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Economics IAS UNIT1 NOTES

The Basic Economic Problem
Factors of Production
➢ Land: Includes all natural resources, raw materials
...

➢ Capital: Any man made aids to production, including factory buildings, machinery and IT
equipment which are used to make other goods and services
...
Bringing together the other factors of production so that goods and
services can be produced
...
Taking the risks involved in the production

Nature and purpose of economic activity
❖ The central purpose of economic activity is the production of goods and Services to satisfy
needs and wants
...

Services: Are intangible such as a haircut and a hotel stay
Needs: Are basic requirements people NEED to SURVIVE
...
Such as
FOOD, WATER
Wants: Are things people desire
...
Such as
an iPhone or a sports car

The Basic Economic Problem: Is the Scarcity created by unlimited wants and the
limited resources
...

Consumer Goods: Are those which give satisfaction to consumers, (iPhone, Car)
Capital Goods: Are those required to produce other goods – both other capital and consumer
goods like machinery and factory buildings
...


Production Possibility Frontier (PPF)
•

Shows the maximum output of a combination of two types of products which an economy
is able to produce if all resources in the economy are fully and efficiently employed
...
We are using the factors of
production we have to their maximum potential
...

Any point OUTSIDE a PFF means that the combinations of goods cannot be achieved with
existing resources and without trade
...

As resources are transferred from one good to another, the amount of output sacrificed by
one good and gained by the other is constant
...


Reasons of Economic Growth:
a) The quantity of resources available for production increases
b) Increase in the quality of services

Renewable Resources: are replaced automatically by nature and so can be used on a
continual basis such as solar power
...


Positive Statements: Are statements about economics which can be proven to be true or
false and they are dealing with facts
...
It can
be verified as being true or false by reference to data
...
Mainly Include the words “ought to be”, “Should be”, “Might
be good/bad”, “would be fair or unfair” and they reflect people’s opinions and views
...

Advantages of Specialisation:
1
...
Workers have to learn only a small, simple
task therefore become very proficient at that task
...
Time is saved because a worker is not constantly changing tasks, moving around
from place to place and using different machinery and tools
...
Individual workers become more productive since they gain skills in a narrow range
of tasks
...
Job Specialization reduces training costs
...

Disadvantages of Specialisation:
1
...

2
...

3
...


Glaswegian Pin Factory Example
•
•
•

18th

Adam Smith an
century economist described how division of labour was used in a
pin factory to improve productivity
...

Smith claimed by using division of labour 10 men were able to produce 48,000 pins in a
day, whereas each man would only be able to produce 20 pins per day
...


Advantages of Division of Labour
➢ Training cost falls due to each worker specialises in tasks for which is best suited for them
thus they will only be trained in one task
...

➢ Allows an Increased use of machinery thus Efficiency and productivity rises
...

➢ Training costs are cut due to labour is only trained in a specific task
...

➢ Loss of skills since workers are only trained in one particular task thus have limited skills
which could be a problem when they are made redundant
...


Moves away from Division of labour
•

To avoid problems of worker boredom, low quality output, high labor turnover and lack of
flexibility some companies move away from Division of labor
...
Therefore, by carrying out a number of tasks
motivation of workers increases enabling them to increase the range of jobs they can apply
for in the future
...


Function 1: Medium of Exchange
•
•
•

Money can be exchanged for goods and services when buyers and sellers trade
...

The difficulty with a barter system is that in order to obtain a particular good or service
from a supplier, one has to possess a good or service of equal value, which supplier also
desires
...

Money may not even be the best store of value because it depreciates with
inflation
...


Function 3: Unit of account
•
•

Money also functions as a unit of account, providing a common measure of the
value of goods and services being exchanged
...


Function 4: A Standard of deferred payment
•
•

This means that money can be used to settle debts
...


The Economic Systems
1
...
Free Market Economy – Where all economic decisions are taken by the private
sector (FIRMS) with no government interventions
...
Mixed Economy (UK, Cyprus, USA)- Where all economic decisions are made
partly by the government and partly through the firms (Private sector through
the price mechanism – supply and demand)

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Economics IAS UNIT1 NOTES

Free Market Economy
•
•
•
•
•
•

Usually associated with a pure capitalist system, where land and capital are
privately owned
...

Individuals are free to make their own economic choices
...

Workers are free to choose where and how much to work
...


Advantages of the Free Market Economy
1
...

➢ No need for costly and bureaucracies to co-ordinate economic decisions
...


2
...

➢ Consumers will not buy from firms that charge high prices and that do not produce
the products they want
...


3
...

➢ The more efficiently firms can combine their factors of production, the more profit
they will make
...

➢ The more carefully consumers decide what to buy, the greater the value for money
they will receive
...
Consumer Sovereignty (power): The concept of the consumer as the one whom, his
spending ultimately determines which goods and services will be produced in the
economy
...
Changes in consumer tastes and demand for workers are signaled quickly and
automatically through the price mechanism and market forces
...

➢ Producers can choose what to make and can select the prices that they believe
consumers will pay and will cover their costs
...


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Economics IAS UNIT1 NOTES

Disadvantages of the Free Market Economy
1
...

➢ The giant firms can charge a higher price and make large profits
...

2
...

3
...

4
...
Power and property may be unequally distributed
...

➢ People have different income levels and so different purchasing power thus some
products wanted by the poor may not be produced
6
...

7
...

➢ People with high incomes can spend more on their health care, education and training
where as people with low earning capacity may fall into poverty
...

 The Government has control of resources and economic decisions making is
centralized
...


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Economics IAS UNIT1 NOTES

Characteristics of Mixed Economies
A Market economy where there is some government intervention
...

The Public Sector is motivated by considerations of the benefit of the community
...

Competition: In the private sector of the economy there is competition
...
Consumers are offered
choice with the private sector of the economy but little or no choice within the public sector
...

❖ HOWEVER, Free markets lead to an unequal distribution of income since owners of
capital and entrepreneurs tend to accumulate the most income/wealth and many people
such as elderly are unable to work
...

❖ They do this by raising revenue through taxation, and redistributing in the form of
benefits to the poor
...

Relative incomes, by using income taxes, welfare payments or direct controls over
wages, profits, rent etc
...
(Making it illegal to
produce unsafe goods)
Dealing with macroeconomic problems of unemployment, inflation, lack of economic
growth and BOP deficits by using taxes and government expenditure, as well as the
control of banks’ lending and interest rates
...

A Market is the coming together of buyers and sellers
...


Different types of Markets
 Organized Markets- Commodities (Raw Materials) e
...
rubber, oil, sugar, wheat, gold
 Financial Markets- Stocks, shares, currencies, any financial instruments
 Good Markets- The supply and demand of goods and services in general, food, clothing,
cars, houses
...

-

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Reflects the cost of resources used in production and the returns/profit
required

Economics IAS UNIT1 NOTES

Demand
The quantity of a product consumers are willing and able to buy at different prices in a specified
time period
...
Consumers must have sufficient real purchasing power
...
The substitution effect: When there is a Rise in the price the consumer will tend to
buy more of a relatively lower- priced good and less of a higher priced one
...
The income effect: This is the effect of a change in real income on the quantity
demanded, with relative prices unchanged
...

The law of diminishing marginal utility states that when we consume more of a good or
service, our total utility will continue to increase
...


Criticisms of the Utility theory
1
...
Everyone had a different level of utility thus
rather difficult to attach a value
...

2
...
Items such as
money will have a constant rising marginal utility
...


• When we consume a second unit, it would give us less utility and since the need or desire is
lesser than before, we are prepared to pay less
...


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Economics IAS UNIT1 NOTES

Determinants of Demand

 INCOME: Normal goods:

Income

Inferior goods:

Demand

Income

Demand

 Consumer Preferences: The more desirable people find the product the more they will
demand
...


 Number & Price of other goods:
i
...


Demand for its substitute (E
...
Higher income in the future
spend more today
...


Future Prices

 Population: Larger the Market

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Accelerate current purchases of goods

More goods or services purchased
...

• EXPANSION: Increase of demand due to a fall in price

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Economics IAS UNIT1 NOTES

Shifts in the Demand Curve
❖ Shifts in Demand curve response to a change in any other determinant of
demand (NOT THE PRICE)
•
•

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INCREASE IN DEMAND
DECREASE IN DEMAND

RIGHTWARD SHIFT
LEFTWARD SHIFT

Economics IAS UNIT1 NOTES

Factors causing demand to shift to the right
•
•
•
•
•
•

Increase in income (For normal goods)
A fall in income (For inferior goods)
Successful advertising
Fall in price of complementary goods
Rise in price of substitute goods
Good becomes more fashionable

Factors causing demand to shift to the left
•
•
•
•
•

A fall in income (For normal goods)
A rise in income (For inferior goods)
Rise in price of complementary goods
Fall in price of substitute goods
Good becomes less fashionable

Inferior goods: Cheap poor quality goods

Consumer Behavior
Impulse buys: Purchases that are not needed, were not intended and are often regretted once
the ‘high’ has wont off
...

Rational Decision making: Where consumers allocate their expenditure on goods and services
to maximize utility ( satisfaction) and producers allocate their resources to maximize profit
...

1) The Influence of other people’s behavior:
•
•

Consumers are influenced by the behavior of others; if one person purchases something
others may follow which could lead to an increase in the price
...

2) The Importance of habitual behavior:

•
•

Consumers are creatures of habit and prefer what they know and have rather than risking
something new where there is more uncertainty
...


3) Inertia:
❖ Consumers might not make an active effort to change their behavior for several reasons
including:
➢ Information overload
➢ The complexity of the information available
➢ Too much choice
❖ Inertia might arise because people are loss averse i
...
they will put more effort into
preventing a loss than gaining a win
...

❖ Customers may simply lack the skills required to calculate the best buy
...


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Economics IAS UNIT1 NOTES

Supply Analysis
 Supply shows the quantity that producers are willing and able to supply at each and
every price, all other things unchanged
...

➢ If they cannot charge higher prices, then profits will fall and firms will produce
less of the good or might even stop producing it
...

➢ A Fall in the Cost of production will lead to an Increase in supply of a good

2) Technology: Sate of technology is another factor which effects supply of a particular
good
...

➢ This will encourage firms to produce more at the same price or produce the
same amount at a lower price
...


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Economics IAS UNIT1 NOTES

Determinants of supply
3) The Profitability of alternative products (substitutes in supply): If a product which is
a substitute in supply becomes more profitable to supply than before, producers are
likely to switch from the first good to this alternative
...
These are said to be goods in joint supply
...
If consumers buy more
milk, then an increase in supply of milk is likely to lead to an increase in the
supply of butter and other cream products as they are jointly produced with
milk
...

 Weather and diseases affecting farm output, wars affecting the supply of
imported raw materials, the breakdown of machinery, earthquakes, floods
and fires
...

7) Expectations of future price changes:
 If prices are expected to rise, producers may temporarily reduce the amount
they sell
...

8) Producer Cartels
 Producing firms or countries band together to restrict supply
...


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Economics IAS UNIT1 NOTES

Movements along and shifts in the supply curve

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Economics IAS UNIT1 NOTES

Movements along and shifts in the supply curve
• If any other determinants of supply change, the whole supply curve will shift
• A rightward shift illustrates an increase in supply
•

A leftward shift illustrates a decrease in supply

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Economics IAS UNIT1 NOTES

Factors causing supply to shift to the right:
•
•
•
•
•
•
•

Increase in productivity
Improvement in technology for production
Increased availability of materials
A fall in the price of raw materials
A fall in labor/ capital cost
Introduction of a subsidy
A rise in the number of firms in the industry

Factors causing supply to shift to the Left:
•
•
•
•
•
•

A fall in productivity
Reduced availability of materials
A rise in the price of raw materials
A rise in labor/ capital cost
Imposition of tax
A fall in the number of firms in the industry

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Economics IAS UNIT1 NOTES

Price Determination
Equilibrium Price: The price where the quantity demanded EQUALS quantity supplied;
the price where there is no shortage or surplus
Market clearing price: Is the price at which all products supplied to the market are
bought from the market, no buyer is left frustrated in his wishes to buy a good
...

❖ Producer Surplus: The difference between the market price which firms receive
and the price at which they are prepared to supply
...

➢ Price has 3 Important functions in a market:
1
...
Signaling Device
3
...

The Price Mechanism allocates these goods and services to those who are prepared to
pay the most for them
...

The low price ensures that high numbers of goods will be bought, reflecting the lack of
scarcity of the good
...

❖ Higher, prices provide an incentive to producers to supply more or to enter the
market, because of the possibility of more revenue and profit
...

❖ Rising prices give a signal to consumers to reduce demand or withdraw from a market
completely, and they give a signal to producers that they should increase production
or enter the market
...


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Economics IAS UNIT1 NOTES

How the price mechanism responds to shortages and surpluses?
➢ Shortages (excess demand) will cause prices to rise and surpluses (excess supply) will
cause prices to fall
...

❖ The resulting shortage will cause the price of the goods to rise
...

❖ Price will continue rising until shortage has thereby been eliminated and reaches the
new equilibrium point
...

 The resulting surplus will cause the price of the good to fall
...

 Price will continue falling until the surplus has thereby been eliminated
...

▪ A fall in demand is signaled by a fall in price-surplus, which then acts as an incentive
for supply to fall
...

▪ Conversely, a rise in the cost of production will induce suppliers to decrease supply,
while consumers will react to the resulting higher price by reducing demand for the
good or service
...

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Economics IAS UNIT1 NOTES

Price elasticity of demand
Price elasticity of demand- Measured the responsiveness of quantity demanded to a
change in price
...

❖ When a change in Price causes a proportionately larger change in quantity demanded
...

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Economics IAS UNIT1 NOTES

Unitary Elastic Demand: When the price and Quantity Demanded change by the same
proportion
...
Availability of Substitutes:
PED ELASTIC
LARGE NUMBER OF SUBSTITUTES (Chocolate)
PED INELASTIC
NO/ FEW SUBSTITUTES (oil)
2
...
Addictive and habit- forming goods:
PED ELASTIC
NOT A HABIT OR ADDICTION
PED INELASTIC
IS A HABIT OR ADDICTION ( Cigarettes)
4
...

❖ When demand is ELASTIC then a fall in price will cause TR to Rise
...

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Economics IAS UNIT1 NOTES

Importance of Price elasticity of demand for a business
➢ If Firms know that demand for their product is price inelastic then they know that they
can increase TR by increasing price
...


Importance of Price elasticity of demand for the government
➢ If the government wishes to maximize its tax revenue then it will place indirect taxes
(VAT) on those products whose demand is price inelastic (alcohol)
...
Increase taxes on Inelastic goods to increase
government revenue
...
Decrease
taxes on elastic goods to increase government revenue
...


YED=

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒

% 𝐶𝐻𝐴𝑁𝐺𝐸 =

𝐶ℎ𝑎𝑛𝑔𝑒
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙

❖ Demand is INCOME INELASTIC if it lies between +1 and -1
❖ Demand is INCOME ELASTIC if Its over 1 or less than -1

 Normal Goods have a positive income elasticity of demand
 As consumers income rises, thus more is demanded at each price level
...


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𝑋100

Economics IAS UNIT1 NOTES

Positive(NORMAL GOODS) Income Elasticity Demand Diagram

Negative(INFERIOR GOODS) Income Elasticity Demand Diagram

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Economics IAS UNIT1 NOTES

ZERO Income Elasticity Demand Diagram
 This occurs when a

change in income
has NO effect on the
demand for goods

To Summarize:
 NORMAL GOODS – ALWAYS POSITIVE; Between 0-1
 LUXURY GOODS- ALWAYS POSITIVE; OVER 1
 INFERIOR GOODS- ALWAYS NEGATIVE
Significance of Income Elasticity of Demand
▪ High Income Elasticity
➢ Demand is sensitive to changes in real incomes
➢ Demand is therefore Cyclical – in an economic expansion, demand will grow strongly
...

➢ Can be difficult for businesses to accurately forecast demand and make capital
investment decisions
...

➢ Over time, the share of consumer spending on inferior goods and normal necessities
tends to decline
...


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Economics IAS UNIT1 NOTES

Upward sloping demand curve
▪

The main reasons that the Demand curves for some products are upward sloping are as
follows:
1
...

These goods are demanded because few people can afford to buy them
because their price is high
...
Speculative Goods: The higher the price of shares, the higher the demand
because buyers associate high share prices with large speculative gains in the
future
...
Quality goods: Some consumers judge quality by price
...
Hence, the higher the price the greater the quantity demanded
...
Giffen goods: Type of inferior good
...
(Such as BREAD)
...
Substitution effect: If the price of a good rises, consumers will buy less of that
good and more of others, because it is now relatively more expensive than
other goods and vice versa
...
Income effect: If the price of a good rises, the real income of consumers will
fall, as they will not be able to buy same basket of goods and services as
before
...

OR
Cross Price Elasticity of Demand (XED): Is the sensitivity of Demand for one product (good
A) to a change in the price of another product (Good B)
𝑋𝐸𝐷 =

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎𝑛𝑜𝑡ℎ𝑒𝑟 𝐺𝑜𝑜𝑑 𝐵

XED – Substitutes vs Complements
▪ Two goods which are substitutes will have a positive cross elasticity, where an
increase in the price of one good, leads to an increase in the quantity demanded of
a substitute
...


Cross Elasticity of Demand (XED) – Substitutes (POSITIVE)
➢ An increase in the price of one good will lead to an increase in demand for the rival
product(Substitutes)
 Weak Substitutes – INELASTIC XED <1
 Strong Substitutes – ELASTIC XED >1

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Economics IAS UNIT1 NOTES

Cross Elasticity of Demand (XED) – Complements(NEGATIVE)
➢ Goods that are jointly demanded to satisfy one want
...

 Weak complementary – INELASTIC XED >1
 Strong complementary – ELASTIC XED <1

Importance of XED for businesses
Firms can use XED to predict:

• The impact of a rivals pricing strategies on demand for their own products:
Pricing Strategies for complementary Goods:
 Popcorn and cinema tickets are strong complements
...
e
...

 If firms have reliable estimate of XED they can estimate the effect, say of
a two for one cinema ticket offer on the demand for popcorn
...

𝑃𝐸𝑆 =

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

▪ Elastic (PES>1): When a change in price causes a proportionately larger change in the
▪
▪
▪
▪

quantity supplied
...
Curve Cuts the quantity axis
Unitary (PES=1): When a % change in price causes the exact same change in supply
...
Any change in price will see quantity supplied fall to 0
Perfectly Inelastic (PES=0): When a change in price has no effect on quantity supplied
...


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Economics IAS UNIT1 NOTES

Determinants of PES
1
...
g
...
The state of the economy:
 In a recession, there are many unemployed resources and so there is a high
level of spare capacity; firms find it relatively easier to raise supply thus supply
is ELASTIC
...
Level of stocks of finished goods in a firm:
 A high level of stocks means that firms cam increase supply quickly, so supply is
ELASTIC
...


4
...

 Manufactured goods tend to be non-perishable and so can be stockpiled by
firms in order to meet anticipated increase in demand
...
(Fridges, Freezers)

5
...

 Existing producers may deliberately create entry barriers, so supply may be
restricted and INELASTIC
...
The time period (long run VS
...

 At least one factor input is likely to be fixed in quantity in the short run, which
makes it difficult for a firm to raise production
...

LONG RUN


The long run is the period of time in which a firm is able to increase supply by
adding to its production capacity
...

 Therefore, supply tends to be relatively ELASTIC, therefore the longer the time
period the more ELASTIC supply is likely to be
...

It takes an even longer period of time to raise the supply of dairy products such
as milk and beef because these depend on the feeding of animals over several
years
...

The costs and technical complexities involved could be phenomenal
...

➢ Most likely to be used to reduce the number of resources allocated to the product
and therefore can be used to tackle problems associated with negative externalities
...


VAT is an example of an AD VALOREM (The tax levied increases in proportion to the value of
good base as a percentage)
EXCISE DUTIES are an example of a specific or unit tax, where the amount of tax levied does not
change with the value of goods but with the amount of goods purchased
...

➢ A combination of price inelastic demand and price elastic supply tends to place most of
the tax burden on consumers
...


Specific Tax are a set amount per unit of the product, therefore the effect it to cause the
supply curve to shift to the left, parallel to original supply curve
...


Evaluation of an indirect tax policy
Advantages
Increase the firms costs so that the firm is
forced to take into account the external
costs that it generates
Lower level of output and a more efficient
allocation of resources
Raise substantial revenue for the
government and help fund public services
...

Producers may shift production to countries
with lower taxes

Subsidy Analysis
Subsidy is a grant given by government to encourage the production or consumption of a good
or service
...

1) Perfectly Elastic Supply
2) Perfectly Inelastic Demand

3) Perfectly Inelastic Supply
4) Perfectly Elastic Demand








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The incidence of tax falls
wholly on the CONSUMER

The incidence of tax falls
wholly on the PRODUCER

Summary Points:
The more elastic the demand curve or the more inelastic the supply curve, the
greater the incidence of tax on producers
...

Thus, the higher the elasticity, the larger will be the fall in quantity demanded and
hence the lower will be tax revenue received by government
...

The Largest fall in price will occur when either demand is highly inelastic or supply
is highly elastic
...
Since producers will not
pass on the subsidy to consumers and they will absorb the subsidy which will allow
them of course to increase their profits
...
The price for workers = wage rate
...

Supply for Labour: The number of workers willing and able to work at any given wage rate
...

Derived Demand: Demand for labour is dependent on the demand for final goods
...
Example: An increase in demand for new housing will cause an increase in demand
for building workers
...
Thus, more
incentive there is to substitute capital for labour
...
Producers will then pass on
these higher costs to customers by setting higher prices; pushing the supply curve to the
left
...


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Economics IAS UNIT1 NOTES

Factors affecting Demand for labour
•
•
•

•

•

The Price of other factors of production: If the price of other factors of production like
machinery changes, then the demand for labour will change too
...

New Technology: The introduction of new technology often means that machines will
replace workers
...
On the other hand, the demand for labour
for workers servicing new technology will rise
...
For the frim it’s important to keep lower
the cost per unit labour so demand for the labour could increase
...

➢ If the price of a substitute good falls, then the demand for the
product will fall leading to a fall in its demand for labour
...


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Economics IAS UNIT1 NOTES

Elasticity of demand for labour
▪

Factors that influence the elasticity of demand for labour to a particular occupation or
industry are:
A
...

❖ A fall in wage rate leads to higher employment, hence more output
...

❖ If the market demand for the good is elastic, this fall in price will lead to a lot
more being sold and hence to a lot more people being employed
...

PED INELASTIC: When demand for labour is less than 1 (INELASTIC) than the response by firms
to changes in wage will be relative smaller
...
The greater the wage rate as a proportion of total cost the greater will be the
elasticity of demand for labour
...

❖ …Therefore, production will increase significantly, so too will the demand for
labour
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Economics IAS UNIT1 NOTES

C
...

❖ If labour can be readily substituted with machinery, then a reduction in wage
rate will lead to a large increase in labour used to replace machineries
...

D
...

❖ Given sufficient time, firms can respond to a fall in wage rates by reorganising their
production process to make use of the now relatively cheap labour
...

➢ This increase in supply of course will depress wage rates
...

➢ Birth rates have been low over the past 30 years and the numbers entering the
workforce have been falling
...

➢ These trends have increased the supply of labour and put a downward pressure
on wage rates
...
This reduces wage rates
...

➢ The key tax rate for a worker is the marginal tax rate
...

➢ High unemployment benefits will provide an incentive for unemployed workers
either to take longer to find the right job or to simply not look at all
...

5) Government labour regulations
➢ Government often protect workers through laws
...

➢ Therefore, they could be seen as affecting the demand for labour
...
(shift to the left of the demand
curve)
6) Trade Unions
➢ Trade unions are organisations which represent workers and aim to increase the
welfare of workers
...
So they have the effect of
pushing up the supply curve for labour, where the employers have to pay more to
unionised workers than they would have to non-unionised workers
...

At any given level of employment, workers are not prepared to work for their previous
wages because they are now in a trade union
...

 Decrease in Equilibrium level of employment

Elasticity of supply of labour
1) Skills, Qualifications and experience required: If these are high then the supply of
labour will tend to be inelastic
...

3) The Mobility of labour (the willingness and ability of labour to move to another job): Elasticity of
supply for labour will be higher when there are alternative jobs in the same location,
when alternative jobs required similar skills and when people have good information
about these jobs
...
If price elasticity of supply is elastic(>1) then workers respond quickly if
wages rise and supply will expand
...

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Economics IAS UNIT1 NOTES

The Minimum wage

•
•
•
•
•
•
•

55 | P a g e

Minimum wages are imposed by governments in order to raise very low incomes to a
minimum level
...

It is a floor wage which protects workers in low paid occupations like shop assistants,
cleaners and laundries
...

The more inelastic labour is the lower will be the cost of a minimum wage in terms of
unemployment
...

Firms will have to pay workers more as an incentive to work, and so the wage rate will be
bid up to the market clearing wage
...

 Encourage those on state benefits to return to work as the gap between wages and benefits will
rise
...

 Raise wages and employment hence economic inefficiency is reduced
Disadvantages of National Minimum Wage
 Possibility of unemployment, since firms will have to follow the legislation and raise the
wage rate(Increase in costs)
 Lead to inflation as wage bills will rise and firms may increase product prices
...


Maximum wage Rate
Maximum wage Rate: Set by the government in order to reduce the rate at which the top earners are racing away
salaries from medium paid workers and usually their target groups are executives or footballers
...

Disadvantages of Maximum Wage: Destroy incentives
...

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Economics IAS UNIT1 NOTES

Market Failure
Market Failure: Occurs when the price mechanism causes an inefficient allocation of resources or where
the forces of demand and supply lead to a net welfare loss in society
...

Economic efficiency: Occurs when markets operate in a way which most benefits consumer by making
best use of resources
...

Allocative efficiency: Is achieved when resources are allocated in a way which maximises consumers
satisfaction
...


Externalities
➢ Costs and benefits to third parties who are not directly part of a transaction between producers and
consumers
...

➢ Externalities are therefore a form of market failure because market forces will not result in an
efficient allocation of resources
...
e
...

Example: A chemical firm polluting a river causes and external cost to the fishing and water
supply industries
...


Private Costs
Private costs are those paid directly by the producer and consumer in a transaction
...

➢ These costs include, wages for workers, rent , payment of raw materials
...
e other than to the producer or consumer
directly involved in the transaction
...


Private Benefit
➢ Private benefits are those benefits that are received directly by the producer and
consumer in a transaction
...

➢ Private benefits to consumer includes the satisfaction gained by the consumer from the
consumption of the product
...

Third Party: Person not involved in decisions of the company

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Economics IAS UNIT1 NOTES

Welfare losses from the external costs of production
 The free market ignores negative externalities
 When external costs are ignored there is under- pricing and over production and there

is an excess of social costs over social benefits for the marginal output
...
POSITIVE EXTERNALITITES
...


Remember:
➢ Whenever there are external benefits, there will be too little produced or consumer(underproduction)
➢ Whenever there are external costs, there will be too much produced or consumed
...

The analysis seeks to establish whether the benefits to society from the project OUTWEIGH
the costs, in which case the project should go ahead
...

It is very difficult to value external costs and benefits because different people have different
opinions as to their value
...
Owners of the goods can exercise Private
property rights Preventing other people from using the good or consuming its
benefit
...
)
• The second property of a private good is RIVALRY or DIMINISHABILITY
...

Public Goods
•
•
•

A Public good benefits many people rather than just one individual
Examples: Lighthouse, pavements, Police
Public goods have two important characteristics:
1) Non- Rivalry: This means that consumption by one person does not limit
consumption by others
...

2) Non- Excludability: This means that if a good is available for one person, then
it is available for everyone
...


Free- Rider Problem
Free- Rider Problem: When it is not possible to exclude other people from consuming a good
that someone has bought
...

•
•
•
•
•

Once a public good has been provided for one individual, it is automatically
provided for all
...

Examples include National defence, security along a street
...

However, if everyone waits for others to supply a public good then it may
never be provided
...

✓ For markets to work efficiently, there needs to be perfect and symmetric information i
...
consumers
and producers have the same level of knowledge about the products, and they know everything
there is to know about them
...

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Economics IAS UNIT1 NOTES

Misallocation of Resources
✓ Asymmetric information can lead to a misallocation of resources and market failure, there are a
number of important markets where misallocation of resources occurs:

1
...

Principal agent problem: Where people (Principals) , as a result of lack of
knowledge, cannot ensure that their best interests are served by their agents
...
The agents are the parents and guardians
of the child
...

➢ Therefore, it may act in ways, such as truanting from school or failing to work to its full
potential, which act to harm its long-term interests
...

➢ However, the principal- agent problem occurs when parents and guardians collude with the
child to avoid education
...


2
...

➢ The main reasons for this is asymmetric information
...

➢ Workers have to pay National Insurance contributions and other taxes which pay
for the state retirement pensions and benefits
...
Drugs:
➢ Drugs, such as alcohol, tobacco and heroin cause a misallocation of resources partly
because of asymmetric information
➢ Individuals are sometimes unaware of the long-term costs of drug use
...
Health Care:
➢ One problem is that health care professionals overprovide health care due to its profitable
...

This is called the ADVERSE SELECTION
...
This is called MORAL HAZARD
...
Therefore, they may take out health insurance without informing the health
insurance company about it
...


Geographical Immobility of Labour
✓ It involves factors which limit the movement of workers from one region of the country to another

Reasons:
1) Differences in regional house prices: This is often regarded as the most significant
barrier to the mobility of labour because a person living in an area of relatively low
house prices will find it very difficult to move to an area where house prices are much
higher
...

3) Social and family ties: Some people may be reluctant to move away from an area
because they have family and friends in the area and/or have other links to the area
...

5) Asymmetric information on Job availability
...
Relaxation of planning laws which enable construction firms to build housing
...
Increasing construction of social housing like council properties
C
...

D
...


Occupational Immobility of Labour
✓ Occupational immobility refers to the inability of workers to move between jobs due to lack of
appropriate skills or training

Reasons:
1) Lack of relevant skills: Unemployed workers may be unable to secure jobs because they do not
have the skills required to take the jobs available
...

3) No Relevant experience: Some employers insist on the need for experience in the occupation
before employing a worker
...


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Economics IAS UNIT1 NOTES

Government measures to increase the occupational mobility of Labour
A
...

B
...

C
...

D
...


Structural Unemployment
 Structural unemployment arises because of the immobility of labour
...

 Moreover, structural unemployment can also be present at a time when there are skill
shortages and many vacancies
...


Market Stabilisation
Commodity markets
Commodities refer to raw materials used in the production of goods like agriculture
produce, metals and fuels
...
Commodity markets are notorious for exhibiting price volatility
...

❖ There is a time-lag problem, owing to the fact that crops can take up to a year to
grow and animals several years to raise meaning that farmers have to base their
decisions on how much to plant or raise to sell in future
...


Government intervention to fix market failure
Governments can tackle these problems in the following ways:
1) Minimum and Maximum Prices
2) Buffer Stock Scheme

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Economics IAS UNIT1 NOTES

Minimum Prices
▪
▪

▪

Governments introduce a guaranteed minimum price, where goods cannot be sold below this which
may stabilise commodity prices and producer incomes
...
This is designed to ensure greater certainty and therefore act as an incentive to
producers to supply sufficient quantities
...


Government dealing with excess supply (surplus)
Method 1: The Government could buy the surplus and store it
...

➢ Solutions include:
1) Selling wheat mountains to third world countries at rock bottom prices
...

3) Offering at a reduced price to those in need in the EU
4) Simply DESTORYING IT
Method 2: The second solution to the problem of excess supply is to restrict production
➢ Governments can either force, or pay farmers to reduce the size of their herbs or leave part of their
land uncultivated
...

b) Farm incomes are stabilised and increased, leading to greater investment in agriculture
...

d) Employment in the countryside is maintained, helping to reduce rural-urban inequality
...


Disadvantages of a minimum Price
a) The price of food increases, which could lead to hardship for consumers on low incomes
...

c) Increased storage and security costs
d) Goods may have to be destroyed
e) The food surpluses may be sold in overseas markets at very low prices which could damage
farmers in developing countries who are unable to compete against the cheap imports
...
These schemes are used in the house rental market
...


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Economics IAS UNIT1 NOTES

Advantages of a Maximum Price
i
...

iii
...
E
...

the EU had capped the price of some mobile phone calls across member states
...

2) Problems arise over how to allocate supply to meet the excess demand since price cannot
increase and this mainly involves a first come first served basis or sellers preference both of
which are unfair
...


Buffer stock System
➢ Buffer stock schemes may be operated by a government agency to reduce price fluctuations of a
commodity and stabilise producer incomes
➢ It involves the agency setting a target price range for a commodity(A maximum and a minimum) and
then intervening to ensure the price remains within this band despite sudden changes to demand and
supply
...

• In times of a Poor harvest ( a decrease in supply) the price may be in danger of rising too high
and so the government agency sells from its stockpile
...
(P3)
TOTAL Spending = XYQ1L

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Economics IAS UNIT1 NOTES

Bad Harvest
The government agency sells
quantity VW from its stockpile
preventing the price rising above
the maximum price
...
Storage is expensive and involves an opportunity cost
...
Destroying surpluses especially if its food is morally questionable in a world devastated by
c
...


poverty and hunger
...

Giving the food as aid could, lead to a dependency culture
...


Greater certainty in the market, leading to
more investment

Storage costs and security costs (OPPORTUNITY COST)

Help ensure provision of commodities for
consumers even in years of poor harvests

Stocks may be perishable over a long period of time
...

ALL COUNTRIES MUST BE PART OF BUFFER STOCK FOR
IT TO BE EFFECTIVE
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Economics IAS UNIT1 NOTES

Government Intervention
Government Regulations
❖ Government imposes rules and regulations regarding the production, sale or use of a
product/service and backs this up legally by fines/prison sentences
...

❖ There are regulations relating to the consumption of a product, i
...


Advantages

Disadvantages

Simple to understand

Expensive to Monitor since inspectors may have
to be employed to ensure that rules are obeyed
May be extra costs to firms: for example, the
cost of installing pollution monitoring
equipment
May be difficult to quantify and attach a
monetary value to pollution emissions as well
as problems of determining the socially efficient
levels of the production process
...


Property Rights
All too often negative externalities like pollution arises when there is a lack of property rights over a
resource like an ocean
...

Property Rights: Property rights are the authority to determine how a resource is used, whether that
resource is used and whether that resource is owned by government, collective bodies or by individuals
...
For example, common resources like common land could be divided up by the
government and given to local people as private property
...
And so there could be an incorrect payment

Economics IAS UNIT1 NOTES

Taxation
Advantages

Disadvantages

Forces firms to take on board the social costs and
benefits of their actions and the taxation solution
is adjustable according to the magnitude of the
problem

Each firm produces different levels and types of
externality and operates under different degrees
of imperfect competition
...

Difficult to measure the cost of each firm and the
blame on each firm

If firms are taxed they are encouraged to find
cleaner ways of producing, hence, the tax acts as
an incentive over the long run to reduce pollution
Source of revenue for the government and few
administration costs

Ineffective in reducing pollution if demand is
price inelastic
...

✓ The government might provide grants to producers to lower production costs so that the
product or service can be provided at a lower price
...


Advantages

Disadvantages

Reduction in cost of
production enabling
suppliers to reduce the
price
Incentive for people to
increase consumption
...

 They are issued by the government to firms that allow them to pollute up to a certain
limit
...

 Permits may be traded between firms and firms which are clean can sell their surplus
permits to firms which are more polluting

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Economics IAS UNIT1 NOTES

Tradable Pollution Permits

Advantages

Disadvantages

A market is created for buying and selling
carbon permits, just like other goods and
services
...


Too many carbon permits may be issued so
that there is little incentive for firms to
reduce pollution
Disputes have arisen over the allocation of
carbon permits to firms, where some firms
believe they should receive larger
allowances and have taken legal
proceedings against the European
commission
Less pressure on major polluting firms to
clean up their act if it is possible to buy
extra permits
...


There is a cost to the government of
monitoring pollution emissions from the
many companies within the scheme

Government intervention (Labour mobility)
▪

Governments uses 3 methods to tackle the immobility of labour:
1) Education and training
2) Relocation subsidies and housing
3) Relocating industry

Education and training
❖ Education provides young people with the skills to compete in the labour market
...

❖ There is an emphasis on continued adult learning with universities offering adult students a
chance to gain qualifications
...

❖ Governments often subsidise training directly or indirectly

Relocation subsidies and housing
❖ Governments may provide a variety of financial incentives for workers to mo0ve to where there
are jobs
...

❖ Labour was too immobile to expect workers to move to regions where there were job vacancies,

Asymmetric Information
❖ Public information/advertisements designed to close the information gap
...

❖ To discourage the production and consumption of unhealthy goods and services, i
...

❖ Government provision of information, along with other measures plays an important role in
reducing market failure
...

✓ Ensures that the product or service is provided
✓ Politicians will determine the amount of resources allocated to these public goods without
reference to the electorate
...

Reasons why Government Failure Occurs:
1)
2)
3)
4)

Distortion of price signals
Unintended consequences
Excessive administration costs
Information Gaps

Distortion of price signals
Distortion of price signals: The actions of government which distort (change) the operation of the price
mechanism and so misallocation resources
...

➢ Long term implications include a reduction in both the quality and the quantity of rental housing
available, possibly leading to an increase in the number of homeless
...

➢ Long term implications include problems of disposing of food surpluses, which are perishable
and expensive to store, as well as an opportunity cost in the case of surplus
...

Examples:
 Indirect Taxes: May lead to the development of illegal markets which leads to a growth in
organized crime and of course a loss of tax revenue for the government
...
It may
also be difficult to withdraw subsidies once they are in place
...

 Regulations: May lead to regulatory capture, where the regulator acts in the interest of the firms
rather than of the consumer whom its meant to protect
...
e tax
changes in a government Budget may take a year to implement
...

3) Regulations require constant monitoring to ensure they are implemented, i
...
ensuring
fishing boats don’t exceed their quotas
...

1
...

2
...

3
...


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