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4EC / 3EC 1.

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2018 - 2019 THE MARKET SYSTEM

Revision Book
ECONOMICS
IGCSE
1. THE ECONOMIC PROBLEM

A) THE PROBLEM OF SCARCITY

a) finite resources

" resources are finite (= the quantity available is limited)


" resources are grouped in four categories called factors of production:
1. land (water, fertile soil, energy…)
2. labour (physical and intellectual work done by people)
3. capital (machinery, components, money…)
4. entrepreneurship (business ideas, business administration)
" resources can become scarce if used up / destroyed without being replaced

b) limited needs / unlimited wants

" needs are basic requirements for human survival, they are limited
" wants correspond to desires (fashion, obsolescence…) they are infinite (= unlimited)

B) THE ECONOMIC PROBLEM

" resources are finite but wants are infinite


" demand is greater than supply
" choices have to be made about the allocation of resources between different uses
1. what to produce?
2. how to produce?
3. for whom to produce?

C) OPPORTUNITY COST

" when making choices, people give up certain opportunities when resources are scarce
" the benefits of the opportunities that have been given up are the opportunity cost

D) PRODUCTION POSSIBILITY CURVES (PPCS)

" a PPC shows the different combinations of two goods that can be produced if all
resources in an economy are fully used up
" it shows the maximum quantities of goods that can be produced with all available
resources

CONSUMER PPF CONSUMER PPF AND GROWTH


GOODS GOODS
C F
× A ×
×
opportunity
cost

×B

E
×
D
×
CAPITAL GOODS
CAPITAL GOODS

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E) FACTORS THAT IMPACT GROWTH

Growth corresponds to an increase in the production level of in a country. This can come from:

1. new technology (machinery)


2. improved efficiency (production methods)
3. education, training (human skills)
4. new resources

LIMITS
resource depletion, climate change, political instability, emigration, restriction in public services
(healthcare, education…)

2. ECONOMIC ASSUMPTIONS

A) CONSUMERS AIM TO MAXIMISE BENEFIT

When making decisions, economists assume that consumers will always choose the option that
gives them the greatest benefit (= satisfaction). Consumers may choose:

1. the best price


2. the highest quantity
3. the best quality
4. according to individual preferences

LIMITS
difficulty to calculate benefit /price, habits preventing consumers to switch to a better option
(brand loyalty), peer pressure, lack of information

B) BUSINESSES AIM TO MAXIMISE PROFIT

When business owners make decisions, they are expected to choose the option that gives the
best financial results. Businesses take decisions that enable:

1. lowest costs when buying material, components…


2. highest possible prices when selling goods (sales revenue, sales receipts)
3. highest profit (= sales revenue – costs)

LIMITS
inefficient organisation when taking decisions, alternative objectives (purpose, ethics,
reputation…), lack of information

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3. THE DEMAND CURVE

A) EFFECTIVE DEMAND

Demand is the amount of a good that will be bought at given prices over a period of time.
Effective demand is the amount that will be bought considering what consumers can afford.

B) THE DEMAND CURVE

The demand curve represents all the combinations of prices and quantities bought on a graph.
9 the demand curve is downward sloping as there is an inverse relationship between
price and quantity bought: consumers are willing / able to buy more as prices
decrease
9 at different prices, there is a movement along the demand curve

PRICE
DEMAND CURVE
MOVEMENT ALONG THE CURVE

P
=> change in
demand following a
change in price

P’ => downward
sloping curve

Q Q’ QUANTITY

4. FACTORS THAT MAY SHIFT THE DEMAND CURVE

A) FACTORS AND THE SHIFT IN THE DEMAND CURVE

For prices remaining unchanged, there may be other factors that lead to an increase or
decrease in the quantity demanded.
9 the entire demand curve shifts to the right (increase) or to the left (decrease)

PRICE
DEMAND CURVE
SHIFT IN THE CURVE

D’’ D D’

Q’’ Q Q’ QUANTITY

=> decrease in => increase in


demand demand

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B) ADVERTISING / TRENDS / FASHION

Businesses try to influence demand for their products, determining trends and fashions.
9 more advertising is likely to lead to an increase in demand

C) INCOME

Consumers need an income to spend on goods.


9 the part not being spent are the savings
9 normal goods: demand for these goods increases when incomes rise
9 inferior goods: demand of these goods falls when incomes rise

D) PRICE OF SUBSTITUTES
Goods that are substitutes can replace each other.
9 when the price of a substitute falls, demand for a good is likely to increase as
consumers prefer the cheapest option

E) PRICE OF COMPLEMENTS

Goods that are complements are consumed together.


9 when the price of a complement falls, demand for a good is likely to rise as the total
expenditure falls

F) DEMOGRAPHIC CHANGES

Demand can be affected by changes in the population.


9 these changes impact:
1. the age distribution
2. the gender distribution
3. the geographical distribution (rural / urban areas…)
4. the ethnical distribution
5. migrations

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5. THE SUPPLY CURVE

A) SUPPLY

Supply is the amount of a good that sellers are willing to sell at any given prices over a period of
time.

B) THE SUPPLY CURVE

The supply curve represents all the combinations of prices and quantities sold on a graph.
9 the supply curve is upward sloping as there is a proportionate relationship between
price and quantity businesses are willing to sell more as prices increase because
profit expectations improve
9 at different prices, there is a movement along the supply curve

PRICE
SUPPLY CURVE
MOVEMENT ALONG THE CURVE

S
P’ => change in supply
following a change
in price

=> upward sloping


P
curve

Q Q’ QUANTITY

C) FIXED SUPPLY

Supply is fixed when it is impossible to adjust the quantity supplied when prices change.
9 as the quantity sold remains unchanged whatever the price level, the supply curve is
vertical

PRICE
FIXED SUPPLY

P’ => no change in
supply following a
change in price

=> vertical curve


P

Q QUANTITY

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6. FACTORS THAT MAY SHIFT THE SUPPLY CURVE

A) FACTORS AND THE SHIFT IN THE SUPPLY CURVE

For prices remaining unchanged, there may be other factors that lead to an increase or
decrease in the quantity supplied.
9 the entire supply curve shifts to the right (increase) or to the left (decrease)

PRICE
SUPPLY CURVE
SHIFT IN THE CURVE

S’’ S S’

Q’’ Q Q’ QUANTITY

=> decrease in => increase in


supply supply

B) COSTS OF PRODUCTION

The businesses incur costs when they pay for rents, wages, raw materials, energy, machinery…
9 when production costs rise, profit expectations fall
9 businesses reduce supply as they seek better opportunities in other markets
9 production costs may rise when resources become scarce

C) TAXES

Taxes are considered to increase production costs and make profit expectations fall.
9 when taxes increase, businesses reduce supply
9 this may reduce the production of dangerous / polluting products

D) SUBSIDIES

Subsidies are grants given by the government to businesses in order to encourage the
production of goods.
9 businesses use subsidies to pay off part of their production costs
9 as production costs decrease, profit expectations rise and businesses increase supply

E) CHANGES IN TECHNOLOGY

New technologies increase efficiency in businesses and enable to increase production levels and
thereby supply.

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F) NATURAL FACTORS

Unfavourable weather conditions or natural disasters may harm the production of goods
(agriculture, transportation…) and reduce supply.

7. MARKET EQUILIBRIUM

A) EQUILIBRIUM PRICE

The equilibrium price of a good is set exactly where the quantity demanded by buyers equals
the quantity supplied by sellers.

EQUILIBRIUM PRICE => QD = QS

PRICE
EQUILIBRIUM

PE

QE QUANTITY

B) TOTAL REVENUE (TR)

Total revenue is the amount generated from the sales of output (=production).
9 it necessarily equals the amount buyers have spent, the total expenditure.

TR = P × Q = TOTAL EXPENDITURE

PRICE
TOTAL REVENUE

PE

QE QUANTITY

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C) SHIFTS IN DEMAND AND SUPPLY

The shifts of the demand or the supply curve lead to a new equilibrium with a new equilibrium
price and equilibrium quantity.

a) shortages

An increase in demand or a decrease in supply lead to shortages.


9 prices are pushed up as the good become scarce

PRICE PRICE
INCREASE IN DEMAND DECREASE IN SUPPLY

S S’
S

P’
P P’
P
D’
D D

Q Q’ QUANTITY Q’ Q QUANTITY

b) gluts

A decrease in demand or an increase in supply leads to gluts.


9 prices are pushed down as some goods remain unsold and businesses try to get rid
of them

PRICE PRICE
DECREASE IN DEMAND INCREASE IN SUPPLY

S S
S’

P’ P
P’
D
D’ D

Q’ Q QUANTITY Q Q’ QUANTITY

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D) EXCESS DEMAND AND EXCESS SUPPLY

a) excess demand

If the price charged for a good is below the equilibrium price, demand will be superior to supply
as buyers can afford larger quantities and businesses produce less due to lower profit
expectations.
9 there is excess demand
9 shortages push prices up to the equilibrium level

PRICE
EXCESS DEMAND

PE

QS QE QD QUANTITY

QD > QS
excess demand

b) excess supply

If the price charged for a good is above the equilibrium price, supply will be superior to demand
as firms are encouraged to sell larger quantities as profit expectations have improved but
buyers cannot afford as much.
9 there is excess supply
9 gluts push prices down to the equilibrium level

PRICE
EXCESS SUPPLY

PE

QD QE QS QUANTITY

QS > QD
excess supply

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8. PRICE ELASTICITY OF DEMAND (PED)

A) DEFINITION

Price elasticity of demand (PED) measures the responsiveness of demand to a change in price: it
analyses how significantly the quantity demanded changes if the price changes.

B) CALCULATIONS AND THEIR INTERPRETATION

% CHANGE IN DEMAND
PED =
% CHANGE IN PRICE

PED < -1
If demand changes more than proportionately to the price, demand is elastic. Buyers react
significantly to a change in price.

PRICE
PRICE ELASTIC DEMAND

=> a change in price


leads to a significant
P change in demand
PED < -1
P’

Q Q’ QUANTITY

PED -> -¥
Demand is perfectly elastic if buyers purchase as much as possible at a given price and nothing
at all at any other price.

PRICE
PERFECTLY ELASTIC DEMAND

=> a change in price


leads to no demand
at all
PES -> -∞
P D

Q Q’ QUANTITY

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-1 < PED < 0
If demand hardly changes after a change in price, demand is inelastic. Buyers hardly change the
quantity they buy after a change in price.

PRICE
PRICE ELASTIC DEMAND

=> a change in price


leads to a significant
P change in demand
-1 < PED < 0
P’

Q Q’ QUANTITY

PED = 0
Demand is perfectly inelastic if a change in price leads to no change at all in the quantity
demanded at all.

PRICE
PRICE INELASTIC DEMAND

=> a change in price


P leads no change in
demand
PED = 0
P’

Q QUANTITY

C) FACTORS THAT IMPACT PED

a) availability of substitutes

Consumers are likely to switch to the cheapest option when they consider that two goods
can easily replace each other. If a good has substitutes, demand will be elastic. Time
increases the possibility of finding substitutes and raises elasticity.

b) degree of necessity

Consumers buy more or less the same quantities of goods that consider to be necessities
(= goods essential to their lives), even if prices change. If the degree of necessity they attach
to a good is high, they will hardly change the amount they buy and demand will be inelastic.

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c) proportion of income spent on a good

If consumers spend a high proportion of their income on a good, they will react more
significantly to a change in price as it will impact their budget. Demand will be elastic.

D) PRICE ELASTICITY OF DEMAND (PED) AND TOTAL REVENUE (TR)

A change in price leading to a change in the quantity demanded will impact the total revenue
(TR) collected by firms on their sales.

a) elastic demand and TR

If demand is elastic, a change in price will lead to a more than proportionate change in the
quantity demanded (= quantity sold).

" an increase in price will lead to a more than proportionate fall in the quantity
demanded
9 TR will fall

" a decrease in price will lead to a more than proportionate rise in the quantity
demanded
9 TR will rise

b) inelastic demand and TR

If demand is inelastic, a change in price will lead to a less than proportionate change in the
quantity demand (= quantity sold).

an increase in price will lead to a less than proportionate fall in the quantity demanded
9 TR will rise

a decrease in price will lead to a less than proportionate rise in the quantity demanded
9 TR will fall

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9. PRICE ELASTICITY OF SUPPLY (PES)

A) DEFINITION

Price elasticity of supply (PES) measures the responsiveness of supply to a change in price: it
analyses how significantly the quantity supplied changes if the price changes.

B) CALCULATIONS AND THEIR INTERPRETATION

% CHANGE IN SUPPLY
PES =
% CHANGE IN PRICE

PES > 1
If supply changes more than proportionately than the price, supply is elastic. Sellers react
significantly to a change in price as their profit expectations change.

PRICE
PRICE ELASTIC SUPPLY

S => a change in price


leads to a significant
P change in supply
PES > 1
P’

Q Q’ QUANTITY

PES -> ¥
Supply is perfectly elastic if businesses supply as much as possible at a given price and nothing
at all at any other price.

PRICE
PERFECTLY ELASTIC SUPPLY

=> a change in price


leads to no supply at
all
PES -> -∞
P S

Q Q’ QUANTITY

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0 < PES < 1
If supply hardly changes to a change in price, supply is inelastic. Businesses hardly change the
quantity they sell after a change in price.

PRICE
PRICE INELASTIC SUPPLY

S
=> a change in price
leads to a significant
P change in supply
0 < PES < 1
P’

Q Q’ QUANTITY

PED = 0
Supply is perfectly elastic if a change in price leads to no change in the quantity sold at all.

PRICE
PERFECTLY PRICE INELASTIC SUPPLY

=> a change in price


P leads no change in
supply
PES = 0
P’

Q QUANTITY

C) FACTORS THAT IMPACT PES

a) factors of production " availability of resources

Producers can only adjust their production level to changes in prices if the resources they
need are available. If resources can be easily sourced, supply will be elastic.

b) stocks " finished goods

Producers can easily respond to changes in prices if they have stocks of unsold goods they
can immediately bring to the market. The ability of keeping stocks increases elasticity of
supply.

c) factors of production " spare capacity

Producers cannot increase their production levels if they have already reached full capacity
(= all resources being used at maximum). Supply will be inelastic. Spare capacity increases
elasticity.

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10. INCOME ELASTICITY OF DEMAND (IED)

A) DEFINITION

Income elasticity of demand (IED) measures the responsiveness of demand to a change in


income: it analyses how significantly the quantity demanded changes if the income changes.

B) CALCULATIONS AND THEIR INTERPRETATION

% CHANGE IN DEMAND
IED =
% CHANGE IN INCOME

IED > 0

Buyers buy more normal goods as income increases.

IED < 0

Buyers buy less inferior goods as income increases.

IED > 1 or IED < -1

If demand changes more than proportionately than the income, demand is income elastic.
Buyers react significantly to a change in income as they can afford more luxuries.

-1 < IED < 0 or 0 < IED < 1

If demand changes less than proportionately than the income, demand is income inelastic.
Buyers hardly react to a change in price as they buy necessities.

C) IED AND BUSINESSES

Businesses try to anticipate demand in order to adjust the quantity to produce and supply:

" recession (= economic crises)


9 lower incomes / unemployment
9 demand for inferior goods is likely to rise
9 demand for normal goods is likely to fall
9 businesses will try to concentrate on the production of goods with negative, high
income elasticity

" boom (= strong economic growth)


9 higher incomes / less unemployment
9 demand for normal goods is likely to rise
9 demand for inferior goods is likely to fall
9 businesses will try to concentrate on the production of goods with positive, high
income elasticity

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D) IED AND GOVERNMENT

a) taxes

The government chooses to tax goods with price inelastic demand: demand will hardly be
impacted by the rise in price and the tax revenue will be important

LIMIT
the government will avoid to tax necessities

b) subsidies

The government chooses to subsidies goods with price elastic supply as they want these
goods to be produced in large quantities

LIMIT
producers may not pass on the fall in production costs to consumers by lowering their prices

11. THE MIXED ECONOMY

A) DEFINITIONS

An economic system is a system that attempts to solve the economic problem: decisions about
what to produce, how to produce, for whom to produce.

In the private sector, goods and services are produced by individuals or group of individuals and
supplied in a market where they are sold/bought.

In the public sector, government organisations produce and supply goods and services that are
partly or entirely financed by taxes.

B) REASONS FOR MARKET FAILURE

Markets determine resource allocation as businesses will use the resources to produce goods
and services that will be demanded in the market. But sometimes, resources are wasted due to
inefficiency. There is market failure because of:

a) externalities

The cost to society has not been completely considered when the good was produced.

SOLUTION
government regulation, taxes

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b) lack of competition

If there is no competition, businesses can charge high prices and they are likely to be more
careless about waste of resources as they can charge high prices

SOLUTION
government preventing excessive growth of firms

c) missing markets

Some goods are likely to be underprovided by the private sector because profit expectations
would not be attractive enough.

SOLUTION
government providing goods financed by taxes

d) lack of information

Producers may be insufficiently informed about the costs of the resources they or the most
efficient production processes. Resources may get wasted. Consumers may not be well
enough informed about quality and prices

SOLUTION
obligation to label products, information campaigns

e) factor immobility

Producers can only achieve maximum efficiency when factors can be moved from the
production of one good to the production of another good.

SOLUTION
training

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C) THE ROLE OF THE GOVERNMENT

a) public goods

Public goods are goods that have these two characteristics:

" non-excludability
once a goods is provided, no consumer can be excluded from consuming it

" non-rivalry
when a good is consumed by a consumer, it does not prevent another consumer from
consuming it too

Therefore, public goods cannot to be properly charged and offer no profit expectations to
firms. They will not provide it at all. The government takes over their production and will use
tax revenue to finance them.

b) merit goods

Some goods may be provided by firms but at a high price as production costs are high. Only
a few consumers will be able to afford them. These goods are merit goods, they are
underprovided. The government can decide to produce or to subsidise them.

D) OWNERSHIP AND CONTROL IN THE PRIVATE AND PUBLIC SECTOR

a) in the private sector

Businesses are owned and controlled by individuals or group of individuals. They can be sole
traders (one person) or grouped in partnerships or companies. Large companies are owned
by shareholders who brought money to the business and elect a board of directors to run
the businesses on their behalf.

b) in the public sector

Public organisations are owned and controlled by the government (central government
departments, local authorities, public corporations…). Their directors are elected or
appointed.

E) AIMS IN THE PRIVATE AND PUBLIC SECTOR

a) in the private sector

" survival (avoiding bankruptcy, the inability to pay the money owed)
" profit maximisation (profit will be distributed to shareholders under the form of
dividends)
" growth, market leadership
" social and environmental responsibility (consideration of stakeholders’ interests, those
who are impacted by the businesses’ activity: workers, clients, residents…)

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b) in the public

" quality of service


" minimising costs, avoiding waste
" interests of stakeholders
" profit to be reinvested

F) TYPES OF ECONOMIES

a) market economy (free enterprise economy)

" the role of the public sector is limited to providing a legal and monetary system as well as
policing and defence
" almost all goods and services are produced by the private sector
" price is set in the market by demand and supply

b) command economy (planned economy)

" the government takes all decisions about the production and the distribution of goods
" prices are set by the government

c) mixed economy

" goods are mainly produced by the private sector and producers adjust supply to demand
" competitive pressure ensures that goods are produced at the lowest price
" the government takes in charge public and merit goods

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12. PRIVATISATION
A) DEFINITION

Privatising involves transferring public sector resources to the private sector.

B) DIFFERENT METHODS OF PRIVATISATION

a) sale of nationalised industries

The government sells these industries to private investors who become the shareholders of
the newly formed business.

b) contracting out

Contracts are signed with private businesses to carry out a task previously supplied by a
government organisation.

c) sale of property (buildings, land…)

The government sells assets that were in public ownership before.

C) REASONS FOR PRIVATISATION

" to generate income that adds to tax revenue


" to increase efficiency as private businesses face competition (= rivalry from other
businesses)
" to avoid political interference

D) CONSEQUENCE OF PRIVATISATION J / L

a) consumers J

Consumers try to buy the best quality at the lowest price and switch to the cheapest
product.
9 private businesses face competition (= rivalry from other businesses)
9 they will avoid waste and supply goods that match demand at the lowest price

LIMIT
In markets without competition, a business being the sole supplier can charge higher prices
as consumers find no substitutes.

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b) workers L

When businesses are privatised, they are often restructured to reduce the costs and many
workers may be laid off in order to reduce the wages to pay.

LIMIT
Businesses lose experienced workers and efficiency or quality may decline.

c) businesses J

Investors are likely to invest in the business in order to introduce new technologies.

LIMIT
Investors may be averse to risk and only seek their share of profit.

d) government L

The government may find it difficult to control privatised industries when it comes to
limiting polluting activities or improving work conditions.

SOLUTION
New legislations may be passed.

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13. EXTERNALITIES

A) PRODUCTION AND COSTS

a) private costs

Private costs are the costs registered and paid by firms when they produce goods and
services

b) external costs (= negative externalities)

External costs are spillover effects that impact third parties: individuals are impacted by
negative consequences coming from production decisions made by businesses.

c) social costs

Social costs are the costs to the society as a whole.

SOCIAL COST = PRIVATE COSTS + EXTERNAL COSTS

B) CONSUMPTION AND BENEFITS

a) private benefits

Private benefits are the benefits felt by consumers relating to the satisfaction of consuming
goods and services.

b) external benefits (= positive externalities)

External benefits are spillover effects that impact third parties: individuals are impacted by
positive consequences coming from consumption decisions made by individuals.

c) social benefits

Social benefits are the benefits to the society as a whole.

SOCIAL BENEFITS = PRIVATE BENEFITS + EXTERNAL BENEFITS

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C) GOVERNMENT POLICIES TO DEAL WITH EXTERNALITIES

a) taxes

Taxes reduce the purchase of goods with negative externalities as their price increases.

LIMITS
The efficiency of the government intervention depends on price elasticity of demand of the
taxed goods.

b) subsidies

Subsidies increase the purchase of goods with positive externalities as their price decreases.

LIMITS
The efficiency of the government intervention depends on price elasticity of supply of the
taxed goods. Businesses may not pass on the decrease in production costs to the consumers.

c) regulations and fines

The government may pass laws in order to forbid or limit activities with external costs and
fine businesses that do not comply.

LIMITS
There is an opportunity cost to tracking businesses that do not comply.

d) polluting permits

The government may decide to issue polluting permits that can be traded among firms if left
unused.

LIMIT
The government may find it difficult to set the maximum limit allowed.

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