Sunday, December 29, 2013

Introduction to New Topics in Unit 1: Markets in Action (Edexcel IAL)

This posting is dedicated to international candidates who are affected by the changes in the London Edexcel A-Level to the Edexcel International A-Level (IAL) programme. As all of you are fully aware of, there are major revamps not just to the curriculum but also in terms of assessment. Even the name for all the four units is different. Let us have a look:
Unit 1: Markets: How They Work and Why They Fail (GCE)
Unit 1: Markets in Action (IAL)

Unit 2: Managing the Economy (GCE)
Unit 2: Macroeconomic Performance and Policy (IAL)

Unit 3: Business Economics and Economics Efficiency (GCE)
Unit 3: Business Behaviour (IAL)

Unit 4: UK and the Global Economy (GCE)
Unit 4: Developments in the Global Economy (IAL)

The new Unit 1 is pretty much the same as the legacy Unit 1 except with few additional topics. They are the Theory of Utility, Consumer Behaviour, Functions of Money, Price Elasticity of Demand for Labour, Price Elasticity of Supply for Labour

We will go through all this topics part by part

Theory of Utility
Utility is the satisfaction or enjoyment derived from the consumption of a good or service. According to this theory, when we consume more of a good or service, our total utility will continue to increase. However it will come to a point where our total utility is maximized and additional one more unit of output consumed will no longer contribute any satisfaction to our existing total utility. If we continue to consume despite our total utility has been maximised, it is not surprising to see that the total utility starts to fall.

Let me give you some real life applications. If you are fasting in the holy month of Ramadhan, that means you are refrained from having any meals or drinks in between. There will be no late breakfast, lunch or tea time for you until break-fasting dinner/ ‘iftar’. Now let me ask you, what is the feeling soon after you break? I am pretty sure that you will say it is very fulfilling. Now, let just assume that you decide to go for another round. What is the feeling of having your ‘second’ dinner? You might go for it but the fact is that your second round will not be as fulfilling as your first, although you still gain some utility out of it. If you are asked to go for third serving, you will most probably reject it because you know what will happen after that. In this case, your total utility is maximised at the second serving

Let us consider another example. If you are quite frequent to bars and clubs, what is the normal late night scene? Yes, you are right! There will always be some people throwing out after having so much wine. These are just two examples. In fact, the theory of utility can be applied in almost all situations. The fact that I am trying to preach here is that, by having more and more of something, our total utility will increase. However, our marginal utility, which is the additional utility due to extra one unit of consumption, will start to decline. If we continue to consume an output beyond our maximum total utility, the marginal utility will become negative. The relationship between these two can be best considered in the following diagram

Criticisms of the utility theory
1. First, utility is an extremely subjective issue. Every individual has different level of utility/ satisfaction even from the consumption of the same good or service and so, it is rather difficult to attach a value. Bear in mind, the value of utility between different individuals can vary so much

2. Second, the theory of diminishing marginal utility (MU) does not apply to all everything. Items such as money will probably have a constant positive/ rising marginal utility. The same goes for some rare collectibles or limited edition items. The more the collectors have it, the greater will be the pride and satisfaction

3. Next, it is assumed that consumers will always try to maximise their utility when they purchase a good or service. This is not entirely true as many purchases in the real world are more of habitual reasons. As an example, some people do not switch their energy suppliers while some still loyal with their mobile phone service providers despite there are financial gains from doing so. Bear in mind, habits will lead to inertia. Inertia here means, you feel ‘heavy’ to switch. Clearly, there are other issues in task such as brand loyalty, the trouble to find out the additional benefits and others

Diminishing marginal utility and demand curve
Let us try to analyse both cases separately. According to the theory/ law of demand, if the price is high, then the quantity demanded is low. Likewise, if the price falls, then the quantity demanded will increase. Since both are inversely related, this explains why the demand curve slopes downward from left to right

Now, let us consider the same issue from another angle. When we purchase a good or service, the first unit will always give us the highest level of satisfaction and as such, we are prepared to pay more. When we consume the second unit, it would give us less utility and since the need or desire is lesser than before, we are prepared to pay less. The same goes for the third and subsequent units where our desire will be lower and lower than before and so we are going to pay lesser and lesser than the previous units

From these two cases, we can clearly see that the inverse relationship between price and quantity demanded can actually be explained using the law of diminishing marginal utility. In fact, price (P) = marginal benefit (MB) = marginal utility (MU). Please refer to the diagram below for better illustration

Functions of money
This is another new topic making its way into the Edexcel IAL. When the word ‘money’ is used, the first thing that all of us will see is the dollar, pound, euro, renminbi or even the dong that we use to pay for all the bills. Yes, you are not wrong, except that the function of money is not just limited to that. In fact, economists have generally classified the roles of money into four:

1. Medium of exchange. Money has taken many forms through the ages. Our ancestors used shells, wheels, beads and even animals like cows in exchange for other goods and services. Such process is known as barter, which of course, is only possible if there is double coincidence of wants. You have what I want, and I have what you are looking for, and if this condition is fulfilled, then we can trade. Everything is based on mutual need. However, if there is no proper solution to this, then men would have to travel days and nights just to look for the right things. Luckily, money solves all these problems because they are generally accepted as a legal tender. All sections within the society sell goods and services in exchange for money and with that, they buy goods and services that they want

2. Unit of account. With this feature, money has also facilitated modern business and trade. In the past, barter system makes it almost impossible for business transactions to take place. On top of requiring both sides to have mutual needs, there is also the issue how much is sufficient to trade. For an instance, to pay for a cow, how many oranges are needed? Is it 1000 or 1200 or some other amounts? If a person wants to pay with chicken instead, then how many will do? Is it 100 or 110? Without a generally accepted uniformity in measurement, trade is doomed to fail almost all times. In the present, value of all goods and services can be easily measured. For an example, £10 per metre, £200 per kilogram and so forth

3. Storage of value. In order to function as a medium of exchange, money must also be able to hold its value over the time, or else it will not be accepted as a mode of payment. In one or two countries, their own currency has seized to become an effective medium of exchange such as the Zimbabwe. During hyperinflation, prices will increase at an unbelievable level. A 200 trillion Zimbabwean dollar may be able to purchase a crate of beers but two weeks down the road, a person may only be able to purchase a bottle of beer instead. Since its buying power shrinks so fast, people generally lose confidence with its ability to hold value and therefore, US dollar, Botswana pula and South African rand are accepted as a mode of payment there. Clearly, money itself may not be able to hold value well compared to properties, artworks, stamps and rare collectibles but it is certainly favoured due to its liquidity. In some colleges in Zimbabwe, petrol is also accepted as a mode of payment

Zimbabwe maybe an isolated extreme case. In normal circumstance, although money is able to store value, its value will still decline due to inflation. Somehow, it is a much better alternative than say, pear or banana which will probably go rot in couple of days

4. Standard deferred payment. The modern economy set up is based on credit and credit is paid in the form of money only. It allows trades and economic growth to take place. If money does not serve this function then car firms, housing developers, furniture shops and many other forms of business to go bankrupt. Without the credit facility, how many of us that can actually pay the car, house and all the nice sofas by cash? It is because of such facility, a win-win situation has been created for all the three sides. Banks get more money if they lend to you because at the end of the day, you would have ended up paying more. You benefit too and your living standards will increase because you get to own a nice 40 inch Samsung plasma TV, drive your dream car and many more. For the business, they get to sell more units and that means more profits. In short, it serves a buy-today-and-pay-tomorrow function

Price elasticity of demand for labour

The concept is exactly the same like the PED for a product market. Some firms are wage sensitive while some are wage insensitive. Wage sensitive means, a small increase in wages will lead to a large fall in the quantity demanded for workers. On the other hand, wage insensitive means, even if wages increase significantly, the quantity demanded for workers will not fall by much. These are some of the determinants:

1. Labour costs as a percentage of total costs. If labour costs already form a large proportion of total costs, then a further rise in wages would definitely put more pressure onto firms. In this case, demand for workers is elastic. On the other hand, if labour costs are just about 10% of total costs, a rise wages is unlikely to have much effect. In such circumstance, firms are likely to give in and wouldn’t mind if labour costs now rise to 12% of total costs. From these two, it is quite obvious that labour-intensive industries have high PED for labour while capital-intensive industries have low PED for labour

2. The ease with which labour can be replaced by capital. In some industries, labour and capital are viewed as substitutes. If wages continue to increase and firms can easily replace human workers with robots, then the demand for workers is elastic. Firms are not willing to pay. On the other hand, some jobs must be done manually instead of mechanisation and in case if wages increase, firms have no choice but to pay for whatever is the increase. Demand for labour is wage insensitive

3. Elasticity of demand for the product. An increase in wages will lead to higher production costs which in turn raise the price of the product. This causes the demand for the product to contract. However, if the product has high PED, that means its quantity demanded will fall significantly and therefore more workers will be laid off. In this case, we say that demand for labour is elastic. On the other hand, if the product has low PED such as healthcare, education and oil sector, then its quantity demanded will not fall by much and therefore, doctors, teachers and oil engineers get to keep their jobs. Demand for labour is inelastic

4. Time period under consideration. In the short run, PED for labour is inelastic. The most likely reason is, employers are bound by employment contracts. Even if the wage rate increases, firms cannot do anything but to pay, or else may face legal consequences. In the long run however, demand for workers will be more elastic as firms by then would have discovered more cost efficient ways to produce e.g. capital-intensive or hire more skilled workers at reasonable rate and others

Price elasticity of supply of labour
In this case, we are the suppliers and we behave like ‘firms’. If the wage rate is attractive, then more of us will want to supply our labour and if wage rate is low, then fewer of us would want to supply ourselves for employment. It works exactly the same like a typical supply curve. However, there are also situations where the wage rates may be high but not many of us can actually supply ourselves for employment. In this case, supply of labour is inelastic. On the other hand, there are certain occupations where so many people offer themselves for employment despite only a minimal increase in wage rates. Therefore, supply of labour in this case is elastic

1. Qualifications and skills. The higher are the job requirements, the fewer will be the number of people who will actually supply themselves for employment. For an example, a large increase in the wages paid to heart surgeons will not have much effect onto the quantity supplied of labour. This is especially true in the short run because it will take years to gain the requisite qualifications and experience

2.Level of employment. If the economy is near or already in full employment, then supply of labour is likely to be inelastic. High wage rates may be offered to entice workers but the fact is that, quantity supplied of labour of will not increase by much. If a firm still insist of getting more workers, then perhaps the wage rate has to increase by a much larger quantum to encourage the workers who are currently employed elsewhere to switch jobs. However, this will only further increase the costs of production. Likewise is true if the economy has spare capacity

3. Mobility of labour. The easier workers find it to change jobs or move from one location to another, the easier it will be for firms to recruit more workers by raising the wage rate. Therefore, occupational or geographical mobility makes the supply of labour elastic. Some areas in the UK have been identified to face acute shortage of nurses and teachers. Despite measures like higher pay and relocation subsidy is provided, still not many people are interested to supply themselves for employment. Reason being, costs of living far outweigh the incentives provided. Job seekers find it not worthwhile to go all the way to places like South East or 

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