Economics microeconomics the UK economy and the international economy

Introduction: Student Induction Pack 5Unit 1: Microeconomics Topic 5: Types of market for Higher only 79 Unit 2: The UK Economy Topic 3: The role of government in the economy 122 Topic 4

Microeconomics,

The UK Economy and

The International Economy

[INTERMEDIATE 2;

HIGHER]

Martin Duguid

Learning and Teaching Scotland gratefully acknowledge this contribution to the National Qualifications support programme for Economics.

First published 2005

© Learning and Teaching Scotland 2005

NQ support materials, whether published by LT Scotland

or others, are reminded that it is their responsibility tocheck that the support materials correspond to therequirements of the current arrangements

Introduction: Student Induction Pack 5

Unit 1: Microeconomics

Topic 5: Types of market (for Higher only) 79

Unit 2: The UK Economy

Topic 3: The role of government in the economy 122

Topic 4: Government economic policies (for Higher only) 143

Unit 3: The International Economy

Topic 1: International trade and payments 179Topic 2: The international economic environment 206

The aim of this pack is to provide information which will help you

during your Economics course at Intermediate 2 or Higher level

Rationale

All societies, organisations and individuals face the economic problem ofallocating scarce resources among competing uses Economics is thesocial science which provides the knowledge and skills required to makedecisions about the production and consumption of goods and services.This course is concerned with the ways in which such decisions aremade and the implications which these decisions have for individuals,organisations and society The course will help you to build up

knowledge of economic principles You will develop skills in

interpreting and analysing economic information as well as evaluatingthe costs and benefits of decisions

This economics course looks at both the world of business and theeconomic environment in which business is set It will benefit anyonethinking of a career in central or local government, commerce, finance

or industry

Course aims

The course aims to develop:

• a knowledge and understanding of the basic economic problem ofallocating scarce resources among alternative uses

• an understanding of the economic roles and responsibilities of theindividual as a consumer, employee, producer and citizen

• an understanding of the economic roles and responsibilities of firmsand governments in the use of resources

• an understanding of the environmental and social costs involved ineconomic decisions

• an understanding of the economic relationships between countries

• an ability to explain and analyse economic problems and to suggestpossible solutions

• an ability to communicate economic ideas in a logical and effectivemanner

Course details

The course is made up of three units:

• Microeconomics

• The UK Economy

• The International Economy

Each unit is divided into topics It will help you to organise your notes ifyou have a ring binder for each unit with a separate section for eachtopic The topics are:

2 Inflation and Unemployment

3 The Role of Government in the Economy

4 Government Economic Policies

Unit 3: The International Economy

1 International Trade and Payments

2 The International Economic Environment

Methods of teaching and learning

Different methods of teaching and learning will be used during yourcourse but emphasis will be placed on examining, explaining and

analysing current economic events and issues in the UK, European andworld economies You will be using articles from newspapers, magazinesand journals and programmes recorded from TV or radio The Internet

it useful to scan radio/TV listings to look for and record relevant

programmes Reading a newspaper and compiling a file of articles willalso be of great benefit to you

Homework

Your teacher will give you homework This may consist of written

exercises, completing work started in class or researching information.Study is also important and you should spend time as soon as possibleafter each lesson reading and learning your notes and textbook It isimportant that you identify any problems of understanding as soon aspossible and ask your teacher for help Do not let problems drift – theywill not go away by themselves Keeping up with events (as outlined

above in Methods of Teaching and Learning) should also be considered

as part of your homework It follows that planning, setting deadlines andsticking to them is vital for homework and study This will contributegreatly to your success

Because part of your assessment is continuous, it is important that yourattendance is good Poor attendance, together with a failure to coverany work which has been missed, will inevitably result in lack of success

Assessment

You will be assessed on your performance in two main ways – internalassessment and external assessment

Internal assessment

There are three internal assessments, one for each unit Each

assessment will be one hour long

External assessment

At the end of the course you will sit an examination This assessment will

be set and marked by the Scottish Qualifications Authority If you passyou will awarded a grade A–C

You must pass all the internal assessments and the final examination topass the course

Intermediate 2

The examination will be a written paper and you will be allowed 1 hour

45 minutes

Part 2 One question from a choice of five

Each question will be normally divided upinto three sections You will have to write

Higher

The examination will be a written paper and you will be allowed 2 hours

30 minutes

Section B Two questions from a choice of six

Each question will require you to write

Prelim examination

You will also be given an examination in the spring which will be of the

same type as your final examination The prelim exam is to give you

Learning outcomes

The following pages provide you with a checklist for revision purposes.You should tick each learning outcome when you have revised it inpreparation for (1) an internal assessment, (2) your prelim exam, (3)your final exam You will also find it useful to compare your

performance in internal assessments and in your prelim exam with theselearning outcomes

Unit 1: Microeconomics

Topic 1 – The Basic Economic Problem

For Intermediate 2 and Higher, you should be able to:

explain the basic economic problem

explain the meaning of scarcity

explain with examples the meaning of opportunity cost as

it is faced by individuals, firms and governments

describe the choices (what, how, for whom) faced by

different economic systems

describe three different types of economic system (see also

Topic 3 in Unit 2: The Role of Government in the Economy)

classify resources/factors of production and describe their

characteristics

explain the meaning of economic efficiency and why

countries seek to achieve it

explain the meaning of substitution of resources

explain the meaning of geographical and occupational

mobility of resources

describe measures to increase the substitution and mobility

of resources

and in addition for Higher, you should be able to:

explain how substitution of resources and mobility of

resources may contribute to improved economic efficiency

explain the term potential output

draw production possibility curves

calculate opportunity costs from production possibility

Unit 1: Microeconomics

Topic 2 – Demand

For Intermediate 2 and Higher, you should be able to:

define the term effective demand

distinguish between individual and market demand

distinguish between total and marginal utility

draw a demand curve and explain its shape in terms of

marginal utility

define the law of demand in words and in graph form

describe factors which influence demand and explain the

effects of changes in these factors on demand

distinguish between movements along and shifts of

demand curves

outline the economic objectives of consumers in terms of

marginal utility

and in addition for Higher, you should be able to:

describe price elasticity of demand in words and in graph

form

calculate price elasticity of demand

describe the effects of price changes on revenue for

different price elasticities

explain the factors which may influence price elasticity of

demand

describe and calculate income elasticity of demand

explain the significance of positive and negative income

elasticity

outline the significance of price and income elasticities of

demand for firms and governments

Internal assessment Prelim exam Final exam

Unit 1: Microeconomics

Topic 3 – Supply

For Intermediate 2 and Higher, you should be able to:

define the law of supply and draw a supply curve

explain the factors which influence supply

describe the effects on supply of changes in these

influencing factors

distinguish between movements along and shifts of supply

curves

and in addition for Higher, you should be able to:

explain and calculate elasticity of supply

analyse the importance of time in influencing elasticity of

supply

Internal assessment Prelim exam Final exam

Unit 1: Microeconomics

Topic 3 – Supply – Cost, Revenue and Profit

For Intermediate 2 and Higher, you should be able to:

explain the meanings of specialisation and division of

labour by product and by process

describe the advantages and disadvantages of specialisation

to employees, employers and consumers

distinguish between the short and the long run period of

define fixed and variable costs of production

calculate total, average costs and marginal costs from a

given set of figures

draw fully labelled graphs of total, average and marginal

costs as they vary with output in the short run

explain the shape of the short run average cost curve in

terms of increasing and diminishing returns

define optimum output

explain the shape of the supply curve in terms of the

marginal cost curve

define economies of scale; internal and external

describe the different internal economies of scale

explain diseconomies of scale

describe the trends and motives towards globalisation

amongst multi-national enterprises

describe the process and motives for downsizing

Internal assessment Prelim exam Final exam

Unit 1: Microeconomics

Topic 3 – Supply – Cost, Revenue and Profit (contd.)

explain the relationship between long run output (returns

to scale) and average cost

draw a fully labelled graph showing the behaviour of

average cost in the long run

define optimum size

define and calculate total, average and marginal revenue

define and calculate profit

describe the role of profit for a firm

Internal Assessment Prelim Exam Final Exam

Unit 1: Microeconomics

Topic 4 – The Operation of Markets

For Intermediate 2 and Higher, you should be able to:

define what a market is, and give examples

describe and explain, both in diagrams and in words, how

equilibrium or market-clearing price is arrived at in a free

competitive market

describe and explain the effects on equilibrium price and

output of changes in demand and supply

define what is meant by market intervention and describe

the types of such intervention

explain why intervention in free markets may take place

and in addition for Higher, you should be able to:

explain the meaning of ceteris paribus.

show on a diagram the effects of intervention such as

maximum price, minimum price, tax, subsidy

analyse data, in textual, numerical or graphical form, of

given market situations

Internal assessment Prelim exam Final exam

Unit 1: Microeconomics

Topic 5 – Types of Market

This is for Higher level only, and you should be able to:

distinguish between a perfect and an imperfect market

describe and analyse the different types of competition in

markets, i.e competitive, oligopolistic, monopolistic and

monopsonistic in terms of the number and size of firms in

the market

describe how firms may differentiate their products

outline the possible barriers to entry to a market and the

effects of such barriers

explain and analyse how prices are determined in perfect

and imperfect markets

Internal assessment Prelim exam Final exam

Unit 2: The UK Economy

Topic 1 – National Income

For Intermediate 2 and Higher, you should be able to:

explain the term national income

describe the relationship between national output, income

and expenditure

describe what national income statistics are used for

identify the problems of measuring national income

describe the circular flow of income

explain the meaning of injections and withdrawals and

their effects on output, employment and income

and in addition for Higher, you should be able to:

distinguish between GDP, GNP and national income

explain the difference between nominal and real

measurement

describe the difficulties in using national income statistics

for making comparisons over time, or between countries

describe aggregate demand and its components

describe aggregate supply (including potential/full

employment supply)

explain how equilibrium national income is arrived at,

using an aggregate demand and supply diagram

explain reasons for change in equilibrium national

income

describe and explain, using the circular flow of income

diagram, how the multiplier process works

calculate the multiplier and its effect on national income

describe the phases of the business cycle

Internal assessment Prelim exam Final exam

Unit 2: The UK Economy

Topic 2 – Inflation and Unemployment

For Intermediate 2 and Higher, you should be able to:

define inflation

explain how the rate of inflation is measured in terms of

the Retail Price Index (headline rate) and the Consumer

Price Index (underlying rate)

list and describe the factors which can cause inflation

explain the difference between measuring prices and

incomes in money terms and in real terms

explain the effects of inflation on individuals, firms,

government and the economy

and in addition for Higher, you should be able to:

describe what is meant by money

explain the quantity theory of money and the role of

money in inflation

describe and explain the main trends in inflation in recent

years

For Intermediate 2 and Higher, you should be able to:

define unemployment in terms of unused resources

describe how unemployment may be measured using the

claimant count and labour force survey

list and explain the demand side causes of unemployment

list and explain the supply side causes of unemployment

explain the effects of unemployment on individuals, firms,

government and the economy

and in addition for Higher, you should be able to:

explain patterns and trends of unemployment from given

statistics

Internal assessment Prelim exam Final exam

Unit 2: The UK Economy

Topic 3 – The Role of Government in the Economy

For Intermediate 2 and Higher, you should be able to:

describe the characteristics of different economic systems,

namely free market, planned, mixed

describe the economic objectives of government

describe the main types of government expenditure in

terms of programme and type, i.e capital or current

explain the reasons for government expenditure on

non-marketable goods (public and merit) and transfer

payments

describe the changes in recent years in government

provision of goods and services

list the main sources and types of government income

explain direct, indirect, progressive and regressive taxes

describe the change in balance between direct and indirect

taxation in recent years

explain the Budget and its role

explain the effects of changes in the Budget on individuals

and the economy

state the meaning of economic growth

describe how economic growth is measured

describe the sources of economic growth

distinguish between private and external costs and

benefits

In addition for Higher, you should be able to:

distinguish between macroeconomic and microeconomic

objectives

list government macroeconomic objectives and identify the

possible conflicts between them

list government microeconomic objectives

Internal assessment Prelim exam Final exam

Unit 2: The UK Economy

Topic 4 – Government Economic Policies

This is for Higher only and, you should be able to:

explain fiscal policy and how it may be used to achieve a

government’s macroeconomic objectives

explain monetary policy and the role played by the Bank

of England in attempting to achieve a government’s

explain the reasons for market failure

describe and explain the policies which a government may

use to address failings of the market mechanism

Internal assessment Prelim exam Final exam

Unit 3: The International Economy

Topic 1 – International Trade and Payments

For Intermediate 2 and Higher, you should be able to:

describe and explain the gains from trade in terms of

absolute advantage and comparative advantage

describe the benefits of international trade to countries

and consumers

analyse patterns and trends in trade from given statistics

outline the main trends in recent years in the pattern and

direction of UK trade

describe the barriers to free trade

describe the purpose and structure of the current account

of the balance of payments

explain what is meant by an exchange rate and how it is

determined

explain the effects of changes in an exchange rate for visitors

and travellers and on prices of exports and imports

describe the progress towards and features of European

Monetary Union

In addition for Higher, you should be able to:

explain the reasons for governments imposing barriers to

free trade

explain the effects of trade barriers on consumers, firms

and the economy

describe the purpose and structure of the capital account

of the balance of payments

explain the factors which influence the capital account

explain the relationship between exchange rates and

interest rates, and capital movements

distinguish between fixed, floating and managed

exchange-rate systems

outline the advantages and disadvantages of fixed, floating

Internal assessment Prelim exam Final exam

Unit 3: The International Economy

Topic 2 – The International Economic Environment

For Intermediate 2 and Higher, you should be able to:

describe the main economic features of the European

Union

describe the main characteristics of developing countries

describe the main characteristics of newly industrialised

countries

In addition for Higher, you should be able to:

list and explain the advantages and disadvantages of

monetary union

explain the economic problems of developing countries

explain the role of developed countries in promoting

development

describe the work of the World Trade Organisation and its

recent achievements

explain the role of international trading and monetary

organisations in the world economy

Internal assessment Prelim exam Final exam

Topic 1: The Basic Economic Problem

1.1 The basic economic problem is scarcity In economics scarcitymeans that there are not enough resources to produce all thegoods and services which consumers want Scarcity arises becausehuman wants for goods and services are unlimited but the

resources required to produce them are limited

1.2 Scarce goods and free goods Scarce goods, also called economic

goods, are those which have a price, i.e something has to be

sacrificed to obtain them Free goods are those goods of which

there is enough to satisfy everyone’s wants, e.g fresh air, sea

water Free goods have no price All scarce goods have an

opportunity cost whereas free goods do not

1.3 Scarcity is not the same as shortage

• A shortage is when the demand for a product is greater than its

supply

• Scarcity is when wants for a product are greater than its supply.

Demand means what consumers want and can afford to buy

Therefore if there is enough of a product to meet the demand ofthose consumers who want and can afford to pay the prevailingprice there is no shortage However the product will remain scarcebecause of all those consumers who want the product but cannotafford to pay the price

2 Choice and opportunity cost

2.1 Because of the problem of scarcity it follows that choices have to

be made Consumers must choose what to buy out of their limitedincomes Producers must choose what to produce with their

limited resources Governments must choose what services toprovide out of their limited tax revenues

2.2 Every choice involves a sacrifice and this sacrifice is called

opportunity cost Opportunity cost is the sacrifice of the next best

alternative choice For a consumer the opportunity cost of

choosing a product is the next item on his/her scale of preference.For a producer the opportunity cost of producing a good is thenext most profitable product which could have been producedwith the resources used For a government the opportunity cost ofproviding a service is the next best service which it could haveprovided with the resources used

2.3 In economics we assume that people are rational, i.e when facedwith a choice they will always choose the alternative that will givethem the greatest satisfaction This involves weighing up all thealternatives and then choosing the one that has the lowest

opportunity cost

3 Resources: factors of production

3.1 Resources may be classified as natural, human or man-made Theyare sometimes called factors of production and are then classified

as land, labour, capital and enterprise

3.2 Land refers to all the gifts of nature and includes not only landitself, but also all the minerals in and on the land, the sea andeverything in the sea, the air, sunlight, etc

3.3 Labour refers to any human effort (manual or mental), which isdirected to the production of goods or services

3.4 Capital refers to those man-made resources which are used toproduce goods or services Capital may be categorised as

industrial, social, private or financial

• Industrial capital is used by firms, e.g factories, offices, plantand machinery, tools, vehicles

• Social capital belongs to the whole community, e.g schools,hospitals, roads

• Private capital belongs to individuals, e.g houses

• Financial capital is money waiting to be used to buy capital

goods When capital goods are bought this is called investment.

(Note the difference between saving and investment!)

caused by business uncertainties An entrepreneur is an organiser and a risk taker.

4 Mobility of resources

4.1 Modern industrial economies are dynamic This means that theyare in a continual state of change Changing consumer demandsand changing production methods mean that some industries will

be growing, e.g electronics, finance while others are declining,e.g coal, shipbuilding In such a world there is a need for

resources to be mobile – to be able to change their location ortheir use Resources which cannot change either their location ortheir use run the risk of becoming unemployed

4.2 Factor or resource mobility is the speed and ease with which a

resource can move from place to place (geographical mobility) or can change use (occupational mobility).

4.3 In practice there are obstacles to factor mobility and to ensure thatresources are used efficiently these obstacles need to reduced

4.4 Land tends to be geographically immobile Its mineral wealth andthe crops it produces are commonly transported from one area toanother but the great majority of land is used where it is For thisreason, attention is focused not so much on where it might beused as on how

4.5 People may become geographically and occupationally immobile.Many factors influence people’s mobility Willingness to moveelsewhere is determined largely by age and by family and culturalties Willingness and ability to do another type of job is closelylinked to age, education and training

4.6 Capital has varying degrees of mobility Some capital is highlyspecialised As a result it is difficult to adapt it to other uses Powerstations and swimming pools are examples, as also are screwdriversand staplers The geographical mobility of capital is determinedlargely by its size and weight Money capital is much more mobile

It can be moved about the world quickly and cheaply by electronicmeans

5 Economic efficiency

5.1 All countries have the problem of scarce resources and so shouldfind ways of making best use of them Best use of resources iscalled economic efficiency

5.2 Economic efficiency in the use of a country’s resources is achievedwhen the following three conditions are met:

(a) when technical efficiency is achieved, i.e when products

are produced at minimum unit cost, in other words when thefewest necessary resources are used to produce each

product

Example

In building a bridge, using the least amount of steel while ensuringthe bridge will not collapse Building a bridge strong enough totake 1000-ton lorries would be wasting steel, which could be usedfor making other products

(b) when allocative efficiency is achieved, i.e when resources

are allocated (used) to produce those goods and serviceswhich consumers most want

Example

One hundred bridges could be built over the River Don in

Aberdeen in a technically efficient way, but this would be a wastefuluse of resources if consumers don’t want 100 bridges The

resources could have been used to make products which

consumers want more

(c) when all resources are employed Idle resources will result

in lost output

Equity concerns social justice or fairness The aim of economicefficiency can conflict with the aim of equity, e.g a country with afree-market economy could be achieving economic efficiency bysatisfying many of the wants of a few rich people at the expense of

• What goods and services will be produced?

• How will these goods and services be produced? This means

who will do the production and which methods of productionwill be used

• To whom will the goods and services be distributed? This

means who will consume the goods and services after they beenproduced – how will it be decided who receives them

7.2 To address these questions a nation needs an economic system.There are three different economic systems: the command orplanned economy, the market economy, and the mixed economy.Each has different ways of allocating resources and of distributinggoods and services to consumers

8.1 All decisions about resource allocation are made by government.The government owns the resources and directs them into theproduction of the goods and services decided on This system isbased on the principle of equity This was the type of economicsystem which used to exist in the communist countries of EasternEurope

8.2 A command economy answers the three questions in the followingways:

• What to produce? – government planners estimate what their

population need They fix the quantity of each good to be

produced

• How to produce? – government sets quotas for each factory and

decides how many resources should be employed in producingthe goods

• For whom to produce? – prices and incomes are controlled so

that each citizen has an almost equal entitlement to what hasbeen produced

9 Free-market economy

9.1 The features of a market economy are:

• Resources are owned by private individuals

• Producers are free to produce what they wish

• Consumers have consumer sovereignty (literally meaning the

consumer is king) and rule the market, i.e the freedom ofconsumers to decide what to buy influences what producersproduce

• Decisions are made on the basis of self-interest Producers aim

to maximise profit Consumers aim to maximise value for money

• Competition exists between producers and between consumers

• Resources are allocated by the price mechanism Price acts as a

signal to producers Products which consumers demand will rise

in price thus encouraging producers to supply them Producerswill need more resources They will attract them by offeringhigher incomes to those who own them Falling demand forproducts will result in lower prices and lower rewards to owners

of resources so that they will then be encouraged to move theirresources to where the rewards are greater

9.2 A market economy answers the three questions as follows:

• What to produce is decided by consumers.

• How to produce is decided by producers using the most

efficient methods of production in order to keep down cost sothat they can compete and maximise profit

• To whom products is distributed is decided by the buying

power of those consumers who earn the highest incomes fromthe resources which they own

In this system there is a private sector and a public sector In theprivate sector the price mechanism allocates resources but thepublic sector, i.e government, intervenes when the private sectorfails to produce in an efficient way the goods and services whichconsumers want In practice, all economies are mixed – what varies

is the degree of mix Some are planned rather than free, e.g North

Higher only

11 Production Possibility Curves (PPC)

11.1 Production possibility curves can be drawn (in theory) for a

country or firm to show the possible combinations of goods thatcan be produced

goods This maximum output is called the country’s potential

output.

11.3 Points on the curve are possible if all existing resources are beingfully and efficiently employed, i.e if resources are being used in atechnically efficient way If the economy is producing at a pointinside the curve then it is producing less than it could This could

be because some resources are unemployed, or because someresources are being used inefficiently Points outside the curve arenot possible because the economy does not have the productivecapacity Given that any point on the curve represents a technicallyefficient use of resources, an economy still has to make the

decision about which combination of goods to produce

Remember that to use resources in an economically efficient way,the combination chosen must be that which satisfies most wants

Capital goods

Consumer goods

11.4 A production possibility curve can be used to show the

opportunity cost of producing a product, e.g the opportunity cost

of producing OD consumer goods is EB capital goods The

resources required to produce OD could have been used to

produce more capital goods, i.e EB

11.5 A production possibility curve (PPC) can also show the opportunitycost of a change in production, e.g the opportunity cost of

increasing the production of consumer goods from OD to OF is EGcapital goods

Capital goods

Consumer goods

Capital goods

Consumer goods

11.6 The usual PPC curves outwards from the origin because the

opportunity cost of producing one good usually increases as more

of it is produced This is because more resources are required toproduce each extra unit Notice that as more consumer goods areproduced the opportunity cost in terms of lost capital goodsincreases

11.7 If an economy’s productive capacity increases, the PPC will moveoutwards and more of both goods can be produced This is known

as economic growth This would result from an increase in thequantity of a country’s resources, e.g discovery of North Sea oil;

an advance in technology, e.g the invention of the microchip; or

an increase in the efficiency of resources, e.g training of workers

Capital goods

Consumer goods

Capital goods

Consumer goods

Topic 2: Demand

1.1 Consumers gain satisfaction from consuming goods and services

Economists call this satisfaction utility The utility gained from

consuming a product is difficult to measure accurately but threepossible ways of measuring it are by noting:

• how people react when they are consuming

• how much of the product people consume

• the price that people are willing to pay for it

Note that none of these measures is totally reliable, but the third isthe most commonly used

1.2 Total utility is the total satisfaction gained from consuming a

product in a period of time Marginal utility is the satisfactiongained from consuming an extra unit of a product Total utility,then, is the total of the marginal utilities gained from each unitconsumed

1.3 Diminishing marginal utility As a person consumes more of a

good or service in a certain period of time, the utility gained fromeach extra unit (the marginal utility (MU)) decreases Total utilitywill continue to increase, although at a decreasing rate, until amaximum is reached At this point there is no further satisfaction

to be gained from consuming more of the product Marginal utilitywill be zero

Example

Using the price the consumer is prepared to pay as a measure ofutility:

Pints of beer (per night) Marginal utility Total utility

This is the same as saying that:

• if price were £2.00 the consumer would be willing to buy 1 pintbecause he gets £2 worth of utility

• if price were £1.80 the consumer would be willing to buy 2 pintsbecause he gets £2 worth of utility from the first pint and £1.80’sworth from the second

• if price were £1.50 the consumer would be willing to buy 3 pints

• if price were £1.10 the consumer would be willing to buy 4pints

1.4 The information in 1.3 can be converted into a demand schedule:

per night (in pints)

1.5 The same information can be shown on a graph as a demand curve.

Note that the demand curve and the marginal utility curve youdrew in para 1.3 are the same curve

1.6 Consumer surplus is the difference between how much a

consumer would be prepared to pay and what is actually paid, e.g

if beer were £1.80 per pint, 2 pints would be bought The

consumer was prepared to pay £2 for the first pint so he gets 20p

of utility free i.e he gets a consumer surplus of 20p If the pricewere £1.50, he would gain consumer surplus of 80p (50p + 30p) ofutility free

1.7 Rational consumer behaviour Economists assume that

consumers act in a rational way i.e they spend their money in theway that gains them maximum utility or, in plain English, best valuefor money Of course, in practice, this does not always happen.Several factors may prevent this, e.g.:

• imperfect knowledge of the product or of rival products

• the actions of other people (both positive and negative)

• lack of self-control – the consumption of some addictive

products may be involuntary

Demand for beer

Assuming rational behaviour, a consumer will achieve maximumutility in the spending of their income when the marginal utility(MU) per p, spent on the last unit of each good is equal, i.e when:

MU of last unit of good A MU of last unit of B MU of last unit of C

sandwich Beer costs £1 per pint and sandwiches cost £1 each.How should she spend her £10 in order to gain maximum

satisfaction? See the following table

Beer Marginal Marginal Sandwiches Marginal Marginal(pints) utility utility per p utility utility per p

opportunity cost of 0.4 units of utility from the seventh pint ofbeer given up

2 Demand

2.1 Definition Demand (sometimes called effective demand) is the

quantity of a good or service which consumers are willing and able

to buy at a particular price in a certain period of time

2.2 Individual demand and market demand Individual demand

refers to the demand of an individual consumer for a product.Market demand is the sum of all individual consumers’ demand for

a product, i.e total demand

2.3 The Law of Demand states that the demand for a product varies

inversely with its price

2.4 As the price of a commodity goes up then there is a fall in thequantity which consumers are willing and able to buy This

happens for two main reasons:

• The income effect As the price of a good rises then a person’s

real income (i.e their buying power) falls They are not able to

buy the same quantity

• The substitution effect As the price rises then the marginal

utility per p of the last unit(s) consumed falls The rationalconsumer would switch to substitutes which would give a highermarginal utility per £ (better value for money) They are less

Price of A Price of B Price of C

If the price of apples were to rise then the MU per p gained fromthe last apple would fall The consumer would switch that

spending to bananas or chocolate until equality of MU per p wasrestored By consuming fewer apples the MU per p from the lastapple will rise and by consuming more bananas or chocolate the

MU per p from the last unit of these will fall

2.5 Exceptions to the Law of Demand

• Goods of prestige or ostentation, e.g the demand for certainbrands of jeans, training shoes or cars may rise as their pricerises

• Assumption of link between price and quality – consumers mayequate a rise in the price of a product as meaning that its qualityhas improved

• Expectation of future price rises, e.g speculators may react to arise in the price of shares by buying more, expecting them torise even further

• Giffen goods – Giffen, a nineteenth-century economist,

observed that during the Irish potato famine, the demand forpotatoes rose as their price rose This was because living

standards were so low that most people spent nearly all theirincome on potatoes, a filling food, so that when the price rosethey had so little money to buy meat, etc., that they boughtmore potatoes This effect can apply to any basic foodstuff inconditions of poverty

The demand curve in any of the above situations will slope

upwards but note that above a certain price it will resume its

normal shape, as the income effect will reduce people’s ability tobuy the product

3 Changes in conditions of demand

3.1 Ceteris paribus One difficulty in economics is predicting the

effect of a change in a variable because there may be a number ofdifferent causal factors The economist’s way round this is to

assume ceteris paribus ‘Ceteris paribus’ is a Latin phrase meaning

other things remaining the same Ceteris paribus is assumed so that

the effect of one changing variable can be predicted

Example

Price is only one of many factors which determines the demand for

a product – others include changes in income, prices of othergoods, population, etc With all these conditions affecting demand,one cannot predict a fall in demand as price rises unless theseother conditions remain the same Ceteris paribus is thereforeassumed in the Law of Demand, i.e the only changing influence isprice, and all other conditions which could cause demand to

change have not changed Of course, in real life things are not sosimple!

3.2 What are the conditions of demand? These are the factors, otherthan the price of the product, which may cause demand to change.They include:

• number of consumers (think of the effects of a change in total

population and of a change in age distribution)

• disposable income (think of the effect on normal goods and

on inferior goods)

• prices of other goods (think of complementary goods e.g.

central heating and gas, and of substitute goods, e.g gas and

electricity)

• tastes and preferences, e.g the influence of fashion and

advertising

3.3 Note the different ways of showing the effect of a change in price

on a demand curve and the effect of a change in a ceteris paribuscondition A change in price is shown by a movement along thedemand curve, whereas a change in a condition is shown by a shift

4.1 Price elasticity of demand (PED) This is a measure of the

responsiveness of demand to a change in price Price elasticitymeasures the reaction of consumers to a change in the price of aproduct It is measured by comparing the percentage change ofdemand to the percentage change in price, i.e

% change in demandPrice elasticity of demand =

• If PED is less than 1, then demand is price inelastic

• If PED is 0, then demand has not changed at all Demand isperfectly inelastic

• If PED is equal to infinity (meaning that demand changed

without a price change) then demand is perfectly elastic

• If PED =1, then demand has unitary elasticity This means thatthe % change in demand and the % change in price are thesame

Note that the value of PED will usually be negative because anincrease in price will cause a decrease in demand and vice versa.PED would only be positive in cases where demand does not

follow the normal law of demand This would be when demandincreases as price rises (see para 2.5)