Section A
The Market System
Part 1: Demand and supply
Petrol, rice and insurance all have one thing in common; to buy them, consumers have to pay a price. Why
does the price of rice change? Why is the price of a kilogram of flour sometimes more expensive than a
kilogram of rice? Just as a car has a mechanism to make it work; so too has price. Fortunately there are less
parts to the price mechanism than to a car engine.
Question
Figure 1: World export price of rice
800
700
The price of rice fluctuates.
US$/ton
600
Identify:
(a) in which year was the price highest? (1)
(b) in which year was the price lowest? (1)
500
400
300
200
100
0
’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10
Demand
There is a simple relationship between price
and the quantity demanded (the amount
consumers buy at a given price).
Consider the price of rice in Figure 1. Would
you buy more rice as the price rises or as it
falls? For most goods and services the answer
is as follows:
• if the price of a good or service rises then
consumers buy less
• if the price of a good or service falls then
consumers buy more
The relationship between price and the
quantity demanded is shown in Figure 2
which refers to the demand for training shoes.
The horizontal axis shows the quantity (q)
and the vertical axis shows the price (p). As
price changes there is a movement along the
demand curve (the ‘curve’ is in fact drawn as
a straight line, just one of the many
peculiarities of economics!).
Would you buy more rice as the price rises or as it falls?
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IGCSE Economics
Question
Figure 2: The demand curve for training shoes
90
80
70
Price $
60
The relationship between price and quantity
demanded
50
40
30
D
P D
P D
20
10
0
0
1
2
3
4
5
6
Quantity Demanded, 000’s
7
8
Using the data in Figure 2:
(a) How many pairs of training shoes are demanded when the price is $60? (1)
(b) By how much does the demand for training shoes change when the price falls from $60 to $40? (2)
Supply
Just as there is a simple relationship between price and quantity demanded, so there is a simple relationship
between price and the amount which producers supply to the market.
A farmer in India who produces rice may try to produce more when the price rises, taking advantage of the
increase in his income. If the price falls he may decide to produce less and use his land to produce other
goods which may be more profitable.
The normal relationship between price and the quantity supplied by producers is as follows:
• if the price of a good or service increases suppliers will supply more,
• if the price of a good or service falls suppliers will supply less.
Supply is shown on Figure 3 which refers to the supply of training shoes. The axes are the same as for the
demand curve, quantity (q) on the horizontal axis and price (p) on the vertical axis. As price changes there
is a movement along the supply curve.
Question
Figure 3: The supply curve of training shoes
70
S
60
Price $
50
The relationship between price and quantity
supplied
40
30
20
P S
P S
10
0
0
1
2
3
4
5
6
Quantity Supplied, 000’s
7
8
Using the data in Figure 3:
(a) How many pairs of training shoes are supplied when the price is $60? (1)
(b) By how much does the supply of training shoes change when the price falls from $60 to $40? (2)
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IGCSE Economics
Market equilibrium
In the 21st century consumers and suppliers come together not just face to face in shops and street
markets but also via the internet, postal services and telecommunications. Consumers and suppliers form
a market whether they meet physically or not.
Consumers decide demand for a product and producers decide supply. In a market, demand and supply are
brought together and the result is an equilibrium price. At the equilibrium price (pe) the amount demanded
is equal to the amount supplied.
Figure 4: Market for training shoes
90
80
The equilibrium price occurs when
quantity demanded = quantity supplied.
70
S
Price $
60
50
In Figure 4 the equilibrium price is $50.
40
D
30
The equilibrium quantity at this price is
4000 pairs of training shoes.
20
10
0
0
1
2
3
4
Quantity, 000’s
5
6
7
Excess demand
Figure 5: The market for coconuts
Price
Rupees
S
45
30
Excess Demand
D
Qe
Figure 5 shows the demand and supply of coconuts
in a market. The equilibrium price is 45 rupees. If
sellers charge only 30 rupees they will soon sell all
their coconuts, leaving some would-be consumers
unhappy as there are no coconuts left to buy. The
price, 30 rupees is below the equilibrium and
consumers demand more coconuts than can be
supplied. Excess demand exists.
Quantity
When demand is greater than supply, suppliers can
increase their price until the equilibrium price
(demand = supply) is reached.
Excess supply
Figure 6: The market for coconuts
Price
Rupees
S
Excess Supply
60
45
D
Qe
Figure 6 again shows the demand and supply of
coconuts in a market. The equilibrium price is still
45 rupees. If sellers charge 60 rupees some
consumers will be unwilling to pay this high price.
At the end of the day some coconuts will remain
unsold. The price, 60 rupees, is above the
equilibrium so fewer consumers demand coconuts
than are supplied. Excess supply exists.
Quantity
When supply is greater than demand suppliers will
reduce their price until the equilibrium price
(demand = supply) is reached.
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IGCSE Economics
Question
Figure 7: The market for chocolate bars
3.5
Price per bar $
3.0
Supply
2.5
2.0
1.5
1.0
0.5
Demand
0
0
50
100
150
200
Quantity, 000’s
250
300
350
Study Figure 7 which shows the demand and
supply for chocolate bars.
(a) What is the equilibrium price and equilibrium
quantity? (2)
(b) Calculate the excess demand if the price of a
chocolate bar is $1. (2)
Demand curve: a line which shows the relationship between price and quantity demanded.
Supply curve: a line which shows the relationship between price and quantity supplied.
Equilibrium price: the price at which quantity demanded and quantity supplied are equal.
Market forces: the action of demand and supply on price and quantity bought and sold.
Excess demand: demand is greater than supply at the current price.
Excess supply: supply is greater than demand at the current price.
Changes in demand
A change in the price of a product will result in a change in the quantity demanded. This is a movement
along the demand curve. There are factors, other than price, which can affect the demand for a product
and result in a new demand curve. These factors cause the demand curve to shift.
With reference to Figure 8 consider what happens to the demand for fresh flowers before a festival e.g.
Valentine’s Day. As young and old men rush to buy their wives and sweethearts fresh flowers the demand
increases, D1 to D2, and this leads to an increase in price, P1 to P2. In this case it is the change in demand
which causes the price to change.
Figure 8: Increase in demand for fresh flowers
Price
S
P2
P1
D2
D1 and S
D2
P1
P2
Q1
Q2
= original curves
= increase in demand
= original price
= new price
= original quantity
= new quantity
D1
Q1
Q2
Quantity
When demand increases the demand curve shifts to the right and price rises.
With reference to Figure 9, if it becomes fashionable to give wives and sweethearts silk flowers rather than
fresh flowers, the demand for fresh flowers will fall, D1 to D2. This change in demand will cause the price
of fresh flowers to fall, P1 to P2.
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IGCSE Economics
Figure 9: Decrease in demand for fresh flowers
Price
S
P1
P2
D1
D1 and S
D2
P1
P2
Q1
Q2
= original curves
= decrease in demand
= original price
= new price
= original quantity
= new quantity
D2
Q2
Q1
Quantity
When demand decreases the demand curve shifts to the left and price falls.
Factors which cause the demand to shift
Advertising
The reason why producers and retailers advertise their products is to increase demand. They attempt to
shift the demand curve to the right.
Firms often use celebrities to advertise their goods. The celebrity makes the good memorable and also
gives the buyers the opportunity to pretend that they too are celebrities, if only in a small way. The
perfume firm, Chanel, uses the actresses, Nicole Kidman and Keira Knightley to advertise their perfume.
Bad publicity will cause the demand curve to shift to the left. The outbreak of Avian (bird) flu in 2008
reduced the demand for chickens in India.
Income
How much consumers have to spend will influence demand. If incomes rise most demand curves will shift
to the right as people have more money, but if incomes fall people have less money and demand curves
will shift to the left.
When a government reduces the rate of income tax people will have more money to spend, so demand for
most goods and services will shift to the right.
In a period of recession some people will be unemployed, their incomes will fall. During this time demand
for many goods and services will fall.
Tastes and fashion
Over time products can become fashionable and this leads to an increase in demand. At the same time
some products become unfashionable or out of date. Demand for these products falls.
Digital technology has brought changes to many items. Most people have replaced traditional film cameras
with digital cameras. The demand for digital cameras has grown and the demand for traditional cameras
has fallen.
Related products
1. Substitutes (goods which are close alternatives). The price and demand of a close substitute will
influence demand for the alternative product. When the price of contact lenses fell this led to a fall in
demand for spectacles. The high demand for Nintendo’s Wii console reduced the demand for Sony
Playstations.
2. Complements (goods which have a positive relationship, often used together). The price of a
complement will influence the demand for its related product. When the price of digital cameras fell,
this led to an increase in demand for media memory cards. The fall in demand for traditional cameras
reduced the demand for film compatible with these cameras.
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IGCSE Economics
Population (see later Section)
When the total population of a country changes then demand will change. An increase in population will
lead to an increase in demand for most products, demand curves will shift to the right. The population of
Kenya has risen by about 1 million people per year in this century. This will result in an increase in the
demand for many things. A fall in population will reduce demand.
The size of the population is not the only factor affecting demand. The age distribution of the population,
how many people are in different age groups, can also have a considerable effect. When there is a higher
proportion of old people in a population there will be an increase in the demand for medical services.
Changes in supply
A change in the price of a product will bring about a change in the quantity supplied, a movement along
the supply curve (see Figure 3). There are factors, other than price, which can affect the supply of a
product. These factors result in a new supply curve. This is called a shift in supply.
Figure 10: Increase in supply (shift to right)
Price
S1
S2
P1
P2
D and S1
S2
P1
P2
Q1
Q2
= original curves
= increase in supply
= original price
= new price
= original quantity
= new quantity
D and S1
S2
P1
P2
Q1
Q2
= original curves
= decrease in supply
= original price
= new price
= original quantity
= new quantity
D
Q1
Q2
Quantity
Figure 11: Decrease in supply (shift to left)
Price
S2
S1
P2
P1
D
Q2 Q1
Quantity
Factors which cause the supply to shift
Costs of production
A change in the costs of production e.g. materials, wages, rent, will lead firms to reconsider how much they
produce. When costs fall producers increase supply. This is shown on Figure 10. The price falls and the
quantity demanded and supplied increases. If costs rise they will supply less, see Figure 11.
Due to improvements in technology, the price of flash memory used in the production of MP3 players has
steadily decreased. This trend is expected to continue for several years. This reduction in production costs
has led to a rise in the supply of MP3 players.
Natural disasters and wars
There are many factors over which producers have no control. They include the weather, disease and war.
Such factors can have profound effects on the supply of goods. In September 2012, heavy rain in Pakistan
devastated 80% of crops in Sindh province, so the supply of food fell sharply.
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IGCSE Economics
In February 2009 the presence of infectious salmon anaemia, a virus which can severely damage stocks of
farmed salmon, was found on fish farms in Scotland. The virus is so infectious that the infected fish were
killed to prevent the disease spreading. The supply of farmed Scottish salmon was reduced.
Remember that a fall in supply shifts the curve left.
Indirect taxation and subsidies
Indirect taxes are taxes on goods and services. When a consumer buys a good or service which is taxed, the
tax is not paid directly to the government. Instead it is the producer who passes on the tax to the
government. Such a tax is in effect an increased cost to the producer. The supply curve will shift to the left.
An indirect tax increases the costs of production. An increase in the rate of an indirect tax leads to a fall in
supply just like any other increase in costs.
Figure 12: Indirect tax
S2
Price
Amount
of tax
An indirect tax increases costs
Supply shifts S1 to S2
Price rises P1 to P2
Quantity falls Q1 to Q2
S1
P2
P1
D
Q2
Q1
Quantity
Subsidies have the opposite effect to an indirect tax. A subsidy is money paid to producers by the
government and is related to the amount they supply. It shifts the supply curve to the right and acts like a
reduction in costs. It leads to a reduction in price.
Figure 13
S1
Price
S2
A subsidy reduces costs
Supply shifts S1 to S2
Price falls P1 to P2
Quantity increases Q1 to Q2
Subsidy
P1
P2
D
Q1
Q2
Quantity
Question
Figure 14: The market for LCD televisions in Cyprus
Price
D1 and S1 represent the original demand and
supply curves for new LCD televisions.
S2
S1
S3
D3
D1
D2
Quantity
Starting at the original D1 and S1 in each
question state the new curves in the following
situations:
(a) The manufacturing cost of LCD screens
decreases. (1)
(b) The government imposes a tax of ¤20 on
new LCD televisions. (1)
(c) Cyprus qualifies for the 2014 football World
Cup in Brazil. (1)
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IGCSE Economics
Question
With the aid of demand and supply diagrams, explain the effect of the following on the market price
of foreign holidays:
(a) an indirect tax on aviation fuel. (4)
(b) a decrease in income tax. (4)
Complementary goods: goods which are related to each other: if the price of one increases the
demand for the other falls and vice versa, e.g. petrol and cars.
Substitute goods: these are close alternatives, e.g. butter and margarine. If the price of one good
increases the demand for the other increases and vice versa.
Indirect taxes: taxes on expenditure, e.g. value added tax (VAT). They shift the supply curve to the
left and increase the price to the consumer.
Subsidies: money paid to a producer by the government. It shifts the supply curve to the right and
reduces the price to the consumer.
Part 2: Population
Changes in population can have profound effects on the world economy, individual countries and the
environment.
Changes in total population
The population of the world is increasing by more than 200,000 people every day. This will affect the
future demand and supply of all products and services. Many predict that the increase in the world’s
population will also have dramatic effects on the environment.
Changes in a country’s population
The size of a country’s population can change because of:
• birth rate – the average number of live births occurring in a year per 1000 of the population
• death rate – the average number of deaths occurring in a year per 1000 of the population
• net migration – immigration minus emigration
Population may increase because:
• Birth rate is greater than death rate
• Immigration is greater than emigration
Population may decrease because:
• Death rate is greater than birth rate
• Emigration is greater than immigration
Changes in the birth rate may be caused by:
• Availability of contraception. In many countries contraception and advice on family planning is provided
free of charge by the state.
• Social changes. More women are entering the workforce. As they take advantage of education
opportunities they are becoming more qualified and their earnings are increasing. Some of these women
prefer more working years and smaller families (or no children) so the birth rate falls. It is also becoming
more normal for women to work in developing countries.
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IGCSE Economics
• Economic changes and expectations. As more couples prefer a higher standard of living rather than
large families, so the birth rate falls. The cost of bringing up children has been widely publicised in
developed countries and this may influence the size of families. The latest figures for the UK estimate
that the cost of bringing up a child to the age of 21 years is over £215,000.
Changes in the death rate may be caused by:
• The general standard of health of the population. If the state spends more on hospitals, information
about preventing disease (e.g. how to stop smoking) and more on research into diseases and vaccination
programmes, then the death rate will fall.
• Outbreaks of disease, especially those which are contagious e.g. cholera will increase the death rate.
• Standard of living. Increased incomes may lead to better nutrition and a fall in the death rate. Famines
lead to a rise in the death rate, so do wars, which are also associated with a fall in the standard of living.
Net migration
Net migration can be positive (more people entering the country than leaving) or negative (more people
leaving the country than entering). In 2008-12 the net migration in China and Poland was negative
whereas in the UK it was positive. Migration can be caused by:
• Different standards of living in countries. People will be attracted to countries with higher standards of
living, better employment prospects, better state benefits e.g. health, education, financial benefits.
Workers from Eastern European countries like Poland, which have joined the European Union (EU),
have been attracted to the Western EU countries because of higher wage rates. There has been a
growing number of retired people leaving the UK for parts of the world which provide a better climate,
which they feel contributes to a better standard of living.
• War and civil unrest. This type of migration can be temporary, as people leave but return home when
their country becomes politically stable, or it can be permanent.
Main effects of population changes
Population changes affect all aspects of the economy.
1. Firms
• As the size of the population changes so there may be a change in the quantity of goods and services
demanded.
• As the age distribution in an economy changes there may be a change in the type of goods and services
demanded and supplied. An increase in younger age groups may lead to an increased demand for
educational toys. An ageing population has led software and games manufacturers to produce a series
of games which mentally stimulate older people in an attempt to prevent dementia.
• The workforce will change. If the number of people available to work falls, then firms may be faced with
higher wage bills as demand exceeds the supply of labour. They may consider replacing workers with
machines. As the composition of the workforce changes, productivity might be affected. Older workers
are sometimes seen as less productive as they may not adapt to new technology, and are physically not
as fit as young workers. On the other hand, older workers have experience and skills.
2. Government
• Government expenditure. If the size of the population increases then the government has to provide
more public services and benefits so expenditure will increase. If the age distribution changes then the
services and benefits it provides will change so the allocation of public funds will change. An ageing
population is usually associated with an increase in government expenditure as the provision of health
care and pensions increases.
• Government revenue. The working population pays a variety of taxes, e.g. income tax, which usually
provide a large proportion of government revenue. If the working population falls, then government
revenue will fall. The non working population may have less to spend, so there can also be less revenue
from taxes on goods and services.
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IGCSE Economics
3. The Economy
The size of the population will affect the economy.
• A rise in population may put pressure on scarce resources and lead to excess demand and inflation.
• It may reduce the standard of living and economic growth, topics which are dealt with in later Sections.
• Alternatively, more people can mean a larger workforce and more output.
• If the country cannot produce enough for its population then imports may increase, which may create
a balance of payments deficit (Section 4).
4. The Environment
• An increase in population usually has an adverse effect on the environment. Pollution from increased
production in the form of contaminated air, land or water can be detrimental to the environment. Roads
become more congested.
Population pyramids
Population pyramids show the age distribution of a country’s population. The following population
pyramids show a developed country, Japan, in Figure 15 and a developing country, Kenya, in Figure 16.
Figure 15: Japan 2010, population 126,536,000
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
Female
Male
10
7.5
5
2.5
0
Population, %
2.5
5
7.5
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
10
Source: populationpyramid.net
A developed country like Japan tends to have a narrow base which indicates a falling birth rate. The middle
bands are wider as the average age of the population is increasing. After the age of 55-59 years the
number of people in each age band falls as the death rate in the older age groups is higher.
Figure 16: Kenya 2010, population 40,514,000
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
10
Female
Male
7.5
Source: populationpyramid.net
10
5
2.5
0
Population, %
2.5
5
7.5
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
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IGCSE Economics
A developing country like Kenya has a typical pyramid shape. This indicates a high birth rate but also a
relatively high infant mortality rate (the number of deaths of infants one year of age or younger per 1000
live births). Many children die because of illness. There is a lower percentage of people over the age of 59
compared to Japan and a lower percentage in the working population.
Question
Figure 17: Percentage of population in major age groups
70%
Kenya
Japan
60%
50%
40%
30%
20%
10%
0%
0-14 years
15-64 years
65 years and over
1. Which country’s population seems likely to be ‘ageing’? With reference to Figure 17, explain your
answer. (4)
2. Identify and briefly explain two possible differences in government expenditure caused by the
differing age distributions in Japan and Kenya. (4)
3. Which country is likely to face greater economic problems related to population in the next 50
years? With reference to the data, explain your answer. (4)
Question
World population and food supply
The world is too reliant on a handful of key crops. Around 80% of the world’s food comes from just
a few plants. The threat of pests, disease and climate change means that the supply of key crops like
wheat, maize, oats, barley and rice is extremely vulnerable. This and the global increase in population
make food shortages inevitable. The International Panel on Climate Change has warned that food
shortages will become far more common over the next 20 years. They predict droughts in some of
the most important food producing areas including southern Europe, Western Australia and southern
Africa.
Food prices have already soared. In 2007, wheat prices rose more than 77%. Maize output in Europe
fell by 25% in 2008. Profitable non-food crops grown to provide bio-fuels have led to some land no
longer being used for food production.
From the data:
1. Identify one demand factor which has led to an increase in the price of food. (1)
2. With the aid of a demand and supply diagram, explain how supply factors have increased the price
of food. (4)
Age distribution: the number of people in each age group of the population. This can be shown on
a population pyramid. It may be simplified into three categories: under working age, working age and
retirement age groups.
Ageing population: the average age of the population is increasing.
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IGCSE Economics
Part 3: Elasticity
Price Elasticity of Demand
Study the demand curves for Product A and Product B in Figure 18 and Figure 19. The demand curves of
the two products have some similarities and some differences.
Figure 19: Product B
14
14
12
12
10
10
8
DA
6
Price $
Price $
Figure 18: Product A
8
6
4
4
2
2
0
0
DB
0
2
4
6
8 10 12 14 16 18 20 22 24
Quantity Demanded
0
2
4
6
8 10 12 14 16 18 20 22 24
Quantity Demanded
Similarities
Differences
• At price $10 demand for A and B is 10 units
• As price falls from $10 to $8 demand rises
for both A and B
• As price rises from $8 to $10 demand falls
for both A and B
• The demand curve for B is steeper than the
demand curve for A
• Product A: when price falls from $10 to $8
demand rises from 10 units to 20 units
• Product B: when price falls from $10 to $8
demand rises from 10 units to 11 units
Product A and Product B have normal
demand curves
The same change in price results in a different
change in quantity demanded
Price Demand Price Demand The demand for Product A is more responsive
to changes in price
The demand for Product B is less responsive to
changes in price
In Economics the responsiveness of demand to a change in price is called ‘price elasticity of demand’.
When a change in price results in a more than proportionate change in quantity demanded the demand
curve is said to be ‘elastic’, e.g. Product A, when price falls from $10 to $8 (-20%) the quantity demanded
rises from 10 units to 20 units (100%).
When a change in price results in a less than proportionate change in quantity demanded the demand
curve is said to be ‘inelastic’, e.g. Product B, when price falls from $10 to $8 (-20%) the quantity demanded
rises from 10 units to 11 units (10%).
The numerical formula for price elasticity of demand (PED) is:
% change in quantity demanded
% change in price
Price elasticity of demand is normally negative, but economists don’t always show a minus sign.
When price falls from $10 to $8 the PED for Product A is:
100%
= -5
-20%
This demand is price elastic. Elastic demand curves have a PED greater than 1.
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IGCSE Economics
When price falls from $10 to $8 the PED for Product B is:
10%
= -0.5
-20%
This demand is price inelastic. Inelastic demand curves have a PED less than 1.
In extreme cases, say Product C, a change in price will have no effect on demand. In such cases the demand
curve is said to be perfectly inelastic. This can be seen on Figure 20.
Figure 20: Product C
When price falls from $10 to $8 the PED for
Product C is:
0%
= 0
-20%
16
D
14
12
Price
10
8
The demand is perfectly inelastic.
6
4
Perfectly inelastic demand curves have a PED
equal to zero.
2
0
0
2
4
6
8
10 12 14
Quantity Demanded
16
18
20
Another extreme type of elasticity is shown for Product D. A change in price has a normal effect on
demand. However total revenue remains the same for any quantity. This can be seen on Figure 21.
Figure 21: Product D
16
14
When a demand curve has a PED of -1, it is said
to have unit or unitary elasticity.
12
Price
10
8
As shown later, total revenue (price x quantity)
remains unchanged.
6
4
2
D
0
0
5
10
15
20
25
Quantity Demanded
30
35
Application of price elasticity of demand
The relationship between a change in price and the response of the quantity demanded, price elasticity of
demand, can be used by firms and governments.
Knowledge of the price elasticity of demand enables firms to maximise total revenue. Total revenue (TR) is
the price of product multiplied by the number of products sold. To help to set a price for their products,
firms use knowledge of their price elasticity of demand.
A firm producing Product A, which has a price elastic demand curve, will find that total revenue increases
as it reduces price; but a firm producing Product B (with price inelastic demand) will find total revenue
decreases as it reduces price.
Product A (elastic demand, ed >1)
Price
Quantity demanded
(price x quantity)
Total revenue (TR)
$10
$8
$100
$160
10
20
Elastic demand
Price TR Price TR 13
IGCSE Economics
Product B (inelastic demand, ed <1)
Price
Quantity demanded
(price x quantity)
Total revenue (TR)
$10
$8
$100
$88
10
11
Product C (perfectly inelastic demand, ed = 0)
Price
Quantity demanded
Total revenue (TR)
(price x quantity)
$10
$8
10
10
$100
$80
Product D (unit elasticity of demand, ed = 1)
Price
Quantity demanded
(price x quantity)
Total revenue (TR)
$10
$8
$100
$100
10
12.5
Inelastic demand
Price TR Price TR Perfectly inelastic demand
Price TR Price TR Unitary elasticity
Price TR no change
Price TR no change
Governments can use price elasticity of demand to their advantage when taxing goods and services. If
taxed goods have an inelastic demand curve then the taxes imposed on the goods will have little effect on
demand so governments’ revenues will increase.
Factors affecting price elasticity of demand
If no numerical data is available firms can estimate price elasticity of demand by considering the factors
which affect it.
Availability of close substitutes
If a good or service has a close substitute then the PED will be elastic. If the price of coffee rises, many
consumers will stop buying it and buy tea or other drinks instead. There will be those consumers who will
still buy coffee despite the price rise, as they don’t consider other drinks to be a close substitute.
Habits and addictions
Sometimes consumers buy a product even if the price has risen, because it has become a habit. An extreme
habit might become an addiction as in the case of cigarettes. As the price of cigarettes rises demand falls
by only a small amount, as most smokers cannot stop smoking. Demand for cigarettes is price inelastic.
Advertising and brand loyalty can reinforce consumers’ habits so that consumers buy a particular brand
despite price rises. If Coca-Cola, a multinational producer of soft drinks, increases the price of its products,
consumers may still buy the brand even though alternatives are available a lower price.
Necessities and luxuries
Products which are considered to be necessities are price inelastic, a change in price will have little effect
on demand. Rice in India, pasta in Italy, and potatoes in England are staple foods, they are considered an
essential part of the diet. When price changes, there is little change in their demand.
Products which are considered to be luxuries are price elastic; a change in price will have a large effect on
demand. The price of mobile phones has fallen and the demand has risen by a more than proportionate
amount, which suggests that they are luxury goods. Whether a good is a necessity or a luxury depends
upon the income of the consumer. It can be argued that mobile phones are now regarded as necessities by
middle income earners, whereas they are still luxury goods for low income earners.
Time
Consumers may not react quickly to sudden price changes but they may change their demand over a
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IGCSE Economics
longer period of time. Their reluctance to change the demand for certain products may be because they
lack knowledge of close substitutes or the cost of changing from one to another may be prohibitive. Over
time consumers can investigate the market and discover alternatives.
There are many mobile phone tariffs. It takes time to investigate and compare the tariffs and sometimes a
consumer may have a contract with one provider e.g. Vodaphone, so may have to wait until the contract
has finished before changing to a different tariff with another mobile phone provider.
Percentage of income spent on goods and services
If the amount spent on a product is small compared to total income then it can be argued that the price
elasticity of demand will be inelastic. Salt is inexpensive and represents only a small percentage of total
income. When price rises demand will fall but only by a very small amount.
The price elasticity of demand of a good or service can be affected by more than one of the factors listed.
Sometimes the factors conflict and a judgement must be made as to which factors are the most important.
Estimating the price elasticity of demand of chocolate
The price elasticity of demand of chocolate is probably elastic as it is considered by most people to be a luxury
item. Only those people who are addicted to chocolate consider it a necessity. If the price of chocolate
increases many consumers might look for alternatives, e.g. crisps, sugar coated sweets. This could lead to a
large fall in demand as there are many substitutes available. If consumers buy a small amount of chocolate
each week, then a rise in price might not affect demand as only a small amount of income is spent on it; in
which case it might be considered inelastic. Overall, the price elasticity of demand for chocolate might be
considered elastic because of the number of close substitutes and because it is not necessary to everyday life.
Summary of factors affecting price elasticity of demand:
More price elastic
Less price elastic
Goods with close substitutes
Not addictive
Luxuries
Longer time period
High percentage of income spent on good
No close alternatives
Habit forming/addictive
Necessities
Shorter time period
Low percentage of income spent on good
Question
Price Elasticity of Demand for tobacco products in India
A study in India found that the price elasticity of demand estimates for different tobacco products
ranged between -0.4 to -0.9 with bidis (an Indian hand-rolled smoked tobacco preparation) and
chewing tobacco having price elasticities close to 1. Cigarettes were the least price elastic of all the
tobacco products.
High taxes and regulatory controls on cigarettes have failed to lower the number of smokers in India.
As older smokers stop smoking or die, there are always younger Indians willing to take up the habit
because they see it as trendy. The higher taxes tend to drive some low income smokers to switch from
expensive cigarettes to cheaper alternatives like bidis and chewing tobacco.
1. (a) The price elasticity of demand for tobacco products in India is
Inelastic □
Positive □
Elastic □
(b) With reference to the data explain your answer. (3)
(1)
2. Briefly explain two reasons why high taxes have failed to reduce the number of smokers in India. (4)
3. Assess the case for the government of India imposing future tax increases on cigarettes. (6)
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IGCSE Economics
Price Elasticity of Supply
Just as demand curves are elastic and inelastic so too are supply curves.
Study the supply curves for Product A and Product B in Figure 22 and Figure 23. Like the demand curves
for Products A and B, the supply curves of the two products have some similarities and some differences.
Figure 22: Product A
Figure 23: Product B
14
14
SA
10
Price $
10
Price $
SB
12
12
8
6
8
6
4
4
2
2
0
0
0
2
4
6
8 10 12 14 16 18 20 22 24
Quantity Supplied
0
2
4
6
8 10 12 14 16 18 20 22 24
Quantity Supplied
Similarities
Differences
• At price $8 quantity supplied for A and B
is 10 units
• As price rises from $8 to $10 quantity supplied
rises for both A and B
• As price falls from $10 to $8 quantity supplied
falls for both A and B
• The supply curve for B is steeper than the
supply curve for A
• Product A: when price rises from $8 to $10
supply rises from 10 units to 20 units
• Product B: when price rises from $8 to $10
supply rises from 10 units to 11 units
Product A and Product B have normal
supply curves
The same change in price results in a different
change in quantity supplied
Price Quantity supplied The supply of Product A is more responsive
to changes in price
Price Quantity supplied The supply of Product B is less responsive
to changes in price
In Economics the responsiveness of supply to a change in price is called ‘price elasticity of supply’.
When a change in price results in a more than proportionate change in quantity supplied the supply curve
is said to be ‘price elastic’, e.g. Product A, when price rises from $8 to $10 (25%) the quantity supplied
rises from 10 units to 20 units (100%).
When a change in price results in a less than proportionate change in quantity supplied the supply curve
is said to be ‘inelastic’. e.g. Product B, when price rises from $8 to $10 (25%) the quantity supplied rises
from 10 units to 11 units (10%).
The numerical formula for price elasticity of supply (PES) is:
% change in quantity supplied
% change in price
Price elasticity of supply is positive.
When price rises from $8 to $10 the PES for Product A is:
100%
= 4
25%
The supply is elastic. Elastic supply curves have a PES greater than 1.
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IGCSE Economics
When price falls from $10 to $8 the PES for Product B is:
10%
= 0.4
25%
The supply is inelastic. Inelastic supply curves have a PES less than 1.
In extreme cases, say Product D, a change in price will have no effect on supply. In such cases the supply
curve is said to be perfectly inelastic. This can be seen on Figure 24.
Figure 24
When price falls from $10 to $8 the PES for
Product D is:
0%
= 0
20%
16
S
14
12
Price
10
8
The supply is perfectly inelastic.
6
4
Perfectly inelastic supply curves have a PES
equal to zero.
2
0
0
2
4
6
8
10 12 14
Quantity Supplied
16
18
20
Factors affecting price elasticity of supply
Time
Time is a major factor affecting elasticity of supply. If producers have difficulty changing their levels of
production in response to a change in price then price elasticity of demand is inelastic. In economics, time
can be divided into:
• this moment in time: a change in price produces no response in supply. Price elasticity of supply = 0,
it is perfectly inelastic.
• short run: different amounts of the variable factors of production, e.g. labour, can be used to change
the amount produced in response to a change in price. Price elasticity of supply becomes more elastic.
• long run: all the factors of production can be altered, e.g. factories built. Price elasticity of supply
becomes even more elastic.
Figure 25: Price elasticity of supply over time
In the long cold English winter of 2012/13, the
demand for road salt used to clear the roads of ice
Long run
increased. Despite a rise in price, there was no
immediate increase in the amount of road salt
available because of the time it takes for it to be
mined. The major company which supplied the road
salt asked its workers to work longer hours. With
the aid of machinery and extra man hours, the mine
Quantity
was able to increase the supply of road salt within a
few days. If demand and prices continue to rise in the future, the company could increase supply by
looking for new sources of salt, but this might take several years.
Price
This moment
in time
Short run
The table below shows the effect of time on the supply of road salt.
February 2013 (the moment)
Short run (weeks)
Long run (years)
Even though the demand and
price had risen, no more salt
was supplied.
Variable factors of production,
e.g. labour was employed for
longer hours, so supply of salt
increased.
New mines could be found, all
factors of production can rise.
Supply of road salt can
increase more.
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IGCSE Economics
Level of stocks
If the producer has large stocks of finished goods or raw materials, then supply can be very responsive to
changes in price. If the producer of road salt had held large stocks, then supply to the market could have
increased. Therefore for a while, until stocks are used up, elasticity of supply will be more elastic.
Goods which cannot be stored e.g. perishable goods like tomatoes, will be less elastic. The price of these
perishable goods may increase, but because they cannot be stored for long, supply cannot change
immediately.
Price elasticity of supply of the factors of production
If all available factors of production are currently employed, supply cannot be increased. Finished products
will be price inelastic as an increase in price will not affect supply. If the factors of production are price
inelastic, then the elasticity of supply of the finished goods will also be inelastic.
If all the skilled workers in the computer industry are employed producing computers, the supply of
computers cannot change in response to a change in price. It might be argued that this is another example
of time playing a major role in price elasticity of supply as, over time, more workers could be trained and
elasticity of supply of computers could become more elastic.
If the supply of a raw material like gold is limited because there are no more gold mines being discovered,
then the elasticity of supply of gold jewellery will be inelastic.
Summary of factors affecting price elasticity of supply:
More price elastic
Less price elastic
• Longer period of time available for factors
of production to be increased
• High level of stocks
• Supply of factors of production can easily
be increased
• Short period of time available so difficult to
increase factors of production
• Low level of stocks e.g. perishable items
• Supply of factors of production cannot easily
be changed
The differences in elasticity of supply of manufactured (secondary) goods and primary products
The primary sector of the economy consists of farming, fishing, forestry and mining. The price elasticity of
supply of primary products is usually less elastic than price elasticity for manufactured goods. The difference
in price elasticity of supply of primary and manufactured goods is due to the following reasons:
Time period
The time period needed to increase the supply of primary products is usually longer than that needed to
increase the supply of manufactured goods.
Primary products:
• Farming: Crops need to be planted. It may take months or years before supply can be changed. The
increase in demand for rice in Vietnam has led to an increase in its price. The supply of rice cannot
change until more has been planted and harvested. McDonald’s created a demand for beef for their
burgers. This increased the price of beef. The supply could not change until more beef cattle had been
reared.
• Fishing: Over fishing means the amount of fish in the seas and rivers is being reduced. When price
rises, there is no increase in supply. Fish stocks in the oceans have declined. In Asia, fish stocks have
gone down by up to 30 percent in the past 25 years. To give the fish time to breed and replenish stocks
takes time.
• Forestry: Trees are needed for building and paper. Like crops and cattle, trees take time to grow so an
increase in price does not immediately produce an increase in supply. It takes 80-100 years for hardwood
trees like oak to reach maturity and 30-40 years for pine trees to be ready to be used for building timber.
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IGCSE Economics
• Mining: New sources have to be found if the supply of resources like natural gas is to increase. The price
of natural gas is increasing as demand increases. At present the supply is fixed, although firms are already
exploring new areas like the Arctic. However, it will take years to bring any new supplies to the market.
Manufactured products:
• The supply of manufactured goods can be increased by increasing the factors of production. Workers
can be asked to work more hours per day, more workers can be employed. Machines can be used for
more hours, more machines can be bought. This enables the supply of manufactured goods to increase
more rapidly than primary goods in response to a change in price.
Availability of stocks
Primary products like pineapples and fish are often perishable so they cannot be stored. Therefore the
supply cannot respond quickly to changes in price. There are often unsold stocks of manufactured goods
which can be quickly put onto the market.
Question
Figure 26: Fresh flowers
Price
Figure 27: Artificial flowers
S
Price
S
P
P
D
D
Q
Quantity
Q
Quantity
Figures 26 and 27 show the markets for fresh flowers and artificial flowers.
1. (a) What will happen to the supply and price of fresh flowers if bad weather destroys the crop? (2)
(b) What is likely to happen to the price of artificial flowers when the fresh flowers are destroyed
by bad weather? (2)
(c) Why will this change occur? (2)
The price elasticities of supply of fresh flowers and artificial flowers are different.
2. (a) What is the numerical value of the price elasticity of supply of fresh flowers as shown on the
diagram? (1)
(b) Explain why the price elasticity of supply of primary products, like fresh flowers, is different
from the price elasticity of supply of manufactured goods, like artificial flowers. (4)
Price elasticity of demand: the responsiveness of quantity demanded to a change in price. Price
elasticity of demand equals the % change in quantity demanded, divided by the % change in price.
Elastic demand/elastic supply: an increase in price will result in a more than proportionate
decrease/increase in quantity demanded/supplied. Elasticity will be greater than 1.
Inelastic demand/supply: an increase in price will result in a less than proportionate decrease/
increase in quantity demanded/supplied. Elasticity will be less than 1.
Unit elasticity: an increase in price results in a proportionate increase in quantity demanded/
supplied. Elasticity is equal to 1.
Primary sector: that part of an economy which consists of farming, fishing, forestry, mining, i.e. the
extractive industries.
Secondary sector: processing of primary products into manufactured goods.
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IGCSE Economics
Income elasticity of demand
As we have seen, the responsiveness of demand to a change in price is called ‘price elasticity of demand’.
The responsiveness of demand to a change in income is called ‘income elasticity of demand’.
If the amount paid to people in the form of wages, salaries, pensions or even pocket money changes, this
will lead to a change in the amount they spend. This in turn will lead to a change in demand for goods and
services. Not all goods and services will be affected in the same way by a change in income.
Normal goods
When an increase in income leads to an increase in the quantity demanded the good is said to be ‘normal’.
When an economy is growing and people have more to spend, then the demand for normal goods increases.
When an economy is in recession and incomes are falling, the demand for normal goods decreases.
At the beginning of the 21st century the Chinese economy experienced rapid growth and incomes
increased. This led to an increase in demand for most goods e.g. cars.
The recession in Europe from 2008 reduced the demand for meals in restaurants and foreign holidays.
Inferior goods
When an increase in income leads to a fall in the quantity demanded, the good is said to be ‘inferior’. When
an economy is growing and people have more to spend then the demand for inferior goods decreases.
When an economy is in recession and incomes are falling, the demand for inferior goods increases.
Recession in Europe led to people staying at home rather than enjoying an evening out at the cinema or
theatre. One of the winners during the recession were the Pay TV companies which offered live coverage
of major sporting events and the latest films, for people to watch in their own homes. Restaurants suffered
as consumers stayed at home, whilst take-away pizza firms enjoyed increased demand. Pay TV and take
away pizzas are inferior goods as the demand increased as incomes fell. The normal goods, cinema, theatre
and meals in restaurants, suffered a fall in demand as incomes fell.
The numerical formula for income elasticity of demand is:
% change in quantity demanded
% change in income
Consider products A and B in Figure 28.
Figure 28
Annual income ($)
10000
15000
Quantity demanded
of product A
Quantity demanded
of product B
2000
2500
2000
1000
Product A:
As income rises from $10000 to $15000 the quantity demanded rises from 2000 to 2500 units.
Calculation:
percentage change in quantity demanded
percentage change in income
=
25%
50%
= +0.5
Product A is a normal good.
• Normal goods have an income elasticity of demand which is positive.
• Normal goods which have an income elasticity of demand greater than one are usually luxury goods.
• Normal goods which have an income elasticity of demand less than one are usually necessities.
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IGCSE Economics
Foreign holidays have a positive income elasticity of demand.
Product B:
As income rises from $10000 to $15000 the quantity demanded falls from 2000 units to 1000 units.
Calculation:
percentage change in quantity demanded
percentage change in income
=
-50%
50%
= -1
Product B is an inferior good.
• Inferior goods have an income elasticity of demand which is negative.
Summary of income elasticity of demand:
Normal good
Inferior good
Incomes rise
Demand rises
Demand falls
Incomes fall
Demand falls
Demand rises
Income elasticity of demand
Positive
Necessities: less than 1
Luxuries: greater than 1
Negative
Examples
Cars, foreign holidays,
restaurant meals
Public transport,
potatoes
Application of income elasticity of demand
The relationship between a change in income and the response of the quantity demanded is important to
firms and governments. It can be used to forecast changes in consumer demand as economies grow or
decline.
• Firms
If the income elasticity of demand is positive for their products (normal goods) firms will plan to increase
supply during periods of rising incomes. If income elasticity of demand is negative for their products
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IGCSE Economics
(inferior goods) firms will need to reduce supply and perhaps consider switching to other products as
incomes rise.
The UK chocolate manufacturer Cadbury’s saw sales of its biggest brand, the Dairy Milk chocolate bar,
grow by 11% during the recession in 2008-2009. Consumers ate more chocolate during the recession.
Its chewing gum products, which tend to sell in small stores, petrol stations and airport shops, were hit
as people travelled less. Therefore, in periods of recession and falling incomes, Cadbury’s could consider
increasing production of the Dairy Milk bar and reducing production of chewing gum.
• Governments
Governments can use income elasticity of demand to forecast tax revenues from indirect taxes placed
on goods and services. If a good is normal then tax revenues will rise as incomes rise but if it is inferior
tax revenues will fall. During a period of rising incomes, consumers demand more cars and petrol so
governments could consider increasing indirect taxes on these normal goods.
Question
February 2009: Daimler’s Mercedes Benz car sales fall 25%.
The German car manufacturer, Daimler, announced that sales of its Mercedes Benz cars fell by 25%
worldwide in February 2009, as the deepening economic downturn decreased demand. Falling
incomes and higher unemployment led to the company admitting that car sales had fallen from
96,800 in February 2008 to 72,000 in February 2009.
In the United States, although total Mercedes car sales were down 24% in February 2009 from a year
earlier, sales of its smaller Smart car rose 29% to 1,400 cars from 1,100 a year earlier. Sales of the
Smart car in Germany also rose sharply, recording a 28% increase for February 2009.
Daimler said it was also seeing increased demand for its used cars. A spokesman for Mercedes-Benz
Cars stated, “The demand for our one year old used vehicles has been increasing since the beginning
of the year”.
1. According to the data, new Mercedes cars can be considered to be:
Inferior goods □
Luxury goods □
Necessities □
Normal goods □
With reference to the data and income elasticity of demand, explain your answer. (3)
(1)
2. According to the data, Smart cars and second-hand Mercedes cars can be considered to be:
Normal goods □
Inferior goods □
Luxury goods □
Necessities □
(1)
With reference to the data and income elasticity of demand, explain your answer. (3)
3. Briefly explain how the different income elasticities of demand for Smart cars and other Mercedes
car models will affect future production decisions of the firm. (4)
Income elasticity of demand: measures the responsiveness of demand to a change in income.
Income elasticity of demand equals the % change in quantity demanded, divided by the % change
in income.
Normal goods: goods which increase in demand as income increases. Income elasticity of demand
for normal goods is positive.
Inferior goods: goods which decrease in demand as income increases. Income elasticity of demand
for inferior goods is negative.
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IGCSE Economics
Part 4: The role of the market in solving the economic problem
Scarcity
There are not enough productive resources to supply all the goods and services that people want. Economists
call this scarcity. We all want more, our demand seems unlimited, but unfortunately our incomes are not –
we cannot afford all the things we want. To decide how resources will be used, choices must be made. In
the free market system, consumer choices ultimately decide how scarce resources will be used.
The individual makes a choice every time he/she makes the decision to buy a good. By choosing to buy
one good the individual is deciding to do without another. Take for example a student who has saved $300
and would like to buy a tablet computer but also a new mountain bike. Both items are priced at $300. The
student chooses to buy the tablet computer so no longer has the opportunity to buy the mountain bike,
because he has spent his limited amount of money.
When a choice is made the good which is not chosen is the opportunity foregone. In economics this is
called ‘opportunity cost’. The term can also be applied to time, allocating time to one activity rather than
another gives rise to opportunity cost. Whilst reading this book you are giving up the opportunity of (say)
watching television. In this case, watching television is the opportunity cost.
Firms and government also have to make choices. A firm may choose to buy a new delivery van rather than
a new computer network. The new computer network would be the opportunity cost.
A government has to choose between different items of expenditure. A government may choose to build
a new hospital instead of a new school. The new school is the opportunity cost.
Question
Identify a possible opportunity cost of:
(a) a government building a new airport, (1)
(b) a firm increasing the wages of its workers, (1)
(c) a student working in a restaurant in the evenings. (1)
Opportunity cost can be illustrated on a production possibility curve. The curve shows combinations of two
goods which can be bought or produced using a given amount of income or resources.
Figure 29 shows a production possibility curve for a country which is able to produce consumer goods e.g.
clothing, and capital goods e.g. machines.
Figure 29
If the country uses all its resources in the production
of capital goods, it can produce OA capital goods.
Capital
Goods
A
If the country uses all its resources in the production
of consumer goods, it can produce OF consumer
goods.
B
C
0
D
E
F
Consumer
Goods
It can produce combinations of capital and
consumer goods e.g.:
• OB capital goods and OD consumer goods
• OC capital goods and OE consumer goods
When production in a country changes e.g. an increase in the production of capital goods from OC to OB,
there is an opportunity cost involved which can be measured in terms of consumer goods. In this case
production of consumer goods falls from OE to OD.
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IGCSE Economics
Economic growth can be illustrated on the production possibility curve shown in Figure 30, as an outward
movement of the curve. This shows that the economy is able to increase production of both consumer and
capital goods.
Figure 30
Capital
Goods
A
B
C
0
D
E
F
Consumer
Goods
Scarcity: this is caused by people’s wants and needs being greater than the resources available to
satisfy them.
Opportunity cost: the cost of the next best alternative foregone.
Capital goods: goods used to produce other goods, e.g. machines in a factory.
The mixed economy
Every economy has to solve the problems of what to produce, how to produce, and for whom to produce.
These questions are partly solved by firms. Sometimes these firms are owned by the state (public sector)
and sometimes by individuals either as sole traders or as shareholders (private sector).
Economies today are a mixture of public sector and private sector organisations. The percentage of
economic activity undertaken by each of these sectors in a country can be attributed to history and
politics. In the previously communist states of Eastern Europe, there has been a change from almost
complete domination by the public sector to an increasingly important private sector. Figure 31 shows the
decline of the public sector in the Czech Republic, previously a communist state.
The transfer of state owned firms to the private sector (privatisation) became popular in the last 20 years
of the twentieth century and the beginning of the twenty first century. However, the banking crisis of
2008/09 resulted in some banks in the private sector, in some countries, being brought under state control
(nationalised). The percentage of economic activity in state and private sectors can vary not only from
country to country but also from year to year.
Figure 31: Czech Republic, decline of public sector
% Gross Domestic Product
100
Public Sector
Private Sector
90
80
70
60
50
40
30
20
10
0
1989
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IGCSE Economics
Efficiency
Efficiency in an economy means using scarce resources for the most valued purposes and producing at the
lowest possible cost. The private sector allocates resources according to the price mechanism, the
interaction of demand and supply. As previously seen, a change in the factors affecting demand and supply
will affect what and how much is produced.
A change in price will make producers consider the best quantity to sell and the best means of producing
the good or service, to maximise profits. To do well, private sector businesses must supply products that
consumers value enough to pay a profitable price for. A change to a new equilibrium price will also
determine who will be able to afford the product.
Mixed economy: combination of free market and planned economies. Some resources are allocated
through the price mechanism and some by the state.
Market economy: allows market forces (price mechanism) to determine prices and the allocation of
resources.
Planned economy: the state allocates resources and decides what to produce, how to produce and
what price to set.
Public sector: the part of the economy owned and controlled by the government on behalf of the
country.
Private sector: the part of the economy owned and controlled by shareholders or individuals.
Privatisation: the sale of state-owned firms and assets to the private sector.
Nationalisation: taking privately owned firms into the public sector.
Market failure
The market mechanism of demand and supply does not always work to the advantage of the country and
its inhabitants. Some goods may fail to be produced (public goods) or may not be produced in the amounts
needed by society (merit goods). Other goods which are detrimental to society may be produced because
they are profitable (demerit goods). Firms may fail to take into account adverse costs of production like air,
noise and water pollution (externalities) which affect the welfare of society. When market failure occurs
governments can try to intervene in an attempt to overcome these problems. There is more on this in
Section B.
Public goods
There are some goods and services which the private sector will not provide but which are essential for a
country. These must be provided by the state e.g. police, the justice system, road traffic signs.
Merit goods
Private firms may provide education and health care (merit goods) but at a price which many people may
not be able to afford. The market fails to meet the needs of the population. It is therefore up to the state
to meet these needs.
Demerit goods
Whilst private firms will not provide public goods or sufficient merit goods, they are willing to provide
profitable demerit goods e.g. cigarettes and guns. These goods are thought by the state to have harmful
consequences for the population of the country. The state may intervene to reduce the supply of these
goods. Cigarettes are considered to be demerit goods as they are harmful to health. To reduce the amount
of cigarette smoking in a country, a government may impose indirect taxes, or place government warnings
on cigarette packets or even ban smoking in public places. Most governments restrict the sale of guns and
other weapons.
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IGCSE Economics
Externalities
Production of goods and services can result in both positive and negative externalities. Negative externalities,
e.g. pollution and congestion, are perhaps the most important. The government may have to introduce
measures to reduce them. Such measures can include taxation of polluting firms, fines and tradeable pollution
permits. The permits are issued to firms but can be sold on to other firms if they are no longer needed.
Market failure: this occurs when the price mechanism fails to allocate goods and services to the
best advantage of society. It includes externalities e.g. pollution.
Public goods: goods provided by the state which cannot be charged for according to use, e.g. street
lighting.
Merit goods: goods and services provided by the state which are considered to be of benefit to the
people and country. They may be provided by the private sector, but then some people may not be
able to afford them e.g. education.
Demerit goods: goods which are thought to be harmful to consumers/society, e.g. cigarettes and
addictive drugs.
Externalities: costs and benefits due to production, but which are not accounted for in a firm’s
costs and revenues. The main externalities are negative (costs), e.g. pollution and congestion. They
have an impact on ‘third parties’, not the original buyer or seller.
Part 5: Wages and employment
Labour is a factor of production. High wages often result from a limited supply of people with valued skills,
training and experience. For example, top sports personalities are highly paid for playing a game. Other
factors such as how ‘important’ a job is have less impact on wage levels than demand and supply. Workers
earn wages, this is the price of their labour. Like the price of any other good or service, wages are
determined by demand and supply. The number of workers employed is also determined by demand and
supply. In this Section we shall look at not only wages and employment but also how the tasks labour
performs have changed over time.
Division of labour
Consider who does the following tasks in your home.
• Cooking
• Washing up
• Laundry
• Paid employment
• Maintenance of the home e.g. putting up shelves, decorating
In most homes the above tasks are undertaken by different individuals. This is called division of labour. The
same principle is applied by firms.
In order to make labour more efficient, firms have split up the production process into small tasks. In the
fabric printing process of batik, one person could perform all the tasks but the process is speeded up by
employing more than one person and developing each person’s skills. Production is increased, the workers
become specialised in one process, so they become particularly expert at it. On the other hand, the workers
can become dissatisfied. Performing the same task over and over again may become monotonous.
Division of labour has advantages and disadvantages for workers, firms, consumers and the economy:
Division of labour and workers
Advantages
• Workers may be able to choose the task for which they are best suited. In this way they can enjoy their
work and become more skilled at this task.
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• Increased skill may be rewarded with an increase in wages.
• If paid by the number of units they produce, then as the number of units produced increases their pay
will increase.
• Workers may suffer less stress as the tasks they perform become simplified.
• There may be fewer injuries at work as specialist machines and robots can perform dangerous tasks like
cutting and welding.
Disadvantages
• Workers may find the work monotonous if it is simple and repetitive.
• If there is little training required to undertake simple tasks, unskilled labour can be paid low wages.
• Lack of job satisfaction.
• Threat of unemployment if workers are easily replaced by machines which can complete the tasks
without taking breaks.
Division of labour and firms
Advantages
• Production will be increased, as time is saved when workers become more skilled at one task.
• Increase in production can decrease cost per item so profits increase.
• Less time and expense on training as workers need only train for their specialist task.
• Machines can replace workers for some tasks. Machines can work 24 hours a day, 7 days a week, reduce
wage bills, produce consistent quality and take over dangerous tasks.
Disadvantages
• Bottlenecks can occur if one process is quicker than another.
• A machine failure or other problem at one process can stop the entire flow of goods.
• The increased use of machinery/robots can lead to certain problems:
– The firm may have to borrow money to purchase the machinery. This will have to be repaid plus a rate
of interest.
– Machines may break down so production time is lost.
– Machines may become obsolete and in time will need to be replaced. Most firms put money aside for
this in the form of a depreciation allowance.
– The machines will require trained people to maintain them.
Division of labour and consumers
Advantages
• As productivity increases firms may pass a decrease in unit costs on to consumers as lower prices.
• The increased use of machines may result in the goods produced having a consistent quality.
Disadvantages
• The goods may become standardised, they may lack variety.
Division of labour and the economy
Advantages
• Prices may fall and this may:
– reduce inflation
– make domestic goods more competitive in foreign markets.
• Increases in productivity may increase economic growth and the standard of living.
Disadvantages
• Unemployment may rise as machines replace workers.
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Division of labour is common in small and large firms
Batik garments
Throughout Indonesia and Sri Lanka the art of making garments using batik fabric is well known. The batik
process involves several stages. In even the smallest firms division of labour is applied as shown below.
Stage 1
Worker A: Draws a pattern with a pencil onto a white or beige fabric.
Stage 2
Worker B: Applies the hot wax with a canting needle to the outline of the pattern.
Stage 3
Worker C: Dips the cloth into dye. The waxed parts of the fabric remain undyed. The cloth is returned to
Worker B who continues applying hot wax to the pattern.
Stage 4
The waxing and dyeing processes continue with different colours being used until the final dyeing process.
After this Worker D will remove all the wax which has been applied by heating the fabric and melting the
wax.
Stage 5
Workers E, F and G use the batik fabric to make garments.
Car factory
Assembly lines
Cars are produced on assembly lines with hundreds of workers specialising in different tasks e.g. one group
of workers will install the engines, another group will fix the car hood into position and another group will
put on the wheels. Because the assembly line produces a continuous flow of cars, no workers are idle and
this speeds up the production process.
An early and famous use of division of labour in car manufacturing was by the Ford motor company in
1914. The process led to a car coming off the production line every 3 minutes. Before division of labour,
one car required 12.5 hours on the production line, after 1914 it took only 1.5 man hours. Thus production
was increased whilst at the same time less manpower was used.
One major problem at the Ford factory was a bottleneck when cars were ready for painting. The paint did
not dry fast enough. This problem was overcome by using a particular quick drying black paint. Hence,
Ford cars after 1914 were painted black.
The advantages of Ford’s production line quickly led other car manufacturers to adopt the process.
Automation in car production
For most of the twentieth century car production remained unchanged. In the 1980’s, robots were
introduced to take the place of some human workers.
At first robots were introduced to perform repetitive tasks which workers found monotonous. They were
also used for the more hazardous tasks like welding. As well as reducing injuries to workers, robots turn out
more consistent products as their work is more precise than that of workers. Robots can be cheaper than
humans, as they do not take time off for sickness or strikes and can work 24 hours a day, 7 days a week,
with the minimum of supervision.
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Question
(a) With the aid of examples, discuss the advantages and disadvantages of division of labour to large
and small firms. (6)
(b) To what extent is division of labour beneficial to workers? (6)
Division of labour: breaking down of a job into smaller tasks.
Productivity: the amount produced per unit, e.g. labour productivity = amount produced divided
by the number of workers.
Wages in a free economy
In a free market economy wages (the price of labour) and employment (quantity demanded and supplied)
are determined by the interaction of demand and supply, like other goods and services.
Figure 32
Wages
$
Supply of
Labour
WR
Demand
for Labour
N
No. of Workers
Factors affecting the demand for labour
Labour is a derived demand
The need for labour is dependent upon the demand for the output it produces or service it provides. If
there is an increase in the number of school aged children, there will be an increase in the demand for
teachers; the demand curve for teachers will shift to the right.
Availability of substitutes for labour
If labour can easily be replaced by suitable machines then the demand for labour will fall, the demand
curve will shift to the left. Automation of the motor car industry led to a fall in the demand for labour.
Where production can easily move from country to country, lower wages (costs) can attract firms to
substitute production in one country for another.
Productivity of the workforce
Output per worker is known as productivity. If productivity increases then fewer workers are needed to
produce the same amount of output, the demand for labour may shift to the left. Alternatively, high
productivity can reduce the labour costs per unit of output. This might lead to a reduction in the price of
the final product and increase its demand. The increase in demand for the final product may lead to an
increase in demand for labour.
Often wage deals are related to productivity, the more productive the workforce, the higher the wage
increase they might negotiate with employers.
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Factors affecting supply of labour
The size of the working population
The most important factors affecting the supply of labour are the number of people who are no longer in
full time education and who are below retirement age. The age distribution of the population is therefore
of prime importance. The population pyramids of Japan and Kenya, on page 10, show that Japan has a
much larger proportion of people who can be part of the working population than Kenya.
The working population is made up of those people who are too old for full time education and too young
for retirement. Laws regarding these ages can vary from country to country. In Kenya, primary school
education provided by the state is free and compulsory, and there are plans for free and compulsory
secondary education. However, at present there is no minimum school leaving age. In Japan the minimum
school leaving age is 15 years.
The retirement age in a country depends on whether or not the state provides financial assistance to old
people. If it provides no state pension, then people can only retire with family help. This is the case in many
developing countries. Where there are state pensions, the retirement age can vary. In Japan, the retirement
age is 55, but many workers continue in employment beyond this age. In Denmark and Germany, the
retirement age is 65 years but there are plans to raise it to 67 years. The retirement age might be raised to
increase the size of the working population, and also to control problems governments may have in
financing pensions for an ageing population.
Governments can alter the school leaving age and the retirement age to increase or decrease the size of
the working population.
The number of women in the population who are willing and available to work also influences the size of
the working population. In industrialised countries, the participation rate for men and women is almost
equal. In developing countries women make up only 31% of the labour force, though this is rising.
The increase in the number of women working can be attributed to education, improved child care facilities
enabling mothers to return to work, the ability of couples to limit the size of their families and changes in
attitudes towards women working. The increased number of part-time jobs on offer in industry has also
enabled many women to work. In some countries e.g. the Gulf States, there is little increase in female
participation in the workforce except that the number of female migrant workers to these countries is
increasing steadily.
Qualifications and training
Jobs which require no training can be performed by the majority of the workforce. As the level of skills,
qualifications and training increases for a particular occupation so the number of workers available for this
occupation diminishes. To qualify as a doctor a person must have numerous qualifications, undertake
rigorous training and have the aptitude to deal with sick people. Therefore, few people qualify as doctors.
Supply is less where more qualifications and training are required. Jobs which require little or no skill can
be performed by most workers. Supply of unskilled workers is greater than for occupations which require
highly skilled workers and wages are lower.
Question
The wages of computer programmers have increased by 10% but the wages of nurses have only
increased by 3% in a year.
Briefly explain possible reasons why the wages of computer programmers have increased by more
than the wages of nurses. (4)
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IGCSE Economics
Interference in the labour market
Minimum wage rate
Wages are determined by demand and supply
of labour. Unskilled workers often receive low
wages as excess supply of these workers
drives the wage rate down. In order to provide
a minimum standard of living for all, a
government may decide to impose a minimum
wage rate – which will increase the wages of
these low paid workers. The government
interferes with the price mechanism as it feels
such action is in the interests of the low paid
workers. The minimum wage rate is above the
market equilibrium rate for the lowest paid
workers.
In Japan the minimum school leaving age is 15 years.
Figure 33: Minimum wage rate
Wage
Rates
MWR
S
a
b
c
Px
D
Quantity
of Labour
Px
b
MWR
a
c
a to b
=
=
=
=
=
=
Original market wage rate
Number of workers employed at Px
Minimum Wage Rate
Number of workers demanded at MWR
Supply of willing workers at MWR
number of workers made unemployed
by MWR
a to c = excess supply of workers at MWR
Effects of minimum wage rate
Advantages
Disadvantages
Improves standard of living for low paid workers
Possibility of unemployment. Some studies
suggest this possibility, but some have shown
that minimum wage rates need not cause
unemployment
May encourage those on state benefits to return
to work as the gap between wages and benefits
will increase
May lead to inflation
• wage bills will rise, so firms may increase
product prices
• other workers will want higher wages to
maintain wage differentials
May improve industrial relations and perhaps
productivity
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IGCSE Economics
Question
The table below shows the minimum wage rate in New Zealand:
Wage Rate, $ pe hour
Adult rate (18+ years)
Youth rate (16-17 years)
10.0
9.5
9.0
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
Since 1st April 2004
Before 1st April 2004
$9.00 hour
$7.20 hour
$8.50 hour
$6.80 hour
Supply
Demand
0
10
20
30
40 50 60 70 80
Number of Workers
90 100 110
The diagram shows the wages of adult workers in a cheese factory before 1st April 2004.
1. (a) How many workers are employed at the increased minimum wage rate? (2)
(b) How many workers are willing to work at the new minimum wage rate? (1)
(c) Discuss the possible effects of the introduction of a minimum wage rate on an economy of
your choice. (6)
2. Explain one reason why the youth minimum wage rate is different from the adult minimum wage
rate in New Zealand. (3)
Trade Unions and their effects on wages and employment
One worker has very little bargaining power with an employer but if workers join together they can exert
more power through collective bargaining. In this way a trade union can influence working conditions and
the wage rate for its members. Trade unions negotiate with employers. Employers want to avoid industrial
unrest which will slow down or even stop production. The ultimate weapon of the trade union is a strike,
which can harm firms and workers.
The power of a trade union is dependent upon:
• the proportion of the firm’s or industry’s workers in the union. The more workers in the union the more
its bargaining power.
• the importance of the firm or industry in the economy. A strategic industry e.g. transport, is necessary
to other industries and to the economy as a whole. The government and other firms will put pressure on
the union and employers to bring the dispute to an early end.
As well as bargaining for higher wages, trade unions represent workers in other negotiations with employers.
The unions can negotiate safer or better working conditions, shorter working hours, longer holidays and
redundancy payments. They also put forward the views of workers when employers are considering changes
to the workplace e.g. the introduction of new technology.
Trade unions and professional associations have been known to restrict the number of qualified workers
entering an industry. In this way the union can protect the wages and the employment of its own workers.
In 2006 British ski instructors won a legal battle in the French courts to allow them to work as ski instructors
in France. The l’École de Ski Francais (ÉSF), the association of French ski instructors, claimed that British
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ski instructors were not qualified as they had not taken the difficult speed test required of French ski
instructors. Before being legally recognised, British ski instructors had faced large fines and even the threat
of imprisonment when reported to police by the ESF, and found guilty of teaching without the French
qualifications. In this way the French association restricted the supply of ski instructors in France, keeping
the wages at a higher level.
Trade unions can also represent individual members when they have a grievance at work and feel they have
been unfairly treated. They provide information to members about employment law e.g. maternity leave
regulations. Some unions may provide financial assistance to members and their families e.g. when they
are sick. They can also provide education and training courses on a variety of work related subjects.
In many countries unions organise themselves into pressure groups, which attempt to influence
governments’ economic objectives. The Trades Union Congress in the UK and the Central Organisation of
Trade Unions (COTU) in Kenya are two such organisations.
As with minimum wage rates, there is the possibility that an increase in wages might be offset by a
reduction in the number of workers employed. Trade Unions must consider this possibility in their
negotiations. If the wage rate is forced above the market equilibrium, then unemployment may result,
especially if workers can easily be replaced by machines.
Question
Study the following data which refers to two incidents of industrial action by trade unions.
1. One Day Strike in West Bengal
In August 2008 eight major trade unions in West Bengal and Kerala, including the All India Trade
Union Congress (AITUC) and Centre for Industrial Trade Union (CITU), called a one day strike to
protest about surging inflation and government economic policies in India. The strike affected shops
and offices, schools and colleges were also shut. The transport system, including Kolkata airport was
affected, as 22,000 airport staff joined the strike. Banking transactions across the country were also
hit, as public sector banks joined the strike. The bank employees were particularly concerned with
the new economic policies of the government with regards to mergers, which have led to job cuts.
2. Kuwait port workers strike for higher pay
In March 2009, hundreds of Kuwaiti port workers went on strike demanding a pay rise and better
working conditions. Workers were demanding a 35% increase in their basic salary and better working
conditions.
Using the data:
(a) Identify reasons why industrial action took place in India and Kuwait. (2)
(b) If the port workers in Kuwait were successful in their demands what would be the likely economic
consequences? (3)
Minimum wage rates: a legal minimum hourly wage set by the government of a country.
Trade unions: workers’ organisations which aim to improve wages and working conditions of their
members.
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