1MARKET FORCES (3.3) Market Forces

Transcription

1 MARKET FORCES (3.3) 9 Market Forces

2 0 MARKET FORCES (3.3) BEFORE you start this unit (in pencil)... write the key idea of this unit in the centre of the page write what you know about this idea around it and draw lines to them. try and group the ideas together mind-map Mind-maps are very good revision tools. Our minds learn by making patterns. Mind-maps help you to make these patterns and so makes the content easier to learn and remember. AFTER you finish this unit (in pencil)... remove anything that doesn t belong to this unit ensure that things are grouped together appropriately. Move stuff around if needed add any extra ideas that you think are missing

3 MARKET FORCES (3.3) unit overview may the forces be with you!! The more that you read about business and economics, the more you will hear references to the price mechanism and market forces. Both of these phrases refer to how supply (firms) and demand (consumers) interact in markets to use society s scarce resources to produce what consumers demand. This unit introduces the idea of market forces and how they achieve allocative efficiency through or between different markets in the economy. By the end of the unit, you should be able to... o explain how demand curves are derived from marginal utility o explain how supply curves are derived from marginal cost o explain how market forces allocate resources between markets

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5 MARKET FORCES (3.3) 3 topic. demand & marginal utility just one more... If you like it, buy it. That s the general reason for consumers demanding goods and services. If the benefit you get from something equals or exceeds the price you pay... then buy it. This unit looks at how the extra benefit or marginal utility we get from consuming a good or service determines how much or many we will buy, i.e. our demand for that good or service. by the end of this topic, you should be able to... o describe marginal utility o describe the law of diminishing marginal utility o describe the optimal purchase rule o explain the law of demand o identify and describe consumer equilibrium remember - try the exercises and then read the notes to learn what you don t know...

6 4 MARKET FORCES (3.3) Tom loves tomatoes. Read the information below and answer the questions.. Complete the table below to show the utility Tom gets from consuming tomatoes. 2. Use the information from the table to draw Tom s monthly demand for tomatoes on the axes. TOM S UTILITY SCHEDULE FOR TOMATOES Tomatoes (kg/month) Total Utility Marginal Utility ($/kg) uantity (kg/month) 3. Tom s total utility is the same whether he consumes 7 or 8 kilograms of tomatoes. Is this possible? Explain your answer. 4. Is it possible for Tom s total utility to go down as he consumes more of a good or service? Explain your answer. Exercise. Marginal Utility 5. With reference to the Law of Diminishing Marginal Utility, explain why Tom s demand curve is downward sloping. 6. If the price of tomatoes is $0.60 per kg, what is Tom s optimal purchase? Why? optimal purchase: kg Reason:

7 MARKET FORCES (3.3) 5 Over the holidays, Tom likes to do three activities going to the movies, playing golf and wind-surfing. Based on his marginal utility for each product, Tom does one activity per day.. The table below shows the price of each activity and the marginal utility Tom derives from each activity. Use this table and your understanding of consumer equilibrium to work out what Tom will do each day, for the first ten days of his holiday. Day : Day 2: Day 3: Day 4: Day 5: Day 6: Day 7: Day 8: Day 9: TOM S MARGINAL UTILITY SCHEDULE (MU is measures in $) Movies (price = $0) Golf (price = $2) Windsurfing (price = $20) Day 0: 2. The movies are the cheapest holiday activity. Why does Tom not always go to the movies? 3. Tom s sister, Maia, loves eating fresh strawberries over summer. Use Maia s demand schedule below to draw her demand curve for strawberries on the axis to the right. Label this curve D. MAIA S MONTHLY DEMAND FOR STRAWBERRIES uantity Demanded ($/punnet) (punnets / month) 5 2 4½ ($/punnet) uantity (punnets/month) 4. The current market price for strawberries is $3. Show the market price as P and Maia s resulting quantity demanded as. 5. This year, Maia s marginal utility from eating bananas and oranges has increased. Show the impact of this on the graph above. Label your changes appropriately. Exercise.2 Marginal Utility

8 6 MARKET FORCES (3.3) Define the following terms. Check that you can define each term and use it in an appropriate context. ceteris paribus consumer equilibrium law of diminishing marginal utility marginal utility optimal purchase rule 2. At a price of $3 for jellybeans and $4 for chocolates, William cannot decide which packet he should buy next. Which of the following statements is most likely to be correct? a. William receives the same total utility from jellybeans as he does from chocolate. b. William receives the same marginal utility from jellybeans as he does from chocolate. c. William considers that the marginal utility for jellybeans is greater than that for chocolate. d. William considers that the marginal utility for jellybeans is less than that for chocolates. 3. When making purchases the consumers will always try to... a. always buy the cheapest good. b. spend the same amount on everything they buy. c. maximise their total satisfaction. d. buy until marginal utility is maximised. Exercise.3 Marginal Utility 4. The price of Commodity A is $4 and that of Commodity B is $0. If a consumer evaluates the marginal utility of A to be 0 units then she is in equilibrium when the marginal utility of B is... a. 4 units. b. 0 units. c. 25 units. d. 40 units. 5. A fall in the price of DVD s leads to increased sales of DVD s. As a result the... a. marginal utility of DVD s falls. b. total utility obtained from DVD s falls. c. total and marginal utility obtained from DVD s rise. d. marginal utility of DVD s rises. 6. Diminishing marginal utility means... a. as consumption of one product increases, holding all else constant, total utility begins to decrease. b. as consumption of one product decreases, holding all else constant, total utility begins to increase. c. there will be no demand for the product. d. as consumption of one product increases, holding all else constant, total utility increases but at a decreasing rate. 7. Explain why marginal utility falls as people consume more goods or services.

9 MARKET FORCES (3.3) 7 State the consumer equilibrium rule (or formula) Noi should use to ensure she maximises the total utility she receives from purchasing shoes and dresses. 2. Use Table below to determine the quantity of shoes and dresses Noi should purchase to maximise her total utility. Assume each dress cost $200 and a pair of shoes costs $00. a. Number of dresses Noi should purchase: b. Number of pairs of shoes Noi should purchase: uantity of Dresses Table : MARGINAL UTILITY NOI RECEIVES FROM SHOE AND DRESS PURCHASES Marginal Utility ($) uantity of Shoes (pairs) Marginal Utility ($) Look at the changing values of marginal utility in Table and state the law of economics they show. 4. Use the optimum purchase rule (P = MU) to explain why Noi would buy fewer dresses if their price increased. Exercise.4 Optmal Purchase Rule

10 8 MARKET FORCES (3.3) Marginal Utility notes The majority of our decisions are marginal i.e. they are concerned with one more. We tend to think about economic (and non-economic) decisions in terms of one more or not?. e.g. A firm will produce one more good if it produces a profit, i.e. its marginal revenue exceeds the marginal cost. A consumer will buy one more good if the benefit is greater than the price she pays. Many decisions that we make are marginal. Shall I buy one more hamburger? Will I buy a 80Gb mp3 player rather than a 30Gb one? Shall I do one more hour s homework? Decisions are easier when you think of them in marginal terms. Describe Marginal Utility When you buy a good or service, you do it because you think you will get some benefit from it. For example if you buy an ice cream, you will feel less hungry. Another word for this benefit is utility. For the purposes of this analysis, we will measure benefit or utility in terms of dollars. This is a reasonable assumption, as in everyday life we use money as a way of comparing the value of different goods and services. In economics we are concerned with individuals marginal utility. This is the extra benefit that someone gets from buying one more good or service. Marginal utility helps us to work out how much of a good or service an individual consumers will buy. Figure. illustrates this. Marginal Utility ($) Figure.... Marginal Utility Marginal utility (MU) is the extra utility or benefit that a consumer gets from consuming one more unit. As an individual consumes more of a good, his or her MU falls. Measured in dollars, the MU curve is also a consumer s demand curve MU = D uantity Imagine you go shopping and see a shirt for sale. You decide you like it and are prepared to pay $50 for it, i.e. you would get $50 worth of utility (benefit) from it. If the price is $50 or less you will buy it. Having bought one shirt, the question is how much would you pay for a second one? Typically the extra benefit (marginal utility) you get from the second shirt will be less than the first say $40. If the price of the shirts is $40 or less, you will buy that one also. And so this continues for the third and fourth shirts. You will continue to buy more shirts as long as the marginal benefit is equal or greater than the price you have to pay. This information can be used to work out how much of a good or service an individual consumer is willing to buy at different prices. Assuming the consumer has the money to buy the goods then this information shows the consumer s demand for a good or service. If you plot these points with marginal utility on the vertical axis and quantity on the horizontal axis, you get a downward sloping marginal utility curve. As we will see later, the MU curve is also the consumer s demand curve - because it shows how much of a good that a consumer is willing and able to buy at each price. Marginal Utility: The extra benefit gained from consuming one more good or (unit of) service.

11 MARKET FORCES (3.3) 9 Describe the Law of Diminishing Marginal Utility Figure. shows how marginal utility falls as the consumer buys extra shirts. This characteristic of marginal utility is normal and is erferred to as law of diminishing marginal utility. This is an important law of economic behaviour. When combined with the optimal purchas rule it explains why consumers will only demand more if the price falls, i.e. the law of demand. Law of Diminishing Marginal Utility: The extra benefit gained from consuming one more good or (unit of) service falls as we increase consumption. Describe the Optimal Purchase Rule Marginal utility is important because it helps to explain consumer demand, i.e. how much of a good or service consumers will choose to purchase. The optimal purchase rule states that consumers will keep buying more of a good or service up to the point where the price equals the marginal utility of a purchase. The example in Figure.2 shows how based on this rule, we can work out how much of a good or service, a consumer will buy at a given price. Marginal Utility ($) price = $20 MU = D uantity Figure.2... Optimal Purchase Rule If the market price is $20 then this consumer will continue to buy goods until her MU is below that price. In this example, she will buy the first good because her MU exceeds the price. She will also buy the second and third goods for the same reason. She will buy the fourth good because MU = P, i.e. the optimal purchase rule. But she will not buy the fifth good as price exceeds her marginal utility. if the market price was $30 in figure.2, how many shirts would the consumer purchase? why? In this example, the consumer will buy the first shirt because her marginal utility ($50) exceeds to market price of $20. She will also buy a second and third shirt for the same reason. We also assume that she will buy the fourth shirt because her extra benefit, or marginal utility, equals the price. However she will not buy a fifth shirt as her marginal utility is only $0... less than the current market price. Based on the optimal purchase rule, we can therefore determine that at a market price of $20, this consumer will purchase four shirts. Optimal Purchase Rule: Consumers will continue to buy more of a good or service up to (and including) where the price equals their marginal utility, i.e. P = MU.. Explain the Law of Demand Together, the law of diminishing marginal utility and the optimal purchase rule explain the law of demand... i.e. why consumers will only buy more of a good if the price drops, and vice versa. The optimal purchase rule states that consumers will buy up to the point where the price equals their marginal utility. They won t buy more because the extra value (MU) they receive is less than the price they pay. Because marginal utility falls as consumers purchase more (the law of diminishing marginal utility), consumers will only buy more of a good or service if the price drops to match their lower marginal utility. Hence the law of demand... quantity demanded increases when the price of a good or service falls, and decreases when its price rises.

12 20 MARKET FORCES (3.3) Identify and Describe Consumer Equilibrium One problem with the above analysis is how do consumers choose what to buy when the price of different goods and services vary so much? For instance, how does a consumer decide whether they want a new computer, jandals or shirt? Consider the following table which compares the marginal utility for Jack from consuming each of the products shown: uantity Marginal Utility ($) Computer Jandals Shirt Looking at the marginal utility alone, Jack would be better to buy four computers and nothing else. But common sense suggests this doesn t make sense. We need to do is compare his marginal utility to its price. Whichever product gives the highest relative marginal utility (i.e. MU/P) is what Jack will buy first. uantity Computer (price = $ 000) Marginal Utility ($) Jandals (price = $0) Shirt (price = $20) MU MU/P MU MU/P MU MU/P MU 30 =.50 P 20 When we compare the marginal utility to price, we see that the first thing Jack will get the most benefit from compared to its price is a computer but then the next thing he should buy is a pair of jandals. He will then buy a second pair of jandals, before buying either a shirt or a third pair of jandals. Where the relative marginal utility of different goods is equal, Jack would choose either. This point is called consumer equilibrium. Consumer Equilibrium: Where the marginal utility compared to price is the same for all goods or services. = = MU A MU B MU C P A P B P C

13 MARKET MARKET FORCES FORCES (3.3) (3.3) 2 2 topic.2 supply and marginal cost productivity If demand slope downwards to the right because of the law of diminishing marginal utility and the optimal purchase rule... why does supply slope upwards to the right. This topic looks at the law of diminishing marginal return (or the principle of increasing costs) and how this explains the shape of the supply curve... i.e. why firms will only supply more if the price rises. by the end of this topic, you should be able to... o describe the law of diminishing returns (principle of increasing costs) o explain the law of supply remember - try the exercises and then read the notes to learn what you don t know.

14 22 MARKET FORCES (3.3) Patchy Helicopters provides high quality attack helicopters for New Zealand secondary schools. Below is a summary of their marginal costs of production. Assuming Patchy Helicopters lowest average cost of production (i.e. its shut-down point) is $40 000, use the information below to complete Patchy Helicopters Supply Schedule. PATCHY HELICOPTERS Marginal Cost Schedule PATCHY HELICOPTERS Supply Schedule Helicopters Supplied Marginal Cost ($) uantity Supplied At what level of output does Patchy Helicopters start to face diminishing returns? Exercise.5 Supply Schedules and Curves 3. Use the information in the table draw a supply curve for Patchy Helicopters on the graph alongside. ($000) 4. Imagine New Zealand schools are prepared to pay up to $70,000 for their own helicopter, how many helicopters would Patchy Helicopters produce? Show your answer to question 4 on the graph above, indicating the price (P ) and quantity supplied ( ) Patchy Helicopters Supply of Attack Helicopters

15 MARKET FORCES (3.3) 23 Norm s Gnomes designs and creates designer garden gnomes for Auckland homes.. Use the supply schedule below to draw Norm s Gnomes supply curve. NORM S GNOMES Supply Schedule ($) uantity Supplied NORM S GNOMES Supply of Garden Gnomes 2. If the market price for garden gnomes in Auckland is $40, how many gnomes will Norm supply? Show your answer to question 2 on the graph as P and On the graph, show the consequence (P 2, 2 ) of the market price rising to $ With reference to Norm s Gnomes as an example, explain they law of supply... i.e. why do firms supply more if the price of a good or service rises? 6. Norm s costs of production rose by $5 per gnome produced. Show the impact of this on the graph above. 7. With the price of garden gnomes still at P 2, describe how Norm will respond to the increase in his costs of production... and explain why he does this. Exercise.6 Marginal Cost and Supply

16 24 MARKET FORCES (3.3) Supply Analysis Describe The Law of Diminishing Marginal Returns notes In Achievement Standard 3.2 we saw than in a perfectly competitive market, the marginal cost curve is the firm s supply curve, with the starting point depending on whether we are considering the short-run or long-run. Figure.3 below shows the short-run supply curve for a perfectly competitive Figure.3... A Perfectly Competitive Firm s Short-run Supply Curve ($) MC = S SHORT-RUN AC A firm s short-run supply curve is the MC curve above the lowest point on the AVC curve or shutdown point. AVC But why does the marginal cost curve slope upwards to the right? The answer is the Law of Diminishing Marginal Returns, otherwise known as the Principle of Increasing Costs. This law describes a short-run situation where the output of a business is limited by the availability of fixed resources. In the short-run at least one resource (cost of production) is fixed. A firm can expand its output by using more variable resources, but can t change its fixed resources. Initially adding more resources will improve the firm s productivity (i.e. its output grows in relation to its resources). For example the firm may employ extra staff who are able to specialise and therefore work faster. However, eventually the limited fixed resources will slow any growth in productivity. For example the firm may employ extra staff but they can t access the fixed resources. Output may continue to grow, but at slower and slower rates, i.e. diminishing marginal returns occur. This is shown in Figure.4 below. Figure.4... The Law of Diminishing Marginal Returns Imagine a small bakery. Assume it has one oven and employs staff on a casual basis, depending on demand. The oven is a fixed resource (cost), while staff are a variable resource. The table below shows how many loaves the bakery can produce as it employs more staff and the extra output (or marginal physical product) achieved by employing one more staff member. Number of Staff Output (loaves/hour) Extra Output (Marginal Physical Product) As the firm employs more staff, its total output grows. The extra output column shows the change in output resulting from extra variable resources (staff) being added. For the first three workers, total output grows at faster and faster rates... hence the bakery is said to be achieving increasing returns. This typically happens as employing more staff allows them to specialise and increase productivity. However, from the fourth worker on, while the total output is still growing, it does so at slower rates. The marginal physical product starts to get smaller. This typically occurs as the limited number of fixed resources (e.g. the oven) hinders the productivity of variable resources (e.g. the staff). After the third worker, the bakery is said to be facing diminishing returns.

17 MARKET FORCES (3.3) 25 The Law of Diminishing Returns can also be called the Principle of Increasing Costs, as shown in Figure.5 below. This states that to increase output in regular amounts, the extra costs of production eventually get higher and higher. This happens as the productivity of variable resources (e.g. staff) are limited by the availability of fixed resources, e.g. space in a factory, machinery. Figure.5... The Principle of Increasing Costs The following table is exactly the same firm as in Figure.4 but rather than increasing the number of staff in regular intervals, we show the output rising in regular amounts. Output (loaves/hour) Total Cost ($) Extra Cost (marginal cost of producing 00 more loaves) Initially as the firm increases its output, the total cost of production rises... but in smaller and smaller amounts. This is shown in the extra cost or marginal cost column. However, eventually the limited fixed resources will decrease productivity of variable resources and so the total cost will rise in larger and larger amounts, i.e. marginal cost starts to rise. Explain the Law of Supply The law of supply states that firms will supply more, i.e. quantity supplied will increase, as the price of a good or service rises. Why? The answer is as follows: firms will supply a good or service if the price equals (or exceeds) the cost of producing it the marginal cost of producing a good or service rises as output grows due to the law of diminishing marginal returns... THEREFORE... firms will only supply more of a good or service if the price rises to cover the extra (marginal) cost of producing it This idea is shown in Figure.6 over the page. Remember that when we refer to costs, we are talking about economic costs. Economic costs refer to the daily running costs as well as a minimum accounting profit as good as the next best possible income - i.e. the opportunity cost of running the business. So when the price equals the marginal cost of production, this includes a minimum level of accounting profit.

18 26 MARKET FORCES (3.3) Figure.6... The Law of Supply Useful Yachts produces made-to-order yachts. The left-hand table below shows the marginal cost of producing more yachts. Notice that the marginal cost of producing more yachts rises due to the law of diminishing marginal returns / principle of increasing costs. USEFUL YACHTS Cost Schedule Yachts Supplied Marginal Cost USEFUL YACHTS Supply Schedule uantity Supplied Useful Yachts will supply more yachts if the price covers the marginal (extra) cost of producing the yacht. For example, Useful Yachts will produce a 5 th yacht if its customers are willing to pay the marginal cost of $ It will only produce a 6 th yacht (i.e. increase its quantity supplied) if customers pay a higher price that covers the higher marginal cost of $ ($000) 65 Useful Yachts Supply of Luxury Yachts Supply Based on this, we can derive the firm s supply schedule, i.e. how much will the firm produce at various prices, and then draw a supply curve The supply curve slopes upwards to the right to reflect the law of diminishing returns and that firms will only supply more as the price rises to cover their higher marginal cost Note: This supply curve only starts at 3 yachts. This occurs because this is a price above the Useful Yacht s average variable cost curve, i.e. its shut-down point (see AS 3.2)

19 MARKET MARKET FORCES (3.3) topic.3 market forces & resource allocation between markets we aim to please This topic is arguably the most important of the first three achievement standards. It identifies what Adam Smith refers to as the invisible hand, i.e. the interaction of market forces to provide the goods and services demanded by consumers. Market forces, or the price mechanism, are very good at causing firms to change how they use scarce resources to produce what consumers want. This topic describes how these market forces work to switch production from one good or service... to production of another. by the end of this topic, you should be able to... o explain how and why market forces allocate resources between markets o explain how market forces achieve allocative efficiency across an economy remember - try the exercises and then read the notes to learn what you don t know.

20 28 MARKET FORCES (3.3) Over half of the phones sold around the world today are now smart phones. And this percentage is growing as consumers preferences for smart phones grow.. The graphs below show the markets for smartphones and dumbphones. Show the impact of consumers growing preference for smart phones on the market for smart phones. Clearly label your changes. P ($) Smart Phones S D (million) ($) P Dumb Phones S D (million) 2. Explain how the changes you made to the market for smart phones, will affect the supply of dumb phones. Your answer should clearly refer to the concept of opporutnity cost (note: assume ceteris paribus, i.e. no change to the demand for dumb phones) Exercise.7 Smart vs Dumb Phones 3. Show the changes you have described in question 2 on the market for dumb phones. 4. Using smart phones and dumb phones as an example, explain how the price mechanism helps to achieve allocative efficiency across markets.

21 MARKET FORCES (3.3) 29 In the 2000 s growth in the international demand for milk products alongside regulatory changes relating to forestry, meant that the profitability of growing trees dropped significantly in comparison to farmers producing milk.. The graphs below the markets for milk and timber. Show the current equilibrium price (P )and quantity( ) in both markets. ($/M 3 ) Timber S ($/kg) Milk S D D (m M 3 ) (m kg milksolids) 2. Show the impact of growing demand for milk on BOTH markets - ceteris paribus. 3. Clearly explain how an increase in demand in one market (milk) can affect the equilbrium price and quantity in another market (timber). 3. The allocation of resources from producing timber to producing milk took 2-3 years. With reference to the concepts of short-term and long-term, explain why this change took so long. 4. If the price of milk dropped dramatically tomorrow, explain why farmers would not immediately switch back to growing timber. 5. Using timber and dairy products as an example, explain why the full mobility of resources, a characteristic of a perfectly competitive market, is so important for an economy to achieve allocative efficiency. Exercise.8 Timber and Dairy Products

22 30 MARKET FORCES (3.3) Another shift in technology is from laptop computers to tablet computers as consumers prefer smaller, more mobile technology. ($) Tablet Computers S. Why does the supply curve for tablet computers slope upwards to the right? P D 2. Why does the supply curve for tablet computers slope upwards to the right? 3. Show the impact of growing demand for tablet computers on the graph above. 4. Show the impact of growing demand for tablet computers (ceteris paribus) on the market for laptop computers shown below. Exercise.7 Smart vs Dumb Phones 5. Explain, step by step, how the market for laptops shifts from the old to new equilibrium price and quantity. 6. Adam Smith, a famous economist, coined the phrase the invisible hand to refer to the price mechanism or market forces. Using one of the examples from exercises.5 to.7, explain how the invisible hand or price mechanism benefits consumers AND producers. ($) P Laptop Computers S D

23 MARKET FORCES (3.3) 3 Market Forces and Resource Allocation Between Markets notes Explain How and Why Market Forces Allocate Resources Between Markets Having seen how an individual market responds to changes in Achievement Standard 3., we now need to examine how two or more markets operate together. Few, if any markets are completely alone. Changes in one market such as increased demand for a good, will affect other markets. Producers will respond to these changes by allocating resources away from the production of one good to producing another. This happens as firms try to shift resources to the most profitable goods and services. Figure.7 shows how producers in two markets will respond to a change in one market (ceteris paribus). Figure.7... Allocation of Resources Between Markets. Both markets are in equilibrium. MARKET FOR MOTOR BIKES MARKET FOR CARS $ S $ S P P 2. The demand for motorbikes falls. D D... this causes D to shift to the left.... this results in a surplus at P. MARKET FOR MOTOR BIKES MARKET FOR CARS $ S $ S P P D D 2 2 D 2 D surplus continued over the page

24 32 MARKET FORCES (3.3) Figure.7... Allocation of Resources Between Markets (cont d) 3. Motorbike producers will drop the price to shift stock that is not selling.... as the price falls, D will rise.... the fall in price will cause S to fall until it equals D. MARKET FOR MOTOR BIKES MARKET FOR CARS $ S $ S P P P 2 2 D 2 3 D D 4. The price of cars (a related good) is now proportionally higher, making them relatively more profitable to produce. Firms will switch (some) resources from the production of motorbikes to producing cars. MARKET FOR MOTOR BIKES MARKET FOR CARS $ S $ S S 2 P P 2 D D surplus 5. Faced with surplus stock in their showrooms that won t sell at the current price, producers will drop the price of cars until S = D MARKET FOR MOTOR BIKES MARKET FOR CARS $ S $ S S 2 P P 2 P 2 D 2 D The net effect of these changes is that the price falls in both markets, the output of motor bikes has fallen and the output of cars has risen. Firms have shifted some resources from producing motor bikes to producing cars.

25 MARKET FORCES (3.3) 33 In Figure.7 the price of motor bikes affects the market for cars because they are related goods. Car producers could use their resources to also produce motor bikes. Assuming no other products, i.e. ceteris paribus, selling motor bikes is the opportunity cost of producing cars. If the price of motor bikes falls, the opportunity cost of selling cars falls. Opportunity cost is part of firms economic costs. So if the opportunity cost of producing cars falls then car manufacturers marginal cost of production falls... causing supply to shift down or to the right. This analysis can apply to a range of factors that will cause producers to respond to changes in the market and so allocate resources to the goods and services most demanded by consumers. In this way firms respond to changes in consumers demand and markets achieve allocative efficiency. Explain How Market Forces Achieve Allocative Efficiency Across an Economy In Achievement Standard 3., we looked at how an individual market achieves allocative efficiency... when consumer and producer surplus are maximised. We also briefly looked at the idea of allocative efficiency across the economy, which is when all of an economy s resources are used to produce the goods and services that society (consumers) want. And we used a production possibility frontier (PPF) graph to illustrate this. The benefit of markets is that they are very good at responding to changes in consumer preferences. Figure.8 shows the shift in production away from dumb phones to smart phones. This is a shift in production due to changes in consumer demand, and occurs through market forces creating incentives (i.e. more profit) for firms to reduce production of dumb phones and switch the use of these resources to the use of smart phones. Smart Phones 4 3 B Figure.8... Markets & Allocative Efficiency A This PPF graph shows a change in an economy s use of resources. As consumers preference for smart phones increases, the profit from selling them encourages firms to reduce less dumb phones, and instead use resources to produce smart phones. This shift will occur through market forces / the price mechanism. 2 Dumb Phones

26 34 MARKET FORCES (3.3) UNIT Market Forces Unit Content:. Demand and Marginal Utility Describe Marginal Utility Describe the Law of Diminishing Marginal Utility Describe the Optimal Purchase Rule Explain the Law of Demand Identify and Describe Consumer Equilibrium.2 Supply and Marginal Cost The Law of Diminishing Marginal Returns Explain the Law of Supply.3 Market Forces and Resource Allocation Between Markets Explain How and Why Market Forces Allocate Resources Between Markets Explain How Market Forces Achieve Allocative Efficiency Across an Economy (poor) Understanding 2 3 (good) checklist: I have... done a mind-map of the main ideas (before and after I ve done the work) tried (and marked) all of the exercises watched the online videos of this work read the notes and summarised the key ideas in the margins of the pages made (or downloaded from quizlet) flashcards of the key ideas and definitions relevant current events and examples: relevant events and examples for this unit are: I didn t really get the following parts of this unit and I m going to ask to help me with this