Real-world issue 1

Real-world issue 1: How do consumers and producers make choices in trying to meet their economic objectives?

Conceptual understandings

  • Interaction between consumers and producers in a market is the main mechanism through which resources are directed to meet the needs and wants in an economy.

  • Consumer and producer choices are the outcome of complex decision-making.

  • Welfare is maximized if allocative efficiency is achieved.

  • Constant change produces dynamic markets.

  • Key concepts: scarcity, choice, efficiency, equity, economic well-being, sustainability, change, interdependence, intervention.

2.1 Demand

  • The law of demand—relationship between price and quantity demanded

  • Assumptions underlying the law of demand (HL only)

    • The income and substitution effects

    • The law of diminishing marginal utility

  • Demand curve (Diagram: downward-sloping demand curve)

  • Relationship between an individual consumer’s demand and market demand

  • Non-price determinants of demand

    • Income

    • Tastes and preferences

    • Future price expectations

    • Price of related goods (in the cases of substitutes and complements)

    • Number of consumers

  • Movements along the demand curve and shifts of the demand curve (Diagram: movements along the demand curve and shifts of the demand curve)

2.2 Supply

  • The law of supply—relationship between price and quantity supplied

  • Assumptions underlying the law of supply (HL only)

    • The law of diminishing marginal returns

    • Increasing marginal costs

  • Supply curve (Diagram: upward-sloping supply curve)

  • Relationship between an individual producer’s supply and market supply

  • Non-price determinants of supply

    • Changes in costs of factors of production (FOPs)

    • Prices of related goods (in the cases of joint and competitive supply)

    • Indirect taxes and subsidies

    • Future price expectations

    • Changes in technology

    • Number of firms

  • Movements along and shifts of the supply curve (Diagram: movements along and shifts of the supply curve)

2.3 Competitive market equilibrium

  • Demand and supply curves forming a market equilibrium (Diagram: market equilibrium)

  • Shifting the demand and supply curves to produce a new market equilibrium, with reference to excess demand (shortage) and excess supply (surplus)(Diagram: showing changes in equilibrium/role of price mechanism)

  • Functions of the price mechanism

    • Resource allocation

      • Signalling

      • Incentive

    • Rationing

  • Consumer and producer surplus

  • Social/community surplus

  • Allocative efficiency at the competitive market equilibrium:

    • social/community surplus maximized at equilibrium

    • marginal benefit (MB) equals marginal cost (MC)

  • Diagram: showing consumer surplus and producer surplus (social/community surplus)—maximized at competitive market equilibrium

  • Calculation (HL only): consumer surplus and producer surplus from a diagram

2.4 Critique of the maximizing behaviour of consumers and producers (HL only)

  • Rational consumer choice (HL only)

    • Assumptions—consumer rationality, utility maximization and perfect information

    • Behavioural economics—limitations of the assumptions of rational consumer choice

      • Biases—rule of thumb, anchoring and framing, availability

      • Bounded rationality

      • Bounded self-control

      • Bounded selfishness

      • Imperfect information

  • Behavioural economics in action (HL only)

    • Choice architecture—default, restricted, and mandated choices

    • Nudge theory

  • Business objectives (HL only)

    • Profit maximization

    • Alternative business objectives

      • Corporate social responsibility

      • Market share

      • Satisficing

      • Growth

2.5 Elasticities of demand

  • Concept of elasticity (Diagram: relatively elastic and inelastic demand)

  • Price elasticity of demand (PED)

    • Degrees of PED—theoretical range of values for PED

    • Changing PED along a straight line downward sloping demand curve (HL only)

    • Determinants of PED—number and closeness of substitutes, degree of necessity, proportion of income spent on the good, time

    • Relationship between PED and total revenue

    • Importance of PED for firms and government decision-making

    • Reasons why the PED for primary commodities is generally lower than the PED for manufactured products (HL only)

    • Diagram: constant PED—perfectly elastic, perfectly inelastic and unitary PED along a demand curve

    • Diagram (HL only): PED along the straight line demand curve

    • Diagram: showing changes in revenue as a result of price changes when demand is price elastic and price inelastic

    • Calculation: PED, change in price, quantity demanded or total revenue from data provided

  • Income elasticity of demand (YED)

    • Income elastic demand (services and luxury goods) and income inelastic demand (necessities)

    • Significance of sign

      • Positive YED (normal goods) and negative YED (inferior goods)

      • Less than one (necessities) and greater than one (services and luxury goods)

    • Importance of YED (HL only):

      • for firms

      • in explaining changes in the sectoral structure of the economy.

    • Diagram: showing income elastic, income inelastic and inferior goods on an Engel curve

    • Calculation: YED, change in income, quantity demanded from data provided

2.6 Elasticity of supply

  • Price elasticity of supply (PES)

    • Degrees of PES—theoretical range of values for PES

    • Determinants of PES—time, mobility of factors of production, unused capacity, ability to store, rate at which costs increase

    • Reasons why the PES for primary commodities is generally lower than the PES for manufactured products (HL only)

    • Diagram: relatively elastic and inelastic supply

    • Diagram: constant PES —perfectly elastic, perfectly inelastic and unitary PES along a supply curve

    • Calculation: PES, change in price or quantity supplied from data provided

Inquiry—possible areas to explore (not an exhaustive list)

  • An investigation into the problems associated with volatile prices of commodity-dependent countries.

  • An investigation into how choice architecture influences decision-making in different contexts (for example, its role in a supermarket, or how it may influence the rate of organ donation in different countries).

  • A critical investigation into the CSR practices of different companies.

  • An investigation into the extent to which firms actually use knowledge of elasticity to inform pricing decisions.

Theory of knowledge questions

  • Is the assumption of rational consumer choice realistic?

  • Can laws in economics, such as the law of demand and the law of supply, have the same status as laws in the natural sciences?

  • Can the use of empirical evidence ever allow us to arrive at the truth about the real world?

  • What practical problems does economics try to solve?

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