Pearson Edexcel A-Level Economics PDF

 My Revision Planner My Revision Planner Countdown to my exams Exam breakdown Theme 1 Introduction to markets and market failure 1 The nature of economics...

 My Revision Planner My Revision Planner Countdown to my exams Exam breakdown Theme 1 Introduction to markets and market failure 1 The nature of economics 11 Economics as a social science 11 Positive and normative economic statements 13 The economic problem 15 Production possibility frontiers 18 Specialisation and the division of labour 20 Free market economies, mixed economy and command economy 2 How markets work 24 Rational decision-making 24 Demand 27 Price elasticity of demand 31 Cross elasticity of demand 32 Income elasticity of demand 34 Supply 35 Price elasticity of supply 38 Price determination 41 The price mechanism 42 Consumer and producer surplus 43 Indirect taxes and subsidies 46 Alternative views of consumer behaviour 3 Market failure 49 Types of market failure 50 Externalities 54 Non-provision of public goods 55 Information gaps 4 Government intervention 57 Government intervention in markets 62 Government failure Theme 2 The UK economy: performance and policies 5 Measures of economic performance 66 Economic growth 69 Inflation 74 Employment and unemployment 78 Balance of payments 6 Aggregate demand 82 Characteristics of aggregate demand 4 84 Consumption (C) Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_FM_MRN_EdA_Ec3_001-010.indd 4 12/2/20 3:55 PM  86 Investment (I) 88 Government expenditure (G) My Revision Planner 88 Net trade (X – M) 7 Aggregate supply 91 Characteristics of aggregate supply 94 Short-run aggregate supply 94 Long-run aggregate supply 8 National income 97 National income, output and expenditure 98 Injections and withdrawals 99 Equilibrium levels of real national output 101 The multiplier 9 Economic growth 107 Causes of growth 107 Factors that could cause economic growth 109 Output gaps 110 Trade (business) cycle 112 The impact of economic growth 10 Macroeconomic objectives and policies 116 Possible macroeconomic objectives 117 Demand-side policies 123 Supply-side policies 125 Conflicts and trade-offs between objectives and policies Theme 3 Business behaviour and the labour market 11 Business growth 130 Size and types of firms 132 Business growth 135 Demergers 12 Business objectives 137 Profit maximisation 138 Revenue maximisation 138 Sales maximisation 139 Satisficing 13 Revenues, costs and profits 141 Revenue 144 Costs in the short run 149 Costs in the long run 152 Profit 14 Market structures 156 Efficiency 158 Perfect competition 161 Monopolistic competition 162 Oligopoly 5 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_FM_MRN_EdA_Ec3_001-010.indd 5 12/2/20 3:55 PM  165 Monopoly 169 Monopsony My Revision Planner 170 Contestability 15 The labour market 173 The demand for labour 173 The supply of labour 174 Wage determination 16 Government intervention in product markets 181 Types of government intervention 183 The impact of government intervention Theme 4 A global perspective 17 International economics 185 Globalisation 187 Specialisation and trade 191 Patterns of trade 192 Terms of trade 193 Trading blocs and the World Trade Organization 195 Restrictions on free trade 198 The balance of payments 200 Exchange rates 204 International competitiveness 18 Poverty and inequality 207 Poverty 208 Inequality 19 Emerging and developing economies 212 Measures of development 213 Factors influencing growth and development 218 Strategies influencing growth and development 20 The financial sector 228 Financial markets 229 The role of financial markets 229 Market failure in the financial sector 231 The role of central banks 21 The role of the state in the macroeconomy 233 Public finance 233 Public expenditure 236 Taxation 240 Public sector finances 242 Macroeconomic policies in a global context Glossary Exam practice answers and quick quizzes online at 6 www.hoddereducation.co.uk/myrevisionnotesdownloads Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_FM_MRN_EdA_Ec3_001-010.indd 6 12/2/20 3:55 PM  1 The nature of economics Economics as a social science Thinking like an economist ✚ Economics is concerned with the ways in which societies organise Exam tip scarce productive resources in order to satisfy people’s wants. ✚ It provides a unique and special way of examining many areas of human From the start of the course it behaviour, which involves using the economist’s toolkit of concepts, is important to adopt a critical theories and techniques to analyse economic issues and problems. approach to the assumptions ✚ Economists often use models to develop theories of behaviour. These behind the models that are models are usually based on assumptions from which certain deductions being considered so that you may be made. develop skills of evaluation. The use of the ceteris paribus assumption in building models ✚ When building models, economists work on the basis that all other Ceteris paribus means that variables are held constant to enable deductions to be made. when the effect of a change ✚ This is called the ‘ceteris paribus’ assumption, which means ‘other things in one variable is considered, being equal’. it is assumed that all other ✚ This helps to simplify analysis so that the impact of a single change in a variables are held constant. variable can be examined. Now test yourself Exam tip Analysis is usually based 1 Why is the ceteris paribus assumption necessary when building economic models? on the ceteris paribus Answers available online assumption. However, removing this assumption may be useful in evaluation. The inability in economics to make scientific experiments ✚ It is impossible for economists to conduct laboratory experiments because economics is a social science involving people. ✚ Consequently, economic policies that may have been effective at one time in one country may not have the same impact at another time or in another country. Positive and normative economic statements Positive economics ✚ Positive economic statements are based on facts that can be proved or Positive economic disproved. They include what was, is or will be, and these statements can statements are objective be verified as being true or false by reference to data or evidence or by statements based on using a scientific approach. evidence or facts that can, therefore, be proved or disproved. 11 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 11 12/2/20 3:35 PM  ✚ Economists often use models as a way of predicting behaviour. It is possible to make positive statements on the basis of ‘models’, such as the impact on price of a product following an increase in demand. ✚ Positive economics relates official data such as gross domestic product 1 The nature of economics (GDP), the price of oil, the rate of unemployment and the rate of tax on sugar. It may also be associated with the use of models as a way of predicting behaviour. Now test yourself 2 Why do economists use models to predict economic behaviour? Answers available online Normative economics Normative economic statements are based on value judgements and are, therefore, subjective. They relate to what: Normative economic ✚ might be good or bad, or statements are subjective ✚ should be or ought to be, or statements based on value ✚ would be fair or unfair. judgements and cannot be proved or disproved. Normative economics is usually associated with discussions about economic policy. In this unit, for example, it is concerned with issues such as whether or not there should be: Exam tip ✚ a minimum price for alcohol When defining normative ✚ subsidies for green energy, e.g. solar energy statements it is better ✚ road tolls to use the terms ‘value ✚ an increase in the tax on cigarettes judgements’ or ‘subjective ✚ more private sector provision in the health service. views’ rather than ‘opinions’ to describe them. The role of value judgements in influencing economic decision-making and policy ✚ As explained previously, scientific, laboratory experiments are impossible in economics. ✚ Economists often develop models to help them to predict what might happen in the real world. However, the assumptions underlying these models are invariably based on value judgements. ✚ Similarly, the economic policies promoted by economists are likely to be heavily influenced by their values and politics. For example, if a government wanted to reduce its budget deficit, a left-wing economist might favour wealth taxes or higher taxes on those with high incomes. In contrast a right-wing economist might prefer cuts in welfare benefits to the unemployed. Now test yourself 3 Which of the following are positive statements and which are normative statements? a) Healthcare workers should be paid more. b) The USA’s GDP fell by over 30% in the second quarter of 2020. c) The use of robots will create unemployment in jobs that can be automated. d) High energy prices are unfair on the poor. e) Wealth inequality is greater than income inequality in the UK. Answers available online 12 Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 12 12/2/20 3:35 PM  The economic problem The problem of scarcity 1 The nature of economics All societies face the problem that wants are infinite but resources are limited Scarcity exists because in supply. This is the underlying reason for the fundamental economic resources are finite whereas problem of scarcity. Therefore, choices must be made. The issue of scarcity wants are infinite. means that societies face a series of questions: ✚ What to produce and how much to produce? This relates to the different types of goods the economy should produce and how much of each. Exam tip ✚ How should the goods and services be produced? Production may be To avoid confusion between labour intensive, i.e. a high proportion of labour used relative to capital, or capital goods and consumer capital intensive, i.e. a high proportion of capital used relative to labour. goods, consider how they ✚ How should the goods produced be allocated? This is concerned with the are used: anything that is distribution of the goods produced and affects the degree of equality in the an aid in the production of society. other goods is classified as a capital good. In contrast, Now test yourself anything used by someone for final consumption is 4 What is the basic economic problem? classified as a consumer Answers available online good. Resources The resources of a country are referred to as ‘factors of production’. Four factors of production may be identified: Factors of production ✚ Land: includes all natural resources, raw materials, the fertility of the soil are resources and include and resources found in the sea. land, labour, capital and ✚ Labour: refers to those involved in the production of goods and services enterprise. and includes all human effort, both physical and mental. ✚ Capital: any man-made aid to production including factory buildings, Exam tip offices, machinery and IT equipment that is used to make other goods and services. When referring to capital ✚ Enterprise: the entrepreneur performs two essential functions: as a factor of production, ✚ bringing together the other factors of production so that goods and remember that it is services can be produced and something used to make ✚ taking the risks involved in production. other goods, and that it does not refer to money. Making links Enterprise is considered more fully in Chapter 11 and labour is considered in Chapter 15. Now test yourself 5 Identify the factor of production in each of the following cases: a) Copper deposits in Zambia b) A woman who opens a hairdressing salon c) Machinery used in car production d) An engineer making computer games for a company Answers available online 13 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 13 12/2/20 3:35 PM  The distinction between renewable and non-renewable resources ✚ Renewable resources are those that can be replaced naturally after use, 1 The nature of economics Renewable resources are e.g. solar energy, wind power, wood and fish. Such resources are likely to those whose stock levels can be sustainable unless they are consumed more quickly than they can be be maintained at a certain replaced. level. ✚ Non-renewable resources are those where continued consumption will eventually result in their exhaustion, e.g. oil, copper, platinum. Non-renewable resources are those that will eventually be completely depleted. The importance of opportunity costs to economic agents Opportunity cost is linked to scarcity as explained below: Opportunity cost is the ✚ Scarcity implies that choices must be made. next best alternative that is ✚ Each choice involves an opportunity cost. forgone when a choice is ✚ This may be explained as follows: if a country’s resources are used to made. manufacture one product, then it must forgo an alternative product that could have been produced. The next best alternative forgone is called the Making links opportunity cost of what has been produced. Opportunity cost is an ✚ Opportunity cost, therefore, is a real cost measured in terms of something important concept that has that is forgone. relevance throughout the Examples of opportunity cost in relation to different economic course so it is important for agents include: exams to ensure that you have a secure understanding ✚ For a consumer: a university student might have enough money to buy of the concept. either a jet ski or a surfboard. If the student decides to buy the jet ski then the opportunity cost is the surfboard. For example, this concept ✚ For a firm: the firm might have to make a choice between its two priorities, is relevant in considering economic growth using e.g. buying a new IT system or building a new factory. If it chooses the IT production possibility system then the opportunity cost is the new factory. frontiers in Theme 1 (see ✚ For the government: suppose the government has £10 million with which page 15), normal profit in to fund one of its two main priorities that both require a £10 million Theme 3 (see page 153) investment — building a new school or building a new university. If it and the law of comparative decides that its first preference is the school while the second preference is advantage in Theme 4 (see the university, then the opportunity cost of building the school is building pages 188–190). the university. Exam tip Now test yourself Opportunity cost must be 6 A firm has £1 million that it could use to build a new factory or to buy five robots. measured as a real cost, What is the opportunity cost if the firm decides to build the factory? in other words in terms Answers available online of goods forgone when a choice is made, and not in money terms. Economic goods and free goods Economic goods are created from resources that are limited in supply and so are scarce. Consequently, they command a price. Free goods are unlimited in supply, such as sunlight or sand on a beach. Consumption by one person does not limit consumption by others. Therefore, the opportunity cost of consuming a free good is zero. Now test yourself 7 Why does the consumption of free goods not incur an opportunity cost? Answers available online 14 Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 14 12/2/20 3:35 PM  Production possibility frontiers A production possibility frontier (PPF) shows combinations of two goods that A production possibility could be produced by an economy if all of its resources are employed fully and 1 The nature of economics frontier illustrates the efficiently (see Figure 1.1). maximum potential output of an economy when Consumer goods all resources are fully A employed. B X C O Capital goods Figure 1.1 A production possibility frontier (PPF) In constructing the PPF in Figure 1.1 it is assumed that the economy can produce either consumer goods or capital goods. ✚ Capital goods are those required to produce other goods — both capital and consumer goods, e.g. machinery, factory buildings. ✚ Consumer goods are those that give satisfaction (or utility) to consumers, e.g. smartphones, curry and cars. ✚ By definition, any point on the PPF, e.g. A, B or C, implies that all resources are fully and efficiently employed. Therefore, all points on the PPF indicate the maximum productive potential of an economy and that resources are being used efficiently. ✚ However, if the economy was operating inside its PPF, e.g. at point X, then it would indicate that there are unemployed resources in the economy. For example, some workers may be unemployed or machinery may be unused. It could also imply that resources are not being allocated efficiently. Now test yourself 8 Classify the following into capital and consumer goods: a) A laptop used by a company director for his business b) A curry eaten by Marie for her lunch c) A visit to a spa by Kirsten d) A car used to transport a manager between offices Answers available online Possible and unobtainable production Any points inside or on the PPF represent combinations of the two products that are obtainable. However, any points to the right of the PPF would be currently unobtainable. They could only become obtainable if there was economic growth. PPFs and opportunity cost ✚ The PPF is drawn as a curve (concave to the origin) in Figure 1.1. This may be Marginal analysis is analysed in terms of the concept of opportunity cost and marginal analysis. concerned with the impact of ✚ Marginal analysis involves consideration of the impact that small changes additions to or subtractions have on the current situation. from the current situation. ✚ Therefore, a marginal increase in the output of capital goods means that The rational decision-maker some consumer goods must be sacrificed (the opportunity cost). will only decide on an option ✚ In Figure 1.2, when output of capital goods is increased from 0M to 0S, the if the marginal benefit output of consumer goods is reduced from 0L to 0R. exceeds the marginal cost. 15 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 15 12/2/20 3:35 PM  ✚ Therefore, the opportunity cost of increasing the output of capital goods by Exam tip MS is LR consumer goods. ✚ Since the PPF has been drawn as a curve, it can be seen that as output of If the PPF were a straight capital goods is further increased, e.g. by SV, the opportunity cost rises, i.e. line then the opportunity 1 The nature of economics by RT consumer goods. The main reason for this is that some resources cost would be constant. will be better suited to the production of consumer goods while others are better suited to the production of capital goods. Therefore, when more and more capital goods are produced, the opportunity cost in terms of consumer goods increases. Consumer goods L A R B T C O M S V Capital goods Figure 1.2 Production possibility frontiers and opportunity cost PPFs, economic growth and economic decline PPFs may be used to illustrate economic growth. Economic growth refers ✚ Refer back to Figure 1.2. Suppose that the economy is currently operating to an increase in the at point A on the PPF with 0L consumer goods and 0M capital goods being productive capacity of the produced. economy indicating an ✚ It is also assumed that the 0M capital goods produced are just sufficient to increase in real output. replace worn-out machinery. ✚ If there is a reallocation of resources so that the production of capital goods is increased to 0S, then only 0R consumer goods can now be produced. ✚ Therefore, the opportunity cost of producing MS more capital goods is LR consumer goods. ✚ This reduction in the output of consumer goods implies a fall in current living standards. ✚ However, in the long run, there will be economic growth because the extra capital goods will cause an increase in the productive capacity of the economy resulting in a rightward shift in the PPF, as shown in Figure 1.3. Consumer goods E A X 0 Capital goods Figure 1.3 Production possibility frontiers and economic growth 16 Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 16 12/2/20 3:35 PM  ✚ It can be seen that if the economy moved from point A to point E then more of both capital goods and consumer goods could be produced. In turn, this implies that living standards would increase in the long run. 1 The nature of economics ✚ In contrast, economic decline would be associated with an inward Economic decline shift in the PPF and might have occurred as a result of resources being refers to a decrease in reallocated from the production of capital goods to the production of the productive capacity of consumer goods. For example, if the production of capital goods was the economy indicating a reduced below 0M then there would be insufficient production of decrease in real output. capital goods to cover depreciation, so reducing the productive capacity of the economy. Other factors causing shifts in the PPF are outlined below. Now test yourself 9 Study the diagram below and answer the questions that follow. Consumer goods Y A R S B Z 0 L M Capital goods a) What does point Z represent? b) What is the opportunity cost of increasing the output of consumer goods by RS? c) Would the opportunity cost of producing more and more consumer goods increase or decrease? 10 How might economic growth be affected if a country produces more and more consumer goods and fewer and fewer capital goods? Answers available online Movements along and shifts in a PPF Movements along a PPF ✚ A change in the combination of the two goods being produced, e.g. capital goods and consumer goods, would cause a movement along a given PPF. ✚ Such a change might occur if the economy devoted more resources to the production of capital goods and fewer to the production of consumer goods. This would involve an opportunity cost (see pages 15–16). Shifts in a PPF A range of factors could cause a shift in the whole PPF. These are outlined in the following two sections. 17 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 17 12/2/20 3:35 PM  Factors causing an outward shift in the PPF Factors that might cause an outward shift in the PPF include: ✚ discovery of new natural resources, e.g. rare minerals 1 The nature of economics ✚ development of new methods of production that increase productivity ✚ advances in technology ✚ improvements in education and training that increase the productivity of the workforce ✚ factors that lead to an increase in the size of the workforce, e.g. immigration, an increase in the retirement age, better childcare enabling more women to join the workforce. Factors causing an inward shift in the PPF Factors that might cause an inward shift in the PPF include: Exam tip ✚ natural disasters, e.g. earthquakes or floods that cause a destruction of productive capacity Remember that the PPF ✚ depletion of natural resources represents the possible ✚ factors causing a reduction in the size of the workforce, e.g. emigration, an outputs of two goods increase in number of years spent in compulsory education that could potentially be ✚ a deep recession that results in a loss of productive capacity with factories produced. Points on the closing down permanently. PPF do not represent what is actually produced unless Making links all resources are fully employed. It can be seen from the above analysis that PPFs may be used in exams when considering opportunity cost and will be of relevance for economic growth (see Chapter 9) and for the law of comparative advantage (see Chapter 17). Now test yourself 11 What will be the effect on a PPF of each of the following? a) An improvement in education and training leading to an increase in labour productivity b) A prolonged drought in North Africa causing agricultural land to be turned into desert c) An increase in the amount of capital per worker d) An increase in immigration of people aged between 16 and 65 Answers available online Specialisation and the division of labour The meaning of the division of labour Division of labour occurs when workers specialise on very specific tasks. For Division of labour occurs example, the work is divided up into many smaller parts so that each worker when the work is split up is responsible for a very small part of the product or service being provided. into small, specialised tasks. Adam Smith and the division of labour ✚ In The Wealth of Nations Adam Smith set out the view that economic growth could be achieved by increasing the division of labour. 18 Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 18 12/2/20 3:35 PM  ✚ This involved the breaking down of a task into many small jobs with workers specialising on a particular task without the need to change jobs during the day. ✚ Smith used the example of pin-making: one person doing all the tasks 1 The nature of economics could make 1 pin a day. However, if each of the skills that go into making a pin were divided into 18 different operations with 18 different operators who pass the pin along an assembly line then 12 pounds of pins per day could be produced. ✚ This would save time and enable each worker to become an expert in one specific task, so increasing their productivity. Advantages and disadvantages of specialisation and the division of labour in organising production Advantages Disadvantages Each worker specialises in tasks for which that worker is Monotony and boredom for workers: this could result in a best suited. decrease in productivity. The worker only has to be trained in one task. Therefore, Loss of skills: workers trained in one particular task have only training costs for the firm are likely to be lower. limited skills. This could be a problem if they are made redundant. Less time is wasted because a worker no longer has to A strike by one group of workers could bring the entire move from one task to another. production facility to a standstill. In manufacturing, such an approach enables production There is a lack of variety because all goods produced on a line methods to be employed and allows an increased production line are identical. use of machinery. In turn, this helps to increase productivity and to reduce average costs of production. Now test yourself Exam tip 12 How might a firm benefit from the division of labour? Note that the division of Answers available online labour enables training costs to be reduced because the worker only Making links has to be trained in one For the exam you should be able to understand the significance of the division particular task. of labour for productivity (see Chapter 7), the labour market (see Chapter 15) and economic development (see Chapter 19). Advantages and disadvantages of specialising in the production of goods and services to trade Advantages Making links If a country specialises in the production of certain goods and services and You will study more then trades these in exchange for goods and services that it does not produce, about specialisation and then it can benefit from increased output, greater choice and lower prices. trade in Chapter 17 when you consider the law of Disadvantages comparative advantage, Such specialisation might mean that a country becomes over-dependent on which provides the basis for free trade. In exams imported goods and services. If its goods and services are uncompetitive you would need to use then unemployment could result, and the country’s value of imports may comparative advantage when persistently exceed the value of its exports. considering specialisation. 19 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 19 12/2/20 3:35 PM  Limits to the division of labour Certain factors limit the extent to which the division of labour can be applied: ✚ The size of the market: if there is only a small market then it is more 1 The nature of economics difficult to specialise. ✚ The type of product: for example, designer fashion products are likely to be unique and not suitable for the division of labour. ✚ Transport costs: if these are high then large-scale production and the division of labour may not be possible. Now test yourself 13 What might limit the division of labour in a firm making individual jewellery? Answers available online The functions of money Money performs various functions, which help to facilitate specialisation and Money refers to anything the division of labour. The key functions are: that is used as a means of ✚ As a medium of exchange enabling people to specialise, exchanging the exchange for goods and money earned from doing a specialist job for the goods and services they services. wish to buy. ✚ A store of value enabling people to save in order to buy goods in the future. ✚ A measure of value enabling people to assess the value of different goods Making links and services by comparing prices. In exams you need to ✚ A means of deferred payments enabling people to buy goods and pay for be able to explain the them on credit. importance of money for specialisation. Now test yourself 14 Explain the importance of money as a medium of exchange. Answers available online Free market economies, mixed economy and command economy Economies may take different approaches to the economic problem of scarcity and of answering the questions of what to produce, how to produce, and how the goods produced should be allocated, as described below. Free market economies The free market economy is one in which the above questions are determined A free market economy by market forces. The main characteristics of such economies are as follows: refers to an economic ✚ There is private ownership of resources. system in which prices ✚ Market forces, i.e. supply and demand, determine prices. are determined by supply ✚ Producers aim to maximise profits. and demand with no ✚ Consumers aim to maximise utility (satisfaction). government intervention. ✚ Resources are allocated by the price mechanism. 20 Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 20 12/2/20 3:35 PM  Adam Smith ✚ In his book The Wealth of Nations, written in 1776, Adam Smith suggested that when individuals follow their own self-interest, they indirectly promote the good of society. 1 The nature of economics ✚ Consequently, the free market economy would result in an ordered market with producers responding to changes in consumer wants in such a way that there was little waste. ✚ Smith believed that the role of the government should be limited to providing defence, justice and some ‘public goods’ such as roads. Friedrich Hayek ✚ In the twentieth century Friedrich Hayek offered a strong defence of the free market along with support for private property. ✚ Further, he argued in his book The Road to Serfdom that attempts by governments to determine the answers to the questions of what to produce, how to produce and for whom were doomed to failure. ✚ State planning would involve restrictions on freedom and the use of force. Now test yourself 15 Identify four characteristics of a free market economy. Answers available online Command economy The command or centrally planned economy is one in which the above A command economy questions are determined by the state. The main characteristics of such or centrally planned economies are as follows: economy is one in which ✚ There is public (state) ownership of resources. resources are allocated by ✚ The state determines price. the state. ✚ Producers aim to meet production targets set by the state. ✚ The state allocates resources. ✚ There is greater equality of income and wealth than in a free market economy. Karl Marx ✚ Writing in the nineteenth century, Karl Marx thought that capitalism was inherently unstable because workers are exploited by the bourgeoisie (the owners of the factors of production). ✚ Ultimately, there would be a proletariat revolution in which communism would result. Mixed economy The mixed economy is a mixture of the free market economy and the A mixed economy is command economy. a combination of a free ✚ In practice, there are no absolutely free market or command economies: market economy and a most are mixed economies. command economy. ✚ In mixed economies, some resources are allocated by the price mechanism while others are allocated by the state. What differs between countries is the degree of that mix. Exam tip Remember that in a pure Now test yourself free market economy 16 What is the main characteristic of a command economy? there is no government intervention. Answers available online 21 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 21 12/2/20 3:35 PM  Advantages and disadvantages of free market economies 1 The nature of economics Advantages Disadvantages Consumer sovereignty: this implies that consumer spending Inequality: those who own resources are likely to become decisions determine what is produced. richer than those who do not own resources. Flexibility: the free market system can respond quickly to Trade cycles: free market economies may suffer from changes in consumer wants. instability in the form of booms and slumps. No bureaucracy: officials are not needed to allocate Imperfect information: consumers may be unable to make resources. rational choices if they have inadequate information or if there is asymmetric information (see Chapter 3, page 55). Efficiency: competition and the profit motive help to Monopolies: there is a danger that a firm may become the promote an efficient allocation of resources. sole supplier of a product and then exploit consumers by charging prices higher than the free market equilibrium. Increased choice: consumers have a wide choice of goods Externalities: these are costs and benefits to third parties and services compared with a command economy. that are not taken into account when goods are produced and consumed. Economic and political freedom: consumers and producers have the right to own resources. Now test yourself Exam tip 17 What is meant by ‘consumer sovereignty’? When thinking about the advantages and 18 Why does inequality occur in a free market economy? disadvantages of a free Answers available online market economy, consider the impact on individuals, businesses and the whole Advantages and disadvantages of economy. command economies Advantages Disadvantages Greater equality: the state can ensure that everyone can Inefficiency: the absence of the profit motive and enjoy a minimum standard of living and that no one is competition may result in an inefficient allocation of extremely rich. resources. Macroeconomic stability: the state can ensure that booms Lack of incentives to take risks: again, the absence of the and slumps are smoothed out. profit motive may reduce incentives for investment. External benefits and external costs: these may be taken Restrictions on freedom of choice: people would be into account when planning production. directed into the jobs the state deems necessary. No exploitation: privately owned monopolies are unable to Shortages and surpluses: if the state miscalculates supply exploit workers and consumers. and demand then there may be excess demand and/or excess supply of goods and services. Full employment: the state can ensure that all workers are Bureaucracy: a vast army of officials is needed to allocate employed. resources. Resources may be allocated by the state to maximise social No consumer sovereignty: decisions by the state rather welfare. than consumers determine what is produced. Inflexibility: the state may be slow to react to changes in consumer needs. Now test yourself 19 Why might there be inefficiency in a command economy? Answers available online 22 Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 22 12/2/20 3:35 PM  The role of the state in a mixed economy The state performs a variety of roles, many of which depend on the Making links political priorities of the ruling party. However, in most economies the 1 The nature of economics state has a number of key roles, which include the following to a In Chapter 3, you will be studying greater or lesser degree: market failure. In exams you may ✚ Defence and internal security use the different reasons for ✚ Provision of public goods market failure as the basis for a ✚ Provision of public services such as education and health mixed economy, i.e. reasons for government intervention in an ✚ Redistribution from the rich to the poor economy. Summary You should have an understanding of: ✚ the distinction between free goods and economic ✚ what economics is goods ✚ the four key factors of production: land, labour, capital ✚ positive and normative economic statements and enterprise ✚ production possibility frontiers including the ability to ✚ the meaning of scarcity and the need to make choices draw them accurately ✚ the difference between consumer goods and services, ✚ the use of PPFs to illustrate opportunity cost and and capital goods and services economic growth ✚ the difference between labour intensive production ✚ factors that cause an inward or outward shift in the PPF and capital intensive production ✚ the meaning of specialisation and the division of labour ✚ opportunity cost and its significance for individuals, ✚ advantages and disadvantages of the division of labour firms and the government ✚ free market, command and mixed economies. Exam skills Having started the course you are beginning to develop the division of labour, or the importance of questioning some of the skills necessary to achieve highly in assumptions behind models, e.g. the assumptions economics. These include: underlying the production possibility frontier analysis. ✚ Precision: it is really important to be able to define ✚ Building blocks: the material covered in this section terms accurately and precisely, e.g. positive and forms the basis of your study of economics so it is normative economic statements, opportunity cost. important to have a clear understanding of concepts ✚ Thinking skills: the ability to see both sides of an such as ‘ceteris paribus’, opportunity cost, resources, issue, e.g. the benefits and problems associated with mixed economies, etc. Exam practice 1 During the years 2010 and 2019 economists disagreed A Reduction in the amount of machinery used about whether to continue with austerity measures. in production a) Statement 1: ‘Austerity measures have resulted in B Increase in the cost of training an individual a reduction in government borrowing.’ worker Statement 2: ‘Austerity measures should be C Reduction in total output abandoned because they harm the poorest people D Increase in output per worker in society.’ b) Explain two advantages of the division of Which of the following best describes the two labour to an airline. statements above? 3 North Korea is an example of a state that makes A Both statements are positive. fundamental decisions about how its economy is B Statement 1 is positive and Statement 2 is organised. normative. a) Explain two possible problems faced by a C Both statements are normative. command economy. D Statement 1 is normative and Statement 2 b) Which one of the following is a function of is positive. the price mechanism in a free market economy? b) Explain one reason why economists might A To stabilise prices disagree about an economic policy. B To enable the government to set prices c) Why do economists use models in their analysis? C To ration scarce goods 2 In the airline industry there is a very high degree of D To reduce consumers’ surplus division of labour. Answers and quick quizzes online a) Which one of the following is most likely to result from an increase in specialisation and the division of labour? 23 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_01_MRN_EdA_Ec3_011-023.indd 23 12/2/20 3:35 PM  2 How markets work Rational decision-making The standard neoclassical analysis makes two very significant assumptions about the ways in which consumers and firms behave: ✚ Consumers act rationally by aiming to maximise their utility (satisfaction). Utility refers to the ✚ Firms also act rationally by aiming to maximise profits. level of satisfaction a consumer receives from the These assumptions provide a powerful tool for analysis and this chapter consumption of a product explores how this can be applied in theory and in real-world examples. or service. However, some economists have criticised the validity of these assumptions which has led to the development of a new branch of economics called ‘behavioural economics’. This is considered at the end of this chapter. Making links In exams you should recognise the assumption of rationality when explaining, for example, price changes in a free market (see pages 39–40) and market structures (see Chapter 14). To secure marks for evaluation, you may then suggest that the outcome may be different if the assumption of rational behaviour is removed. Demand Demand refers to the amount demanded by consumers at given prices over Demand is how much is a certain period of time. It is important to include a reference to prices and to demanded at each price the time period in a definition of demand. over a certain period of Demand is not the same as ‘want’ — ‘wanting’ a product that one cannot time. afford is not demand. Demand must include the ability to pay for the product or service. Shape of the demand curve Figure 2.1 shows that the demand curve is downward sloping from left to Exam tip right, indicating that more will be demanded as price falls. Avoid confusing ‘want’ with Price per unit ($) ‘demand’. ‘Wants’ simply refer to desires, and desires may be unaffordable, whereas ‘demand’ is backed P1 B Contraction in demand by money. A Extension Pe of demand P2 C Demand curve 0 Q1 Qe Q2 Quantity demanded per week (kilos) Figure 2.1 Movements along a demand curve 24 Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_02_MRN_EdA_Ec3_024-048.indd 24 12/2/20 3:41 PM  The demand curve demonstrates how a fall in price will cause an increase in the quantity demanded (or an extension in demand) and a rise in price will cause a decrease in quantity demanded (or contraction in demand). This is based on: 2 How markets work ✚ The substitution effect: when there is a rise in price, the consumer (whose income has remained the same) tends to buy more of a relatively lower- priced good and less of a higher-priced one. ✚ The income effect: when there is a rise in price, consumers will suffer a fall in their real incomes, i.e. the purchasing power of their money incomes falls. With normal goods, the fall in real incomes will lead to a fall in the quantity demanded. Movements along the demand curve ✚ It may be seen from Figure 2.1 that movements along a demand curve would be caused by price changes. ✚ Given that the demand curve has a negative slope, a rise in price would cause a fall in quantity demanded and a fall in price would cause a rise in quantity demanded. Now test yourself 1 When defining demand, what must it be related to? 2 If there is an increase in price, what movement would there be along a demand curve? Answers available online Shifts in the demand curve Various factors can cause a shift in the whole demand curve. These include changes in: ✚ Real incomes: an increase in real incomes implies that incomes (after discounting the effects of inflation) have increased. This would result in an increase in demand for most goods and services, causing a rightward shift in the demand curve. ✚ Size or age distribution of the population: an increase in the size of the population causes an increase in demand for most goods and services. ✚ Tastes, fashions or preferences: for example, a decrease in the popularity of cabbage will cause a leftward shift in its demand curve. ✚ Prices of substitutes or complements: if there is a change in the price of a related good, it will affect the demand curve for the product. For example, Exam tip if the price of beef rises, the demand for a substitute such as lamb will increase. In contrast, if there is a rise in the price of petrol (a complement It is only when there is a to cars), the demand curve for cars would shift to the left. change in the conditions ✚ The amount of advertising or promotion: a successful advertising of demand that the whole campaign would cause an increase in demand. demand curve shifts. Price ✚ Interest rates: affect the cost of borrowing money. For example, a rise in changes cause a movement interest rates increases the cost of borrowing money for mortgages, so along an existing demand causing a decrease in demand for houses. curve. 25 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_02_MRN_EdA_Ec3_024-048.indd 25 12/2/20 3:41 PM  Figure 2.2 illustrates how an increase in demand would cause the whole demand curve to shift to the right, whereas a decrease in demand would cause the whole demand curve to shift to the left. Price per unit ($) 2 How markets work Increase in demand Decrease in demand D3 D1 D2 0 Quantity demanded per week (kilos) Figure 2.2 Shifts in the demand curve Now test yourself 3 What would be the effect of the following on the demand for houses in the UK? a) An increase in immigration into the UK b) A decrease in real incomes c) An increase in the price of rented accommodation d) A rise in mortgage interest rates Answers available online The concept of diminishing marginal utility and its influence on the demand curve This principle is based on the idea that consumers gain satisfaction or utility from the goods they consume. ✚ Total utility represents the total satisfaction gained from the total amount Total utility is the amount of a product consumed. of satisfaction a person ✚ Marginal utility represents the change in utility from consuming an derives from the total amount additional unit of the product. of a product consumed. ✚ The law of diminishing marginal utility states that as a person consumes more and more of a product, the marginal utility (extra satisfaction or Marginal utility is the benefit) falls. Consequently, people are prepared to pay less as their change in total utility from consumption increases with the result that there will be an inverse consuming a unit of a relationship between the price and quantity demanded. product. The law of diminishing Example marginal utility states that as consumption of a Utility of consuming apples product is increased, the The table below is a worked example showing the utility gained from consuming apples. consumer’s utility increases, but at a decreasing or Number of apples Total utility Marginal utility diminishing rate. 0 0 20 1 20 14 2 34 10 3 44 6 4 50 2 5 52 ✚ The table shows that as a person consumes more and more apples to satisfy their hunger, total utility increases but the marginal utility gained from consuming each extra apple decreases. ✚ If monetary values were assigned to marginal utility then it is clear that a rational consumer would be prepared to pay less for each additional apple. This principle 26 provides the basis for the quantity demanded increasing as price falls. Copyright: Sample material Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_02_MRN_EdA_Ec3_024-048.indd 26 12/2/20 3:41 PM  Now test yourself 4 Suppose someone has six ice creams. What happens to marginal utility as each extra ice cream is consumed? 2 How markets work Answers available online Price elasticity of demand Price elasticity of demand (PED) is a measure of the responsiveness of quantity demanded of a product to a change in its price. Price elasticity of demand measures the sensitivity of the quantity Making links demanded of a product to a In exams, price elasticity of demand and price elasticity of supply (see pages 37–39) change in its own price. may need to be considered together, for example, when considering the impact of a tax or subsidy (see pages 43–45) or when considering consumers’ surplus and producers’ surplus (see Pages 42–43). Measuring price elasticity of demand percentage change in quantity demanded PED = percentage change in price Exam tip To calculate a percentage change in, say, quantity demanded, it is necessary to divide the change in quantity demanded by the original quantity demanded and multiply the result by 100. Calculations of PED and interpretation of results PED will always have a negative value because price and quantity move in opposite directions (since the demand curve is downward sloping). Example Price inelastic demand Suppose a 100% increase in the price of oil led to a 20% fall in quantity demanded, then PED would be: –20 = –0.2 100 Exam tip Demand is said to be price inelastic (or relatively price inelastic) because a change in When required to calculate price has led to a smaller percentage change in quantity demanded. PED in the exam, remember When demand is price inelastic, the value of PED will be between 0 and –1. to include the negative sign. Now test yourself 5 Calculate the PED if a 20% fall in the price of petrol leads to a 2% increase in the quantity demanded. 6 Is demand price elastic if a 20% increase in price results in a 10% fall in quantity demanded? Answers available online 27 Copyright: Sample material Edexcel A-level Economics Third Edition Progress Geo KS3_8072.indb 4 8/24/18 5:23 PM 311923_02_MRN_EdA_Ec3_024-048.indd 27 12/2/20 3:41 PM  Exam tip When considering whether demand is price elastic or price inelastic, compare the percentage changes in price and quantity. If the percentage change in 2 How markets work quantity demanded is larger than the percentage price change, then demand is price elastic. Example Price elastic demand Suppose a 5% decrease in the price of a package holiday to Florida led to a 20% increase in quantity demanded, then PED would be: +20 = –4.0 –5