GCSE ECONOMICS (OCR)

Revision Guide: Unit 1

Markets at Work

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(A) The Basic Economic Problem

What is it?

The basic economic problem is the fact that RESOURCES are SCARCE (limited in supply) but WANTS are INFINITE

(never ending). As a result of this, consumers, producers and the government have to make CHOICES about how

to ALLOCATE scarce resources.

When we choice one thing, we often sacrifice or give-up something else. OPPORTUNITY COST is the highest

valued alternative that we forego because scarce resources allocated elsewhere.

What are resources?

Resources are all the elements that go into the production of goods and service. Resources are often known as the

FACTORS OF PRODUCTION. There are 4 factors of production:

(a) LAND: All natural resources used in production, for example building land, oil, water, wheat, apples

(b) LABOUR: The human contribution to production- i.e. workers!

(c) CAPITAL: Capital refers to man-made equipment that is developed to aid the production of other goods

and services. For example machines, computers, vehicles, shop fixtures, tills

(d) ENTERPRISE: The person(s) who has the initial business idea, raises the money and organises the other

factors of production.

Economic Systems

All economies face the basic economic problem. However, they may have different approaches to addressing it and

allocating resources. The approach they choose is known as an “economic system”

(a) PLANNED ECONOMY: All resources are owned by the PUBLIC SECTOR (the sector of the economy owned

and controlled by the government). The public sector determines what goods and services are made and

how. Goods and services are “shared out” amongst the population

(b) FREE-MARKET ECONOMY: All resources are owned by the PRIVATE SECTOR (the sector of the economy

owned and controlled by private individuals). Goods and services are allocated via the MARKET

MECHANISM, that is via demand and supply (prices)

There are pros and cons of planned and free-market economies:

Pros Cons

Planned Economy It is fair, everyone will get something Theoretically, everyone can be given a job The government can provide merit goods such as health and education, and public goods such as defence

There is no incentive to be efficient There will be little choice for consumers or workers There may be corruption Economic growth tends to be great low because of the lack of profit incentives

Free Market Economy There is competition- this is good for consumers (Low prices, better quality, more choice, more innovation) There is more incentive to be efficient as low costs can allow low prices which may be important if markets are competitive

Inequality- there will be absolute and relative poverty- poor people will be reliant on charity and will have no choice Public and merit goods may not be provided/will be under produced/consumed- eg not enough access to education and health care Environmental costs (eg pollution) is likely and there is no incentive to look at sustainable use of resources

In reality, most economies are mixed. This means there is a mixture of a public sector and a private sector owning

and allocating the scarce resources. The UK has a mixed economy that is moving towards being more free market:

Public Sector: Education, Health, Police, Defence

Private Sector: Water, Electricity, Gas, Rail, Airlines, Supermarkets, Clothes stores

Examples of how the UK has become more free-market: Privatisation; de-regulation; contracting out; Free Schools

and Academies

Understanding the key differences between the public and private sector

This can be summarised below:

Ownership Control Aims Finance

Public Sector The government on behalf of the people (tax payers)

A government minister will oversee control

To provide a good quality public good or service To allow as many people as possible access to the good or service

Money will be raised from the taxpayer. Any losses will be funded by the taxpayer. The business/area could continue even if it was loss making

Private Sector Private individuals from: Sole Traders (1) Partnerships (2-20) Private and Public limited companies (shareholders)

Owners/Shareholders will lead the strategic direction. Managers will exercise control on a day to day basis

Mainly to make a profit (unless it is a charity) Wider aims and objectives (see later notes)

Finance will be from: Savings Loans Redundancy payments Share issue

The different sectors of the economy

Definition Examples

Primary Sector The sector of the economy responsible for extracting resources from the natural environment

Fishing, mining, farming

Secondary Sector The sector of the economy that is responsible for manufacturing and construction (ie using the primary resources to make goods and services)

Textiles, Food manufacturing; Car manufacturers;

Tertiary Sector The sector of the economy responsible for providing services to consumers and to other businesses

Banking, Insurance, Leisure and Tourism; Catering; Advertising and Marketing

The UK now has a very large tertiary sector having been through a period of DE-INDUSTRIALISATION. This is the

process by which the secondary sector of the economy shrinks so that it produces less and employs fewer people.

The main reasons for de-industrialisation are:

Increased competition from abroad (globalisation)

Historically low levels of investment and productivity in the UK mean that our goods are more expensive and

poorer quality

Higher wage and tax levels in the UK have contributed to higher costs and therefore higher, less competitive

prices in the UK

As the UK has got more economically developed and richer, the demand for services has risen as they are

income elastic. Businesses have developed to meet this need.

Specialisation

Faced with the basic economic problem, it is important that scarce resources are used as efficiently as possible.

It can be argued that using resources in a more specialised way is more efficient and increases production. There are

different types of specialisation:

What is it? Potential Advantages Potential Disadvantages

Specialisation of labour (division of labour)

The production process is organised so that workers all have a very specific (and often quite narrow) job role so that they repeat a particularly task often

Increased productivity as a result of expertise and repetition. Time is not wasted moving from one job to another Makes more efficient (planned) use of scarce capital Requires less training (in unskilled contexts) as workers only have to do a limited range of tasks

Repetition leads to boredom, de-motivation and a reduction in productivity A break/weakness in the chain (eg a an unproductive worker) could affect the whole production process For workers, wages may be lower if tasks are unskilled

Product specialisation A firm focuses its production on one, or a very narrow range of products

The firm can buy resources to make the product in bulk The firm gains a reputation as an “expert” in the field- this can stimulate demand and make it more price inelastic The above could contribute to a degree of monopoly power in the market The firm can have very specialist buyers and sellers and can focus its research and development budget on one product

It is very risky “all the eggs in one basket”- a decline in the demand for the particular good or service would be catastrophic for the firm It cannot take advantage of cross-subsidising products It does not take advantage of having existing customers who may wish to also buy a range of products from the firm, including compliments (and impulse buys) Consumers increasingly want to buy a range of products under one roof for convenience- they may go elsewhere

Regional specialisation A particular region is focussed on producing a particular good or service. This means that a lot of the jobs in that area are provided by the specialist industry Eg historically: Sheffield – Steel Lancashire- textiles West Midlands- Cars East Anglia- Shoes

Firms in the industry may benefit from external economies of scale (the idea that the growth of an INDUSTRY) leads to lower average costs. This will arise because:

There are skilled workers in the local area

The local infrastructure is set up to meet the needs of the industry (roads etc)

Local banks are financially supportive of the industry

Suppliers move to the region, reducing transport costs and making supplies more flexible

The area is very vulnerable to a fall in demand for the product If demand falls there will be high levels of regional unemployment and the regional problem may arise: Low demand for other G&S in the area Increased crime Poor morale- low educational attainment Increased social problems New firms are reluctant to locate to the area because of the above problems There is a cycle that leads to absolute and relative poverty

International specialisation

Countries specialise in producing goods in which they have an absolute or comparative advantage

World output of goods is increased as all countries focus on what they are good/efficient at and then trade Because Average Costs are lower, prices may be lower Encourages free trade, competition and choice- good for consumers Takes account of the fact that climates and resource endowments vary between countries

Requires trade to allow the exchange of goods and services- this may be affected at times of war/unrest Countries may be unable to access certain G&S if trade is disturbed Some products (such as primary products) have lower prices and more unstable prices. Countries specialising in these find it hard to develop and grow (LDC’s) Countries will be vulnerable if there is a downturn in world demand for the products that they specialise in Trade and international competitiveness may be undermined by fluctuations in exchange rates

The characteristics and functions of money

If countries/firms specialise in production, there has to be a means of exchanging goods.

Historically, this was done by BARTER and SWAPPING goods, but this was difficult for a number of reasons. MONEY

allows exchange to take place.

The Functions of Money (what it does)

What does this mean Example

A means of exchange Money allows people to exchange one good for another without finding a “double of co-incidence of wants”

I have a mountain bike to sell but want a racing bike. I sell the mountain bike for money. I use the money to buy a racing bike

A unit of account Money allows the value of one good to be expressed in terms of another

My racing bike was £500 Your racing bike was £100 My racing bike is 5 times more valuable than your bike

A store of value Money allows you to save I sell my mountain bike but cannot find a racing bike I like. I put the money I earn from the mountain bike in the bank and save it until I can find what I want

A method of deferred payment You can “buy now pay later” The shop allows me to buy the bike on 12 months credit

The Characteristics of Money (what should effective money be like?)

Characteristic What does it mean/why is it important?

Portable You can easily carry it around

Durable It lasts a long time and does not perish

Divisible You can break it into small bits to pay for cheap items

Non counterfeitable It is hard to forge it

(B) What are Competitive Markets?

The Spectrum of Competition

_______________________________________________________________________________________________

(1) (2) (3) (4) (5)

(1) Perfect Competition: Hundreds of firms operate in a market and sell identical products. There are no

barriers to entry so lots of new firms can enter the market.

(2) Competitive Markets: Large numbers of firms exist in the same market. They sell very similar/identical

products. Barriers to entry are very low. Examples: plumbers, hairdressers; builders

(3) Oligopoly: 3-8 large firms dominate an industry and account for a large proportion of market share. The

firms are big and benefit from significant economies of scale. This acts as a barrier to entry. Examples: Fast

Food; Mobile Phones; Supermarkets;

(4) Business Monopoly: 1 firm has more than 25% of market share and dominates the market. Barriers to entry

are very high

(5) Economic Monopoly: There is only 1 firm in a market such that the one firm has 100% market share. Often

firms are “natural monopolies” because barriers to entry are so high?

Sources of monopoly power

Monopolies tend to get their power and market share because of high barriers to entry:

Types of barriers to entry What does it mean?

Ownership of raw materials One firm owns all the resources needed to make a particular product, preventing other firms from entering the market

Legal barriers to entry There are legal things in place that give one firm monopoly power. This may include patents, statutes and copyright

Marketing barriers to entry One firm has a lot of marketing and advertising resources. They use these to create such a strong brand image and identity, that it makes it very difficult for a new firm to break in

Technical barriers to entry The existing firm is very large and benefits from economies of scale. New firms, operating at much lower outputs, know that they will not be able to produce at such low costs and prices

Why are competitive markets seen as desirable?

Typically economists believe that competitive markets give better economic outcomes than monopolies which are

often seen as “bad”. In reality, it may be more complex than this.

Potential Gains Potential Losses

Competitive Markets To Consumers:

Prices will be low

There will be more choice

Quality may be improved

There may be more innovation and new products as firms try and stay ahead

To Firms:

Prices are likely to be driven much lower than in less competitive markets- this may reduce profit margins

Lower profit margins may mean that there are less

of competitors To Firms:

It may be easier to attract workers as there are lots of workers doing similar jobs. This high supply of labour may keep wages down

To the Economy

Competition encourages firms to be more efficient and to keep their average costs as low as possible because prices will be lower. Firms are likely to make more careful/efficient use of scarce resources

funds available for re-investment

Their products are likely to be more price inelastic

There is a constant pressure to cut costs and be efficient. This means that firms have to spend a lot of time managing resources and ensuring labour productivity is as high as possible. This could cause conflict

They may lose workers to competitors if competitors offer better wages/working conditions/training etc

Monopolies To Consumers:

Firms are large and may benefit from economies of scale. Firms MAY choice to pass on the benefits of this to consumers in the form of lower prices

Product quality and range may be higher than in competitive markets. This is because (a) The monopolies have the profits to re-invest in the business and in product development and (b) They have the incentive to do so because they want to maintain their monopoly power and keep barriers to entry as high as possible

To the Firm

Prices are likely to be more price inelastic. This means that they can keep prices higher

The lack of competition means higher prices and hence higher profit margins

The lack of competition means that the monopoly does not need to be as careful about minimising costs

The monopoly does not have to spend as many resources on advertising and marketing

The financial position of the monopoly will be quite stable, this may attract more investors/finance

To the Economy

To Consumers

Less competition is likely to mean higher prices

There will be less choice

Product quality/customer service may decline because the monopoly has a captured market (especially if it is a natural monopoly)

To the Firm

The lack of competitive pressures may make the firm become stale and unresponsive to consumer demand. If the product is not a necessity, consumers may move away from the product over time

To the Economy

The lack of incentive to be efficient may mean that scarce resources are not being used as well as they would be under a competitive market. The output of goods and services may be lower than in a competitive market

The lack of competitive forces may mean that scarce resources are not being used to respond to consumer demand and to make the goods and services that consumers most want/value

Economic resources are focussed on production and not on marketing/advertising

Government Policies that can be used to increase competition/reduce monopoly

Policy How it works Advantages Disadvantages

Ban all monopolies Firms are not allowed to own more than 25% of market share

Removes the disadvantages of monopolies (see above)

There is no incentive for firms to be efficient, innovate, get better because success is penalised! Loses the potential gains of monopolies (see above)

Privatisation

See also: Contracting Out De-Regulation

Makes public sector monopolies private, and thus opens them up to competitive forces

Creates the benefits of competition Reduces the burden on the tax payer of financing nationalised industries

Concern that consumers would be exploited by private companies Worry that some industries are “natural monopolies” Concern that non profitable products/services will go

The government helps to break down barriers to

entry

Removal of barriers to entry, naturally encourages competitive forces Eg: De-regulation: Takes away laws that previously gave firms monopoly power- eg Opticians Eg2: The government forced BT to share its phone lines with other companies- reducing a technical barrier to entry

A more natural way of introducing competition

It is very difficult to do this in some industries where there are very high natural and technical barriers to entry. It is easier to do it when the main barrier to entry is legal (ie a previous law protecting the monopoly power)

Regulation of Monopolies Monopolies are allowed to exist but a regulator is put in place to ensure that they do not exploit the consumer and are run efficiently Examples: OFWAT, OGFAS, OFCOM

Potentially allows us to keep the benefits of monopoly without having the costs

Regulators may be expensive and bureaucratic Regulatory Capture- sometimes over time the regulators become “taken in” by the industry and stop looking at it objectively

How are resources allocated in competitive markets

Resources will be allocated by MARKET FORCES.

Market forces are the forces of DEMAND and SUPPLY. Demand and supply interact to give EQUILIBRIUM PRICE and

EQUILIBRIUM OUTPUTS

The equilibrium price is 35 pence

The equilibrium output is 250

Equilibrium means that this is a stable market outcome where there is no tendency to change (unless demand and

supply change)

Demand

Demand is the amount of a good or service that a consumer is WILLING and ABLE to buy over a SPECIFIED PERIOD

OF TIME

Demand and Price

There is usually an inverse relationship between price and quantity demanded. This can be shown in a demand

schedule (table showing the relationship between price and Qd) and a demand curve.

The demand curve is downward sloping from left to right because it shows that quantity demanded usually rises and

price falls.

A change in price causes a MOVEMENT along the demand curve.

When price changes from $8 to $12 we will move up the demand curve and there is a CONTRACTION in quantity

demanded.

When price changes from $8 to $4 we will move down the demand curve and there is an EXTENSION in quantity

demanded.

The Conditions of Demand

These are the non-price factors that influence the demand for goods and services.

(1) INCOME

For NORMAL goods, a rise in income will lead to a rise in demand (and vice versa)

For INFERIOR goods, a rise in income will lead to a fall in demand (and vice versa)

(2) PRICE OF RELATED GOODS

Substitutes: Goods in rival demand (Pepsi v Coke). A rise in the price of a substitute, may lead to a rise in the

demand for our good and vice versa

Complimentary Goods: Goods in joint demand (CD and CD player). A rise in the price of a complimentary good may

lead to fall in the demand for our good and vice versa

(3) TASTE AND FASHION

This may be positive (a fashion craze) or negative ( a health scare, bad publicity, downturn in demand)

(4) ADVERTISING

Advertising can be persuasive and informative. Advertising is designed to stimulate the demand for a good or

service

(5) THE SIZE AND STRUCTURE OF THE POULATION

Size: How many people there are. The more people, the higher demand may be

Structure: The age distribution of the population. This may influence which products are demanded. For example,

an ageing population may lead to a rise in the demand for health care and SAGA holidays but a fall in the demand for

education and nightclubs!

Changes in the conditions of demand cause the whole demand curve to SHIFT

Elasticities of Demand

There are 3 key elasticities of demand:

(1) Price elasticity of demand: Measures how responsive quantity demand is to a change in the price of the

product

(2) Income elasticity of demand: Measures how responsive demand is to a change in income

(3) Cross elasticity of demand: Measures how responsive the demand for a good is to the change in the price

od a related good (substitute or compliment)

Price Elasticity of Demand

There are 3 alternatives.

(1) Demand is price elastic: A % change in price leads to a bigger % change in quantity demanded

(2) Demand is price inelastic: A % change in price leads to a smaller % change in quantity demanded

(3) Demand has unitary price elasticity of demand. Any % change in price leads to an identical % change in

quantity demanded.

What determines whether demand is price elastic or inelastic?

Demand is more likely to be price elastic if: Demand is more likely to be price inelastic if:

There are lots of substitutes There are few substitutes

The good is a luxury The good is a necessity

The good takes up a high proportion of your income The good takes up a small proportion of your income

The good is durable (lasts a long time) The good is consumable (gets used up)

The good is heavily branded and has a lot of brand loyalty

The good is not branded

Why is PED information useful?

(1) It can inform pricing decisions

If a product has price elastic demand, a firm can increase TOTAL REVENUE by putting prices DOWN.

If a product has price inelastic demand, a firm can increase TOTAL REVENUE by putting prices UP

If there is unitary elasticity of demand, changing price has no effect on TOTAL REVENUE and so is pointless

(2) It can inform stock decisions- for example a firm is told by a wholesaler that the price of tinned salmon has

risen. If the firm know that salmon is price elastic they will foresee a fall in demand and stock less

Income Elasticity of Demand

There are 3 outcomes:

(1) Demand is INCOME ELASTIC: A % change in income leads to a bigger % change in demand

(2) Demand is INCOME INELASTIC: A % change in income leads to a smaller % change in demand

Why is it important?

Knowledge of IED can inform firms about what is likely to happen when there are changes in income.

For example:

(a) A firm knows that it produces an INCOME ELASTIC good or service. If incomes fall (during a recession) they

may predict a downturn in demand and attempt to move into other markets- for example producing inferior

goods or income inelastic normal goods

(b) A firm knows that it produces INCOME INELASTIC good or service. This firm will not need to be as concerned

about changes in income levels

Cross Elasticity of Demand: Why is it important?

There are 3 alternatives:

(1) Demand is CROSS ELASTIC: A % change in the price of a compliment or substitute leads to a bigger %

change in the demand for our good. This is likely to happen when it is a very close compliment/substitute

(2) Demand is CROSS INELASTIC: A % change in the price of a compliment or substitute leads to a smaller %

change in the demand for our good. This is likely to happen when the goods are linked but not that

closely (or there is strong brand loyalty in place)

Knowledge of CED can alert a firm to how concerned they need to be about changes in the price of related products

and how they might adapt to this.

Examples

(1) McDonalds know that there is cross elastic demand between Big Macs and Whoppers. If the price of

Whoppers falls, McDonalds can predict a fall in demand for Big Macs. They will have to respond- either by

cutting the price of Big Macs or trying other offers and promotional deals

(2) HMV stock Wiis and Wii games. They know that the 2 have very cross elastic demand. If they know that the

price of Wiis is going to fall, they can predict a big rise in the demand for Wiis AND Wii games. This might

make them stock more of both products. They may also devise promotional offers that take advantage of

the link between the products.

Supply

Supply is the amount of a good or service that a producer is WILING and ABLE to produce over a SPECIFIED PERIOD

OF TIME

Supply and Price

There is a positive relationship between price and supply.

When price rises, producers are willing and able to supply more of a good or service because the potential to

make profit is greater

When price falls, producers are less willing and able to supply a good or service because they will make less profit

from it. They may wish to re-allocate their scarce resources into more profitable uses.

This can be shown is a supply schedule and a supply curve

A change in price will lead to a MOVEMENT along the supply curve.

A rise in price from £1 to £.50 will lead to a movement from B to C and an EXTENSION in quantity supplied

A fall in price from £1 to 50p will lead to a movement from B to A and a CONTRACTION in quantity supplied

The Conditions of Supply

These are the non-price factors that affect supply. They do so because they affect the firm’s willingness and ability

to supply.

(1) COSTS OF PRODUCTION

The higher the costs of production, the lower the profit margins will be. When costs increase, supply will be fall.

When costs fall, supply will increase

(2) TAXES AND SUBSIDIES

A tax is a sum of money that a business has to pay to the government. Tax acts like an extra cost of production. If

taxes rise, profits fall and supply will decrease. If taxes fall, profits will increase and supply will increase

A subsidy is a sum of money that the government gives to a business. This is usually to encourage the firm to do

something that brings external benefits, for example training or re-locating in an area of high regional

unemployment. A subsidy is an additional source of revenue for the firm. It therefore increases profit and increases

the willingness to supply

(3) TECHNOLOGY

Technology means new capital. New capital can increase supply because it makes firms more physically able to

produce more AND because it might make production cheaper, thus increasing profits and willingness to supply

(4) NATURAL FACTORS

Primary products will be particularly affected by things such as climate and natural disasters

Changes in the conditions of supply cause SHIFTS in the supply curve:

Price Elasticity of Supply

Price Elasticity of Supply measures how responsive supply is to a change in the price of the product. There are 3

alternatives.

(1) PRICE ELASTIC SUPPLY: A % change in price leads to a bigger % change in quantity supplied

(2) PRICE INELASTIC SUPPLY: A % change in price leads to a smaller % change in quantity supplied

(3) UNITARY ELASTICITY OF SUPPLY: A % change in price leads to an equal % change in supply

The factors affecting price elasticity of supply

Supply is more likely to be price elastic if... Supply is more likely to be price inelastic if...

The production process is short- eg making cakes The production cycle is long- eg building houses, growing crops

The firm is currently operating under capacity and has spare resources to put into extra production

The firm is already operating at full capacity

The firm makes a range of similar products- resources can be switched from one product to another

The firm cannot easily switch resources from other products

In the long term. As time goes on, firms have time to hire new workers, buy more supplies, lease bigger premises etc

In the short term- firms do not have the ability to quickly get hold of the resources that they need to increase production

Market Forces and the allocation of resources

In a free market economy, the interaction of demand and supply will determine how much of different products are

produced and at what price.

Prices, and equilibrium outputs will only change when there are changes in market conditions. This means that

there are changes in demand and supply.

Examples

Maximum and Minimum Prices

Sometimes the equilibrium prices reached by market forces may be considered to be too high or too low.

The government may decide to intervene to introduce a minimum or maximum price

Maximum Prices

Introduced when the government feels that market prices are too high

The government introduces a maximum price, above which prices are not allowed to go

For example, the government has, in the past, set a maximum price for rented accommodation to ensure

that everyone has access to shelter

Benefits of a maximum price Potential Problems

Theoretically keeps prices down so allows more people to have access to the good and services

May make the situation worse. At the lower price, landlords are less likely to provided rented accommodation (supply falls) but more people want it. This creates excess demand (a shortage)

Stops firms from exploiting consumers with high prices for necessity products

Minimum Prices

Introduced when the government is concerned that market prices may go too low

The government introduces a minimum price, below which the market price cannot go

Examples include: minimum prices in agriculture; the minimum wage

Some people think that the government should introduce a minimum price for alcohol to deter consumption

and reduce external costs

(Note, this graph is poorly labelled, don’t do this!)

Possible benefits of a minimum price Possible costs of a minimum price

Minimum wage avoids exploitation of labour May backfire and price people out of the market. The higher price will contribute to excess supply

Minimum price in agriculture ensures that farmers stay in the market and secures domestic supply of primary commodities

Minimum prices of demerit goods can reduce the consumption of goods with external costs (eg alcohol)

(C) How do firms operate in competitive markets

The objectives of firms

The aims and objectives of firms will depend on a range of factors, including:

Whether the firm is in the private or public sector

The size/age of the firm

The state of the market/economy

However, key aims will include:

Maximising profit

Increasing sales

Growth

Diversifying into new markets/expanding oversees

Survival

Providing a good quality customer service

Key terms in business economics

Key Term Definition

Total Revenue The amount of money earned from selling your product. Total Revenue = Price x Quantity Sold

Average Revenue AR is the amount earned on average per product made. AR = TR/Output AR is the same as price!

Profit The amount of money earned once costs have been deducted Profit = Total Revenue – Total Costs

Total Costs Total Costs are the total out-goings that a firm faces in order to produce its good or service TC = Fixed Costs + Variable Costs

Fixed Costs Costs which do not vary directly with output Examples: Rent, Insurance,

Variable Costs Costs which vary directly with output Examples: Costs of raw materials, electricity costs

Average Costs The cost of making one unit of a good For example if I make 10 cakes at a total cost of £20, the average cost of each cake is £2

Break-even point The point at which the firm is making neither a profit nor a loss TR= TC

Competitiveness How well a firm is able to compete with other firms. To be competitive firms need: Low prices; good investment to improve product quality; innovation so that new products are constantly being developed

Why is it important for firms to make profit?

To satisfy shareholders and secure further investment

To ensure that there are funds for re-investment and future product development

To finance further growth of the firm

To cover costs

On the other hand, firms can survive for short periods of time without making profit

If the economy is in recession, survival is a more realistic goal

If the firm is new, it may be unrealistic to expect them to make profit for 1-3 years

Public sector firms may be more focused on producing good quality public services even if these are not

profitable

Production and Productivity

Production is the process by which a firm converts inputs (factors of production) into outputs (goods and services)

Land, labour, capital and enterprise Output (Goods and Services)

Productivity

Productivity is the RATE at which production occurs. A rise in productivity will occur if:

(a) A firm can produce more output with its existing resources

(b) A firm can produce its existing output with less resources

Labour productivity refers to how much output can be attributed, on average, to a unit of labour (ie one worker)

Labour Productivity can be calculated by: Output/Number of workers:

Output of cakes Numbers of workers Labour productivity

100 10 10

120 10 12

150 10 15

200 10 20

Labour productivity has clearly increased over the time period shown

The firm

How can a firm increase its productivity/labour productivity?

Invest in better quality capital

Improved training

Offer clear reward systems and opportunities for promotion

Improved management

Use performance related pay- eg piece rate, commission, bonuses

Use more specialisation of labour/capital

Why is high productivity so important to a business?

It produces more output. If sold, this will contribute to more revenue and profit

Rising productivity allows firms to operate at lower average costs. This MAY allow them to reduce prices and

become more competitive, thus increasing demand and market share

If a firm is producing at a lower average cost, it will be increasing its profit per unit. This will provide more

funds for re-investment and growth (see above)

Rising productivity may allow a firm to finance wage increases. This will secure worker morale and further

productivity. It will also allow the firm to attract the best quality workers

In the globalised economy, UK firms are competing with firms from the BRIC economies which have very low

costs and high productivity. If UK firms cannot match this, they will be uncompetitive and lose sales/market

share

The Growth of Firms

Reasons why firms may wish to grow in size

To diversify and spread risk

To take advantage of higher levels of demand that exist

To tap into emerging markets

To take advantage of changing market conditions

To take advantage of economies of scale

To take advantage of globalisation and expand into overseas markets

To increase market share and develop greater monopoly power

How do firms grow in size?

What is it? Example

Internal Growth When a firm increases its output on its own

The firm could:

Take on more workers

Take on a new shop

Hire bigger premises

Buy new capital

Buy in more supplies External Growth When a firm increases its output by

joining with another firm One bank merges with another bank There are different types of mergers/integration- see below

Mergers/Integration

Different types of merger bring different economic advantages

Type of Merger Potential benefits to the firm

Horizontal Merger Increase market share

Reduces competition

Increased output means greater economies of scale

Can rationalise- take the best bits from the two companies

Forwards Vertical Merger Can take control of the distribution network

May contribute to a degree of monopoly power by acting as a barrier to entry for rivals

Backwards Vertical Merger Can take control of suppliers- ensure that they get resources/inputs at cost price

Can prevent rivals from having access to resources

Lateral Merger Spreads risk by diversifying the product range slightly

Can take advantage of links between products in marketing campaigns

Conglomerate Merger Complete diversification and risk spreading

Economies and Diseconomies of Scale

The concept of economies of Scale is a central area in Economics and provides a clear rationale for why firms grow.

Internal Economies of Scale

Internal economies of scale refers to the reduction in AVERAGE COSTS that a firm experiences as a result of

increased output by the firm. This is shown below:

Between 0 and Q2 the firm is encountering economies of scale. The increase in output has lead to a reduction in

Average Costs.

There are a number of types/sources of Economies of Scale:

Type of Economies of Scale Explanation

Financial Economies of Scale Large firms can benefit from cheaper loans and wider sources of cheap finance (investment from shareholders)

Marketing Economies of Scale The advantages that large firms get in relation to buying and selling. Large firms can attract specialist buyers who don’t waste money buying stock that will not sell. They also have specialist sellers/marketing staff who ensure that goods will sell. Big firms benefit significantly from being able to “buy in bulk”

Technical Economies of Scale These are the advantages that large firms have when it comes to the production process. Large firms can employ specialist labour and capital which stimulates productivity and reduces average costs

Managerial Economies of Scale Large firms have the money/resources to attract the most productive/efficient/specialist managers who make the most effective business decisions and increase efficiency over time

Risk- Bearing Economies of Scale Large firms benefit from having wider, more diversified product range. This means that they are better able to withstand the risk of a fall in demand for one good or service

Diseconomies of Scale

Diseconomies of Scale is the idea that it is possible for some firms to become TOO large, such that a rise in output

begins to lead to an increase in average costs. This can be shown on the diagram below, where diseconomies of

scale set in when output increases above Q2

Reasons for Diseconomies of Scale:

As the firm increases, factor inputs (resources) become more scarce and hence more expensive

As the firm grows, communication and decision making becomes more difficult, contributing to inefficiencies

and rising costs

As the firm grows, worker morale and motivation declines as they feel like a “small cog in a big wheel”. This

may contribute to reduced productivity and higher average costs

External Economies of Scale

External economies of scale occur when a firm experiences lower average costs because the whole industry has

grown larger. This is particularly likely to be the case when an industry has grown in a particular region.

Why does this occur?

The area will have a pool of skilled labour. Local colleges/training providers will offer courses to meet the

needs of the industry. This will reduce firm’s training costs and labour will be more productive and efficient

Suppliers are likely to move into the area to support the area. This will reduce transport costs and allow

firms flexible access to supplies

Local banks and financial institutions are more likely to be financially supportive of the industry because they

know that the local economy depends upon it- this may lead to lower interest rates and cheaper

loans/overdrafts

The local infrastructure (roads, rail and communication networks) are likely to receive the investment

necessary so that they support the development of the industry

An example:

Labour Markets

In a free market economy, wages are determined by the interaction of the demand for labour and the supply of

labour. Wage differentials (differences in wages) between jobs and locations occur because of differences in the

levels of demand for/supply of labour

The demand for labour

The demand for labour is the demand for labour by employers

The demand for labour is downward sloping. Employers will take on more workers as wages fall

A change in wage will cause a movement along the demand for labour curve

Elasticity of demand for labour

Measures how responsive the demand for labour is to a change in wage levels

If demand is wage elastic it means that a % change in wages will lead to a bigger % change in the demand for

workers. This is most likely to be the case when labour costs contribute to a high proportion of the firms

costs, where it is easy to substitute capital for labour and when the product has price elastic demand

(making it difficult to simply pass on the wage increase to consumers in the form of higher prices)

If demand is wage inelastic it means that a % change in wages will lead to a smaller % change in the demand

for workers. This is most likely to be the case when labour costs are a small proportion of total costs, when

labour cannot be easily replaced by capital and when the price of the product is price inelastic (making it

possible for the employer to pass on the wage increases in the form of higher prices so not reducing profits)

Labour demand (1) has wage inelastic demand. Labour demand (2) has wage elastic demand.

Factors causing a shift in the demand for labour

Whilst changes in wages cause a movement along the D(L) curve, other factors will cause the whole curve to shift

position. These other factors are:

(1) The demand for the product that labour produces. Labour is an example of “derived demand”- this means

that its demand comes from the demand for the product that it makes. For example, during the recession

there has been an increase in the demand for fast food such as McDonalds. This will have led to an increase

in the demand for McWorkers!

(2) Productivity. The higher labour productivity, the more workers that employers want to take on. This is

because workers are contributing to increased rates of production which become increased revenue and

profit.

The shift from D to D1 shows an increase in the demand for labour

The shift from D to D2 shows a decrease in the demand for labour

The Supply of Labour

The supply of labour shows the amount of workers who are willing and able to work at a given wage rate. The

supply of labour curve is upward sloping, indicating that more people are willing and able to work when wages are

higher.

A change in wage causes a movement along the supply of labour curve

Elasticity of Supply of Labour

If the supply of labour is wage elastic, this means that a % change in wages will lead to a bigger % change in supply.

This is more likely to be the case for unskilled jobs where lots of education and training are not required and there is

no need for any natural skill/talent. A wage elastic supply curve will upward sloping but relatively flat.

If the supply of labour is wage inelastic, this means that a % change in wages will lead to a smaller % change in

supply. This is more likely to be the case when there are high barriers to entry for getting into the job. These will

usually be lots of qualifications, training or unique talents. A wage inelastic supply curve will be upward sloping but

relatively steep

Factors causing a shift in the supply of labour curve

In addition to wages, other factors will cause shifts in the supply of labour curve. This means that any given wage,

the supply of labour is higher/lower in different situations.

(1) Education and Training: The more education and training required, the lower the supply of labour will be

(and the more inelastic it will be)

(2) Natural talents and abilities: Some jobs have very low (and wage inelastic) supply because they require

specialist talents that are unique/rare/hard to learn. This would include top fashion models and premiership

footballers

(3) Danger: If a job is perceived as dangerous the supply of labour is likely to be lower.

(4) Working conditions/hours/flexibility of the job: If working conditions are poor and hours are unsociable, this

may reduce the number of workers who are willing and able to do the job.

S3 shows lower supply than S2

Wage Determination

Wages are determined by the interaction of the demand and supply of labour. This will determine the equilibrium

wage rate and the equilibrium number of workers employed.

The equilibrium wage and number of workers employed will change if there are shifts in the demand and /or supply

of labour:

Using economic theory to explain wage differentials

Wage differentials is a posh way of saying differences in wages. Wages may differ between occupations and

between locations.

The exam will often ask a long question about this. A strategy:

Always start by explaining how wages are determined:

In a free market economy, wages are determined by the interaction of the demand for labour and the supply

of labour. Wage differentials (differences in wages) between jobs and locations occur because of

differences in the levels of demand for/supply of labour

Write a paragraph about the demand for labour, include a discussion of wage elasticity of demand if it is

relevant (link it to the context you are given, explaining why there may be different demands for labour)

Write a paragraph about the supply of labour, including a discussion of wage elasticity of supply if it is

relevant

Evaluate/draw a conclusion about what you think are the most significant factors in accounting for wage

differences

The Minimum Wage

A minimum wage works by guaranteeing that all workers receive at least a minimum wage rate

The aim of this is to avoid the exploitation of workers and to provide a financial incentive for people to work

A minimum wage will only affect those industries where free market wages would fall below the level set.

These are most likely to be jobs involving unskilled workers

In the diagram, the free market wage is W0. However the minimum wage is set above this at W1

Evaluating the impact of an imposition of a minimum wage

Potential Gains Potential Losses

Workers Low paid workers achieve a higher wage, thus reducing relative poverty and increasing living standards

The worker may lose his/her job if the employer responds to the minimum wage by laying off workers (E1-E2 above) Even if the worker earns a higher wage, they will be no better off in real terms if minimum wages lead to higher prices and inflation

Firms There may be limited impact if: Firms already pay above min wage Firms employ few workers Firms can easily pass on wage increase to consumers in the form of higher prices (where demand for the product is price elastic) If workers have higher incomes as a result of the minimum wage, there may be a rise in demand for the firms goods

Higher costs lead to lower profits and less funds for re-investment May have to compensate by putting prices up- this will make them less competitive compared to foreign competitors (BRIC)

Consumers Some consumers in low paid jobs have higher disposable income

May face higher prices as firms pass on wage increases May be less new product development/reduced quality product because firms have less profit to re-invest

Gross, Net, Real and Nominal Income

You need to be aware of these key terms

Key Term Definition/Explanation

Gross Income Total income before taxes are removed.

Net Income Total income after taxes are removed

Nominal Income Money income, not taking into account inflation

Real Income Money income is adjusted to take account of inflation. For example if inflation has been 2%, money income needs to be reduced by 2% to reflect the fact that real purchasing power has been reduced