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)
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)
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)
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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