Microeconomics looks at the decisions of individual decision-makers: households, workers and firms, and how they interact in markets.
3.1 Money and banking
Money
Money is anything generally accepted as payment for goods and services. It exists to solve the problems of barter (swapping goods directly needs a "double coincidence of wants").
Forms: coins and notes (cash), bank deposits (money in accounts, used with cards and transfers), digital money (mobile wallets and electronic transfers).
Functions of money:
- Medium of exchange: accepted in payment.
- Measure of value (unit of account): prices are stated in money, so goods can be compared.
- Store of value: money can be saved and spent later (though inflation reduces its value).
- Method of deferred payment: allows buying now and paying later (credit and loans).
Characteristics of good money: acceptable, durable, portable, divisible (into small amounts), uniform, limited in supply (scarce, so it keeps its value), and hard to counterfeit.
Banks
Central bank (for example the State Bank of Pakistan or the Bank of England): the government's bank; issues notes and coins; manages the country's money supply and interest rates (monetary policy); acts as banker to the government and to commercial banks; lender of last resort to banks in difficulty; regulates the banking system; manages the country's foreign currency reserves.
Commercial banks: provide accounts (savings and current), loans and overdrafts, mortgages, currency exchange, safe storage and payment services. They make a profit by charging a higher interest rate on loans than they pay on deposits. They are important because they channel savings into investment, create credit, and make payments easy.
3.2 Households
A household is a person or group living together who make spending decisions. Households can spend, save or borrow.
| Influence | Effect |
|---|---|
| Income | higher income means more spending and more saving; lower income may mean borrowing |
| Rate of interest | higher rate: saving more attractive, borrowing costlier, so less spending; lower rate: more borrowing and spending, less saving |
| Confidence | if households expect a secure job and rising income, they spend and borrow more; when confidence falls (fear of unemployment) they save more |
| Age | young people spend and borrow (education, housing); middle-aged people may save for retirement; the elderly spend savings |
| Culture | traditions and attitudes towards saving, debt and spending vary (some cultures save more, some religions discourage interest) |
3.3 Workers
Choice of occupation
People choose jobs for wage factors (pay, bonuses, overtime) and non-wage factors: job satisfaction, hours and holidays, job security, working conditions, promotion prospects, location, qualifications needed, status, fringe benefits (pension, healthcare).
Wage determination
The wage in a labour market is set by the demand for labour (from firms) and the supply of labour (from workers), as in any market:
- Demand for labour is a derived demand: firms demand workers because of the demand for the product they make. It depends on productivity and the price of the good (higher demand for the product raises demand for labour).
- Supply of labour depends on the wage offered, qualifications and training needed, working conditions, and population.
- Trade unions negotiate pay and conditions for members (collective bargaining). Their bargaining power is greater when the workers are skilled and scarce, membership is high, and the demand for the product is strong. They can raise wages above equilibrium, but may reduce employment.
- Government policy affects wages: the national minimum wage (NMW) is a legal minimum set above the equilibrium wage for low-paid jobs. Advantages: raises the income of the low paid, reduces poverty and encourages work. Disadvantages: may cause unemployment (a surplus of labour, since firms want fewer workers at the higher wage), higher costs and prices.
Diagram: for the NMW draw the labour market with wage on the vertical axis and quantity of labour on the horizontal. Draw the NMW as a horizontal line above equilibrium; the gap between supply and demand at that wage is the surplus of labour (unemployment).
Differences in wages
| Reason | Effect |
|---|---|
| Demand and supply of labour | scarce skills in high demand earn more (surgeons); jobs many people can do earn less |
| Relative bargaining strengths | strong unions or powerful professional bodies raise pay |
| Discrimination | unequal pay for equal work (for example between men and women, or between ethnic groups) lowers some workers' pay |
| Government policy | the NMW, public sector pay, taxes |
These influence wages depending on the level of skills (skilled workers earn more), the economic sector (primary workers in agriculture are often lower paid than tertiary sector professionals), and discrimination.
Mobility of labour
- Occupational mobility: ability to change jobs or skills. Improved by training and education; reduced by lack of skills and age.
- Geographical mobility: ability to move to where the work is. Helped by transport, information, cheaper housing; reduced by family ties, high housing costs and language and culture.
Consequences of greater mobility: lower unemployment (workers move to jobs), more efficient use of labour and higher output, wages evened out, but may cause depopulation of some regions and pressure on housing and services in others.
Division of labour
Division of labour (worker specialisation) is the splitting of production into separate tasks, each done by a specialist worker.
| Advantages | Disadvantages |
|---|---|
| workers become skilled and faster, so productivity rises | boring and repetitive work, so low motivation |
| saves time moving between tasks | workers' skills become narrow, so they find it harder to change job |
| lower costs and prices, higher output | dependence: one stage's delay stops the whole process |
| use of machines is easier | may cause unemployment if the task is replaced by a machine |
3.4 Firms
Different types of firms
- By sector: primary (extracts natural resources: farming, mining), secondary (manufacturing and construction), tertiary (services: banking, education, transport).
- Private-sector firms are privately owned and aim to make profit. Public-sector firms are owned by the government (state-owned) and often aim to provide a service or protect jobs.
Small and large firms
| Small firms | Large firms | |
|---|---|---|
| Advantages | personal service, flexible, quick decisions, close to customers, can serve niche markets | economies of scale, can afford new technology and research, more market power, can raise finance more easily |
| Disadvantages | higher average costs, difficult to raise finance, more likely to fail, little market power | diseconomies of scale, may be impersonal, slow to change, may abuse market power |
Mergers
A merger is when two firms join to form one.
| Type | Meaning | Example | Advantages | Disadvantages |
|---|---|---|---|---|
| Horizontal | firms at the same stage of production in the same industry | two supermarkets | economies of scale, more market share, less competition | may create a monopoly with higher prices, job losses |
| Vertical | firms at different stages of production in the same industry | a car maker and a tyre maker, or a supermarket with a farm | secure supplies or outlets, lower costs | integration problems, reduces suppliers' independence |
| Conglomerate | firms in different industries | a food company and a telecom company | spreads risk (diversification) | managers may lack knowledge of the new industry, may be inefficient |
Economies and diseconomies of scale
- Internal economies of scale arise within the firm as it grows: purchasing (bulk discounts), technical (larger machines), managerial (specialist managers), financial (cheaper loans), marketing (advertising costs spread) and risk-bearing.
- External economies of scale arise from the growth of the whole industry in an area: a skilled labour force, specialist suppliers, better infrastructure, and shared research and training.
- Internal diseconomies of scale arise when a firm becomes too large: poor communication and coordination, low morale and slow decision-making. External diseconomies: when an industry becomes too concentrated in one area: congestion, higher wages and rents, pollution.
ATC diagram: average total cost (ATC) is drawn as a U-shaped curve with output on the horizontal axis and cost per unit on the vertical axis. As output increases, ATC falls (economies of scale) to a lowest point, then rises (diseconomies of scale). The bottom of the U is the most efficient output.
3.5 Firms and production
Demand for factors of production
Firms demand factors of production because they are needed to produce goods; the demand is derived. It depends on:
- demand for the product (higher demand for the product raises the demand for the factors)
- price of the factors (if labour becomes costly, firms may use more machines)
- availability of the factors
- productivity of the factors (more productive factors are in greater demand).
Labour-intensive and capital-intensive production
| Labour-intensive | Capital-intensive | |
|---|---|---|
| Meaning | uses more workers than machines (for example a hand-made furniture shop) | uses more machinery (a car factory) |
| Reasons for | cheap labour, a personal or skilled service, small market | high wages, large-scale production, repetitive tasks, modern technology is available |
| Advantages | flexible, personal touch, lower set-up cost, creates jobs | high output, consistent quality, lower unit costs in the long run |
| Disadvantages | lower output, higher wage costs, more mistakes | high set-up cost, job losses, breakdowns, needs skilled technicians |
Production and productivity
- Production is the total output produced.
- Productivity is output per unit of input (for example output per worker per hour).
Labour productivity = output ÷ number of workers. A firm can increase production by employing more workers without increasing productivity.
Influences on production and productivity: skills and training, technology and capital, motivation and working conditions, management, and division of labour.
Effects of investment: investment in capital (machines and technology) usually raises productivity (and then production and potential income); in the short run it costs money and in the long run lowers unit costs.
3.6 Firms' costs, revenue and objectives
Costs of production
| Term | Definition |
|---|---|
| Fixed cost (FC) | costs that do not change with output (rent, insurance) |
| Variable cost (VC) | costs that change with output (raw materials, piece-rate wages) |
| Total cost (TC) | FC + VC |
| Average fixed cost (AFC) | FC ÷ output |
| Average variable cost (AVC) | VC ÷ output |
| Average total cost (ATC) | TC ÷ output (= AFC + AVC) |
Diagram: fixed costs are a horizontal line (the same at all outputs). Variable cost and total cost slope upward as output increases; the total cost line starts at the fixed-cost level (it is the fixed cost plus the variable). AFC falls continuously as output rises (the cost is spread over more units); ATC and AVC are U-shaped.
Revenue
| Term | Definition |
|---|---|
| Total revenue (TR) | price × quantity sold |
| Average revenue (AR) | TR ÷ quantity (= price) |
Sales and revenue: more sales raise revenue if price stays the same; the effect of a price change depends on PED (see chapter 2).
Objectives of firms
| Objective | Meaning |
|---|---|
| Survival | staying in business (typical for new firms or in a recession) |
| Profit maximisation | making the greatest possible profit (typical of private firms) |
| Growth | increasing size or market share (for economies of scale and power) |
| Social welfare | aims for society's benefit (public-sector firms, charities and social enterprises) |
3.7 Types of markets
Competitive markets
Characteristics: many firms, many buyers, similar products, easy entry and exit, and full information. (Diagrams and perfect or imperfect competition theory are not required.)
| Advantages | Disadvantages |
|---|---|
| lower prices and more choice for consumers | firms may have low profits, so less to spend on research |
| higher quality and efficiency because firms must compete | some firms fail, causing job losses |
| firms respond to consumers' wants | waste through duplicated advertising and small-scale production |
Effect of having many firms: lower price, better quality, greater choice, lower profit for each firm.
Monopoly markets
Characteristics: one firm (or one that dominates) with significant market power, barriers to entry (high start-up costs, patents, control of resources, legal protection). (Diagrams are not required.)
| Advantages | Disadvantages |
|---|---|
| economies of scale so costs and perhaps prices could be low | higher prices, restricted output and less choice |
| high profits can fund research and development | less incentive to be efficient or improve quality |
| useful for natural monopolies (water, electricity networks) where competition would be wasteful | may exploit consumers and workers |
Effect of having only one firm: higher price, less choice, quality may be lower, higher profit.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.