Edexcel AS Economics Unit 1 Revision Guide

Definitions that you should LEARN for Unit 1

(you should be able to reproduce these definitions EXACTLY under exam conditions)

WHY do I need to learn them off by heart?

§ It is usually a good idea to define any terms used in the question at the beginning of your
answer. If your definition isn’t accurate you won’t get any marks for it.

§ If you know PRECISELY what the terms in a question mean, you are far more likely to
be able to give a top quality answer.

HOW can I learn these definitions?

Everybody has different ways of learning but here is a suggestion that is in three
stages:

1. Cover up the terms side of the page and see if you can remember the terms that go
with each definition. You can check your answers as you go by uncovering the terms one
by one. Keep doing this until you can do it without any difficulty.

2. Cover up the definitions side of the page and see if you can recite the definitions
accurately. Keep repeating this until you can do it without any difficulty.

3. Ask someone to give you terms randomly and check whether you can give the
definitions.

(you may wish to make the above easier by starting off with only 10, or less, terms at a time)

Term

Definition
Scarce resources

Resources that are limited or finite

Opportunity Cost

Cost expressed in terms of the next best alternative that is foregone

Basic economic problem

Resources are scarce but wants are unlimited

Production possibility frontier

A diagram that shows all the combinations of two goods that can be produced when all
factors of production are being used.

Free good

A good that has no opportunity cost

Normative economic statement

An economic statement that is based on a value judgement.

Positive economic statement

An economic statement that can be tested in order to determine whether or not it is true.

Land

Natural resources that are used for production

Labour

Human resources that are used for production

Capital

Manufactured goods that are used for production

Enterprise (Entrepreneurship)

Risk taking in the production process

Demand curve

A demand curve shows how much people are willing and able to buy at each price.

Supply curve

A supply curve shows how much suppliers are willing and able to supply at each price.
Complementary goods

Goods or services that are frequently consumed together

Substitute goods

Goods or services that can be used instead of each other

Price elasticity of demand

A measure of the responsiveness of demand to a change in price

Formula for price elasticity of demand

% change in quantity demanded

% change in price

Price elasticity of supply

A measure of the responsiveness of supply to a change in price

Formula for price elasticity of supply

% change in quantity supplied

% change in price

Income elasticity of demand

A measure of the responsiveness of demand to a change in income

Formula for income elasticity of demand

% change in quantity demanded

% change in income

Cross elasticity of demand

A measure of the responsiveness of demand for one good to a change in the price of
another good.

Formula for cross elasticity of demand

% change in quantity demanded of good A

% change in price of good B

Normal good
A good that has a positive income elasticity of demand because demand for it will increase
as real incomes increase (and vice versa)

Inferior good

A good that has a negative income elasticity of demand because demand for it will decrease
as incomes increase (and vice versa)

Command Economy

An economy in which what, how and for whom to produce are determined by a state
planning process

Free market economy

An economy in which what, how and for whom to produce are determined through the forces
of supply and demand without state intervention.

Mixed economy

An economy in which what, how and for whom to produce are determined partly through
planning and partly through market forces.

Monopoly

A sole supplier of a good or service

Consumer surplus

The difference between the maximum amount of money consumers are willing to pay for
a product and the actual market price.

Producer surplus

The revenue received by producers above that which would have brought the product onto
the market for sale.

Efficiency

How close a firm is to producing at the lowest possible average cost.

Productivity

Measures the efficiency with which resources are used. Often taken to mean output per
person employed.
Division of labour

The way in which tasks in the production process are allocated to different people. (Also
used to refer to the way that people within an economy specialise in different types of job
and the way in which countries specialise in the production of different goods and services.)

Inflation

A sustained rise in the average price level

Unemployment

A situation where people who are willing and able to work are without paid employment.

Structural unemployment

Unemployment caused by a change in the structure of the economy e.g. the decline of a
major industry such as coal.

Recession

Two or more successive quarters of negative economic growth

Market failure
A situation where free market forces have resulted in a good or service being under or over-
provided i.e free market forces do not result in the socially optimal level of output

Private costs

Costs incurred directly by individual producers and consumers when they engage in an
economic activity. These are the costs that are taken into account by free market forces

Private benefits

Benefits directly received by individual producers and consumers when they engage in an
economic activity. These are the benefits that are taken into account by free market forces.

External costs

Costs experienced by third parties i.e. producers and consumers who are not directly
involved in an economic activity. These costs are ignored by free market forces.
External benefits

Benefits received by third parties i.e. producers and consumers who are not directly involved
in an economic activity. These benefits are ignored by free market forces.

Social costs

All of the costs of an activity to society i.e. private costs + external costs

Social benefits

All of the benefits of an activity to society i.e. private benefits + external benefits

Negative externality

If social cost exceeds private cost, the difference is a negative externality i.e. it means the
same as external cost

Positive externality

If social benefit exceeds private benefit, the difference is a positive externality i.e. it means
the same as external benefit

Merit good

A good or service that would be underprovided by the free market because consumption of
the good or service results in substantial external benefits e.g. health care, education

Demerit good

A good or service that would be overprovided by the free market because its consumption
results in substantial external costs e.g. cigarettes, alcohol

Public good

A good or service that would not be provided by the free market because it is characterised
by non-excludability (i.e. if it exists, it is impossible to stop someone from benefiting from it)
and non-rivalry (i.e. its consumption by one person does not reduce its availability to others)
e.g. national defence, lighthouses

Private good
A good that is not characterised by non-excludability and non-rivalry.

Asymmetric information

A situation in which some participants in a market have access to more information than
others

Symmetric information

A situation when all participants in a market have access to the same information.

Efficiency

Situation where a good or service is being produced at the lowest possible average (unit)
cost

National minimum wage

A sum of money that is legally the minimum amount that an employer can pay an employee.
It is usually set at an hourly rate.

Government failure

Situation when government interference in a market to correct market failure results in a

less efficient allocation of resources.

Buffer stock

A reserve of a commodity held to stabilise commodity prices. The stocks are usually held
by an organisation that is separate from the producers – often the government.

Notes on Unit 1 Topics

Basic Concepts

Economics is the study of the allocation of scarce resources. To an economist the term
‘scarce resources’ refers to the fact that nearly all resources are limited. The basic
economic problem that all societies have to face is that while virtually all resources are
limited, human beings have infinite wants. Resources for the production of goods and
services are known as factors of production and can be classified as follows:

1. Land: natural resources used for production e.g. fields, coal, cows.

2. Labour: human resources used for production

3. Capital: manufactured resources used for production e.g. factory buildings, machinery.

4. Enterprise (entrepreneurship): risk taking for production

Every time a resource is used for something, something else has to be given up. Cost
expressed in terms of the foregone alternative is known as opportunity cost. Opportunity
cost can be illustrated on a diagram through production possibility frontiers. Production
possibility frontiers show all the combinations of 2 goods (or 2 types of good) that can
be produced by a firm or an economy when all of its factors of production are being fully
used. The following diagrams are production possibility frontiers showing the combinations
of consumer goods and capital goods that can be produced in an economy when ALL
factors of production are being fully used. Diagram 1 is a straight line which means that
the opportunity cost of, say, producing capital goods remains constant. Every time a capital
good is produced, one consumer good is foregone. This isn’t very realistic since not all
factors of production will be equally good at producing both types of good. Some will be
very suited to the production of consumer goods while others will be more suited to the
production of capital goods. Diagram 2 shows a curved production possibility frontier. The
more capital goods produced the greater the number of consumer goods that have to be
foregone in order to produce another capital good.

If some factors of production are not being used (for example, if there is unemployment),
production will be somewhere inside the production possibility frontier (e.g. at point x on
figure 2). It is impossible to produce in the area outside the curve.

Every society has to have a way of deciding the answers to the following questions:

§ WHAT to produce i.e. what goods and services are going to be produced with the
available factors of production

§ HOW to produce i.e. which factors of production are going to be used for what
§ FOR WHOM to produce i.e. how are the goods and services produced by the economy
going to be distributed among the population.

There are theoretically two extreme ways of answering these questions:

§ COMMAND (PLANNED) ECONOMIES in which all the decisions as to what, how and
for whom to produce are made by the state.

§ FREE MARKET ECONOMIES in which all the decisions as to what, how and for whom
to produce are made by free market forces through the price mechanism (supply and
demand).

In the real world all economies are some form of MIXED ECONOMY in which some
decisions are made through the market and some by the state.

We are now going to look at how a free market would operate and then why and how
governments intervene in markets. As we do this (as with any topic in this subject) we will
be making economic statements. Some of these statements will be positive. A positive
economic statement can be tested to find out whether or not it is true. Some statements
will be normative i.e. they will be based on opinions or value judgements.

(Find out more on pages 1 to 16 in your textbook by Peter Smith)

 Free Market Economies

In a totally free market there is no state intervention in the market. What, how and for whom
to produce is decided entirely through free market forces i.e. demand and supply.

Demand
Demand curves show how much consumers are willing and able to buy at each price. They
are downward sloping because:

§ Substitution effect: as the price of a good falls people will buy more of that good and
less of a more expensive substitute

§ Income effect: as price falls the amount that consumers can purchase with their incomes
(real incomes) increase enabling them to buy more of the good.

If price changes there is a movement along the demand curve. The demand curve will
NEVER shift because of a change in price.
A movement along the demand curve because of a change in price

However, the demand curve might shift in response to a change in its conditions of demand.

A change in any of the following might cause the demand curve to shift:

§ Real incomes

§ Price and availability of substitutes

§ Price and availability of complements

§ Size of the population

§ Age structure of the population

§ Advertising and other publicity

§ Tastes and fashion

§ Weather

If the change in the conditions of demand cause demand to increase, the demand curve
will shift to the right. If the change in the conditions of demand cause demand to decrease,
the demand curve will shift to the left.
There is more about demand on pages 17 to 25 in your textbook be Peter Smith)

Supply
A supply curve shows how much suppliers are willing and able to supply at each price. The
higher the price, the easier it is to make a profit so the more will be supplied. Supply curves
are, therefore, upward sloping. A change in price will cause a movement along the supply
curve. A supply curve will NEVER shift because of a change in price.

However, a supply curve may shift in response to a change in the conditions of supply.

A change in any of the following might cause the supply curve to shift:

§ Costs of production e.g. changes in the cost of wages, salaries, machinery, raw materials
etc.

§ Indirect taxation on the good (if an indirect tax is imposed on a good, the supply curve
will shift to the left)

§ Subsidies on the good (if a subsidy is put on a good the supply curve will shift to the right).

A change in the conditions of supply that cause supply to increase will cause the supply
curve to shift to the right. A change in the conditions of supply that cause supply to decrease
will shift the supply curve to the left.

(There is more about supply on pages 33 to 38 in your textbook by Smith)

Equilibrium price and quantity

If the market is in equilibrium there is no tendency for price or output to change. The
equilibrium price and quantity are determined by the point at which the demand curve and
supply curve cross since this is where the amount that consumers are willing and able to
buy exactly equals the amount that suppliers are willing and able to supply. If the conditions
of either supply or demand change, one of the curves will shift and there will be a new
equilibrium price and quantity.
(There is more about price determination on pages 42 to 48 in your textbook by Peter
Smith)

Price elasticity of demand

Price elasticity of demand is a measure of the responsiveness of demand to a change in
price. It can be calculated using the following formula:

% change in quantity demanded

% change in price

Since a price rise will cause demand to fall and a price fall will cause demand to increase,
price elasticity of demand is always negative. If the percentage change in demand is
greater than the percentage change in price, demand is said to be PRICE ELASTIC. If the
percentage change in demand is less than the percentage change in price, demand is said
to be PRICE INELASTIC. If the percentage changes in demand and price are the same,
demand is said to be of unit elasticity.

If demand for a good is price elastic, i.e. (ignoring the minus sign) it is more than 1, as price
increases revenue from selling the good will decrease and as price decreases revenue will
increase.

If demand for a good is price inelastic, i.e. (ignoring the minus sign) it is less than 1, a
price increase will cause revenue to increase and a price decrease will cause revenue to
decrease.

If demand is of unit elasticity, a price change will leave revenue unchanged.

Factors that affect price elasticity of demand:

§ The degree to which a good is regarded as a necessity (the more it is regarded as a

necessity, the lower the elasticity)

§ The price and availability of close substitutes (the more difficult it is to buy close
substitutes, the lower the elasticity)

§ The proportion of household expenditure spent on the good (the lower the proportion of
household expenditure, the lower the elasticity)

§ The number of uses that the good has (the more uses, the lower the elasticity)

TIME is also important. The greater the period of time involved, the higher will be the price
elasticity of demand.
The more price inelastic demand is, the greater will be the change in price as a result of
a movement in the supply curve.

There is more about price elasticity of demand on pages 25 to 30 in your textbook

by Peter Smith

Price elasticity of supply

Price elasticity of supply is the responsiveness of supply to a change in price. It can be
calculated using the following formula:

% change in quantity supplied

% change in price

Since an increase in price causes supply to increase and a decrease in price will cause
supply to decrease, price elasticity of supply will be positive. If it is more than 1 it is said to
be elastic, less than 1 it is inelastic and if it is 1 it is of unit elasticity.

Factors affecting price elasticity of supply:

§ The amount of excess capacity in the industry. If firms are fully using all of their factors
of production it will be impossible to increase supply in the short run so supply will be price
inelastic.

§ The length of time needed to increase production. If it takes a long time to produce more
of the good, supply will be price inelastic.

§ The extent to which the good can be stored and the costs of storage. If a good is highly
perishable, it cannot be stored and this will tend to make supply price inelastic. If the good
can be stored but storage is expensive relative to the price of the good, supply will tend
to be price inelastic.

TIME is also important. The greater the period of time under consideration the higher the
price elasticity of supply (i.e. the more price elastic supply will be).
The more price inelastic supply is, the greater the change in price will be as a result of a
shift in the demand curve.

Income elasticity of demand

Income elasticity of demand is a measure of the responsiveness of demand to a change in
income. It can be calculated by using the following formula:

% change in quantity demanded

% change in income

If the good is normal (i.e. demand for it increases when real income increases and vice
versa) the value of the elasticity will be positive. If the good is inferior (i.e. demand
decreases when real income increases and vice versa) income elasticity of demand will
be negative.

The factors affecting income elasticity of demand are the same as those for price elasticity
of demand.

If you are asked to comment on the value for income elasticity of demand, there are always
two aspects of the income elasticity of demand that you can look at:

1. Whether the good is normal or inferior. If income elasticity of demand is positive the
good is ‘normal’ but if it is negative the good is inferior.

2. Whether demand is income elastic or income inelastic. If income elasticity of demand

(ignoring any sign) is more than 1, it is elastic. If it is less than 1 it is inelastic. If it is 1 it is
of unit elasticity. So, an income elasticity of demand of +2.5 is elastic as is one of –2.5. An
income elasticity of demand of +0.2 is inelastic as is one of –0.2.

There is more about income elasticity of demand on page 31 of your textbook by

Peter Smith.

Cross elasticity of demand

Cross elasticity of demand is a measure of the responsiveness of demand for one good to
a change in the price of another good. It is calculated as follows:

% change in quantity demanded of good A

% change in price of good B

It is used to look at the effect of a change in the price of a good on the demand for a substitute
or a complement. If the goods are substitutes, the cross elasticity of demand will be positive.
If the goods are complements, the cross elasticity of demand will be negative. How elastic
cross elasticity of demand is will depend on how close the goods are as substitutes or how
dependent they are on each other as complements. Again, there are two things to comment
on, whether the two goods are complements or substitutes and whether cross elasticity of
demand is elastic or inelastic.

There is more about cross elasticity of demand on pages 31 and 32 in your textbook
by Peter Smith

Indirect taxes

An indirect tax is a tax on goods and services rather than on income or wealth. Examples
of indirect taxes in the UK are Value Added Tax (VAT) and Excise Duty. We pay VAT on
most of the goods and services that we buy (two notable exceptions are food and children’s
clothes). Excise Duty is an extra tax that is paid in addition to VAT on some goods e.g.
cigarettes and alcohol. Excise Duty is an example of a specific tax i.e. the same amount of
tax is paid on each item regardless of the value of the item. For example, the same amount
is charged on every bottle of still table wine regardless of whether it is a really cheap one or
whether it is a very expensive chateaux bottled variety. VAT is an example of an advalorem
tax i.e. the tax is a percentage of the value of the good. In the UK VAT is 17.5% (20% from
st
January 1 2011) of the value of the goods we purchase.

When an indirect tax is imposed on a good, the supply curve will shift to the left. This is
because it is the suppliers who actually hand money over to the government so it is like
having another cost as far as they are concerned. A specific tax will shift the supply curve
to the left in parallel to the original supply curve. The degree to which the tax will increase
the price will depend on the size of the tax and the price elasticity of demand for the good -
the lower the price elasticity of demand, the greater the increase in price. In the exam you
may be asked about the incidence of the tax on consumers and producers, in other words,
how much of the tax is paid by the consumers and how much is paid by the producers.
The incidence of the tax on consumers can be shown on a diagram. It is the difference
between the new and old equilibrium price multiplied by the amount that is now being bought
and sold. The incidence of the tax on the producer is the difference between the original
equilibrium price and the amount of money from each sale the supplier can keep after paying
the tax multiplied by the amount bought and sold. The lower the price elasticity of demand,
the higher the incidence of the tax on the consumer and the lower the incidence on the
producer (and vice versa). The total amount of tax revenue received by the government
is the vertical distance between the two supply curves (the tax per unit) multiplied by the
amount bought and sold after the tax has been imposed.

An ad valorem tax will also cause the supply curve to shift to the left but the new supply
curve will be steeper (i.e. less price elastic) than the original.

Subsidies

A subsidy is a sum of money paid to a producer for each item produced. This has the same
effect as reducing the costs of production and therefore shifts the supply curve to the right.
The lower the price elasticity of demand, the greater will be the reduction in the price of the
good. The total cost of the subsidy to the government is the vertical distance between the
two supply curves, multiplied by the amount bought and sold when the subsidy is in place.

There is more about indirect taxes and subsidies on pages 65 to 67 in your textbook
by Peter Smith.

Consumer surplus

Consumer surplus measures the welfare the consumers get from the consumption of goods
and services. It is the difference between what consumers are willing to pay and what
they actually pay. The level of consumer surplus is shown by the area under the demand
curve and above the ruling market price. In the diagram below, if the market price is p, the
consumer surplus is the triangle PBA.

There is more about consumer surplus on page 49 of your textbook by Peter Smith
Producer Surplus

Producer surplus is the difference between the price at which producers are willing and
able to supply a good and the price they actually receive. In the diagram below at price p
the producer surplus is the triangle PBA.

There is more about producer surplus on page 50 of your textbook by Peter

Smith.

The functions of price in a market economy

1. Price is a rationing device. Goods that are in limited supply will go to those who are
prepared to pay the most.

2. Price is a signalling device. An increase in demand raises price and causes supply
to expand (i.e. a movement along the supply curve) and vice versa. An increase in supply
causes demand to expand (i.e. a movement along the demand curve) and vice versa.
th th
Unit 15 (4 edition) or unit 13 (5 edition) in Anderton will give you more information
about the function of prices

The advantages of free market economies

1. Efficiency: firms in a free market economy have to produce at the lowest possible
average cost because otherwise they will find they cannot compete with other firms.

2. Consumer sovereignty: consumers decide what they want to spend their money on
and supply adjusts accordingly.

3. Automatically adjusting: as market conditions change, quantities demanded and

supplied automatically adjust.
Disadvantages of free market economies

1. No provision of public goods. Public goods are goods that it is impossible to stop
someone consuming (non-excludability) and also their consumption by one person does not
reduce the amount available to others (non-rivalry). An example of a public good is national
defence. Everybody in the UK is being protected by the armed forces and it is impossible
to stop anyone in the UK from receiving this benefit. However many people are in the UK,
the level of benefit remains the same.

2. Under provision of merit goods. Merit goods are goods whose consumption yields
substantial benefits to people other than those consuming the good (external benefits). An
example of a merit good is education. Education improves the quality of the workforce and
therefore makes it more productive. The more we can produce the richer, on average, we
will be. If education was provided only through the market, children would only be educated
if their parents were rich enough to pay.

3. Overprovision of demerit goods. Demerit goods are goods whose consumption results
in substantial external costs. Cigarettes are an example of a demerit good because their
consumption causes ill health for others through passive smoking, increases the burden on
the health service, is a major cause of fires and is the cause of a large amount of unsightly
litter.

4. Inequality and poverty. There is nothing in the free market system to ensure the survival
of those with reduced or no capacity for work. There is no social security system to provide
for those who are temporarily or permanently unable to provide for themselves.

5. Unemployment. There is no guarantee in a free market economy that everyone will

be employed.

6. Only private costs and benefits are taken into account so external costs and benefits are
ignored. In a free market system there are no planning controls, no regulations concerning
emissions from cars or factory chimneys or the disposal of toxic waste. Pollution is therefore
likely to be a problem.

7. Monopolies may arise which will be able to exploit consumers by charging higher prices
than if they were in competitive markets. The lack of competition also tends to make them
inefficient.

Mixed Economies
Because totally free market economies have serious disadvantages, nearly all the
economies in the world are some form of mixed economy (an economy in which what,
how and for whom to produce is determined partly through market forces and partly through
state planning). To what extent the government intervenes in markets does, however, vary
considerably from country to country. No economy in the world is a totally free market
economy because this would mean that there would be no national defence. National
defence is an example of a public good. Public goods have two main characteristics:

• Non-rivalry (their consumption by one person does not reduce the amount available
to others)
• Non-excludability (it is impossible to prevent people from consuming the good)

These characteristics mean that it is impossible to charge people as they consume the good
and it is therefore impossible to make a profit from their provision. If it is impossible to make
a profit from producing something, it will not be produced in a free market.

Application of Supply and Demand in Particular Markets

Agriculture

When the prices of agricultural goods are left to be determined by free market forces (supply
and demand) they tend to fluctuate (go up and down) considerably. The reasons for this are:

§ Weather and disease can severely reduce the supply of crops and livestock.

§ The supply of agricultural goods is price inelastic so a small change in demand can
bring about a dramatic change in price. Price elasticity of supply is often close to zero (i.e.
the supply curve is nearly vertical) in the short run because it is impossible to immediately
increase the amount of a crop or the number of animals.

§ The demand for agricultural goods is also price inelastic so a small change in supply can
bring about a dramatic change in price.

§ Farmers often base their decision on how much to produce on the price that they received
in the previous time period. If the price in the last time period was unusually low this will
mean that production will fall causing a large increase in price in the next time period. On the
other hand, if the price in the previous time period was unusually high, farmers will decide
to produce a large amount causing a significant fall in the price in the next time period.
Another problem in agricultural markets results from the fact that the demand for most of
these goods in income inelastic so that as the incomes of most of the population of a
country increases, they do not buy much more food so the incomes of farmers do not go up.

If governments did not intervene in agricultural markets, farmers incomes would fluctuate
and would gradually decline. This would result in many farmers leaving the land, a fall in
agricultural output and an increase in imports of food. Many industries, however, have been
allowed to decline in the past so what makes agriculture different?

§ It is often thought that since food is essential to human survival, individual countries
should ensure that they are capable of feeding their population in case international trade
is disrupted e.g. in times of war

§ The agricultural industry plays an important role in the management of the countryside.

§ A declining agricultural industry might lead to rural depopulation and increased

congestion in urban areas

§ Environmentalists point out that transporting food long distances is a major cause of
pollution.

So what can governments do?

1. In the EU farmers used to be guaranteed a price above the market price. This resulted
in farmers supplying more than was demanded and so the authorities had to buy up the
surplus at the guaranteed price. As a result consumers had to pay more for food and the
EU had to spend about half of its budget on supporting agriculture. This is an example of
government failure

P and q are the free market price and quantity. When the EU guarantees farmers a price
of p1, qs is supplied but only qd is demanded. The EU had to buy the difference between
the amount supplied and the amount demanded at the guaranteed price. EU expenditure
is shown by the shaded area.
Today, farmers in the EU are still subsidised but the subsidies are not based on how
much they produce. Some of the money that they receive is for introducing environmentally
friendly farming methods.

2. Buffer stocks of non-perishable agricultural goods. (See section on commodities

below)

N.B. The prices of many agricultural products have risen sharply in the past 2 years. The
main reasons for this have been:

· Increased demand for meat and dairy products in China and India

· Increased use of agricultural land for the growing of crops for bio fuels

· Extreme weather conditions (probably a result of global warming)

Commodities

The term commodities is usually used to refer to mineral and to agricultural goods that are
not perishable in the short term. The prices of commodities tend to fluctuate for the same
reasons given for agriculture. There has also been a long run downward trend in the prices
of most commodities. The main reasons for this are:

§ A fall in demand for some goods as synthetic substitutes are produced e.g. for rubber
and textiles

§ A fall in demand as many products made with metals have declined in size

§ An increase in world supply especially for cocoa beans and coffee beans as developing
countries try to export more and more in order to earn the foreign currency needed to repay
debt.

In order to maintain prices, countries sometimes make buffer stock agreements. These
involve setting a price ceiling and a price floor. In years when the price drops too low
( because of an increase in supply) the government or buffer stock authority buys large
amounts of the good and stores it. This reduces the supply and so raises the price. In years
when the price is too high (because of reduced supply) the government or buffer stock
authority sell from the stores it made in previous years.
However, there are problems with buffer stock schemes:

· A considerable amount of money is needed to set them up as money is needed to

buy produce and to provide suitable storage.

· Administration costs are high as are the costs of transporting the goods to and from
storage

· It can only work for non-perishable goods

· Producers often put pressure on whoever is running the scheme to set the intervention
price above the average market price. This results in more and more of the product having
to be bought up and stored leading to stockpiles of the good and ever increasing costs.

NB In recent years the price of some commodities (notably oil but also many metals)
has risen. The main reason for this is an increase in demand from the rapidly expanding
economies of China and India.

Find out more about agricultural and commodity markets on pages 59 to 62 in your
textbook by Peter Smith.

The Market for Shares

When someone buys shares in a company, they become one of the owners of that
company. People and organisations buy shares for two reasons:

1. to receive dividends (i.e. to get a share of the company’s profits)

2. in the hope of being able to sell the shares in the future at a higher price than the one
that they had paid.

The demand for the shares of a particular company is determined by:

· the expectation of future profits in that company. This will be affected by demand for
what the business is producing and what is expected to happen to the costs of production.

· the performance of the economy. Most businesses are more profitable when the
economy is doing well (i.e. when the economy is growing at a reasonable pace so that most
people have rising real incomes) because they produce normal goods (i.e. goods with a
positive income elasticity of demand). Companies that produce a large number of inferior
goods (goods with a negative income elasticity of demand) will tend to be more profitable
during a recession. Companies that produce products that are highly income inelastic e.g.
supermarkets tend not to be affected much by the performance of the economy.
· Competition. An increase in the demand for the products of a competitor will tend to
reduce the profitability, and hence the share prices, of a business.

Find out more about the stock market on pages 64 to 65 in your textbook by Peter
Smith.

Labour

Wages are the price of labour. The supply curve for labour for most occupations is upward
sloping as the higher the wage the more willing workers are to supply their labour. The
position of the supply curve depends on:

§ Skills qualifications and training needed

§ How pleasant the job is

§ The social status of the job

§ Whether or not the job is dangerous

§ Migration patterns (e.g. expansion of the EU in 2004 resulted in increased immigration

into the UK from countries such as Poland. This increased the supply of labour to some
occupations).

§ Social trends: a few decades ago, women were a relatively small proportion of the
workforce in the UK. Easier access to childcare and changing social expectations have
resulted in a large increase in female participation in the labour market.

The more difficult it is to acquire the skills and qualifications for a job, the lower the price
elasticity of supply for labour.

The demand curve for labour is downward sloping as employers’ costs of production will
be high at high wage levels and low at low wage levels. The position of the demand curve
depends on:

§ The demand for the good that the workers produce (i.e. the demand for labour is a
derived demand – labour is not demanded for itself but for what it can produce)

§ The ease with which capital can be used instead of labour (labour and capital are
substitutes).
The lower the price elasticity of demand for the good being produced and the more difficult
it is to use capital instead of labour, the lower the price elasticity of demand for labour.

If wages are left entirely to free market forces, some people will have very low wages and
will be living in poverty. Also, if wages are very low, workers who have become unemployed
may not have much incentive to look for work. For these reasons governments often impose
a minimum wage. This only affects the minority of people who work in very low wage
occupations. It is important that the minimum wage is not set too high because if it is the
amount of labour demanded will be less and unemployment is caused.

The effect of setting a national minimum wage above the equilibrium wage. If a national
minimum wage is set at W1 when the equilibrium for the industry is W, employment will
fall from N to Nd.

As well as possibly causing unemployment, there are other problems

associated with putting a national minimum wage in place:

• May cause the costs of production to increase for some industries. This will cause
the supply curve for goods produced in that industry to shift to the left so prices
will rise.
• It may reduce pay differentials and therefore de-motivate some workers who are
paid above the minimum wage

Labour Immobility

The labour market is not very efficient, and market failure results from the inability of workers
to move easily between jobs. There are two main types of labour immobility:

• Geographical immobility is the inability of workers to move around the country in

search of work. This can be caused by:

· The high percentage of home ownership in the UK and the lengthy process required
to buy and sell a house. It is also difficult for people to move from an area of relatively low
house prices to one with relatively high prices

· Social reasons such as not wanting to move away from friends and relatives and
not wanting to disrupt a child’s education
(The UK government provides housing subsidies for Key Workers (nurses, teachers etc.)
in areas where house prices are high, but many of the available homes are in undesirable
areas and waiting lists are long).

• Occupational immobility is the inability of workers to move from one job to another
because of a lack of appropriate skills or training. As the economy has moved from
one largely based on manufacturing to one largely based on services, many low-
skilled manual workers have found themselves without jobs. Schemes such as the
government’s New Deal for Labour have tried to tackle this by providing training
programmes and courses, but many people cannot afford to spend their time in
training rather than work.

Unemployment that is caused by a significant change in the structure of the economy such
as a shift from manufacturing to services or the decline of a major industry, is known as
structural unemployment.

There is more about the Labour Market on pages 68 to 83 in your textbook by Peter
Smith.

Housing

The market for housing is unusual in several respects:

§ Houses cannot be moved from one location to another so there are wide regional
variations in house prices.

§ It is a largely second hand market

§ It is the most expensive item that most households buy

§ Most households finance the purchase of a house through borrowing i.e. they get a
mortgage. In the UK the interest rate on most mortgages changes as interest rates in
general change.

In the UK in recent months, house prices in most parts of the country have risen rapidly. This
is because there has been a big increase in demand but supply has stayed more or less the
same (i.e. the supply of houses is highly price inelastic – the supply curve is almost vertical).
There has been an increase in the demand for houses because:

§ Real incomes have been increasing

§ Interest rates have been low so people can afford larger mortgages

§ As house prices rise, households buy houses in order to increase their wealth

Supply has stayed more or less the same because:

§ There are planning restrictions on much of the land e.g. green belt land in the area around
London

§ The government has been encouraging builders to build on ‘brownfield’ sites (i.e. sites
within existing urban areas) rather than on ‘greenfield’ sites in rural areas. It is much easier
to build on greenfield sites.

§ Little money has been provided for the building of ‘social housing’ (houses built by
councils and housing associations)

Of course, if you can’t or don’t want to buy a house or flat, you can rent one. As house
prices rise the demand for rented housing increases. In the past governments sometimes
imposed maximum rents in order to make sure that they were affordable. The problem was
that if the rent was set above the market equilibrium rent, the supply of housing for rent
would go down and some people would not be able to find somewhere to live.

There is more about the market for housing on pages 62 and 63 in your textbook by
Peter Smith

Merit Goods

A merit good is a good or service that would be underprovided by the free market because
its consumption results in substantial external benefits.

The consumption of health care has external benefits (or positive externalities)

- it can restrict the spread of disease

- it reduces the number of working days lost through ill health

- it makes workers more healthy and therefore more productive

Health care would not be provided at the socially optimal level in a free market
- incomes are unequal so that not everyone can afford it

- medical knowledge is very complex and people have imperfect knowledge. It is

therefore difficult for them to make informed decisions about what care to purchase or, in
some cases, whether to purchase care at all.

- doctors can exploit patients by recommending treatments that they don’t need. This
is because of asymmetric information i.e. the doctor has much more knowledge than the
patient who is not qualified to question the doctor’s recommendation.

- Consumers are not aware of their future needs. Medical care is expensive
and, for more serious conditions, few people can afford to pay out of their current income.
If they haven’t saved in the past, therefore, they will not be able to afford to pay.

- Monopoly power may arise. Health care may be concentrated in only one or just a
few organisations in an area. This could result in higher prices.

In a free market, price and the amount consumed will be determined by the point at which
S(MSC) crosses D(MPB) but the socially optimal point is where MSC crosses MSB. The
free market output and price are q and p. The socially optimal output is at q1.

The government has been spending more and more on health care since the NHS was
established in the late 1940s

- ageing population (older people often require more health care than younger people)

- new medical technology and new drugs mean that more conditions can be treated

- health care is a normal good and real incomes have been rising (the income elasticity
of demand for health care is positive and elastic). As peoples’ real incomes increase they
expect a higher standard of health care

- health care is a lab