Unit one definitions (SL).

Ad valorem tax.
Tax set as a percentage of the price of a good. It will cause the supply curve to diverge.
Example: usually used as a property tax.

Allocation of resources
How resources are distributed in an economy. The assignment of resources (land, labour,
capital and management) to various uses. Resources can be allocated by various means, such
as through the market mechanism or by the government.

Re-allocation of resources
How resources are redistributed in an economy. The reassignment of resources (land, labour,
capital and management) to various uses. Resources can be reallocated by various means,
such as through the market mechanism or by the government.

Average cost
Total cost/output

Average revenue
Total revenue/output

Common access resources

Rivalrous but not excludable. Natural resources over which there is no established private
ownership. They are owned by no one, thus available to anyone to use; this give rise to over
use and therefore destruction: the tragedy of the commons. Examples include fishing grounds
in open seas, forests/jungle, clean air, lakes, rivers, open grazing ground, the ozone layer and
many more.

Community surplus
Community surplus = consumer surplus + producer surplus.
The welfare of society is maximised at this point, which is also known as allocative
efficiency. There is no other combination of price and quantity that could give a greater
community surplus.

Consumer surplus
Consumer surplus is the difference between what consumers are willing to pay (shown by the
demand curve) and the market price. Changes when supply or demand changes.

Complementary goods
Goods that are demanded together. Example: Tennis racket and tennis balls. They have a
negative cross elasticity of demand.

Cross elasticities of demand:

XED measures the responsiveness of quantity demanded for product X to a change in price of
product Y. Formula:
% change in QD of X
% change in price of Y

1
Goods with a positive cross elasticity are substitutes (BIS and ISHMC).
Goods with a negative cross elasticity are complements (broadband and digital downloads).

Demand
The quantity of a good or service that consumers are willing and able to buy at each possible
price.

Demerit Goods
Goods whose consumption creates external costs. Goods that society believes brings lower
than expected benefits to consumers. Demerit goods are over consumed in a free market and
therefore cause market failure. For example, cigarettes.

Derived demand
Many goods and services are demanded only because they are used in the production of other
goods. Labour is derived demand.

Elastic demand
A % change in price leads to a greater % change in quantity demanded.

Elastic supply
A % change in price leads to a greater % change in quantity supplied.

Equilibrium
The point at which demand and supply intersect and therefore market price and quantity are
set.

Equilibrium Price
The price at which quantity demanded equals quantity supplied, often called the market
clearing price.

Excess demand
Excess demand occurs when a maximum price is set below the equilibrium price. More will
be demanded at the lower price and less will be supplied, therefore excess demand occurs.

Excess supply
Excess supply occurs when a minimum price is set above the equilibrium price. More will be
supplied at the higher price and less will be demanded, therefore excess supply occurs.

Free Good
Goods which are unlimited in supply and have no opportunity cost. Example – air.

Free market economy

In a free market economy resources are allocated by the price mechanism. There is little/no
government intervention. Resources are privately owned – land, factories, labour time etc.

Free rider problem

Once a good is supplied by one individual/firm, it is impossible (or very expensive) to
prevent people who have not paid for it from consuming it

2
Government failure
When government intervention in a market leads to a net welfare loss (a more inefficient
allocation of resources).

3
Income elasticity of demand
YED measure the responsiveness of demand for a product to a change in consumers’ income.
It measures the willingness and ability to purchase goods.
Formula:
% change in QD
% change in income

Indirect tax
An indirect tax is a tax on expenditure. It increases the cost of production and therefore
causes a leftwards shift in the supply curve. Example – tax on cigarettes

Inelastic demand
A % change in price leads to a smaller % change in quantity demanded. Example – oil.

Inelastic supply
A % change in price leads to a smaller % change in quantity supplied. Example – agricultural
goods.

Inferior goods
Goods with a negative Income Elasticity of Demand. As income rises demand falls. As
income falls demand rises. Example – public transport (inferior to car ownership)

Marginal cost
The addition to cost of the production of one extra unit of output. Change in cost/change in
output.

Marginal revenue
The addition to revenue of the sale of one extra unit of output. Change in revenue/change in
output.

Market
Any situation where buyers and sellers are brought together

Market Economy
An economy where resource allocation is determined by the market forces of demand and
supply.

Market share
The percentage of sales in a market that a firm has.

Maximum Price/Price Ceiling

The price of a good or service cannot rise above this limit. It is usually set below the
equilibrium. It is imposed by a government or other authority. Causes excess demand.
Example – in Ireland in 2016, the government introduced a rent cap in parts of Dublin which
restricted the amount landlords could charge.

Merit goods

4
Goods that society believes bring unanticipated benefits to the consumer. An individual does
not fully appreciate/is not fully aware of the benefits that they will gain from consuming such
goods and therefore they are under consumed in a free market. Example – healthcare.

5
Minimum price/Price floor
The price of a good or service cannot fall below this limit. It is usually set above the
equilibrium. It is imposed by a government or other authority. Causes excess supply.
Example- the EU in the 1980’s set a minimum price for milk. They also guaranteed that they
would buy up any excess produced by farmers.

Minimum wage
A wage set by the government below which employers must not pay their workers.

Mixed economy
A mixed economy is one in which there is both a private sector (in which resources are
allocated by the price mechanism) and a public sector (in which resources are allocated by
the state/government)

Non excludable
It is impossible (or financially prohibitive) to exclude people who do not pay for a service
from using the service. Example – lighthouse.

Non rivalry
Consumption by one individual does not reduce the amount available (or ability) for other
individuals to consume e.g. street lighting

Normal goods
Goods with a positive Income Elasticity of Demand. As incomes rise, so does demand. As
incomes fall, so does demand. Example – most cars.

Opportunity cost
Opportunity cost is the next best alternative forgone when making a decision.

Planned/command economy
In a planned economy resources are allocated by the state/government. There is little/no role
for the price mechanism. Resources are state owned – land, factories etc

Per unit tax/specific tax

A fixed tax per unit.

Positive externalities
Exists when the social benefit of an action is greater than the private benefits.

PPF
PPF refers to the maximum output of two or more products that a country can produce if they
use all their resources.

Price Elastic
Where a change in price of a good or service leads to a proportionally greater change in
quantity demanded. The absolute value of PED is greater than 1.

Price Inelastic
Where a change in price of a good or service leads to a proportionally smaller change in
quantity demanded. The absolute value of PED is less than 1.

6
7
Price elasticity of demand
PED measures the responsiveness of quantity demanded for a product to a change in price.
Formula:
% change in QD
% change in price

Price elasticity of supply

PES measures the responsiveness of quantity supplied of a product to a change in price:
Formula:
% change in QS
% change in price
Price mechanism
The interaction between demand and supply which sets price in a free market.

Price controls
Government attempts to control the price mechanism in order to enforce a desirable price
(max price below equilibrium or min price above equilibrium).

Price floor
A price set by the government above the equilibrium price below which a good/service cannot be sold.

Producer surplus
A producer surplus is the difference between the market price and the price at which
producers are willing to supply at (shown by the supply curve). Changes when supply or
demand changes.

Public goods.
Public goods are non rivalous and non excludable and therefore suffer from the free rider
problem. Therefore, they would not be provided at all by the market and thus market failure
occurs. Example- street lighting: one person’s consumption of street lighting doesn’t stop
other people using it (non rivalous) and you can stop people using it (non excludable).

Rationing
A function of the price mechanism. A way that scarce goods can be allocated.

Scarcity
The basic economic problem that arises because people have unlimited wants but resources
are limited.

Specific Tax
Specific tax is a fixed charge imposed per unit of good sold. It is paid by the producer. It is a
tax placed on the expenditure on the good. Example – in the US, federal excise taxes on
petrol is the same for each litre of petrol sold.

Subsidy
A subsidy is a sum of money paid by government to a firm per unit of output to lower their
cost of production and encourage output. Example – the EU’s CAP scheme (common
agricultural policy), guarantees farmers receive a subsidy of $85 per acre per year.

8
Substitute goods
Goods which can be purchased instead of each other. Example: butter and margarine. They
have a positive cross elasticity of demand.

Supply
The quantities of a product firms are willing and able to sell at each price (in a given time
period, cet.par.)

Sustainability
The idea we can provide for our own needs in the present (by exploiting resources) whilst
still leaving resources for future generations to provide for their needs.

Total Revenue
Price X quantity sold

Tradable permits
Permits to pollute are allocated to firms in an industry, and if they produce less pollution than
their limit they are able to sell their surplus permits to those who pollute more than their limit.

Wages
Payments made to the factor of production - labour

The economic problem

The economic problem is that resources are scarce and wants are infinite. Therefore, choices
have to be made as to how these resources are allocated.

9
Externalities:
An externality occurs when the production or consumption of a good has an effect on a third
party (those not involved in the purchase transaction i.e. buyer and seller).
Negative externalities
The bad effects that are suffered by a third party when a good or service is produced or
consumed.
Private costs of production:
These are costs paid by a firm producing a good i.e. for labour and raw materials etc.
Private costs of consumption:
The money paid for the purchase of a good.
External costs of production:
These are costs to those other than the producer. For example, pollution from the production
of paint. The paint manufacturer does not pay for any air pollution they cause. Therefore,
they can charge a lower price.
Negative externalities of consumption (demerit goods)
Goods whose consumption creates external costs. Goods that society believes brings lower
than expected benefits to consumers. Demerit goods are over consumed in a free market and
therefore cause market failure. Example- cigarettes. Passive smoking can cause cancer.
Negative externalities of production
This is where production causes external costs that are not paid by the firm (usually
pollution). This allows the firm to charge a lower price and therefore more is demanded.
Example- an oil company in Vietnam that polluted the fishing grounds near Nha Trang.
Positive externalities of production
These occur when the production of a good creates external benefits for third parties. For
example, a firm may have an excellent training provision for its employees. When employees
leave the company they take that training to other companies. This benefits the other
companies (positive externality). Therefore, the social cost of training is less than the private
cost.
Positive externalities of consumption (merit goods)
Examples of merit goods: education and heanthcare
External costs of consumption:
Costs borne by people other than the consumer of a good. Example- passive smoking
Private Costs + External Costs = Social Costs
Social costs are the costs to society from the production or consumption of a good.
Marginal Social Cost
The cost to society of producing/consuming one more unit of a good
Private benefits of production:
Sales revenue to the firm from selling a good.
Private benefits of consumption:
Benefit to consumer from consuming a good.

10
Positive externalities of production:
When the production of a good causes benefits to third parties i.e. firm producing good trains
workers who, in time, work for other firms who benefit from their training
Positive externalities of consumption:
When the consumption of a good benefits third parties. Example- vaccinations benefit those
vaccinated and also other people who will not now catch the disease from the vaccinated
person.
Private Benefits + External Benefits = Social Benefit
Marginal Social Benefit:
The benefit to society of producing/consuming one more unit of a good

11
 Unit one definitions (HL)
Abnormal profits
Average revenue greater than average cost. Total revenue greater than Economic Costs
(explicit and implicit costs)

Accounting profit
Total Revenue – Total cost, where total costs are the explicit costs.

Adverse selection
Occurs when buyers or sellers have asymmetric information and one party takes advantage of
the knowledge or asymmetric information PRIOR to the transaction. Often, sellers face
exactly the buyers they don’t want. Example- people with poor health are more likely to take
out life insurance (the insurance company may not be fully aware of their health condition).

Allocative efficiency
P=MC. A market is allocatively efficient when it delivers the goods required by consumer in
the correct amount. Resources are allocated in the most efficient way and therefore
community surplus is maximised.

Asymmetric information
Asymmetric information is present whenever one party to an economic transaction possesses
greater material knowledge than the other party (normally manifests seller has greater
knowledge than the buyer) leading to market failure. Moral hazard and adverse selection
cause asymmetric information.

Average cost
Total cost divided by the number of outputs produced: TC
Q
Average product
The total output per unit of variable factor being considered (e.g. no of tables per employee)

Average variable cost

The variable cost of one unit of output. Total variable cost divided by total units of output.

Barriers to entry
Factors that make it difficult for a firm to enter a market. Include; economies of scale,
branding and legal barriers.

Barriers to exit
Factors that make it difficult for a firm to leave a market i.e. sunk costs e.g. marketing,
specialist machinery with no resale value etc. Decreases contestability.

Break even level of output

The level of output where total revenue equals total costs.

Cartel
A formal (written or spoken) agreement between firms to fix prices or output.

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Collusion
Firms acting together to reduce consumer welfare e.g. restrict supply, raise prices. Collusive
practices: allocation of market share, exclusive dealing, limit ad expenditure.

Collusive oligopoly
Where a few firms act together to avoid competition by agreeing to fix prices or output.

Concentration ratio
The amount of market share held by the top n firms – measure of market dominance. The
higher the percentage the higher the concentration. If the data is given, work out the
concentration ratio.

Demand function
Represents demand as a function of price. Qd = a - bP
Increase a = curve shifts to right
Decrease a = curve shifts to left
Increase b = curve becomes shallower
Decrease b = curve becomes steeper

Diminishing returns
When increasing variable inputs (usually labour) are added to a process that has a fixed input
(usually capital), at some point the additions to output from the extra input will decrease.
Diminishing returns is a short term concept. Affect on MC…… because inputs cost, as the
amount of inputs to produce the same amount of outputs increase when diminishing returns
sets in, so the marginal cost of producing an extra unit of output must increase

Diseconomies of Scale
Factors that cause an increase in unit costs as output rises above a certain level i.e.
bureaucracy

Diversification
Widening the product range outside current areas of specialism.

Economic cost
The cost of all the resources employed by a firm, including entrepreneurship (implicit and
explicit costs).

Economic profit
Total Revenue – Total Costs, where Total Costs are the explicit and implicit costs.

Economies of scale
Factors that cause a fall in long run unit costs as a result of a firm increasing its scale of
operations.

Explicit costs
The cost of items a firm has to buy in.

Formal collusion
This is where firms openly agree to set prices or output or market share or agree market
expenditure between themselves.

13
Fixed cost (FC)
Short run concept. Costs which do not change when the level of output changes e.g. rent.

14
Game Theory
Game theory illustrates that firms sometimes collude (tacitly) to end up in a position where
joint profits are maximised. However, this is not a stable position. From this position either
firm could decrease their price/increase output and gain higher profits at the expense of the
other firm in the short term. The tacit collusion has broken down and we tend to end up at
the Nash Equilibrium where both firms pursue the dominant strategy. Put another way, firms
engage in a price war and end up in the worst quadrant.

Implicit costs
The opportunity cost of the entrepreneur – what else could the entrepreneur have done.

Limit pricing
Setting price just below the predicted average cost of production of a new entrant, therefore
not allowing new entrant to make a profit. Prohibits market entry.

Long run
When all factors of production are free to vary.

Marginal cost
The extra cost of producing one more unit of output: change in cost
change in output
Marginal product
The additional output gained by the employment of one more unit of variable factor (e.g. the
additional output from one extra worker)

Marginal profit
The addition to total profit from one more unit of output sold.

Marginal revenue
The additional revenue gained for the sale of one extra unit of output: change in revenue
change in output

Minimum Efficient Scale

The level of output where the lowest unit cost of production starts.

Monopolistic competition
Many firms, producers have a little price making ability, no/low barriers to entry or exit
therefore SNP competed away in long run – only normal profit in long run, differentiated
product. Example: Hairdresser, fast food companies.

Monopoly
One firm. Unique product. Price maker. Significant barriers to entry and exit. Abnormal
profits possible in the long term. Example- state electrical utility.

Monopoly power
The ability of a firm to decrease supply to raise price.

Moral Hazard

15
This reflects on the immoral behavior of a party with asymmetric information subsequent to
a transaction. It occurs when a party provides misleading information and changes his/her
behavior when s/he does not have to face consequences of the risk s/he takes. Example-
person behaves recklessly after they take out health insurance.

Natural monopoly
Where a firm which has all the sales in the market has not reached the Minimum Efficiency
Scale (economies of scale are so substantial that they are not exhausted even when there is
only one firm in the industry). Average costs decreases through the whole output range. 2
producers would lead to higher unit cost. Example- state electrical utility.

Non pricing strategies

Advertising, increased quality, innovation, loyalty schemes, competitions, free offers, free
trials, increases in efficiency of service etc

Normal profit (opportunity cost profit)

Earning sufficient profit to keep a firm’s factors of production in their current use. Economic
profit is zero.

Oligopoly
Few firms, differentiated and/or branded product, high barriers to entry and exit, SNP in long
run.

Perfect competition
Many buyers and sellers, producers are price takers, no barriers to entry or exit – SNP
competed away in long run, homogeneous products, consumers have perfect knowledge of all
prices charged, producers have perfect knowledge of all production processes, AR=MR. Best
example- wheat.

Predatory pricing.
When a firm sets its price below its average cost to drive another firm out of the market.

Price discrimination
When different prices are charged for the same good/service for reasons not associated with
the cost of production.

Price discrimination conditions

Conditions necessary for price discrimination are; a firm must have some market power
(price maker), markets must be separable, buyers in different markets must have different
elasticities of demand, no arbitrage/leakage possible, the cost of separating markets must be
low.

Product Differentiation
Where a producer deliberately attempts to distinguish a product from those of its competitors,
often through branding, packaging or other marketing methods.

16
Productive efficiency
This exists when production occurs at the lowest possible cost per unit of output.
Producing at the lowest point of the Long Run Average Total Cost Curve (LRATCC).
Technical efficiency is necessary for productive efficiency to be reached.

17
Productive inefficiency
Not producing at the lowest point of the LRATCC.

Profit maximisation
MR = MC. Marginal profit is 0.

Property rights
Confers legal control or ownership of a good. If an asset is unowned no one has an economic
incentive to protect it from abuse. This can lead to the over use of common land, over fishing
etc

Pure Monopoly
When one firm supplies a market. It has 100% market share

Revenue maximisation
MR = 0. TR is at its height. Adding/taking away one unit of output will decrease revenue.

Regulations/legislation:
A law passed by government which firms must abide by.

Sales volume maximisation

The maximum level of sales a firm can make without making a loss i.e. where AR=AC

Satisfying
Managers (who run the firm) return just enough profit to shareholders (who own the firm) to
keep them happy. Managers then run the firm as they want.

Short run
Any period of time where at least one factor of production is fixed. Diminishing returns occur
in the short run.

Sunk costs
Costs which can not be retrieved when exiting a market e.g. marketing costs, non resale
machinery. Existence decreases contestability.

Supply function
Represents supply as a function of price. Qs = c - dP
Increase c = curve shifts to right
Decrease c = curve shifts to left
Increase d = curve becomes shallower (more elastic)
Decrease d = curve becomes steeper (more inelastic)

Supply function

Tacit collusion
This is where firms don’t formally agree price and output. However, they collude through
things such as price leadership.

Total cost

18
 The total cost (fixed and variable) of producing a certain quantity of outputs.

Total (physical) product

The total quantity of outputs produced over a period of time from a given quantity of inputs

Total revenue
The amount of revenue received from all products sold.

Variable costs
Costs which change when output changes e.g. raw materials.

Welfare loss
The loss of consumer plus producer surplus in imperfect markets

Economies of scale/increasing returns to scale

Long run concept. Factors that cause a decrease in unit costs as output increases e.g. managerial
and technical

Constant economies of scale/constant returns to scale.

Long run concept. A constant unit costs as output increases.

Diseconomies of scale/decreasing returns to scale.

Long run concept. Factors that cause an increase in unit costs as output increases past a certain
point e.g. bureaucracy.

Increasing returns
Short run concept. When an (one) additional variable input is added to a production process where
one factor or production is fixed and it results in greater marginal product. Causes MC to decrease.

Diminishing returns
Short run concept. When an additional variable factor is added to a production process where one
factor is fixed, there comes a point when the extra variable factor added will lead to a decreasing
amount of additional output. Causes MC to increase.

19
 Paper 1 command words (Unit 1 & 2)
10 mark questions
10 mark questions will nearly always have the command word ‘explain’ or ‘analyse’.

You may be asked to ‘distinguish’ and this requires you to “Make clear the differences
between two or more concepts or items.”

15 mark questions
15 mark questions will usually have one of the following command words:

 Evaluate
 Discuss
 Examine
Answer in the usual evaluative manner.

 To what extent
When writing a “to what extent” answer, you must:
- consider the merits or otherwise of an argument or concept
- have a concluding paragraph that addresses........ to what extent

 Justify
When writing a “justify” answer, you must:
- Give valid reasons or evidence to support an answer or conclusion.
- have a concluding paragraph that justifies your answer

 Compare and contrast

Give an account of similarities and differences between two (or more) items or situations,
referring to both (all) of them throughout.

 Contrast
Give an account of the differences between two (or more) items or situations, referring to
both (all) of them throughout.

 Compare
Give an account of the similarities between two (or more) items or situations, referring to
both (all) of them throughout.

Use of examples
Examiners’ guidance:
“Students are expected, where appropriate, to illustrate their answers with examples in order
to reach the highest markbands. Examples should be used to highlight economic concepts,
theories and relationships in the real world. When examples are used, students should not just
state the example (as this is too limited), but should also offer some explanation of the
example in relation to the question asked.”

20
 What it takes to get 9/10 marks in 10 mark questions
There is clear understanding of the specific demands of the question.
Relevant economic terms are clearly defined.
Relevant economic theory is clearly explained and applied.
Where appropriate, diagrams are included and applied effectively.
Where appropriate, examples are used effectively.
There are no significant errors.

Structure:

Definition
3 paragraphs addressing the questions

What it takes to get 13/15 marks in 15 mark questions

There is clear understanding of the specific demands of the question.
Relevant economic terms are clearly defined.
Relevant economic theory is clearly explained and applied.
Where appropriate, diagrams are included and applied effectively.
Where appropriate, examples are used effectively.
There is evidence of appropriate synthesis or evaluation.
There are no significant errors.

Structure:

Definition
3 paragraphs addressing the questions
3 pieces of evaluation

21
 Standard Level
Scarcity
The basic economic problem that arises because
people have unlimited wants but resources are
limited.
Opportunity cost
The next best alternative given up when making a
decision.
Sustainable development
Economic growth which allows an economy to
meet the needs of the present generation, whilst
ensuring that there are enough resources to meet
the needs of future generations. Economic growth
that relies on non renewable resources or depletes
renewable resources too quickly is therefore not
sustainable development.
Production possibility frontier
The PPF shows the maximum potential output of two
or more goods or services that can be produced by an
economy if all resources are used efficiently.
Why is the PPF Curved?
To illustrate that resources are not equally efficient in
all uses. If a country produces bread and guns, as it
produces more and more guns the resources used for
producing bread will have to be turned over to
producing guns (at which they will be less efficient)
and there will be a decreasing amount of guns produced
for every loaf of bread given up. The closer a country
comes to producing only guns the greater opportunity
cost becomes.
Shifts in demand
These are the non-price determinants of demand:
1. Income
2. Prices of related goods (complements and
substitutes)
3. Tastes
4. Demographic changes
2. Prices of related goods (complements)
Goods that are demanded together. Example:
Tennis racket and tennis balls. As the price of one
rises the demand for the other falls.
Basic Economic Problem
We have infinite wants but only finite (non-renewable)
resources to meet our desires. Because of this we have to
make choices.
Free Good
Goods which are unlimited in supply and have no
opportunity cost.
The need for sustainable development has let to:
1. Conservation of resources
2. Greater efficiency in the use of resources.
3. Greater emphasis on using renewable resources instead
of non renewable i.e. development of substitutes
PPFs demonstrate the concept of choice and opportunity cost
— the cost of the next best alternative foregone. If we choose
to produce three more cows it incurs an opportunity cost of six
tonnes of wheat, i.e. we have had to give up some wheat
production if we choose to produce more cows because of our
limited resources.
Law of demand
As price rises less is demanded and vice versa.
An extension in demand for a product is a rise in
demand caused by a fall in its price. A movement down
the demand curve.
A contraction in demand results from a rise in the price
of the product. This is referred to as a decrease in the
quantity demanded. A movement up the demand curve.
Price is the only thing that causes a movement up or
down the demand curve.
1. Income
As income rises the demand for normal goods rises and
vice versa.
As income rises the demand for inferior goods falls and
vice versa.
2. Prices of related goods (substitutes)
Goods that are substitutes for each other. Example: butter
and margarine. As the price of one rises the demand for
the other falls.
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3. Changes in Tastes and Fashions
(preferences):
Over time the demand for goods such as flared
trousers and wigs changes, as these items go in and
out of fashion.
Derived Demand
Goods/services demanded because they are needed The quantities of a product firms are willing and able to
for the production of other goods/services (labour sell at each price.
is derived demand)
An extension in supply – an increase in the
amount supplied caused by an increase in price. A These are the non-price determinants of supply:
movement up the supply curve.
A contraction in supply – a decrease in the
amount supplied caused by a decrease in price. A
movement down the supply curve.
A change in price is the only thing that causes
an movement up or down the supply curve.
1. Costs
Costs increase – supply curve shifts to left –
supply decreases.
Costs decrease – supply curve shifts to right –
supply increases.
3. The prices of other possible outputs
Changes in the prices of some goods can affect the
supply of other goods - if the price of beef
increases significantly there will be an increase in
the quantity supplied. More cows will be bred and
slaughtered. As a result, there will also be an
increase in supply of leather. This is known as
joint supply
5. Subsidies
Subsidies increase - costs decrease – supply curve
shifts to right – supply increases.
Subsidies decrease - costs increase – supply curve
shifts to left – supply decreases.
Equilibrium
The point at which demand and supply intersect
and therefore market price and quantity are set.
4. Demographic changes:
Changes in the following will change the demand for
products:
a. Size of the population:
b. Changes in the Structure of the Population:
c. Changes in income distribution
Supply
Shifts in supply
1.Costs
2. Improvements in technology
3. The prices of other possible outputs
4. Indirect taxes
5. Subsidies
6. Expectations
2. Improvements in technology
Means that more can be produced therefore supply
increases.
4. Indirect taxes
Indirect tax increases - costs increase – supply curve
shifts to left – supply decreases.
Indirect tax decreases - costs decrease – supply curve
shifts to right – supply increases.
6. Expectations
In general, if a firm expects lower prices for their goods
in the future they will reduce production, and if they
expect higher prices in the future they will expand
production.
Excess demand
Excess demand occurs when a maximum price is set
below the equilibrium price. More will be demanded at
the lower price and less will be supplied, therefore excess
demand occurs.
Excess supply
Excess supply occurs when a minimum price is set above
the equilibrium price. More will be supplied at the higher
price and less will be demanded, therefore excess supply
occurs.
23
 Consumer surplus
Consumer surplus is the difference between what
consumers are willing to pay (shown by the
demand curve) and the market price.
Demand/supply increases – consumer and
producer surplus increases.
Demand/supply decreases – consumer and
producer surplus decreases.
Allocative efficiency - a market produces a good
where the Marginal Benefit (Demand Curve) of
the good is equal to the Marginal Cost (Cost
Curve). At this point we can say that the good is
being produced in the right quantity (consumers
are getting what they desire in the right quantity).
Price has 2 important functions:
1. Signalling
Price signals what is available, giving information
which allows all traders to coordinate their
economic activities.
2. Providing incentives
Price creates incentive for buyers and sellers.
Rising prices act as an incentive for producers to
supply more since production will be more
profitable. Rising prices act as a disincentive for
consumers to purchase.
Signalling, incentive and re/allocating in
practice
Demand increases from D to D1, therefore price
increases from P to P1 and this sends a signal and
an incentive to producers to produce more (from Q
to Q1). Producers will produce more at the higher
price as they can make more profit. More
resources are reallocated from other markets to
this market (land, labour, capital and management)
as there are higher rewards available. An example
or this is when a government sets a floor price for
an agricultural good that is above the equilibrium
price.
Why the PED figure is always negative:
The price elasticity of demand is a negative figure
because as prices rise, demand falls and vice versa.
There is an inverse relationship – the Law of
Producer surplus
Producer surplus is the price a firm receives for their
products above that which they are prepared to accept for
that product. Area between demand curve and
equilibrium price.
Community surplus
Community surplus = consumer surplus + producer
surplus. The welfare of society is maximised at this point,
which is also known as allocative efficiency. There is no
other combination of price and quantity that could give a
greater community surplus.
Allocation of resources
How resources are distributed in an economy. The
assignment of resources (land, labour, capital and
management) to various uses. Resources can be allocated
by various means, such as through the market mechanism
or by the government.
Re-allocation of resources
How resources are redistributed in an economy. The
reassignment of resources (land, labour, capital and
management) to various uses. Resources can be
reallocated by various means, such as through the market
mechanism or by the government.
Price elasticity of demand
Measure the responsiveness of demand to a change in
price.
Types of PED
1. Perfectly inelastic demand
2. Inelastic demand
3. Unitary elastic demand
4. Elastic demand
5. Perfectly elastic demand
Limitation of using PED to predict changes in sales
revenue.
 The PED changes constantly…
so even if it a calculated as being inelastic, this might
24
Demand. change in the near future
 Price is not the only thing that will affect sales
revenue
A firm with an inelastic product might expect sales
revenue to rise after it increases price. However, if the
economy enters a recession (and incomes falls) then its
sales revenue may well fall.

1. Perfectly inelastic demand 2. Inelastic demand

Definition: A percentage in price leads to no Definition: A percentage change in price leads to a
change in quantity demanded. smaller change in quantity demanded
PED: 0 PED: <1
Example diagram: pp dd Example diagram:

qq
3. Unitary elastic demand 4. Elastic demand
Definition: A percentage change in price leads to Definition: A percentage in price leads to a greater
the same percentage in quantity demanded. percentage in quantity demand
PED: 1 PED: >1
Example diagram: p Example diagram:
d d
p

q
q

5. Perfectly elastic demand Price elasticity of demand and sales revenue

Definition: A percentage change in price leads to Good with price inelastic demand:
an infinite change in quantity demanded. - an increase in price will increase sales revenue
PED: infinite p - a decrease in price will decrease sales revenue
Example diagram: d Good with price elastic demand:
- an increase in price will decrease sales revenue
q - a decrease in price will increase sales revenue
While PED is important for decision making for a firm
other factors affect decision making e.g. competition,
state of economy etc.
Governments impose indirect tax on inelastic goods in
order to raise lots of tax revenue.

What affects the price elasticity of demand? Why does the elasticity of demand change along a
1. Number of substitutes; if many substitutes linear demand curve?
good likely to be elastic in demand, if few For a linear demand curve the price elasticity of demand
substitutes or none good likely to be inelastic varies along each and every part of the demand curve.

25
2. Necessity or luxury; if good is a necessity then PED is not represented by the slope of the demand
likely to be inelastic in demand, if luxury then curve.
likely to be elastic The gradient of a linear demand curve is constant along
3. Proportion of income: if good takes low the curve. However, the rates of change of price and
proportion of income then more likely to be quantity are not constant. As price increases, the %
inelastic (change in price hardly noticed), if good
change in price diminishes while the % change in
takes high proportion of income then more likely
to be elastic in demand quantity demanded increases.
4. Time. In the short run, goods and more inelastic
in demand. If a good’s price rises demand may not
fall too much in the short run as it takes time for
consumers to find substitutes, therefore the good
will be inelastic in demand. In the longer run,
consumers will find substitutes and demand for the
good will be more elastic.

Examples of PED in action: Price elasticity of supply

In Vietnam when it is wet, the demand for taxis Measure the sensitivity of supply to a change in price.
becomes inelastic d therefore UBER increases its Formula:
fares (surge charges). In the middle of the day % change in Quantity Supplied
during the week in fine weather the demand for % change in Price
taxis is elastic and UBER’s fare are much lower.
Types of PES
1. Perfectly inelastic supply
2. Inelastic supply
3. Unitary elastic supply
4. Elastic supply
5. Perfectly elastic supply
Perfectly inelastic supply Inelastic supply
Definition: A percentage in price leads to no Definition: A percentage change in price leads to a
change in quantity supplied. smaller change in quantity supplied
PES: 0 PES: <1
Example diagram: Example diagram:
p s
p s
q
q

Unitary elastic supply Elastic supply

Definition: A percentage change in price leads to Definition: A percentage in price leads to a greater
the same percentage change in quantity supplied. percentage change in quantity supplied
PES: 1 PES: >1
Example diagram: pp s Example diagram:
s

qq

Perfectly elastic supply What determines the elasticity of supply?

Definition: A percentage change in price leads to 1. Time. Primary sector goods take time to extract/grow

26
an infinite change in quantity supplied. therefore in the short run they are likely to be inelastic in
PES: infinite p supply. In the long run they are likely to be more elastic
Example diagram: s in supply. Secondary sector goods are likely to be elastic
in supply in the short and long run.
q 2. Availability of Producer Substitutes
If a good has a lot of producer substitutes supply will be
more elastic. In other words, the resources are used for a
number of different purposes. If the price of one product
rises, resources can be moved from making one product
to making the one in which price has risen.
3. Its ability to be stored: If a good can easily be stored
(it’s not perishable) then the producer can wait until
prices rise to release their good on to the market. This
makes the good more elastic in supply
4. The level of capacity in the industry: If there is spare
capacity supply will be more elastic.
Income elasticities of demand Types of income elasticities of demand
Measures the sensitivity of demand to a change in 1. Income inelastic demand
income. Formula: 2. Income elastic demand
% change in quantity demanded
% change in income

1. Income inelastic demand 2. Income elastic demand

Definition: A % change in income leads to a Definition: A % change in income leads to a greater
smaller % change in quantity demanded. Normal change in quantity demanded. Normal good that is a
good. luxury.
Numerical value: <1 Numerical value: >1
Example diagram: Y
d Example diagram:
Y d

q
q

Normal goods Inferior good

Normal goods that have a positive income Inferior goods have a negative income elasticity of
elasticity of demand. If incomes rise the demand demand. If incomes rise the demand for these goods will
for these goods will rise as households are more decrease (and vice versa).
willing and able to purchase goods (and vice
versa). If incomes rise and the demand for a good
rise by a greater percentage then it is a normal
good that is a luxury.

Income elasticities and the trade cycle Factors affecting income elasticities of demand
Income elastic goods (luxury) sell very well in a 1. Necessities. These are basic goods that need to be
Boom when incomes are rising fast. However, they purchased. If income change, there will be a smaller

27
sell poorly in a Recession when income may be
decreasing.
Negative income elasticity goods (inferior) sell
better in a Recession when incomes may be
decreasing and they sell poorly in a Boom.
change in the demand for these goods.
2. Luxuries. Spending on these is discretionary.
Therefore, if incomes change the demand for these goods
will change be a greater amount.

Summary: Income elasticities and firms

Type of YED Value 1. Production planning. If a firm has an income elastic
Normal good 0 to +1 (income good they can expect to see a large increase in demand it
inelastic) the economy is entering a boom, therefore they should
Normal good that is a 1+ (income elastic) plan for expansion (or contraction if entering a slump).
luxury 2. Product switching. Some firms have flexible factors of
Inferior good - production and may move production from an income
inelastic good to income elastic good when the economy
is moving into a boom.

Primary goods usually have a low YED (inelastic), Cross elasticities of demand:
manufactured goods have a higher YED and XED measures the responsiveness of quantity demanded
services can normally be said to have an even for product X to a change in price of product Y. Formula:
higher YED (elastic).
% change in QD of X
% change in price of Y

Goods with a positive cross elasticity are substitutes (BIS

and ISHMC).
Goods with a negative cross elasticity are complements
(Broadband and digital downloads).

Positive Cross Elasticity Negative Cross Elasticity

If the two goods are substitutes the answer will always If, however the two goods are complements, for example cars
be positive as the rise in price of one causes a rise in and petrol, then a rise in price of one will cause a fall in
demand for the other. demand for the other; i.e. a negative cross elasticity.
P d
p d
q
q
Zero Cross Elasticity Uses of XED
Unrelated products have zero cross elasticity. For Useful for a firm. Firstly, a firm can estimate the implications
example, a rise in the price of cheese is unlikely to have of price changes by
an effect on the demand for bicycles. Products with - Competitors (suppliers of substitutes) and
zero cross elasticity are referred to as independent - suppliers of complements
goods. A firm can therefore plan a reasoned response to any such
p
changes, by either changing price themselves, or by adjusting
production.
d
P1 For example, if a close competitor increases their prices, the
firm can expect increasing demand. A good estimate of XED
p will show them exactly by how much their sales will be
increased; can they cope? Would it be more profitable to
d
increase prices, or to take the extra sales?

28
 Limitation of using XED to predict changes in
sales revenue.
* The XED changes constantly….
so even if it is calculated as being a close
substitute, this might change in the near future (as
more substitutes enter the market)
* Price of a compliment or substitute is not the
only thing that will affect sales revenue
When the price of a substitute decreases a firm
might expect sales revenue to rise for its product.
However, if the economy enters a recession (and
incomes falls) then its sales revenue may well fall.

Indirect Taxation A Specific Tax

An indirect tax is a tax on expenditure. It increases Fixed tax per unit. Such a tax has the effect of shifting the
the cost of production and therefore causes a supply curve up, parallel to the original supply. Example
leftwards shift in the supply curve. Example- tax – in the US, federal excise taxes on petrol is the same for
on cigarettes each litre of petrol sold.
S1
P s

q
Ad valorem tax If demand is inelastic then the consumer will pay the
Tax set as a percentage of the price of a good. It majority if the tax imposed. If demand is elastic, then the
will cause the supply curves to diverge. Example- producer will pay the majority of the tax.
In the UK, VAT (Value Added Tax) is charged at Government tend to tax goods which as highly inelastic
17.5 % such as cigarettes (especially when they are bad for
peoples’ health).
S1
P s

q
Subsidy
A subsidy is a sum of money paid by government to a
firm per unit of output to lower their cost of production
and encourage output. Example – the EU’s CAP scheme
(common agricultural policy), guarantees farmers receive
a subsidy of $85 per acre per year.
Subsidies Government may give subsidies for a number of
If a government subsidises production of a good reasons:
the supply curve shifts outwards because each  To lower the price of essential goods, such as
good now costs less money to produce. Diagram: milk, to consumers.
S  To guarantee the supply of products that the
P S1
government deem as desirable (merit goods etc)
 To enable domestic producers to compete with
q foreign competition, therefore decreasing imports
If demand is inelastic then the producer will keep and protecting domestic employment
most of the subsidy. If demand is elastic then the
producer will pass most of the subsidy onto the

29
consumer.
Drawbacks of subsidies:
- opportunity cost – what else could the
government have spent its money on?
- the domestic consumer must pay for the subsidy
given to producers in the form of higher taxes.
- subsidising exporting firms can be seen as
dumping and may provoke a protective response.
- subsidies decrease the need for producers to be
efficient
Advantages of subsidy to consumers:
-Decreases the price for consumers and increases
the amount they can consume (consumer surplus
increases)
Disadvantages of subsidy to consumers:
-Subsidies given to producers come from taxation
which is mostly paid by domestic consumers.
Therefore subsidies will increase the taxation they
pay
Maximum Price/Price Ceiling
The price of a good or service cannot rise above
this limit. It is usually set below the equilibrium. It
is imposed by a government or other authority.
Causes excess demand. Example – in Ireland in
2016, the government introduced a rent cap in
parts of Dublin which restricted the amount
landlords could charge.
Market Failure
A situation where the market leads to a under
allocation or over allocation of a good.
Private costs of production: these are costs paid
by a firm producing a good i.e. for labour and raw
materials etc.
Private costs of consumption: The money paid
for the purchase of a good.
Advantages of subsidy to producers:
-lowers their cost of production and therefore makes
them more price competitive. Therefore, their demand
will increase.
Disadvantages of subsidy to producers:
-Decreases the necessity for a firm to become cost
efficient. Therefore if and when the subsidy is removed
the firm may find itself unable to compete.
Advantages of subsidy to the government:
-Increases employment in the subsidised industry. Also,
decreases imports/increases exports of the subsidised
good therefore improves B of P.
Disadvantages of subsidy to the government:
-Subsidies are expensive. Opportunity cost of spending
on healthcare/education which would increase the supply
side of the economy.
Minimum price/Price floor
The price of a good or service cannot fall below this
limit. It is usually set above the equilibrium. It is imposed
by a government or other authority. Causes excess
supply. Example- the EU in the 1980’s set a minimum
price for milk. They also guaranteed that they would buy
up any excess produced by farmers.
Excess demand creates problems. The shortages can lead
to:
 the emergence of a black market where the
product is sold at a higher price
 there may be queues outside shops
 seller may decide on other criteria (usually unfair)
than price as a means of allocating the good
Markets fail to provide the correct number of goods
for a number of reasons:
1. Existence of externalities (SL)
2. Lack of public goods (SL)
3. Common access resources and the threat to
sustainability (SL)
External costs of production: these are costs to those
other than the producer. For example, pollution from the
production of paint. The paint manufacturer does not pay
for any air pollution they cause. Therefore, they can
charge a lower price.
External costs of consumption: costs boune by people
other than the consumer of a good i.e. passive smoking
30
Negative externalities of consumption (demerit
goods)
Goods whose consumption creates external costs.
Goods that society believes brings lower than
expected benefits to consumers. Demerit goods are
over consumed in a free market and therefore
cause market failure. Example- cigarettes. Passive
smoking can cause cancer.
Private Costs + External Costs = Social Costs
Social costs are the costs to society from the
production or consumption of a good.
Marginal Social Cost is the cost to society of
producing/consuming one more unit of a good
Positive externalities of production: when the
production of a good causes benefits to third
parties i.e. firm producing good trains workers
who, in time, work for other firms who benefit
from their training.
Private Benefits + External Benefits = Social
Benefit
Demerit Goods
Goods whose consumption creates external costs.
Goods that society believes brings lower than
expected benefits to consumers. Demerit goods are
over consumed in a free market and therefore
cause market failure.
Merit and demerit goods are rivalrous and
excludable (do not confuse with public goods)
How to decrease the negative externalities of
production:
- Taxation
Example- carbon taxes, where producers are taxed
on the amount of carbon they release into the air.
Ireland's carbon tax covers nearly all of the fossil
fuels used by offices, vehicles and farms, based on
each fuel's CO2 emissions.
- Government legislation
For example- the UK’s Clean Air Act aims to
reduce pollution from smoke, grit and dust. It gives
Negative externalities of production
This is where production causes external costs that are
not paid by the firm (usually pollution). This allows the
firm to charge a lower price and therefore more is
demanded. Example- an oil company in Vietnam that
polluted the fishing grounds near Nha Trang.
Private benefits of production: sales revenue to the firm
from selling a good.
Private benefits of consumption: benefit to consumer
from consuming a good.
Positive externalities of consumption: when the
consumption of a good benefits third parties i.e.
vaccinations benefit those vaccinated and also other
people who will not now catch the disease from the
vaccinated person.
Marginal Social Benefit is the benefit to society of
producing/consuming one more unit of a good
Merit goods
Goods that society believes bring unanticipated benefits
to the consumer. An individual does not fully
appreciate/is not fully aware of the benefits that they will
gain from consuming such goods and therefore they are
under consumed in a free market e.g. healthcare,
education, housing.
Merit and demerit goods are rivalrous and excludable
(do not confuse with public goods)
How to decrease negative externalities of consumption
(consumption of demerit goods):
- Taxation
Example- all countries have indirect tax on cigarettes and
alcohol.
- Government legislation
Example- in Brunei, the sale of cigarettes and alcohol are
banned since 2013.
- Advertising to influence behavior
Example- in the USA, the government ran a campaign
31
local authorities powers to designate Smoke
Control Areas, where it’s an offence to emit smoke
from a chimney unless using an approved fireplace
or fuel.
- Tradable permits
Example- the EU’s Emission Trading System
(ETS) is the largest in the world.
How to increase the production of positive
externalities goods?
- Subsidies
Example- in Ireland, companies that employ
teenagers as apprentices are given a subsidy by the
government to pay part of the wage costs.
- Direct provision
Example- in most countries the government will
provide some or all of the healthcare and education
provision.
Advantages of taxation
- Provides an incentive for firms to reduce their
pollution (less pollution = less tax)
- Increases costs for firms who pollute heavily and
therefore their price, decreasing the product’s
demand, which reduces the pollution from the
production of the product
- Provides revenue for the government which can
then be used to clean up the pollution caused by
the firm (if that’s possible)
Disadvantage of taxation
- May not decrease demand for polluting goods by
much if the PED is inelastic (price up, but demand
down by a smaller percentage)
- Difficult to put a monetary value on pollution and
therefore difficult to find the right level of tax
Advantages of permits:
- Places an absolute limit on pollution
where they put up billboard posters that highlighted the
negative aspects of smoking:
How to increase the consumption of merit goods?
- Direct provision
Example- in most countries the government will provide
some or all of the healthcare and education provision.
- Subsidies
Example- in Ireland, a student is given a subsidy by the
government when they enroll in a private education
institution (like BIS).
- Government legislation
Example- in Ireland, by law all children must be in
education or an apprenticeship (where they learn a trade
i.e. plumbing).
- Advertising to influence behavior
For example- in Queensland, Australia, the local
government ran an ‘track your child’s vaccinations’
advertisement campaign in 2014 which informed parents
about, and promoted vaccinations.
Advantages of regulations/leglisation:
 Easy to understand and cheap to implement
 Necessary when pollution has serious
consequences (uranium etc)
Disadvantages of regulations/leglisation
 Adds to businesses costs, therefore price,
decreasing their international competitiveness
 It may be expensive to monitor whether firms are
abiding by the regulations (factory visits required
etc)
Advantages of advertising:
- May deter people from starting the use of demerit
32
- Provides an incentive for firms to reduce their goods i.e. stop people from starting to smoke.
pollution
- Heavy polluters have to buy permits, which adds Disadvantages of advertising:
to their costs and therefore prices. This decreases - Demerit goods are usually addictive so
demand for their goods (which decreases advertising will do little to influence people who
pollution). already consume them to quit.
- Light polluters sell their permits to heavy - Advertising is costly for the government and
polluters. This decreases light polluters’ costs and comes with an opportunity cost.
therefore their price, which will increase the
demand for their goods.
- Over time the government can reduce the amount
of permits available to an industry, therefore
further incentivising a decrease in pollution.

Disadvantages of permits:
- The cost of running the scheme can be
prohibitive.
- No government revenue generated by scheme.

Advantages of subsidies: Advantages of direct provision:

-Increases output of firm and therefore decreases - Guarantees provision
market failure. - Enormous economic benefits from training and
Disadvantages of subsidies: especially re-training
- Difficult for government to estimate the correct Disadvantages of direct provision:
subsidy deserved by each individual firm. - Expensive
- There is an opportunity costs for the money used - Firms may not bother to train if the government is
for subsidies. It could have been used to increase providing it
healthcare, education etc

Public goods. Non-rivalrous means that consumption of a good/service

Public goods are non rivalous and non excludable
and therefore suffer from the free rider problem.
Therefore, they would not be provided at all by the
market and thus market failure occurs. Example-
street lighting: one person’s consumption of street
lighting doesn’t stop other people using it (non
rivalous) and you can stop people using it (non
excludable).
by one person does not prevent another person from also
consuming that good/service, e.g. streetlight. If one
person uses the light provided by the streetlight it does
not prevent another person from also benefiting from the
light.

Non-excludable means that once a good is Free rider problem

provided, it is impossible (or prohibitively Once a good is supplied by one individual/firm, it is
expensive) to stop people who have not paid for impossible (or prohibitively expensive) to prevent people
the service from using it. For example, once a who have not paid for it from consuming it.
lighthouse is provided, then ships at sea cannot be
prevented from benefiting from it.
However, a car manufacturer can exclude people
from using their cars by charging a selling price
for its use.

33
 Reason why a government should not get
involved in the provision of public goods
- problems of direct provision, eg the
opportunity cost, political conflict
- possible creation of government debt to
finance public goods,
- are the social benefits worth it, how might
they be measured?
Sustainability
Sustainability exists when the consumption needs
of the present generation are met without reducing
the ability of future generations to meet their
consumption needs.
1. Common access resources
Rivalrous but not excludable. Natural resources
over which there is no established private
ownership. They are owned by no one, thus
available to anyone to use; this give rise to over
use and therefore destruction: the tragedy of the
commons. Examples include fishing grounds in
open seas, forests/jungle, clean air, lakes, rivers,
open grazing ground, the ozone layer and many
more.
Common access resources that suffer
from over consumption (Negative
externalities of consumption):
 Fishing grounds (North Atlantic cod)
 Common grazing land (tragedy of the
commons)
Remedying the overuse/destruction of common
access resources:
 Assigning property rights to the resource
(negative externalities of consumption)
 Licensing (negative externalities of
consumption)
 Government legislation (negative
externalities of production) (example
provided earlier)
 Taxation (negative externalities of
production) (example provided earlier)
 Cap and trade (negative externalities of
production) (example provided earlier)
 Funding for clean technologies (negative
externalities of production)
Threats to sustainability
We will cover three threats:
1. Common access resources
2. The use of fossil fuels
3. Poverty in LDCs
Governments have to get involved with regulating
common access resources because the price mechanism
does not work correctly in these situations leading to an
overconsumption or overproduction of goods which
damage/destroy the common access resource.
Common access resources that suffer from
over production (Negative externalities of
production):
 Clean air
 The ozone layer
Assigning property rights to the resource (negative
externalities of consumption – fishing grounds in open
sea)
One possible solution is, where possible, to assign
ownership rights over common access resources. This
will make the resource rivalrous and excludable. The
owner has an incentive to not overuse the resource as
they will not want to damage it as they get the benefit of
the resource in the long term. Example- in the USA some
states give towns ‘ownership’ of rivers that pass through
them. The town can sue any firm that pollute the river
Advantages:
 Encourages owner to take care of the resource and
therefore not overuse it of damage it.
34

Licensing (negative externalities of consumption
– fishing grounds in open sea)
Example- To discourage overfishing in the EUs
fishing grounds, each EU country is given a quota
for the amount of fish they can catch. Each country
then hands out a limited number of licenses to
fishing boat owners to allow them to catch a
certain quota of fish in the EUs fishing area.
Advantages:
 Restricts the amount of fish that can be
caught and therefore
discourages/eliminates over consumption.
Disadvantages:
 Administrative cost of issuing licenses and
ensuring that each license owner collects
only their quota of fish
 Cost of policing the seas and ports to
ensure that only those with licenses are
catching fish
3. Poverty in LDCs (less developed
countries)
Poverty is poor countries results in the over
exploitation of land which leads to soil erosion,
land degradation and deforestation.
Funding for clean technologies
Fossil fuel creates negative externalities.
Governments are keen to promote the use of clean
technology alternatives such as solar/wind/hydro
power by giving these industries subsidies.
Disadvantages:
 Who should be given the property rights?
Obviously, this is going to be a complicated area
to sort out.
Funding for clean technologies (negative externalities
of production – factory pollution that damages
air/ozone layer)
Governments can assist clean technology firm by giving
them subsidies – this will lower their costs and increase
their production, thus decreasing our reliance on fossil
fuels and reduce pollution.
Example- in 2016 South Korea initiated a program where
they give a one time subsidy for the purchase of an new
electric car of $8,000.
Subsidy diagram….. remember!
Advantages of subsidies for clean technology:
- Increases output of clean technology firms and
therefore decreases use of fossil fuels.
Disadvantages of subsidies for clean technology:
- Many people object to wind energy as they see
wind turbines as causing visual and noise
pollution.
- There is an opportunity cost for the money used
for subsidies. It could have been used to increase
healthcare, education etc
2. The use of fossil fuels
When fossil fuels are burned greenhouse gases are
emitted and this causes climate change. The effect of
climate change is thought to include extreme weather
patterns, rising sea levels (therefore flooding) and
changes to agricultural patterns.
Government responses to the threats to sustainability
1. Carbon taxes
2. Legislation
3. Cap and trade scheme
4. Funding for clean technologies
Advantages of subsidies for clean technology:
- Increases output of clean technology firms and therefore
decreases use of fossil fuels.
Disadvantages of subsidies for clean technology:
- Many people object to wind energy as they see wind
turbines as causing visual and noise pollution.
- There is an opportunity costs for the money used for
subsidies. It could have been used to increase healthcare,
education etc
35
36
 Higher Level
3 simple rules regarding the incidence of tax
paid by consumers and producers.
1.If the value of PED is equal to PES then the
incidence of tax will fall equally on consumers and
producers
2.If the value of PED is greater than PES then the
incidence of tax will fall to a greater extent on the
producer
3.If the value of PED is less than PES then the
incidence of tax will fall to a greater extent on the
consumer
When an indirect tax is placed on a good, why
does the price increase by less than the full
amount of the tax?
Because the demand curve slopes downwards, the
producers cannot simply increase the price by the
full amount of the indirect tax. Consumers will
decrease consumption as the price increases so that
the new equilibrium is where supply + Indirect Tax
cuts the demand curve. The price has increased but
not by the full amount and the quantity demand
has decreased.
Supply function
Represents supply as a function of price.
Increase c = curve shifts to right
Decrease c = curve shifts to left
Increase d = curve becomes shallower (more
elastic)
Decrease d = curve becomes steeper (more
inelastic)
Total product
The total quantity of output produced over a period
of time from a given quantity of inputs (e.g. the
number of tables that can be produced in a week
with a certain amount of labour, wood and raw
materials).
Marginal product
The additional output from one more unit of input
(e.g. the additional output which results from
employing one more worker, or using one more
tonne of wood).
Law of diminishing marginal returns
When one or more factors of production are held
constant, and additional units of a variable factor
Summary:
The more elastic the demand relative to supply, the greater
the burden paid by producers and the smaller the
government revenue.
The more inelastic the demand relative to supply, the
greater the burden paid by consumer and the larger the
government revenue.
Demand function
Represents demand as a function of price.
Qd = a – bP
Increase a = curve shifts to right
Decrease a = curve shifts to left
Increase b = curve becomes shallower (more elastic)
Decrease b = curve becomes steeper (more inelastic)
Factors of production
Land
Labour
Capital
Enterpirse
Entrepreneur
A person who combines the factors of production to start a
business. They take risks and they receive the rewards.
Average product (TP/ whatever you’re considering)
The total output divided by the variable factor being
considered (e.g. no of tables per worker, no of tables per
tonne of wood)
When marginal product is above average product it drags
average product up.
When marginal product is below average product it drags
average product down.
Marginal product cuts average product from above at its
highest point
Fixed Costs: Those costs which do not vary with output in
the short run (less than a year). E.g. Rent, insurance.
Variable Costs: Those costs that vary with output. E.g.
37
are being added, there will come a point beyond
which the extra marginal output caused by the
additional unit of the variable factor input will
begin to fall.
Average Total Costs: TC/Q
Average Variable Costs: VC/Q
Average Fixed Costs: FC/Q
Marginal Costs: MC = ΔTC / ΔQ The cost of
producing one more unit
Economies of scale
The factors that lead to a decrease in unit cost as
more is produced.
Specialisation: When firms grow they can hire
specialised workers who will do their job more
efficiently therefore reducing unit costs
Marketing: the cost of advertising is divided by
the amount of units produced, therefore the more
units produced the lower the marketing cost per
unit
Technical: Bigger firms can use their capital
equipment all the time because they produce more.
Therefore the cost of the capital equipment is
divided by a larger amount of output therefore
reducing the cost of machinery per unit of output.
Diseconomies of scale
The factors that lead to an increase in the unit cost
of production as output increases past a certain
point.
Types of diseconomies of scale:
1. Labour relations
2. Control and co-ordination
Revenue: The income received by a firm for
selling its output. Also called sales revenue, total
sales or turnover.
Total revenue (TR): price X quantity.
PXQ
Average revenue (AR): Total revenue/quantity
AR =
Marginal revenue (MR): MR is the extra revenue
a firm collects when it sells one extra unit of
Raw materials, fuel.
When marginal cost is below average cost it drags average
product down.
When marginal cost is above average cost it drags average
product up.
MC cuts AVC and ATC from below and at their lowest
point.
Types of economies of scale:
1. Specialisation economies of scale.
2. Marketing economies of scale.
3. Technical economies of scale
4. Bulk buying economies of scale.
5. Financial economies of scale.
Bulk buying: bigger firms can buy in bulk and therefore
reduce the costs of their inputs which will reduce their unit
cost
Financial: Bigger firms have more collateral; therefore,
banks see them as less of a risk to lend money to.
Therefore they charge them a lower interest rate which
reduces their cost of borrowing.
Labour relations: Larger firms have greater division of
labour which usually leads to a lower unit cost. However,
if taken too far it can alienate and demotivate workers,
therefore their productivity decreases and unit cost
increases.
Control & coordination: The larger the business the more
difficult it is to coordinate the activities of all employees
efficiently (i.e. ensuring that they’re all doing what they’re
supposed to do)
Revenue Maximisation: MR = 0
 When MR is positive selling more will increase
Total Revenue
 When MR is negative making less adds to Total
Revenue
 When demand curve is elastic MR is positive
 When demand curve is inelastic MR is negative
38
output.

MR =
Accounting profit = Total Revenue – Total Costs, If TC=TR a firm is making “normal profit”
where Total Costs are the explicit costs. If TC<TR a firm is making “abnormal profit”
Economic profit = Total Revenue – Total Costs, If TC>TR a firm is making a loss.
where Total Costs are the explicit and implicit
costs.
Explicit costs are the cost of items a firm has to
buy in
Implicit costs are the opportunity cost of the
entrepreneur – what else could the entrepreneur
have done
Economic profit/Abnormal profit = Total
Revenue greater than Economic Costs
Goals of a firm include: Shut down prices
1. Profit Maximisation Short run shut down price Price = AVC
Profit Maximisation: MC = MR. Long run shut down price Price = AC
2. Revenue maximisation
MR = 0. Break even point – where the firm is able to make normal
3. Growth Maximisation profits in the long run (where Price equals its Average
Increasing sales in order to gain market share. This Costs) (where Total Revenue equals Total Cost).
will decrease profit in the short run.
4. Satisfying
Managers (who run the firm) return just enough
profit to shareholders (who own the firm) to keep
them happy.
5. Corporate social responsibility
This is where a business includes public interest in
their decision making.
Market Failure (HL) 4. Asymmetric Information
4. Asymmetric information (HL) For markets to work, there needs to be perfect and
5. Abuse of monopoly power (HL) symmetric information i.e. consumers and
producers have the same level of knowledge about a
product’s quality, range and price. In many cases, however,
information may be asymmetric (producers/consumers
have more information than the other). This leads to
market failure.

Moral Hazard Adverse selection

This reflects on the immoral behavior of a party
with asymmetric information subsequent to a
transaction. It occurs when a party provides
misleading information and changes his/her
behavior when s/he does not have to face
consequences of the risk s/he takes. Example-
person behaves recklessly after they take out
health insurance.
Occurs when buyers or sellers have asymmetric
information and one party takes advantage of the
knowledge or asymmetric information PRIOR to the
transaction. Often, sellers face exactly the buyers they
don’t want. Example- people with poor health are more
likely to take out life insurance (the insurance company
may not be fully aware of their health condition).

39
 5. Abuse of monopoly power
Imperfect competition (lack of competition in a
market) leads to reduced economic efficiency.
Firms with some monopoly power can restrict
output to maximise profits – market failure.
For example, when British Telecom was
privatized they became a private sector monopoly
and proceeded to raise their price as they had no
other competitor in the market.
Perfect Competition
1. A very large number of small firms
2. Price Takers
3. Homogeneous products
4. No barriers to entry or exit of a perfectly
competitive market
5. Perfect Knowledge
Best example: wheat market
There are two types of efficiency:
1. Productive efficiency
Attained when a firm is producing at the bottom of
its AC curve.
2. Allocative efficiency
A market is allocatively efficient when it delivers
the goods required by consumer in the correct
amount. Resources are allocated in the most
efficient way and therefore community surplus is
maximised.
Barriers to entry
Factors that make it difficult for a firm to enter a
market. Include; economies of scale, high start up
costs, branding and legal barriers.
Due to high barriers to entry it is possible for
monopolies to have SNP in the short and long run.
Disadvantages of Monopoly (compared to
perfect competition)
1. Perfect competition is productively (in the long
run) and allocatively efficient whereas a monopoly
is not (in exam draw both diagrams to explain)
2. Monopolists can restrict output and charge
higher prices reducing consumer surplus
3. Monopolist often portray anti competitive
behaviour to maintain their monopoly. Examples:
Predatory pricing, Bundling goods and services….
Government solutions to abuse of monopoly power
include:
1. Legislation - Competition law.
2. Regulation - Regulatory bodies.
3. Trade liberalization
In the short run SNP can be made, however, due to no
barriers to entry other firms will come into the market and
compete away SNP in the long run.
In the short run losses can be made, however, due to no
barriers to exit firms will leave the market and market will
return to normal profit in the long run.
Monopoly
1. One firm
2. Unique product (or at least no close substitutes)
3. Price maker
4. Significant barriers to entry and exit
5. Abnormal profits possible in the long run
Example- EVN (state electrical supplier in Vietnam)
Types of barriers to entry
Economies of scale
High start up costs
Brand loyalty
Legal barriers (Patents and licensing)
Natural Monopoly
Occurs when one firm can supply an entire market at a
lower cost/price than two or more smaller firms.
Economies of scale are so great that the LRAC falls
through the entire output range. Example- EVN (state
electrical supplier in Vietnam)
Advantages of Monopoly (compared to perfect
competition)
1. Research and development possible:
Long run abnormal profits allows monopolies to invest in
research and development. In perfect competition firms
will lack the resources for R&D.
2. A monopoly can exploit economies of scale.
This leads to greater efficiency. In industries with
significant economies of scale these can outweigh the
benefits of (perfect) competition
40
 Evaluation
Whether a monopolist is better than perfect
competition depends upon:
- The extent of economies of scale – the greater the
amount of economies of scale the better served a
market will be by a monopoly
- Whether the monopoly passes the lower costs
gained from economies of scale on to the
consumer in the form of lower prices.
1. Regulation (for public sector firms i.e.
electricity board):
Where (natural) monopolies exist (the market is
better served by one firm and there is no
competition), a regulator is appointed to the
industry to ensure that the firm:
- Charges a fair price
- Produces close to allocatively
efficiency
- Produces a quality service
However:
- Regulatory capture by natural monopoly
diminishes the ability of the
government/regulator to police an industry
- Asymmetric information (natural
monopoly have more information than
regulator) diminishes the ability of the
government/regulator to police an industry
- Administrative cost of regulators means
that they are often underfunded and
therefore ineffective.
3. Trade liberalisation
If a government believes that a firm has too much
monopoly power and that it is detrimental to
consumers, then they can allow other (foreign)
foreign firms into the market.
Advantages:
 Increase competition so therefore increases
choice and may lower price and increase
quality of product/service
Disadvantages:
 Loss of domestic jobs as domestic
monopoly firm loses market share
What the government can do to reduce the monopoly
power of a firm:
1. Regulation
2. Legislation
3. Trade liberalisation
2. Legislation:
Governments use legislation to set agencies up to reduce
the power of monopolies or decrease their ability to
become a monopoly:
They also use legislation to make anti-competitive
practices illegal.
Agencies (with power to fine firms and prosecute directors
which may lead to jail terms):
 Merger and monopolies agencies
Blocks mergers/takeovers which might lead to the merged
firm being able to exact monopoly power (able to restrict
supply and increase price).
 Competition agencies
- Investigates allegations of abuse of monopoly
power/anti-competitive practices
- Promotes competition in markets (reduces
barriers to entry)
Legislation:
Government usually pass anti-competitive laws which
make the following illegal and therefore encourages
competition which decrease the ability of firms to become
monopolies:
Predatory pricing:
Predatory pricing occurs when a firm decreases its price
below its own Average Cost in order to drive a competitor
from an industry. When the competitor has left the industry
the firm will increase their price again. Short term loss for
long term supernormal profits.
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 A worsening of the current account if the
competition is imported goods from overseas
Has government competition policy been
successful in promoting competition between
firms?
Yes, because:
- Fear of action by the government agencies (fines,
prison terms etc) may prevent anti competitive
behaviour
-Risk of bad publicity when caught by government
agency may prevent anti competitive behaviour
- Government attempts to reduce barriers to entry
have increased competition in some industries
Monopolistic competition
1. Large number of small firms (all with small
market share)
2. Product (slightly) differentiation
3. No or low barriers to entry or exit (easy for
firms to enter or leave the industry)
4. Very elastic demand (due to many
substitutes)
Advantages of monopolistic competition
compared to perfect competition may include:
 possible economies of scale gained (even
though monopolistic firms are usually
small they can be bigger than firms in
perfect competition)
 consumer benefits from greater variety of
products/more choice (in perfect
competition goods are homogeneous)
Advantages of perfect competition compared to
monopolistic competition may include:
 allocative and productive efficiency
 consumer gains from low prices
Assumptions of oligopoly
1. Few firms dominate the market
Evaluation
- Asymmetric information (government failure) diminishes
the ability of the government/regulator to police an
industry
- Administrative cost of running agencies and enforcing
legislation means that many companies who adopt anti
competitive policies escape detection
Non price competition
 Advertising
 Quality of service
 Product development
Disadvantages of monopolistic competition compared
to perfect competition include:
 allocatively inefficient (PC allocatively efficient in
short and long run)
 productively inefficient (PC productively efficient
in long run)
 higher price and lower output in monopolistic
competition than under perfect competition
Disadvantages of perfect competition compared to
monopolistic competition may include:
 firms unable to invest in research and development
due to lack of abnormal/ supernormal profits
 lack of choice of products (homogeneous goods)
Concentration ratio
The amount of market share held by the top n firms –
42
2. Price maker.
3. Products are highly differentiated – at least
through advertising (e.g. petrol).
4. Usually significant barriers to entry (therefore
abnormal profits in the short and long run).
5. Interdependence: firms must take into account
the reactions of competitors when making
decisions.
Collusion
Firms acting together to reduce consumer welfare
(restrict supply to raise price). It is illegal in most
countries.
Collusion comes in two types:
1. Formal (cartels)
2. Tacit
Why firms might collude:
 To increase price and therefore profit
 Limit competition and therefore decrease
costs (less advertising required)
 Limit uncertainty regarding the behaviour
of rivals
Problems with collusion/cartels:
1. It’s illegal
In Britain the operation of a cartel is illegal under
the UK Competition Act, under which the Office
of Fair Trading is empowered to fine up to 10% of
a firm’s turnover if they are found guilty of
colluding.
2. There is a temptation to break them
(see Game Theory)
Collusive Oligopoly
* Graph has steep AR/MR curves to illustrate the
lack of substitutes available to consumers when
oligopoly firms act collusively (effectively acting
as a monopoly)
* Formal (cartel) or informal agreement (tacit
collusion) amongst producers to limit competition
between themselves
* Existence of some non-price competition i.e.
measure of market dominance. The higher the percentage
the higher the concentration. If the data is given, work out
the concentration ratio.
Formal collusion: This is where firms openly agree to set
prices or output or market share or agree marketing
expenditure between themselves.
Tacit collusion: This is where firms don’t formally agree
on price or output levels. However, firms choose not to
compete and charge similar prices to each other. This can
happen through “price leadership” where one firm (usually
the biggest) sets the price and the other firms follow.
Game Theory
Game theory illustrates that firms sometimes collude
(tacitly) to end up in a position where joint profits are
maximised. However, this is not a stable position. From
this position either firm could decrease their price/increase
output and gain higher profits at the expense of the other
firm in the short term. The tacit collusion has broken
down and we tend to end up at the Nash Equilibrium.
Non-collusive Oligopoly
* Graph has less steep AR/MR curves to illustrate the
substitutes available to consumers when oligopoly firms
competitively
* No agreement exists between producers
* Existence of non-price competition and price
competition (price wars)
* Kinked demand curve illustrates why price is static and
illustrates that collusion is not necessarily taking place.
43
advertising and branding (although this is more * Existence of strong legislation/agencies/regulators
likely to be done to increase barriers to entry for which deters collusion taking place
new firms and ensure SNP for oligopolists in the
long run)
* Oligopolistic firms act as if they are a monopoly.
Output can be restricted to increase price. Market
can be separated between oligopolists with one
firm supplying each area of the market.
* Game Theory can illustrate that collusion is
taking place (firms in quadrant where joint profits
are maximised and not in the Nash equilibrium
quadrant)
* Lower output and higher price than in market
with competitive oligopolists
*Existence of weak legislation/agencies/regulators
which allows collusion to take place

Factors which makes a cartel structure difficult

to maintain:
- The gains from breaking the conclusive
agreement (shown by game theory), at least
in the short run.
- The larger the number of firms, the more
likely it is that one of them will cheat, and
the more difficult to come to an agreement
on a common price
- Potential entry into the market –
supernormal profits will attract new firms
into the industry. If the barriers to entry can
be overcome, the introduction of new firms
may weaken the cartel and lead to price
competition

How can a government intervene in an Price discrimination

oligopoly market where a firm has too much When different prices are charged for the same
monopoly power? good/service for reasons not associated with the cost of
1. Regulation production.
2. Agencies and legislation
3. Trade liberalisation
Same as for monopoly

Conditions of price discrimination: Benefits of price discrimination to firms:

1.The firm must be a price maker. * Allows firm to gain extra profit from the elastic segment
2.Different consumers must have different of a market that it otherwise would not have got
elasticities of demand (customers with inelastic * Allows firm to gain a higher level of revenue from its
PED pay more than customers with elastic PED) sales as it is selling to the elastic segment as well as the

44
3.Firm must be able to divide the market into inelastic segment of a market
different segments and it must be able to keep * Allows firms to sell more, therefore production
these segments separate at a cost less than profit increases and a firm can gain economies of scale
gained through price discrimination – or else it
wouldn’t be worth it.
Disadvantages of price discrimination to firms:
* Some consumers may resent having to pay a
higher price than others for the good/service and
may seek alternatives in the long run

Benefits of price discrimination to consumers: Disadvantages of price discrimination to consumers:

* Price discrimination allows some consumers to * Some consumers will pay more than the price that
purchase products/services that they may not would have been charged in a single, non-discriminated
otherwise have been able to afford. For example, market, for example the inelastic part of the Third Degree
in Third Degree Price Discrimination the elastic market.
segment of the market enjoys a lower price than
they otherwise would not had have access to
* Price discrimination can lead to economies of
scale for a firm and the lower costs may be passed
on to the consumer in the form of lower prices.

Production possibility frontier

What affects the price elasticity of demand? (there’s 4 – explain 2)

Why does the elasticity of demand change along a linear demand curve?

Income elasticities of demand

Normal goods

45
Production possibility frontier
Producer surplus
Normal goods
Indirect Taxation
Merit goods

46