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 = $\frac{\text{percentage change in quantity demanded}}{\text{percentage change in price}}$

  • 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 = $\frac{\text{percentage change in quantity demanded}}{\text{percentage change in income}}$

  • 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 = $\frac{\text{percentage change in quantity supplied}}{\text{percentage change in price}}$

  • 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?