term, it might be because a basic industry has ceased to be productive. An example is the production of coal in the UK, which fell off severely after the 1980s. Such a decrease in a country's productive potential is shown by a shift to the left of the frontier and you can see this in Figure 2.8 if the movement is from the blue line at B to the red line at A.

Give two reasons why M & S would want its trainee managers to gain experience in a number of units.

The reasons include: finding out where the trainee managers' strengths lie providing the opportunity to cover for managers that are off sick or are on training courses moving managers around when vacancies occur in other units.

The nature of economics

This topic sets the scene. You will be introduced to some key economic methods and concepts, including scarcity, choice and opportunity cost.

Positive and normative statements

To say that the UK economy spends around 42% of national income is a positive statement. This means that it is a factual statement - one for which there is evidence and that can be tested. However, to say that a government should intervene in an economy to a greater extent than it does is a normative statement. This is one that is based on opinion and cannot be disproved. It is a value judgement which is concerned with what the writer believes. Positive economics describes how the economy works. It views economics as a science concerned with provable facts. Positive economics studies the relationship between economic variables and makes predictions about what effect a change in an economic variable (such as the level of unemployment) will have on the economy. Normative economics makes value judgements about how the economy works and what the appropriate economic objectives and priorities should be. In practice, both positive and normative economics play a role in economic decision making and policy. A lot of what you will learn at this level is positive economics. But you will also come across normative statements, which are based on people's opinions and involve value judgements about what is right or wrong, ethical or unethical.

2.1. Advantages and disadvantages of specialisation

When countries specialise in producing particular goods and services, they usually engage in international trade. They export their surplus tradable products and import those products they do not or cannot make themselves. There are advantages of this specialisation. Because they are concentrating on those products at which they are more efficient, they produce better-quality goods and services at a lower cost. The UK specialises in the production of financial services and the City of London is a major financial centre that earns a lot of foreign currency for the country and creates jobs for many people. However, too much specialisation has its disadvantages. A country that specialises too closely in just a few products is 'putting all its eggs in one basket' - it is dependent on those products and risks a fall in demand for them. Countries in the Arabian Gulf specialise in oil production, but if the price of oil falls, as it did in 2014, their income from trade falls and they are not able to switch to the production of other products. In addition, they are vulnerable to the increasing trend towards the development of renewable energy sources. On the other side of the question, there is the disadvantage of relying on other countries for vital products such as foodstuffs and raw materials. Using oil as an example, countries that do not have oil reserves depend on imports for their fuel and energy and risk supplies being cut off in the event of an economic crisis or war.