1 Economic methodology

and the economic

problem
Economics is the study of choice and decision making in a world with
limited resources. It tries to explain the economic behaviour of both
individuals and groups of people, and the economic relationships between
individuals and groups. Related to the noun ‘economics’ is the verb ‘to
economise’. In large part, economics is the study of economising — the
study of how people make choices about what to produce, how to produce
and for whom to produce, in a world in which most resources are limited or
scarce. How best can people make decisions about how scarce resources
should be allocated among competing uses, so as to improve and maximise
human happiness and welfare? This is the economic problem, which is the
main focus of this introductory chapter.

LEARNING OBJECTIVES
These are to understand:
● economics as a social science
● similarities and differences in methodologies from natural and other sciences
● the difference between positive and normative statements
● how value judgements influence economic decision making and policy
● that the central purpose of economic activity is the production of goods
and services to satisfy needs and wants
● the key economic decisions: what to produce, how to produce and who is
to benefit from the goods and services produced
● the economists’ classification of economic resources into land, labour,
capital and enterprise, which are known as the factors of production
● that the environment is a scarce resource
● that the fundamental economic problem is scarcity resulting from
limited resources and unlimited wants
● scarcity means that choices have to be made about how resources are
allocated
● how production possibility diagrams may be used to illustrate resource
allocation, opportunity cost, trade-offs, unemployment, economic
2 growth and efficiency.

1.1 Economic methodology

● Economics as a social science
When answering the question ‘What is economics?’, a good place to start is the
fact that economics is a social science. Social science is the branch of science
that studies society and the relationships of individuals within a society.
 Psychology, sociology and political science are also social sciences, as are
important elements of history and geography.

1.1 Economic methodology

Psychology studies the behaviour and mental processes of an individual.
Sociology studies the social relationships between people in the context of
society. By contrast, economics, as the name suggests, studies the economic
behaviour of both individuals and groups of people, and the economic
relationships between individuals and groups.
Let us give you two examples of what we mean. Our first example (about
individual behaviour) is from an important part of economics known as demand
theory, which is covered in Chapter 3. The theory addresses consumer
behaviour, or how we behave when we go shopping. Why, for example, do
people generally buy more strawberries as the price of strawberries falls?
Our second example introduces an important economic relationship. Having
explained demand, we must go a stage further and look at how consumers
interact with firms or producers. Firms supply and sell the goods that
consumers buy, and economists call the ‘place’ in which goods are bought
and sold a market. Indeed, before you started this economics course, you may
well have heard the phrase ‘supply and demand’ and thought that is what
economics is about. Well, in large measure that is true, particularly in the
early chapters of this book, which cover Unit 1 of the specification.

TEST YOURSELF 1.1

What is economics the study of?

● Economics and scientific methodology

Observing consumer The essentials of scientific methodology, in the context of the
behaviour demand theory we will look at in Chapter 3, are shown in
in the marketplace
the flowchart in Figure 1.1. Scientists start off by observing
some aspect of the universe (in the natural sciences), or some
Forming a hypothesis to aspect of human behaviour, in the case of the social sciences.
explain how consumers In the case of demand theory, the starting point — shown in
spend their money
the uppermost box of Figure 1.1 — is observations of how
individual consumers react to changes in the prices of the
goods and services they buy. Demand theory then develops
Developing predictions from New or from making a tentative description, known as a hypothesis,
the hypothesis revised
hypothesis of what has been observed. Hypothesis construction is
depicted in the second box from the top in the flowchart. In
the third box, predictions about human behaviour are deduced
from the hypothesis, such as that an individual will always 3
Using evidence to test
the predictions respond to a lower price by demanding more of the good in
Further question.
tests
This prediction is then tested against collected evidence about
Concluding that the The evidence does how individuals behave in the marketplace (the fourth box
evidence supports not support the from the top). At this stage, the hypothesis becomes a theory.
the hypothesis, which predictions, so the
now becomes the hypothesis is (The difference between the two is that, whereas a hypothesis
theory of demand amended or rejected is a proposed explanation for something, a theory is when a
Figure 1.1 An example of how scientific methodology
hypothesis is tested and survives the test.)
may be used in economics

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 At this stage, we are in the bottom left-hand box of Figure 1.1. However, this
does not mean that the theory is true in all circumstances. All it says is that the
hypothesis has survived the test or tests to which it has been exposed. It might
not survive stronger tests, which may not yet have been devised. Scientific
method is based on the possibility of falsification or refutation of a hypothesis.
If a hypothesis fails to survive the tests to which it is exposed, one of two
things can happen. The bottom right-hand box of Figure 1.1 shows the first
possibility: outright rejection of the hypothesis. For example, a hypothesis
that consumers always respond to price cuts by demanding less would surely
be rejected (as would the hypothesis that consumers always respond to a price
cut by demanding more of a good). The other possibility, which often occurs
in economics, is that the hypothesis is changed, usually by diluting it, so as to
make it less deterministic. In the case of demand theory, as the extension
material on page 49 in Chapter 3 explains, diluting it means that demand
theory predicts that, in most but not all cases, consumers respond to price cuts
by demanding more of a good. Diluted in this way, the demand hypothesis
survives the tests to which it is exposed, and becomes ‘the first “law” of demand’.
1 Economic methodology and the economic problem

TEST YOURSELF 1.2

Give another example of how a theory can be developed from a hypothesis
in economics.

● Social sciences and natural sciences

Economic theories often survive only through allowing a significant number
of exceptions to their central predictions, which, according to critics, turns the
theories into little more than generalisations with low scientific application.
To quote the economist Ha-Joon Chang, economics is not a science like biology
is a science. In his book Economics: The User’s Guide, Chang argues that many
economists believe, and tell other people, that economics is a ‘value-free’
science, like physics or chemistry. However, Chang argues that economics is a
fundamentally political and moral subject in relation to choosing the best option.
Whereas the particles and compounds studied by natural scientists do not hold
political and moral views, human beings who populate the economy do, and so
we cannot fully understand the economy without understanding politics and
ethics. No economic argument can be free from politics and ethics: for example,
the economic case for trying to persuade people to buy fair-trade products.
Very often economists respond to the criticism that their subject is ‘soft’ by
arguing that they are only concerned with ‘positive economics’, which they
4 claim is based on quite strict use of scientific methodology. Positive economics
is concerned with ‘what is’ and ‘what will happen’ if a course of action is taken
or not taken. In contrast, ‘normative economics’ is concerned with ‘what should
or ought to be’.

TEST YOURSELF 1.3

The study of economics can be helped by looking at other relevant social
sciences. Can you name three?

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 ● The difference between positive and

1.1 Economic methodology

normative statements
A lot of economics is concerned with what people ought to do. This is
KEY TERMS particularly true of the government. Should the government try to reduce
normative statement a
unemployment, control inflation and achieve a ‘fair’ distribution of income
statement that includes a
value judgement and cannot be
and wealth? Most people probably think that all these objectives are desirable.
refuted just by looking at the However, they all fall within the remit of normative economics. Normative
evidence. economics is about value judgements and views, but because people have
positive statement a
different views about what is right and wrong, normative statements cannot
statement of fact that can be be scientifically tested.
scientifically tested to see if it By contrast, a positive statement can be tested to see if it is incorrect. If a
is correct or incorrect. positive statement does not pass the test, it is falsified. A positive statement
does not have to be true, however. For example, the statement that the Earth
is flat is a positive statement. Although once believed to be true, the statement
was falsified with the growth of scientific evidence. The key point is that
positive statements can in principle be tested and possibly falsified, while
normative statements cannot. Normative statements include ethical, or moral,
judgements. Words such as ought, should, better and worse often provide clues
that a statement is normative.
To take an economic example, consider the statement ‘If the state pension were
to be abolished, a million older people would die of hypothermia.’ This is a
positive statement which could be tested, though few if any people would want
to do this. By contrast, the statement ‘The state pension ought to be abolished
because it is a waste of scarce resources’ is normative, containing an implicit
value judgement about the meaning of the word ‘waste’.

STUDY TIP
Make sure you understand fully the difference between a positive and
a normative statement. These concepts are often tested as multiple-
choice questions in the exam and you will need to be able to select which
options are most clearly positive or normative statements. Remember that
normative statements often include clues that they are opinions, by using
words or phrases such as ‘should’, ‘ought to’ or ‘must’.

TEST YOURSELF 1.4

Which one of the following is an example of a normative economic statement?
A Increased use of diesel-engine cars will lead to more atmospheric
pollution.
5
B Higher taxes always lead to higher prices.
C The government should spend more on roads.
D Consumers generally act rationally.

How value judgements influence economic decision

making and policy
Economists emphasise the distinction between normative and positive
economics, but they often forget that the decision to study one over the other is
itself a value judgement, and therefore a normative decision. A value judgement

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 is about whether something is desirable or not — if we believe it is more
desirable to study what is happening in the economy rather than what ought
to happen, we have made a value judgement. Economics necessarily requires
that government ministers make value-based judgements when deciding
on economic policies. Despite this, economists often wrongly insist that the
subject is value-judgement free.
One particular chancellor of the exchequer (the UK government minister
in overall charge of economic policy) once said: ‘Rising unemployment and
the recession have been the price that we have had to pay to get inflation
down. That price is well worth paying.’ Government ministers are often less
frank than this, knowing that their political opponents and the media will
immediately seize on the argument that those in power are uncaring and
cynical people. However, the quote does serve to illustrate how decision-
makers make value judgements when making economic policy decisions.
On occasion, government ministers make decisions on issues such as where
a new airport should be located or whether high-speed trains are worthwhile.
Before making decisions on issues like these, the policy-makers know in
advance that large groups of the population will strongly oppose whatever
1 Economic methodology and the economic problem

decision is eventually made. To try and avoid public hostility, government

STUDY TIP ministers usually create the illusion that the decision-making process
Make sure you understand is completely scientific and objective. To do this, they hire independent
fully how value judgements ‘experts’ to provide advice. But the choice of expert in itself involves a value
link to normative statements. judgement. Do you choose someone you know in advance is sympathetic to
Value judgements concern the government’s cause, or are you more willing to go for someone more
the desirability, or otherwise, impartial? Whichever way you go, the so-called scientific processes used by
of things. The fields of the ‘experts’ to reach their conclusions may be full of value judgements. A
politics and economic policy
classic case involved weighing up the costs and benefits of the location of an
making are based on value
judgements. See if you
additional London airport, which ultimately depended on putting money
can identify the normative values on an hour of a business person’s time, and an hour of a holidaymaker’s
statements made by politicians time. It was quickly found that when different values were put on these, the
on news programmes. airport location recommended by the experts would have ‘lost out’ under
different costing criteria.

Government priorities and spending change — each decision has consequences

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 The impact of moral and political judgements

1.2 The nature and purpose of economic activity

Whatever decision is eventually made in the course of framing government
economic policy, there will always be winners who gain and losers who suffer
as a result of the decision. Governments often claim they have a moral right to
make such decisions. They argue that their political manifesto published before
the previous general election gives them the mandate, supported by the voters,
to carry out their policies, regardless of the fact that among the electorate there
will inevitably be some losers.
One example is provided by former US president Donald Trump’s decision
in 2018 to implement a ‘zero tolerance’ policy on illegal immigration into the
USA. The policy involved splitting adult illegal migrants from their children
and keeping them in wire cages along the US border with Mexico. On
humanitarian grounds the policy was so unpopular in the USA that it was
quickly abandoned in a policy ‘U-turn’, though the other parts of Trump’s
anti-immigrant policy remained in place.

SECTION 1.1 SUMMARY

• Economic methodology involves the application of tested economic
theories to explain real-world economic behaviour.
• It is important to understand the difference between positive and
normative statements. A positive statement can be tested to see if it
is correct or false; a normative statement is a statement that includes
a value judgement which cannot be refuted purely by looking at the
evidence.
• A value judgement is about whether something is desirable or not.
• Government ministers make value-based judgements when deciding on
economic policies.
• There will always be winners who gain and losers who suffer as a result
of government policy decisions.

1.2 The nature and purpose of

economic activity
● Needs and wants
The production of goods and services to satisfy people’s needs and wants is
KEY TERMS the central purpose of economic activity. A need is something people must
need something that is have, something that they cannot do without. Food provides an example. If 7
necessary for human survival, people starve, they will eventually die. By contrast, a want is something people
such as food, clothing, warmth
would like to have, but which is not essential for survival. It is not absolutely
or shelter.
necessary, but it is a good thing to have. Books provide an example. Some
want something that is people might argue that books are a need because they think they can’t do
desirable, such as a mobile
without them. But they don’t need literature to survive. They do need to eat.
phone, but is not necessary for
human survival.
(It is worth noting that food can be both a need and a want, depending on the
type of food. Protein and vitamins are needs, but bars of chocolate are wants.
People don’t need to eat chocolate to survive.)
 Satisfying people’s needs and wants means improving economic welfare.
KEY TERM Welfare is a concept discussed a lot by economists, but often without a clear
economic welfare the
indication of what the concept means. Welfare is anything that makes a person
economic well-being of an
individual, a group within happier and improves their economic well-being. Short-term happiness may
society, or an economy. be at the expense of long-term well-being. The consumption of more material
goods and services usually improves economic welfare, though, in the long
term, consuming more and more food, and the wrong type of food, can lead to
health problems.

STUDY TIP
Make sure you can explain the meaning of the term ‘economic welfare’.
This concept is important throughout your studies because, for example,
it is the benchmark by which economists judge whether a policy is worth
implementing.

There are also important elements of human happiness and welfare that have
nothing to do with the consumption of material goods. These include quality-
of-life factors, such as the pleasure gained from family and friends or from
1 Economic methodology and the economic problem

contemplating a beautiful view.

TEST YOURSELF 1.5

With one example of each, explain the difference between a need and a
want.

● The key decisions of what and how to

produce
We mentioned at the beginning of this chapter that decisions are made about
KEY TERM what to produce, how to produce and who is to benefit from the goods and
economic system the set of services produced. How these decisions are made depends upon the nature
institutions within which a
of the economic system within the economy. The set of institutions within
community decides what, how
which a community decides what, how and for whom to produce is called
and for whom to produce.
an economic system. Although the problem of scarcity is fundamental and
common to all forms of human society, from the indigenous peoples in the
Amazonian rainforest, to wealthy nations such as the United States of America,
different economic systems have evolved in different societies.

SYNOPTIC LINK
The key economic concept of scarcity is explained in section 1.4 of this
8 chapter, and also in section 1.3, in the context of scarce environmental
resources. The existence of scarcity means that societies must make
sometimes difficult choices about what products are made, how they are
made and who will receive them.

Perhaps the most widely used method of defining and classifying economic
systems is according to the way or mechanism through which scarce
resources reach the people who eventually consume or use them. Although
there are varied ways in which wealth and purchasing power can be allocated
among individuals, including inheritance and other types of gift, theft and

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 luck or chance, such as winning a fortune on the National Lottery, the
KEY TERMS two mechanisms by which economic systems are defined are the market

1.2 The nature and purpose of economic activity

market economy an economy
mechanism (or price mechanism) and the command mechanism (or planning
in which goods and services
are purchased through the mechanism). An economic system in which goods and services are purchased
price mechanism in a system through the price mechanism in a system of markets is called a market
of markets. economy, whereas one in which government officials or planners allocate
command economy (also economic resources to firms and other productive enterprises is called a
known as a planned command economy (or planned economy).
economy) an economy in Between these extremes, many economies, particularly those in developed
which government officials or economies such as the UK, are called mixed economies. A mixed economy,
planners allocate economic
as the name suggests, is a mixture of different types of economic system. A
resources to firms and other
productive enterprises.
mixed economy contains both a large market sector and a large non-market
sector in which the planning mechanism operates. Figure 1.2 illustrates mixed
mixed economy an economy
economies in relation to planned and market economies.
that contains both a large
market sector and a large Planned Mixed Market
non-market sector in which economies economies economies
the planning mechanism
operates.
In which the planning contain In which the price
mechanism allocates mechanism allocates
scarce resources to scarce resources in the
their final uses system of markets
Large Large
TEST YOURSELF 1.6 non-market market
which makes up the
economy
To what extent is the UK sector sector
economy a mixed economy?
Figure 1.2 Command economies, mixed economies and market economies

APPLICATION OF ECONOMICS IN THE REAL WORLD 1.1

Allocating resources through the price mechanism and the planning mechanism
In a pure market economy, the price mechanism when, where and for whom to produce are taken by
performs the central economic task of allocating a central planning authority, issuing commands or
scarce resources among competing uses through directives to all the households and producers in
the markets which make up the economy. Transport the society. Such a system could only exist within
costs and lack of information may create barriers that a very rigid and controlled political framework
separate or break up markets. In past centuries, such because of the restrictions on individual decision
barriers often prevented markets from operating making that are implied.
outside the relatively small geographical area of a
In much the same way as a pure market economy,
single country or even a small region within a country.
in which the price mechanism alone allocates
However, while some markets exist in a particular resources, is a theoretical abstraction, so no
geographical location — for example, a street economy in the real world can properly be
market or until quite recently the London Stock described as a complete or pure planned economy.
Exchange — many markets do not. In recent Before the collapse of the communist political
9
years, modern developments have allowed goods system around 1990, some countries in eastern
to be transported more easily and at lower cost, Europe were centrally planned economies.
and have helped in the transmission of market However, they were not pure planned economies.
information via telephone and the internet. This Production but not consumption was planned.
has enabled many markets, especially commodity Consumers often had to queue to get consumer
and raw material markets and markets in financial goods, whose prices were fixed by the planners.
services, to become truly global or international Shortages resulted, which, together with the
markets functioning on a worldwide basis. generally inferior quality of consumer goods,
contributed to the breakdown of the command
A complete command economy is an economy in
economies.
which all decisions about what, how, how much,

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 Some communist countries still exist, namely the Follow-up questions
People’s Republic of China, North Korea, Vietnam 1 What are the differences between a pure market
and Cuba. However, all these countries, with the economy and the market sector of a mixed
exception until recently of North Korea, have economy?
encouraged the growth of markets to a greater 2 What is the other name of a planned economy?
or lesser extent. They have communist political 3 With the help of Chapter 3, explain how the price
systems, but they have moved away from being mechanism allocates scarce resources between
pure command economies. In a sense, China is competing uses.
now more capitalist than the USA and the mixed 4 Why did the command economies of central
economies of western Europe. The term ‘state and eastern Europe, such as the Union of Soviet
capitalism’ is now used to describe much of China’s Socialist Republics (USSR) break up?
economy.

APPLICATION OF ECONOMICS IN THE REAL WORLD 1.2

The UK as a mixed economy
The UK economy developed into a mixed economy the nature of the UK economy fundamentally,
after the Second World War ended in 1945, when a by increasing private ownership and market
1 Economic methodology and the economic problem

number of important industries such as coal, rail production.

and steel were nationalised and taken into public
Successive governments implemented policies
ownership. Previously, the 1944 Education Act
that changed the nature of the mix in favour of
had extended state provision of education, and the
private ownership and market forces, at the
creation of the National Health Service in 1948 did
expense of public ownership and state planning.
the same for healthcare.
The UK economy is now much closer to being a
For about 30 years after the end of the Second pure market and private enterprise economy than
World War, from the 1940s to the 1970s, the it was 45 years ago. The three main policies used
majority of UK citizens (and the major political to change the nature of the UK economy have been
parties) agreed that the mixed economy was privatisation, marketisation and deregulation,
working well. Most people believed that certain policies which collectively can be called ‘economic
types of economic activity, particularly the liberalisation’.
production and distribution of consumer goods and
Privatisation involved the sale of state-owned
services, were best suited to private enterprise and
assets such as nationalised industries to
the market economy. But people also accepted that
private owners. This was often accompanied by
utility industries such as gas and electricity should
marketisation (or commercialisation), whereby
be nationalised, and that important services such
prices are charged for goods and services that
as education, healthcare and roads should in part
the state previously provided free of charge.
be provided by government, outside the market,
Deregulation, the third aspect of liberalisation,
and financed through the tax system. In short, a
attempts to remove barriers to entry (see Chapter
consensus existed around the belief that the mixed
5) and government red tape and bureaucracy from
economy was right for the UK.
the operation of markets.
However, from about 1980 onwards, many
economists and politicians began to blame the Follow-up questions
10 mixed economy for the UK’s deteriorating economic 1 Critics of the UK economy have called it a ‘mixed-
performance relative to that of its main competitors up’ economy rather than a ‘mixed economy’. What
in western Europe and Japan. Critics argued that do you think they mean?
the public and non-market sectors of the economy 2 What is meant by the term ‘private enterprise’?
were inefficient and wealth consuming rather than 3 What is the difference between privatisation and
wealth creating. They felt that these sectors had marketisation?
become too big and that their dominance should 4 Do you think that there is now a case for
be weakened. Critics of the mixed economy argued increasing rather than reducing state ownership of
that a concerted effort should be made to change UK industry? Justify your answer.

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 SECTION 1.2 SUMMARY

1.3 Economic resources

• A need is something people must have; it is something that they cannot
live without.
• A want is something people would like to have, but which is not essential
for survival.
• How decisions are made about what to produce, how to produce and who
is to benefit from the goods and services produced depends upon the
nature of the economic system.
• Market economies, command economies and mixed economies are
examples of economic systems, defined in terms of whether or not the
price mechanism or the planning mechanism allocates scarce resources
among competing uses.
• Economic systems can also be defined in terms of who owns the means
of production.
• The UK economy is often called a mixed economy, being on the one hand
a mix of market and non-market sectors and on the other hand a mix of
privately owned and publicly owned sectors.

1.3 Economic resources

For most people, most of the time, increased consumption of material goods
KEY TERMS is an important part of improving economic welfare. Most of the goods we
production converts inputs or
consume must first be produced. This requires the use of economic resources.
factor services into outputs of
These goods are scarce in relation to demand, which gives rise to the need for
goods and services.
rationing and economising in their use.
capital good (also known as a
producer good) a good which The basic nature of production is shown in Figure 1.3. Production is a process,
is used in the production of or set of processes, that converts inputs into outputs. The eventual outputs are
other goods or services. the consumer goods and services that go to make up our standard of living,
consumer good a good which though inputs are of course also used to produce the capital goods that are
is consumed by individuals necessary for the eventual production of consumer goods.
or households to satisfy their
needs or wants. Land

Labour

Inputs or factors Output of goods or

of production services for sale in markets
Capital

A firm, business
or enterprise
Enterprise

Figure 1.3 The basic nature of production

11

● The factors of production

Economists call the inputs into the production process, which are shown in
KEY TERM Figure 1.3, the factors of production. Four factors of production are usually
factors of production inputs identified. These are land, labour, capital and enterprise, the last often being
into the production process called the entrepreneurial input.
(e.g. land, labour, capital and
enterprise). Entrepreneurs are different from the other factors of production. They are the
people who address the issues introduced earlier, deciding what to produce,
 how to produce it and for whom to produce it. An entrepreneur decides
how much of the other factors of production, including labour, to employ.
The costs of employing land, labour and capital, together with the cost of
the entrepreneur’s own services, become the firm’s costs of production.
In essence, the entrepreneur is a financial risk-taker and decision-maker.
Profit, which is the entrepreneur’s financial reward, results from successful
decision making. Entrepreneurial profit is the profit left over after the
cost of employing the other factors of production is deducted from the
sales revenue gained from selling the goods and services the entrepreneur
decides to produce.

STUDY TIP
It is important to understand that factors of production are inputs used to
produce output of goods and services. The factor of production known as
enterprise is usually seen as the factor which coordinates factor inputs of
capital, land and labour in pursuit of profit.

● The environment as a scarce resource

1 Economic methodology and the economic problem

Environmental resources comprise all the natural resources that are used or
KEY TERMS can be used in the economic system. These are:
renewable resource a
resource (e.g. timber) that with ● physical resources, such as soil, water, forests, fisheries and minerals
careful management can be ● gases, such as hydrogen and oxygen
renewed as it is used. ● abstract resources, such as solar energy, wind energy, the beauty of the
non-renewable resource (also landscape, clean air and water.
known as a finite resource) a
Environmental resources can be split into renewable and non-renewable
resource (e.g. oil) that is scarce
and runs out as it is used.
resources, with the latter further divided into recyclable and non-recyclable
resources. Renewable resources, which are reproducible and perpetually
maintainable, include forests, animals and water. The availability of these
resources depends, however, on their management by humans. By contrast,
non-renewable resources, such as oil, gas and minerals, cannot be regenerated
or their regeneration is so slow that the stock of resources cannot meaningfully
be increased. These are finite resources. Recyclable non-renewable resources
such as minerals, paper and glass can be reused in the economic system. In
theory, all of these resources can be recycled but it is not always possible and
economic to recycle more than a small fraction. Non-recyclable resources such
as coal, gas and oil are finite in the sense that, once used, their stock is no
longer available for future use.
Environmental resources are part of the factor of production, land. Some
12 environmental resources, such as the air we breathe and the water we drink,
are often described as the ‘free gifts of nature’. However, this view can be
questioned. In most countries and regions where large numbers of people live,
clean air and drinkable water are scarce commodities and not the ‘free gifts
of nature’. The need to get rid of the effects of pollution created by humankind
means that clean air and water are scarce and not free. Resources which
could be put to other uses are used instead to produce clean air and water.
Production and consumption activities taking place in the economy affect
and often damage the natural environment.

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 1.4 Scarcity, choice and the allocation of resources
TEST YOURSELF 1.7
Distinguish between a non-
renewable and a renewable
environmental resource.
Oil is a non-renewable resource

SECTION 1.3 SUMMARY

• Increased consumption of material goods is an important part of
improving economic welfare.
• Most of the goods we consume must first be produced.
• This requires the use of economic resources.
• These goods are scarce in relation to demand, which gives rise to the
need for rationing and economising in their use.
• Production is a process, or set of processes, that converts inputs into
outputs.
• Inputs are called factors of production and are economic resources.
• Land, labour, capital and enterprise (often called the entrepreneurial
input) are the factors of production.
• The entrepreneur is the factor of production that decides what to
produce, how to produce and for whom to produce.
• Inputs are also used to produce the capital goods that are necessary for
the eventual production of consumer goods and services.
• Environmental resources comprise all the natural resources that are
used or can be used in the economic system.

1.4 Scarcity, choice and the

allocation of resources 13

● Scarcity: the fundamental economic

problem
We have already mentioned that we live on a finite planet in which most
economic resources are limited. As we have seen, their use usually has to
be rationed either by the price mechanism or by the planning mechanism.
 The fundamental economic problem is therefore scarcity. In a world of
scarcity, people (even the very rich) have limited incomes, which means that
they face a budget constraint. When the price mechanism is rationing scarce
resources between competing uses, a budget constraint represents all the
combinations of goods and services that a consumer may purchase given
current prices and their limited income.

KEY TERMS
fundamental economic problem how best to make decisions about the
allocation of scarce resources among competing uses, so as to improve
and maximise human happiness and welfare.
scarcity results from the fact that people have unlimited wants but
resources to meet these wants are limited. In essence, people would like
to consume more goods and services than the economy is able to produce
with its limited resources.

● The need for choice

1 Economic methodology and the economic problem

If goods are scarce and incomes are limited, a choice or choices have to be
KEY TERM made. Consider, for example, a family with a weekly income of £1,200. The
choice choosing between family currently spends £350 on housing, £350 on food, £300 on other goods
alternatives when making a and services, including heating and lighting, and £100 on entertainment. The
decision on how to use scarce family’s total weekly spending on goods and services is thus £1,100, meaning
resources. the family manages to save £100. Suddenly, the cost of housing rises to £550.
To avoid getting into debt, and assuming that family income cannot increase,
one or more probably unpleasant choices will have to be made. An obvious
possibility is to cut down on entertainment, such as visits to the cinema. Other
possibilities could be spending less on home heating, buying cheaper food,
reducing the purchase of non-essential items and stopping saving. Something
will have to be given up. Unless the family gets into debt or its income
increases, it will have to economise on its spending and saving decisions.
It is important to appreciate that, even without an increase in house prices,
scarcity means that individuals and households are constantly making choices
about how to spend their limited incomes and how to make the best use of
their time. A decision to spend more on a holiday, for example, means that a
family chooses to spend less on other goods, or to save less.

● Choices have an opportunity cost

A need for choice arises whenever an economic agent (e.g. an individual, a
KEY TERM household or a firm) has to choose between two or more alternatives which are
14 opportunity cost the cost mutually exclusive, in the sense that it is impossible or impractical to achieve both
of giving up the next best
at the same time. In the jargon of economics, an opportunity cost is involved.
alternative.
If you ask friends who haven’t studied economics the meaning of the word
‘cost’, typically they will answer that cost is the money cost either of producing
a good or of buying a good. Economists, by contrast, focus on opportunity
cost. The opportunity cost of any choice, decision or course of action is
TEST YOURSELF 1.8 measured in terms of the alternatives that have to be given up.
What is meant by rational
economic behaviour? Economists generally assume that people behave rationally. Rational behaviour
means people try to make decisions in their self-interest or to maximise their

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 private benefit. When a choice has to be made, people always choose what
SYNOPTIC LINK they think at the time is the best alternative, which means that the second best

1.4 Scarcity, choice and the allocation of resources

The assumption that
or next best alternative is rejected. For rational people, the opportunity cost
people are always rational
when making choices is of any decision or choice is the next best alternative sacrificed or forgone. For
questioned in the discussion example, if you choose to spend half an hour watching a TV programme, the
of behavioural economics in opportunity cost is the lost opportunity to spend this time reading a magazine
Chapter 2. or book.

STUDY TIP
TEST YOURSELF 1.9 Make sure you can link together the three concepts of scarcity, choice and
Can you explain one factor opportunity cost. As economic resources are finite, society must make
that in real life may prevent choices about how to allocate them. In doing so, there will always be
a person from making a alternatives which are not chosen that would have given some benefit to
rational decision? society; this is the concept of opportunity cost.

● Rational behaviour and opportunity cost

Look carefully at the sentence in the previous paragraph about opportunity
cost: When a choice has to be made, people always choose what they think at
the time is the best alternative, which means that the second best or next best
alternative is rejected. The words ‘think at the time’ are quite important.
Suppose you decide to see a film, believing at the time you are going to enjoy
the film. Two hours later, coming out of the cinema, you say ‘That was a load
of rubbish, I wish I hadn’t bothered.’ Nevertheless, at the time the decision
was made, deciding to watch the film was a rational decision because you
believed you would enjoy watching it. Having left the cinema, irrational
behaviour would be going back to the box office and paying good money
to see the film again.
Even if the film can be watched freely on television, there is still an
opportunity cost, though in this case it only involves time. Time is scarce,
and the two hours spent watching the film cannot be spent on some other
activity such as reading a book. A choice has to be made between the two
activities. Of course, the way the choice is exercised will differ for different
people, even if everyone enjoys both watching films and reading. People
with plenty of time to spare — for example, retired or unemployed people —
value time less highly than a financial trader working in a dealing room from
TEST YOURSELF 1.10 7 a.m. until 9 p.m.
Give an example of an Going to a cinema to watch a film is, of course, a consumer activity. People
opportunity cost facing an have to think carefully about how they spend their limited incomes. In
A-level student when choosing
economics this is known as a budget constraint. Money spent on one good
to spend a whole evening
cannot be spent on another good. But there is always an opportunity cost 15
playing computer games.
when deciding to consume a good, involving time if not money.
Firms also have to make choices about what and how to produce. Consider a
textile manufacturer which can produce either shirts or dresses from the same
production line, but not both goods at the same time. In this situation, the
opportunity cost of producing more shirts is the number of dresses sacrificed
or forgone. Suppose also that both shirts and dresses can be produced using
one of two different technologies. These are a labour-intensive technology
involving lots of workers but very little capital equipment, and a capital-
intensive technology in which there are very few workers but expensive

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 automated capital equipment. Given the budget constraint facing the firm,
the opportunity cost of choosing one method of production is the sacrificed
opportunity to use the other method.
A further example of opportunity cost arises when a teenager makes a decision
about whether to leave school and get a job, or to go to university. Very often
this involves the choice between income now and income in the future.
Economists call this inter-temporal choice, or choice over time.

QUANTITATIVE SKILLS 1.1

Worked example: calculating an opportunity cost
A small electrical goods manufacturer can If the firm chooses to produce only 1 TV set, its
produce either TV sets or radio sets using all its opportunity cost is 1 radio set forgone (30 − 29
available resources. Table 1.1 shows the different radio sets). Performing a similar calculation when
combinations of the two goods the firm can TV set production is increased by an extra unit, the
produce. opportunity cost of the second TV set is 2 radio sets.
All the opportunity costs are set out in Table 1.2.
Table 1.1 Production possibilities for TVs and radio sets
Table 1.2 Opportunity costs of producing an extra TV set
TV sets Radio sets
1 Economic methodology and the economic problem

0 30 1st TV set 1 radio set (30 - 29)

2nd TV set 2 radio sets (29 - 27)
1 29
3rd TV set 3 radio sets (27 - 24)
2 27
4th TV set 4 radio sets (24 - 20)
3 24 5th TV set 5 radio sets (20 - 15)
4 20 6th TV set 6 radio sets (15 - 9)
5 15 7th TV set 9 radio sets (9 - 0)
6 9 The data show an increasing opportunity cost in
7 0 terms of radio sets forgone as production of TV
sets increases.
What happens to the opportunity cost of TV sets
in terms of radios, as TV set production increases
from 0 to 7 sets?

STUDY TIP
Make sure you understand and can distinguish between the words
‘micro’ and ‘macro’. ‘Micro’ means small, whereas ‘macro’ means large.
Microeconomics, which is covered in the first eight chapters of this book,
looks at the ‘little bits’ of the economy: for example, individual markets,
firms and consumers. By contrast, macroeconomics, covered in Chapters
9-15, looks at the ‘aggregate economy’ or the economy ‘as a whole’.

16
SECTION 1.4 SUMMARY
• The economic problem is how limited resources are used in relation to
people’s desires and wants.
• The economic problem results from relative scarcity.
• Scarcity results in the need for choice.
• Whenever a choice has to be made, there is an opportunity cost.
• The opportunity cost of any decision is the next best alternative forgone.
• Economists generally assume that people are rational, choosing the best
alternative available.

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 1.5 Production possibility

1.5 Production possibility diagrams

diagrams
So far, we have focused mainly on how scarcity and choice may affect
KEY TERMS firms, families and individuals at the microeconomic level. In much
production possibility frontier the same way, but on a far grander scale, the economy of the nation as
a curve depicting the various a whole faces a similar need for choice. To explain how the economic
combinations of two products problem affects the whole economy, we will use a diagram which you will
(or types of product) that can come across again and again in your economics course — a production
be produced when all the possibility diagram.
available resources are fully
and efficiently employed. The key feature of a production possibility diagram is a production
possibility frontier (PPF) or production possibility curve. A PPF illustrates
technical progress new
and better ways of making
the different combinations of two goods, or two sets of goods, that can be
goods and new techniques for produced with a fixed quantity of resource, providing we assume that all
producing more output from available resources are being utilised to the full. The PPF in Figure 1.4
scarce resources. illustrates the different combinations of capital goods and consumer goods
that the whole economy can produce when all the economy’s resources are
employed, with no spare capacity. To put it another way, the PPF shows
Capital what the economy can produce, assuming that all the labour, capital and
goods land at the country’s disposal are employed to the full, and assuming a
Y given state of technical progress.
K2 B
Given that resources and capacity are limited, a choice has to be made about
A the type of good to produce. Look closely at points X and Y on the diagram.
K1
The economy’s Point X shows the maximum possible output of consumer goods, assuming
production that the economy only produces consumer goods (i.e. no capital goods
possibility
frontier (PPF) are produced). Likewise, point Y shows the maximum possible output of
O capital goods, assuming that the economy only produces capital goods. In
C2 C1 X Consumer
goods fact, points X and Y show the two extreme production possibilities, since all
Figure 1.4 Using a production goods are either consumer goods or capital goods. Finally, the line drawn
possibility frontier diagram to between points X and Y in Figure 1.4 is the economy’s production possibility
illustrate the economic problem frontier. The PPF shows all the different combinations of consumer goods
and capital goods that can be produced, given the assumptions mentioned
earlier about full employment of available resources and the state of
technical progress. Point A, for example, shows K1 capital goods and C1
consumer goods being produced. An increase in capital goods production to
K 2, shown at point B, means that consumer goods production falls to C2.
C1 − C2 is the opportunity cost of producing K 2 − K1 additional capital
goods. Whichever combination of capital and consumer goods is actually
chosen reflects decisions made in society about allocating scarce resources
between competing uses.
17

STUDY TIP
You must learn to draw and interpret production possibility diagrams,
which are important in both microeconomics and macroeconomics. At the
micro level they can be used to illustrate scarcity, choice, opportunity cost
and productive efficiency. At the macro level, they can be used to illustrate
economic growth, full employment and unemployment.
3 Price determination in a
competitive market
Chapter 1 introduced you to one of the fundamental economic problems:
how to allocate scarce resources between competing uses in conditions
in which there are limited resources and unlimited wants. In a market
economy, resource allocation is undertaken by the price mechanism
operating in the system of markets that make up the economy. This is
also true in the ‘market sector’ of a mixed economy. However, in a mixed
economy there is also a ‘non-market sector’ in which goods and services
such as roads and police are produced and delivered to final users ‘outside
the market’. This chapter focuses on competitive markets in which the price
mechanism operates. Chapter 5 examines the less competitive markets
of monopoly and imperfect competition, as well as perfectly competitive
market structures. The final chapter of Part 1 of this book, Chapter 8,
introduces the various market failures in which the price mechanism either
does not work at all or produces resource misallocation.

LEARNING OBJECTIVES
These are to understand:
● the nature of demand and supply in a competitive market
● the difference between a movement along a demand or a supply curve
and a shift of a demand or a supply curve
● the concept of elasticity and the different elasticities you need to know
● how demand and supply curves are brought together in a supply and
demand diagram
● market equilibrium and disequilibrium in a supply and demand diagram
● interrelationships between markets.

3.1 The determinants of demand

● Demand and markets
Before we explain what determines the level of demand, we will first examine
the nature of a market in which the demand for, and the supply of, goods and
services interact with each other. 45

KEY TERMS
market a voluntary meeting of buyers and sellers with exchange taking place.
demand the quantity of a good or service that consumers are willing and
able to buy at given prices in a given period of time.
supply the quantity of a good or service that producers are willing and able
to sell at given prices in a given period of time.
 A market is a voluntary meeting of buyers and sellers in which exchange
takes place. Both buyer and seller have to be willing partners to the exchange.
Markets do not have to exist in a particular geographical location. Whenever a
good or service is voluntarily bought and sold, a market transaction occurs. In
the past, market transactions shifted away from open-air street markets to take
place in shops. Shops have higher overhead costs, but they offer a permanent
site of exchange and a continuing relationship between sellers and buyers.
In recent years, the growth of the internet has allowed 24/7 ecommerce. As
a result, many markets, especially those in commodities, raw materials and
financial services, have become truly global.

SYNOPTIC LINK
This chapter mainly focuses on product markets — the markets for the
goods and services which consumers buy and businesses sell. However,
there are a variety of other forms of market. For example, Chapter 6 looks
at the market for the factor of production known as labour, while Chapter
15 considers the market for exchanging foreign currencies.

KEY TERMS Competitive markets occur when there are a large number of buyers and
competitive markets markets sellers all passively accepting the ruling market price, which is set, not
in which the large number of
3 Price determination in a competitive market

by individual decisions, but by the interaction of all those taking part in

buyers and sellers possess
the market. Highly competitive markets lack entry and exit barriers. These
good market information and
can easily enter or leave the
barriers, which exist in non-competitive markets, include the costs of setting
market. up, the costs of acquiring information about the market and the difficulties
in gaining consumer recognition when there are established brands. The
ruling market price (also
known as equilibrium price)
absence of these barriers means that new buyers and sellers can easily enter
the price at which planned the market without incurring costs. In the same way, buyers and sellers can
demand equals planned leave the market if they wish to. Competitive markets also exhibit a high
supply. degree of transparency — buyers and sellers can quickly find out what
everyone else in the market is doing.

● The relationship between price and

quantity demanded
Households and firms operate simultaneously in two sets of markets. The first
KEY TERM of these contains the goods markets, in which members of households demand
effective demand the desire and buy consumer goods and services produced and supplied by firms. But
for a good or service backed by for household demand in the goods market to be an effective demand —
an ability to pay. that is, demand backed up by an ability to pay — households must first sell
their labour, or possibly the services of any capital or land they own, in the
markets for factors of production. These were briefly mentioned in Chapter 1.
46 Households’ roles are therefore reversed in goods markets and factor markets.
In this chapter, we ignore factor markets and focus solely on the determinants
of demand for consumer goods and services.

● What a demand curve shows

A demand curve, such as the one illustrated in Figure 3.1, shows the
relationship between the price of a good or service and the quantity of the
good or service demanded at different prices. If the price starts off high, for

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 Price example at P1, household demand is Q1. But if the price falls to P2, quantity
P1 demanded increases to Q2.

3.1 The determinants of demand

Demand for a good varies according to the time period being considered.
P2 For example, weekly demand is different from daily, monthly and annual
Demand demand. For this reason, the horizontal axis in Figure 3.1 is labelled ‘Quantity
demanded per period of time’. It is normal practice to use the label ‘Quantity’
O Q1 Q2 Quantity on the horizontal axis of a demand curve diagram, as we do in the rest of this
demanded per
period of time book, but this is an abbreviation. It always refers to a period of time.
Figure 3.1 A market demand curve

SYNOPTIC LINK
A microeconomic demand curve, such as the one illustrated in Figure 3.1,
TEST YOURSELF 3.1 looks very similar to a macroeconomic aggregate demand curve, which is
A woman with an income of explained in Chapter 10. It is vital that you don’t confuse the two. A demand
£15,000 a year dreams of curve represents an individual’s demand for a single product, or the total
owning a brand new Bugatti demand for a single product, whereas an aggregate demand curve shows
car priced at over £1 million. the planned expenditure in all markets in an economy. Likewise, don’t
Explain why this is not an confuse demand with consumption, which is a component of aggregate
example of effective demand. demand, also explained in Chapter 10.

● Market demand and individual demand

Normally when economists refer to demand, they mean market demand.
This is the quantity of a good or service that all the consumers in the
KEY TERMS
market demand the quantity market wish to, and are able to, buy at different prices. By contrast,
of a good or service that all individual demand is the quantity that a particular individual, such as
the consumers in a market yourself, would like to buy. The relationship between market and individual
are willing and able to buy at demand is simple. Market demand is just the sum of the demand of all the
different market prices. consumers in the market.
individual demand the
quantity of a good or service
that a particular consumer or QUANTITATIVE SKILLS 3.1
individual is willing and able to
buy at different market prices. Worked example: performing a percentage calculation
1 Calculate to 1 decimal place:
(a) 14% of £605
(b) 4% of £4 million
(c) 0.035% of £800
For question (a), multiply £605 by 0.14, which gives the answer £84.70.
Similarly, for question (b), multiply £4 million by 0.04, for which the
answer is £160,000, and for question (c) multiply £800 by 0.00035, which
gives the answer £0.28.
2 Express to 2 decimal places: 47
(a) 35 as a percentage of 450
(b) 17 as a percentage of 130
(c) £6 million as a percentage of £1 billion
For question (a), divide 35 by 450 and convert into a percentage by
multiplying by 100. This gives 7.777 recurring, which to 2 decimal places
is 7.78%. Repeat the process for questions (b) and (c), which gives the
answers 13.08% and 0.60%.

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 ● Shifts of a demand curve
Students often confuse a movement along a demand curve and a shift of a
demand curve. A movement along a demand curve takes place only when the
KEY TERMS
condition of demand a
good’s price changes. Provided the demand curve slopes downwards, a fall in
determinant of demand, other price results in more of the good being demanded. This is sometimes called an
than the good’s own price, extension of demand. Likewise, a contraction of demand occurs when a rise in
that fixes the position of the price leads to less being demanded.
demand curve.
When we draw a market demand curve to show how much of the good or
substitute goods alternative service households plan to demand at various possible prices, we assume that
goods that could be used for all the other variables that may also influence demand are held unchanged
the same purpose.
or constant. This is the ceteris paribus assumption, which means ‘other
complementary goods when things being equal’. Among the variables whose values are held constant or
two goods are complements, unchanged when we draw a demand curve are disposable income and tastes
they experience joint demand.
or fashion. Collectively, the variables (other than the good’s own price) whose
increase in demand a values determine planned demand are often called the conditions of demand.
rightward shift of the demand A change in a condition of demand shifts the demand curve to a new position.
curve.
decrease in demand a
leftward shift of the demand
curve. STUDY TIP
You must understand the difference between a movement along a demand
3 Price determination in a competitive market

or supply curve and a shift of the curve. A movement along either curve
implies a change in price alone and leads to an increase or decrease in
quantity demanded or supplied. An increase or decrease in demand or
supply results from a change in a factor other than price and leads to a
change in the position of the curve.

● The conditions of demand

The main conditions of demand are:
● the prices of substitute goods (or goods in competing demand) (see pages
56 and 70)
● the prices of complementary goods (or goods in joint demand) (see page 70)
● personal income (or, more strictly, personal disposable income, after tax and
receipt of benefits)
● tastes and preferences
● population size, which influences total market size.
If any of the conditions of demand change, the position of the demand curve
changes, shifting either rightwards or leftwards. Figure 3.2 illustrates a rightward
Price shift of the demand curve, which is also called an increase in
demand, showing that more of the good is demanded at all prices.
48 For example, at a price of P1, the quantity demanded increases
P1 from Q1 to Q2. Conversely, a leftward shift of demand (known as a
decrease in demand) causes the quantity demanded to fall at all
prices.
Events that might cause a rightward shift of a demand curve include:
D1 D2 ● an increase in the price of a substitute good or a good in
O Q1 Q2 Quantity competing demand (see page 69 on the interrelationship
Figure 3.2 The effect of a rightward shift of between markets)
demand ● a fall in the price of a complementary good or good in joint demand

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 ● an increase in personal disposable income (but see the explanation of
normal goods and inferior goods that follows)

3.1 The determinants of demand

● a successful advertising campaign making people think more favourably
about the good
● an increase in population size.

TEST YOURSELF 3.2

Household income increases by 3% in a particular year. This causes
demand for summer holidays to increase by 5%. Is this an example of an
increase in demand or of a movement along a demand curve?

● Normal goods and inferior goods

When disposable income increases, demand for a good increases if the good
KEY TERMS is a normal good. However, some goods are examples of an inferior good, for
normal good a good for which
which demand decreases as income increases.
demand increases as income
rises and demand decreases To take an example, private car transport and bus travel are not just substitutes
as income falls. for each other. As people’s incomes rise, demand for cars generally increases,
inferior good a good for which while, at the same time, demand for bus travel usually falls. If people respond
demand decreases as income in this way to changes in income then private transport is a normal good, but
rises and demand increases as certain forms of public transport are inferior goods. For an individual, whether
income falls. a good is normal or inferior depends on personal income, tastes and, possibly,
age. For young children, junk food such as sweets is usually a normal good,
but later in life, tastes change and sweets may become an inferior good.
If a good is a normal good, an increase in income shifts the good’s demand
curve to the right. However, if the good is inferior for most people, its demand
curve shifts to the left when income increases.

Junk food may be a normal good for a child and an inferior good for an adult

EXTENSION MATERIAL

Must demand curves always slope downwards?

Demand curves don’t have to slope downwards, though rise, people may speculate that in the near future 49
they usually do. However, there are circumstances in the price will rise even further. In this situation,
which a demand curve may be horizontal or vertical, or demand is likely to increase. In the case of house
indeed slope upwards, showing that more is demanded prices, young people who wish to become first-
as the good’s price increases. time buyers may scramble to buy houses even
There are a number of possible explanations for when prices are rising, fearing that if they wait,
upward-sloping demand curves. Some of these are they may never be able to afford to get on the
as follows: ‘housing ladder’.
• Goods for which consumers use price as an
• Speculative demand. If the price of a good such
indicator of quality. Consumers may lack accurate
as housing, shares or a foreign currency starts to

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 information about the quality of some goods that few people can ever acquire it. Some people
they want to buy, such as second-hand cars and wish to consume Veblen goods, such as Ferrari
computers. In this situation, a potential buyer may cars, as a signal of their wealth. The ‘reassuringly
demand more as a good’s price rises, believing expensive’ advertising campaign for Stella Artois
that a high price means high quality. beer is another good example. Until around 2007
• Veblen goods. Some companies try to sell their Interbrew, the Belgian company (now part of AB
goods based on the fact that they cost more InBev) that then owned the Stella brand, decided to
than those of their competitors. Veblen goods, sell its beer as a premium brand. Interbrew hoped
named after the Norwegian-American economist that high prices would attract more customers.
Thorstein Veblen, are goods of exclusive or However, if you look at the prices of Stella beer
ostentatious consumption, or ‘snob’ goods. They today, you will find that AB InBev has now changed
are sometimes called positional goods, though tack, selling its beer on a ‘stack ’em high, sell ’em
strictly speaking, a positional good is so scarce fast’ principle, at discounted prices.

SECTION 3.1 SUMMARY

• Demand means effective demand, based on ability as well as willingness
to pay.
• A market demand curve shows how much of a good all the consumers in
the market intend to buy at different prices.
• For most goods, demand curves slope downwards.
3 Price determination in a competitive market

• The conditions of demand fix the position of the demand curve.

• If any of the conditions of demand change, the demand curve shifts to a
new position.
• Movements along a demand curve must not be confused with a shift in
the position of the curve.

3.2 Price, income and cross

elasticities of demand
● The meaning of elasticity
Whenever a change in one variable (such as a good’s price) causes a change to
KEY TERM occur in a second variable (such as the quantity of the good that households
elasticity the proportionate
responsiveness of a second
are prepared to demand), an elasticity can be calculated. The elasticity
variable to an initial change in measures the proportionate responsiveness of the second variable to the
the first variable. change in the first variable. For example, if a 5% increase in price were to
cause households to reduce their demand by more than 5%, demand would be
elastic. In this example, a change in price induces a more than proportionate
50
response by consumers. But if the response were less than a reduction of 5%,
demand would be inelastic. And if the change in price were to induce exactly
the same proportionate change in demand, demand would be neither elastic
nor inelastic — this is called unit elasticity of demand.
Elasticity is a useful descriptive statistic of the relationship between two
variables because it is independent of the units, such as price and quantity
units, in which the variables are measured.
 Although, in principle, economists could calculate a great many elasticities for
all the economic relationships in which they are interested, the three demand

3.2 Price, income and cross elasticities of demand

elasticities you must know are:
● price elasticity of demand
● income elasticity of demand
● cross elasticity of demand.
The following formulae are used for calculating these elasticities:
percentage change in quantity demanded
price elasticity of demand =
percentage change in price
percentage change in quantity demanded
income elasticity of demand =
percentage change in income
percentage change in quantity of A demanded
cross-elasticity of demand =
percentage change in price of B

STUDY TIP
Remember that elasticities are calculated by dividing the percentage
change in quantity demanded (or supplied) by the percentage change in the
variable that caused the change.

● Price elasticity of demand

Price elasticity of demand measures consumers’ responsiveness to a change
KEY TERM in a good’s price. (It is sometimes called ‘own price’ elasticity of demand to
price elasticity of demand distinguish it from cross-elasticity of demand for good A with respect to the
measures the extent to price of B, which measures the responsiveness of demand for a particular good
which the demand for a good to a change in the price of a completely different good.)
changes in response to a
change in the price of that
good.
STUDY TIP
You should apply elasticity analysis when assessing the effects of a shift
of a demand or supply curve. The extent to which the good’s price or
equilibrium level of output changes depends on the price elasticity of the
curve that has not shifted. For example, when the supply curve shifts
leftwards, the price elasticity of the demand curve determines the extent
to which the good’s price and quantity change.

TEST YOURSELF 3.3

When the price of a small car is £15,000, there are 100,000 people in the 51
UK who wish to buy it. When the price falls to £10,000, the number wanting
to buy the car rises to 200,000. What does this information tell you about
the market for small cars in the UK?

Infinite and zero price elasticity of demand

Horizontal and vertical demand curves have constant elasticities at all points
on the curve. A horizontal demand curve, such as the demand curve in
Figure 3.3(a), is infinitely elastic or perfectly elastic. At the other extreme,

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 the vertical demand curve in Figure 3.3(b) is completely inelastic or perfectly
inelastic, displaying a zero price elasticity of demand at all points on the curve.
When the price falls, for example from P1 to P2, the quantity demanded is
unchanged.

(a) Perfectly elastic demand (b) Perfectly inelastic demand

Price Price
Demand PED = 0
P2

Demand
P1 P1
PED = ∞

P2

O Quantity O Q1 Quantity
Figure 3.3 Horizontal and vertical demand curves

Figure 3.4 summarises the five demand curves you need to know.

(a) Perfectly elastic (b) Elastic demand (c) Unit elastic (d) Inelastic demand (e) Perfectly inelastic
3 Price determination in a competitive market

demand demand demand

P P P P P
D

PED = ∞ PED > 1

PED = 0
D
PED = 1
D PED < 1
D
D
O Q O Q O Q O Q O Q
Elasticity falls moving Elasticity rises moving
down the curve in panel (b) up the curve in panel (d)
Figure 3.4 Five demand curves you need to know

Factors determining price elasticity of demand

Substitutability
Substitutability is the most important determinant of price elasticity of
demand. When a substitute exists for a product, consumers respond to a price
rise by switching expenditure away from the good and buying a substitute
whose price has not risen. When very close substitutes are available, demand
for the product is highly elastic. Conversely, demand is likely to be inelastic
when no substitutes or only poor substitutes are available.
52
Percentage of income
The demand curves for goods or services on which households spend a large
proportion of their income tend to be more elastic than those of small items
that account for only a small fraction of income. This is because, for items
on which only a very small fraction of income is spent, particularly for those
which are rarely purchased, people hardly notice the effect of a change in price
on their income. The same is not true for ‘big-ticket’ items such as a new car or
an overseas holiday.

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 Necessities or luxuries

3.2 Price, income and cross elasticities of demand

It is sometimes said that the demand for necessities is price inelastic, whereas
the demand for luxuries is elastic. This statement should be treated with
caution. When no obvious substitute exists, demand for a luxury good may
be inelastic, while at the other extreme, demand for particular types of basic
foodstuff is likely to be elastic if other staple foods are available as substitutes.
It is the existence of substitutes that really determines price elasticity of
demand, not the issue of whether the good is a luxury or a necessity.

The ‘width’ of the market definition

The wider the definition of the market under consideration, the lower the price
elasticity of demand. Thus the demand for the bread produced by a particular
bakery is likely to be more elastic than the demand for bread produced by all
bakeries. This is because the bread baked in other bakeries provides a number
of close substitutes for the bread produced in just one bakery. And if we widen
the possible market still further, the elasticity of demand for bread produced
by all the bakeries will be greater than that for food as a whole.

Time
The time period in question will also affect the price elasticity of demand. For
KEY TERMS many goods and services, demand is more elastic in the long run than in the
short run the time period in short run because it takes time to respond to a price change. For example, if
which at least one factor of the price of an electric-powered car falls relative to the price of a petrol-engine
production is fixed and cannot car, it will take time for motorists to respond because they will be ‘locked in’ to
be varied. their existing investment in petrol-engine cars.
long run the time period in
which no factors of production In other circumstances, the response might be greater in the short run than
are fixed and all the factors of in the long run. A sudden rise in the price of petrol might cause motorists
production can be varied. to economise in its use for a few weeks before getting used to the price and
drifting back to their old motoring habits.

APPLICATION OF ECONOMICS IN THE REAL WORLD 3.1

Elasticity and tobacco taxation
Various studies have calculated the price elasticity adults. They found an average price sensitivity of
of demand for cigarettes of different groups in −0.50 for men and −0.34 for women. Studies have
society, such as the young and the old, and men and also tended to show greater price sensitivity among
women. low-income groups.
A World Bank review concluded that price rises
Follow-up questions
of about 10% would on average reduce tobacco
consumption by about 4% in richer countries. 1 What is the formula which is used for calculating
Smokers in poorer nations tend to be more price elasticity of demand?
2 Name the other two types of elasticity of demand 53
sensitive to price changes.
besides price elasticity of demand.
Reviewing 86 studies, Gallet and List found a 3 Suggest two reasons why adult smokers may be
mean price elasticity of −0.48, meaning that, on less responsive to a rise in the price of cigarettes
average, a 10% increase in price will be followed than teenage smokers.
by a decrease in consumption of 4.8%. They also 4 Most of the elasticity statistics quoted above lie
found greater responsiveness among younger between zero and −1. Discuss the significance of
people, with an average price elasticity of −1.43 this for governments.
for teenagers, −0.76 for young adults and −0.32 for

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 QUANTITATIVE SKILLS 3.2
Worked example: performing an elasticity calculation
People’s average incomes fall from £1,000 a week to £600 a week. As a
result, demand for potatoes increases from 1 million tonnes to 1.2 million
tonnes a week. Calculate the income elasticity of demand for potatoes.
The formula for calculating income elasticity of demand is:
percentage change in quantity demanded
income elasticity of demand =
percentage change in income

The percentage change in quantity demanded is +20%. The percentage

change in income is −40%. Placing these figures into the formula:
+20%
income elasticity of demand = = − 0.5
−40%
The minus sign indicates that the good is an inferior good. The number
0.5 indicates that demand is inelastic.

Price elasticity of demand, total consumer

expenditure and firms’ total revenue
3 Price determination in a competitive market

As an alternative to using the formula to calculate price elasticity of demand

between two points on a demand curve, a simple rule can be used to
determine the general nature of the elasticity between the two points:
● If total consumer expenditure increases in response to a price fall, demand
is elastic.
● If total consumer expenditure decreases in response to a price fall, demand
Price
is inelastic.
a ● If total consumer expenditure remains constant in response to a price fall,
P1
b
demand is neither elastic nor inelastic, i.e. elasticity = unity (or since the
P2 demand curve slopes downwards, the elasticity is minus unity or −1).
Elastic
demand Consider, for example, Figure 3.5, which shows an elastic demand curve
curve (D)
D. At price P1, total consumer expenditure is shown by the rectangle
bounded by P1, a, Q1 and O. When the price falls to P 2, the consumer
O Q1 Q2 Quantity expenditure rectangle changes to the area bounded by P 2, b, Q2 and O.
Figure 3.5 The effect of a price fall Clearly, the second of these rectangles is larger than the first rectangle, so
on total consumer expenditure when total consumer expenditure increases, following a fall in price, when the
demand is elastic demand curve is elastic.

54 STUDY TIP
Total consumer expenditure is exactly the same as firms’ total sales
revenue, so if we prefer, we can state the rule in terms of revenue rather
than consumer expenditure.

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 EXTENSION MATERIAL

3.2 Price, income and cross elasticities of demand

The slope of a demand curve and its elasticity
Although economists typically illustrate price along the curve, falling below unity and towards zero
elastic demand with a shallow-sloping demand along the bottom half of the curve.
curve and price inelastic demand with a steep one, If elasticity falls from point to point moving down
it is interesting to note that the elasticity of demand a linear demand curve, it follows that a non-linear
varies along the length of a demand curve. Take a curve (i.e. a curved line) is needed to show the same
careful look at the two demand curves in Figure 3.6. elasticity at all points on the curve. Figure 3.6(b)
In Figure 3.6(a), a straight line (or linear) demand shows a demand curve with a constant elasticity of
curve has been drawn. Obviously, a straight line has 1 at all points on the curve: that is, elasticity equals
a constant slope. But although the slope is the same unity at all points on the curve. Mathematicians call
at all points on the curve, the elasticity is not. this a rectangular hyperbola. Whenever the price
Moving along a linear downward-sloping demand falls, the proportionate change in quantity demanded
curve, the price elasticity of demand falls from exactly equals the proportionate change in price. In
point to point along the curve. Demand is elastic (or this case, consumer expenditure remains unchanged
greater than unity) at all points along the top half of following a rise or fall in price.
the curve. Elasticity equals unity exactly half way

(a) Elasticity varying from point (b) Constant elasticity of 1 (unity)

to point moving down a at all points on a rectangular
linear demand curve hyperbola demand curve
Price Price
Fall in Fall in
Elastic expenditure expenditure
P1
P2 Increase in Increase in
expenditure expenditure
P1

P3 Inelastic
P2
P4
Demand Demand

O Q1Q2 Q3 Q4 Quantity O Q1 Q2 Quantity

Figure 3.6 Price elasticity of demand and the slope of the demand curve

TEST YOURSELF 3.4

Draw a diagram to illustrate what happens to total consumer expenditure
in the event of a price fall when the demand curve is inelastic.

● Income elasticity of demand

The nature of income elasticity of demand — which measures how demand
KEY TERM responds to a change in income — depends on whether the good is a normal
income elasticity of demand good or an inferior good.
measures the extent to 55
which the demand for a When disposable income increases, a demand curve shifts rightwards, but only
good changes in response if the good is a normal good, for which demand increases as income increases.
to a change in income; it is However, some goods are inferior goods, for which demand decreases as income
calculated by dividing the increases, and an increase in income shifts the demand curve leftwards.
percentage change in quantity
demanded by the percentage Income elasticity of demand is always negative for an inferior good and positive
change in income. for a normal good. This is because the quantity demanded of an inferior good
falls as income rises, whereas the quantity demanded of a normal good rises
with income.

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 Normal goods can be further divided into superior goods or luxuries, for which
the income elasticity of demand is greater than +1, and necessities, with an
income elasticity lying between zero and +1. Although the quantity demanded
of a normal good always rises with income, it rises by a greater percentage for
a superior good (such as a luxury car). Conversely, demand for a basic good or
necessity such as shoe polish rises by a smaller percentage than income.

TEST YOURSELF 3.5

The UK’s income elasticity for overseas holidays is +1.6. What does this tell
you about UK demand for overseas holidays?

The size and sign (positive or negative) of income elasticity of demand affect
how a good’s demand curve shifts following a change in income.

● Cross elasticity of demand

Cross elasticity of demand (or cross-price elasticity of demand) measures how
KEY TERM the demand for one good responds to changes in the price of another good. The
cross elasticity of demand
cross elasticity of demand between two goods or services indicates the nature of
measures the extent to
which the demand for a good the demand relationship between the goods. There are three possibilities:
3 Price determination in a competitive market

changes in response to a ● complementary goods (or joint demand)

change in the price of another ● substitutes (or competing demand)
good; it is calculated by ● an absence of any discernible demand relationship.
dividing the percentage change
in quantity demanded by the Cars and petrol or diesel fuel, for example, are complementary goods: they
percentage change in the price are in joint demand. A significant increase in fuel prices, such as the 30.7%
of another good. increase in petrol prices in the year to March 2022, will have some effect on
the demand for cars, though the effect may not be great. By contrast, private
car travel and bus travel are substitute goods. A significant increase in the cost
of running a car will cause some motorists to switch to public transport —
provided its price does not rise by a similar amount as well.
As with the case of income elasticity of demand, the size and sign (positive or
negative) of cross elasticity of demand affect how a good’s demand curve shifts
following, in this case, a change in the price of another good. For example, a cross
elasticity of demand of +0.3 for bus travel with respect to the price of running
a car indicates that a 10% increase in the cost of private motoring would cause
the demand for bus travel to increase by just 3%. For most demand relationships
between two goods, cross elasticities of demand are inelastic rather than elastic,
both when the goods are in joint demand and when they are substitutes.
Complementary goods, or goods which are demanded together, such as
56 bicycles and bike lamps, have negative cross elasticities of demand. A rise in
the price of one good leads to a fall in demand for the other good. Suppose, for
example, that the cross elasticity of demand for bike lamps with respect to the
price of new bicycles is −0.5: this tells us that a 10% increase in the price of a
new bicycle leads to a 5% fall in the demand for bike lamps.
By contrast, the cross elasticity of demand between two goods which are
substitutes for each other is positive. A rise in the price of one good causes
demand to switch to the substitute good whose price has not risen. Demand
for the substitute good increases. For example, a new bicycle and a new motor
scooter are substitutes for each other. If the cross elasticity of demand for a new

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 bicycle with respect to the price of a motor scooter is +0.4, this tells us that a
TEST YOURSELF 3.6 10% increase in the price of a new motor scooter will lead to a 4% increase in

3.3 The supply of goods and services

The price of a gaming console
the demand for new bicycles as consumers switch between the two types of
for a particular games
provider rises by 30%. In private transport.
subsequent years, the demand If we select two goods at random — for example, pencils and suitcases — the
for games cartridges for this cross elasticity of demand between the two goods will be zero. When there is
system falls by 10%. What no discernible demand relationship between two goods, a rise in the price of
does this tell you about the
one good will have no measurable effect upon the demand for the other. The
cross elasticity of demand
between the two products?
cross elasticity of demand is zero, unless, of course, both items make up an
important part of household expenditure.

STUDY TIP
Elasticity basically means responsiveness. Demand elasticities measure
how consumers respond to a change in a good’s price, income, or the price
of another good. You should learn the formulae for each type of elasticity
— for example, income elasticity of demand — and avoid making three
basic mistakes when using them. The mistakes are:
• missing out the word ‘percentage’ (or the % sign) from the formula
• writing the formula ‘upside down’
• confusing the different elasticities.

SECTION 3.2 SUMMARY

• Elasticity means responsiveness.
• There are three important demand elasticities: price, income and cross
elasticity of demand.
• The slope of a demand curve is not the same as price elasticity of demand.
• It is important to understand the determinants of all the elasticities you
need to know.
• It is important to learn all the elasticity formulas, and not confuse them.
• You should be able to interpret elasticity statistics.

3.3 The supply of goods and

services
● Market supply
Normally when economists refer to supply, they mean market supply. Market 57
KEY TERM supply is the quantity of a good or service that all the firms or producers in the
market supply the quantity market plan to sell at different prices. By contrast, supply by a single firm is the
of a good or service that all quantity that a particular firm within the market would like to sell. As with
the firms in a market plan to demand, the relationship between the two is simple. Market supply is just
sell at given prices in a given the sum of the supply of all the firms or producers in the market at different
period of time. market prices.
Figure 3.7 shows a market supply curve which indicates that as a good’s price
rises, more is supplied. If the price starts off low, for example at P1, firms are
willing to supply Q1. But if the price rises to P2, planned supply increases to Q2.
 Price The main reason for upward-sloping supply curves stems from the profit-
P2 Supply maximising objective which economists assume firms have. If we assume
that a firm always aims to make the biggest possible profit, it follows that a
firm will only want to supply more of a good if it is profitable to do so.
P1 For a firm, profit is the difference between the total revenue the firm
receives when selling the goods or services it produces and the costs of
O Q1 Q2 Quantity
producing the goods. Assuming firms do not change their size or scale,
supplied per the cost of producing extra units of a good generally increases as firms
period of time produce more of the good. As a result, it is unprofitable to produce and
Figure 3.7 A market supply curve sell extra units of a good unless the price rises to compensate for the
extra cost of production. Rising prices will also encourage new firms to
enter the market. The result is the upward-sloping market supply curve
we have illustrated.
As with demand, the supply of a good varies according to the time period
KEY TERMS being considered. Hence the words ‘Quantity supplied per period of time’
profit the difference between on the horizontal axis in Figure 3.7. In later diagrams, this is shortened to
total sales revenue and total ‘Quantity’. But again, as with demand, remember that this is an abbreviation.
costs of production.
total revenue all the money
received by a firm from selling TEST YOURSELF 3.7
A farmer sells 100 sheep at a price of £20 per sheep. What is the farmer’s
3 Price determination in a competitive market

its total output.

total revenue and why is this not the same as the farmer’s profit?

SYNOPTIC LINK
Microeconomic supply curves look very similar to aggregate supply
curves, which are explained in Chapter 10. Don’t confuse the two.
Microeconomic supply curves show the willingness of individual firms
or the total number of firms in one market to supply a single product,
whereas aggregate supply curves show the total planned output of all
firms in an economy taken together.

● Shifts of a supply curve

Earlier in the chapter, we saw that a market demand curve shows how much
all the consumers in the market plan to buy at different prices of the good,
assuming all the other factors that influence demand remain constant. These
‘other factors’ were called the conditions of demand and we explained how, if
KEY TERM any of them change, the demand curve shifts to a new position.
condition of supply a
In exactly the same way, a market supply curve shows the quantities of the
determinant of supply, other
58 good that all the firms in the market plan to supply at different possible prices,
than the good’s own price, that
fixes the position of the supply assuming the conditions of supply remain unchanged. Again, if the ceteris
curve. paribus assumption no longer holds, one or more of the conditions of supply
change and the supply curve shifts to a new position.

The conditions of supply

The main conditions of supply are:
● costs of production, including
● wage costs
● raw material costs

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 ● energy costs
KEY TERMS costs of borrowing

3.3 The supply of goods and services

●
increase in supply a rightward
● technical progress
shift of the supply curve.
● taxes imposed on firms, such as VAT, excise duties and the business rate
decrease in supply a leftward
● subsidies granted by the government to firms.
shift of the supply curve.
As we have noted, if any of the conditions of supply change, the supply
curve shifts to a new position. As with demand, a rightward shift of
supply is known as an increase in supply, whereas a leftward shift is
known as a decrease in supply. An increase in wage costs, which for
Price S2 many firms are the most important cost of production, shifts the supply
S1
curve leftwards (or upwards). Firms reduce the quantity of the good they
are prepared to supply because production costs have risen. For example,
P1 when the price is P1 in Figure 3.8, a leftward shift of supply from S1 to S2
causes the quantity firms are prepared to supply to fall from Q1 to Q2. An
expenditure tax such as VAT imposed by the government on firms would
have a similar effect to an increase in costs of production.
Supply curves tend to shift rightwards when technical progress occurs,
O Q2 Q1 Quantity reducing production costs, or when firms enter the market. A subsidy
Figure 3.8 A leftward shift of the supply given to firms by the government, being similar to a reduction in costs of
curve production, would also shift the supply curve to the right.

TEST YOURSELF 3.8

Having set the price of bread at £3 a loaf, bread shops bake 10 million
loaves, which they then try to sell. However, 8 million of these loaves
remain unsold. What is likely to happen next in the bread market?

EXTENSION MATERIAL

Expenditure taxes and subsidies

A supply curve shifts leftwards (or upwards) when How the supply curve shifts depends on whether
the government imposes an expenditure tax such the tax that firms are forced to pay is an ad valorem
as customs and excise duties or VAT on firms. From tax or a specific tax. In the case of an ad valorem tax
a firm’s point of view, the tax is similar to a rise in such as VAT, which is levied at the same percentage
production costs. Firms try to pass the tax on to rate (e.g. 20%) on the price, the new supply curve
consumers by increasing the price of the good. For this is steeper than the old supply curve. This is shown
reason, expenditure taxes provide examples of indirect in Figure 3.9(a). If a good is priced at £1, 20% of the
taxes. The higher price charged means consumers price without the tax is 20p. However, if the price
indirectly pay the tax, even though the firms and not of a good is £2, the government collects 40p of tax
the consumers pay the tax to the government. revenue for each unit of the good sold.
(a) Ad valorem or percentage tax (b) Specific or unit tax But in the case of a specific tax or unit tax, such as 59
Price Price the excise duty levied on tobacco, the tax levied does
Supply
Supply after tax after tax not depend on the good’s price. Because of this, the
P2 P2 new and old supply curves are parallel to each other,
Supply Supply separated, as Figure 3.9(b) illustrates, by the size
before before
P1 tax P 1 tax of the tax levied on each unit of the good. When an
indirect tax is imposed on a good, the supply curve
shifts vertically upwards by the amount of the tax.
D D A subsidy given by the government to producers
O Q2 Q1 Quantity O Q2 Q1 Quantity has the opposite effect to an expenditure tax; it
Figure 3.9 An expenditure tax shifting a supply curve shifts the supply curve to the right. In the case of

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 Price Supply before
a specific subsidy, which is illustrated in Figure
subsidy
3.10, the sum of money paid to firms for each unit
of the good produced is the same whatever the P1 Supply
price of the good and hence the vertical distance after
P2
subsidy
between the two supply curves equals the subsidy
per unit. By contrast, the size of the subsidy would
vary if the subsidy were dependent on the price of D
the good. O Q1 Q2 Quantity
Figure 3.10 A specific or unit subsidy shifting a supply curve

TEST YOURSELF 3.9

Suppose the government subsidises private education by giving parents £5,000
a year if their child attends a private school. Would this shift the demand curve
for, or the supply curve of, private education? Justify your answer.

SECTION 3.3 SUMMARY

• A market supply curve shows how much of a good all the firms in the
3 Price determination in a competitive market

market intend to supply at different prices.

• Supply curves usually slope upwards because higher prices lead
to higher profits, encouraging existing firms to produce more and
attracting new firms into the market.
• The conditions of supply fix the position of the supply curve.
• If any of the conditions of supply change, the supply curve shifts to a
new position.
• Movements along a supply curve must not be confused with a shift in the
position of the curve.

3.4 Price elasticity of supply

In contrast to demand elasticities explained earlier in the chapter, there is only
KEY TERM one supply elasticity you need to know. This is price elasticity of supply, which
price elasticity of supply measures how the supply of a good responds to an initial change in a good’s price.
measures the extent to which
the supply of a good changes The formula for price elasticity of supply is:
in response to a change in the
price of that good. percentage change in quantity supplied
price elasticity of supply =
percentage change in price

60 Just as with demand curves, you must not confuse the slope of a supply curve
with its elasticity. Upward-sloping straight-line (linear) supply curves display the
following price elasticities:
● If the supply curve intersects the price axis, the curve is elastic at all
points, though elasticity falls towards unity as you move from point to
point up the curve.
● If the supply curve intersects the quantity axis, the curve is inelastic at all points,
though elasticity rises towards unity as you move from point to point up the curve.
● If the supply curve passes through the origin, elasticity equals unity (+1) at
all points on the curve.
 (a) Elastic supply (b) Inelastic supply (c) Unit elasticity of supply

3.4 Price elasticity of supply

Price Price Supply Price Supply
Supply

P2 P2
P1 P2

P1 P1

O Q1 Q2 Quantity O Q1 Q2 Quantity O Q1 Q2 Quantity

Figure 3.11 Price elasticity of supply and linear supply curves

(a) Perfectly elastic (b) Elastic supply (c) Unit elastic (d) Inelastic supply (e) Perfectly
supply supply inelastic supply
P P P P P
PES = 1 S
S
S S
PES > 1
PES = ∞ PES = 0
S PES < 1

O Q O Q O Q O Q O Q

Figure 3.12 The five linear supply curves you should know
TEST YOURSELF 3.10
If the price of a good with a
price elasticity of supply of 2.5
increases by 10%, the quantity STUDY TIP
supplied will: You should understand why price elasticity of supply is usually positive
A fall by 25% and why price elasticity of demand is usually negative. This is because
we assume that a standard demand curve slopes downwards left to
B rise by 25%
right, showing that as the price of a product falls, the quantity demanded
C fall by 40% increases. Conversely, a standard supply curve slopes upwards left to
D rise by 0.4% right, showing that an increase in the price of a product usually leads to an
increase in the quantity supplied.
Explain your answer.

● The factors determining price elasticity of

supply
The length of the production period
If firms can convert raw materials into finished goods very quickly (e.g. in
just a few hours or days), supply will tend be more elastic than when several 61
months are involved in production, as with many agricultural goods.

The availability of spare capacity

When a firm possesses spare capacity, and if labour and raw materials are readily
available, production can generally be increased quickly in the short run.

The ease of accumulating stocks

When stocks of unsold finished goods are stored at low cost, firms can respond
The supply of most agricultural quickly to a sudden increase in demand. Alternatively, firms can respond to
goods is price inelastic a price fall by diverting current production away from sales and into stock

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 accumulation. The ease with which stocks of raw materials or components can
be bought from outside suppliers and then stored has a similar effect.

The ease of switching between alternative methods

of production
When firms can quickly alter the way they produce goods — for example, by
switching between the use of capital and labour — supply tends to be more
elastic than when there is little or no choice. In a similar way, if firms produce
a range of products and can switch raw materials, labour or machines from one
type of production to another, the supply of any one product tends to be elastic.

The number of firms in the market and the ease of

entering the market
Generally, the more firms there are in the market, and the greater the ease with
which a firm can enter or leave, the greater the elasticity of supply.

Time
Price S1 S2
We have already noted that demand is more elastic in the long run than in the
P2 X short run because it takes time to respond to a price change. The same is true
P3 Y S3 for supply. Figure 3.13 shows three supply curves of increasing elasticity, S1,
P4 Z S2 and S3, which illustrate respectively market period supply, short-run supply
3 Price determination in a competitive market

P1
W and long-run supply.
D2 ● Market period supply. The market period supply curve S1 is shown by a
D1 vertical line. S1 depicts the situation facing firms following a sudden and
O Q1 Q2 Q3 Quantity unexpected rightward shift of demand from D1 to D2. When surprised by a
Figure 3.13 The effect of the time sudden increase in demand, firms cannot immediately increase output. In
period upon price elasticity of supply the market period, supply is completely inelastic, and the price rises from
P1 to P2 to eliminate the excess demand brought about by the rightward
shift of the demand curve.
● Short-run supply. The higher price means that higher profits can be made,
creating the incentive for firms to increase output. In the short run, firms
increase output by hiring more variable factors of production, such as
labour. The short-run increase in output is shown by the movement up the
short-run supply curve, S2. The short-run supply curve is more elastic than
the market period supply curve, S1. In the short run, supply increases to
Q2, and the price falls from P2 to P3.
● Long-run supply. If firms believe the increase in demand will be long-
lasting, and not just a temporary phenomenon, they may increase the scale
of production by employing more capital and other factors of production
that are fixed in the short run, but variable in the long run. When this
happens, firms move along the long-run supply curve S3. Output rises to
Q3 and the price falls once again, in this case to P4.
62

STUDY TIP
You should understand why, for most goods, both the demand curve and the
supply curve are more price elastic in the long run than in the short run.

In a competitive industry with low or non-existent barriers to entry, elasticity

of supply is greater in the long run than in the short run, because in the long
run firms can enter or leave the market. Short-run supply is less elastic because
supply is restricted to the firms already in the industry.

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 APPLICATION OF ECONOMICS IN THE REAL WORLD 3.2

3.4 Price elasticity of supply

Housing market elasticities in the UK Table 3.1 Price elasticity of supply in the housing
market for different countries
UK households have an income elasticity of
demand for housing that exceeds +1. However, Country Price elasticity of supply
demand for housing is price inelastic. These Canada +1.2
demand elasticities, combined with a low
UK +0.4
price elasticity of supply for housing, push
the UK’s housing market towards long-term USA +2.0
rising prices. France +0.3
To prevent rapid price rises, new housing would Ireland +0.6
need to have a price elasticity of supply of +10 for
supply to equal demand in the long term. But if the Follow-up questions
price elasticity of supply for new housing remains 1 State the formula used for measuring price
low, as Table 3.1 shows, house prices will never elasticity of supply.
be stable in the UK when the demand for housing 2 Distinguish between the slope and the elasticity of
is increasing. Prices are also likely to be unstable a supply curve.
when both demand and supply are highly price 3 Suggest why the price elasticity of supply of new
inelastic. houses is lower in the UK than in the USA.
4 ‘To prevent rapid price rises, new housing would
need to have a price elasticity of supply of +10 for
supply to equal demand in the long term.’ Explain
this statement.

EXTENSION MATERIAL

A closer look at perfectly elastic demand and supply

Figure 3.14 shows a perfectly elastic demand curve demand is perfectly price elastic. Customers cease
and a perfectly elastic supply curve. (These can also to buy the good as soon as the price rises above the
be labelled infinitely elastic demand and infinitely demand curve, switching spending to the perfect
elastic supply.) Although the two parts of Figure substitutes whose prices have not changed.
3.14 appear to be identical (apart from the labels), By contrast, in Figure 3.14(b), supply is infinitely
this is misleading. The apparent similarity disguises elastic at all prices on or above the supply curve,
a significant difference between perfectly elastic though if the price falls below the supply curve (e.g.
demand and perfectly elastic supply. In Figure from P1 to P2), the amount supplied immediately
3.14(a), demand is infinitely elastic at all prices on drops to zero. P1 is the minimum price acceptable to
or below the demand curve, though if the price rises firms. If they are paid this price (or any higher price),
above the demand curve (e.g. from P1 to P2), the firms stay in the market. The incentive to stay in
amount demanded immediately falls to zero. This the market disappears at any lower price and firms
is because perfect substitutes are available when leave the market, unable to make sufficient profit.

(a) Perfectly elastic demand (b) Perfectly elastic supply

Price Price
63
P2

Demand Supply
P1 P1
PED = ∞ PES = ∞

P2

O Quantity O Quantity
Figure 3.14 Perfectly price elastic demand and supply curves

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 TEST YOURSELF 3.11 SECTION 3.4 SUMMARY
Draw a diagram which shows a • There is only one supply elasticity you need to know: price elasticity of
demand curve shifting supply.
rightwards along a supply • The slope of a supply curve is not the same as price elasticity of supply.
curve with a zero price • It is important to understand the determinants of price elasticity of supply.
elasticity of supply. Explain • You should be able to interpret price elasticity of supply statistics.
what happens to the
equilibrium price and quantity.
Suggest a
real-world market which 3.5 The determination of
the diagram illustrates.
equilibrium market prices
● The interaction of demand and supply
We now bring together the market demand and market supply curves
explained earlier in the chapter to see how the equilibrium price is achieved
in a competitive market within the economy. The market we will look at is the
tomato market. Its essential features are shown in Figure 3.15.
Price The market demand curve in Figure 3.15 shows how many tomatoes
Market supply
all the consumers in the market plan to purchase at different prices in
3 Price determination in a competitive market

a particular period of time. The market supply curve shows how many
tomatoes all the farmers and firms in the market wish to supply at
P*
different prices in the same time period. The equilibrium market price,
P* in Figure 3.15, is located where the market demand curve for tomatoes
intersects or cuts through the market supply curve of tomatoes. We will
Market demand now look at the concept of equilibrium (and its opposite, disequilibrium)
O Q* Quantity
in greater depth.
Figure 3.15 Market equilibrium
in the tomato market
KEY TERMS
equilibrium a state of rest or balance between opposing forces.
disequilibrium a situation in which opposing forces are out of balance.

● Market equilibrium and disequilibrium

The concepts of equilibrium and disequilibrium are important in economic
KEY TERMS theory and analysis. You should think of equilibrium as a state of rest or a state
market equilibrium a market of balance between opposing forces and of disequilibrium as a situation of the
is in equilibrium when planned opposing forces being out of balance. In a market, the opposing forces are
demand equals planned supply, supply and demand. Market equilibrium in Figure 3.15 occurs where the
64 where the demand curve demand curve and the supply curve cross each other. At price P*, households
crosses the supply curve. plan to demand exactly the same quantity of tomatoes that firms plan to supply.
market disequilibrium exists P* is therefore the equilibrium price, with Q* being the equilibrium quantity.
at any price other than the
In summary, market disequilibrium occurs when:
equilibrium price, when either
planned demand < planned ● planned demand < planned supply, in which case the price falls, or when
supply or planned demand > ● planned demand > planned supply, in which case the price rises.
planned supply.
Market equilibrium occurs when:
● planned demand = planned supply, in which case the price does not change.
 SYNOPTIC LINK STUDY TIP

3.5 The determination of equilibrium market prices

Refer back to the mention of It is important to understand the concepts of equilibrium and disequilibrium in
‘ruling market price’ on page economics. These concepts help to explain why markets move from one state
46. This tends to be the price of rest to another. You will come across many other examples besides market
at market equilibrium. equilibrium and disequilibrium. In your later studies, look out for profit-
maximising equilibrium, equilibrium wage rate, equilibrium national income
(or macroeconomic equilibrium) and balance of payments equilibrium.

TEST YOURSELF 3.12

What is meant by the equilibrium price of a good?

● How excess demand and excess supply

Price
Excess supply S lead to changes in price
P1
It is impossible at most prices for both households and firms simultaneously
P* to fulfil their market plans. In Figure 3.16, P1 is a disequilibrium price for
tomatoes because the tomato growers and sellers cannot fulfil their plans at
P2
Excess demand
this price. When price is P1 in Figure 3.16, firms would like to supply Q2, but
D
households are only willing to purchase Q1.
O Q1 Q* Q2 Quantity
To explain this further, it is useful to divide the market into two ‘sides’ —
Figure 3.16 Disequilibrium and the short side and the long side. When the price is P1, households, or the
equilibrium in the tomato market people wishing to buy tomatoes, are on the short side of the market, while
tomato producers are on the long side. The economic agents on the short
side can always fulfil their market plans, but those on the long side cannot.
KEY TERMS Thus, when the price is P1, households can purchase exactly the quantity
excess supply when firms wish of tomatoes they wish to, namely Q1. Farmers and other tomato producers,
to sell more than consumers
however, are in a different situation. They would like to sell Q2, but can only
wish to buy, with the price
sell Q1, as long as the price remains at P1. The difference between Q2 and Q1
above the equilibrium price.
is excess supply or unsold stock.
excess demand when
consumers wish to buy more The market is also in disequilibrium at price P 2 because households are
than firms wish to sell, with unable to buy as much as they wish to at this price. Households would like
the price below the equilibrium to buy Q2 tomatoes, but they cannot because at this price tomato producers
price. are only willing to supply Q1. The situation is now reversed compared to P1.
Tomato buyers are on the long side of the market and farmers and tomato
sellers are on the short side. In this case, the difference between Q2 and Q1
Price is excess demand or unfulfilled demand. Households end up buying Q1
S1
tomatoes because this is the maximum quantity that tomato producers are
S2
prepared to sell at this price.
Excess
X supply
P1 V How a shift of supply disturbs market equilibrium 65
Z Once supply equals demand in a market — for example, at point X in
P2
Figure 3.17 — the market remains in equilibrium until an external event
D
hits the market and causes either the market supply curve or the market
O Q1 Q3 Q2 Quantity demand curve to shift to a new position.

Figure 3.17 The effect of a rightward

Figure 3.17 illustrates what happens in the tomato market when an
shift of the market supply curve of event such as a bumper harvest causes the supply curve of tomatoes
tomatoes to shift rightwards, from S1 to S2. Before the shift of the supply curve,

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 P1 was the equilibrium price of tomatoes. However, once the supply
curve shifts, P1 becomes a disequilibrium price. Too many tomatoes are
offered for sale at this price, which means there is excess supply in the
market. The excess supply is shown by Q 2 − Q1, or the distance between
X and V.
To get rid of this unsold stock, tomato producers reduce the price they are
prepared to accept. The market price falls from P1 to P2, which eliminates
the excess supply. In the new equilibrium, planned supply once again equals
planned demand, but at the lower equilibrium price of P2.

TEST YOURSELF 3.13 STUDY TIP

The equilibrium price for Make sure you can distinguish between a shift of a supply or demand
centre court tickets at an curve, and the adjustment to a new equilibrium along the curve that does
international tennis final is not shift.
£5,000. The official ticket
provider sells these tickets for
£100. What do you think How a shift of demand disturbs market equilibrium
happens in the second-hand
Figure 3.18 shows what happens in the market for tomatoes following an
market for tickets to watch the
increase in consumers’ incomes. Tomatoes are usually considered a normal
tennis match?
good: that is, a good for which demand increases as income increases. Before
3 Price determination in a competitive market

the increase in consumers’ incomes, the equilibrium price of tomatoes was

Price P1, determined at the intersection of curves D1 and S. At this price, planned
S
J demand equals planned supply. However, increased incomes shift the market
P2
demand curve rightwards from D1 to D2. Immediately, disequilibrium replaces
H Excess K equilibrium in the market. The rightward shift of demand creates excess
P1
demand
demand in the market, as long as the price remains at P1. Excess demand is
D2 shown by Q2 − Q1, or the distance between H and K.
D1 The market adjustment mechanism now swings into action to get rid of the
O Q1 Q3 Q2 Quantity excess demand. The price increases to P 2 to eliminate the excess demand,
Figure 3.18 The effect of a rightward
and the quantity of tomatoes bought and sold rises to Q3. In response
shift of the market demand curve for to the increase in demand from H to K, there is a movement along the
tomatoes supply curve between H and J (an extension of supply) to establish the
new equilibrium.

TEST YOURSELF 3.14

There are 30 million customers and 1 million firms producing the good in a
particular market in the UK. Explain why you would classify this market as
being competitive or uncompetitive.

66
SYNOPTIC LINK
See Figure 3.8 on page 59, which shows a leftward shift of a supply curve.
This could be caused by the imposition of a specific tax or by a cut in a
subsidy previously given to firms.

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 EXTENSION MATERIAL

3.5 The determination of equilibrium market prices

How the effect of an expenditure tax depends on elasticity
of demand
Figure 3.8, earlier in the chapter, can be used to show Price
Excess supply S2
what can happen when an expenditure tax is imposed
P1 + T S1
on a particular good. The tax shifts the good’s supply P2
curve to the left. From the point of view of the firms that P1
Shifted incidence
Unshifted incidence
produce and sell the good, the tax has the same effect Demand
as a rise in costs of production, such as a rise in wage
costs. As is the case with cost increases, by raising the T
price of the good to cover the tax, firms try to increase
the price charged to customers by the full amount of the
O Q2 Q1 Quantity
tax. However, their ability to do this depends on price
elasticity of demand for the good or service in question. Figure 3.19 Shifting the incidence of a tax when demand
is price elastic
Figure 3.19 shows that when demand is relatively
elastic, consumer resistance means that some, but You should now draw diagrams similar to Figure 3.19,
not all, of a tax (in this case, a specific tax) is passed but with perfectly elastic, relatively inelastic and
on to consumers as a price rise. The tax per unit completely inelastic demand curves. The diagrams
(labelled T in Figure 3.19) is measured by the vertical will show that firms’ ability to pass the incidence of a
distance between S1 (the supply curve before the tax on to consumers as a price rise is greatest when
tax was imposed) and S2 (the supply curve after the demand is completely inelastic, and non-existent
tax was imposed). Immediately after the imposition when demand is perfectly elastic.
of the tax, firms may try to raise the price to P1 + T,
Students often confuse the effect of an increase in
passing all the tax on to consumers. However, there
an indirect tax imposed on firms with the effect of a
is excess supply at this price. To get rid of the excess
direct tax such as income tax imposed on individuals.
supply, the price falls to P2. In the new equilibrium,
Whereas a tax imposed on firms shifts the supply
part, but not all, of the tax has been passed onto
curve of a good, income tax shifts the demand curve
consumers as a price rise.
for a good by reducing consumers’ incomes. An
The part of the tax passed on to consumers is called increase in income tax shifts the demand curve for
the shifted incidence of the tax. The rest of the tax (the normal goods leftwards, but if the good is an inferior
unshifted incidence) is borne by firms or producers. In good, the demand curve shifts rightwards.
Figure 3.19, the total tax revenue paid by firms to the
Finally, note that subsidies granted to firms have the
government is shown by the rectangle bounded by
opposite effect to taxes imposed on them. Subsidies
heavy black lines. The part of the tax rectangle above
granted to firms shift the supply curve rightwards,
what was previously the equilibrium price (P1), shows
showing that firms are prepared to supply more of
the shifted incidence of the tax. The part of the tax
the good at all prices.
rectangle below P1 shows the unshifted incidence.

TEST YOURSELF 3.15

Distinguish between an expenditure tax and an income tax. Illustrate on a
supply and demand graph the possible effect of an increase in both the
percentage rate at which VAT is levied on the good and the rate at which 67
income tax is levied, assuming the good is an inferior good.

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 STUDY TIP QUANTITATIVE SKILLS 3.3
Many students never really get
Worked example: calculating the equilibrium price of a good
to grips with microeconomic
analysis because they fail to Table 3.2 shows the demand and supply schedules for chocolate bars.
understand the difference Table 3.2 Demand and supply schedules for chocolate bars
between market plans and
market action. Your market Price per Quantity of bars Quantity of bars
plans are what you wish to do bar (£) demanded per week supplied per week
when you go shopping. Your 0.75 180 240
market action is what you end 0.70 200 200
up doing, i.e. the goods you
0.65 220 160
actually purchase.
0.60 240 120

As a result of a fall in the price of cocoa beans, the supply of chocolate

bars rises by 60 bars at all prices. What is the new equilibrium price of
chocolate bars?
According to the table, the initial equilibrium price of chocolate bars
is 70p, at which demand and supply are equal at 200 chocolate bars. If
60 more chocolate bars are supplied at each price, following the fall in the
cost of manufacturing the bars, 300 bars are supplied at a price of 75p,
260 bars at a price of 70p, and 220 bars at a price of 65p. This is the new
3 Price determination in a competitive market

equilibrium price because at this price, demand equals supply at 220 bars.
The supply curve has shifted upwards by 60 at each price.

APPLICATION OF ECONOMICS IN THE REAL WORLD 3.3

Auctions
In theory, an auction provides a quick and efficient from a high initial value until the first moment
method of establishing equilibrium in a market. when a bidder accepts and pays the current price.
Auctions have been brought into many people’s These auctions are called Dutch auctions because
everyday lives through sites such as eBay. But flowers have long been sold in the Netherlands
they also have a long history spanning many using this procedure.
different domains. For example, the US government • First-price sealed-bid auctions. In this kind of
uses auctions to sell Treasury bills and timber and auction, bidders submit simultaneous ‘sealed
oil leases, ‘auction houses’ Christie’s and Sotheby’s bids’ to the seller. The terminology comes from
use them to sell art, and Morrell & Co. and the the original format for such auctions, in which
Chicago Wine Company use them to sell wine. bids were written down and provided in sealed
envelopes to the seller, who would open them all
Each bidder has an intrinsic value for the item
together. The highest bidder wins the object and
being auctioned — the bidder is willing to purchase
pays the value of their bid.
the item for a price up to this value, but not for any
higher price. Follow-up questions
68 1 What is meant by ‘equilibrium in a market’?
Three types of auction at which a single item is sold are:
2 What type of auction are eBay auctions?
• Ascending-bid auctions, also called English 3 Research another example of a descending-bid
auctions. The seller gradually raises the price, auction.
bidders drop out until only one bidder remains, 4 In the UK, second-hand or used cars are
and that bidder wins the object at this final price. sometimes sold at auction. Describe another way
• Descending-bid auctions, also called Dutch in which second-hand cars are sold.
auctions. The seller gradually lowers the price

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 SECTION 3.5 SUMMARY

3.6 The interrelationship between markets

• Market equilibrium occurs at the price at which the demand
curve crosses the supply curve: that is, where demand equals
supply.
• Disequilibrium occurs when there is either excess demand or
excess supply in the market.
• In a competitive market, changes in the market price eliminate excess
demand or excess supply; this is how the price mechanism helps to
allocate scare resources.

3.6 The interrelationship between

markets
So far in this chapter we have looked at how the price mechanism operates in
a competitive market. We have seen how shifts of either the demand or supply
curve for the good disturb market equilibrium and trigger an adjustment
process to establish a new equilibrium.
Shifts of curves are often caused by events taking place in other markets in
the economy. On the supply side, they can be caused by a change of price of
a good in joint supply (see below). On the demand side, shifts can be caused
by a change in price of a good in complementary demand (joint demand) or
a substitute good, both of which we have already mentioned. They can also
be caused by a change in the price of a good in composite demand or derived
demand, as will be explained below.

● Joint supply, joint demand, competitive

demand, composite demand and derived
demand
Joint supply
Joint supply occurs when production of one good leads to the supply of a
KEY TERM by-product. Suppose, for example, that the demand for beef increases,
joint supply when one good
possibly because of rising incomes in economically developing countries. In
is produced, another good is
also produced from the same
these countries, meat is a relatively expensive luxury which people tend to
raw materials, perhaps as a buy more of if their incomes rise. The slaughter of more cows to meet this
by-product. demand leads to production of more cow hides, which increases the supply
of leather.
The interrelationship between the beef and leather markets is shown in 69
Figure 3.20. Note that the price of beef rises following the rightward shift of
the demand curve for beef, but the price of leather falls following the rightward
shift of the supply curve of leather. A rise in the price of the first good leads to
a shift of the supply curve of the other good in joint supply. In this example,
beef is the main product and leather is the by-product, though the relationship
could be reversed.