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GCSE ECONOMICS (OCR)

Revision Guide:
Unit 1

Markets at Work
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(A)

The Basic Economic Problem

What is it?
The basic economic problem is the fact that RESOURCES are SCARCE (limited in
supply) but WANTS are INFINITE (never ending). As a result of this, consumers,
producers and the government have to make CHOICES about how to ALLOCATE
scarce resources.
When we choice one thing, we often sacrifice or give-up something else.
OPPORTUNITY COST is the highest valued alternative that we forego because
scarce resources allocated elsewhere.
What are resources?
Resources are all the elements that go into the production of goods and service. Resources
are often known as the FACTORS OF PRODUCTION. There are 4 factors of production:
(a)LAND: All natural resources used in production, for example building land,
oil, water, wheat, apples
(b)LABOUR: The human contribution to production- i.e. workers!
(c) CAPITAL: Capital refers to man-made equipment that is developed to aid the
production of other goods and services. For example machines, computers,
vehicles, shop fixtures, tills
(d)ENTERPRISE: The person(s) who has the initial business idea, raises the
money and organises the other factors of production.
Economic Systems
All economies face the basic economic problem. However, they may have different
approaches to addressing it and allocating resources. The approach they choose is known as
an economic system
(a) PLANNED ECONOMY: All resources are owned by the PUBLIC SECTOR (the sector of
the economy owned and controlled by the government). The public sector determines
what goods and services are made and how. Goods and services are shared out
amongst the population
(b) FREE-MARKET ECONOMY: All resources are owned by the PRIVATE SECTOR (the
sector of the economy owned and controlled by private individuals). Goods and
services are allocated via the MARKET MECHANISM, that is via demand and supply
(prices)
There are pros and cons of planned and free-market economies:
Planned Economy

Free Market Economy

Pros
It is fair, everyone will get
something
Theoretically, everyone can be
given a job
The government can provide
merit goods such as health and
education, and public goods
such as defence
There is competition- this is
good for consumers (Low prices,
better quality, more choice,
more innovation)
There is more incentive to be
efficient as low costs can allow

Cons
There is no incentive to be
efficient
There will be little choice for
consumers or workers
There may be corruption
Economic growth tends to be
great low because of the lack of
profit incentives
Inequality- there will be absolute
and relative poverty- poor
people will be reliant on charity
and will have no choice
Public and merit goods may not
be provided/will be under

low prices which may be


important if markets are
competitive

produced/consumed- eg not
enough access to education and
health care
Environmental costs (eg
pollution) is likely and there is no
incentive to look at sustainable
use of resources

In reality, most economies are mixed. This means there is a mixture of a public sector and a
private sector owning and allocating the scarce resources. The UK has a mixed economy that
is moving towards being more free market:
Public Sector: Education, Health, Police, Defence
Private Sector: Water, Electricity, Gas, Rail, Airlines, Supermarkets, Clothes stores
Examples of how the UK has become more free-market: Privatisation; deregulation; contracting out; Free Schools and Academies

Understanding the key differences between the public and private sector
This can be summarised below:
Public Sector

Private Sector

Ownership
The government
on behalf of the
people (tax
payers)

Private
individuals from:
Sole Traders (1)
Partnerships (220)
Private and
Public limited
companies
(shareholders)

Control
A government
minister will
oversee control

Owners/Sharehol
ders will lead the
strategic
direction.
Managers will
exercise control
on a day to day
basis

Aims
To provide a
good quality
public good or
service
To allow as many
people as
possible access
to the good or
service

Mainly to make a
profit (unless it
is a charity)
Wider aims and
objectives (see
later notes)

Finance
Money will be
raised from the
taxpayer.
Any losses will
be funded by the
taxpayer.
The
business/area
could continue
even if it was
loss making
Finance will be
from:
Savings
Loans
Redundancy
payments
Share issue

The different sectors of the economy


Primary Sector

Definition
The sector of the economy

Examples
Fishing, mining, farming

Secondary Sector

Tertiary Sector

responsible for extracting


resources from the natural
environment
The sector of the economy
that is responsible for
manufacturing and
construction (ie using the
primary resources to make
goods and services)
The sector of the economy
responsible for providing
services to consumers and to
other businesses

Textiles, Food manufacturing;


Car manufacturers;

Banking, Insurance, Leisure


and Tourism; Catering;
Advertising and Marketing

The UK now has a very large tertiary sector having been through a period of DEINDUSTRIALISATION. This is the process by which the secondary sector of the economy
shrinks so that it produces less and employs fewer people.

The main reasons for de-industrialisation are:

Increased competition from abroad (globalisation)


Historically low levels of investment and productivity in the UK mean that our goods are
more expensive and poorer quality
Higher wage and tax levels in the UK have contributed to higher costs and therefore
higher, less competitive prices in the UK
As the UK has got more economically developed and richer, the demand for services
has risen as they are income elastic. Businesses have developed to meet this need.

Specialisation
Faced with the basic economic problem, it is important that scarce resources are used as
efficiently as possible.
It can be argued that using resources in a more specialised way is more efficient and
increases production. There are different types of specialisation:
What is it?
Specialisation of
labour (division of
labour)

The production
process is organised
so that workers all
have a very specific
(and often quite
narrow) job role so
that they repeat a
particularly task often

Potential
Advantages
Increased
productivity as a
result of expertise
and repetition. Time
is not wasted moving
from one job to
another

Potential
Disadvantages
Repetition leads to
boredom, demotivation and a
reduction in
productivity

Makes more efficient


(planned) use of
scarce capital

A break/weakness in
the chain (eg a an
unproductive worker)
could affect the whole
production process

Requires less training


(in unskilled contexts)

For workers, wages


may be lower if tasks

Product
specialisation

A firm focuses its


production on one, or
a very narrow range
of products

as workers only have


to do a limited range
of tasks
The firm can buy
resources to make
the product in bulk
The firm gains a
reputation as an
expert in the fieldthis can stimulate
demand and make it
more price inelastic
The above could
contribute to a
degree of monopoly
power in the market
The firm can have
very specialist buyers
and sellers and can
focus its research and
development budget
on one product

are unskilled

It is very risky all the


eggs in one basketa decline in the
demand for the
particular good or
service would be
catastrophic for the
firm
It cannot take
advantage of crosssubsidising products
It does not take
advantage of having
existing customers
who may wish to also
buy a range of
products from the
firm, including
compliments (and
impulse buys)
Consumers
increasingly want to
buy a range of
products under one
roof for conveniencethey may go
elsewhere

Regional
specialisation

A particular region is
focussed on
producing a particular
good or service. This
means that a lot of
the jobs in that area
are provided by the
specialist industry
Eg historically:
Sheffield Steel
Lancashire- textiles
West Midlands- Cars
East Anglia- Shoes

Firms in the industry


may benefit from
external economies of
scale (the idea that
the growth of an
INDUSTRY) leads to
lower average costs.
This will arise
because:
There are
skilled workers
in the local
area
The local
infrastructure
is set up to
meet the
needs of the

The area is very


vulnerable to a fall in
demand for the
product
If demand falls there
will be high levels of
regional
unemployment and
the regional problem
may arise:
Low demand for other
G&S in the area
Increased crime
Poor morale- low
educational
attainment

International
specialisation

Countries specialise
in producing goods in
which they have an
absolute or
comparative
advantage

industry (roads
etc)
Local banks are
financially
supportive of
the industry
Suppliers move
to the region,
reducing
transport costs
and making
supplies more
flexible
World output of goods
is increased as all
countries focus on
what they are
good/efficient at and
then trade
Because Average
Costs are lower,
prices may be lower
Encourages free
trade, competition
and choice- good for
consumers
Takes account of the
fact that climates and
resource endowments
vary between
countries

Increased social
problems
New firms are
reluctant to locate to
the area because of
the above problems
There is a cycle that
leads to absolute and
relative poverty

Requires trade to
allow the exchange of
goods and servicesthis may be affected
at times of war/unrest
Countries may be
unable to access
certain G&S if trade is
disturbed
Some products (such
as primary products)
have lower prices and
more unstable prices.
Countries specialising
in these find it hard to
develop and grow
(LDCs)
Countries will be
vulnerable if there is
a downturn in world
demand for the
products that they
specialise in
Trade and
international
competitiveness may
be undermined by
fluctuations in
exchange rates

The characteristics and functions of money


If countries/firms specialise in production, there has to be a means of exchanging goods.

Historically, this was done by BARTER and SWAPPING goods, but this was difficult for a
number of reasons. MONEY allows exchange to take place.
The Functions of Money (what it does)

A means of exchange

A unit of account

A store of value

A method of deferred
payment

What does this mean


Money allows people to
exchange one good for
another without finding a
double of co-incidence of
wants
Money allows the value of
one good to be expressed in
terms of another
Money allows you to save

You can buy now pay later

Example
I have a mountain bike to sell
but want a racing bike.
I sell the mountain bike for
money.
I use the money to buy a
racing bike
My racing bike was 500
Your racing bike was 100
My racing bike is 5 times
more valuable than your bike
I sell my mountain bike but
cannot find a racing bike I
like. I put the money I earn
from the mountain bike in the
bank and save it until I can
find what I want
The shop allows me to buy
the bike on 12 months credit

The Characteristics of Money (what should effective money be like?)


Characteristic
Portable
Durable
Divisible
Non counterfeitable

What does it mean/why is it important?


You can easily carry it around
It lasts a long time and does not perish
You can break it into small bits to pay for
cheap items
It is hard to forge it

(B)

What are Competitive Markets?

The Spectrum of Competition


_______________________________________________________________________________________________
(1)
(2)
(3)
(4)
(5)
(1) Perfect Competition: Hundreds of firms operate in a market and sell identical products.
There are no barriers to entry so lots of new firms can enter the market.
(2) Competitive Markets: Large numbers of firms exist in the same market. They sell very
similar/identical products. Barriers to entry are very low. Examples: plumbers,
hairdressers; builders
(3) Oligopoly: 3-8 large firms dominate an industry and account for a large proportion of
market share. The firms are big and benefit from significant economies of scale. This
acts as a barrier to entry. Examples: Fast Food; Mobile Phones; Supermarkets;
(4) Business Monopoly: 1 firm has more than 25% of market share and dominates the
market. Barriers to entry are very high
(5) Economic Monopoly: There is only 1 firm in a market such that the one firm has 100%
market share. Often firms are natural monopolies because barriers to entry are so
high?
Sources of monopoly power
Monopolies tend to get their power and market share because of high barriers to entry:

Types of barriers to entry


Ownership of raw materials

Legal barriers to entry

Marketing barriers to entry

Technical barriers to entry

What does it mean?


One firm owns all the resources needed to
make a particular product, preventing other
firms from entering the market
There are legal things in place that give one
firm monopoly power. This may include
patents, statutes and copyright
One firm has a lot of marketing and
advertising resources. They use these to
create such a strong brand image and
identity, that it makes it very difficult for a
new firm to break in
The existing firm is very large and benefits
from economies of scale. New firms,
operating at much lower outputs, know that
they will not be able to produce at such low
costs and prices

Why are competitive markets seen as desirable?


Typically economists believe that competitive markets give better economic outcomes than
monopolies which are often seen as bad. In reality, it may be more complex than this.
Competitive Markets

Potential Gains
To Consumers:
Prices will be low
There will be more

Potential Losses
To Firms:
Prices are likely to be
driven much lower

Monopolies

choice
Quality may be
improved
There may be more
innovation and new
products as firms try
and stay ahead of
competitors
To Firms:
It may be easier to
attract workers as
there are lots of
workers doing similar
jobs. This high supply
of labour may keep
wages down
To the Economy
Competition
encourages firms to be
more efficient and to
keep their average
costs as low as
possible because
prices will be lower.
Firms are likely to make
more careful/efficient
use of scarce resources
To Consumers:
Firms are large and
may benefit from
economies of scale.
Firms MAY choice to
pass on the benefits of
this to consumers in
the form of lower
prices
Product quality and
range may be higher
than in competitive
markets. This is
because (a) The
monopolies have the
profits to re-invest in
the business and in
product development
and (b) They have the
incentive to do so
because they want to
maintain their
monopoly power and
keep barriers to entry
as high as possible

than in less
competitive marketsthis may reduce profit
margins
Lower profit margins
may mean that there
are less funds available
for re-investment
Their products are
likely to be more price
inelastic
There is a constant
pressure to cut costs
and be efficient. This
means that firms have
to spend a lot of time
managing resources
and ensuring labour
productivity is as high
as possible. This could
cause conflict
They may lose workers
to competitors if
competitors offer
better wages/working
conditions/training etc

To Consumers
Less competition is
likely to mean higher
prices
There will be less
choice
Product
quality/customer
service may decline
because the monopoly
has a captured market
(especially if it is a
natural monopoly)
To the Firm
The lack of competitive
pressures may make
the firm become stale
and unresponsive to
consumer demand. If
the product is not a
necessity, consumers
may move away from
the product over time

To the Firm
Prices are likely to be
more price inelastic.
This means that they
can keep prices higher
The lack of competition
means higher prices
and hence higher profit
margins
The lack of competition
means that the
monopoly does not
need to be as careful
about minimising costs
The monopoly does not
have to spend as many
resources on
advertising and
marketing
The financial position
of the monopoly will be
quite stable, this may
attract more
investors/finance
To the Economy
Economic resources
are focussed on
production and not on
marketing/advertising

To the Economy
The lack of incentive to
be efficient may mean
that scarce resources
are not being used as
well as they would be
under a competitive
market. The output of
goods and services
may be lower than in a
competitive market
The lack of competitive
forces may mean that
scarce resources are
not being used to
respond to consumer
demand and to make
the goods and services
that consumers most
want/value

Government Policies that can be used to increase competition/reduce monopoly


Policy
Ban all monopolies

How it works
Firms are not allowed
to own more than
25% of market share

Advantages
Removes the
disadvantages of
monopolies (see
above)

Privatisation

Makes public sector


monopolies private,
and thus opens them
up to competitive
forces

Creates the benefits


of competition
Reduces the burden
on the tax payer of
financing nationalised
industries

See also:
Contracting Out
De-Regulation

Disadvantages
There is no incentive
for firms to be
efficient, innovate,
get better because
success is penalised!
Loses the potential
gains of monopolies
(see above)
Concern that
consumers would be
exploited by private
companies
Worry that some
industries are
natural monopolies
Concern that non
profitable
products/services will
go

The government
helps to break
down barriers to
entry

Removal of barriers
to entry, naturally
encourages
competitive forces

A more natural way of


introducing
competition

It is very difficult to
do this in some
industries where
there are very high
natural and technical
barriers to entry. It is
easier to do it when
the main barrier to
entry is legal (ie a
previous law
protecting the
monopoly power)

Potentially allows us
to keep the benefits
of monopoly without
having the costs

Regulators may be
expensive and
bureaucratic

Eg: De-regulation:
Takes away laws that
previously gave firms
monopoly power- eg
Opticians

Regulation of
Monopolies

Eg2: The government


forced BT to share its
phone lines with
other companiesreducing a technical
barrier to entry
Monopolies are
allowed to exist but a
regulator is put in
place to ensure that
they do not exploit
the consumer and are
run efficiently
Examples: OFWAT,
OGFAS, OFCOM

Regulatory Capturesometimes over time


the regulators
become taken in by
the industry and stop
looking at it
objectively

How are resources allocated in competitive markets


Resources will be allocated by MARKET FORCES.
Market forces are the forces of DEMAND and SUPPLY. Demand and supply interact to give
EQUILIBRIUM PRICE and EQUILIBRIUM OUTPUTS

The equilibrium price is 35 pence


The equilibrium output is 250
Equilibrium means that this is a stable market outcome where there is no tendency to change
(unless demand and supply change)
Demand
Demand is the amount of a good or service that a consumer is WILLING and ABLE to buy
over a SPECIFIED PERIOD OF TIME
Demand and Price
There is usually an inverse relationship between price and quantity demanded. This can be
shown in a demand schedule (table showing the relationship between price and Qd) and a
demand curve.

The demand curve is downward sloping from left to right because it shows that quantity
demanded usually rises and price falls.
A change in price causes a MOVEMENT along the demand curve.
When price changes from $8 to $12 we will move up the demand curve and there is a
CONTRACTION in quantity demanded.
When price changes from $8 to $4 we will move down the demand curve and there is an
EXTENSION in quantity demanded.
The Conditions of Demand
These are the non-price factors that influence the demand for goods and services.
(1)INCOME
For NORMAL goods, a rise in income will lead to a rise in demand (and vice versa)

For INFERIOR goods, a rise in income will lead to a fall in demand (and vice versa)
(2)PRICE OF RELATED GOODS
Substitutes: Goods in rival demand (Pepsi v Coke). A rise in the price of a substitute, may
lead to a rise in the demand for our good and vice versa
Complimentary Goods: Goods in joint demand (CD and CD player). A rise in the price of a
complimentary good may lead to fall in the demand for our good and vice versa
(3)TASTE AND FASHION
This may be positive (a fashion craze) or negative ( a health scare, bad publicity, downturn in
demand)
(4)ADVERTISING
Advertising can be persuasive and informative. Advertising is designed to stimulate the
demand for a good or service
(5)THE SIZE AND STRUCTURE OF THE POULATION
Size: How many people there are. The more people, the higher demand may be
Structure: The age distribution of the population. This may influence which products are
demanded. For example, an ageing population may lead to a rise in the demand for health
care and SAGA holidays but a fall in the demand for education and nightclubs!
Changes in the conditions of demand cause the whole demand curve to SHIFT

Elasticities of Demand
There are 3 key elasticities of demand:
(1)Price elasticity of demand: Measures how responsive quantity demand is to a
change in the price of the product
(2)Income elasticity of demand: Measures how responsive demand is to a
change in income

(3)Cross elasticity of demand: Measures how responsive the demand for a good
is to the change in the price od a related good (substitute or compliment)
Price Elasticity of Demand
There are 3 alternatives.
(1) Demand is price elastic: A % change in price leads to a bigger % change in quantity
demanded
(2) Demand is price inelastic: A % change in price leads to a smaller % change in quantity
demanded
(3) Demand has unitary price elasticity of demand. Any % change in price leads to an
identical % change in quantity demanded.

What determines whether demand is price elastic or inelastic?


Demand is more likely to be price elastic
if:
There are lots of substitutes
The good is a luxury
The good takes up a high proportion of your
income
The good is durable (lasts a long time)
The good is heavily branded and has a lot of
brand loyalty

Demand is more likely to be price


inelastic if:
There are few substitutes
The good is a necessity
The good takes up a small proportion of your
income
The good is consumable (gets used up)
The good is not branded

Why is PED information useful?


(1) It can inform pricing decisions
If a product has price elastic demand, a firm can increase TOTAL REVENUE by putting prices
DOWN.
If a product has price inelastic demand, a firm can increase TOTAL REVENUE by putting prices
UP
If there is unitary elasticity of demand, changing price has no effect on TOTAL REVENUE and
so is pointless
(2) It can inform stock decisions- for example a firm is told by a wholesaler that the price of
tinned salmon has risen. If the firm know that salmon is price elastic they will foresee a
fall in demand and stock less

Income Elasticity of Demand


There are 3 outcomes:
(1)Demand is INCOME ELASTIC: A % change in income leads to a bigger %
change in demand
(2)Demand is INCOME INELASTIC: A % change in income leads to a smaller %
change in demand
Why is it important?
Knowledge of IED can inform firms about what is likely to happen when there are changes in
income.
For example:
(a) A firm knows that it produces an INCOME ELASTIC good or service. If incomes fall
(during a recession) they may predict a downturn in demand and attempt to move into
other markets- for example producing inferior goods or income inelastic normal goods
(b) A firm knows that it produces INCOME INELASTIC good or service. This firm will not
need to be as concerned about changes in income levels
Cross Elasticity of Demand: Why is it important?
There are 3 alternatives:
(1)Demand is CROSS ELASTIC: A % change in the price of a compliment or
substitute leads to a bigger % change in the demand for our good. This is
likely to happen when it is a very close compliment/substitute
(2)Demand is CROSS INELASTIC: A % change in the price of a compliment or
substitute leads to a smaller % change in the demand for our good. This is
likely to happen when the goods are linked but not that closely (or there is
strong brand loyalty in place)
Knowledge of CED can alert a firm to how concerned they need to be about changes in the
price of related products and how they might adapt to this.
Examples
(1) McDonalds know that there is cross elastic demand between Big Macs and Whoppers.
If the price of Whoppers falls, McDonalds can predict a fall in demand for Big Macs.
They will have to respond- either by cutting the price of Big Macs or trying other offers
and promotional deals
(2) HMV stock Wiis and Wii games. They know that the 2 have very cross elastic demand.
If they know that the price of Wiis is going to fall, they can predict a big rise in the
demand for Wiis AND Wii games. This might make them stock more of both products.
They may also devise promotional offers that take advantage of the link between the
products.

Supply
Supply is the amount of a good or service that a producer is WILING and ABLE to
produce over a SPECIFIED PERIOD OF TIME
Supply and Price
There is a positive relationship between price and supply.
When price rises, producers are willing and able to supply more of a good or
service because the potential to make profit is greater
When price falls, producers are less willing and able to supply a good or service
because they will make less profit from it. They may wish to re-allocate their
scarce resources into more profitable uses.
This can be shown is a supply schedule and a supply curve

A change in price will lead to a MOVEMENT along the supply curve.


A rise in price from 1 to .50 will lead to a movement from B to C and an EXTENSION in
quantity supplied
A fall in price from 1 to 50p will lead to a movement from B to A and a CONTRACTION in
quantity supplied
The Conditions of Supply
These are the non-price factors that affect supply. They do so because they affect the firms
willingness and ability to supply.
(1)COSTS OF PRODUCTION
The higher the costs of production, the lower the profit margins will be. When costs increase,
supply will be fall. When costs fall, supply will increase
(2)TAXES AND SUBSIDIES

A tax is a sum of money that a business has to pay to the government. Tax acts like an extra
cost of production. If taxes rise, profits fall and supply will decrease. If taxes fall, profits will
increase and supply will increase
A subsidy is a sum of money that the government gives to a business. This is usually to
encourage the firm to do something that brings external benefits, for example training or relocating in an area of high regional unemployment. A subsidy is an additional source of
revenue for the firm. It therefore increases profit and increases the willingness to supply
(3)TECHNOLOGY
Technology means new capital. New capital can increase supply because it makes firms more
physically able to produce more AND because it might make production cheaper, thus
increasing profits and willingness to supply
(4)NATURAL FACTORS
Primary products will be particularly affected by things such as climate and natural disasters
Changes in the conditions of supply cause SHIFTS in the supply curve:

Price Elasticity of Supply


Price Elasticity of Supply measures how responsive supply is to a change in the price of the
product. There are 3 alternatives.
(1) PRICE ELASTIC SUPPLY: A % change in price leads to a bigger % change in quantity
supplied
(2) PRICE INELASTIC SUPPLY: A % change in price leads to a smaller % change in quantity
supplied
(3) UNITARY ELASTICITY OF SUPPLY: A % change in price leads to an equal % change in
supply
The factors affecting price elasticity of supply
Supply is more likely to be price elastic
if...
The production process is short- eg making
cakes
The firm is currently operating under capacity
and has spare resources to put into extra
production
The firm makes a range of similar productsresources can be switched from one product
to another
In the long term. As time goes on, firms have
time to hire new workers, buy more supplies,

Supply is more likely to be price inelastic


if...
The production cycle is long- eg building
houses, growing crops
The firm is already operating at full capacity

The firm cannot easily switch resources from


other products
In the short term- firms do not have the
ability to quickly get hold of the resources

lease bigger premises etc

that they need to increase production

Market Forces and the allocation of resources


In a free market economy, the interaction of demand and supply will determine how much of
different products are produced and at what price.

Prices, and equilibrium outputs will only change when there are changes in market conditions.
This means that there are changes in demand and supply.
Examples

Maximum and Minimum Prices


Sometimes the equilibrium prices reached by market forces may be considered to be too high
or too low.
The government may decide to intervene to introduce a minimum or maximum price
Maximum Prices

Introduced when the government feels that market prices are too high
The government introduces a maximum price, above which prices are not allowed to go
For example, the government has, in the past, set a maximum price for rented
accommodation to ensure that everyone has access to shelter

Benefits of a maximum price


Theoretically keeps prices down so allows
more people to have access to the good and
services

Potential Problems
May make the situation worse. At the lower
price, landlords are less likely to provided
rented accommodation (supply falls) but
more people want it. This creates excess
demand (a shortage)

Stops firms from exploiting consumers with


high prices for necessity products
Minimum Prices

Introduced when the government is concerned that market prices may go too low
The government introduces a minimum price, below which the market price cannot go

Examples include: minimum prices in agriculture; the minimum wage


Some people think that the government should introduce a minimum price for alcohol
to deter consumption and reduce external costs
(Note, this graph is poorly labelled, dont do this!)

Possible benefits of a minimum price


Minimum wage avoids exploitation of labour

Minimum price in agriculture ensures that


farmers stay in the market and secures
domestic supply of primary commodities
Minimum prices of demerit goods can reduce
the consumption of goods with external costs
(eg alcohol)

Possible costs of a minimum price


May backfire and price people out of the
market. The higher price will contribute to
excess supply

(C)

How do firms operate in competitive markets

The objectives of firms


The aims and objectives of firms will depend on a range of factors, including:

Whether the firm is in the private or public sector


The size/age of the firm
The state of the market/economy

However, key aims will include:

Maximising profit
Increasing sales
Growth
Diversifying into new markets/expanding oversees
Survival
Providing a good quality customer service

Key terms in business economics


Total Revenue

Key Term

Definition
The amount of money earned from selling
your product.

Average Revenue

Total Revenue = Price x Quantity Sold


AR is the amount earned on average per
product made.

Profit

AR = TR/Output AR is the same as price!


The amount of money earned once costs
have been deducted

Total Costs

Profit = Total Revenue Total Costs


Total Costs are the total out-goings that a firm
faces in order to produce its good or service

Fixed Costs

TC = Fixed Costs + Variable Costs


Costs which do not vary directly with output

Variable Costs

Examples: Rent, Insurance,


Costs which vary directly with output

Average Costs

Examples: Costs of raw materials, electricity


costs
The cost of making one unit of a good
For example if I make 10 cakes at a total cost
of 20, the average cost of each cake is 2
The point at which the firm is making neither
a profit nor a loss

Break-even point

TR= TC
How well a firm is able to compete with other
firms. To be competitive firms need:
Low prices; good investment to improve
product quality; innovation so that new
products are constantly being developed
Why is it important for firms to make profit?
Competitiveness

To
To
To
To

satisfy shareholders and secure further investment


ensure that there are funds for re-investment and future product development
finance further growth of the firm
cover costs

On the other hand, firms can survive for short periods of time without making profit

If the economy is in recession, survival is a more realistic goal


If the firm is new, it may be unrealistic to expect them to make profit for 1-3 years
Public sector firms may be more focused on producing good quality public services
even if these are not profitable

Production and Productivity


Production is the process by which a firm converts inputs (factors of production) into outputs
(goods and services)

The
firm
Land, labour, capital and enterprise
(Goods and Services)

Productivity

Output

Productivity is the RATE at which production occurs. A rise in productivity will occur if:
(a) A firm can produce more output with its existing resources
(b) A firm can produce its existing output with less resources
Labour productivity refers to how much output can be attributed, on average, to a unit of
labour (ie one worker) Labour Productivity can be calculated by: Output/Number of workers:
Output of cakes
100
120
150
200

Numbers of workers
10
10
10
10

Labour productivity
10
12
15
20

Labour productivity has clearly increased over the time period shown

How can a firm increase its productivity/labour productivity?

Invest in better quality capital


Improved training
Offer clear reward systems and opportunities for promotion
Improved management
Use performance related pay- eg piece rate, commission, bonuses
Use more specialisation of labour/capital

Why is high productivity so important to a business?

It produces more output. If sold, this will contribute to more revenue and profit
Rising productivity allows firms to operate at lower average costs. This MAY allow them
to reduce prices and become more competitive, thus increasing demand and market
share
If a firm is producing at a lower average cost, it will be increasing its profit per unit.
This will provide more funds for re-investment and growth (see above)
Rising productivity may allow a firm to finance wage increases. This will secure worker
morale and further productivity. It will also allow the firm to attract the best quality
workers
In the globalised economy, UK firms are competing with firms from the BRIC economies
which have very low costs and high productivity. If UK firms cannot match this, they
will be uncompetitive and lose sales/market share

The Growth of Firms


Reasons why firms may wish to grow in size

To
To
To
To
To
To
To

diversify and spread risk


take advantage of higher levels of demand that exist
tap into emerging markets
take advantage of changing market conditions
take advantage of economies of scale
take advantage of globalisation and expand into overseas markets
increase market share and develop greater monopoly power

How do firms grow in size?


Internal Growth

External Growth

What is it?
When a firm increases its
output on its own

When a firm increases its


output by joining with

Example
The firm could:
Take on more workers
Take on a new shop
Hire bigger premises
Buy new capital
Buy in more supplies
One bank merges with
another bank

another firm
There are different types of
mergers/integration- see
below
Mergers/Integration

Different types of merger bring different economic advantages


Type of Merger
Horizontal Merger

Forwards Vertical Merger

Backwards Vertical Merger

Lateral Merger

Potential benefits to the firm


Increase market share
Reduces competition
Increased output means greater
economies of scale
Can rationalise- take the best bits from
the two companies
Can take control of the distribution
network
May contribute to a degree of
monopoly power by acting as a barrier
to entry for rivals
Can take control of suppliers- ensure
that they get resources/inputs at cost
price
Can prevent rivals from having access
to resources
Spreads risk by diversifying the product


Conglomerate Merger

range slightly
Can take advantage of links between
products in marketing campaigns
Complete diversification and risk
spreading

Economies and Diseconomies of Scale


The concept of economies of Scale is a central area in Economics and provides a clear
rationale for why firms grow.
Internal Economies of Scale
Internal economies of scale refers to the reduction in AVERAGE COSTS that a firm experiences
as a result of increased output by the firm. This is shown below:

Between 0 and Q2 the firm is encountering economies of scale. The increase in output has
lead to a reduction in Average Costs.
There are a number of types/sources of Economies of Scale:

Type of Economies of Scale


Financial Economies of Scale

Marketing Economies of Scale

Technical Economies of Scale

Explanation
Large firms can benefit from cheaper loans
and wider sources of cheap finance
(investment from shareholders)
The advantages that large firms get in
relation to buying and selling. Large firms
can attract specialist buyers who dont waste
money buying stock that will not sell. They
also have specialist sellers/marketing staff
who ensure that goods will sell. Big firms
benefit significantly from being able to buy
in bulk
These are the advantages that large firms
have when it comes to the production

Managerial Economies of Scale

Risk- Bearing Economies of Scale

process. Large firms can employ specialist


labour and capital which stimulates
productivity and reduces average costs
Large firms have the money/resources to
attract the most productive/efficient/specialist
managers who make the most effective
business decisions and increase efficiency
over time
Large firms benefit from having wider, more
diversified product range. This means that
they are better able to withstand the risk of a
fall in demand for one good or service

Diseconomies of Scale
Diseconomies of Scale is the idea that it is possible for some firms to become TOO large, such
that a rise in output begins to lead to an increase in average costs. This can be shown on the
diagram below, where diseconomies of scale set in when output increases above Q2

Reasons for Diseconomies of Scale:

As the firm increases, factor inputs (resources) become more scarce and hence more
expensive
As the firm grows, communication and decision making becomes more difficult,
contributing to inefficiencies and rising costs
As the firm grows, worker morale and motivation declines as they feel like a small cog
in a big wheel. This may contribute to reduced productivity and higher average costs

External Economies of Scale


External economies of scale occur when a firm experiences lower average costs because the
whole industry has grown larger. This is particularly likely to be the case when an industry
has grown in a particular region.
Why does this occur?

The area will have a pool of skilled labour. Local colleges/training providers will offer
courses to meet the needs of the industry. This will reduce firms training costs and
labour will be more productive and efficient
Suppliers are likely to move into the area to support the area. This will reduce
transport costs and allow firms flexible access to supplies
Local banks and financial institutions are more likely to be financially supportive of the
industry because they know that the local economy depends upon it- this may lead to
lower interest rates and cheaper loans/overdrafts
The local infrastructure (roads, rail and communication networks) are likely to receive
the investment necessary so that they support the development of the industry

An example:

Labour Markets
In a free market economy, wages are determined by the interaction of the demand for labour
and the supply of labour. Wage differentials (differences in wages) between jobs and
locations occur because of differences in the levels of demand for/supply of labour

The demand for labour

The demand for labour is the demand for labour by employers


The demand for labour is downward sloping. Employers will take on more workers as
wages fall
A change in wage will cause a movement along the demand for labour curve

Elasticity of demand for labour

Measures how responsive the demand for labour is to a change in wage levels
If demand is wage elastic it means that a % change in wages will lead to a bigger %
change in the demand for workers. This is most likely to be the case when labour costs
contribute to a high proportion of the firms costs, where it is easy to substitute capital
for labour and when the product has price elastic demand (making it difficult to simply
pass on the wage increase to consumers in the form of higher prices)
If demand is wage inelastic it means that a % change in wages will lead to a smaller %
change in the demand for workers. This is most likely to be the case when labour costs
are a small proportion of total costs, when labour cannot be easily replaced by capital
and when the price of the product is price inelastic (making it possible for the employer
to pass on the wage increases in the form of higher prices so not reducing profits)

Labour demand (1) has wage inelastic demand. Labour demand (2) has wage elastic
demand.
Factors causing a shift in the demand for labour
Whilst changes in wages cause a movement along the D(L) curve, other factors will cause the
whole curve to shift position. These other factors are:
(1) The demand for the product that labour produces. Labour is an example of derived
demand- this means that its demand comes from the demand for the product that it
makes. For example, during the recession there has been an increase in the demand
for fast food such as McDonalds. This will have led to an increase in the demand for
McWorkers!
(2) Productivity. The higher labour productivity, the more workers that employers want to
take on. This is because workers are contributing to increased rates of production
which become increased revenue and profit.

The shift from D to D1 shows an increase in the demand for labour


The shift from D to D2 shows a decrease in the demand for labour

The Supply of Labour


The supply of labour shows the amount of workers who are willing and able to work at a given
wage rate. The supply of labour curve is upward sloping, indicating that more people are
willing and able to work when wages are higher.

A change in wage causes a movement along the supply of labour curve


Elasticity of Supply of Labour
If the supply of labour is wage elastic, this means that a % change in wages will lead to a
bigger % change in supply. This is more likely to be the case for unskilled jobs where lots of
education and training are not required and there is no need for any natural skill/talent. A
wage elastic supply curve will upward sloping but relatively flat.
If the supply of labour is wage inelastic, this means that a % change in wages will lead to a
smaller % change in supply. This is more likely to be the case when there are high barriers to
entry for getting into the job. These will usually be lots of qualifications, training or unique
talents. A wage inelastic supply curve will be upward sloping but relatively steep
Factors causing a shift in the supply of labour curve
In addition to wages, other factors will cause shifts in the supply of labour curve. This means
that any given wage, the supply of labour is higher/lower in different situations.
(1) Education and Training: The more education and training required, the lower the supply
of labour will be (and the more inelastic it will be)
(2) Natural talents and abilities: Some jobs have very low (and wage inelastic) supply
because they require specialist talents that are unique/rare/hard to learn. This would
include top fashion models and premiership footballers
(3) Danger: If a job is perceived as dangerous the supply of labour is likely to be lower.
(4) Working conditions/hours/flexibility of the job: If working conditions are poor and hours
are unsociable, this may reduce the number of workers who are willing and able to do
the job.

S3 shows lower supply than S2

Wage Determination
Wages are determined by the interaction of the demand and supply of labour. This will
determine the equilibrium wage rate and the equilibrium number of workers employed.

The equilibrium wage and number of workers employed will change if there are shifts in the
demand and /or supply of labour:

Using economic theory to explain wage differentials


Wage differentials is a posh way of saying differences in wages. Wages may differ between
occupations and between locations.
The exam will often ask a long question about this. A strategy:

Always start by explaining how wages are determined:


In a free market economy, wages are determined by the interaction of the demand for
labour and the supply of labour. Wage differentials (differences in wages) between
jobs and locations occur because of differences in the levels of demand for/supply of
labour
Write a paragraph about the demand for labour, include a discussion of wage elasticity
of demand if it is relevant (link it to the context you are given, explaining why there
may be different demands for labour)
Write a paragraph about the supply of labour, including a discussion of wage elasticity
of supply if it is relevant
Evaluate/draw a conclusion about what you think are the most significant factors in
accounting for wage differences

The Minimum Wage

A minimum wage works by guaranteeing that all workers receive at least a minimum
wage rate
The aim of this is to avoid the exploitation of workers and to provide a financial
incentive for people to work
A minimum wage will only affect those industries where free market wages would fall
below the level set. These are most likely to be jobs involving unskilled workers

In the diagram, the free market wage is W0. However the minimum wage is set above
this at W1

Evaluating the impact of an imposition of a minimum wage


Workers

Firms

Potential Gains
Low paid workers achieve a
higher wage, thus reducing
relative poverty and
increasing living standards

There may be limited impact


if:
Firms already pay above min
wage
Firms employ few workers
Firms can easily pass on wage
increase to consumers in the
form of higher prices (where
demand for the product is
price elastic)
If workers have higher

Potential Losses
The worker may lose his/her
job if the employer responds
to the minimum wage by
laying off workers (E1-E2
above)
Even if the worker earns a
higher wage, they will be no
better off in real terms if
minimum wages lead to
higher prices and inflation
Higher costs lead to lower
profits and less funds for reinvestment
May have to compensate by
putting prices up- this will
make them less competitive
compared to foreign
competitors (BRIC)

Consumers

incomes as a result of the


minimum wage, there may be
a rise in demand for the firms
goods
Some consumers in low paid
jobs have higher disposable
income

May face higher prices as


firms pass on wage increases
May be less new product
development/reduced quality
product because firms have
less profit to re-invest

Gross, Net, Real and Nominal Income


You need to be aware of these key terms
Key Term
Gross Income
Net Income
Nominal Income
Real Income

Definition/Explanation
Total income before taxes are removed.
Total income after taxes are removed
Money income, not taking into account
inflation
Money income is adjusted to take account of
inflation. For example if inflation has been
2%, money income needs to be reduced by
2% to reflect the fact that real purchasing
power has been reduced

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