Transport summary chapter 2

Market structure & competitive behaviour in transport

Goods and services are produced by firms, this firm takes the risk by employing land, labour and capital to produce and sell goods and services. The reward for the risk is the profit(difference between revenue and costs) they make.
As long as there is profit to be made in an industry (all firms together selling a particular product in a given market) new competitors will try to enter the market and get some market share. Not always are firms free to enter an industry, sometimes there are barriers to entry(like high start-up costs in the metal-industry)
More firms in a market leads to more supply, the supply curve shifts to the left.( S to S1)



Note: Consumer surplus increases as new suppliers enter the market.

Perfect & imperfect competition:



Firms in an oligopolistic or monopolistic environment have a lot of market power. They can influence price by varying their output because consumers have limited choice of rival products. Market power is measured in the concentration ratio, this is the proportion of output accounted for by the five largest firms.
Assume a firm want to make more output, and there are just two resources employed: labour and capital. Firms can use both to higher their output. However their behaviour in constrained by time:
- In the short run, the amount of capital in a firm is fixed, so the company will only be able to increase production levels by hiring more workers.
- In the long run , production levels can be increased using both labour and capital.
Diminishing returns.

Let’s look at a bicycle factory in the short run, so capital is fixed and the bicycle factory is only capable of increasing output by hiring more workers.


The marginal product of labour is the addition to output made by each extra worker. In the beginning each worker is adding more to total product than their predecessor, (Marginal product is rising so increasing returns occur) however, eventually the addition to total product made by the extra worker is less than the previous worker.
This is known as the law of diminishing returns.

Cost & Revenues:



Now we know this we can look at the bicycle factory also looking at costs. The fixed cost is capital.We assume every machine costs the firm GBP 200 each month in interest charges and each worker earns GBP 100 each month.(making total fixed costs always GBP 1000 and variable costs GBP 100 per worker)


Note: The factory is most profitable with 6 employees.
If we would plat the Marginal Cost and the Average Cost curves it would look like this:



A firm uses the marginal cost curve to decide how much of a product to make at different prices. The upward shape of the supply curve is determined by the law of diminishing returns.

We’ve looked at the bicycle company for the short run. Now let’s have a look at the long run for a taxi company. What happens if we are able to increase the amount of capital employed?
There are mainly three potential outcomes:
1) Constant economies of scale, this happens if unit costs are identical after buying the second taxi then the new SAC curve shifts horizontally to the right. The Long run Avarage Cost curve (LAC) is horizontal. In this case capacity has doubled and the costs stay the same.


2) Economies of scale, this happens if unit costs fall with the introduction of the second taxi. The SAC curve shifts downwards to the right. Capacity doubled but costs have fallen. The firms experiences economies of scale and the LAC curve slopes downwards.
Economies of scale refer to the cost advantages that a firm can enjoy when the volume of production increases, in the long run.


There can be two kinds of economies of scale:

1) Internal economies of scale: Lower long run unit costs are achieved within a firm with higher levels of output. As the firm produces more, so long run average cost fall because of various factors. For example:

- Technical economies E.G. Large firms can use expensive vehicles, intensively. Train operators van make intensive use of expensive IT systems to manage the deployment of drivers and vehicles. Large-scale production allows the gains from division to labour to be exploited.
- Managerial economies. Big fixed costs are spread across a larger output. Average fixed costs go down.
- Financial economies made by borrowing money at lower rates than smaller firms.
- Marketing economies made by spreading the high cost of advertising on E.G. television across a large level of output.
- Purchasing economies made when buying supplies in bulk and therefore gaining a larger discount.
- Research and Development economies by spreading the high cost of developing new and better products.

Mostly the average cost can internally be cut because of spreading the fixed costs across a higher level of output.

2) External economies of scale: Long run unit cost reductions made outside the firm as a result of it’s location and occur when:
- A local skilled labour force is available
- Specialist local back-up firms can supply parts or services.
- An area has a good transport network
External economies arise from a growing local economy and industry rather than through an individual firm.

3) Diseconomies of scale, this happens if unit costs increase with the introduction of the second taxi. The SAC curve shifts upwards to the right. Capacity doubled but costs have risen. The firms experiences diseconomies of scale and the LAC curve slopes upwards.



There can also be two kinds of diseconomies of scale.

1) Internal diseconomies of scale occurs when the firm had become too large and inefficient. As the firm increases production, eventually average costs begin to rise because:

- The disadvantages of the division of labour take effect.
- Management becomes out of touch with the workforce and some machinery vehicles become over-manned
- Decisions are not taken quickly and there is too much bureaucracy e.g. form filling.
- Lack of communication in a large firm means that management tasks sometimes get done twice
- Poor labour relations may develop in large companies.

2) External diseconomies of scale are long run unit cost reductions made outside the firm as a result of its location and occur when:
- Local labour becomes scarce and firms now have to offer higher wages to attrackt new workers.
- Land and factories become scarce and tents begin to rise.
- Local roads become congested and so transport costs begin to rise.

Over time, changes from economies of scale to diseconomies of scale are made. (En visa versa)



If as a result of increasing both labour and capital in the long run, the firm experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely, if long run average unit cost rises as the firm expands, diseconomies of scale are occurring.
The table above shows a simple example of the long run average cost of a firm that experiences economies of scale up to output level 1000. The minimum efficient scale (MES) is the scale of production where internal economies of scale have been fully exploited. It corresponds to the lowest point on the long run average cost curve, the MES. Between 1000 and 1400 we speak of constant economies of scale and beyond 1400 we speak of diseconomies of scale.

Short run revenues. There are three types of revenues:


We must stress the difference between the marginal revenue in a perfectly competitive market and the marginal revenue in a monopoly market.
Lets look at the taxi company again, now suppose it operates in a perfectly competitive market.

Note that the marginal revenue is always equal to the fare, the price is set by the market so the fare doesn’t change.
Because of the taxi company being in a perfectly competitive market they are price takers and accept the price set by the market. The firm faces a perfectly elastic demand curve.


Now assume the taxi company operated in a monopolistic market.

Note that the taxi company can set the prices, the marginal revenue is no longer constant but declines with output.
Because of the taxi company having a monopoly they can set the prices and output. The firm has a diverging average and marginal revenue curve.



There are two types of profit(π):
- Normal profits: the minimum the amount of money a firm must receive to carry on production of a given good. Normal profit is included as a cost.
- Abnormal profits occur when revenue exceeds costs so the profit is greater than 0 (so actual profit is made) so also when TR is greater than TC.

So: Even if no abnormal profits are made, normal profits are earned – the firm is still rewarded for managing resources.

Profit maximising output. (Maximising profits)

For the perfect competition market profits are being maximised at the point where MC = MR



In the chart you see that after around 25 trips diminishing returns set in and after 50 trips the marginal cost is already higher than the marginal revenue.
However, in a pure monopoly market a monopolist has market power and so can set his price.



A profit maximiser increases output until MC=MR at Q1. The intersection of MC with MR gives the profit maximising level of output. The intersection of MC with MR gives the profit maximising level of output. To find the market price one must project up from Q1 to the demand curve and across the vertical price axis, P1. Consumers are willing to pay P1 for Q1. Unit costs are only P2 so the firm is making an abnormal profit of (P1-P2)*Q1

The objectives of a firm.

The main objective of a firm is growth. Growth often allows firms to enjoy the benefits of:
- Economies of scale and the competitive advantage that comes from the resultant lower unit costs.
- market leadership and the enhanced ability to set a price that meets objectives.
- higher profits which mean higher salaries for managers and higher share price for owners.
stakeholders are groups who have an interest in the activity of a business eg shareholders, managers, employees, suppliers, costumers, government and local communities. Different stakeholders have different objectives eg owners want maximum profits.
stakeholder conflict occurs when different stakeholders have different objectives. Firms have to choose between maximising one objective or satisfactorily meeting several stakeholder objectives, so called satisficing.
In public limited companies, ownership and control are separate . Owners seek profits; managers may seek sales maximisation as these increase bonuses.

In perfectly competitive markets:
- No individual customer receives preferential treatment
- There are no barriers to entry or exit
- Consumers and producers have perfect market knowledge
- There is perfect mobility of factors of production
- Each firm is price taker.



Note: Q1 is also the point where MC=MR, so on this point it is maximising profits.

The perfectly competitive industry will self-correct itself to P1 equilibrium price. If we look at the next graphs:

At first, demand increases which makes the demand line shift from D1 to D2. Demand increases and therefore the price shifts upwards to P2. As soon as this extra demand is noticed new suppliers will enter the market making the supply line shift from S1 to S2.
This brings the equilibrium price back to P1. The market is self-correcting


An imperfect competitive firm produces differentiated products to rival firms and so has the ability to set price or output. It faces a downwardly sloping demand curve.

Categories of imperfectly competitive firm are:
- Monopolistically competitive
- Oligopoly
- Pure monopoly

Monopolistic competition.

Monopolistic competition is a market structure with:
1) A large number of firms producing slightly differentiated products.
2) Each firm selling a differentiated (non-identical) product ie a firm is price maker and its demand curve is downward sloping
3) The large number of close substitutes means demand is relatively price elastic
4) No barriers to entry or exit mean normal profits are earned in the long run.




Oligopoly

An Oligopolistic market has these characteristics:
- A high concentration ratio(relatively high market share by top-5 companies) and each firm is price maker
- Firms produce differentiated, branded products supported by intensive advertising and marketing
- There are significant barriers to entry & exit
- Firms are interdependent. The behaviour of one firm will influence – and be influenced by – the behaviour of its rivals E.G. oligopolists take into account likely reactions of rivals to price changes.
- Generally stable prices as firms fear a price war where firms cut prices and rivals respond. Price wars are only initiated if a firm feels it has a cost advantage and its objective is to increase long term market share/growth at the expense of short term profits.
- Firms wishing to increase sales use non-price competition such as promotion campaigns.
- Abnormal profits It can be argued profits are not distributed to shareholder but retained to fund R&D into new products.
The key characteristic of oligopoly is interdependence - there are so few firms that each one has to anticipate on actions on the rivals. “What will rivals do?” is an important question.
Within the oligopoly there can occur a collusive oligopoly. This occurs when firms within an industry agree to act together to restrict competition. E.G. they set up a price fixing cartel where each firm restricts output.
The oligopolistic kinked demand curve model is an illustration of interdependence between firms. Under the price of P1 it isn’t profitable anymore to decrease prices because the demand will become inelastic. That’s why price wars are so infrequent and short lived.



Pure monopoly.

A pure monopoly is a firm that has 100% of market share. Not all monopolies are pure monopolies, monopolies is a firm that holds more than 25% of market share.
Characteristics of a pure monopoly are:
- Significant barriers to entry and exit. E.G. high costs of entry or legal restraints.
- Monopolists are price makers an can set price or output for their own product.
- Monopolists are usually assumed to be profit makers and can set price or output for their own product.
- Monopolists are likely to earn abnormal profits in the long run.
A monopolist can only sustain abnormal profits by erecting barriers to entry:
- legal monopolies E.G. TOCs run exclusive train services.
- Natural monopoly argument E.G. NATS
- High sunk costs - expenditure that cannot be recovered if an unsuccessful entrant leaves an industry – deters competition.
- predatory pricing( Price war) where monopolists lower prices to a level that forces new entrants to operate at a loss.
- Because of the economies of scale the established market leaders have the new entrants cannot compete on cost and price.
Transports are known for being relatively monopolistic, the government mainly three tools to remove the monopolistic character of transport.
1) Privatisation by moving ownership and control of state owned firms such as british rail into the private sector
2) Deregulation , removing barriers to entry and allowing new firms into previously closed markets. (E.G. busses)
3) Make markets contestable

Negatives to deregulation (=‘opening up’) bus-industry in the UK.

In the beginning the competition increased resulting in more frequent bus rides and lower prices. However: because of the more frequent busses the loading is less(busses are not full) adding to existing congestion.
Also, trough mergers the companies created an oligopoly market meaning many regions now have a monopoly local bus company, resulting in higher fares, lower levels of service and withdrawal of marginally commercial routes.


Pure monopoly vs Perfect competition


Profit maximising monopolists set their output where MC=MR. In perfect competition MC gives the supply curve S. Perfectly competitive industries result in lower price and higher output.

Monopoly isn’t always an inappropriate market structure. It may be the best market structure where:
- Only monopolies can generate sufficient profits to enable large-scale high cost Research & development (R&D)
- Domestic monopolies can compete internationally more easily than small firms.
- There is the potential for significant economies of scale ie one large firm can produce at lower unit cost than many small firms. The natural monopoly argument.
Price discrimination in imperfectly competitive transport modes.
One of the advantages of being a price maker is being able to use price discrimination ie they don’t have to charge the same price for the good to everyone. (E.G. peak and off-peak travel)
So for price discrimination we require:
- That firms who apply price discrimination are price makers.
- No market seepage (reselling between sub markets)
- Different price elasticities of demand (PEDs) in each sub market. (sub markets like peak and off peak travel)
Price discrimination is a very good tool for extracting all consumer surplus. For example:



Imagine this is an airline company and customers are invited to bid for a limited number of seats. The first customer is willing to pay more so he will get Q1st. And so on until the plane is full.
The only negative is that the company will have to know how much the customers are willing to pay for their flight. (starting bid prices)
So what most flight companies do is: they set their price at MC=MR (profit maximising), at the price of P1. The spare capacity (only up to Q1 will be sold) will be sold in a last-minute for the P2 price.

Another way of extracting consumer surplus is by charging different prices in sub-markets. For example peak and off-peak fares.


The firm basically picks the MR=MC level for the entire market and applies it in the sub-markets.

Despite government tries to deregulate (remove entry barriers) the transport industry there still are some significant barriers like:
- Legal monopoly eg the Train operating companies have been given regional monopolies with a time-limited franchise by law.
- Vertical integration: Where by acquiring suppliers or distributors a firm can exclude rivals from a producing a product or supplying a market.
- Predatory pricing where established firms lower price to force competitors into losses and so force their withdrawal from industry.
- Economies of scale Initially, new entrants with low output cannot enjoy the same economies of scale and low unit costs of established firms.
- Large potential sunk costs deter new entrants from risking entry.
- Branding establishes products as unique. New entrants require expensive advertising to establish sales deters entrants.

Contestable markets.

Contestability theory states the mere threat of new firms entering a market impels existing firms to act competitively ie earn normal profits and deliver allocative and productive efficiency.
Contestable market theory is based around four concepts:
- Barriers to entry: the technical or economic factors preventing firms from entering an industry and competing with existing firms
- Sunk costs are the costs associated with leaving an industry. E.G. R&D costs.
- A franchise is the legal right to operate a given service for a given period of time.
- Hit& Run Rival firms attracted by abnormal profits ‘hit’ ie enter an industry. As increased supply forces down prices, then they ‘run’ ie leave.
Note: The contestability theory does not require firms to enter the market; it is about the threat of potential competition.
A contestable market has:
- One or only a few firms in the industry ie a pure monopoly or oligopoly structure
- No or minimal barriers to entry
- Minimal sunk costs.

But do not confuse perfect competition with contestable markets!



In the UK the government tried to privatise the transport sector. The main arguments for privatisation are:
- As ‘efficient’ private sector firms now has the profit that encourages technical efficiency ie assets in private hands have higher productivity. Higher productivity leads to lower unit costs so the average cost curve shifts down.



- Losses turn into profits and a reduced government subsidy is needed which allows public expenditure elsewhere eg in education and lower government borrowing.
- Privatisation raises standards increase usage of public transport and associated positive externalities.
- Contestable market argument. Privatisation introduces competition.
The main arguments against privatisation are:
- Public sector monopolies become private sector monopolies. (Government attempts to create contestable markets do not work)
- Private sector firms ignore significant externalities generated by transport causing market failure.
- The services in rural areas will reduce drastically because the private companies want to acquire maximised profit.

AS chapter 2 summary.

Definitions:

- Market: Where or when buyers and sellers meet to trade or exchange products. Markets use the price system, which reflects the price suppliers wish to sell their products for and the price buyers are willing to pay for it.
- Sub-market: A recognized or distinguishable part of a market. Also known as a market segment.
- Demand: The quantity of a product that consumers are able and willing to purchase at various prices over a period of time. This splits up to two things:

1) Notional demand: The desire for a product. (= want, will always be there)
2) Effective demand: The willingness and ability to buy a product. If you want the product, are you actually willing to pay the price for it? Demand mostly refers to effective demand.
- Ceteris paribus (assumption): Leaving all the other things out. (everything is fixed except for the thing you’re looking at.
- Demand schedule: Data used to draw the Demand curve. ( as shown below.)



Note: The move from the price of $400,- to $200,- is called a movement along the demand curve. The move upwards along the demand curve ( from $200,- to $400,-) is called an extension in demand. And a move downwards(from $400,- to $200,-) is referred to as a contraction of demand.
Also note: The shape of the demand curve isn’t always straight, it can also be curved.

There are three non-price factors affecting demand which are:
1) Consumer Income (causing income elasticity)
2) The prices of other goods (causing cross-elasticity)
3) Tastes and fashion

- Consumer surplus: The extra amount that a consumer is willing to pay for a product above the price that is actually paid.



Imagine this demand curve shows the demand(per month) for the cinema. If the price is $2,- the demand will be 4 times per month. However, the demand for a price of $3,- would have been 2 times. The person who goes 4 times per month would have been prepared to pay $3,- for the first two visits each. The consumer surplus of the first two visits will therefore be $2,-. The total consumer surplus at a price of $2,- is the total colored area, the total consumer surplus at the price of $3,- is the light-gray colored area.

- Total revenue = Price*Quantity = area under curve.
- Disposable income: Income after tax on income have been deducted and state benefits have been added. (= spendable income)
- Real disposable income: Inflation corrected disposable income.
- Normal goods: Normal goods are goods for which an increase of income results in an increase in demand
- Inferior goods: goods for which an increase of income will lead to a fall in demand.
- Substitutes: Competing goods. (apples and banana’s)
- Complements: Goods for which there is joint demand. ( Printer and cartridge )
- Change in demand: This is where a change in a non-price factor leads to an increase or decrease in demand for a product. This makes the demand line shift!

Summary of demand line shifts.

Demand line shifts to the RIGHT(more demand @ same price) if there is:
1) An increase in consumer income.
2) A rise in the price of substitutes.
3) A fall in the price of complements
4) A positive change in tastes and fashion
Demand line shifts to the LEFT(less demand @ same price) if there is:
1) A fall in consumer income
2) A fall in the price of substitutes
3) A rise in the price of complements
4) A positive change in tastes and fashion.

- Supply: The quantity of a product that producers are willing and able to provide at different market prices over a period of time.
- Profit: The difference between the total revenue of a producer and total costs.

To make profit, firms have to apply the various factors of production. Let’s take mobile phones for example, you’ll need:
1) Capital: The assembly of components and parts.
2) Labour: Employing skilled labour.
3) Land: Producing at a suitable location.
4) Entrepreneurs: Having the business skills and contacts to survive.

- Supply schedule: the data used to draw up the supply curve of a product.
- Supply curve: This shows the relationship between the quantity supplied and the price of a product.
The supply curve looks like:



- Producer surplus: the difference between the price a producer is willing to accept and what is actually paid.
The producer surplus is the gray part in the picture below. P is the market price, producers are willing to supply from the price P,1. Everything they get ‘extra’ is the producer surplus.



There are some other factor affecting supply such as:
1) Costs of production: E.G. oil prices go up, increase of labour prices but also positive effects such as improving technology.
2) Size and nature of the industry, monopolistic companies can easily charge more for their goods if oil prices go up.
3) Government policy, increase in taxes.
4) Other factors, like the weather ruining the Caribbean’s banana’s.

- Change in supply: occurs when a change in a non-price influence leads to an increase or decrease in the willingness of a producer to supply a product. This makes the supply line shift!

Summary of supply line shifts.

Demand line shifts to the RIGHT(more supply @ same price) if there is:
1) A fall in raw material costs.
2) An improvement in labour efficiency.
3) A reduction in the rate of indirect taxation
4) A positive technological advance.
Demand line shifts to the LEFT(less supply @ same price) if there is:
1) An increase in cost of raw materials
2) An increase in labour costs.
3) An increase in the rate of indirect taxation
4) A failed technological advance.

- Price: The amount of money that is paid for a given amount of a particular good or service.
- Equilibrium price/ Clearing price: The price where demand and supply are equal.
- Equilibrium quantity: The quantity that is demanded and supplied at the equilibrium price.
- Disequilibrium: Any position in the market where demand and supply are not equal.
- Surplus: An excess of supply over demand
- Shortage: And excess of demand over supply.

Market pricing in free market will look like:



Note: Pe = price equilibrium , Qe = quantity equilibrium
Demand and supply curves may shift; causing new equilibria. Therefore, a shift from the demand curve to the right will make the Pe an Qe rise. Also, both can be shifted simultaneously (supply-line shift to the left and demand line shift to the left) causing lower Qe but the same Pe.

Elasticities.

- Price Elasticity of Demand(PED) is something used in microeconomics to see how much a change in price affects the demand.

The formula for PED = %change Demand/ %change price
Since changes in price and demand nearly always move in opposite direction economists mostly don't bother to put in the '-' sign.

There can be 4 outcomes of this formula:

1) PED= 0, the demand is perfectly elastic. The graph will show a vertical line.
2) PED is between 0 and 1,inelastic. The graph will show a steep line.
3) PED=1, demand is unit elastic, 15% increase in price will make demand fall for 15%.
4) PED is greater than 1, demand is elastic. The graph will show a (nearly) flat line.

In case of outcome 2 and 4 producers will be able to raise the total revenues by using the PED.



The situation shown on the left shows a relatively inelastic demand. In the picture it shows that a move from P1 to P2 caused the move from Q1 to Q2. However, due to the inelasticity of this good the move from P1 to P2 is way bigger than the move from Q1 to Q2. That's why the total revenues are increased going from situation 1 to situation 2.( Dark area shows total revenues in situation 1, light area shows total revenues in situation 2)
So for an inelastic environment producers should increase prices to make total revenues increase.

The situation shown on the right shows a relatively elastic demand. In the picture it shows that a move from P1 to P2 caused the move from Q1 to Q2. However, due to the elasticity of this good the move from P1 to P2 is way smaller than the move from Q1 to Q2. That's why the total revenues increase going from situation 1 to situation 2.( Dark area shows total revenues in situation 1, light area shows total revenues in situation 2)
So for an elastic environment producers should decrease prices to make total revenues increase.

- Price Elasticity of Supply (PES) measures the relationship between the change in quantity supplied and change in price.
The formula for PES = %change quantity supplied / %change price

There can be 4 outcomes for this formula:

1)PES = 0, supply is perfectly inelastic.
2)PES is bigger than 1, the supply is price elastic. Producers can increase output without a rise in cost or a time delay.
3)PES is less than 1, the supply is price inelastic. Firms find it hard to change production in a given time period.
4)PES = infinity. Supply is perfectly elastic following a change in demand.

There are four main factors that influence the PES, those are:

1) Spare production capacity.
If there is spare production capacity the business is able to increase the output without a rise in costs and therefore supply will be elastic in response to demand. This happens mostly during recession because there is plenty of spare labour and capital resources available.
2) Stocks of finished products and components.
If stocks are on a high level, businesses are more able to respond to a change in demand quickly. Therefore the businesses with big stocks will be elastic in response to demand, and businesses with small stocks will be inelastic in response to change in demand.
3) The ease and cost of factor substitution.
If labour and capital can easily be switched businesses are more able to respond to a changing demand, those business are elastic in response to change in demand.
4) Time period involved in the production process.For many agricultural products there are time lags in the production process which means that elasticity of supply is very low.

I stated companies that have a relatively elastic demand would be able to increase their total revenues by lowering their price. However, knowing this, there is just one thing to mention. To be able to respond to the higher demand companies will have to be elastic in response to demand. Companies are able to influence this and become more elastic by increasing stocks and increasing production capacity. However, companies won’t be able to fully influence this. That’s why the most companies have a non-linear supply curve.



- Income elasticity of demand(YED): Measures how responsive demand is following a change in income.
Formula: %change demand / %change income; a positive outcome of the income elasticity’s shows the good is a normal good.

There may be two outcomes:

1) Outcome smaller than 1: Good is income inelastic; inferior good.( goods for which an increase in income leads to a fall in demand)
2) Outcome greater than 1: Good is income elastic; normal good.

- Cross elasticity of demand(XED): Measures the responsiveness of demand for one product following a change in the price of another related product.
Formula: %change demand product A / %change price product B

There may be three outcomes:

1) Outcome positive: Products are substitutes. (E.G. Mercedes and Renault)
2) Outcome negative: Products are complements. (E.G. printer and cartridge)
3) Outcome 0: Products don’t have any particular relationship ( E.G. paper and airline tickets)

Chapter one AS economics summary

Definitions:
- Economics: The study of how to allocate scarce resources in the most efficient way, divided in microeconomics( the study of how households and firms make decisions in markets) and macroeconomics. (the study of issues that affect economies as a whole)
- Household: Group of people whose spending decisions are connected.
- Model: A simplified view of reality that is used by economists as a means of explaining economic relationships.
- Factor of production: The resource inputs that are available in an economy for the production of goods and services. Land, Capital, Labor and entrepreneurship.
- Factor endowment: The stock of factors of production.
- Production: The output of goods and services.
- Goods : tangible products such as cars, food and washing machines.
- Services: Intangible products, such as banking, beauty therapy and insurance.
- Land: natural resources in an economy
- Capital: man-made aids to production.
- Entrepreneurship: Management.
- Labour: The quantity and quality of human resources.
- Division of Labour: The specialisation of labour where the production process is broken down into separate tasks. One part producing half-fabricate, other part making final product (perhaps in other countries, improving transport.)
- Opportunity cost : The cost of the next best alternative which is foregone when a choice is made. So if I buy a DVD of 5 pounds I will not be able to buy two sandwiches with the total of price of 5 pounds. The opportunity cost for the DVD is two sandwiches.
- Want: anything you would like, irrespective of whether you have the recourses to buy it.
- Scarcity: A situation where there are insufficient resources to meet all wants. (There is always scarcity)
- Specialisation: The concentration by a worker or workers, firm region or whole economy on a narrow range of goods and services. Specialisation has a wide range of benefits:
1) An increase in the output of goods and services when compared to circumstances where each country provides itself with everything it needs. Globally, this has had an important bearing on raising living standards, since there is more output from a particular volume of resources.
2) A widening range of goods that are available in an economy. Like the Caribbean selling banana’s because of the climate. (Oil-exporting countries!)
3) Exchange between developed and developing countries. This is often influenced by the factors of production. For example: China has been able to grow because of the high export. The high export was the result of the cheap labour in China.

Specialisation isn’t without risks. For example:
1) Countries that have specialized in E.G. oil might have a problem when oil runs out. (Dubai)
2) De-industrialisation. Because of specialization E.G. the British textile industry has moved to low-wage companies like China. This resulted in a huge amount of job-losses.
3) Bad weather, if the Caribbean focus on banana’s and the crops get wiped out because of bad weather they will be in some serious problems.
4) The taste of consumers might change, asking for other goods which will make the demand for you specialized good drop.

- Exchange: The process by which goods and services are traded. The trades can be internal (domestic) and external (international).
- Productivity: Output, or production of a good or service, per worker.
- Developed economy: an economy with a high level of income per head
- Developing economy: an economy with a relatively low level of income per head.
- Productive potential: the maximum output that an economy is capable of producing.
- Economic system: the way in which production is organised in a country or group of countries.

The basic economic problem: the fact that resources are scarce in relation to wants that are unlimited leading to choices having to be made.



Production possibility curve.

The production possibility curve shows how resources are allocated. It shows the maximum quantities of different combinations of output of two products, given current resources and the state of technology.
To explain this model we need to imagine the economy just produces two goods, say: cars and TV’s . It is also assumed that these two industries use all of the economy’s current resources. Sometimes the production possibility curve is called the production possibility frontier, since it draws a type of boundary between what can and cannot be produced.

CARS TV’s
1000 0
800 400
600 800
400 1200
200 1600
0 2000

Also involves opportunity cost: The opportunity cost of making 200 cars is 400 TV’s.

In the example of the cars and TV’s, there are two extremes: producing 1000 cars and producing 2000 TV’s.



Point A and B are on the PPC and are important since they are indicative of an efficient allocation of resources. Point C, however, shows an inefficient allocation of resources because there are less cars and tv’s produced than it could from the resources available. Point D isn’t a possible outcome because this point indicates there are more resources being used than there are resources available.
The graph also indicates there is a trade-off involved. A trade off is the calculation involved in deciding on whether to give up one good for another. If we choose to make more tv’s, we’ll produce less cars.

PPC will move outwards because of:
- Increase in technology; this leads to an over-time increase of productive capacity. (because of higher efficiency)
- More resources, we will be able to produce more because the amount of resources increases. ( With fixed efficiency)
- Economic growth; causes increase of productive capacity due to an increase of capital.

The PPC will move inwards when the productive capacity decreases.

The problems of developing countries in relation to the PPC.
If we look at a PPC for capital goods and consumer goods the problem for the developing countries is that they have a relatively high population in relation to the GDP. Therefore, there is a relatively high demand for consumer goods and there are relatively a lot of consumer goods produced. However, due to the steepness of the line near the extreme of consumer goods a small decline in the production of consumer goods will make the production of capital goods increase significantly.



However, to ensure economic growth in the future capital goods are very important because this will make the productive potential increase.
The choice is always between meeting the current needs and wants of the people(by producing consumer goods) and insuring economic growth. (by producing capital goods)


Economic market systems and the role of the market.


Scarcity involves the choice of governments and organizations to choose:
- What goods and services are to be produced;
- How these goods and services are produced and
- Who should receive these goods and services (allocation)

There are three main types of economic systems:
-Market economy: An economic system whereby resources are allocated through the market forces of demand and supply. Decisions on how resources are allocated are made by millions of people and firms. Price and free operation of the price system are central to the way in which resources are allocated.



-Command economy or centrally planned economy: An economic system in which resources are state owned and allocated by the state.
In the command economy the government has a central role in all decision made like: what to produce, how to produce and for whom the produced goods are. Also, prices of essential items and wages are controlled.
The market does not have a substantive role in the allocation of resources.
Also, in the command economy the government will try to move the PPC more to the capital goods as it would have been in the free market system to ensure future economic growth.
-Mixed economy: an economic system in which resources are allocated through a mixture of the market and direct public sector involvement.
Mostly in mixed-economy the most important companies involving E.G. oil; gas; electricity would have been government owned. However, the last 20 years there has been the trend of privatisation. Those companies are becoming private companies.
Worldwide there has been a move from government-owned companies to privatisation, which mostly caused an extra flow of money to the countries involved due to additional foreign investments. (China, command economy to mixed)