Market

Buyers and sellers communicate and exchange goods

and services
Functions
Resource allocation
Goods and services go to those who need it the most and
can afford it (show this by offering high prices)
Resources allocated to producing profitable goods and
services those which have high demand and thus
needed the most

Price determination
Negotiation
Price mechanism if prices are too high then people will
seek substitutes, if prices are too low then firms can earn
extra profit by raising price

Demand
Effective demand
How much would be bought how much people
are willing to and can afford to buy
Shows inverse relationship
When prices increases quantity demanded
decreases and vice versa
The Income Effect: When prices decreases, a
person can maintain current spending with less
money. The good is normal more of it is
consumed
The Substitution Effect: Price decreases
becomes cheaper option relative to other
alternatives and substitutes

Factors that affect demand

Income:
Infinite needs and wants able to satisfy these
when income increases
Normal goods people consume more of this
when incomes increase
Inferior goods decrease in quantity demanded
when incomes increase
Adequately fulfill their purpose but less desirable
(provide less utility) than more expensive goods
Example: frozen meals (people will prefer to eat out at
restaurants if they have more money), public
transport (i.e. buses) taxis more comfortable and
saves time (usually)

Advertising and brand recognition

Increases awareness and informs consumers of
potential (and possibly nonexistent) benefits
Population
Age distribution i.e. increase in elderly population
more healthcare, increase in population of children
more education
Gender different preferences i.e. clothing
Geographical distribution i.e. urban residents
taxis, transport; rural population farming and
agricultural tools
Ethnic groups cultural products from country of origin

Tastes and fashion

in fashion clothes
trends
Price of substitutes
Substitutes alternative goods and services that serve
similar/identical functions i.e. coffee and tea, Pepsi and Cola
If the price of Pepsi drops then people who usually drink Coca Cola
may want to save some money and drink Pepsi instead since the
taste is similar
Price of complements
Complements goods that are usually consumed together i.e. hot
dog buns and sausages
i.e. if the price of Starbucks coffee increases then the quantity
demanded for croissants should decrease since people usually have
them together

Interest rates
Spending is often fueled by borrowed
money especially for luxury goods that are
expensive i.e. cars, holidays, furniture
Most people have mortgages if interest
rates decrease disposable incomes
increase and vice versa

Supply
Positively correlated if the price of the good or
service increases the quantity supplied increases as
well
Explaining this relationship
The profit motive incentivized to invest more/ hire
more labor to produce more
Production and costs as capital and other factors of
production are usually fixed in short run, firms can only
hire more labor to increase output but diminishing
returns to labor means increased average costs
New entrants into market -- firms can earn more
money producing this compared to other goods with
their limited resources esp if production processes
similar i.e. cabbages vs. turnips

Factors affecting supply

Costs of production
If costs increase it becomes less profitable to sell
the good, if costs decrease it becomes more
profitable
Subsidies
Help reduce production costs government grants
for product produced to help encourage goods that
are basic needs for most people i.e. agricultural
products
Technology
New production methods could help reduce costs

Factors affecting supply

Natural factors
Weather, natural disasters particularly impactful on
agricultural crops
Prices of other goods (substitutes in production)
If the same factors of production can be used to produce
goods that have higher prices (i.e. more profitable) then firms
will switch to producing that good
Taxes
Counts as a cost of production that is paid to the government
VAT percentage of the price of good; shift of supply curve is
non-parallel
Unit tax lump sum added to price of good; parallel shift of
supply curve

Prices of complements in production

Production process may yield or produce
two goods i.e. in producing timber sawdust
might be produced if price of sawdust
increases then entire activity become
more profitable

Equilibrium price
A price set at which the quantity supplied
and demanded for are equal
Also known as the market clearing price
there are no buyers left who are willing
to purchase the good at the price, and
without goods, and no sellers left with
unsold stock
Total revenue = price x quantity

 Excess supply results when the price is

set above the equilibrium price more
goods are produced than the amount
consumers are willing to buy, therefore
resulting in unsold goods
Excess demand results when the price is
set below the equilibrium price more
goods are demanded for than actually
produced resulting in shortages

Price elasticity of demand

Refers to the responsiveness of demand to a
change in price i.e. by how much will the
quantity demanded change if the price
changes?
Price inelastic when the percentage change
in quantity demanded is smaller than the
percentage change in price i.e. if the price of
oil increases by 20% and the quantity
demanded only decreases by 10%, then it is
said to be price inelastic

How to calculate price elasticity of

demand
Price elasticity of demand =
percentage change in quantity demanded
percentage change in price

If the PeD is less than 1 then it is said to be price

inelastic
If the PeD is greater than 1 then it is elastic.
If the PeD is 0 then it is said to be perfectly inelastic
a price change will not affect demand
If the PeD is infinity then it is said to be perfectly
elastic buyers will purchase as much as they can at
one price point, but will not purchase any at any other
price point

Examples
There are very few perfectly inelastic goods in the real world
but some that come close include life-saving medicine or
surgery
There are also very few perfectly elastic goods.
Hypothetical example explaining how a good could theoretically
have a demand that is perfectly price elastic.
In the market of pink tennis balls, say, for example, tennis
players dont care what the color of their tennis balls are. The
price of a pink tennis ball is set at $5, but there are also other
colors, such as neon green and vivid yellow, which are available
at $5.
In this case, consumers will buy no pink balls (switch to buying
other colored tennis balls) if they cost more than $5 per dozen
but will buy only pink balls if they cost less than $5.

Factors affecting price elasticity of

demand
Availability of substitutes
Consumers can simply switch to another product if they feel
they are being overcharged
Degree of necessity
Prices of essentials such as food, water and housing the
opportunity cost of doing without them is too high and people
are thus willing to pay high prices for them
Proportion of income spent on good
i.e. 5% of a flat screen TV might be $500 whilst 5% of a pencil
is probably only a few cents
Time period
Due to imperfect information, consumers may not be aware of
other goods out there more time to find substitutes

Price elasticity of supply

Price elasticity of supply =
percentage change in quantity demanded
percentage change in price

If the PeS is less than 1 then it is said to be price

inelastic
If the PeS is greater than 1 then it is elastic.
If the PeS is 0 then it is said to be perfectly inelastic
a price change will not affect suppply
If the PeS is infinity then it is said to be perfectly
elastic sellers will sell as much as they can at one
price point but not at any other price point

A theoretical example of a good with a perfectly price

elastic supply:
A generic cheese sandwichs production cost is exactly
one dollar per sandwich. This cost is the same for one
sandwich or one billion sandwiches no increasing
opportunity cost or economies of scale. Factories can
also produce a generic BLT sandwich, whose production
cost is also exactly one dollar. All the factors of
production are completely mobile and can be used to
produce both sandwiches.
If the price is any less than one dollar, cost > price and
thus no sellers would sell the cheese sandwich. If the
price was any higher then every single firm selling the
BLT sandwich would now sell the cheese sandwich.

Factors affecting price elasticity of

supply
Factor mobility: some firms can produce a variety
of goods with the same or similar factors of
production and production processes and can
switch to producing the more profitable good
easily i.e. firms producing cars or motorcycles
The availability of factors of production: some
inputs are readily available whilst some are hard to
obtain; the cost of getting these extra inputs has to
be considered if the economy is at full
employment then getting extra labor to increase
production would have a huge cost (no one willing
to work unless high wages offered)

 Spare capacity: If the factors of production are not

at full capacity yet, then firms can still increase
output quickly i.e. by paying workers to work
overtime or by changing settings on machines
Stocks of unsold goods: When it is impossible to
hold stocks of goods (i.e. food products that dont
last very long) then supply is likely to be price
inelastic
Time: Theoretically in the long run supply in most
cases is elastic as firms can take the time to
expand production facilities and invest and react to
change in price

 Time it takes to produce the good: Some

goods take a certain amount of time to
produce i.e. agricultural crops have to be
planted two or three months beforehand
so it is difficult to change supply
instantaneously
Barriers to entry: whether or not firms ca
enter into the market easily

Income elasticity of demand

Income elasticity of demand =
(percentage change in quantity
demanded)/(percentage change in income)
If income elasticity is between 1 and -1,
demand is said to be income inelastic
If income elasticity is greater than 1 or less
than -1, demand is said to be income elastic
Normal goods positive income elasticity
Inferior goods negative income elasticity

Factors affecting income elasticity

of demand
Income inelastic goods include
necessities basic goods that consumers
need to purchase i.e. food, electricity,
water opportunity cost of doing without
them is usually quite high
Income elastic goods include luxuries
spending is discretionary (does not have
to be undertaken) opportunity cost of
doing without them is usually quite low

Applications of PeD
Demand inelastic if price rises then total revenue
increases
Demand elastic if price rises total revenue
decreases
Unitary elasticity of demand price change results
in no change in total revenue
This explains many business decisions such as
lower prices for off-peak rail travel; this is because
demand at these times is elastic consumers are
not in a rush and therefore an increased variety of
services will serve the same function as rail travel
(more substitutes) i.e. buses
By decreasing the price total revenue increases
during these times

Applications for PeD for

government
Taxation often source of government
revenue
Imposed on price inelastic goods
quantity demanded does not change much
and thus huge amounts can be taxed if
good was price elastic people would
simply switch to substitutes / not buy good
and tax would be ineffective

Applications of income elasticity

Production planning
Producers of normal goods if they knew
recession was coming or government
announced increase in direct taxes then
they could start investing in machinery
now / start piling up stocks to prepare for
increase in demand

Resolving scarcity
Resources are scarce there is only a limited amount
of them
Needs vs. wants
needs are basic requirements for human survival i.e.
water, food, warmth, shelter, clothing
wants are desires that people could do without and still
survive

People always want more despite current

circumstances
Basic economic problem: current resources are not
enough to satisfy all needs and wants how do we
allocate these scarce resources and which
needs/wants do we satisfy?

Decisions surrounding basic

economic problem
What to produce? Libraries versus roads? Apple
computers or Samsung tablets?
How to produce? Factors of production can be
organized in different ways and used in different
production methods to produce same goods; using
capital vs. labor?
For whom to produce? Resource allocation
who do we give these goods to?

depends on the economic system of the nation

Choice and opportunity cost

Resources can be used in many different
ways to satisfy different needs and wants
A choice has to be made
Whenever someone makes a choice the
person sacrifices something else when
presented with two options that both require
the same resources, doing one thing means
not being able to do the other
The opportunity cost is therefore what you
give up in order to do something

Opportunity cost
Theoretical example
Suppose youre given a free coupon to either redeem either a
new bag or a new purse.
Suppose you exchange it for a new bag. Whats the opportunity
cost? Well, its what youve given up to obtain the new bag the
enjoyment you would had have if you bought the new purse.
Theoretical example 2
Suppose now, you can use the free coupon to redeem a new
purse, or pay an extra $50 to get the new bag.
Suppose you choose to pay $50 to get the new bag. Now, the
opportunity cost (what youve given up) is the enjoyment of
having the purse as well as the enjoyment you wouldve had by
spending that $50 on something else.

Production possibilities frontier

(PPF)
Shows what an economy can produce if all of its
resources are used efficiently
It is a curve because some resources are
more suitable to producing one good
compared to another i.e. grass for raising
sheep and wet marshes for rice
At points A, B and C the economy is
maximizing its productive efficiency it is
using its resources to produce maximum
output
When moving from point A to point B there is
an opportunity cost you are sacrificing some
of product A to produce more of product B
(shown by blue bracket)
Point Y is not possible with current resources
Point X not all resources are being used /
not being used efficiently
Whether an economy choose to be at A or B
or C depends on consumer needs do
people want more rice or wheat? (allocative
efficiency)

PPF over time

The PPF can increase
through:
Discovery of new
resources however this is
short-term as resources
are depleted
Technology is essentially
the set of possible
production methods. A
development in technology
occurs when people
innovate and discover new
production methods and
new ways to organize our
factors of production to
create more output given a
limited number of
resources

The public and private sectors

Private sector individuals or groups of
individuals setting up businesses or supply
goods and services
Public sector government organizations
provide goods and services that are often
neglected by the private sector

Types of economy
Market or free enterprise
goods/services provided by public sector
resource allocation determined by supply and
demand
public sector limited to providing legal system,
policing and defense services, monetary system

Command economy
public sector chooses, produces and distributes
goods
government planning -- all resources belong to
government
prices set by the state

Mixed economy
What to produce?
Consumer goods provided by private sector ensures that
economy reaches allocative efficiency
Merit goods and public goods provided by the state
Supply of certain goods that may have social costs, or be
dangerous/harmful are banned or restricted (taxes, quotas, etc.)

For whom to produce?

Private sector sold to anyone who can afford + is willing to
Public sector goods provided free or at very low prices to
everyone, also provides for those who cannot work
(illness/disability)

How to produce?
Private sector firms (due to competition) minimize costs and
maximizes quality
Public sector gov. organizations try to supply efficiently by
setting performance targets etc
Some public/merit goods i.e. roads are contracted out to private
firms more efficient

Market failure
Resources are often wasted (not being used in a way that brings
the most benefit) and economies are being inefficient
Merit goods / public goods being underprovided
Merit goods i.e. those with positive externalities underprovided
Public goods i.e. streetlights
Difficult to charge people for it firms cannot make profit
non-rivalrous: more than one person can enjoy the light that it gives off
at any point in time without detracting from each others experience
non-exclusive: difficult to prevent non-paying consumers from using
streetlight

Lack of competition
Monopolies charging higher prices / restricting choice /reducing
quality

Externalities:
third-party costs i.e. pollution discharges not being met by
private firms
legislation fines or forcing companies to pay

Market failure
Factor immobility
Capital and labor that are specialized difficult to
transfer from one industry to another
unemployed

Lack of information
Consumers: unaware of full range of products or
specifics of one product i.e. quality make wrong
decision or paying the wrong price
Firms Unaware of most efficient way to produce
a product
Solved by government legislation i.e. forced to
put ingredients list / allergy information on food
labels and technology (Internet research)

Characteristics of labor
Different from other factors of production
Supply of labor increase (population
increase)
Expensive resource
Need breaks, can only work certain hours,
holidays, sickness, maternity and paternity leave

Difficult to manage
complex needs
emotional + may react adversely to instructions
quality inconsistent as may become tired / cannot
be as precise as machines

Specialization
(Small) firms usually produce one type of
good
Departments in firms i.e. marketing,
production, finance, etc.
Regional and national specialization (due
to external economies of scale)
Division of labor production process
broken down into small tasks; labor
concentrates on task/skill they are best at

Division of labor (advantages to the

individual)
Advantages
Easier to increase human capital as focusing on one
skill (repetition leads to increase in skill) better paid /
more employment opportunities
Differences in abilities and interests can concentrate
on skill youre best at
= faster increase in human capital
= job satisfaction due to development of skills

Disadvantages
Boring and repetitive esp. if requires little skill
motivation
Risk of unemployment can be easily replaced by
capital

Division of labor (advantages to the

firm)
Advantages: Efficiency
Workers can perform tasks more productively
Greater use of specialist tools, machinery and equipment
available that can only be used by experts in the task
Saves time moving around workplace (collecting tools) Ford
production line
Organization of production easier can fit onto production line
/easier to monitor and manage
Workers incentivized to innovate and find new methods of
production (technology) to make life easier for themselves

Disadvantages:
Poorly motivated absenteeism, poor-quality work, alienation
reduction in productivity
Interdependence and loss of flexibility: one stage of production
breaks down entire process has to be halted

Labor market
Demand for labor = firms
Supply of labor = workers (their work is
counted as a service)
Price = wage rate

Factors affecting demand for

labor
Labor is derived demand depends on
goods and services that the workers help
produce
Cost and availability of substitutes i.e.
capital machines may be a lot faster at
doing very specific and repetitive tasks
however professional services (i.e. legal)
require skilled labor
Productivity of labor extra output means
extra wage is justified
Non-wage costs retirement and selection
costs, perks (company car, health insurance,
meals), sick pay, maternity pay and holiday

Factors affecting supply for

labor
Education and training i.e. vocational courses or
more university spots more people with required
skills
Changes in net advantages of an occupation i.e.
perks, number of hours, insurance, etc.
Size of nations workforce and demographic
changes

school leaving /retirement age

role of women
age distribution
foreign workers (i.e. Canada very loose immigration
policies)

Wage differences
In different occupations
Greater supply for jobs which require no skill or training vs. jobs that
require many years of education higher wage compensatory for
opportunity cost of pursuing further education or training
Dangerous or unpleasant jobs compensating differential
Job satisfaction higher supply
Wages higher in booming industries businesses more likely to take
risks and expand
Private sector vs. public sector public sector considered more
stable; in HK wages adjusted for inflation
Fringe benefits
Same occupation
Presence of trade unions
Immobility job located somewhere else where living costs are
higher, or where there are no friends or family

Minimum wage legislation

Passing legislation that requires employers
to pay an hourly rate above the minimum
wage employers face penalty if not
followed
Reasons for minimum wage
Benefit disadvantages workers (ethnic
minorities and low-income families)
Reduce poverty
Counteract discrimination (gender, age,
ethnicity, etc.)

Effects of minimum wage

Disadvantages
As seen in this diagram, as the
wage rate increases, there is an
excess supply of labor, and the
quantity of labor hired reduces.
This surplus of labor represents
people who are unemployed.
However
The Keynesian argument: Because
these workers are often quite poor
(thus affected by minimum wage),
the extra income they earn is likely
to be spent thus fueling demand in
the economy -> more employment
Also, productivity might rise as a
result of increased wages thus
increasing demand for labor
It also depends on the price
elasticity of demand for labor

Effects of minimum wage

Disadvantages:
Illegal or black market workers who are
exploited yet cannot go to government for
help
Inefficient allocation of jobs among workers:
workers who are keen to work at lower wages
more desperate for a job may not receive
a job whilst people who are less desperate
may get one
Wasted resources: due to the shortage of
jobs (surplus of labor) people waste time
searching for jobs (i.e. queuing at

Trade unions
Protect interests of workers through
Negotiating pay, benefits and working conditions
(safety)
Ensuring worker participation in business
decisions
Legal protection (i.e. against employers due to
discrimination or poor working conditions)
Pressuring government to pass legislation
Financial benefits i.e. strike pay during collective
action
Recreational facilities and training

Collective bargaining
Shift in balance of power -- trade unions
are monopolies in the labor market (sole
supplier)
Can threaten industrial action i.e. strikes
(refuse to work and protest), work-to-rule
(following every rule regarding the
workplace to slow production), overtime
ban, go-slow (working deliberately slowly),

Trade unions
Made less powerful:
Laws requiring secret ballot before strike
Banning closed shops (requiring all
workers in organization to join trade union
regardless of preference part of contract)
and secondary picketing (workers from
other organizations protesting as well)
Businesses able to sue trade unions if
they do not abide by law

Trade Unions

Wage rate

Strade union
S1
W2
W1

D1
Q2

Q 1 Q3

Quantity of labor

Explanation
Trade unions control supply of
labor no supply of labor for
wages below W2
If firm needs to hire more
workers beyond Q3, wage rates
need to rise further
Contraction in demand
increase in wage represents
rising business costs ->
unemployment
However:
Job losses avoided if
productivity increases at same
time demand of labor
increases
Depends on price elasticity of
demand for labor and whether
employers able to pass on wage
increase to consumers through

Sectors of economy
Primary extraction of raw materials from the
earth i.e. mining, extraction of oil and natural
gas, fishing, forestry, farming
Secondary converting raw materials into
finished or semi-finished goods i.e. metal
working , textiles, engineering, construction
Tertiary sector provision of services:
professional (legal, medical), transport,
household, leisure (i.e. tourism), financial
(banking)

De-industrialization
The decline in manufacturing
Causes:
Consumer demand as incomes increase people
can afford luxury goods i.e. tourism which are
usually services
Fierce competition from developing nations
lower production costs due to less expensive labor
in India, China and Brazil
Public sector in developed countries (high tax
revenue)
Advances in technology machines replace labor
in production

Production costs
Fixed costs (overheads) costs that remain the
same regardless of level of output i.e. rent,
advertising, interest payments
Variable costs costs that rise as output increases
Total costs = fixed costs + variable costs
Average cost is the cost of producing a single
unit of output
total cost
Average costs = quantity
produced

Total revenue = price x quantity

Profit = total revenue total costs

Economies of scale
Average costs decrease as a firm
increases size and output up to a point
called the minimum efficient scale
(MES)
Average costs increases after that point

Causes of economies of scale

Globalization
Integration of worlds economies firms and
people behaving as though there is only one
global economy
Key features
production and selling of goods in various
countries goods and services traded freely
high level of interdependence one economy
likely to affect another
capital flows freely savings

Reasons for globalization

Deregulation
Privatization international provision of goods and
services
Barriers to trade dropped legislation loosened,
supply of currency dictated by market forces

Development in technology and the Internet

allows consumers to find out about and purchase
goods
sellers can set up online shops
easier to organize factors of production in foreign
countries (better communication channels) and
contact staff reduces costs of hiring large numbers
of managers to oversee process

Reasons for globalization

Tourism consumers aware of range of
products available in other countries ->
consumer demand
Many firms looking to expand
domestic markets saturated no room for
growth i.e. refrigerator market in HK (everyone
already owns one!)
cheaper costs i.e. labor and economies of scale

International transport networks

Shipping of goods cheaper, faster, more
destinations
Makes it easier for entrepreneurs managing
multinationals air travel

Multinationals
A large firm that operates sells and produces
goods -- in several countries
Why do multinationals exist?
Economies of scale
Saturated domestic markets
Able to exploit global recognition of product
effective marketing and branding
Have resources to take risks very stable
company (highly diversified) also able to take on
high initial fixed costs of entering new market in
foreign country

Foreign direct investment and

development aid
Business investment (the purchasing of
goods that contribute to the future
production of goods i.e. capital such as
factories, machines, special equipment) in
a foreign country
Sometimes investment is shared among
two companies, one of which is from the
host nation

FDI
Governments often encourage multinationals to
invest in country:
Offering tax breaks, subsidies, low-interest
loans
Lift restrictions, relax regulations and reduce
bureaucracy (reducing administrative costs
for multinationals)
Investing in own infrastructure i.e.
communication networks, roads, water
supply, transport, etc.
Investing in education providing high-skilled
labor

Development aid
Assistance given to less developed
countries