Notesale: Turn your study into money

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COMPLETE THEME 1 NOTES
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Economists
develop models which attempt to simplify and improve our understanding of
how consumers and producers behave
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● Economics = the allocation of scarce resources to provide for unlimited
human wants
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This arises when there
are infinite human “wants” but finite resources
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This incurs an opportunity cost - the value of the next best
alternative foregone
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● Consumers are assumed to want to maximise utility, whilst firms are assumed
to want to maximise profits
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● Productivity = the output per unit input
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It does not carry a value judgement
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The economic problem
● The economic problem = this involves 3 parts: what to produce, how to
produce it and how to distribute it
...
g
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● Non-renewable resource = one whose stock level decreases over time as it
is consumed (e
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coal, oil and steel)
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● Opportunity cost = the value of the next best alternative foregone
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● Consumer goods = directly provide utility to consumers (e
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food, clothes
and holidays)
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PPF and opportunity cost
● If a point lies within the PPF, this is an inefficient combination because not
all resources are being fully utilized
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● If a point lies anywhere on the PPF then it is an efficient combination
because no resources are being wasted
...
g
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This shows productive efficiency
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● If a point is located above the PPF then that combination is not yet attainable
(but it could be if economic growth occurred)
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● If a PPF is curved then the opportunity cost will vary
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Shifts in the PPF
● If the PPF shifts outwards then this shows economic growth
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● PPFs occasionally shift inwards, indicating a decrease in the potential output
of an economy (e
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after a natural disaster)
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g
...
g
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Movement along the PPF
● There is no need for a change in the quantity or quality of the factors of
production for a movement along the PPF to occur
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● However there will still be an opportunity cost involved
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● This is because some resources are better suited for the production of some
things than others (e
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many economic resources are not easily adaptable or
transferable)
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However, if all resources are equally suited to all forms of production,
then the PPF would be a straight line,
Specialisation and the division of labour
● Specialisation = The process by which individuals, firms and economies
concentrate on producing those goods and services in which they have an
advantage (a limited range)
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g Adam Smith’s pin factory)
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Specialisation advantages

● Leads to economies of scale - lowers the long run average cost for the firm
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● Rising standards of living
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● Countries may become over reliant on the production of one product, so if
there is a shortage/depletion of resources then their economies will suffer
(e
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Zambia and fluctuating global copper prices)
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Overall, this should aid economic growth and living standards
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● Higher productivity achieved by…
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➔ Workers should become more skilled (faster) over time
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➔ Capital machinery can be used continuously in production
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Division of labour disadvantages
● Monotony of work - consequences include: workers becoming less
productive, increased staff turnover and therefore greater costs for
recruitment
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This could leave them structurally
unemployed
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So if one group of workers
go on strike, or one part breaks down then the whole production process will
be halted
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Functions and characteristics of money
● Money is anything that is generally acceptable in the payment of a good or
service, or a debt
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● Money has to act as
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This makes buying and
spontaneously, by the operation of market forces, would be far superior to any
state planning system
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● So he thought that the price mechanism was consumers’ and producers’
method of communication
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2 How markets work
● Rational decision making = where consumers allocate their expenditure on
goods and services that will maximise utility, whilst producers allocate their
resources to maximise profit
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● Consumer weakness at computation describes how consumers do not think
fully about the consequences of their actions and how probable these
consequences are
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Demand
● Demand = the amount of a good or service that consumers are willing and
able to buy at a given price in a given time period (effective demand)
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● Utility = the amount of satisfaction gained from consuming a good or service
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● A fall in price causes an
expansion in demand,
whilst a rise in price
causes a contraction in
demand
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● Diminishing marginal
utility = as one

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●
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●

●
●
●
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consumes more of a good, the utility gained from each extra unit will tend to
fall
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So whilst total utility actually increases, this occurs at a diminishing rate
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Equilibrium = when demand equals supply
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Income effect = when prices rise but real incomes stay the same so demand
decreases
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Substitution effect = spending money on a cheaper product
...
g
...
g
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Elasticities of demand
Price elasticity of demand
● PED = a measure of how responsive demand is to a change in price
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● Inelastic = if a similar price change leads to a much smaller change in
demand
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● Any PED number over 1 = elastic
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● PED of 0 = perfectly inelastic (demand does not change at all if price
changes)
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● If the answer is equal to 1 (or -1) then a change in price will lead to the same
percentage change in demand - it is unit elastic
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Tips
➔ Make sure you say “price elastic” not just “elastic”
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price graph (e
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for demand and supply), write
the 2 goods referenced in the question on the axis
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Income elasticity of demand
● YED = a measure of how responsive demand is as a result of a change in
income
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● If goods have a positive YED, then they are normal (income rises, so demand
increases)
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Cross elasticity of demand
● XED = when the quantity demanded of good X changes as a result of a
change in the price of good Y
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● An XED of 0 suggests that the goods have no relationship (e
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car tyres and
strawberries) - these are called independent goods
...
g
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● A negative XED = the goods
are complements (e
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oranges and juicers)
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● Law of supply = as price
increases, quantity supplied

increases (and vice versa - direct relationship)
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When
firms do increase their supply due to this, their costs may rise so a higher
price is needed to justify the extra output and cover these extra costs of
production
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● Factors that cause a shift in the
supply curve (PINTSWC) =
Productivity, Indirect taxes,
Number of firms, Technology,
Subsidies, Weather and Costs of
production
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● A decrease in supply OR
demand = always a shift to the left
...
g
...

● Competitive supply = when an increase in the price of good x, leads to a
contraction in the supply of good y (because producers reallocate their
production to good x)
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● PES = % change in quantity supplied / % change
in price
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g
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● In the short term, PES is relatively inelastic
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● Things which can influence PES (PSSST) = Production lag, Spare capacity,
Stocks, Substitutability of factors of production and Time
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● Excess supply = where the quantity supplied exceeds the quantity
demanded for a good at the current market price
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Price mechanism
● The Price Mechanism = where the free markets allocate resources through
the interaction of supply and demand
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● Signalling device = indicates changes in demand or supply
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● Signalling also occurs with the supply curve
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● Incentive device = when demand is high, suppliers have the incentive to
produce more
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● Rationing device = rations demand: when demand increases there will be a
shortage of a good or service so only those who are willing and able to pay
the higher price can afford them
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Consumer and producer surplus
● Consumer surplus = the
difference between what
consumers are willing and able
to pay for a good and the price
that they actually pay
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● Producer surplus + consumer
surplus = society’s surplus
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● Direct taxes = paid directly to the government by the taxpayer (e
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income
tax)
...
g
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● Ad valorem tax = a tax which is taken as a percentage of the value of a
product, like VAT = 20%
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5p
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● Subsidy = a grant provided by the government to encourage the production
and consumption of a particular good or service
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Consumers end up paying the socially
efficient price which includes the external benefit
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In the long term, subsidies for a good will
help change preferences
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➔ Reduction in external costs - external benefits are internalised
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g
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Subsidies - disadvantages
➔ The cost will have to be met through taxation
...
g
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Though the most efficient way to raise

➔

➔
➔
➔

revenue for subsidising positive externalities would be to tax goods with
negative externalities, e
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tax cars driving in city centres (congestion charge)
and use the money to pay for public transport
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Therefore the
government may have poor information about the service and how much to
subsidise
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Opportunity costs for the government
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The effect depends on the elasticity of demand
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● Consumer weakness at computation describes how consumers do not think
fully about the consequences of their actions and how probable these
consequences are
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However, people do not
always behave rationally and this occurs for three main reasons:
1
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For example, someone may buy something to
‘fit-in’ or because everyone else has it, and so they are expected to too
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‘Herding behaviour’ occurs when
an individual copies the actions of a large group
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2
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Habits create a barrier to
decision making since they limit or prevent consumers considering an
alternative
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Another habit many consumers have is
buying their products at eye level so supermarkets tend to keep higher priced
products near the top and lower priced products lower
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Consumer weakness at computation: Many consumers aren’t willing or
able to make comparisons between prices and so they will buy more
expensive goods than needed, for example many customers buy multipack
goods because they assume they are cheaper but this is not always the case
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Similarly, consumers will make decisions without looking
at the long term effects, and so make irrational decisions
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1
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● Externalities, the under-provision of public goods and information gaps are all
types of market failure
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g
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● Partial market failure occurs when the private sector may provide the good or
service, but at the wrong price or quantity (e
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private healthcare vs NHS)
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● External costs = negative third party effects outside of a transaction (e
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passive smoking)
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● External costs = negative externalities
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● Social costs = external costs + private costs
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g
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● Private benefits = benefits that are internal to a transaction, so affect me or
the firm (taken into account by the price mechanism) - utility from consuming
a good or service OR revenue
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● By ignoring the external costs of production and consumption, this can lead
to: overproduction, underpricing, welfare loss and environmental issues
...
g
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● Market equilibrium = where marginal private benefit equals marginal private
cost
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Solutions to market failure = education, taxes, legislation or making it free
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● Marginal private cost (MPC) is drawn as a “supply curve” (but don’t say that
in the exam)
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This graph (above) shows the difference between MSC and MPC
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It shows that from Q 1 to Q2 there is an
overconsumption of cars
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The vertical line AB represents the value of the external cost
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The blue
triangle forms the welfare gain to society
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This
can only be corrected by government
intervention
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We only need to know the
positive externalities of
consumption graph
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Examples
External costs

External benefits

Production

Plastic bottles getting
dumped out at sea,
burning coal adds to
global warming and
increased production of
chairs leads to more
deforestation and habitat
destruction
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Consumption

Excess alcohol intake can
lead to more crime and
violence, if Heathrow
airport expands then
there will be more traffic
on the roads surrounding
it and smoking tobacco
near children can harm
their development
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Public goods
● Pure public goods = goods that have non-rivalry and non-excludability in
their consumption
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➔ As more people consume a good, it does not reduce the amount
available for others (non-rivalry)
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● There are also quasi public goods which have some of the traits of pure
public goods, but not all - e
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they might have non-excludability but have
rivalry, like police protection or healthcare
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The free-rider problem
● In a free-market economy, public goods are underprovided because once a
public good has been provided for 1 individual, you cannot exclude others
from reaping the benefits of it
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● Firms are reluctant to supply public goods, as they are difficult to gain profits
from
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● Therefore people will get the benefits of a good or service without incurring a
cost from it
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● Missing market = associated with the difficulties the free market has in
providing pure public goods, meaning that they are simply not provided
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● Non-excludability = when benefits derived from pure public goods cannot be
confined to those who have paid for it, giving rise to the free rider problem
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● Imperfect information can lead to an overconsumption of demerit goods and
an underconsumption of merit goods (because people are not aware of their
costs/benefits)
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● Asymmetric information = where consumers and producers have unequal
access to information about a good or service in the market (e
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“lemon
markets” emerge, such as in the market for used cars where producers have
more knowledge about their condition than consumers)
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1
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g
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➔ If there is an underconsumption of merit goods
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➔ To meet people’s basic needs (especially if they’re on low incomes)
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● Direct taxes are paid directly to the government by the taxpayer (e
...
income
tax) whilst indirect taxes are taxes levied on the expendi

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