Homework answers / question archive / THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL FP0002 International Foundation Programme Foundation Course: Economics Thursday 2 May 2019: 10:00 to 12:15 (2 hours and 15 minutes) Candidates should answer ELEVEN of the following THIRTEEN questions: ALL SIX from Section A (30 marks), ALL FOUR from Section B (30 marks) and ONE from Section C (40 marks)

THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL FP0002 International Foundation Programme Foundation Course: Economics Thursday 2 May 2019: 10:00 to 12:15 (2 hours and 15 minutes) Candidates should answer ELEVEN of the following THIRTEEN questions: ALL SIX from Section A (30 marks), ALL FOUR from Section B (30 marks) and ONE from Section C (40 marks)

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THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL FP0002 International Foundation Programme Foundation Course: Economics Thursday 2 May 2019: 10:00 to 12:15 (2 hours and 15 minutes) Candidates should answer ELEVEN of the following THIRTEEN questions: ALL SIX from Section A (30 marks), ALL FOUR from Section B (30 marks) and ONE from Section C (40 marks). Candidates are strongly advised to divide their time accordingly. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given with your Admission Notice. The make and type of machine must be clearly stated on the front cover of the answer book. PLEASE TURN OVER © University of London 2019 UL19/0556 Page 1 of 4 SECTION A Answer all questions from this section (30 marks) 1. Draw an example of a production possibility frontier (PPF) for food and shelter, labelled ‘A’. On the same diagram, draw a second PPF, labelled ‘B’, which shows the effect following emigration of the prime workforce. (5 marks) 2. Due to an increase in tax, a firm had to raise the price of its product from $10 to $12. It was observed that the quantity demanded by consumers of the product decreased from 500,000 units to 375,000 units. (a) Calculate the price elasticity of demand for this product. (b) Based on your answer in (a), is demand elastic, unit elastic or inelastic? Briefly explain why. (5 marks) 3. Suppose a market had the following market shares distributed across six firms. Firm number Market share (in %) 1 30 2 30 3 20 4 10 5 5 6 5 Calculate the Herfindahl index and use its value to classify the degree of competition or concentration in this market. (5 marks) 4. The national income identity equation is: Y ≡ C + I + G + N X. State the names of the variables Y , C, I, G and N X. No description of these variables is required other than their names. (5 marks) 5. Distinguish between absolute advantage and comparative advantage in the production and trade of two goods. (5 marks) 6. State any five factors, other than economic growth, which could be used to determine the level of economic development in a country. No explanation is required for the factors proposed. (5 marks) 4 556 SECTION B Answer all questions from this section (30 marks) The article below, written on 16 January 2019, reports on falling UK inflation. Inflation falls to lowest level in nearly two years The UK inflation rate fell to 2.1% in December 2018, from 2.3% the previous month, according to the Office for National Statistics (ONS). The consumer price index (CPI) figure was the lowest in nearly two years, pushed down by petrol price falls due to increased production. Airline fares also helped push down the rate, with seasonal prices rising less than they did last year. These were partially offset by small rises in hotel prices and mobile phone charges. The reported inflation rate was in line with analysts’ expectations. The figure is close to the Bank of England’s inflation target of 2% and may mean the Bank of England is less likely now to consider any interest rate rises in the near future. Inflation peaked at a five-year high of 3.1% in November 2017, but is now at its lowest since January of that year. The inflation figures also pointed to less short-term pressure in the near future for consumer prices, the ONS added. For manufacturers, the cost of raw materials – many imported – was 3.7% up on December 2017, down steeply from annual inflation of 5.3% in November and marking the weakest increase since June 2016. Stephen Clarke, senior economics analyst at the Resolution Foundation, said the easing of inflation provides a ‘welcome relief to households amid wider economic uncertainty’. Adapted from https://www.bbc.co.uk/news/business-46889433 ??ˆ??? 4 556 Using your own knowledge and the information , answer the following questions: 7. Describe the changes in the wage growth and the CPI from 2014 to 2018 shown in Figure 1. (5 marks) 8. According to the article, the price of petrol fell. Explain why this happened using an appropriate diagram. (8 marks) 9. The article references the consumer price index (CPI). Explain what the CPI is, and also how it is different from the retail price index (RPI). (7 marks) 10. Based on the article, do you expect monetary policy in the UK to become expansionary or contractionary in the near future? Explain your answer, making sure you include an appropriate diagram. (10 marks) SECTION C Answer question from this section (40 marks) 11. Do you think a government should subsidise the provision of higher education? Justify your view. You are encouraged to support your answer with the use of relevant diagrams. 12. Are consumers affected by the type of market structure? You are encouraged to discuss perfect competition, monopolistic competition, oligopoly and monopoly in your answer. 13. Are fixed exchange rates better than floating exchange rates? Justify your view. You are encouraged to illustrate your answer with the use of relevant diagrams. 4 556 4 International Foundation Programme Economics James Abdey FP0002 This guide was prepared for the University of London by: J.S. Abdey, The London School of Economics and Political Science This is one of a series of subject guides published by the University. We regret that due to pressure of work the author is unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, please use the online form found on the virtual learning environment. University of London Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom london.ac.uk Published by: University of London © University of London 2019 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know. ECONOMICS i Contents Introduction to the course Unit 1: The nature and scope of economics Introduction to Unit 1 Section 1.1: The basic economic problem, opportunity cost and economic systems Section 1.2: Production possibility frontiers Concluding comments Unit 2: Microeconomics I: markets and the consumer Introduction to Unit 2 Section 2.1: Demand, supply and price determination Section 2.2: Elasticities Section 2.3: Consumer and producer surplus, tax and social welfare Section 2.4: Consumer choice Concluding comments Unit 3: Microeconomics II: firms and production Introduction to Unit 3 Section 3.1: Production Section 3.2: Market structure Section 3.3: Market failure and externalities Section 3.4: Labour markets Concluding comments Unit 4: Macroeconomics I: closed economy Introduction to Unit 4 Section 4.1: Introduction to macroeconomics and national income accounting Section 4.2: Aggregate demand and aggregate supply Section 4.3: Unemployment © University of London 2019 1 10 12 18 26 27 30 46 58 69 82 83 86 97 108 122 130 131 134 142 153 Contents ii Section 4.4: Inflation Section 4.5: Monetary policy and fiscal policy Concluding comments 162 171 182 Unit 5: Macroeconomics II: open economy Introduction to Unit 5 Section 5.1: International trade Section 5.2: Balance of payments and exchange rates Section 5.3: Measures of economic development Concluding comments 183 186 193 202 210 Unit 6: Global financial crisis Introduction to Unit 6 Section 6.1: Contributory factors leading to the global financial crisis Section 6.2: Consequences of the crisis and possible cures Concluding comments Appendix A: Economic history Glossary 211 213 223 230 231 235 Introduction to the course 1 Introduction to the course Route map to the guide 2 Interrelated courses 3 Syllabus 3 Aims of the course 5 Learning outcomes for the course 5 Microeconomics vs. Macroeconomics 6 Overview of learning resources 7 Examination advice 8 © University of London 2019 Introduction to the course Route map to the guide Welcome to the world of economics! Although the discipline of economics is often referred to as the ‘dismal science’, in reality it offers a fascinating window into the behaviour and decisionmaking of ‘agents’ (people) in the global economy. For economics, at its heart, is the study of people – the aim of all social sciences. Decisions ranging from oil production in the Gulf (whether to increase or decrease production?), manufacturing your product in Europe or Asia (where to produce?), to central banks across the world setting interest rates (should interest rates be changed?), even commercial spaceflight (to boldly go, or not?) all reduce to economic decision-making. As economists, we seek to analyse, understand and explain human behaviour in the economic sphere. When studying this course, it is important to appreciate that the real world is highly complex - a web of ‘interdependencies’ between a large number of variables. In our attempt to analyse, understand and explain economic behaviour, it will be necessary for us to simplify the real world using models. Always keep in mind that a model is a ‘deliberate simplification of reality’, where a good model retains the most important features of the real world, while ignoring factors which (we think) do not matter. Ultimately, we face a trade-off. The benefit of a model is that we simplify the complex real world. The cost of a model is that the consequence of this simplification of reality is a departure from reality, and so the analysis of the effects of an economic policy, say, in a model may deviate from what would actually happen in practice. To assist our model-building, we will often make simplifying assumptions. Of course, we must be aware that assumptions can be wrong, running the risk that the conclusions drawn from our model are invalid. However, such assumptions are necessary (and inevitable) as we analyse the real world which is far too complex to be considered in its entirety. For the most part, we will often assume people are rational decision-makers. However, people do not always behave rationally! Maps are a great example of widely-used models. Metro systems across the world have maps allowing people to navigate the network with relative ease. The world-famous London Underground map is an excellent example of a model used for getting from point A to point B. You can view the map here http://content.tfl.gov.uk/standard-tube-map.pdf. The London Underground Map is ‘schematic’ and represents only the most important pieces of information needed for reaching your intended destination: distinct names and colours to distinguish each line the order of stations on each line the interchange stations between lines. However, less important details are ignored, such as: the depth of each tunnel the exact distance between stations the non-linear nature of the tunnels under the ground. An engineer would likely need to know these ‘less important details’, but for a tourist visiting London such information is not essential and the schematic map is very much fit-for-purpose. However, as mentioned above, a model means a departure from reality, hence some caution should always be exercised when using a model. Supporting a belief entirely based on a model might be misleading. 2 Introduction to the course For example, take a look at this geographically accurate map of the London Underground where the lines are simply overlaid onto a regular city map https://www.telegraph.co.uk/travel/ destinations/europe/united-kingdom/england/london/articles/Accurate-distance-Londontube-map/. In contrast to the schematic map, we can see that this one accurately represents the precise geographic locations of stations. If you were to follow the schematic map outright, you could end up taking a longer route. The route from Holborn to Temple appears quite far away on the schematic map, requiring at least two trains and lines to get there. When in fact, geographically, they are only around ten minutes apart by foot. Also, even line names can be a model. Most notably, the Circle line (in yellow) is clearly not a true circle. Does it matter? Well, the Circle line forms a loop and it is an easy name to remember, so arguably here the simplification of the name outweighs the slight depature in reality from a true circle! Our key takeaway is that models inevitably involve trade-offs. As we further simplify reality (a benefit), we further depart from reality (a cost). In order to determine whether or not a model is ‘good’, we must decide whether the benefit justifies the cost. Resolving this cost-benefit trade-off is subjective – further adding to life’s complexities! Interrelated courses As you embark on the International Foundation Programme it is important to appreciate the links across courses. Indeed, as you recognise the connections between disciplines there will be economies of scale in your studies, allowing you to obtain a deeper understanding of content and become more efficient at studying! For example, economists are keen consumers of economic statistics – data on variables of interest (such as the price of crude oil, the level of unemployment and foreign exchange rates). Of course, when analysing data we need to apply data visualisation and descriptive statistics as covered in Units 12 and 13 of FP0001 Mathematics and Statistics. Also, when interested in exploring the relationship between variables, such as price and quantity when modelling demand and supply, we use algebra to form mathematical equations (as seen in Unit 2 of FP0001 Mathematics and Statistics). Assuming rational behaviour, a firm makes a decision on its level of production in order to maximise profits and differential calculus can solve such an ‘unconstrained optimisation problem’ (as seen in Unit 7). Whereas in your mathematics course you focus on the mathematics of calculus, the economic interpretation of such results is of importance in your study of economics. Government intervention in markets, as well as the tax-and-spend decisions of government (known as fiscal policy) are clearly political decisions with links to FP0004 Politics, while FP0003 International Relations can be useful when understanding the challenges when forming international agreements such as trade blocs. Syllabus The course is divided into six units, each of them further divided into two to five smaller sections. You should be aware, however, that they are not mutually exclusive, that is the sections do not cover completely separate issues, and you will soon start to find links between them. The best way to study is to work through the subject guide starting with Unit 1, as each subsequent unit builds on everything else covered before. Unit 1: The nature and scope of economics This unit introduces the central economic concepts of scarcity and choice, including the extent of government involvement in economic decisions. By the end of this unit, you should be able 3 Introduction to the course 4 to consider different mechanisms by which society determines what, how and for whom to produce. Unit 2: Microeconomics I: markets and the consumer This unit explores the determination of market prices and quantities and the behaviour of consumers. By the end of this unit, you should be able to apply analytical tools to model microeconomic problems related to consumers. Unit 3: Microeconomics II: firms and production This unit explores the behaviour of firms when deciding on the level of production, different types of market structure and labour markets. By the end of this unit, you should be able to apply analytical tools to model microeconomic problems related to firms. Unit 4: Macroeconomics I: closed economy This unit models the national economy as a system featuring feedback mechanisms. Core variables of unemployment and inflation are introduced along with the tools of monetary policy and fiscal policy. By the end of this unit, you should be able to conduct macroeconomic analysis for a closed economy, including the impact of monetary and fiscal policies. Unit 5: Macroeconomics II: open economy This unit considers trade with the rest of the world. Balance of payments and exchange rates are introduced, concluding with measures of economic development. By the end of this unit, you should be able to discuss the international economy and appraise different measures of economic development. Unit 6: Global financial crisis This unit examines the major economic event of modern times – the global financial crisis of 2008. By the end of this unit, you should be able to outline events which contributed to the global financial crisis and critique different economic policy responses. Week 1 Unit Section 1: The nature and scope of economics Introduction to the course 2 3 4 1.1: The basic economic problem, opportunity cost and economic systems 1.2: Production possibility frontiers 2: Microeconomics I: markets and the consumer 2.1: Demand, supply and price determination 2.2: Elasticities 5 2.3: Consumer and producer surplus, tax and social welfare 6 2.4: Consumer choice 7 8 3: Microeconomics II: firms and production 3.1: Production 3.2: Market structure 9 3.3: Market failure and externalities 10 3.4: Labour markets Introduction to the course Week 11 5 Unit Section 4: Macroeconomics I: closed economy 4.1: Introduction to macroeconomics and national income accounting 12 4.2: Aggregate demand and aggregate supply 13 4.3: Unemployment 14 4.4: Inflation 15 4.5: Monetary policy and fiscal policy 16 17 5: Macroeconomics II: open economy 18 19 5.1: International trade 5.2: Balance of payments and exchange rates 5.3: Measures of economic development 6: Global financial crisis 20 6.1: Contributory factors leading to the global financial crisis 6.2: Consequences of the crisis and economic responses You should be aware, however, that the above topics are not mutually exclusive, that is the sections do not cover separate issues and you will soon start to find links between them, as well as links to other disciplines. The best way to study is to work through the subject guide in order, as each subsequent topic builds on everything else covered before in a cumulative way. Aims of the course The major aims of the course are to: introduce you to a range of key issues and questions at the centre of the study of economics appreciate how economics contributes to the understanding of the wider economic and social environment develop an understanding of current economic affairs and the role of institutions which affect everyday life provide tools which support you in the critical evaluation of economic models and methods of inquiry interpret appropriate data from a range of different sources and understand the relationship between data, decisions of economic agents and policy formation. Learning outcomes for the course At the end of the course, and having completed the background reading and activities, you should be able to: demonstrate familiarity with key economic concepts use a range of simple microeconomic and macroeconomic models to analyse the relationship between economic variables provide reasons for, and explain the implications of, market failure and the impact and effectiveness of government policies contrast and assess different approaches to the same economic problem interpret data presented in different formats, carry out simple calculations and construct diagrams Introduction to the course compare measures of economic development provide an economic critique of the global financial crisis. Microeconomics vs. Macroeconomics Before we embark on our first unit looking at the nature and scope of economics, let us spend a few moments considering the differences between microeconomics and macroeconomics – which comprise the core of this course (Units 2 to 5). Microeconomics Microeconomics is concerned with modelling the behaviour of individual consumers and firms. Consumers decide what quantity to buy of different goods and services based on a variety of factors such as price, income, tastes and preferences. Firms produce the goods and services which consumers buy and can be assumed to be profit-maximising, i.e. firms decide on their output subject to the price, for example, the revenue they receive per unit, as well as their cost of production, with profits being the difference between revenues and costs. Demand and supply curves can be used to illustrate the relationship between price and quantity from the consumer’s and firm’s perspectives, respectively. Equilibrium is achieved when demand equals supply. Throughout the microeconomics units you will see several links to the mathematics part of FP0001 Mathematics and Statistics, and these connections will be emphasised in this subject guide. This is because economic relationships can be modelled mathematically as well as graphically. The price which a firm receives per unit of output sold will depend on the market structure, i.e. how many firms operate in a particular market. At one extreme there is a pure monopoly (only one firm in the market), while at the other extreme there is perfect competition (in principle an infinite number of firms). The type of market structure affects the influence the firm has over the price and hence revenues. Market failure sometimes occurs whereby the price mechanism fails to allocate resources efficiently. In such circumstances there is a possible role for government intervention to achieve a socially-acceptable allocation. We will look at reasons for market failure and examples of how and when governments should intervene. Other topics which you will meet in microeconomics include elasticities (the sensitivity of demand to changes in a variable), consumer and producer surplus, tax, social welfare and labour markets. Macroeconomics Macroeconomics considers an economy at the aggregate level, sacrificing analysis of individual consumers and firms for an economy as a whole. The concepts of demand and supply met in microeconomics will be extended to aggregate demand and aggregate supply when summed over all individual units. When you hear economic stories in the news, these usually concern macroeconomic variables such as economic growth, unemployment and inflation – all of which will be discussed in this course. Given the prevalence of macroeconomics in the news, you will no doubt see several time series graphs of macroeconomic data. When you do, relate these to the data exploration units (Units 12 and 13) of FP0001 Mathematics and Statistics. The primary macroeconomic policy tools are monetary policy (the setting of interest rates by central banks) to combat inflation (among possible other objectives) and fiscal policy (the tax-and-spend decisions of governments). A graphical treatment will allow us to consider how different policy mixes, for example, an expansionary monetary policy combined with a contractionary fiscal policy, can affect the economy. 6 Introduction to the course Modern economies trade with each other, and we will explore the international economy through a study of exchange rates (the price of one currency in terms of another) and the impact these have on the balance of payments (which compares the value of imports and exports), as well as international trade in general. Finally, we will look at different measures of economic development. While economic development may seem desirable, how do we quantify this? A purely monetary measure may be misleading, so different measures will be introduced enabling you to critique each one. Overview of learning resources Economics in the News Economics is all around us in the media. Every day there are stories in the news about topics in this subject guide which are going on in the real world in the present. ‘Economics in the News’ is available on the Virtual Learning Environment (VLE) and consists of weekly news articles covering a broad cross-section of microeconomic and macroeconomic news stories. Each post links to a real news article, complemented with several key takeaways which cross-reference back to this subject guide. A summary discussion point concludes, which you are encouraged to use for the basis of an in-class discussion with your peers. Make every effort to keep up-to-date with current affairs both in your home country as well as internationally. Over time, as your knowledge of economic concepts deepens, increasingly you will be able to ‘read between the lines’ of any economics-themed story and be able to provide your own economic critique of it! Background reading The subject guide gives you a comprehensive commentary on the issues discussed and will help you to understand the main ideas – you should always refer to it first as the subject guide represents the definitive examinable content. Once you have read the subject guide, you may wish to deepen your knowledge by reading relevant sections from the following textbooks: • Anderton, A. and D. Gray (Ed) Economics. (Lancashire: Anderton Press, 2015) 6th edition [ISBN 9780993133107]. • Gillespie, A. AS & A Level Economics through diagrams. (Oxford: Oxford University Press, 2009) 3rd edition [ISBN 9780199180899]. Further reading The following texts, although not compulsory, can help you gain more knowledge of economics as a whole. If you have time, you may want to read some of the following: • Davies, H. The financial crisis - who is to blame? (Cambridge: Polity Press, 2010) [ISBN 9780745651644]. • Frank, R.H. The economic naturalist: why economics explains almost everything. (New York: Virgin Books, 2008) [ISBN 9780753513385]. • Harford, T. The undercover economist. (London: Abacus, 2007) [ISBN 9780349119854]. • Jevons, M. The fatal equilibrium. (New York: Penguin Random House, 1986) [ISBN 9780345331588]. • Klein, G. and Y. Bauman The cartoon introduction to economics, Volume I: Microeconomics. (New York: Hill and Wang, 2010) [ISBN 9780809094813]. • Klein, G. and Y. Bauman The cartoon introduction to economics, Volume II: Macroeconomics. 7 Introduction to the course (New York: Hill and Wang, 2012) [ISBN 9780809033614]. • Krugman, P. End this depression now! (New York: W.W. Norton & Company, 2013) [ISBN 9780393345087]. • Levitt S.D. and S.J. Dubner Freakonomics: A rogue economist explores the hidden side of everything. (London: Penguin Random House, 2007) [ISBN 9780141019017]. • Levitt S.D. and S.J. Dubner Superfreakonomics: Global cooling, patriotic prostitutes and why suicide bombers should buy life insurance. (London: Penguin Random House, 2010) [ISBN 9780141030708]. • Sloman, J. and D. Garratt Essentials of economics. (Harlow: Pearson Prentice Hall, 2016) 7th edition [ISBN 9781292082240]. Useful web links In addition, you could also benefit from the following web links: www.anforme.co.uk – provider of online educational resources www.bankofengland.co.uk – central bank of the United Kingdom www.bbc.co.uk/news – BBC news website www.bized.co.uk – provider of online educational resources www.economist.com – weekly newspaper with economic and socially liberal views www.edexcel.org.uk – education and examination board www.guardian.co.uk – left-of-centre newspaper www.oecd.org – Organisation for Economic Co-operation and Development www.philipallan.co.uk – publisher and conference provider www.statisticsauthority.gov.uk – United Kingdom Statistics Authority www.telegraph.co.uk – right-of-centre newspaper www.treasury.gov.uk – HM Treasury www.tutor2u.net – provider of online educational resources. Accessing the Student Portal and virtual learning environment To manage all of your student administrative processes you will need to log in to the Student Portal via: my.london.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register. As soon as you register, you will automatically be granted access to the VLE, Online Library and fully functional University of London email account. If you have forgotten these login details, please click on the ‘Forgotten your password’ link on the login page. In order to access your learning materials for each course, you can click on the VLE tab within the Student Portal or login to the VLE directly via: https://ifp. elearning.london.ac.uk/ Examination advice Important: the information and advice given in the following section are based on the examination structure used at the time this subject guide was written. We strongly advise you to check both the current Regulations for relevant information about the examination and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. You may think it is too early to think about your examination, but you could not be further from 8 Introduction to the course the truth! The year will pass quickly, and without even realising it you will soon be only a few weeks away from your final assessment - a two-hour unseen written examination. The examination will seek to test the following specific areas and skills: 1. subject knowledge applied to short qualitative and quantitative questions 2. ability to respond and apply economic knowledge/theory to data provided, i.e. ‘stimulus response’ 3. ability to consider at length a particular area of economics and then to write an answer in a coherent and structured way. This answer must include knowledge, analysis and judgements based on an objective review of the evidence presented. It must clearly consider different perspectives. Economics cannot be learned by heart through memorisation. It must be understood and this is a gradual process taking both time and effort. Here are a few useful study tips to help you prepare for the final examination. Be systematic – do not leave all the work until the last moment. It is impossible to squeeze the whole course into one month before the examination. Neither is it possible to do well by learning only selected topics. Remember that all topics are interrelated. The examination consists of questions of similar difficulty to activities in this subject guide and on the VLE, testing your knowledge of the course material, your analytical skills and your ability to apply tools learned in the course to real-life situations. Therefore, the best way is to regularly complete the activities. You will not learn simply by accessing the answers before you try the questions on your own! Graphs are essential – the best way to learn is to draw them several times. When drawing a graph, make sure you explain what it is showing. Label the axes and key points of your diagram, such as any points of intersection of curves, as well as any shifts of curves. Mind maps and revision sheets – after each topic create a mind map or a revision sheet which highlights the most important ideas that you have learned so far. Do not rewrite the whole book because a summary should be short and informative. Doing this will save you a lot of time when revising for the final examination. Glossary – definitions in economics are very important. You may want to learn some of these by heart, but it is always more useful to try to explain the concepts using your own words. As there are many new terms to learn, you are advised to review the glossary at the end of the subject guide. Last, but not least, here is a little secret about economics – it’s not all that complicated. It’s really all about us and our behaviour. With this subject guide, you will very soon discover how exciting and universal it is. Good luck! James Abdey 9 Unit 1: The nature and scope of economics 10 Introduction to Unit 1 Overview of the unit 11 Aims 11 Learning outcomes 11 Background reading 11 Further reading 11 © University of London 2019 Unit 1: The nature and scope of economics Overview of the unit This first unit begins with an introduction to economics by considering the basic economic problem (how to satisfy unlimited wants when faced with scarce resources) which leads to the fundamental concept of an opportunity cost (what must be sacrificed to gain more of something). We consider different types of economic systems and outline their key features. Our first economic model (the production possibility frontier) provides a visual representation of the productive potential of an economy. As with all models, we are interested in analysing the model when something changes. Week 1 Unit 1: The nature and scope of economics 2 Section 1.1: The basic economic problem, opportunity cost and economic systems 1.2: Production possibility frontiers Aims This unit aims to: introduce you to the concepts of the basic economic problem and opportunity cost provide you with a general overview of different economic systems provide you with tools which support the critical evaluation of the productive capacity of a given economy. Learning outcomes By the end of this unit, and having completed the background reading and activities, you should be able to: define the concepts of the basic economic problem, scarcity, efficiency, opportunity cost and specialisation explain the main features of different economic systems explain what is meant by the production possibility frontier and analyse its position and shape. Background reading • Anderton, A. and D. Gray (Ed) Economics. (Lancashire: Anderton Press, 2015) 6th edition [ISBN 9780993133107]. Please read the following units from Anderton (2015): • Unit 3, pp. 12–16 • Unit 4, pp. 17–21 • Unit 5, pp. 22–25 • Unit 6, pp. 26–31. Further reading • Frank, R.H. The economic naturalist: why economics explains almost everything. (London: Virgin Books, 2008) • Introduction. 11 Unit 1: The nature and scope of economics 12 Section 1.1: The basic economic problem, opportunity cost and economic systems Introduction 13 Opportunity cost 14 Division of labour as an example of specialisation 15 Different economic systems 16 Unit 1: The nature and scope of economics • Section 1.1: The basic economic problem, opportunity cost and economic systems Introduction Think of Planet Earth, home to around seven billion people, as the provider of resources for the population such as food and shelter. Ideally, we would wish to allocate resources such that everyone’s wants, or demands, are satisfied. Of course, the planet has finite resources while our individual wants can be infinite. Therefore, we need to make choices and decide how to allocate scarce resources between competing uses in the best possible way. This notion is referred to as the basic economic problem. Due to the scarcity of resources, it is impossible to meet the demands of all of us as individuals and collectively – we cannot completely reconcile limited resources with our infinite wants. Hence economics looks at what, how and for whom society produces goods and services. Scarcity itself can be thought of as having to distribute a fixed stock of resources to best meet our insatiable wants. However, what are these ‘resources’? Formally, we view these economic resources as factors of production – the means for producing the goods and services which people demand. We consider the four factors of production, known as CELL for short: Capital – human-made assets, such as machinery or buildings. Entrepreneurship – the ability and originality to combine all factors of production to make profits. ‘Confidence’ is sometimes also considered as part of entrepreneurship. Land – all naturally-occurring resources, such as soil, air, water, minerals, flora and fauna. Labour – people who provide physical and intellectual skills (human capital). Some resources are renewable (they can be replaced), while others are not. Almost all resources, however, are limited (at least in the short term) – there is a finite amount of water, oil, land, coal, and so on, which is why economists say that these resources are scarce. For example, if you want to buy a car, you can only purchase the one which you can afford. If the latest high-performance car is beyond your budget, you cannot have it. If a government wants to build a new hospital, it needs resources. If there is not enough money to fund it, no hospitals can be built. All goods which are scarce are called economic goods. However, not all resources are limited. Take air as an example. There is more air than anyone could ever need. All such goods which are (effectively) infinite are called free goods. Although, you may argue that clean, breathable air is in short supply in some of the world’s most polluted cities, as well as underwater! DISCUSSION POINT 1.1 ‘Economics is the study of how people eliminate scarcity.’ Do you agree or disagree? Why? ACTIVITY 1.1 Explain the difference between human needs and wants. ACTIVITY 1.2 If we would all like more money, why does the government not print a lot more? Could it not thereby solve the problem of scarcity instantly? 13 Unit 1: The nature and scope of economics • Section 1.1: The basic economic problem, opportunity cost and economic systems Opportunity cost Economists think about ‘costs’ in a slightly different way to most people. They use the term opportunity cost to represent the cost of the best alternative forgone. It is a cost associated with engaging in a certain activity evaluated as the value of the best alternative you must give up pursuing it. Every day we face the same problem – what to do with our time. An hour has only 60 minutes; a day has only 24 hours. The average life expectancy of a person born today is around 79 years (of course, there are significant regional variations, as well as sex differences). Time is one of the most valued of all scarce resources. Each of us needs to decide what to do with the finite amount of time we have, to decide between leisure and study or work. Parents must decide how much time to devote to their work and how much time they spend with their children. Every extra hour at work means one less hour with family. Finding the right ‘work-life balance’ is difficult as it means deciding which aspects of your life should be prioritised – what is most important in your life? As you consider your university options you will face opportunity costs. You can only enrol in one degree programme at one institution. You cannot take multiple degrees at the same time (dual degree programmes aside!), so you must decide which discipline to study and where to study. Some career destinations may require a certain type of degree. For example, if you want to become a doctor you will need to study medicine, whereas if you aspire to be an economist then an economics degree would be appropriate. Therefore, pursuing a BSc in Economics would typically prevent you from becoming a doctor – there is an opportunity cost from specialising in a particular discipline. Admittedly, some professions may have a degree as an entry requirement, but are not specific about the subject area. Therefore, any degree in a broad class of subjects may be sufficient. However, employers may place different weights on the degree-awarding institution. For example, an internationally-recognised degree from the University of London (regardless of subject) would be deemed of higher quality than degrees awarded by many other universities. As such, the university you choose to study at has an opportunity cost in terms of the best alternative university forgone! DISCUSSION POINT 1.2 Discuss the opportunity cost of studying the International Foundation Programme (IFP). What factors would make the opportunity cost of pursuing the IFP relatively high? Is the cost of food included in the opportunity cost? What impact would it have on the calculation of opportunity costs if you really disliked the nature of the work in the best alternative job available to you? Suppose now you have graduated from the IFP and you are an undergraduate student. Is the opportunity cost to you (as an individual) of attending university different from the opportunity cost to society as a whole? Are the benefits of higher education for society different from those for you? 14 Unit 1: The nature and scope of economics • Section 1.1: The basic economic problem, opportunity cost and economic systems Division of labour as an example of specialisation Specialisation occurs when a country, firm or individual focuses on the production of a limited range of goods or services. Specialisation can occur for a number of reasons. For example, almost 30 per cent of all potatoes produced in the United States are grown in the relatively small state of Idaho due to the particularly favourable combination of climate, soil and geography. Another reason for specialisation is when a ‘critical mass’ of expertise, money and talent is concentrated in a single location. For example, such a critical mass can be found in Silicon Valley, California, where there is a high concentration of high-tech firms, also Bangalore in India. One of the forms of specialisation is the division of labour which is a major source of growth. Production is broken down into a series of tasks which are conducted by individual workers – an idea famously, and successfully, implemented by Henry Ford, by the time of his death one of the wealthiest and most famous men of his day. Many people believe he invented the automobile, and others think he was the first to come up with the idea of an assembly line. The truth is he did neither. So, what was his success? Ford’s dream was to build fast, reliable cars as quickly and cheaply as possible so that everyone, including the working class, could afford to own one. After a series of failures, in 1903 Ford finally founded his own motor company. It was not until 1908, however, that he came up with the idea of the ‘Model T’ (often referred to as the ‘Tin Lizzie’) – a car which revolutionised the US automobile market. The car was simple to operate, powerful, sturdy, easy to repair and could carry the whole family. More importantly, it was much cheaper than options offered by Ford’s competitors. In the beginning Ford produced one vehicle at a time, but soon the demand for cars greatly exceeded supply (known as excess demand). Ford realised that a more efficient process of production was needed. In 1913, the Ford Motor Company established what was, at the time, regarded as the largest moving assembly line. All pieces were produced according to strict rules so that they were virtually the same and would fit with any other. Assembly of the Model T was broken down into smaller tasks. Each worker was trained to specialise in only a few steps in the chain. Thanks to this division of labour, Model T production was faster, cheaper and more efficient. The assembly time of a single car was cut down to just 93 minutes! As great as the idea of an assembly line sounds, it also had some inevitable drawbacks. Since the tasks were mindless, repetitive and required almost no skill, workers were easily bored and discouraged. Yet, again, it was Ford who quickly realised the need to invest in human capital. Since most of the workers employed in the factory were immigrants, the vast majority of them could not communicate in English. He opened a dedicated school for them, established a hospital at the factory and doubled their wages to give incentives and boost morale. Although many commentators predicted bankruptcy, Ford managed to double Model T production in each of the next three years. Henry Ford and his ‘Tin Lizzie’ changed the automobile industry forever. The next great advance in mass production techniques took place in the 1970s in Japan – the Toyota production system. Toyota saw their workers as assets and encouraged them to come up with new ideas and methods to improve production. Above all, the company wanted to concentrate on quality. They believed that no car should leave an assembly line unless it was free from any fault. The traditional friction between management (whose objective was to maximise production) and workers (who were bored and not motivated) was replaced by cooperation and mutual respect. This system has now been exported and adopted by firms in many industries worldwide. Over time you will increasingly appreciate that when analysing a topic (be it economic, political, or otherwise) there are often advantages and disadvantages. As you continue your study of the social sciences, it is important when forming opinions and judgements on something that you 15 Unit 1: The nature and scope of economics • Section 1.1: The basic economic problem, opportunity cost and economic systems consider both sides of the argument. Indeed, we have already considered the benefit and cost of working with models (simplicity versus departure from reality). Here, we consider the advantages and disadvantages of the division of labour. The advantages of the division of labour are that: a person who spends time focused on one task quickly becomes highly-skilled no time is wasted in moving from one job to another capital equipment (such as machinery) can be used continuously in production less time is required to train workers for specific tasks, as they only need to focus on one task at a time there is more choice of jobs for workers and they can specialise in tasks to which they are best suited (in other words, if you are not good at something, you can focus on something else). These benefits lead to a higher output per worker (a type of mean, or average) and help to reduce the cost of single-unit production. Overall, the standards of living within the population increase. There are, however, also some drawbacks. Disadvantages of the division of labour are that: repetition of the same, easy tasks often creates monotony and boredom for the workers in a large plant, where workers focus only on their own task, there might be a widespread feeling of alienation due to the lack of interaction between workers breaking down production into different tasks makes it easier to replace skilled workers with machines, leading to structural unemployment specialisation creates interdependence in production – if one group of workers goes on strike, it could halt production across the whole industry. ACTIVITY 1.3 Describe any three innovations which you would implement to minimise the disadvantages of the division of labour. Different economic systems So far, we have established that the central economic problem of scarcity arises from infinite wants and finite resources. All societies have to deal with this issue; they differ, however, in the approaches which they adopt. The main difference comes from the degree of economic intervention and control over resources. We therefore distinguish between: free-market economies centrally-planned economies mixed economies. In a free-market (or capitalist) economy, resources are privately-owned and therefore decentralised – decisions about what to produce, and in which quantities, are decided by the forces of demand and supply. The price mechanism ensures that prices adjust to achieve equilibrium (i.e. when demand equals supply) and hence determines how much of a good will be produced and sold in the market. Government intervention is minimal, and such minimised intervention can be observed in countries such as Singapore. Advocates of the free-market system argue that it achieves the most efficient allocation of scarce resources due to individuals 16 Unit 1: The nature and scope of economics • Section 1.1: The basic economic problem, opportunity cost and economic systems pursuing their own self-interest which is meant to be optimal for society overall. Critics argue that market failure can sometimes occur, leading to third-party effects such as pollution (an example of an externality which will be discussed in Section 3.3) for which government intervention is required. In a centrally-planned economy, the central authority, i.e. the government, decides which goods are to be produced. Such decisions were taken in the former Soviet Union in the 1930s, for example, and were carefully described in so-called ‘Five-Year Plans’. Each plan dealt with virtually all aspects of development (such as the use of natural resources, production of consumer goods and education) with the aim of creating an advanced industrial economy. The growth of the economy was visibly boosted under Stalin, but at the cost of severe human suffering. Not only is it impossible for one person to be able to determine the right amount of output, but the whole process of gathering data is costly, time-consuming and liable to error. Most 21st-century economists agree that, unless there is a sound reason to believe that the solution offered by the market is not the best from society’s point of view, for example when there is monopolistic pricing and supernormal profits (which will be discussed briefly later in the course), price and quantity decisions should be left to demand and supply forces. In practice the majority of developed countries (such as France and Germany) can be classified as mixed economies, as their governments intervene to improve efficiency, correct market failures (for example, in the education or health sectors) or provide public goods, such as defence. In all systems, however, production decisions do not come without a cost. Unit 2 will begin by introducing the price mechanism as the means to resolve differences in demand and supply. While the price mechanism is central to the capitalist system, Section 2.3 will examine the impact of taxation (where governments raise revenue for spending and/ or redistributing to combat income or wealth inequality) and Section 3.3 will look at market failure including examples of government intervention to correct this, as can be seen in mixed economies. ACTIVITY 1.4 Rank the following economies from the most centrally-controlled to the least centrallycontrolled: Australia Japan North Korea Singapore United Kingdom. 17 Unit 1: The nature and scope of economics 18 Section 1.2: Production possibility frontiers Introduction 19 Inefficient production 21 Economic growth and the PPF 22 Shapes of PPFs 24 A reminder of your learning outcomes 26 Unit 1: The nature and scope of economics • Section 1.2: Production possibility frontiers Introduction One of the main objectives for governments is the sustained economic growth of their country – the long-term expansion of the productive potential of the economy. This, however, is not easy to achieve because of the issues discussed in the previous section (for example, scarce resources and the need to choose between them, as well as the associated opportunity costs). The following question naturally arises – is there any way to represent the productive potential of the economy? The answer is ‘yes’, with a production possibility frontier (PPF). This is our first example of an economic model, i.e. a simplified way of representing a real-world economic phenomenon. A PPF shows all the possible combinations of two or more goods or services which can be produced in an economy if all the available resources are fully and efficiently used with the best available technology. Therefore, if an economy is fully utilising its resources, it is producing on the frontier. Throughout this course, we will keep the analysis rather simple – from now on we will consider only two goods. However, the model and its conclusions can easily be extended to include more goods and services. It is possible to consider two goods as one specific good (such as coffee) and ‘everything else’. Note that although this is an extreme simplification (given the vast number of available goods and services), it still allows us to analyse the specific good in detail, so serves us well as a model (we gain simplicity without departing from reality too much). Figure 1.1 is a typical PPF showing the possible combinations of the two goods, A and B, which can be produced by an economy. All points on and below the PPF are feasible points of production, with the points on the frontier itself representing the full and efficient use of resources. Figure 1.1: A simple production possibility frontier for an economy producing two goods, A and B. Imagine that the economy can produce only food and shelter and that all raw resources (the CELL factors of production - capital, entrepreneurship, land and labour) are needed to produce both. If all resources are devoted to the production of food, then there are no resources available to build shelter. This situation is represented in Figure 1.2 as point Q0 (with no shelter), where Q stands for ‘quantity’ (note the same notation used in Unit 2 of FP0001 Mathematics and Statistics). Alternatively, if all resources are used to build shelter, then there would be no resources available to grow food. This situation is represented by point Q1 (with no food). If resources were divided 19 Unit 1: The nature and scope of economics • Section 1.2: Production possibility frontiers between the two - a mixture of food and shelter - then a range of combinations of the two goods is available. Consider point X. Here the economy is producing Q2 of food and Q3 of shelter. However, point Y (Q4 of food and Q5 of shelter) is also possible. Similarly, there are other points on the frontier representing different combinations of food and shelter which the economy could potentially produce. The set of all points for which all resources are fully utilised is the curve itself, known as the PPF. Any combination of outputs represented by a point on the frontier is said to be productively efficient, since no resources are wasted. The only way of producing more food is by producing less shelter; the only way to build more shelter is by reducing the production of food. Therefore, the PPF (or more precisely, its slope) also illustrates the concept of opportunity cost. This is calculated by finding out how many units of shelter must be sacrificed to obtain one more unit of food. For example, in Figure 1.2 the opportunity cost of moving from X to Y, and so producing Q4 rather than Q2 units of food, is by giving up Q3 – Q5 units of shelter. Figure 1.2: Opportunity cost of moving from point X to point Y, sacrificing shelter for more food. So far, we have established that a PPF represents all combinations of goods which can be produced when all resources are used efficiently, but exactly which combination should the economy choose? How do we decide? In a free-market economy, forces of demand and supply ensure that the correct equilibrium is reached (the concept of equilibrium is formally discussed later in the course). Suppose that there is a sudden increase in the need for shelter. To meet the increased demand, the economy will need to build more houses. As a result, this sector would need more resources and the price paid for those resources would increase. Therefore, suppliers would be willing to sell their goods to house builders rather than to food producers because they would get more money for the same products from house builders. As a result, resources would be shifted away from food production and towards the construction of shelter. The very same market forces which trigger an increase in demand for one product will also ensure that the necessary resources for production are available. For example, by the late 1970s Kodak (founded in 1888) products accounted for approximately 90 per cent of the US traditional film and camera market. However, the 21st century presented a great challenge for the company. The sales of traditional photography devices started to decline as the market for new digital photography grew rapidly. As a result, Kodak had to 20 Unit 1: The nature and scope of economics • Section 1.2: Production possibility frontiers transfer all of its resources to digital-oriented production; otherwise it would not have been able to keep up with market demand. Inefficient production The ideal situation of productive efficiency is, unfortunately, rarely achieved in practice. This is because the curve is only a hypothetical concept and so can only be estimated. For example, some resources which may be needed may not yet be known, or the cost of accessing others might be too high. Therefore, even the best economies are very often producing inefficiently. This can be represented graphically as a point within the PPF, such as point W in Figure 1.3. Figure 1.3: Points W and S, where W is inefficient and S is not feasible. Production at W is inefficient due to some unused resources and the possibility of increasing output without any opportunity cost. Production at point S is not feasible due to the lack of available resources. In this example, the production of one or both goods can be increased without the need to sacrifice production of the other. There is no opportunity cost involved, as there are still some spare resources which can be used, i.e. there is slack in the economy since it is not producing at full capacity. What about point S? Since it lies outside the PPF, even though it would be desirable, it is not feasible as there are not enough resources and technology to be able to produce at that point. Another reason for an economy not to produce at the frontier is time trade-offs. For example, you could put money into a bank account now and go on holiday with the money next year or, alternatively, you could spend the money now on new clothes. In a similar manner, we can use all of our available resources now or, alternatively, save some of them for future generations. By sacrificing some of our current consumption, we increase consumption for future generations. So, let us summarise what we have learned so far: a PPF represents all the different combinations of goods (and/or services) which can be produced within the economy if all resources are used efficiently only one point on the curve can be produced – which demonstrates the need for choice if all resources are fully utilised, to produce more of one good some quantity of other goods must be sacrificed – therefore, the slope of a PPF represents the opportunity cost 21 Unit 1: The nature and scope of economics • Section 1.2: Production possibility frontiers production of all goods is not always achievable. All points outside a PPF are points the economy would want to achieve but cannot reach due to resource scarcity all points within a PPF are feasible, but not desirable, as there are some spare resources which are not fully utilised. There is no opportunity cost of expanding production from any point within a PPF some economies may choose to produce within a PPF because of time trade-offs. Economic growth and the PPF Once the frontier is reached, expansion is the only way to increase production. Expansion can be achieved by either inventing new resources and/or new technologies. Such growth is represented by an outward shift of a PPF. Possible reasons for such increases include: increased training of employees making them more productive – fewer resources are needed to produce the same quantity of output, so some of the workforce can be shifted to the production of other goods a greater increase in capital or the discovery of new resources an increase in population – more labour means greater human capital an improvement in technology, new discoveries, specialisation or the division of labour. To put these factors into context, let us use the earlier example of food and shelter. Here are a few scenarios and their corresponding graphs. Scenario A: The entire workforce is required to attend special training before being employed and during the training they acquire all of the skills necessary for their work. Evidence suggests that this increases efficiency of an average worker by 30 per cent. This is depicted in Figure 1.4 where there is an outward shift of the original PPF as the productive capacity of the economy has increased. Figure 1.4: Scenario A showing an increase in the productive capacity of the economy. Scenario B: At a recent international summit it was agreed that Country 1 should get its fertile land back from Country 2. So, from Country 1’s perspective, it gains more land on which to cultivate food and/or build shelter. Given it is fertile land, it would be better suited to producing food rather than shelter. So, although the PPF would shift outward, it would expand further in the direction of food, as indicated in Figure 1.5. 22 Unit 1: The nature and scope of economics • Section 1.2: Production possibility frontiers Figure 1.5: Scenario B showing a country gaining more fertile land which is bettersuited to food production rather than building shelter. Scenario C: Following the opening of a country’s frontiers and market liberalisation (freer markets), the net outflow of people aged between 20 and 45 doubled. People in this age group are likely to be some of the most productive in the economy. Therefore, the productive capacity would decrease significantly due to the net emigration of this age group. Given building shelter is likely to be more labour-intensive than food production, there would be a greater effect on shelter capacity than on food production. Therefore the PPF would shift inwards, as shown in Figure 1.6. Figure 1.6: Scenario C showing how emigration of the prime workforce reduces the productive capacity of the economy, with labour-intensive shelter being more severely affected. Scenario D: A new, faster and cheaper way of building houses has been discovered by a team of researchers. This is effectively a new technological discovery, and hence the PPF expands 23 Unit 1: The nature and scope of economics • Section 1.2: Production possibility frontiers outward although food production techniques are unchanged so if the economy only produced food there would be no change to the total amount of food produced. The PPF expansion would be as shown in Figure 1.7. Figure 1.7: Scenario D showing how technological advances in house building increase the capacity of the economy to build more shelter for any particular level of food production. Note that the shift of a PPF does not have to be parallel as a new technology can benefit some goods more than others. Even if increased productivity affects only one of the goods, production of all goods can increase. This is because resources saved on production of one good can be transferred to the production of all other goods. For example, if fewer people are required to produce food, those people could be used to build more shelter. Shapes of PPFs The most common shape of a PPF is the one we have drawn so far – concave to the origin (curved like a circle). This is because we assume that the opportunity cost is not the same along the curve due to diminishing marginal returns (that is, the more resources you use, the less productive one extra unit becomes). However, this shape is not the only one which can exist. Suppose you can read twenty pages of a history book per hour or forty pages of a Harry Potter book per hour. If your reading speed does not change with time (suppose you do not become tired), then no matter how long you read, the opportunity cost of reading one more page of the history book is to give up two pages of Harry Potter. The situation described here represents a constant opportunity cost. Therefore, the relevant PPF would be a (downward-sloping) straight line, as shown in Figure 1.8. (You will cover straight lines mathematically in Unit 2 of FP0001 Mathematics and Statistics.) 24 Unit 1: The nature and scope of economics • Section 1.2: Production possibility frontiers Figure 1.8: Production possibility frontier representing a constant opportunity cost (i.e. a straight line) where the cost of obtaining one more unit of one good is fixed in terms of the other good, regardless of level. In real life, things are often much more complicated than the examples given above. Nevertheless, the idea of the PPF helps us to illustrate and understand general principles. As previously discussed, a model is not reality, but a good model allows us to represent the main features of reality, which the above PPFs achieve. ACTIVITY 1.5 Suppose a country can produce combinations of cars and boats each day. Making full use of the available factors of production (CELL) the country can produce the following possible combinations of each: Cars (quantity) 0 60 110 150 180 200 Boats (quantity) 50 40 30 20 10 0 a. Draw the production possibility frontier for this country with cars on the vertical axis and boats on the horizontal axis. b. Are the following combinations of cars and boats feasible for this country? Explain why in each case. i. 150 cars and 20 boats ii. 50 cars and 30 boats iii. 190 cars and 15 boats. c. Determine the opportunity cost, in terms of cars, of producing 10 additional boats when the country is currently producing: i. 180 cars and 10 boats ii. 150 cars and 20 boats iii. 110 cars and 30 boats iv. 60 cars and 40 boats. d. Suppose now that advances in technology allow three times as many cars to be produced and twice as many boats for any specific amount of resources. Assume that the available factors of production are unchanged. Determine the new possible production combinations and draw the new production possibility frontier. 25 Unit 1: The nature and scope of economics 26 Concluding comments This introductory unit has outlined the basic economic problem of how to reconcile unlimited wants with finite resources. The concept of an opportunity cost was defined, with a brief discussion of the different types of economic systems along with their main characteristics. Our first graphical economic model, the production possibility frontier, enabled us to show opportunity costs visually as the slope of the frontier. Shifts of the PPF under different scenarios allowed us to demonstrate a fundamental idea of economic analysis, i.e. what happens when something changes. For interested students, you may wish to read Appendix A which provides a summary of economic history, including some of the main historical figures who have contributed to the development of modern economics. Although this material is non-examinable, it is always beneficial to understand what came before, ahead of studying current developments. A reminder of your learning outcomes Having completed this unit and the background reading and activities, you should be able to: define the concepts of the basic economic problem, scarcity, efficiency, opportunity cost and specialisation explain the main features of different economic systems explain what is meant by the production possibility frontier and analyse its position and shape. Unit 2: Microeconomics I: markets and the consumer 27 Introduction to Unit 2 Overview of the unit 28 Aims 28 Learning outcomes 28 Background reading 29 References cited 29 © University of London 2019 Unit 2: Microeconomics I: markets and the consumer Overview of the unit Microeconomics explores the behaviour of consumers and firms and the determination of market prices and quantities. Over the next eight weeks you will cover several aspects of microeconomic theory as well as real-world examples to help you relate key terms and concepts to everyday life. We begin by exploring markets and the consumer, moving on to firms and production in the following unit. Week 3 4 Unit 2: Microeconomics I: markets and the consumer 5 6 Section 2.1: Demand, supply and price determination 2.2: Elasticities 2.3: Consumer and producer surplus, tax and social welfare 2.4: Consumer choice Section 2.1 describes the individual human objectives and motivation behind demand and supply curves, and seeks to explain their shape, slope and how interaction between the two forces should result in a stable equilibrium price and quantity. Section 2.2 deals with elasticities and their importance in determining the response to changes in the demand and supply environment. Section 2.3 explains the benefits which can accrue to the consumer and to the producer and investigates the effect of outside action and ‘interferences’. Section 2.4 discusses the consumer choice problem of maximising utility subject to a budget constraint, an example of constrained optimisation. Aims This unit aims to: introduce you to the demand and supply model introduce you to the concepts of elasticities and their real-life applications provide tools which support you in the critical evaluation of the impact of taxes on the consumer, producer and social welfare explain the consumer choice problem. Learning outcomes By the end of this unit, having completed the background readings and activities, you should be able to: define the concepts of demand and supply and list their determinants distinguish between movements along, and shifts of, curves in relation to demand and supply explain how the price mechanism helps to allocate scarce resources define price elasticity of demand, price elasticity of supply, income elasticity and cross-price elasticity and explain their importance for making decisions identify consumer and producer surplus explain how taxes influence social welfare model the consumer choice problem. 28 Unit 2: Microeconomics I: markets and the consumer Background reading Anderton, A. and D. Gray (Ed) Economics. (Lancashire: Anderton Press, 2015) 6th edition [ISBN 9780993133107]. Please read the following units from Anderton (2015): Section 2.1 – Units 8 (pp. 36–43), 11 (pp. 61–68) and 12 (pp. 69–75) Section 2.2 – Units 9 (pp. 44–53) and 10 (pp. 54–68) Section 2.3 – Unit 14 (pp. 81–86) Section 2.4 – Unit 15 (pp. 87–90). References cited Arnold, R.A. Economics (Mason, USA: Cengage Learning, 2008) 9th edition, p.64 Free exchange, ‘As price goes up, so does demand: Are the Giffen goods of legend real?’ (July 2007) www.economist.com/free-exchange/2007/07/18/as-price-goes-up-so-does-demand (last accessed 31/08/2018) 29 Unit 2: Microeconomics I: markets and the consumer 30 Section 2.1: Demand, supply and price determination Introduction 31 Demand and its determinants 31 What influences the amount people want to buy of a certain good? 32 What influences the amount of a certain good which firms want to supply? 37 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Introduction Broadly speaking, a market is a ‘place’ where buyers and sellers ‘meet’ to exchange goods and services. Some markets, like flower stalls and grocery shops, are limited to a specific time and location. They require buyers and sellers to meet physically. Others, such as Alibaba, Amazon or eBay, are online and global. In the latter kind of market, buyers and sellers seldom actually meet. In all cases, however, for trade to be successful both sides need to agree the price at which the goods and services should be exchanged. How can we model this behaviour in economics? Well, this introduces the ideas of demand and supply. Demand and its determinants Demand is the relationship between price and quantity which tells us how many units of a certain good consumers are willing to purchase at every possible price. You need to be careful here because ‘wanting to have’ and ‘willing to buy’ are not necessarily the same thing. Most sports fans would want to have a ticket for at least one match involving their favourite player or team, but not all of them are willing, or able, to pay the asking price. Remember that demand includes only those who would buy the ticket at the price, should they have the opportunity to do so. Quantity demanded, on the other hand, is the single value which tells us how many units of goods and services consumers want to buy at a specific price. You should not confuse the two as they are not the same thing! Figure 2.1 shows a simple demand ‘curve’ (which here is a line!). Note that demand is the whole line. An example of quantity demanded is six units at a price of £10 per unit. Appreciate that it is simpler to express demand graphically as a line rather than as a curve, although in practice the real world is typically non-linear. However, remember our desire to simplify reality as much as possible while retaining the main characteristics of reality. Mathematically, it is easier to work with linear functions instead of non-linear functions. In Unit 2 of FP0001 Mathematics and Statistics you cover linear equations so to demonstrate the connection with this course, we will represent demand curves as lines! Figure 2.1: A simple demand ‘curve’ (which is actually a line). With respect to Figure 2.1, let p denote price (on the y-axis) and q denote quantity (on the x-axis). The inverse demand function is when we represent price as a function of quantity, whereas the demand function is when we represent quantity as a function of price. Suppose in Figure 2.1 the y-intercept was at £20 (i.e. when q = 0), then the inverse demand function would be: 31 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination p = 20 – 10 q 6 q = 12 – 6 p. 10 and the demand function would be: This ensures that these pass through the points (0, 20) and (6, 10). Of course, in reality demand for a good will not follow such a linear equation exactly. However, as an approximating model it offers a sufficiently simplified way of thinking about demand. Strictly speaking, a demand ’curve’ should be precisely that, i.e. a curve, although linear demand equations (as above) are simpler for us to deal with unlike non-linear demand equations. As usual, we face the familiar trade-off between our preference for simplicity and our desire for a realistic model! What influences the amount people want to buy of a certain good? The following are the most common determinants of demand. Price of the product The law of demand pinpoints a negative (downward) relationship between quantity demanded and price, as shown in Figure 2.1. This means that people buy more of a good when its price decreases and buy less when its price increases. As a result, demand for most goods is downward-sloping. These goods are known as ordinary goods, which includes normal and inferior goods. Normal goods are all goods for which demand increases when income increases and falls when income decreases. Cars and holidays are examples of normal goods – we buy more cars and holidays as our income grows. Inferior goods, on the other hand, are characterised by decreased demand when income rises, and increased demand when income falls. Examples of inferior goods include inexpensive foods such as frozen or ready-made meals – as people’s incomes increase, they can afford to replace inferior goods with better-quality (and hence more expensive) substitutes. There are, however, a few exceptions to the law of demand. Unlike normal and inferior goods, the demand curve for ‘luxury goods’ and ‘Giffen goods’ is upward-sloping. Luxury goods, such as branded clothes, bags or cars, are often bought by people to signal their wealth and social position. Therefore, the more they cost, the more they are valued. These can be considered as ‘status symbols’ and are an example of conspicuous consumption – if people are seen displaying such goods on their person then others assume they are wealthy. Giffen goods are often regarded as unusual – the law of demand fails because people paradoxically consume more of such goods as their prices increase. Many textbooks use the infamous nineteenth century Irish potato famine as an example. In this instance, potatoes were an important part of the Irish diet and when the price rose, people had to spend more of their money on them. As a result, people could no longer afford to buy meat, which meant that they needed to consume even more potatoes to survive – they were still cheaper than other goods, despite the increase in price. In this example, ‘Ireland was experiencing a potato famine at the time and the rising potato price was caused by a supply shortage, making it highly unlikely that people were able to consume more of them’ – potatoes had become scarcer (The Economist, 2007). Price of complements (goods which are consumed together) and substitutes (replacements) Tennis balls and tennis rackets are complements – if the price of tennis rackets goes up, fewer people will be able to afford them. As a result of this, fewer people will play tennis and would not need as many tennis balls as before and, therefore, the demand for tennis balls will fall (Arnold, 32 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination 2008, p.64). This is shown in Figure 2.2 – when the price of a good increases, the demand curve for complementary goods shifts to the left. Figure 2.2: Impact of the change in price of tennis rackets on the demand for tennis balls. The demand curve for tennis balls shifts to the left from D to D’. Buses and private cars are substitutes – if the price of maintaining a car increased, fewer people would be able to afford to drive one. They would, therefore, need to find a cheaper alternative method of transport and so the demand for buses, for example, would go up. This is shown in Figure 2.3 – when the price of a good increases, the demand curve for substitute goods shifts to the right. Figure 2.3: Impact of the change in the price of private cars on the demand for public transport. The demand curve for public transport shifts to the right from D to D’. 33 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Income The amount of money you earn determines what you can afford and in which quantities. If you start earning more money, you can afford a better car and your demand for better cars will increase. You can also afford better quality food and, therefore, instead of consuming cheap fast food, for example, you may decide to switch to organic meat and vegetables (which are usually more expensive). As a result, your demand for fast food will decrease. The goods for which demand goes up as income increases remember are called normal goods. Inferior goods, on the other hand, are goods for which demand decreases when income increases. This is shown in Figure 2.4 – when income increases, the demand curve shifts to the right for normal goods and shifts to the left for inferior goods. Figure 2.4: Impact of an increase in income on the demand for normal and inferior goods. When income increases the demand curve for normal goods shifts to the right (from D to D’), while for inferior goods it shifts to the left (again, from D to D’). Wealth Wealth, or your net worth, means the difference between the value of everything you own (for example, cars, houses and shares in companies, i.e. assets) and the value of everything you owe (for example, mortgages, credit card debt and other loans, i.e. liabilities). The higher the value of your wealth (i.e. the richer you are), the higher your credit rating is (ceteris paribus1) which means that banks are more likely to give you a loan (or allow you to borrow more). Therefore, even if you do not have enough liquid funds now to buy something (perhaps your wealth is tied up in long-term investments), you can borrow money and pay it back later – therefore your spending decisions are more flexible. Latin term for ‘other things equal’. This means that other things which could change are, for the moment, assumed not to. The term allows us to isolate the relationship between two economic variables controlling for all other variables. For example, the demand curve represents the effect of a price change on the quantity demanded assuming all other determinants of demand (such as income, tastes or preferences) remain unchanged. Beware, though, that in the real world other things are rarely equal -– when one variable changes there is usually a change in at least one other variable! Nevertheless, when conducting economic analysis ‘ceteris paribus’ is a very convenient way of investigating the effect of one variable on another without the complexity of worrying about other variables. 1 34 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Note wealth is different from income. Wealth is a stock variable, i.e. wealth is fixed at a particular point in time, while income is a flow variable considered over a period of time, such as annual income. Of course, changes to your net, i.e. after-tax, income may change your wealth. Tastes, preferences, advertising People are easily influenced by current trends and celebrity endorsements, therefore their demand for goods changes with them. Product placements in television shows, movies and video games can affect demand – people see the products and may be persuaded to buy them! Expectations of future price increases If people expect prices of goods to increase (known as inflation, covered in Section 4.4), they sometimes buy them now for consumption later and, therefore, save money. Climate Some goods (such as ice-cream and winter coats) are only needed in certain weather conditions. For example, winter coats are usually bought during cold winter months rather than in the middle of a hot summer. Population Total market demand for goods increases with a higher number of people (for example, due to a higher birth rate, or immigration) – there might be only one pharmacy in a small village, but there would be many more in a larger city where there is a larger population and, therefore, more demand for pharmaceutical goods and services. Demographics Young people and old people have completely different needs. Therefore, we observe more bars and nightclubs in cities mainly inhabited by students than in areas comprised mainly of pensioners. Shifts versus movements along the demand curve Demand is not constant over time. It varies as its determinants change. For example, if the price of a good decreases, ceteris paribus people would be able to afford more units and the quantity demanded would increase. This would result in a movement along the demand curve. When any other factor changes, such as preferences, income or population, the whole demand curve shifts. For example, if there are more children born in a town, the demand for toys would increase (in other words, the quantity demanded at every single price increases) and so the demand curve would shift to the right. Figure 2.5 illustrates the distinction between movements along a demand curve and a shift of the demand curve. 35 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Figure 2.5: The difference between movements along the demand curve and a shift of the demand curve. A price change leads to a movement along the demand curve, while a change in any of the other determinants of demand leads to a shift of the demand curve (here, from D to D’). Supply and its determinants Supply is the relationship between price and quantity which tells us how many units of a certain good firms are willing to sell at every possible price. As with demand, it is important to distinguish between supply and the quantity supplied. Quantity supplied, similar to quantity demanded, is the single value which tells us how many units of goods or services firms want to sell at a specific price. Figure 2.6 shows a simple supply ‘curve’ (which, again, we depict as a line for mathematical simplicity). Note that supply is the whole line. An example of quantity supplied is twenty units at a price of £80 per unit. Figure 2.6: A simple supply ‘curve’ (which is actually a line). 36 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination The inverse supply function is when we represent price as a function of quantity, whereas the supply function is when we represent quantity as a function of price. Suppose in Figure 2.6 the y-intercept was at £0 (i.e. when q = 0), then the inverse supply function would be: p = 4q and the supply function would be: q= 1 p. 4 This ensures that these pass through the points (0, 0) and (20, 80). As with demand, in reality supply of a good will not follow such a linear equation exactly. However, as an approximating model it offers a simplified way of thinking about supply. Note how (inverse) demand functions are usually downward-sloping as represented by a negative slope coefficient, while (inverse) supply functions are upward-sloping as represented by a positive slope coefficient. Consumers demand more of a product as its price decreases; producers are willing to supply more of a product as its price increases. What influences the amount of a certain good which firms want to supply? The following are the most common determinants of supply: Price of the product The law of supply states that there is a positive (upward) relationship between price and quantity supplied. This means that firms supply more goods when the price increases and fewer goods when the price decreases. As a result, the supply curve is upward-sloping. With a higher price, firms receive greater revenue per unit of product sold. Technology The better the technology available to firms, the more efficient is the process of production. Fewer resources are used up per item, which results in a lower per-unit cost and the ability to supply more at the same price. Weather conditions Production of some goods, agricultural ones in particular, greatly depends on weather conditions. For example, in years of drought or excessive flooding, food harvests are limited. During good years, on the other hand, farmers enjoy bumper crops. Cost of inputs The amount of goods which suppliers are willing to offer at any given price depends first and foremost on their costs of production. These costs, in turn, mainly depend on the cost of inputs – labour, capital and raw materials. If the cost of any of these inputs increases, then the cost of the whole production process will increase, and therefore fewer goods would be offered at the old price. Access to raw materials Some raw materials, such as diamonds and amber, are very rare. The more limited they are, the higher their cost. Regulations The supply of certain goods or services may be regulated by government or other institutions. Common examples include goods, such as electricity, and services, such as rented accommodation. Governments may also implement some import quantity quotas. 37 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Number of firms in the industry The more firms there are which can supply a certain product to the market, the greater the total quantity supplied of that product at any given price will be. With an increased number of firms, the supply schedule shifts to the right, as shown in Figure 2.7. (Note: supply can be defined for an individual firm, for a few firms, or for the whole market. Market supply is the summation of individual supplies.) Figure 2.7: A shift of the supply curve caused by new firms entering the market. More firms means more total production and an outward shift of the supply curve, from S to S’. Taxes and subsidies Most countries impose taxes (compulsory payments collected by the government) on at least some goods and services. Relatively fewer countries, however, offer subsidies (monetary benefits given by the government). Nevertheless, both taxes and subsidies effectively change the costs of production faced by firms – taxes increase costs while subsidies lower costs. For example, a higher tax on alcohol would limit the amount supplied at a given price, while agricultural subsidies would lower the price of certain foodstuffs. Shifts versus movements along the supply curve Supply, like demand, is not constant over time. It varies as its determinants change. For example, if the price of a good increases, ceteris paribus firms would be willing to offer more units and the quantity supplied would increase. This would result in a movement along the supply curve. When any other factor changes, such as technology, weather conditions or the cost of inputs, the whole supply curve shifts. For example, if the price of labour decreases, textile factories are able to employ more workers and the amount of clothes produced increases (in other words, the quantity supplied at every single price increases – the supply curve shifts to the right). Figure 2.8 illustrates the distinction between movements along a supply curve and a shift of the supply curve. 38 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Figure 2.8: The difference between movements along the supply curve and a shift of the supply curve. A price change leads to a movement along the supply curve, while a change in any of the other determinants of supply leads to a shift of the supply curve, such as from S to S’. ACTIVITY 2.1 By referring to the above determinants of supply, explain how: a. the supply of coffee beans could decrease b. the supply of commercial flights could increase. ACTIVITY 2.2 Consider the market for fossil fuels (oil, coal and gas). For each case below, explain whether there is a movement along the supply curve (including the direction of the movement) or a shift of the supply curve (to the left or right). a. The government imposes a pollution tax on the use of fossil fuels. b. New oil, coal and gas fields are discovered. c. Consumers becoming more environmentally conscious. d. The price of energy increases. e. Prolonged very cold weather. Determining equilibrium Let us recall what we have learned so far: A market is a place (either physical or virtual) where buyers and sellers meet to exchange goods and services. Demand is the relationship between price and quantity which tells how many units of a certain good consumers are willing to buy at every possible price. Supply is the relationship between price and quantity which tells us how many units of a certain good firms are willing to produce at every possible price. Movements along the curves are caused by price changes, while changes of other demand or supply determinants result in shifts of the curves. 39 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination It is no secret that sellers and buyers often have different valuations of various goods and services which they either own or want to own. So, what determines the actual price and amount of goods traded in the market? It is the price mechanism – the ‘invisible hand’ which responds to changes in demand and/or supply of a certain good or service to maintain the balance in the market. The price mechanism has three main functions: rationing – it allocates scarce resources to those who are willing to pay the most for them signalling – changing prices indicate changes in market conditions (demand and/or supply) incentivising – changing prices give incentives to sellers to either increase or decrease their production. In short, the price mechanism is responsible for maintaining equilibrium in different markets. Equilibrium is when the demand for a certain good is exactly the same as the supply of that good, i.e. where the demand and supply curves intersect. Section 2.3.3 of FP0001 Mathematics and Statistics shows the application of simultaneous equations to demand and supply analysis in economics. Figure 2.9 illustrates, graphically, the determination of the equilibrium point as the intersection of the demand and supply curves (or rather lines!). p equilibrium point S D O q Figure 2.9: Determining the equilibrium point, as shown in Section 2.3.3 of FP0001 Mathematics and Statistics. ACTIVITY 2.3 Assume that the equations for demand and supply of a specific good are: qD = 100 – 3p and qS = 4 + 5p. Calculate the equilibrium price and quantity. In other words, when in equilibrium, economists would say that the ‘market clears’. There is neither excess demand nor excess supply. Existence of either excess demand or excess supply is referred to as disequilibrium – a situation where the quantity demanded is different from the quantity supplied so the market cannot clear. Excess demand happens when, at the given price, people are willing to buy more goods than producers are willing to offer. In this case, the price will continue to rise until equilibrium is reached. Excess supply, on the other hand, is a situation when, at the given price, firms are offering more goods than consumers are willing to buy. In this case, the price will fall until the market clears again. These cases are illustrated in Figure 2.10. 40 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Figure 2.10: Two cases of disequilibrium in a market: excess demand (demand exceeds supply) when the price is below the market equilibrium, and excess supply (supply exceeds demand) when the price is above the market equilibrium. Price adjustments: worked examples Example 2.1: Taxi services The taxi industry is initially in equilibrium at price p0 and quantity q0 in Figure 2.11, i.e. the intersection of the demand curve, D, and supply curve, S. Suppose that the price of petrol decreases. In this case, taxi companies incur lower costs per kilometre travelled. As a result, they are able to offer cheaper prices for their services. We can illustrate this situation as an overall shift of the supply curve to the right, from S to S’. However, at the old equilibrium price, p0, there is an excess supply of taxi services. Therefore, the price will fall, increasing quantity demanded and decreasing quantity supplied (here we have movement along the demand curve) until the new equilibrium is reached at price p1 and quantity q1, i.e. the intersection of the (original) demand curve, D, and the new supply curve, S’. The equilibrium price has dropped while the equilibrium quantity has increased. Figure 2.11: Impact of lower petrol prices on the taxi market. The supply curve shifts from S to S’, ultimately leading to a new equilibrium with a lower price and a higher quantity. 41 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination Example 2.2: Olive oil Suppose the olive oil industry is originally in equilibrium with price p0 and quantity q0 in Figure 2.12, i.e. the intersection of the demand curve, D, and supply curve, S. However, the government now decides to launch a campaign promoting a better and healthier lifestyle. As a result, demand for olive oil greatly increases. This situation can be illustrated by a shift of the demand curve to the right from D to D’. At the old price, however, there is excess demand and firms cannot supply as much as consumers would want to buy. Therefore, the price starts increasing, reducing the quantity demanded and increasing the quantity supplied. The price keeps rising until the new equilibrium is reached at price p1 and quantity q1, i.e. the intersection of the new demand curve, D’, and the (original) supply curve, S. Both the equilibrium price and the equilibrium quantity have increased. These changes are shown in Figure 2.12. Figure 2.12: Impact of a government health campaign on the olive oil market. The demand curve shifts from D to D’, ultimately leading to a new equilibrium with a higher price and a higher quantity. In real life, markets are rarely in equilibrium and so prices are constantly adjusting due to excess demand and excess supply. Price controls In certain cases, governments may want to intervene in markets to control prices. They usually do this by setting either the minimum price or maximum price which can be charged for particular goods. A minimum price, also known as a price floor, is the legally-established threshold value below which the market price cannot fall. It will, however, only have an impact on the market, when the minimum price is set above the equilibrium price (otherwise the market price would settle at the equilibrium price, which would be above the price floor). As a result, excess supply would be created. A well-known example of a price floor is the minimum wage, which will be considered in Section 3.4 in the context of labour markets. A maximum price, also known as a price ceiling, is the legally-established threshold value above which the market price cannot rise. It will, however, only have an impact on the market when the maximum price is set below the current equilibrium price (otherwise the market price would settle at the equilibrium price, which would be below the price ceiling). As a result, excess demand would be created. A well-known example of this is rent control, as illustrated in Figure 2.13. Suppose the government imposes a maximum price pmax which can be charged for apartments, that is 42 Unit 2: Microeconomics I: markets and the consumer • Section 2.1: Demand, supply and price determination (significantly) below the current equilibrium price p*. The government’s objective is to increase the affordability of accommodation. The number of people willing to rent an apartment increases while the amount of apartments offered decreases. As a result, there are plenty of people willing to pay but are still unable to rent an apartment. Without a price ceiling, the ‘invisible hand’ would tend to raise the price to p*, therefore reducing demand and increasing supply. Figure 2.13: Excess demand as a result of rent control. The price ceiling of pmax is below the market equilibrium, p*, creating excess demand. A similar situation to the one described above happened in New York when soldiers returned home at the end of World War II. Another example of a maximum price would be the Sri Lankan government’s introduction, in 2008, of price restrictions after the price of rice significantly increased. Interrelationships between markets Frequently, changes in one market will cause changes in other markets. Therefore, economists say that markets are interrelated. Consider the following example. Suppose that, in a year, the harvesting of olives was extremely bad. The immediate consequence of this would be a much higher price of olives due to the limited supply. This is illustrated in Figure 2.14, with the supply curve shifting to the left from S to S’. However, the price of olive oil and other cooking oils would also be affected. Figure 2.14: Impac...