CHAPTER 1 : THE ECONOMIC PROBLEM

FINITE RESOURCES
 The world has finite resources. This means having an end or a limit such water,
minerals soil, animals and people. These resources are generally referred to as the
four factors of production: Land, Labour, Capital and Enterprise. Resources are more
scarce in some countries than others.
 Other than needs, humans have wants or desires. These wants are said to be infinite
such as more holidays abroad, a better house, more meals out, a bigger car, new golf
clubs, a better education, improved health care and a cleaner environment. This
means without limits.
 People have needs such as water, food, warmth, shelter and clothing.

THE ECONOMIC PROBLEM

The basic economic problem involves deciding how to allocate a nations resources
between different uses. The problem is that the worlds resources are finite.The worlds
wants are infinite. Decisions have to be made as how to allocate those scarce resources.

The basic economic problem

Note: To overcome the

basic economic problem,
important decisions have to
be made.
1.What to produce.
It is impossible to produce
all of the goods a country
wants. For example, should
resources be used to provide more libraries, build more schools, expand the armed forces,
make more houses, construct more roads, make more toys, print more books, increase
state pension or train more doctors.
2. How to Produce?
Goods can be produced using a variety of different production methods. The four factors
of production can be organised in different ways to produce the same goods.
3. For whom to produce?
Once goods have been produced, there has to be a method of distribution. This means the
goods have to be shared in some way between members of the population. Should
everybody get the same quantity of each good?

OPPORTUNITY COST
Whichever approach is used to solve the basic economic problem, all decision makers are
faced with choices. Resources often have a number of alternative uses; as a result people
have to make a choice about which way to use them

Individuals, firms and government have to choose how to spend their limited budgets.
 For example, a firm with limited funds US$10M may have to choose between(in
 order of preference) 1. Factory extension 2. New product development or 3.
Retraining workers
 A sacrifice has to be made when making this choice. It is called opportunity cost.
 If the factory extension is chosen, the opportunity cost will be the benefit lost from
the next best alternative-that is, the benefit lost from not developing a new product

Individuals and government will also incur opportunity costs. For example, a government
may have to choose between different items of expenditure such as education or road
maintenance when allocating funds.

PRODUCTION POSSIBILITY CURVES (PPCs)

The production possibility curve diagram should be used to show:
 The maximum productive potential of an economy or productive efficiency.
 Fully employed or unemployed resources.
 Opportunity cost.
 Positive or negative economic growth that shifts the production possibility frontier
(PPF) outwards and inwards.
 Possible and unobtainable production.

Note
Therefore:
 Any point on the PPF shows efficient production or maximum quantities that can be
produced (Productive Efficiency)
 Any point inside the PPF shows inefficient production or unemployed resources.
Example: unemployed workers, factories idle, production inefficiently organised.
any point outside the PPF is currently unobtainable

A production possibility of a country

 Points A, B, C and D
are efficient
production-At this
point, resources are
fully employed
 Point f is inefficient
production. At this
point , not all resources
in the country are being used-there are unemployed resources.
 The combination of goods at point E is not possible(unobtainable production)
because it is outside the PPC. The country does not have resources to produce 12
millions units of consumer goods and 7 million units of capital goods.

WHAT HAPPENS WHEN AN ECONOMY MOVES FROM ONE POINT ON THE

PPC TO ANOTHER?
 If economy moves from B to C along the PPC, an opportunity cost incurred. At point
 B, 14 millions units of consumer goods are being produced and 4 millions units of
capital goods. The production of capital goods rises to 7 million units but production
of consumer goods falls (sacrificed) to 8 million units. The sacrificed consumer
goods is the opportunity cost.
 If a country produces more capital goods, it will probably be able to produce more
consumer goods in the future. This is because capital goods are used to produce
consumer goods. However, by doing so there will be fewer consumer goods today
and some people will have less in the short-term

CAUSES OF POSITIVE AND NEGATIVE ECONOMIC GROWTH

Economic growth is the increase in the level of output by a nation

CAUSES OF POSITIVE ECONOMIC GROWTH

Positive economic growth-if countries produce more, the PPC will shift outwards.

Effect of improved efficiency on the PPC

Positive economic growth

reasons:
 Increasing Immigration
 Increasing birth rate
 Reducing school leaving
age
 Increasing retirement age
 Investment in capital goods
 Investment in training and education
 Increased quantity and quality of capital
 Research and development some countries find new resources that enable them to
produce more
 Improved efficiency
 New or improved technologies
 Discovery of a natural resource such as oil

CAUSES OF NEGATIVE ECONOMIC GROWTH

Negative economic growth-if countries productive potential falls, the PPC will shift
inwards.
Negative economic growth reasons:
 Economic decline such as recession
 Wars and conflicts
 Diseases
 Natural disasters
 Harvest failures
 Increasing emigration highly qualified, skilled and experienced workers.
 Resource depletion such as natural resources e.g. Oil and Coal.
 Dry weather for agricultural production

Key terms
 Goods are things that are produced in order to be sold.
 Needs are basic requirements for human survival.
 Wants are people's desires for goods and services.
 Finite having an end or limit
 Infinite without limits
 Choices is deciding between alternative uses of scarce resources.
 Opportunity cost is the cost of the next best alternative given up (When making a
choice)
 A Sacrifice is something valuable that you decide not to have, in order to get
something that is more important.
 Scarce resources amount os resources available when supply is limited
 Basic economic problem allocation of a nation's resources between competing uses
that represent infinite wants
 Capital goods those purchased by firms and used to produce other goods such as
factories, machineries, tools and equipment
 Consumer goods those purchased by households such as food, confectionery, cars,
tablets and furniture
 Production possibility curve(PPC) line shows the different combinations of two
goods an economy can produce if all resources are used up

CHAPTER 2: ECONOMIC ASSUMPTIONS

Underlying assumptions in Economics

Economists assume that individuals behave in a rational way. They make the following
two assumptions in relation to rationality:
 Consumers aim to maximise benefit
 Businesses aim to maximise their profit

Consumers aim to maximise benefit

We assume that consumers will always choose a course of action that gives them the
greatest satisfaction. “that they will act rational”

Two other examples of consumer rationality are below:

 Consumers will always buy from the supplier that offers the lowest price
 If all suppliers have the same price consumers will buy the best quality.

Reasons why consumers may not always maximise their benefit

 Its possible that some consumers have difficulty in calculating the benefits from
consuming a product.
 Some consumers develop buying habits that may affect their ability to make rational
choices.
 Some consumers do not maximise their benefit is because they are influenced by the
behaviour of others

Businesses aim to maximise their profit

Business owners will always choose a course of action that results in the best possible
financial outcome.
We assume that business owners want to make a as much profit as possible.

Two examples of businesses rationality are below:

 Business owners will always attempt to buy the cheapest raw material as long as
quality is the same.
 When setting a price for a product, a business owner will always choose the highest
price that the market can stand.

Reasons why producers may not always maximise their profit

 The performance of some businesses may be influenced by the behaviour of other
people in the organisation.
 Some producers have alternative business objectives. Producers may be more
interested in offering a high quality or caring service to customers at the expose of
profits
 Some commercial enterprise operate as charities. Charities often seek to maximise
surplus rather than profit to be able to help the group they support.
Other reasons
Consumers will be prevented from maximising their benefits, and producers from
maximising their profits if they do not have access to all information.
Key terms
 Assumptions things that you think are true you have no definite proof
 Irrational not based on clear thought or reason
 Rational based on clear thought or reason
 Variables something that affects a situation in a way that means you cannot be sure
what will happen.
 Maximise to increase something such as profit, satisfaction or income as much as
possible
 Revenue money that a business receives over a period of time, especially from
 selling goods and services.
 Enterprise companies, organisations or business

CHAPTER 3: THE DEMAND CURVE

EFFECTIVE DEMAND
The amount of a good people are willing to buy at given prices over a given period of
time backed by the ability to pay.
Effective demand indicates how much people can afford to and will actually buy
(hence, it does not mean how much people would like to buy if they have endless amount
of money)

THE DEMAND CURVE

Demand can be expressed graphically. This means that the relationship between price and
demand can be shown on a graph

The Demand Schedule of South Korean Electronics Company

The demand schedule lists the different quantities demand of a product at different prices
over a particular period of time. The information in the demand schedule can be
presented on a graph.

How to
construct
demand curve
Rules for drawing a demand curve:
 Label the y axis price and the x axis quantity
 Draw the demand curve downward sloping from left to right and label it demand (or
D) using the values in the demand schedule.
 To find the quantity demanded at any given price:
a) Select a price (P), shown on the y axis
b) Draw a dotted line towards the demand curve
c) Draw a dotted line down towards the x axis to show quantity (Q)
The Demand Curve for South Korean Electronics company

 Price and quantity

demanded are
INVERSELY related.
This means:
 When prices increase
demand will fall.
 When prices go down, demand will rise.
Note
The demand curve slopes down from left to right; for most goods this is always the shape
of the demand curve. That is why it has the inverse relationships between price and
quantity demanded.

MOVEMENT ALONG THE DEMAND CURVE

When there is a price change, there is a ‘movement’ along the demand curve. For
example when price falls from US$1 to US$0.5, we move demand curve from A to B to
identify the new level of demand hence quantity demanded rises as in the above diagram

STRAIGHT-LINE DEMAND CURVES

The demand curves are both downwards sloping curves. It is common to show demand
using a straight-line demand curve.
Straight -line demand curve showing the demand for spaces at city-center car park
To save time and for clarity,
economists often drawn
demand curves as straight
lines.

The shift in the demand curve

Shift in demand curve
The shift in the demand curve movement to the left or right of the entire demand curve
when there is a change in any factor affecting demand except the price. For example,
decrease in income shifts the curve to left such as from D1D1 to D2D2 and increase in
income shift the curve to the right such from D1D1 to D3D3.
Shift in the demand curve for holidays to the Maldives

Key Terms
 Demand: is the amount of
a good that will be bought
at given prices over a
period of time.
 Effective demand amount
of a good people are willing to buy at given prices over a given period of time
supported by the ability to pay.
 Demand Curve: a line drawn on a graph which shows how much of a good will be
bought at different prices.
 Demand schedule table of the quantity demanded of a good at different price levels-
can be used to calculate the expected quantity demanded.
 Inverse Relationship (between price and quantity demanded) when the price goes
up the quantity demanded falls and when the price goes down, the quantity demand
arises.
 Shift in the demand curve movement to the left or right of the entire demand curve
when there is change in any factor affecting demand except the price.
 Individual demand: demand of just one consumer
 Market Demand: total demand for that product from all its consumers
CHAPTER 4 FACTORS THAT MAY SHIFT THE DEMAND CURVE
Price is the main factor that affects the quantity demanded. However, there are many
other factors and each of them may actually shift the demand curve. Some of the most
important factors are:
The factors that may shift the demand curve

Shifts in the demand

curve

The market
demand curve shifts
outwards(a rise in demand))-
D1D1 to D2D2
Possible causes are:
 An increase in advertising
 An increase in disposable incomes after tax (Note: Normal goods demand increases
when income increases and inferior goods demand decreases when income increases)
 Tastes and fashion favour the product
 A rise in the price of substitutes
 A fall in the price of a complement
 Demographic changes- a rise in the population
 Other factors, e.g. hot weather increases demand for cold drinks and sun creams
The market demand curve shifts inwards(a fall in demand)-D1D1 to D3D3.
Possible causes are:
 A reduction in advertising
 A fall in disposable incomes after tax (Note: Normal goods and inferior goods)
 Tastes and fashion favour other products
 A fall in the price of substitutes
 A rise in the price of a complement
 Demographic changes-a fall in the population
 other factors, e.g. hot weather reduces the demand for winter coats

Key Terms
 Disposable income-Income that is available to someone over a period of time to
spend; It includes state benefits but excludes direct taxes.
 Inferior goods-Goods for which demand will fall if income rises or rise if income
falls.
 Normal goods-Goods for which demand will increase if income increases or fall if
income falls.
 Substitute goods-Goods bought as an alternative to another but perform the same
function.
 Complementary goods-Goods purchased together because they are consumed
together.
 Demography-It is the study of human populations and the way in which they
change.
CHAPTER 5: THE SUPPLY CURVE
SUPPLY AND SUPPPLY CURVE
Supply amount that producers are willing to offer for sale at different prices in a given
period of time.
The supply of any product can be expressed graphically. This means that the relationship
between price and quantity supplied can be shown on a graph.

Supply Schedule for Handmade golf shoe by M. Crammer and Son

Supply curve for

golf shoes made by M. Crammer and Son
The information in the schedule can be presented on the graph. Like the demand curve,
price is shown on the vertical axis and quantity on the horizontal axis.
Supply curve for golf shoes made by M. Crammer and Son

Note:
 The supply curve slopes
from left to right which
means there is a
proportionate
relationships between price and the quantity supplied. This shows:
 When price go up, supply will also go up
 When prices go down, supply will also go down

MOVEMENT ALONG THE SUPPLY CURVE

As with demand, when there is a price change, there is movement along the supply curve.
When the prices rises from US$200 to US$300, for example, we move along the supply
curve from A to B to identify the new level of supply. The movement along the supply
curve in this case shows that the quantity supplied is increased from 1200 pairs of golf to
1800 pairs when the price rises. This happens where there is price change. If there are
changes in any other factor influencing supply, the effect on the supply curve is different.
A SHIFT IN THE SUPPLY CURVE
 If there is a rise in production costs, the quantity supplied will fall at every given
price. This will cause the supply curve to shift to the left, to S2. At the price p1, the
quantity of goods offered for sale fall from q1 to q2
 If there is a fall in production costs, the quantity supplied will rise at every given
 price. This will cause the supply curve to shift to the right, to S3. At the price p1, the
quantity of goods offered for sale rise from q1 to q2
Shift in the supply curve for a product

FIXED SUPPLY
In some circumstances, the
supply of a product or
service may be fixed.
Supply will be fixed if it is impossible for sellers to increase supply even when prices
rise. Supply at venues where sports matches and other events are held may be fixed such
stadium.

Fixed supply-the capacity of Wimbledon's Court

Key Terms
 Supply amount that
producers are willing to
offer for sale at different
prices in a given period
of time
 Supply curve line drawn on a graph which shows how much of a good sellers are
willing to supply at different prices.
 Proportionate relationship(between price and the quantity supplied) when the price
goes up, the quantity supplied also goes down
 Shift in the supply curve movement to the left or right of the entire supply curve
when there is any change in the conditions of supply except the price

CHAPTER 6: FACTORS THAT SHIFTS SUPPLY CURVE

Price is the main factor that affects supply. However, a range of other factors may also
have an impact. Unlike a change in price, which results in a movement along the supply
curve, changes in these factors cause the supply curve to shift.

Factors that can shift the supply curve

COST OF
PRODUCTION
If production costs such as wages and raw materials rise, sellers may reduce supply
because their profits will be reduced
If costs fall, supply increases because production becomes more profitable

Note:
The availability of resources, such as workers or materials, will also affect supply, if there
is shortage, producers may struggle to supply the market.

Example
 If there is a rise in production costs, the quantity supplied will fall at every given
price. This will cause the supply curve to shift to the left, to S2. At the price p1, the
quantity of goods offered for sale fall from q1 to q2
 If there is a fall in production costs, the quantity supplied will rise at every given
price. This will cause the supply curve to shift to the right, to S3. At the price p1, the
quantity of goods offered for sale rise from q1 to q2
Shift in the supply curve for a product

INDIRECT TAXES
 Indirect taxes on
spending such as Value
added Tax and excise
duties
 When taxes are
imposed or increased, supply will fall because indirect taxes represent a cost to firms
 If indirect taxes are reduced, supply will increase because costs are lower.
Note:
 Government use indirect taxes to raise revenue for government expenditure and
discourage the consumption of harmful products, such as cigarettes and alcohol

SUBSIDIES
 A subsidy is government grant given to producers to encourage production of certain
good
 If a producer receives a subsidy, supply will increase because costs are reduced

CHANGES IN TECHNOLOGY
 Overtime, businesses can use new technology such as machinery and new production
techniques
 New technology increases supply because costs fall. For example, new solar cell
technology is being used to cut energy costs

NATURAL FACTORS
 Natural factors such as the weather can affect the supply of some goods-particularly
agricultural products
 Good growing conditions improve crop yields which increases supply. Poor weather
 may cause shortages and supply may be reduced which forces prices up

THE PRICES OF OTHER GOODS

 Some producers can switch production form one product to another. For example,
farmers can often produce a number of different crops.
 Firms may switch production to a workable alternative if its price starts to rise. As a
result, the supply of this alternative product will increase, while the supply of the
existing product will fall

NOTE
1. An outward shift in the Supply Curve
An outward shift or a shift to the right means that there is an increase in supply at every
given price level
Possible causes are:
 Other products become less profitable to produce
 A fall in the cost of factors of production
 An increase in the supply of resources
 Technical progress and improvements in production processes and machinery
 The government subsidises production and/or cuts taxes on profits
 Other factors, e.g. good weather boosts crop harvests

2. An inward shift in the Supply Curve

An inward shift or a shift to the left means that there is less supply at every given price
level
Possible causes are:
 Other products become more profitable to produce
 A rise in the cost of factors of production
 A fall in the supply of resources
 Technical failures, such as a cut in power supplies or mechanical breakdowns
 The government withdraws subsidies and/or increases taxes on profits
 Other factors, e.g. wars and natural disasters

Key terms
 Indirect taxes taxes levied on spending, such as VAT
 Productivity rate at which goods are produced, and the amount produced in relation
to the work, time, and money needed to produce them
 Consumption amount of goods, services, energy, or natural materials used in a
particular period of time
 Subsidy money that is paid by a government or organisation to make prices lower,
reduce the cost of producing goods or providing a service, usually to encourage
production of certain good
CHAPTER 7: MARKET EQUILIBRIUM
Equilibrium price(market clearing price) and quantity is that price and quantity at
which demand is equal to supply:
 At this price all products will be sold
 All buyers can purchase everything they want
 All sellers can supply everything they want
 The market has cleared i.e. there is nothing left to buy or sell

Market equilibrium

Total revenue
Total revenue is the amount
of money generated from the
sale of output. It is
calculated by multiplying
price and quantity.
Total revenue = Price X
Quantity or TR = P X Q
In this example, the shaded area in the diagram shows the total revenue. It is: TR = P X Q
= £ 30 X 3000 = £ 90, 000

SHIFT IN DEMAND
Supply and demand diagrams can be used to understand the impact of changes in
equilibrium market prices
 An increase in demand will see the demand curve shift upwards and to the right from
D1 to D2. This will cause price to rise to P2 and quantity demanded to Q2. At this point
we have a new market equilibrium (P2Q2).

Effect of a shift in demand for a product

SHIFTS IN SUPPLY
 An increase in supply
will see the supply curve
shift downwards and
towards the right from S1 to S2. This will cause price to fall to P2 and quantity
supplied to rise to Q2. At this point we have a new market equilibrium (P2Q2).
Effect of a shift in supply for a product`

SHIFTS IN SUPPLY AND

DEMAND

It is possible for both supply

and demand to change at the
same time in a market. For
example, demand might increase and supply decrease at the same time.
The new equilibrium price, where D2 = S2, is P2. The price is higher and the amount sold
in the market has fallen from q1 to q2.
Shift in supply and demand for a product

Note
It would be possible to
redraw the diagram to show
that although the price will
be will be higher, the
quantity sold could also be
higher. This can be possible if increase in demand is greater than decrease in supply
EXCESS DEMAND
Excess demand and excess
supply
 If price is set lower at £40, the market is not in equilibrium. At this lower price, the
quantity demanded is 9 million units and the quantity supplied is only 4 million units.
There is excess demand, which means there is shortage of goods in the market. In
this case, there is shortage of 5 million units (9 million-4 million) at the price £40
 To improve profitability firms could raise price, thus reducing the excess demand.

EXCESS SUPPLY
 If the price is set higher at £80, the quantity demanded is only 3 million units while
the quantity supplied is 8 million units. This time there is excess supply. This means
that goods would remain unsold. In this case, the quantity of goods that would be
unsold in the market if the price were set at £80 is 5 million units (8 million- 3
million)
 To solve this problem firms would need to lower price to get rid of excess products.

REMOVING EXCESS SUPPLY AND EXCESS DEMAND

1. Excess demand occurs when demand is greater than, supply
 This means that firms can raise their price in order to improve profitability
 Alternatively, they could increase supply and leave price the same
2. Excess supply occurs when supply is greater than demand
 This means that firms will have to lower their price in order to sell their product
 Alternatively, they could reduce supply and leave price the same

Note
 Market forces are always pushing prices towards market equilibrium – the price at
which demand equals supply and there are no products left over in the market. Too
much supply leads to lower prices, too much demand to higher prices.
 Where demand is equal to supply we have the market equilibrium price.

Key terms
 Equilibrium price price at which supply and demand are equal
 Market equilibrium price at which the amount supplied in a market matches exactly
the amount demanded
 Total revenue amount of the money generated from the sale of goods calculated by
multiplying price by quantity
CHAPTER 8: PRICE ELASTICITY OF DEMAND
Price elasticity of demand (PED) is a measure of the responsiveness of demand to a
change in price
 When price changes demand for a normal good will also change
 The extent to which demand changes will depend upon its PED
 When price changes some goods see a big change in demand, others a small change
 Goods that see a more than proportional change in demand if price changes are called
price elastic
 Goods that see a less than proportional change in demand if price changes are called
price inelastic
 Goods that see a proportional change in demand if price changes are said to have
unitary elasticity i.e. = -1

PED formula and calculations

We can measure PED using the formula:
% change in Qd
% change in P
Example: If a rise in price of 10% leads to a fall in demand of 5% then we have:
= -0.5
 A figure less than 1 is price inelastic meaning that demand is not very responsive to a
change in price
 A figure greater than 1 is price elastic meaning that demand is very responsive to a
change in price

PRICE INELASTIC DEMAND

A price inelastic product will have a PED coefficient between 0 and -1 e.g. -0.4. If price
was to change the quantity demanded would change by a lesser amount. Therefore, a firm
should look to raise price. This would lead to higher sales revenue.

PRICE ELASTIC DEMAND

A price elastic product will have a PED coefficient between -1 and ∞ e.g. -1.5. If price
was to change the quantity demanded would change by a greater amount. Therefore, a
firm should look to lower price. This would lead to higher sales revenue.
Effect of a price change on the demand for two different products: A and B

Note:
 Product A demand curve
represents inelastic
demand while product B
demand curve represents
elastic demand
Other Demand curve of
different elasticities
1. A perfectly inelastic product will have a PED coefficient of 0. If price was to change
the quantity demanded would not be affected. In theory, the firm could charge as high a
price as it wanted.
Perfectly inelastic demand where PED=0

2. A perfectly elastic product

will have a PED coefficient of
∞ . If price was to change the
quantity demanded would be
infinite. In theory, the firm
could not increase price as there would be no demand.
Perfectly elastic demand where PED = ∞

3. Unitary elastic. The demand

curve shows the shape of a
demand curve where PED = -1.
This is a special case in
economics and when there is a price change the effect on total revenue is unique. The
demand curve for a product that has unitary elasticity is called a rectangular hyperbola (a
mathematical term). Therefore, a price change will result in no change in total revenue.

Demand curve with unitary elasticity

FACTORS AFFECTING
PRICE ELASTICITY OF
DEMAND
There are a number of factors that affect PED
 The availability of substitutes – if there are closer or many substitutes will tend to
have elastic demand. This is because consumers can switch easily from one product
to another. In contrast, if there are few or no real substitutes for a product, demand
will be inelastic.
 Degree of necessity
- A necessity good or essential good will be price inelastic as demand will be less
sensitive to changes in price
-A luxury good or non-esssential will be price elastic as demand will be more sensitive to
changes in price
 Percentage of income spent on goods or services – it may be argued that if
consumers spend a large proportion of their income on a product, demand will be
more elastic. Such items are one-off or infrequent purchase and consumers may be
prepared to wait a few months to see if the price drops.In contrast, demand for
products that cost very little in relation to income are more price inelastic
  Time – In the short term, goods have inelastic demand because it can often take time
for consumers to find substitutes when the price rises. In the long term, demand is
more elastic because consumers can search for alternatives and are more prepared to
switch.

THE RELATIONSHIP BETWEEN PED AND TOTAL REVENUE

PRICE ELASTICITY VALUE OF ELASTICITY PRICE CHANGE EFFECT ON TR
Inelastic <1 Decrease Fall
Inelastic <1 Increase Rise
Elastic >1 Decrease Rise
Elastic >1 Increase Fall

The difference between price elastic demand and price inelastic demand
 Price elastic demand means that demand is very responsive to a change in price
a. If the price of a good goes up demand will fall by a greater proportion
b. If the price of a good goes down demand will rise by a greater proportion
 Price inelastic demand means that demand is not very responsive to a change in price
a. If the price of a good goes up demand will fall by a lesser proportion
b. If the price of a good goes down demand will rise by a lesser proportion

 The implications of price elasticity of demand for producers and consumers

If a good is price elastic then producers should lower price
 This will lead to a rise in demand and a rise in revenue
 Producers will have to ensure that unit costs are low enough to cover selling price
 Consumers will benefit from lower prices
 If a good is price inelastic then producers should raise price
 This will lead to a fall in demand but a rise in revenue
 Producers will be able to make higher profits, despite selling less
 Consumers will have to pay higher prices

The implications of price elasticity of demand for producers and consumers

 Producers will spend time and money trying to develop products that are price
inelastic
 This might be through branding/advertising or creating a unique selling point making
the product stand out from the competition
 Consumers will have less options available if goods are price inelastic
 Government will try to create competition in order to stop firms from raising price
 Over time, new producers will enter markets, which will increase competition
 However, firms with a price inelastic good will try to maintain this advantage over a
period of time

Total revenue calculations to show the relationship between a change in price and the
change in total revenue, to determine whether demand is price elastic or price inelastic
Key terms
 Price elasticity of demand the responsiveness of demand to a change in price
 Inelastic demand change in price results in a proportionately smaller change in
quantity demanded (alternative term: price inelastic)
 Elastic demand change in price results in greater change in the quantity demanded
(alternative term: price elastic)
 Perfectly elastic demand where PED = ∞ (an increase in price will result in zero
demand)
 Perfectly inelastic demand where PED=0 (a change in price will result in no change
in the quantity demanded)
 Unitary elasticity where PED=-1 (the responsiveness of demand is proportionately
equal to the change in price)

CHAPTER 9: PRICE ELASTICITY OF SUPPLY

Price elasticity of demand (PES) is a measure of the responsiveness of supply to a change
in price

Price elasticity of demand (PES) = % change in Qs

% change in P

INELASTIC SUPPLY
A price inelastic supply curve will have a PES coefficient between 0 and 1.
If price was to change the quantity supplied would change by a lesser amount.
This may be because of difficulties in increasing supply or that the incentive to increase
supply is not great enough for some firms.

ELASTIC SUPPLY
A price elastic product will have a PES coefficient between 1 and ∞ e.g. 1.5.
If price was to change the quantity supplied would change by a greater amount.
Firms find it easy to increase supply or the incentive to increase supply has become
greater.

Effect of a price change in the supply of two different products: A and B

Note
 Product A demand curve
represents inelastic
demand while product B
demand curve represents
elastic demand

INTERPRETING THE VALUE OF PRICE ELASTICITY OF SUPPLY

 If values of PES is less than 1 (that is, a fraction or a decimal), supply is said to be
inelastic. Product A has inelastic supply because price elasticity is 0.5
 If PES = 0. Supply is said to be perfectly inelastic. Put up the price and the quantity
supplied will not change
 If PES = 1. Supply has unitary elasticity. Any straight-line supply curve that passes
through the origin has a price elasticity equal to 1. This means that the percentage
change in price is always the same as the percentage change in the quantity supplied
 If PES = infinity..Supply is perfectly elastic. Nothing will be supplied at any other
price
PRICE ELASTICITY AND THE SLOPE OF THE SUPPLY CURVE
 Straight-line supply curves that cut the price axis(SB) are elastic and those that cut the
quantity axis(SA) are inelastic.

There are also some special

cases:
 A perfectly inelastic
supply curve, S1 is
vertical. This means that
a price change will not
affect the quantity supplied at all.
 A perfectly elastic supply curve, S2 is horizontal. This means that producers are
prepared to supply any amount at a given price.
 Any straight-line supply curve that passes through the origin, S3 has a price
elasticity equal to 1. This means that the percentage change in price is always the
same as the percentage change in the quantity supplied.
Supply curves-special cases
FACTORS INFLUENCING PES
There are a number of factors that affect PES
1. Factors of production – If producers have easy access to factors of production they
will be able to boost production if necessary. This means that supply will be elastic.
Supply will also be more elastic if production factors are mobile. If production factors
such as labour and materials can be switched to other uses easily, supply will be elastic.
However, if specialised resources are needed for production ,such as skilled labour. It
may take time to train workers in new skills and supply will be more inelastic
2. Availability of stocks – Producers that can hold stocks can respond quickly to price
changes so supply will be elastic. However, where it is possible or expensive to hold
stocks, supply will be inelastic. The supply of some perishable goods, such as fruit and
vegetables, will be inelastic because they cannot be stored for very long
3. Spare capacity – With spare capacity, producers have the ability to produce more with
their resources. Supply will be more elastic if producers have spare capacity.
If there is little spare capacity then PES will be price inelastic
4. Time – in the short run products are likely to be more price inelastic as producers find
it difficult to increase production
In the long run products are likely to be more price elastic as producers adjust to
changing market conditions by buying more machinery, building new factories etc.
Therefore, it is easier to increase capacity
Where it is not possible to increase supply quickly, due to production limitations, supply
will be inelastic. For example, it will take nearly a year to increase the supply of many
agricultural goods, are not able to respond to react quickly to price changes.

PES FOR MANUAFCURED AND PRIMARY PRODUCTS

 Manufactured products tend to have higher PES so are price elastic
Possible reasons are:
 With globalisation it is easy to source products from around the world, therefore
increasing productive capacity
 Factors of production such as labour and capital are fairly easy to substitute
 Capital intensive industries can easily produce more machinery
 Buffer stocks can be kept in warehouses and other storage areas

 Primary products tend to have lower PES so are more price inelastic
Possible reasons are:
 It takes time to plant and grow crops
 There is limited capacity unless more land can be found
 Difficult to keep buffer stocks as products tend to be perishable
 Hard to find a labour force

Key terms
 Price elasticity of supply responsiveness of supply to a change in price
 Inelastic supply change in price results in a proportionately smaller change in the
quantity supplied (alternative term: price inelastic)
 Elastic supply change in price results in a proportionately greater change in the
 quantity supplied (alternative: price elastic)
 Perfectly elastic (supply) where PES =∞ (producers will supply an infinite amount
at the given price)
 Perfectly inelastic (supply) where PES = 0 (the quantity supplied is fixed and cannot
be adjusted whatever the price)
 Unitary elasticity (with regard to supply) where PES = 1( a change in price will be
matched by an identical change in the quantity supplied)
 Raw materials substance used to make a product

CHAPTER 10: INCOME ELASTICITY

Income elasticity of demand (YED) is a measure of the responsiveness of demand to a

change in income
Calculated by the formula:
YED = % change in Qd
% change in Y

YED coefficient Title Relevance to business

YED < 1 Income inelastic Demand changes at a lower proportion than the
increase in income.

YED > 1 Income elastic Demand changes at a higher proportion than the
increase in income.

Income elasticity of demand can be negative or positive i.e. income and demand can
move in the same direction or opposite directions
 When demand for a product increases when incomes increase we call this a normal
good. Normal goods will always have a positive income elasticity of demand i.e. a +
sign
 When demand for a product decreases when incomes increase we call this an
inferior good. Inferior goods will always have a negative income elasticity of
demand i.e. a – sign

INTERPRETING THE VALUES OF INCOME ELASTCITY OF DEMAND

NECESSITIES
Necessities are basic goods that consumers need to buy. Examples include food in
general, electricity, petrol and water. Demand for this goods will be income inelastic.
Therefore, if the value of income elasticity of demand is between +1 and -1, demand is
said to be income elastic

LUXURY GOODS
Luxuries are goods that consumers like to buy if they can afford them. Spending on these
types of goods is called discretionary expenditure-this means that it is optional. Demand
for these goods is income elastic Examples include air travel, satellite television, designer
clothing and tourism industry. It is also argued the demand for imported goods is income
elastic. If the value of income elasticity is greater than 1 or less than -1, demand is said to
be income elastic.

NORMAL GOODS AND INFERIOR GOODS

The value of income can also show whether goods are normal or inferior that is positive
or negative income elasticity respectively.

Factors influencing income elasticity of demand

Income elasticity of demand is determined by:
1. Whether the good is a necessity or a luxury
 At higher standards of living increased consumer incomes see additional demand
tend towards luxury goods(elastic) as demand for necessities(inelastic) is satiated
 Normal goods that are necessities will have lower positive YED coefficients. As
consumer incomes increase they are likely to spend some of their income on luxuries.
These products e.g. cars and foreign holidays will have higher positive YED
coefficients
2. The level of income of a consumer
 Poorer consumers tend to spend their income on necessities. As they become
wealthier the YED for necessities moves towards zero as consumers are satisfied
with the amount of the product e.g. staple foods that they can buy

The significance of PED and YED to businesses and the government

1. The imposition of indirect taxes and subsidies
 Businesses know that if they raise price for a price inelastic product total revenue
will increase. Therefore, they will spend on areas such as advertising and product
quality in order to reduce the PED of their products
 Government knows that if they place an indirect tax on a price inelastic good tax
revenue will increase. Therefore, they continually raise taxes on products such as
alcohol, tobacco and petrol. As these products are addictive or necessities total
revenue on them will increase. Businesses will be able to pass much of the tax
increase on to the consumer in the form of higher prices
 If the product is price elastic and the government see it as a merit good e.g. education
or health care then a subsidy will increase supply as costs to producers fall. Total
revenue will increase and more of the merit good will be produced
2. Changes in income
 Businesses know that if incomes rise demand for income elastic products will
increase. Therefore, they will ensure that they have enough capacity to meet the
increase in demand
 Government knows that if incomes are increasing tax revenues are likely to increase
as the majority of goods and services are normal. Therefore, economic growth and
 rising incomes will be beneficial to government income. The price elasticity of
products is impacted by the state of the economy. Price becomes less important as the
economy is doing well. Businesses are likely to raise prices, benefiting the
government in terms of tax revenue

Key terms
 Income elasticity of demand responsiveness of demand to a change in income
 Discretionary expenditure non-essential spending or spending that is automatic
 Excise duty government tax on certain goods, such as cigarettes, alcoholic drinks
and petrol that are sold in the country
 Value-added tax(VAT) tax on some goods and services-businesses pay value-added
tax on most goods and services they buy and if they are VAT registered, charge
value-added tax on the goods and services they sell
CHAPTER 11: THE MIXED ECONOMY

THE PUBLIC AND PRIVATE SECTORS

An economy is a system that attempts to solve the basic economic problem: decision
makers in an economy have to decide what to produce, how to produce and for whom to
produce.
 Private sector -the provision of goods and services by businesses that are owned by
individuals or groups of individuals.
 Public sector- government organisations that provide goods and services in the
economy.

In the public sector, a range of organisations, such as government departments, public

corporations and other agencies, provides services that are often supplied inefficiently by
the private sectors.
Examples: Health care, education and defence.
Note: Most public sector services are provided free by the state and are paid for from tax
revenue or borrowing.

PRIVATE SECTOR ORGANISATION

Ownership and control
Goods and services in this sector are provided by businesses that are owned and
controlled by individuals or group of individuals.
Private sector enterprises can vary in size and type of ownership. They may be:
1. Sole traders: Where the business is owned and controlled by one person
2. Partnership:where the business is owned and controlled by two or more people
working together.
3. Companies. Where shareholders own the business. They elect a board of directors to
run the business on their behalf.

AIMS
In the private sector, the aims of firms are likely to be determined by their owners. The
main aim of most owners is to make profit. However, a number of other aims needed to
be considered. They include:
 Survival
 Profit maximisation
 Growth
 Social responsibility

PUBLIC SECTOR ORGANISATION

OWNERSHIP AND CONTROL
Public sector organisations are owned and controlled by local or central government.
Some of the main examples are:
 Central government department
 Public corporations or state-owned enterprises
 Local authority services
 Other public sector organisation
AIMS
Public sector organisations have different aims fro those in the private sector.
Each organisation in the public sector will have its own specific aims depending on the
services they provide. However, there will be some common themes. They include:
 Improving the quality of services
 Ministering costs
 Allow for social costs and benefits
 Profit:in some countries, the government owns a number of large businesses that aim
to make a profit.

TYPES OF ECONOMY
A market or free enterprise economy relies least on the public sector for the provision
of goods and services.
A command or planned economy relies entirely on the public sector to choose, produce
and distribute goods.
A mixed economy relies both the public sector and private sector to provide goods and
services.
THE MIXED ECONOMY
Most countries have mixed economies and the decisions what to produce, how to produce
and for whom to produce are made jointly by between consumers and state.

WHAT TO PRODUCE?
The market system ensures that businesses produce the consumer goods that people want.
The public sector tends to provide goods that the private sector might fail to provide in
sufficient quantities. This is often caused by market failure.

HOW TO PRODUCE?
To meet consumers' needs firms will use production methods that help them to maximise
quality and minimize costs.
On the other hand public sector will decide how services should be provided and attempt
to supply them efficiently.
However, some public sector goods are produced by the private sector.
FOR WHOM TO PRODUCE?
The goods produced in private sector are sold to anyone who can afford them while
public sector goods are provided free to everyone and paid for from taxes.
Also state makes provision for people who cannot work due to illness or disability.
Note:
 Different governments around the world will decide on the 'degree of mixing' in this
type of economy.
MARKET FAILURE AND THE NEED FOR GOVERNMENT INTERVENTION
Market failure is where markets lead to inefficiency. It can occur for a number of reasons.
1. EXTERNALITIES
Sometimes firms do not take into account all the costs of production. For example, a firm
producing chemicals may pollute the atmosphere because it has not taken measures to
clean its waste.
Any damage done to people or things outside the business such as ill health, as a result of
this activity is called external cost.
The market system has resulted in the chemical firm failing to meet any cost imposed on
those affected by the pollution.
2. LACK OF COMPETITION
A market may fail if there is no competition and it becomes dominated by one or a small
number of firms which might exploit consumers by charging higher prices and limiting
choice.
3. MISSING MARKETS
Some goods and services, called public goods are not provided by the private sector.
Other goods, called merit goods, such as education and health care are under-provided by
the private sector. This is because they are so expensive that many people would not be
able to afford them.
4. LACK OF INFORMATION
Markets will only be efficient if there is free flow of information to all buyers and sellers.
A lack of information may result in the wrong goods being purchased or produced, or the
wrong prices being paid.
5. FACTOR IMMOBILITY
For markets to work efficiently, factors of production need to be mobile. This means that
factors, such as labour and capital, must be able to move freely from one use to another.
In practice, though, factors can be quite immobile.
Examples of government intervention
 Businesses that impose externalities may be heavily regulated or fined.
 The government can use legislation to prevent businesses from dominating markets.
 State money can be used to provide public goods and merit goods.
 To overcome the problem of poor information, the government can help by passing
legislation forcing firms to provide more information about products.
 The government may be able to help to make some factors more mobile, such as
retraining workers when their previous jobs become redundant

ROLE OF THE RIVATE AND PUBLIC SECTORS IN THE PRODUCTION OF

GOODS AND SERVICES
In most countries, the private sector is responsible for providing the everyday goods and
services bought by people.
The public sector tends to provide public services. In particular, it focuses on the
provision of public and merit goods. For example, public goods would not be provided
at all.
The reason for this is because public goods have two particular characteristics. They
include:
 Non-excludability. This means that once a public good is provided in the market,
any individual consumer cannot be prevented or excluded from its consumption.
Also, an individual consumer cannot refuse consumption of the good even if they
wanted to.
 Non-rivalry. This means that consumption of a public good by one individual cannot
reduce the amount available to others.
Note:
 Government have to provide public goods because of market failure. If the private
sector were to provide public goods there would be a free rider problem.
 Free rider individual who enjoys the benefit of a good but allows others to pay for
it. Examples of the goods street lighting, Prison, Judiciary system and Defence.

THE PUBLIC SECTOR AND PRVATE SECTOR IN DIFFERENT ECONOMIES

In contrast, some governments believe that a greater quantity of goods and services
should be provided by the private sector. In countries such as USA, Singapore and
Australia, the state has much less involvement in the provision of public services.

Note:
 In many countries, the number of public corporations has been reduced.
Privatisation is the act of selling company or activity controlled by the government to
private investors.

Key terms
 Economy is a system that attempts to solve the basic economic problem
 Private sector -the provision of goods and services by businesses that are owned by
individuals or groups of individuals.
 Public sector- government organisations that provide goods and services in the
economy.
 Shareholders people or organisations that owns shares in a company
 Dividend a part of company's profit that is divided among the people with shares in
the company
 Assets things or resources belonging to an individual or a business that has value or
the power to earn money
 Liabilities amount of debt that is owed or must be paid
 Market failure where markets lead to inefficiency
 Mixed economy economy where goods and services are provided by both the private
and public sectors
 Merit goods goods that are under-provided by the private sector
 Public goods goods that are not likely to be provided by the private sector
 Free rider individual who enjoys the benefit of a good but allows others to for it

CHAPTER 12 PRIVATISATION
WHAT IS PRIVATISATION?
Privatisation involves transferring public sector resources to the private sector.
Privatisation has taken a number of forms:
1.Sale of nationalised industries.
2.Contracting out. Many government and local authority services have been 'contracted
out' to private sector businesses. This is where contractors are given a chance to bid for
services previously supplied by the public sector.
3.The sale of land and property. Tenants of local council owned properties were given
the right to buy their own homes.

WHY DOES PRIVATISATION TAKE PLACE?

Different reasons have been put forward for privatisation.
 To generate income.
 Public sector organisations were inefficient.
 To reduce political interference .
EFFECTS OF PRIVATISATION
Privatisation has had a big impact in those nations where it has been undertaken.
The effects have been felt in a number of quarters.
 Consumers
 Workers
 Businesses
 Government
 The economy

CONSUMERS
Many would argue that the prices of some goods and services has fallen since
privatisation. However. prices of other services risen sharply.
It was also hoped that newly privatised firms would improve and innovate their services.
However, some services have still been poor.

WORKERS
May have been fired from their jobs as privatised firms aim to minimize costs, so they do
not employ those they don't need
In an effort to improve efficiency, some workers may have been pressurized into raising
their productivity (e.g. adopt more flexible working practices).

BUSINESSES
Once in the private sector, firms are left without government interference and have to
face up to competition. They have been affected in a number of ways:
1.Their objectives have changed. In recent years however profits have fallen due to
competition and poor acquisitions.
2. Many firms have increased investment following privatisation.
3. There have been a number of mergers and takeovers involving newly privatised
firms.
4. Many privatised businesses have diversified into new areas.
GOVERNMENT
Has benefited from privatisation with the huge amount of revenue it has generated

Because the government is now no longer responsible for running the newly privatised
companies, it can focus more sharply on the business of government.

However, privatisation has also been expensive, in particular the amount of money spent
on advertising each sale has been criticized.
Note:
 One reason for the change in policy was that too many state-owned companies were
the subject of a hostile takeover.

Key terms
 Nationalised industries public corporations previously part of private sector that
were taken into state ownership
 Natural monopolies situation that occurs when one firm in an industry can serve the
entire market at a lower cost than would be possible if the industry were composed of
many smaller firms
 Diversified if a company or economy diversifies, it increases the range of goods or
services it produces
 Hostile takeover takeover that the company being taken over does not want or agree
to
 Takeovers act of getting control of a company by buying over 50 per cent if its
shares
CHAPTER 13 EXTERNALITIES
INTRODUCTION
Economic activity, such as building a new factory or transporting a tanker full of oil from
Qatar to Japan, will affect those inside the business.
However, economic activity can also have an impact on the outside. There are spillover
effects that may be positive or negative.

EXTERNAL COSTS OF PRODUCTION

Some production activity results in costs that are incurred by third parties
Third parties someone who is not one of the two main people or organisations involved
in an agreement or legal case. For example, they are neither owners nor employees they
may be individuals, such as local residents, organisations and property owners

External costs negative spillover effects of consumption or production-they affect third

parties in a negative way.
Examples of external costs; Noise pollution, air pollution, water pollution, resource
depletion, traffic congestion and overcrowding.

EXTERNAL BENEFITS OF CONSUMPTION

The consumption of certain goods can have positive spillover effects. These are called
external benefits.
External benefits positive spillover effects of consumption or production-they bring
benefits to third parties.
Examples of External benefits of consumption
1. EDUCATION
Private benefit for those who attend schools, universities and colleges. They are likely to
get better jobs, earn more money and enjoy better quality of life. These is private benefit

Education can also benefit the wider society. Educated people may do highly skilled and
socially useful jobs, such as doctors, teachers, pilots, senior administrators or research
scientist hence productivity will be higher and the standard of living for society as whole
will rise.
Also higher levels of education will lower unemployment, improve household mobility
and raise rates of political participation in the society.

2. HEALTH CARE
The consumption of health care by an individual can also benefit third parties. For
example, if people are healthier they are able to work more effectively making
contributions to the economy output and paying taxes which will benefit the society

3. VACCINATIONS
If more individuals are given vaccinations to prevent infection, the likeliness of others
(who do not get vaccinated) contracting diseases is lower. This is because the number of
people who might pass on the disease is reduced because they have been vaccinated.

SOCIAL COST
The production or consumption of a good will have costs. These are divided into private
costs and external costs
 Private costs are costs of an economic activity to individuals.
 Social cost = Private cost + External cost (negative externalities)

Note:
 Social costs of an economic activity to society as well as the individual firm

SOCIAL BENEFIT
The production or consumption of a good will also have benefits. They are divided into
private benefits and external benefits.
 Private benefits is the benefit derived by an individual or firm directly from an
economic activity such as consumption or production.
 Social benefit = Private benefits + External benefits (Positive externalities)

Note:
 Social benefits of an economic activity to society as well as the individual or firm.

EXAMPLE OF SOCIAL COSTS AND SOCIAL BENEFITS PRODUCTION

China State Construction Engineering: In 2007, the company bought a plot of land in a
run-down part of a Weifang suburb. The plot was abandoned 18 years ago when a textile
company ceased trading. It had become an eyesore and a danger to trespassers. Express
built a small retail centre, a restaurant and some accommodation for the elderly costing
¥ 32 million.

During the construction period about 130 temporary jobs were created with further 90
permanent jobs on completion. However, there was some disruption during construction
period. The demolition of the site created a lot of noise and dust. There was also 12
months of congestion due to the temporary closure of an important road.

The social costs and benefits are summarized below:

 Private cost = ¥ 32 million
 Negative externalities (External cost)- Demolition of old site created a lot of noise
and dust.
 Private benefit- Financial returns it makes from the investment in retail centre. This
could be rent from those who lease the retail units.
 External benefits (Positive externalities)- Removal of an eyesore and creation of
employment.

EXAMPLE OF SOCIAL COOSTS AND SOCIAL BENEFITS

The examples of externalities used so far feature production. However, the consumption
of a good can also result in externalities. For example, consider a University student who
buys a small car for ¥23,000.

The social costs and benefits are summarized below:

 Private cost = ¥23,000 + any other running costs such as fuel and insurance.
 External cost (Negative externalities) = the pollution resulting from exhaust fumes
and the contribution to congestion.
 Private benefit = the convenience and flexibility which car-owning provides.
 External benefit (Positive externalities) = the possible free lifts given to friends
and family in the car.

GOVERNMENT POLICIES TO DEAL WITH EXTERNALITIES

A government will want to discourage economic activities that result in negative
externalities and encourage those that result in positive externalities. How can this be
done?
1. TAXATION
It can be used to reduce externalities such as pollution.
Example
Tax imposed on chemical firm producing damaging emissions. Increase production cost
leading to increase in prices which result to fall in demand eventually reducing pollution.
Taxes can also be used to reduce the external costs of consumption. For example, high
taxes on cigarettes should reduce supply, which will raise the price. As a result the
demand for cigarettes should fall and fewer third parties will be affected by smoke.
However, cigarettes are addictive therefore, demand may not fall by very much.

2. SUBSIDIES
Government can offer grants, tax allowance and other subsidies to firms as an incentive
to reduce externalities.

Example
A firm receive a subsidy if it builds plastics recycling plant.

The government can also give subsidies to firms that generate positive externalities. For
example rail reduce congestion and carbon emissions.
One of the problems with government subsidies is the opportunity cost. The money spent
by governments on subsidies to reduce external costs or raise external benefits might be
spent more effectively on other government projects.

3. FINES
In some countries fines are imposed on those who damage the environment. There is also
a system of on the spot fines for people who leave rubbish on the streets.

4. GOVERNMENT REGULATION
Pressure has grown on the government to pass more legislation to protect the
environment. Much of the pressure has emerged due to growing concerns about global
warming.

One of the problems of with government regulation:

i. In some countries is that even though laws exist it is not easy to make companies and
people obey them.
ii. Governments may lack commitment to enforce laws or they may not have enough
resources for enforcement.
iii.Some companies responsible for pollution are powerful, well-resourced multinationals
and are prepared to stand firmly against governments in legal disagreements.

5. POLLUTION PERMITS
Pollution permits are government issued document that gives a business the right to
discharge a certain quantity of a polluting material into the environment.
These permits are 'tradable'.This means that a business can sell its pollution permit to
another business if it has found a way of reducing its own level of pollution.

This creates an incentive in the market for companies to introduce new technology that
reduces pollution because they can then sell their pollution permits for cash. This can
help raise profits.
One problem of using pollution permits is that:
i.A government has to decide how many of these permits to issue. However, pollution is
difficult to measure and a government might end up giving out too few or too many
permits.
ii. Also, the costs of permit administration are quite high and businesses may disguise
their levels of pollution if it is difficult to measure.

Key terms
 Third parties someone who is not one of the two main people or organisations
involved in an agreement or legal case
 External costs negative spillover effects of consumption or production-they affect
third parties in a negative way
 External benefits positive spillovers of consumption or production-they bring
benefits to third parties
 Private costs costs of an economic activity to individuals and firms
 Social costs costs of an economic activity to society as well as the individual or firm
 Social benefits benefits of an economic activity to society as well as the individual
or firm