Notesale: Turn your study into money

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ECONOMICS

Contents
SCARCITY, CHOICE AND OPPORTUNITY COST
...
2
SPECIALISATION, DIVISION OF LABOUR AND EXCHANGE
...
4
THE DETERMINATION OF EQUILIBRIUM PRICE AND OUTPUT IN A FREELY COMPETITIVE
MARKET
...
7
PRICE, INCOME AND CROSS PRICE ELASTICITIES OF DEMAND, PRICE ELASTICITIES OF SUPPLY

...
11
LABOUR MARKET ISSUES
...
15
UNDERSTANDING MARKET FAILURE
...
18
THE EFFECTS OF GOVERNMENT INTERVENTION
...
21
THE UNITS OF AGGREGATE DEMAND
...
23
THE AGGREGATE SUPPLY FUNCTION
...
24
GOVERNMENT POLICY OBJECTIVES
...
26
FISCAL POLICY: DEMAND-SIDE
...
27
MONETARY POLICY: FRAMEWORK
...
29
EXCHANGE RATES IN A FREE MARKET
...
30
FREE TRADE AND PROTECTIONISM
...
32
THE GROWTH OF FIRMS
...
1
BACKGROUND TO MARKET STRUCTURES
...
3

1

SCARCITY, CHOICE AND OPPORTUNITY COST

There are only finite resources available, and wants for these resources are always greater
than the amount available
...

Because resources are scarce, choices must be made
...
A consumer must decide whether to purchase good X or to
purchase good Y
...

Every decision has an opportunity cost
...
For example, if you walk to the shop to buy a pack of crisps, the
opportunity cost is the price of the crisps, which could have been spent on something else,
and also your time, which could have been used in other ways
...
It shows the amount of one good on the x axis, and amount of another good on
the y axis
...
A point inside the curve shows
that resources are being wasted in the economy, that it’s inefficient
...
The
curve can, however, move outwards
...
A decrease in
the size of the economy will be shown by an inwards shift
...
If
you move from point A to point B, you’ll produce more capital goods, but fewer consumer
goods
...

In the short term, an economy which focuses more on consumer goods will be better off;
they’ll be wealthier
...
Government
must make decisions leaning towards either producing more or fewer capital goods, and
decide which will be the best for their country
...
As you try to produce more and more of one good,
efficiency decreases
...
For example, if an economy decided to produce only
bespoke wooden furniture, there wouldn’t be enough carpenters to meet the demand, and
so unskilled workers would fill the posts, giving decreased efficiency
...
There
would be a shortage of land, and so less fertile land would be used, which decreases
efficiency
...


SPECIALISATION, DIVISION OF LABOUR AND EXCHANGE

Specialisation is the production of only a limited range of goods by an economic agent
...

Specialisation increases efficiency in the following ways:
•
•
•
•

Less time is spent changing between tasks
...

By doing only one task, you get very good at it
...
A machine in the hands of
a specialist is much more efficient than the same machine in the hands of a nonspecialist
...
That is,
output per worker and output per unit of capital
...
One person
wouldn’t be able to gather all the resources, and gain all the necessary knowledge and
skills required to create a mobile phone
...
For example, a country like Germany can produce cars very efficiently,
because it has a skilled work force, and large amounts of the necessary capital
...
But, due to lower wages, Vietnam can produce clothing much more
cheaply than Germany
...

Productivity can also be increased by advances in technology
...
It can be a physical place, like a
shop, but it can also be online
...
It’s assumed that all economic agents are
rational
...

A demand curve always slopes down
...
A
high price means fewer items are bought
...
The more items that are offered, the less the last item is
valued at
...
If they eat
another packet, they might only value it at 20p, because they don’t want it as much
...

The demand curve shows the value to the buyer of the nth product
...

The conditions of demand (the main factors influencing demand) are:

4

•
•

•

•
•
•

•

Price - a higher price lowers demand
...
An increase in income will decrease the demand for an inferior good, like bus
tickets
...
An example is tennis balls and tennis rackets
...
If good x substitutes good
z, then a decrease in the price of z will decrease demand for x
...
If the price of pork falls, more people will buy pork over beef, so demand
for beef will fall
...

Fashion - a product that’s in fashion will have a higher demand
...
For example, when
the government passed a law requiring cigarette companies to put the dangers on
the box, demand fell
...


The conditions of supply are:
•
•
•
•

•

•
•
•
•

Price - a higher price leads to increased supply
...

Technology - new advances in technology can increase the efficiency of production,
so supply increases
...
So, for example, if the demand for beef increases, more cows will be reared
and slaughtered, and so the supply of leather will increase
...
For example, the book selling industry is
made up of many small sellers more interested in selling books than making a big
profit
...

Legislation - the abolition of regulations may increase supply
...

Weather - this can affect agricultural yields
...


5

A supply curve goes up and to the right
...

Also, producers can afford the increased marginal cost of producing more products
...
For
example, you may have to build a new factory to increase the amount of a good you
produce
...
This only applies in the short term
...

It is assumed in this model that firms are price takers
...


THE DETERMINATION OF EQUILIBRIUM PRICE AND OUTPUT IN A FREELY
COMPETITIVE MARKET

The equilibrium point is where the demand and supply curves meet
...
An
increase in supply will decrease price and increase quantity
...


6

CONSUMER AND PRODUCER SURPLUS

The consumer surplus is the difference between the price the consumer is willing to pay
and the price the consumer actually pays
...
The total surplus
is the area of the triangle under the demand curve and above the equilibrium point
...
If you look at a supply curve, you’ll
see that the first product sold is valued at much less than the equilibrium price
...


In a free market economy, producer and consumer surplus are always maximised, and are
both equal
...

An elasticity of less than one means the product is inelastic, so a change in price will lead
to a smaller proportional change to demand
...
An increase in price will lead to an increase in revenue
...
The demand curve will have a gradient of less
than one
...

A product with an elasticity of one is unitarily elastic, and demand will change linearly
with price
...
A change in price won’t affect
revenue
...

Elasticity of demand is always given as a positive number
...

Width of the market - the wider the marker, the less likely the product is to be
elastic
...

Time - In the short term, it can be impossible to change spending habits, but they
may be changeable in the long term
...
In the short term, oil will be
very inelastic, people need to drive places, and so they’ll buy oil no matter the
price
...
This will lower demand for
oil in the long term
...


The income elasticity of demand is how much demand changes relative to income
...

If income elasticity is a negative number, then the product is an inferior good
...
An example of an inferior good is bus tickets
...

If income elasticity is positive, then the product is a normal good
...
Most goods fall into this category
...
Bread, for example, is a normal
good at very low incomes
...
But, as incomes increase, bread becomes an inferior good, because it gets
replaced by meat and vegetables
...
It’s given by the formula:
𝐸𝐶𝐷 =

∆𝑄𝐷(𝑋) ∆𝑃(𝑌) ∆𝑄𝐷(𝑋) × 𝑃(𝑌)
÷
=
𝑄𝐷(𝑋)
𝑃(𝑌)
∆𝑃(𝑌) × 𝑄𝐷(𝑋)

If good X compliments good Y, then the cross elasticity will be negative
...

If good X substitutes good Y, then the cross elasticity will be positive
...


Elasticity of supply is how supply changes with a change in price
...
e
...
If a
producer can quickly change what they produce then the product will be more
elastic
...
Current car
producing factories can then be used to make that model, without a lot of
expense
...

Production times - some crops may take months to grow, and so you can’t respond
to changes in price quickly
...
As a result,
when price increases, people can release a large quantity of wheat
...


9

The creation of taxes increases the costs of supply
...


The introduction of an Ad Valorem tax, such as VAT will shift the supply curve up, and also
increase its gradient, because it’s proportional to the price
...
Part of the cost
will be taken on by the firm
...
The greater the elasticity of demand for a
product, the less the consumer has to pay of the tax
...

The more inelastic the demand for a good is, the more revenue is collected from the tax
...
If a tax is put on an inelastic good, then quantity bought won’t change massively,
and so tax revenues will be quite high
...
A subsidy lowers the supply curve
...
A high elasticity of demand would mean less saving for the consumer
...

10

WAGE DETERMINATION

The demand for labour is shown using an MRP diagram
...
The more workers employed,
the lower the marginal gain per worker, due to less effective use of capital
...


The factors affecting the demand for labour are:
•

•
•

Productivity - the more productive a worker, the higher their MRP is
...
An increase in productivity can come from advances in
technology, a more skilled workforce, or investment in capital
...

Imperfect competition - in an imperfectly competitive market, the price of each
successive product produced is lower
...
This
doesn’t occur in a perfectly competitive market
...


The supply of labour to a firm without monopolistic powers, in a large industry, will give
a straight line graph
...
In a monopolistic firm or a small industry, however, the line goes
up and to the right
...
As a result, the marginal cost of each new worker in a
monopoly is very high, because you not only have to pay the new employee more; you
have to raise every employee’s salary to meet that level
...

How many new workers are recruited
...

Education - the amount of people that pursue higher education
...

Retirement - how early or late people retire
...

Legislation - some argue that cutting unemployment benefits and cutting income
tax would increase the size of the workforce by motivating the unemployed to seek
work
...

Trade unions

The supply curve for the economy is upward sloping, because higher wages lead to more
people seeking work
...

The elasticity of supply of labour is affected by:
•

The amount of people in the industry, or similar industries (the amount of people
with the required skills for the job) - the elasticity of supply of doctors is very low,
because people from other fields generally can’t move in to fill the positions
...

12

•

•

Time - in the short run people can’t become doctors, but in the long run more
young people may train to become doctors
...

Levels of unemployment - the higher the unemployment, the higher the elasticity
...


The wage rate is determined by the equilibrium position on a supply/demand graph
...

Gender and ethnicity - many argue that these factors affect wages
...

Personal traits - intelligence, perseverance, etc
...
Many also
don’t maximise their wage, for example by being too scared to ask for a raise
...


LABOUR MARKET ISSUES

Labour market flexibility is the ability of labour to respond to a change in market
conditions
...


13

Trade unions are groups of workers who join together to attempt to better their working
conditions
...
A union, however, has much greater power
...
This leads to a supply curve which is perfectly flat
at this minimum price, until it reaches the normal supply curve
...


Trade union strength is affected by several factors
...
A union with
100% membership will have more power than one with 10%
...
If the demand curve is
inelastic, then a rise in wages will lead to fewer lost jobs, to the benefit of the union
...

Regulation can make it harder to hire and fire workers, so firms are less likely to have a
change in staff
...
If
income tax is high, then the same is true
...

The aim of a minimum wage is to that the lowest paid are paid enough to support
themselves
...
It also increases
investment, as firms have more incentive to drive down costs
...
In the
case of a monopsony, imposing a minimum wage could actually increase employment
...
If the minimum wage is higher then the
equilibrium wage, then supply will outweigh demand
...
Care
workers, for example, are often paid the minimum wage
...
In other industries, firms simply
choose to retain their profits by simply increasing prices to offset the cost of higher
wages
...

The average cost of living in the UK is £8
...
In London it’s £10
...
Wales’ cost of
living is significantly lower than the average
...
A regional
minimum wage would prevent this kind of problem form occurring
...
A
majority of immigrant workers fill gaps in the UK economy
...
You could argue, however, that this would lead to unemployment for
native citizens
...


HOW RESOURCES ARE ALLOCATED IN A FREE MARKET ECONOMY

The main economic question is deemed to be: what to produce, how to produce it, and for
whom it’s produced
...
How to produce it is dictated by profit seeking firms
...
All of these factors are dictated by
consumers’ self interest, and should in theory should lead to the most efficient economic
system
...

Free markets, however, can become distorted in the real world
...

In reality, economic agents aren’t rational
...
Things are also sometimes
bought on impulse
...
People may be altruistic
...

Market often interact with each other
...
An increase in
the price of cars would decrease the demand for petrol
...
However, due to a variety of reasons, this doesn’t always happen
...
This means that when
one person uses it, it isn’t used up, someone else can use it too, and that everybody can
use it at once
...
Because once one
person pays for it, everyone can use it; people are usually unwilling to pay for public
goods
...
Most public goods are supplied by governments
...
This is
often due to a lack of information, or a disregard of long term effects
...
If left to market forces, these will be undersupplied
...
The opposite is true of demerit goods
...
One example is
cigarettes
...

An externality occurs when the cost or benefit to society is different to the private cost
...
The social

16

benefit is you don’t give the disease to someone else
...
This means that vaccines have a positive externality of
consumption
...

MSB is marginal social benefit, MPB is marginal private cost
...

The free market assumes that the equilibrium position is at P1 Q1, when in fact it’s at P*
Q*
...
To
correct this, subsidies are often given to goods with positive externalities
...


An externality of production affects supply
...
An example of a negative externality of production is the creation of toxic waste
from a factory
...
This results in
the MSC greatly outweighing the MSB, leading to a loss of welfare
...


In a monopoly, firms often seek to raise prices
...
This
leads to a lower quantity and a higher price
...
This means
the supplier knows more about the product than the consumer, which can lead to either
too high a demand or too low a demand
...
Many people think they
have even odds of winning, and so gamble, when in fact the odds are in favour of the
house
...
Another example is second hand cars
...
This is because someone buying it doesn’t know if there’s
anything wrong with it
...


17

Private property rights are important in reducing the effects of externalities
...
If someone owns the river, they’re free gain compensation for the
pollution or take legal action to stop it
...
Often, it’s the government of the country that owns
all of the land
...
This is because if you are very poor, you will
not be able to buy things you otherwise would, so demand for that good may be lower
...
This leads to a misallocation of resources
...
This means
prices are subject to quick change
...
As a result, a small change in supply, which often occurs, changes prices wildly
...
This doesn’t
maximise the surplus of the producer
...


WHY AND HOW GOVERNMENTS INTERVENE IN MARKETS

Governments often intervene in markets, in an attempt to either reduce income equality
or correct market failure
...
If a product has a
negative externality, imposing a tax on production will increase costs, and bring
consumption down to the socially optimum level
...


If a tax equal to the difference between the MSC and the MPC is imposed, then MPC will
equal the MSC, and the externality will be eliminated
...
Taxes
can be difficult to impose
...

While the fact that taxes bring in revenue for governments is good, this often leads to
taxes that are too large, and create more market failure
...

18

Subsidies can increase total social welfare, but they cost money, which can conflict with
some politicians’ policies to reduce spending
...
Like taxes, they can also
be too small or too large
...
A subsidy can make a new entrant in a market more competitive,
and so reduce the effects of a monopoly
...

A way of correcting the market failure of a public good is through state provision
...

The government may however misallocate resources, because it can be hard to determine
the exact number of things required
...

Regulation is a cheap, although sometimes crude way of reducing market failure
...
They can reduce the information gap, by forcing
companies to disclose any relevant information, like all of the fees for booking an airline
ticket
...
This,
however, is very hard to implement perfectly
...
If reducing carbon emissions by £1 million costs £2 million, then the regulation is
too tight, and welfare is lost
...
One clever solution to this is tradeable carbon permits
...
These permits
are tradeable, so those who can’t afford to decrease their carbon emissions below the set
level can buy more permits form companies who can afford to do it cheaply
...
Those who can
meet the requirements cheaply have incentives to sell their carbon permits, because it
leads to a profit for them
...
This makes the item,
usually something like bread, or housing, easier to afford for the poorest in society
...
So, while some are better off, because they can better afford a
good, others are worse off because they can’t buy the good at all
...
Rationing often creates black
markets
...
This raises prices to the socially optimum level, but leads to a massive
production surplus, which often leads to a black market
...
They’re almost
always bought by the government at a loss, and because there’s a surplus, much of it is
wasted
...
This means they aren’t competitive in the free market, and the difference
between the minimum price and the free market price will only increase, and the
government’s losses will get bigger and bigger
...
One example of this is market distortion
...
Tariffs are often imposed on foreign imports , which
allows local farmers to compete
...
It’s very easy for the cost to the consumer
to be greater than the benefit to the farmer, and this would be government failure
...
This lead to a boom in agriculture in the EU people were attracted to it because of the high profits
...
These were all offloaded on the global market, which depressed
their price greatly
...
It also had the effect of
halting development - the EU was acting like a monopoly undercutting global prices, which
meant that other countries didn’t have large enough profits to invest in capital and
technology, so the long term cost of these goods will be higher
...
In 2005, the cost of sugar was 4p a pound in the world market, and 15p a pound in
the EU
...
In 1985 it accounted for 73% of the EU’s total spending, at almost
£100 bn, which was much higher than the EU ever planned to spend
...
It did do that; but it
also lead to higher food costs for the other 500 million EU citizens, which not only caused
problems for the poorest in society, but also reduced the purchasing power of the Euro,
leading to an unsustainable trade deficit
...
Overall, the social cost of the policy greatly outweighed the social
benefit
...
If it’s set too high, then a lot of
workers will be laid off, and so the msc will be large
...
Firstly, the national output (O)
...
Secondly, there is national expenditure (E)
...
This is national income (Y), which is the amount paid to households
by firms in return for land, labour and capital
...
In
reality, however, the economy is subject to injections and withdrawals, which add and
subtract from the national income respectively
...
They consist of:
•
•
•

Government spending
Investment
Exports

A withdrawal is when household income is not spent in firms
...
If
injections are larger than withdrawals, then Y is rising
...
An increase or decrease Y will change the equilibrium level
...
Any money invested in firms requires workers
...
Households, however, don’t spend all of their
income
...

It’s calculated like this:

21

𝐾=

1
1
1
=
=
1 − 𝑀𝑃𝐶 𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀 𝑀𝑃𝑊

Where MPC is the marginal propensity to consume,

Δ𝐶
Δ𝑌

, MPS, MPT and MPM are the

marginal propensity to save, tax and import respectively, and MPW is the marginal
propensity to withdraw
...
4, MPS was 0
...
2, then an investment of £100
million would increase national income (Y) by:
£100 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ×

1
= £143 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
0
...
1 + 0
...


THE UNITS OF AGGREGATE DEMAND

The aggregate demand is the total demand in the economy
...

Investment (I) – The spending by firms on investments
...

Net Exports (X-M) – Exports minus imports
...
One is the interest rates
...
In times of low interest, demand for items like cars goes up
...
A fall in the real value of wealth will also
decrease consumer spending
...

In times of deflation, consumption also falls, because consumers think that they’ll be able
to buy an item cheaper in the future, so stop buying now
...
New technologies can also
increase AD, as households go out and buy these new products
...
The higher the interest rates, the less
profitable a venture will be, and so less firms will invest
...
If Keynes’ ‘animal spirits’ are high, for example if the economy is in
a boom, then investment will increase
...


22

THE AGGREGATE DEMAND FUNCTION

The AD function is downwards sloping
...

The real balance effect, also known as Pigou’s wealth effect, states that as prices fall,
consumption increases
...
When prices fall, everyone is wealthier, which induces more
spending
...
When price levels are low, consumers put more money in banks, as they have a
larger money surplus
...
Lower interest rates leads to higher investment
...
Imports will likely fall, and exports will likely increase
...

A change in any of these four factors will shift the aggregate demand curve
...
This means no
matter how much the AD increases, output won’t increase
...

The factors which affect the Keynesian LRAS are:
•

•

An increase in the quantity of factors of production – an increase in the amount of
labour, capital or land
...

An increase in the quality of the factors of production
...

23

•

•

An increase in the efficiency of the factors of production
...

An increase in labour market flexibility will maximise the allocation of labour in
the economy, and so increase the LRAS
...
These are called supply-side
policies
...
By breaking up a state monopoly, the market is subject to more
competition, which should increase efficiency
...
By increasing the duration of mandatory education, or providing
subsidised further education and training, you can increase the quality of the
economy’s human capital
...
Trade unions decrease the flexibility of labour
markets, which may lead to unemployment or inefficiently used capital, as the
industry won’t be in it’s free market equilibrium position
...
If unemployment benefits are high enough, it may
increase unemployment, and so the LRAS will fall
...
If the AD is low enough, then
the economy will never reach it’s maximum capacity
...
An increase in AD at full output will
be purely inflationary
...
An increase in the LRAS when the economy is at it’s full
potential will increase national output
...


24

If the economy is operating below full capacity, there will be unemployment
...
Reaching maximum
output is therefore desirable for governments
...

Low inflation, to avoid all of the problems that come with high inflation or
deflation
...

A balanced account of payments, so as not to incur debt
...
A large growth in the economy or a
rapid fall in unemployment can both lead to high inflation
...

When the economy is doing well, British consumers tend more towards imports, lowering
the net export
...

High rates of economic growth can also lead to damage to the environment, and inequality
amongst citizens
...
The purpose of the budget is to announce the
country’s fiscal policy for that year
...

Government spending is made up of capital and current expenditure
...
Current expenditure
is comprised of:
•
•
•

General consumption – wages, fuel costs, etc
...

Debt interest

It is generally not a good idea to incur a deficit on current expenditure alone; that would
be unsustainable in the long term
...

The main categories of government spending are: social protection, social services,
health, transport, education, defence, debt interest, housing and the environment, and
public order and safety
...
There are two main types of tax: direct taxes,
and indirect taxes
...
Examples
of this are income tax, corporation tax, and national insurance
...

Direct taxes are often progressive taxes
...
Indirect taxes are often regressive, which means as your
income rises, these taxes form a smaller and smaller percentage of your income
...
Indirect taxes are
much more efficient than direct taxes
...
Direct taxes are better targeted at the rich, and indirect taxes are better targeted
at the poor
...
Because 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀, as government spending
increase, so does AD
...


26

Whilst an increase in taxation would increase government income, it will only do so up to
a certain extent
...


FISCAL POLICY: DEMAND-SIDE

Demand side fiscal policy is the use of taxation and government expenditure to increase
the AD function
...
If it
were used in times of full output, demand side fiscal policy would be purely inflationary
...

Decreasing taxes leads to a higher disposable income amongst the populous
...
Another way to increase the AD is to increase government
spending
...

Excessive demand side fiscal policy often leads to a government deficit
...
It can also lead to high inflation, which is
unsustainable, and so leads to boom-bust cycles
...


FISCAL POLICY: SUPPLY-SIDE

Supply side fiscal policy aims to shift the LRAS to the right, which would lead to
sustainable long term economic growth without high inflation
...


27

Supply side policies often create jobs, and so decrease unemployment
...
This will decrease the trade deficit
...
Free market
policies reduce aim to minimise government involvement in the economy
...
This is not always desirable,
as some industries, like water, are natural monopolies
...

Cutting income tax – this incentivises workers to work more hours, which will
increase national output
...

Deregulating labour markets – by decreasing trade union power, and abolishing
redundancy pay, it becomes easier to hire workers, which incentivises firms to hire
more workers
...
Examples are:
•
•
•

Education – a more educated workforce will have a higher output than a less
educated workforce
Infrastructure investment – a decrease in transport costs will encourage
investment
...


Supply side policies are often dependent on private enterprise, so the results can be
variable
...
Some can also be counter-productive
...


MONETARY POLICY: FRAMEWORK

Monetary policy is the actions of a central bank (e
...
The Bank of England, Federal
Reserve, ECB) which affect the supply of money, and consequently inflation rates
...
The inflation
target is said to be symmetrical, as being below the target is just as bad as being above it
...
The inverse is also true
...
This means they will provide
liquid funds for an institution in dire financial need, when it will prevent a bank run or
financial panic
...
They also hold massive gold reserves to back up the value of the GBP
...

Expansionary policy is designed to stimulate the economy
...

This leads to more investment in the private sector, because any venture will become
more profitable, and also an increase in consumer spending as they can buy things on
credit more easily
...
Expansionary monetary policy will reduce unemployment, and is useful in times
of recession
...

Contractionary policy involves increasing interest rates
...

While in the short term it may lead to negatives, contractionary policy provides a basis for
stable economic growth in the future, and prevents high levels of inflation from being as
damaging
...

A decrease in interest rates will shift the AD curve outwards, and an increase in interest
rates will shift the AD curve inwards
...
This will lead to fewer
exports and more imports
...
e
...

The Bank of England’s interest rates are set nationally, and so although they may be
appropriate for London, they may be too high or too low for Wales
...


EXCHANGE RATES IN A FREE MARKET

In a free market, the exchange rate is dictated by supply and demand for that currency in
international markets
...

The demand for a currency is equal to exports plus capital inflow, minus imports and the
capital outflow
...

The exchange rate is affected by:
•
•
•

Interest rates – the higher the interest rates, the more valuable the pound
...

Trade balance – the more the UK exports, and the less it imports, the higher the
demand for the currency
...
If the Keynesian ‘animal spirits’ are
high, then demand for that currency will increase
...
e
...
An example of a ‘safe haven’ currency is the Swiss
Franc
...
A revaluation of the currency can lead to a decrease in
the ad, which can be counter-productive if you’re attempting to increase it
...
It would also devalue the currency, which
would increase the trade balance, and increase the ad further
...
32
...
If the pound is more valuable, then imported goods
are cheaper
...
It would also make a foreign holiday cheaper
...


EXCHANGE RATE POLICY

The value of a currency is determined solely by supply and demand in the Forex market
...
This is seen as a form of monetary policy, and is widely used by
China
...
This leads to an increased ad, but more expensive imports
...
This and an increase
in the ad are both inflationary
...


FREE TRADE AND PROTECTIONISM

Free trade means countries can import and export goods without any form of
protectionism
...
This means a larger
consumer surplus
...
This will mean they sell less, but also mean that they
will increase heir efficiency to compete
...
It will
also increase exports, because in the areas in which the UK has an advantage, they can
sell things cheaper, and so will sell more
...

An increase in the availability of imports means that a country can specialise more in one
specific market
...
It also allows for efficient use of raw materials, allowing
them to be distributed more efficiently
...
Infant industries
in developing may not be able to compete with large international corporations
...

Senile industries, which are industries in decline, can also benefit from protectionism
...

Protectionism also raises revenue for the government, and helps balance the balance of
payments, as it decreases imports
...

Dumping is when one firm or country has a large excess of one good, so sells it cheaply in
international markets, making domestic firms unprofitable
...
g
...

Quotas – a quantitative limit on how many items can be imported from a certain
region, e
...
Vietnam can only exports 1000 tonnes of shoes to the UK each year
...

Technical restrictions – this usually comes from different legislature in the two
countries i
...
labelling standards, sanitary standards
...


31

COSTS, REVENUES, AND PROFITS

The law of diminishing returns states that in a productive process, if you keep adding one
factor of production, then eventually, ceteris paribus, your marginal returns will decrease
...

Here’s an example of diminishing returns, in a bakery, where a workers wage is £10 an
hour:

Workers

Cakes produced
per hour (Total
Product TP)

1
2
3
4
5

2
5
9
11
12

Cakes produced by
the new worker
per hour (Marginal
Product MP)
2
3
4
2
1

Cost of each new
cake added
(Marginal Cost MC)
£5
...
33
£2
...
00
£10
...
But,
as you add more and more staff, the bakery becomes crowded, capital is used
inefficiently, and efficiency decreases
...

The same principle applies in all industries, for example chemical fertilizers
...

After diminishing returns kick in, each new worker decreases average product, has a lower
marginal product, and usually increases total product, although may decrease it in

extreme cases
...
When the curve is
accelerating, you get increased marginal returns
...
When the curve is negative, you get negative returns
...

Fixed costs are costs that you pay no matter how much you produce or sell, i
...
they
aren’t dependent on output
...

Variable costs are dependent on output, and are used in the production or sale of goods
...

In the ‘short term’ at least one factor of production is fixed
...

An ‘economy of scale’ refers to the decreased cost per unit in a larger business
...

Bulk orders, with reduced costs per unit
...

Examples of integrated costs are accounting, ICT and design
...

Large firms can better handle risk
...

Better infrastructure and communication networks may lead to reduced costs
...
An external factor affects the whole
industry
...
This happens because:
•

•

•

Communication issues
...
This means a business may fall
behind, due to lack of awareness of new trends
...
The management of large companies may get complacent,
and end up paying higher prices for goods, wasting materials, and receiving salaries
that are too high
...
In a very large firm, delegation is a necessary function
...
It can also lead to lower down managers making the decision best
for themselves personally rather than the decision that’s best for the company
...


34

The LRAC (Long Run Average Cost) curve is tangential to a series of possible SRAC curves
...
So, a firm can pick which SRAC it
wants to have in the future by investing appropriately
...
Accounting
profit is how much money was made when all expenses, including depreciation in value
and taxes, have been taken into account
...
For example, if someone starts a business at a cost
of £100,000, and makes a return of £160,000, his accounting profit is £60,000
...

The normal profit is the minimum profit required to attract suppliers, investors and
managers to an industry
...
A profit higher than the normal profit is
an abnormal profit, and usually occurs in a monopoly or an oligopoly
...
It can also gain scale externally, through mergers and acquisitions
...
A horizontal merger is between two companies in
direct competition, for example Time Warner Cable and Comcast
...
A conglomeration is a merger between two completely different
businesses, like when GE expanded into finance, and healthcare
...

Technology acquisition – a merger may give a company access to new and more
advanced technology, giving it an edge in the industry
...

Improved market share – this gives the company improved investment prospects
and also the possibility of access to new markets
...


There are also disadvantages and risks to mergers
...

It can lead to less choice and higher prices for consumers
...

Mergers often lead to a loss of jobs
...


EFFICIENCY

Productive efficiency is a firm is using resources in a way to produce an output at the
lowest possible price
...
This point is also where the SRAC meets the MC
...
This
is because the price the consumer is willing to pay is equal to the marginal utility they’d
gain from buying it
...
MU is equal to the demand
curve
...


1

Dynamic efficiency is the efficiency of a firm in the long run
...

A Pareto improvement is one which benefits one person without harming another
...


BACKGROUND TO MARKET STRUCTURES

The structure of a market is based on how many firms operate in it, and how high or low
the barriers to entry are
...
A market with many firms and low barriers to entry are likely to be
competitive
...

Barriers to entry can include (Structural barriers are in red, behavioural barriers are in
brown):
•
•
•
•

•
•
•
•
•

Economies of scale - some industries benefit more than others form economies of
scale
...
e
...

Vertical integration - it can be hard for new entrants into the market to form the
necessary supply chains to compete, if the market integrates vertically heavily
...
e
...
A factor in
this is sometimes loyalty schemes
...
g
...

High R and D costs - some industries, like pharmaceuticals, have very high R and D
costs, so new firms will have to meet or exceed this cost to be competitive
...

Predatory acquisition - a firm may buy the competition
...


The government can increase contestability in several ways:
•
•
•

•

Privatise a public service - e
...
when the Royal Mail’s state monopoly was broken
...
g
...

Legislation against monopoly power - The Competition and Markets Authority (CMA)
can stop the abuse or acquisition of monopoly power by stopping mergers and
acquisitions, fining companies, or restricting supply
...

2

The government can’t fix all of the problems that cause low contestability
...
These can include:
•
•
•
•

Maximisation of profits - a common objective in the private sector, in order to
reward the executives, reinvest in the company, and improve worker welfare
...
They often do this by growing the firm
...

Social and community objectives - these can include: providing a good
service/product at a good price, fair wages for employees, creating employment,
building schools, etc
...
This is someone who is affected by the actions of the
business
...

All of these stakeholders have different aims
...
There is
obvious conflict between some of the stakeholders wants, and many companies attempt to
fic this by satisficing, i
...
meeting the minimum requirements of everybody
...


PERFECT COMPETITION

A perfectly competitive market is one where competition is at its greatest possible level
...
e
...
If they
raised their prices, they’d sell nothing, and if they lowered their price they’d still
sell everything, just at a lower price
...


You begin with a price, P1 in the market, which is dictated by market supply = market
demand
...
In the short run,
quantity for the firm is equal to the MC, and price is well above the AC, which leads to
supernormal profits
...
In the long
run, more firms enter the market due to the abnormal profits, which shifts the market
supply curve to the right, lowering the price in the market to P2
...
Q falls from Q1 to Q2
...
This is productively efficient
...


MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure which has elements of both competitive
markets and monopolies
...

No barriers to entry/exit
...

Firms are price setters not price takers
...


4

•

There is good, but not perfect information
...
In the short run, this will lead to supernormal profits, as the AR is greater than the
ATC
...
This makes the demand at the original firm more elastic, and so
lowers demand (D=AR)
...
Eventually, all
supernormal profits are lost
...
They
can do this by differentiating more, e
...
more advertising, making better products, etc
...
This is also productively inefficient, as production
isn’t at the point where ATC is at its lowest
...
e
...
In the UK, a firm is considered a monopoly if it has over 25% of the market
share
...


The disadvantages of a monopoly are:
•
•
•
•

Higher prices - the firm can afford to take supernormal profits, at the expense of
the consumer
...

Allocative inefficiency - MC won’t ever equal AR in a monopoly
...

Possible diseconomies of scale
...

Lack of choice
...

Big R & D budget - some industries, like pharmaceuticals, require very large
amount of research, which can only be paid for by supernormal profits
...

Global competition - a domestic monopoly may still face pressure from overseas
firms, increasing competition
...
e
...


The diagram for a monopoly is the same as the short run diagram for a market in
monopolistic competition
...
This leads to a supernormal profit, and a
welfare loss of the area between the MC and the AR
...
There are no real
economies of scale, and customers value choice highly
...
A natural monopoly is one which occurs in an industry where there are
naturally very high barriers to entry, and isn’t usually harmful
...
g
...
Natural monopolies
are sometimes formed by the first firm into the industry, like Microsoft
...
Examples of these are
pharmaceuticals and aerospace
...
These
monopolies are usually either state run or heavily regulated
...
Sometimes they’re formed
through horizontal mergers, like Lloyds TSB
...


OLIGOPOLY

An oligopolistic market is one in which few firms dominate
...
The strength of an oligopoly can be
measured by the concentration ratio of the top few firms (the exact number can vary)
...
This gives a four firm concentration
ratio of 88% (the sum of the four largest firms’ market shares)
...
An oligopoly often has high
barriers to entry
...

In an oligopoly, firms are said to be interdependent
...
When making decisions, a firm must evaluate carefully what
the other firms might do, e
...
a firm wanting to lower prices in order to gain market share
must consider that their competitors may do the same, leading to no increase in market
share and a loss of profits for all firms
...
Here is a Profit-Payoff
matrix
...
The prices begin at £20 /
£20
...
This would lead B to decrease their prices too, which would increase B’s profits,
but decrease A’s
...
This is called a price war, and is usually detrimental to all involved, at least in the
short run
...
This is called collusion, and there are two main types
...
The other is explicit collusion, where two
firms meet and discuss collusion
...
Collusion is the Nash equilibrium of this game
...

A form of collusion is price leadership
...

Using price competition in an oligopoly is often to the detriment of a firm, so firms use
non price competition to gain market share instead
...

The disadvantages of an oligopoly are:
•
•
•
•

High firm concentration reduces choice
Reduced competition can lead to loss of efficiency and higher prices
There can be artificial barriers to entry, e
...
predatory pricing, predatory
acquisition, superior knowledge
There may be a loss of economic welfare, as oligopolies are both productively and
allocatively inefficient
...

Oligopolies may be more dynamically efficient, i
...
more efficient in the long run
due to innovation funded by supernormal profits
...
Collusion may lead to price stability, which helps customers to plan
ahead, and also minimize the effects of the trade cycle
...
The role
of a competition authority is to protect the public interest
...

The CMA stops the abuse of monopoly power, or prevents monopolies form being formed
at all
...
To combat this, the CMA

8

•

•

•
•

can create new regulations and/or price caps, e
...
the EU commission put a cap on
the data roaming prices presented by mobile networks
...
The CMA prevents this by forcing companies to act in the public
interest, for example forcing the royal mail to deliver to every house, every day
...
g
...

Surrogate competition - the government can make the market act as though it
were competitive by putting regulations on a non competitive market
...


PRIVATISATION

Privatisation is an attempt at increasing the competition in a market
...
Examples
of privatised businesses are British Petroleum (BP), British Telecom (BT) and Rolls Royce
...

The potential benefits of privatisation are:
•
•

•

•
•
•

Increased efficiency - a private firm is more interested in making profit than a
public one, which leads to increased efficiency
...
For example, the government may be reluctant to cut
jobs due to bad press, or a prime minister may promise more jobs in a certain
sector in order to gain popularity, even though more jobs may be superfluous
...

Shareholder pressure - a private firm will have pressure from the shareholders to
perform well, and bad performance may result in a takeover
...

The government will make money from the sale - although it’s a one off, this can
be billions
...

Public interest - some industries act for the public good, like schools, and shouldn’t
be profit motivated
...

9

•

The government loses out on any dividends - some state run companies may be
very profitable
...
g
...


SHORT RUN AGGREGATE SUPPLY

In the short run, some things are assumed to be fixed
...
You can however, make the use of the factors you already
have, e
...
by making employees work more hours
...

The SRAS can shift for several reasons, including:
•
•
•
•

Wages – the higher the wage, the higher the cost of a unit of labour, which leads to
a smaller SRAS
...

Government action – there may be taxes, quotas or regulation which affects the
SRAS
...

Exchange rate – if the currency depreciates, then importing goods will be more
expensive
...


LONG RUN AGGREAGTE SUPPLY

In the long run, all factors are said to be changeable
...
The Keynesian view is that the curve tails off
...
Neo-Classical economist believe that demand side policy will be purely
inflationary in the long run, and that to get out of a recession, supply side policy is
needed
...

Classical economist believe that an increase in unemployment will lead to a cut in real
wages
...
Keynesians disagree, arguing that wages are sticky downwards, i
...
workers
will refuse to take wage cuts, and strongly resist it
...

Classical economist make the assumptions of flexible product markets and flexible factor
markets
...


An increase in the AD curve leads to an increase in real GDP
...

As the economy gets closer and closer to its full capacity, there are more inflationary
pressures
...
Due to a lack of unemployment,
workers can demand higher wages
...

Recently, the Bank of England has tolerated inflation above the 2% target, because they
worry if inflation falls then unemployment may become a problem
...
e
...
They argue that if there’s been an increase
in demand (due to higher employment) then workers will demand higher nominal wages
...
But, in the long run, however, workers
will realise that real wages haven’t changed, so they stop working those extra hours, and
unemployment goes back to the level it was at before
...
The NAIRU is the non
accelerating inflation rate of unemployment, i
...
the level of unemployment in which
inflation will be stable
...
This will lead to a shift in the
equilibrium on the Phillips curve from A to B
...
This shifts the Phillips curve
outwards, returning unemployment to the NRU (natural rate of unemployment) but with a
higher rate of inflation
...


ECONOMIC GROWTH

Economic growth means a long term increase in the productive capability of an economy,
and not a short term change in the level of income
...
Potential growth is how much
the economy could grow if all resources were used to maximum capacity
...

12

The economy tends to move in ‘the business cycle’
...

Peak - expansion slows and peaks
...

Trough - recession slows and peaks
...


The definition of a recession is two consecutive quarters of negative economic growth
...

Increase in factor market flexibility
...


The benefits of economic growth are:
•
•
•
•
•

Higher real average incomes
...

Higher tax revenue
...

More R and D
...
If the increase in wealth is
spread evenly across the population, then it will be of large benefit and poverty will fall
...


UNEMPLOYMENT

Unemployment is the percentage of people that can work and are actively looking for
work, but aren’t working
...
This
isn’t 100% accurate however as some wait before claiming, or are on the list
...

The International Labour Organization (ILO) survey - the EU’s ILO does a survey of
about 80,000, and estimates unemployment rates form that
...

The costs of unemployment are:

13

•
•
•
•
•

Lost potential output for the economy
Waste of resources - unused capital, plus anything spent on education/training is
wasted if the individual doesn’t work
...

Loss of human capital - after long periods of unemployment skills can be lost
...


Unemployment can be caused by:
•
•
•
•
•

•
•
•

Cyclical unemployment - as the economy goes through the business cycle, the
economy grows and shrinks, leading to jobs being created and lost
...

Frictional unemployment - workers may be looking for jobs after leaving
school/university, re-joining the workforce form retirement, losing your job, etc
...

Occupational inflexibility - the worker may have a very specific set of skills and if
they cannot find work in their industry will become unemployed due to a lack of
other skills
...

Technology - some unskilled labour is being replaced by machines, and new jobs
are being made in building and processing these machines
...


Unemployment can be prevented by:
•
•
•
•
•
•
•
•

An increase in GDP created by demand side policy - this will lead to more jobs
...

Removing regulation in the labour market
...

Subsidise investment in areas with job shortages
...

Reduce the amount paid in benefits, or introduce stricter standards - this should
increase the incentive to work
...


14

INFLATION

Inflation is calculated using the consumer price index
...
Inflation is calculated from this
...
g
...
Seasonal differences should also be taken into account, e
...
prices are always
higher before Christmas
...
The retail price index excludes house prices
...
If demand increases without an
increase in supply, then prices will increase
...

Inflation can also be caused by cost push inflation
...

The wage price spiral effect states that as wages rise so do prices
...

The quantity theory of money states that the velocity of money (V - how many times it’s
spent in a given time) times the stock of money (M - how much money is in circulation) is
equal to the quantity of money (Q)
...

𝑄 = 𝑀𝑉 = 𝑃𝑇
If you set T as equal to the number of final transactions, then q will be equal to the GDP
...

The costs of inflation are:
•
•
•
•
•
•
•
•

Loss of international competitiveness - this will reduce exports, and so cause a
trade deficit
...

Uncertainty - high inflation makes people unsure of what the future may hold,
which discourages investment
...

Menu costs - if prices change often then there’s a cost in repricing items
...
This reduces
spending
...
Pensioners are often
affected, and some fixed rate loans and mortgages
...

Fall in real incomes - pay raises often lag behind high inflation, making peoples
real incomes lower
...

Fiscal policy - reducing government spending will lower AD
...


Deflation is negative inflation
...
Deflation can be good or bad, depending on its cause
...
It also increases the value of any
outstanding debt
...
This leads to a fall in consumption and
confidence, which leads to lower wages and lower prices
...
If prices are falling due to a shift
in supply, then it means that efficiency is increasing, and the economy can grow at the
same time as prices fall
...

The terms of trade is the average export price over the average import price
...
This will give the banks that hold these bonds more money, which
should encourage them to lend
...
The aim is to increasing lending, and so increase the AD from both
investment and consumption
...

When the economy is strong enough, the bank will resell all of the bonds, undoing the QE
...
The industry is a
large net exporter, creates a lot of jobs, and pays a lot of tax
...
A large financial sector can also mean the best
and brightest choose to work there instead of science and technology
...
This may be because demand was predicted to go up, so people want to get
in early, and turn a good profit
...

Banks and financial institutions are regulated in the following ways:
•
•

Any abuse of monopoly power is punished
...

16

•
•

It’s ensured that consumer data is kept safe
...


INTERNATIONAL TRADE

Free trade can be beneficial to all parties involved, because it can lead to lower prices for
everyone, even if one country has an absolute advantage over the other
...
e
...

Free trade can still be beneficial if the opportunity cost of producing items is different
...

Say Germany could produce 1 car at the cost of 2 tonnes of trainers, and Vietnam could
produce 1 car at the cost of 5 tonnes of trainers
...
They could then trade cars for, say, 3 tonnes of trainer per car
...
Vietnam would get 1 car for 3 tonnes if trainers, instead of a car for 5
tonnes, which is what it would have cost otherwise
...

The possible advantages are:
•

•
•
•

Protecting infant and senile industries - companies that aren’t competitive on the
international stage now might be in the future if given a chance to grow or
recover
...

Safeguard jobs
...


Possible disadvantages are:
•
•
•
•

Retaliation - other countries may impose their own tariffs
...
g
...

Promote inefficiency
...


Types of protectionism are:
•
•
•

Tariffs - a tax on imports
Quotas - a limit to the number of imports
Exchange rate manipulation - making exports more competitive by devaluing
the currency
...

Subsidies - a government can subsidise producers in an economy to make them
more competitive in international markets
...

More investment
Hard for developing countries to compete

The UK’s main exports are:
•
•
•

Finance
Aerospace
Pharmaceuticals

THE EU

The disadvantages of the EU are:
•
•
•
•
•
•

Cost - the UK pays more than it gets back
...
g
...

Problems with the Euro
...

Net migration
...


The advantages are:
•
•
•
•
•
•
•
•

European harmony - no wars
...

Modernisation of prospective members, e
...
turkey
...

Free movement of people
...

Tax from migrants
...


18

The benefits of the Euro are:
•
•
•
•
•

Lower transaction costs
...

Incentives to keep inflation low
...

More tourism and trade within the eurozone
...

No scope for devaluation of currency
...
g
...

Limits fiscal policy - countries can’t have too much debt
...
It would need:
•
•
•

High amounts of trade between regions
...

Member nations are willing to make fiscal transfers to each other for the sake of
stability
...
The GNP is the same, but includes all foreign sources, and nationals living
abroad
...
It can measure the
material wealth of the people, but can’t measure things like longevity, education, or
quality of life
...

When converting GDP into a common currency through traditional means, the domestic
prices aren’t taken into account
...
Similar to how inflation is measured, a basket of goods is found and weighted,
and this is used to calculate conversion rates
...
It uses a weighted measure consisting of:
•
•
•

Income - GDP per capita
...

Health - the average life expectancy of a new-born in the country
...

Another indicator of development is the structure of the economy
...
A
more developed economy will be mainly focused on more complex products, like R and D,
tourism, etc
...

Gender equality
...

Access to the internet/phones
...

Low life expectancy - workers are in the workforce for shorter, and so productivity
is lost
...

Poor infrastructure - this makes it difficult to commute and transport goods,
decreasing efficiency
...

Poor technology and capital - productivity could be higher with better tech and/or
facilities
...

Poor governance - government failure can reduce welfare
...

High public sector debt - this will lead to the government spending on debt
payments, and the country will lose credibility as a borrower
...


Possible solutions are:
•
•
•

Liberalisation - moving more toward a free market system
...

Debt relief
...


21



---