AS Economics Revision Notes

Micro

Positive and Normative Statements

• Positive economics deals with scientific or objective explanations and

statements about the economy.
• For example it is possible for me to state that in the case of normal goods an
increase in the price will lead to a decrease in the quantity demanded.
• Normative economics attempt to describe the economy through value
judgements.
• For example "the rich should be taxed at a far higher rate than the poor"
contains value judgement about the role of the government, therefore it is a
normative statement.

Factors of Production

• Capital - This refers to all of the tools, buildings, machines etc used in the
production of goods and the money that firm have and use.
• Enterprise - This is carried out by entrepreneurs who think of ideas, take
risks with their own money and the financial capital of others, and organise
the other 3 factors of production.
• Land - Not only the land, but all of the natural resources as well, e.g., gold,
oil, fish, wheat. There are two types of land: renewable and non renewable
resources.
• Labour - This is the workforce of the economy. All workers possess different
qualities.

Scarcity

• There are only a limited amount of resources on the earth e.g. coal, oil, gold.
• Economists describe these resources as being scarce and label them
‘economic goods’.
• Non-scarce resources are called ‘free goods’.
• Humans have a minimum level of needs which are necessary for survival,
food, shelter, heat and clothing.
• Despite this people would rather enjoy a higher standard of living, this is
because we all have an unlimited number of wants.
• The fact that resources are scarce and our wants are infinite gives rise to the
basic economic problem.
• How do we decide to allocate the limited resources?
• Economic agents (individuals, firms, governments etc.) have to make choices
regarding what to do with their limited resources.

Opportunity Cost

• Due to the existence of the economic problem economic agents are forced to
make choices regarding how resources are to be allocated.
• You have £40, do you spend it on a t-shirt or a night out?
• Does the government spend £100 million on healthcare or weapons?
• A rational economic agent will choose whatever gives them the greatest
amount of satisfaction (economists call this utility).
• The utility you lose from not being able to have your next best alternative
(the second choice) is called the opportunity cost.
• If you spend £40 on a night out the opportunity cost will be the t-shirt.
• If the government spends £100 million on weapons the opportunity cost will
be healthcare.
• If a school decides to spend £1,000 on a new computer the opportunity cost
will be 20 tables.

The PPF

• The PPF illustrates the concepts of choice and opportunity cost.

• If we assume that a country only produces food and clothing.
• If that country wishes to produce more food, then it would have to
sacrifice the production of some food.
• Therefore we can say the opportunity cost of producing more food is
clothing.
• If the economy is producing at point inside its PPF is can be seen that it is
not producing efficiently, as it could increase production of clothing and food
with the resources it already has.
• We can also demonstrate the concept of increasing opportunity costs.
• In other words that as a country produces more and more of one good it
has to sacrifice increasing amounts of the other.
• This occurs because different factors of production have different
properties, people have different skills, land differs in different parts of the
country etc..
• Therefore as a nation concentrates more on the production of one good, it
has to start using resources that are less and less suitable.
• The production of more and more clothing involves a growing marginal
cost - ever-increasing amounts of food have to be sacrificed for each
additional unit of clothing produced.
• It is because of increasing opportunity costs that the PPF is bowed
outwards, rather than being a straight line.
• Also there is the example of a nation going to war and having to produce
guns after only producing food.
• Shifts of the PPF
• As you know, a nation is unable to produce outside of the PPF. A nation is
able to shift its PPF to the right (so that it can produce a greater amount of
goods) in one of two ways:
o Increasing the number of resources available for production, e.g.,
increase in the number of workers or factories.
o Increasing the quality of resources available for production, e.g.,
education and training makes workers more productive,
technological progress allows machines to produce more with the
 same amount of resources.

Specialisation

• Specialisation is occurs when an economic agent chooses to concentrate on

producing a particular good or service and then trade with others in order to
survive.
• Specialisation by individuals is called the division of Labour. Adam Smith
described the effects of the division of labour on pin workers in 1776.
• He stated that one worker might be able to make 20 pins a day, but if division
of labour occurred and 10 workers each specialised in a different task he
estimated they could make 48,000 pins.
• This increase in labour productivity occurs for a number of reasons:
o Specialisation allows workers to gain skills in a narrow range of
tasks. This means workers are far more productive then if they
were a jack-of-all-trades.
o It makes it cost effective to provide workers with specialist tools,
e.g., it wouldn't make sense to give every farm worker a tractor, but
it's possible to provide a group of workers a tractor they can share.
o Time is saved as workers don't constantly have to change tasks, e.g.
moving from one workstation to another.
o Workers are able to specialise in tasks they are best suited to.
• The division of labour does have limitations.
• Jobs that are very narrow can become tedious and boring.
• Workers will do everything possible to avoid work, e.g. calling in sick, long
break, frequent visits to the toilet.
• This will result in a drop in productivity as output per worker falls.
• The size of the market might limit the degree of specialisation.
• A chemist or post office might open in a small village, but finds that he has to
sell other products in order to survive.
• Too much specialisation has disadvantages.
• African countries are often dependant on only one crop. If the price falls or
crop fails, it can be a disaster for the economy and workforce.
• The north of England has suffered greatly due its dependence on heavy
manufacturing. Shipyard, steel and textile workers paid a heavy price for
specialisation when demand for their skills fell.

Short Run and Long Run

• In the shortrun producers are faced with a problem if they wish to

increase their output.
• They can increase the number of hours their employees work and buy
more raw materials, in other words labour and land (raw materials) are
variable in the shortrun.
• The amount of factory space and machinery (capital) are fixed as they
can't simply be added.
• In the shortrun land and labour are variable and capital is fixed.
 • In the longrun all economic resources are variable as land, labour and
capital can all be changed.
• The only variable that is fixed is the level of technology, but this can be
introduced in the very long run, e.g., new IT or production techniques are
introduced.
• There is no standard measure for these time periods as they vary greatly
from industry to industry, e.g., a market trader can increase its capital (the
market stall) a lot quicker than ICI (a new chemical plant).

Demand

• Our wants become a demand when we have the money to back up our
desires. We call this effective demand, i.e., how much consumers will be
prepared to buy at a particular price.
• Assuming ceteris paribus, as price increases demand will fall and as prices
decreases demand will rise. This leads to a downward sloping demand
curve.
• A change in price will lead to a movement along the demand curve. An
increase in price will lead to demand contracting and a decrease in price will
cause demand to expand.
• A number of factors will cause the demand curve to shift, either to the
right (increase in demand) or left (decrease in demand):
o Income - when income rises demand for a normal good will also rise.
o The price of other goods - if the price of a substitute good falls then
demand will fall (e.g., Coca-Cola and Pepsi). If the price of a
complement good falls then demand will rise (e.g., computers and
computer games).
o Population - an increase in population is likely to lead to an increase
in demand.
o Changes in fashion - as goods go out of fashion demand for them
will fall.
o Changes in legislation - e.g., demand for gun in the UK decreased
after it became illegal to own one.
o Advertising - this aims to influence consumer choice.
o The time of the year - e.g., demand for holidays in Spain will be
lower in the winter and demand for gas will be higher during the
winter.

Supply

• If the price of a good increases, ceteris paribus then firms are likely to be
more willing to supply larger amounts.
• This leads to an upwards-sloping supply curve.
• A change in price will lead to a movement along the supply curve, whilst a
change in any other factor will lead to a shift in the supply curve.
• We are able to identify two main reasons for the supply curve being
upwards sloping:
• Incentives for increasing production - if the price of particular good rises
 then producers will find it more financially rewarding to devote resources to
that good and away from others.
• Theory of increasing costs - due to the increasing opportunity costs of
production as less and less well-suited resources are switched to it, a higher
price must be available in the market place to make it economically viable to
use these resources.

Equilibrium

• There is only one price where planned demand equals planned supply,
this is known as the equilibrium price.
• This price is also known as the market clearing price, because all of the
goods supplied to the market are bought (or cleared), but no buyer is left
frustrated by his wish to buy.
• We can state that equilibrium occurs when demand equals supply. This
can be shown on the graph where the demand curve crosses the supply
curve
• Say the price is above the equilibrium price.
• At this price firms are willing to supply more than consumers demand,
giving rise to excess supply.
• When a shop holds a sale it implies there has been excess supply in the
past, firms tried to sell the goods at a higher price in the past and failed.
• Say the price is below the equilibrium price.
• At this price consumers demand more than firms are willing to supply,
leading to excess demand.
• This can occur in the sports car market where there is often a waiting list
that can run into years.
 • Shifts in equilibrium
• Shifts in demand and supply will cause the equilibrium position to change.
• Imagine that demand has increased and shifted to the right.
• This will lead to an excess demand, suppliers will realise that they can
charge higher prices.
• Price will keep rising until equilibrium is reached.
• The opposite would occur for a shift in demand to the left.
• Imagine supply has decreased and shifted to the left. This will lead to an
excess demand and the resulting surplus will allow firms to raise their prices.
• Price will keep rising until equilibrium is reached.
• The opposite would occur for a shift in supply to the right.
• If demand and supply both shift the resulting equilibrium will depend upon
the size of their relative shifts.
• It is possible to derive a number of different outcomes.

The Concept of Elasticity

• Elasticity looks at whether it is worth changing your price or not.

Price Elasticity of Demand (PeD):

• Price elasticity of demand refers to how much demand changes when there is a
change in price.
• A firm might decide to cut prices to get rid of surplus stock in the Christmas sales.
• The question facing the managers is how much should they reduce prices by to get
rid of remaining stock whilst maximising their revenue and profit.
• If they knew that by cutting price by 20% they would get 50% more sales this would
be helpful.
• Price elasticity of demand attempts to measure the likely effect on demand of price
changes.
• The elasticity of demand measures the responsiveness of demand to a change in
price.

Percentage change in quantity demanded OR %QD

Percentage change in price %P

• Any answer greater than 1 represents elastic demand; less than 1 represents
inelastic demand and equal to 1 (i.e. a proportionate change) results in unitary
demand, which means any change in price will bring about an equal change in
demand.
• The concept is very important to businesses.
• They need to know how to set their prices for their goods and services and
whether to alter prices.
• If they knew their price elasticity of demand it would certainly help them in their
business planning.
• Unfortunately in reality it is hard to calculate the exact effect of price changes
because many other variables are changing at the same time and the effects of
previous changes in price might not be a good guide as to how demand will now be
impacted by price changes.
•
 When the What it is What it means Effect on a firm’s total
answer is: called (analysis) revenue of a price cut
(evaluation)
0 Perfectly When price changes When prices fall, because
inelastic there is no effect on demand does not change,
demand at all. Demand total revenue must fall.
remains the same.
Between 0 and Price inelastic When prices fall demand Total revenue will fall.
-1 demand increases but by a There are more customers
smaller proportion than but each one paying a
the fall in price. Demand proportionately lower price
is relatively unresponsive and therefore overall
to price changes. expenditure falls.
1 Unitary price That a change in price Total revenue will remain
elasticity of brings about the same the same from a price cut.
demand proportionate change in
demand.
Above 1 Price elastic A fall in price means Total revenue will rise.
demand demand rises by
proportionately more
than the price cut.
Infinity Perfectly elastic That a fall in price leads A fall in price leads to
demand to an infinite level of huge increases in total
demand. revenue.

Applying price elasticity to demand and supply:

• Where demand is fairly elastic, a small change in price will bring about a
large change in the quantity traded.
• When demand is relatively inelastic, a large change in price will bring
about a relatively small change in the quantity traded.
• For this reason, governments tax cigarettes, alcohol and petrol heavily.

Factors of elasticity:

• Availability of substitutes – the more substitutes available, the more

elastic the demand.
• Time - in the short term, demand may be inelastic because people will
accept increase in prices, however in the long run they may be able to switch
to lower priced alternatives, and so the demand is more elastic.
• Luxury vs. necessity – the demand for luxury goods is more elastic than
that of necessity goods.
• Proportion of income – low priced items take up a small proportion of
income and so demand for them is fairly inelastic, where as high priced
goods take up a large proportion of income and so demand for them is
elastic.

Price Elasticity and the Incidence of Tax

• Quite often when market forces are not working effectively to allocate
resources, governments intervene either through taxes or subsidies.
 • When considering the impact of indirect taxes in particular we need to
consider the proportion of any tax rise that gets passed onto the customer;
this is called the incidence of tax.
• Applying price elasticity to this topic area is interesting and may give a
reason why governments tend to tax some products but not others.
• If the producer or retailer pays a tax imposed on a product in the first
instance, then the supply curve shifts left.

Discussing the effect on taxes can be split into four areas:

• The effect on price
• The effect on equilibrium quantity sold
• The effect on tax revenues
• The effect on employment in that industry

THE EFFECT ON PRICE

• Firms will usually pass as much of an indirect tax onto consumers in the
form of increased prices as it can.
• However, when price elasticity of demand is fairly elastic they struggle to
do this as it would bring about significant falls in demand for the good.
• Therefore producers often have to absorb the taxes and reduce profits,
passing only a small proportion of he tax rise onto consumers, otherwise the
fall in quantity demanded would be too great.
• Here the vertical distance between the two supply curves shows the tax.
• However, the price increase is much less than the tax.
• In this case the incidence of tax is said to be low. In the second diagram
demand is price inelastic and in this case taxes can be more easily passed on
to the consumer, hence the bigger increase in prise.

THE FALL IN QUANTITY SOLD

• As we have seen with price elastic demand curves the quantity demanded
will fall sharply if taxes are imposed.
• The additional tax adds to costs and therefore prices and, as consumers
are by definition and in this case price-sensitive, the rises in price cause
large changes in demand.
• With inelastic demand curves there is only relatively little impact on sales.

THE IMPACT ON TAX REVENUES

• Increased taxes mean that although the government might collect quite high
taxes per unit of sales because of the big reduction in demand caused by the
increased price, in actual fact the total revenue government receive from tax
will fall quite sharply or in the cases of new taxes be much lower than a
government might hope for.
• If on the other hand demand for cigarettes was price inelastic then increases
in taxation lead to more government revenue that can then be used to fund
government spending.
• This tends to mean that governments are often less keen to tax products
 where demand is price elastic because of the effects on tax revenue and, as
we shall see next, employment.

EFFECTS OF TAXES ON EMPLOYMENT

• Taxes on price elastic products also mean that employment in those
industries is likely to fall as the quantity demanded would fall significantly.
• Labour is derived demand, so a fall in the demand for the product will
typically mean falls in the demand for labour that produces it.
• The effect on employment in price inelastic markets is much less severe.

EFFECT OF A TAX ON EQUILIBRIUM PRICE AND QUANTITY OF OUTPUT

• Subsidies operate in much the same way except that they bring about a shift
in the supply curve to the right and thus a subsidy on products that are
demand inelastic cause relatively bigger falls in price and small increases in
quantity.
• Therefore we can see that price elasticity is an important concept for firms,
because it influences both the level of sales and their revenues when
changing prices, thus affecting profits.
• It also impacts on governments through the incidence of taxes and subsidies
and therefore affects households as well.
• Clearly if government impose taxes that have an affect on demand then it is
likely there will be effects on employment in that industry as well.

• Cross-Price Elasticity of Demand (Xped)

• This concept examines the extent to which changes in price of product X
affect demand for product Y.
• This applies to both substitute goods and complimentary goods.
• For example, if prices for Vauxhall cars went down then fewer people would
buy Ford cars.
• Furthermore, if the price of rolling paper (for cigarettes) goes up then the
demand for normal cigarettes will go up, regardless of the price of tobacco.

E.g.
Cross price elasticity = Percentage change in the quantity demanded of Good Y
= -12 = +1.2
Percentage change in price of Good X
-10

• Thus we can say that the demand for Ford cars was relatively cross price
elastic.
• In other words, demand does respond to changes in price of other goods by a
greater proportion than the change in price.
• Positive results mean that goods are “substitutes”.
• Negative results mean that goods are “complementary”.
• Close complements tend to be more cross price elastic although it is
important to realise that the relative prices of the goods plays quite an
important role in affecting the degree of Xped.
• Price Elasticity of Supply (PeS)
• PeS measures the responsiveness of supply to a change in price.

Percentage change in quantity supplied

Percentage change in price

• The sign doesn’t matter here. >1 is elastic, <1 is in elastic and =1 is unitary.
• Evaluation:
• Entrepreneurs are keen to increase output and supply more when the price
level is high because they stand to increase their profits.
• Commodity markets in general often have the same characteristics.
• The supply of oil is relatively inelastic in the short term, as is the supply f
petrol.
• Both of these supply curves are inelastic because despite increases in price
levels, it is difficult to increase oil production - there is a need to drill new
wells and build pipelines, etc.
• Petrol needs refining and refineries may take years to build and come on
steam and therefore if there is no spare capacity it is very hard to increase
production even if the prices rise sharply.

Factors Affecting the Price Elasticity of Supply:

• Time
• If a producer sees prices rising in the market they would ordinarily want to
take advantage of this and sell more.
• However it may take time to produce extra output and so in the shortrun
they cannot meet the additional demand.
• A rapid increase in the demand for vintage wines cannot be met until new
wine has been made and allowed to mature.
• CAP is meant to buffer delays in supply in agriculture.
• Supply of raw materials
• Raw material supply is relatively inelastic as firms need to find and explore
new resources before they can increase supply.
• January Queensland floods – reduction in supply of sugar and coal.
• Alternative production
• If firms can switch between the production of different goods relatively easy
then it can expand production of one product quite quickly should its price
rise.
• Therefore PES is relatively elastic.
• Spare capacity
• Spare capacity means output can increase relatively quickly.
• However, the utilisation of spare capacity might not always be the best
business strategy e.g. in independent schools.
• Availibility of stocks
• If you have stockpiles, PES is more elastic, but this can have disadvantages:
expensive, bulky and fragile.
• Number of firms in the market/ease with which firms can enter the
 market
• If it is easy to enter a market then resources not currently involved in the
supply of a particular good might enter a market if they see prices rising and
an opportunity to generate profits.
• If there are little or no barriers to entry and exit from a market then it is likely
that firms will move into a market swiftly, increasing the supply when prices
in that market rise.
• If there are no restrictions on foreign workers coming into the UK, rises in
average wages will act as an incentive for new migrants to come to the UK,
thereby increasing the supply of labour.
• Similarly, if overseas firms see prices rise in the UK of a particular good, they
may rush to enter the UK market, thus increasing supply.
• Ability to alter production methods
• If a firm can transfer quickly to alternative methods of production