Introduction

How to use this book .

1 The basic economic problem

1 .1 Factors of Production 2
1.2 Scarcity and Opportunity Cost 6

2 The allocation of resources

2.1 Economic Systems 12
2.2 How Markets Work 18
2.3 Social Costs and Benefits 28

3 The individual as producer, consumer and borrower

3.1 Money and Finance 34
3.2 Occupations and Earnings 40
3.3 The Role ofTrade Unions 46
3.4 Spending, Saving and Borrowing 50
EXAM GUIDANCE AND PRACTICE 1 56

4 The private firm as producer and employer

4.1 Types of Business Organization 70
4.2 Organizing Production 76
4.3 The Growth of Firms 82
4.4 Competition 86

5 Role of government in an economy

5.1 Government Economic Policy 92
5.2 Types of Taxation 96

6 Economic indicators
6.1 Price Inflation 102
6.2 Employment and Unemployment 106
6.3 Output and Growth 110
EXAM GUIDANCE AND PRACTICE 2 116

7 Developed and developing economies

7 .1 Developed and Less Developed Economies 126
7 .2 Population 130

8 International aspects
8.1 International Specialization and Trade 136
8.2 Balancing International Payments 140
EXAM GUIDANCE AND PRACTICE 3 146

ANSWERS . 155

INDEX .. 171
 Every person has needs and wants. We all have a basic need for
food, clean water and shelter. In addition we may want to eat in
restaurants, drive a car, watch television, play computer games and
use up many other different goods and services.
Resources are used to produce goods and servicesto satisfy all the
different needs and wants we all have. However, resourcesare just
too scarce to satisfy them all. For example, in some areas resources
are so scarce that people are starving and have no clean water to
drink.

Productive resourcesare also known as factors of production.These are:

• Land refers to all natural resources used in production

• Labour is the productive effort provided by people, or human resources

• Capital consists of human-made resources used in the production of other

goods and services,such as tools, machinery, offices and factory buildings.
 The basic economic problem

PRODUCTION
GOODS AND

Production involves combining land, labour and capital to make goods and
services to satisfy the needs and wants of consumers. An entrepreneur is a
person who combines and organizes resources in a firm to produce goods and
services.

• Entrepreneurs have 'business know-how' or enterprise. They are willing

to take risks starting and running firms. Enterprise is often described as the
fourth factor of production.

Entrepreneurs and people who provide their labour to make goods and
services are called producers.

Goods + Services
A Land, labour, capital and enterprise are needed to produce goods and services.

The outputs or products of productive activity are goods and services. People
and organizations that use up, or consume, goods and servicesto satisfy their
needs or wants are called consumers.

Durable consumer goods, such as washing machines, DVD players and cars,
can be consumed over a long period of time.

Non-durable consumer goods are used up quickly or are perishable, such as

many foods and drinks, cosmetics and soaps.

Con sumer services include personal servicessuch as hairdressing and

dentistry, and leisure services including those provided by holiday companies
and cafes.
Revision guide: Economics

.._ Some durable and non-durable consumer goods

Capital goodsare used by firms to produce other goods and services.They

include shops, offices or factory buildings, machinery, vans and trucks.

Semi-finished goodsare also used in the production of other products.

These include component parts such as memory chips for computers, buttons
for clothing and wiring for electrical products, and human-made materials
including plastics, petrol, glass and paper.

Firms also use business services provided by other business organizations

including insurance, banking, transportation and advertising.

PRODUCERS AND
AND SERVICES

Production uses up scarce resourcesto provide goods and servicesto satisfy

the needs and wants of consumers. The using up of goods and services by
consumers to satisfy their needs and wants is called consumption.

Few people will be able to produce all the goods and servicesthey will need or
want. They must therefore trade or exchange with producers of goods and
services. In modern economies most people do this by selling their labour to
firms to earn money in the form of wages.

People then use the money they have earned to buy goods and servicesfrom
other producers. In turn, entrepreneurs use the money they earn from selling
goods and servicesto pay for the scarce resourcesthey need to make them.
 The basic economic problem

EXAM PREPARATION

Below is a list of different factors of production. Which factors would

an economist classify as land, labour or capital? Which of the factors
listed could be used to produce the two products shown 7 Use the table
below for your answers.

'5/\ND (U'5W IN liL/\'5'5) OIL (IN 1'/\INT'5, 1'L/\'5Tll'5)

SLtLW.ll/\L SNlilNSS\Z-'5 OffllS'5
lDMl'UTS\Z-'5 rlN/\Nll/\L /\C.lDUNT/\NT'5
MOBILS TSLS-PHONS'5 '5DLDS\Z-IN&i SQUll'MSNT
1'/\INT '51'\Z-/\YIN&i M/\lHINS'5 T\Z-UC.k':>
W/\TS\Z- WOOD
r/\lTO\Z-Y BUILDIN&i'5 M/\CHINS Ol'S\Z-/\TO\Z-'5
DS'51liNS\Z-'5 C.LS/\NS\Z-'5
COTTON MST/\L ?\Z-S'5'5S'51\Z.DLLS\Z-'5
\Z-UBBS\Z- L/\'5S\Z-'5

Car

Example exam questions

• Explain with the use of examples what is meant by a natural
resource.
• What are factors of production 7 Describe briefly how they might be
used in the production of bread.
• What is the difference between a capital-intensive firm and a labour-
intensive firm?
 REVISION SUMMARY

There are too few productive The problem of resource SYLLABUS

resources to make all the goods allocation is choosing how best to This section will
and servicesthat consumers need use limited productive resourcesto •define the nature of
and want. Scarcity of resources is satisfy as many needs and wants as the economic problem
the basic economicproblem possible and maximise economic (finite resources and
Opportunity cost is the cost of welfare unlimited wants)
choosing between alternative uses The aim of economics is to find • define opportunity cost
of resource the most efficient allocation and analyse particular
circumstances to
of resources. Th · · nt
illustrate the concept
allocation of scare ill
• demonstrate how
s satisfy as many needs and wants as
production possibility
possible curves can be used to
illustrate choice and
resource allocation
• evaluate the
implications of
You have chosen to use two hours of your
particular courses
time today to refresh your knowledge of
of action in terms of
economics and to prepare for your exam. opportunity cost.
You could have used this limited amount ·•· .. ~ - ~.- ; -.-:~ .
of time and your energy to play computer
games or go out with friends instead, but you are giving up the benefit
from these opportunities. This is the opportunity cost of your decision
to revise. You have chosen to study because the benefit of revising
economics to improve your exam performance is greater than the benefit
you could have enjoyed from alternative uses of your time.
In the same way, every society must decide how best to use its resources
for maximum benefit. This is because resourcesare scarce. This is the
basic economic problem.

CONSUMERS AND PRODUCERS MUST DECIDE HO

SCARCERESOURCES
Very few consumers can satisfy all their needs and wants. This is because the
world's productive resources are scarce relative to their needs and wants for
goods and services.
Consumers must therefore choose what goods and servicesthey will consume
and producers must choose what goods and servicesto produce and who to
produce them for.
That is, all societies must choose how best to use their limited resourcesto
satisfy as many needs and wants as they can.
Choosing how best to use scarce resources is the problem of resource
allocation. For example, allocating more productive resourcesto the
production of, say, military equipment will mean fewer resourcesare available
to produce cars and other consumer goods.
 The basic economic problem

RESOURCES

Although resources such as raw materials, land, skilled workers, machinery,

factories and offices are scarce, they can all be used in different ways to make
many different goods and services.

The problem of resource allocation therefore involves making choices and

evaluating 'trade-offs' between alternative uses. Choosing one use means
going without another.

The true cost of something is what you have to give up to get it. The r··ro;·i~;·································:
opportunity cost of a decision to use resources one way is the benefit
look for the
foregone from their next best or highest valued alternative use.
opportunity costs
Recall how your decision to use two hours of your time to study economics Many exam questions
meant you chose to go without the benefit of going out with your friends. describe economic
Similarly, a person who spends a day at the beach may have to forego a day's decisions or actions.
wages. Everything we do has an opportunity cost. These will all involve
trade-offs and
Similarly, using an area of open land to build houses on means the same area opportunity costs. A good
of land is no longer available to grow crops for food. The benefit that could be answer will explain as
derived from the food that could have been grown on the land has been given many as possible.
up. The loss of this benefit is the opportunity cost of the decision to use the · ··
scarce land for housing.

Similarly the labour and capital equipment that was used to build the houses
were not available to make other goods and servicesduring the construction
of the houses.

A An area of land could be used to grow . .. or for housing to provide homes for people ... or for road space so people can travel to
crops to provide food for people to live in work and firms can transport their goods

There are a great many examples of opportunity cost at the level of the
individual consumer, household, employee, firm, government and the
economy. Here are just a few:

e The opportunity cost to a consumer of deciding to buy a new bicycle is the

lost opportunity to buy and benefit from some new clothes or a portable
music player instead
Revision guide: Economics

• A household decides to save $200 in a bank account towards a holiday

next year. This means they will be unable to spend that money on current
consumption
• The opportunity cost of the decision by an employee to give up work will
be his or her lost wages
• $10 billion allocated to building new roads by a government could have
been used to build more schools instead. Alternatively, income taxes could
have been cut. More roads may also result in more car use and pollution

A productionpossibilitycurve (PPC) or production possibility frontier is a

useful way to show the opportunity cost of different production decisions. A
PPC shows the combined maximum possible output of two products
(or groups or products) a firm or even an entire economy can produce with
its existing resources and technology.
For example, the first diagram below shows the PPC for a firm producing
cars and trucks. It can produce a maximum of either 100 cars or 120 trucks
each week with its resources if they are used efficiently. The firm is currently
producing 60 cars and 80 trucks each week with its resources (at point A). To
increase its output of trucks to 100 per week (point B) it must move some of
its resources out of car production. Its output of cars will therefore fall to 50
cars per week. The opportunity cost of an extra 20 trucks per week is therefore
10 cars foregone.

100 100

U)
"Cl
~Q) 0
0 65
Q) Ol
~
©
60
. ©
E 50
o._
~
50 ..
---------------------------------~------- :J
U)
c
co
0 . 0
0

0 80 100 120 0 50 60 80
Trucks per week Capital goods

The second PPC diagram is for an entire economy. Producers can choose
between allocating scarce resourcesto the production of consumer goods or
capital goods. It is currently producing a combination of consumer and capital
goods at point C. The PPC shows that in order to produce an additional 15
tonnes of consumer goods each period the economy must give up 10 tonnes
of capital goods.
 The basic economic problem

THE 'BEST' USE OFSCARCE RESOl.JF{tES\l\/iEW

ECONOMIC WELFARE

Owning and using goods and services can make consumers feel happier,
healthier and even wealthier. Consumers are therefore willing to pay for those
goods and servicesthat satisfy their needs and wants because they value them.

However, some uses of resources may cause dissatisfaction by harming the

natural environment or causing suffering to people or animals. These are
economic bads because they impose costs on others and lower economic
welfare.

The aim of economics is to find the most efficient allocation of resources.The

most efficient allocation of scarce resourceswill satisfy as many needs and
wants as possible. If and when this is achieved the economic welfare of people
will be maximized.
Revision guide: Economics

IMPORTANT THINGS TO REMEMBER

Fill in the missing key words.

_________ are people or firms who need and want goods and
services.

_________ are used to produce goods and services. They are

too scarce to satisfy all consumers' needs and wants.

____ refers to natural resources used in production, such as water,

minerals, oils, plants and animals.

______ is productive effort supplied by people to make goods and

services.

_______ goods are human-made resources, including machinery,

equipment and factory buildings, used to produce other goods and
services.
_____________ organize and combine resources in firms
to produce goods and services.

Productive resources are also known as _______ of

__________ involves using resources to make goods and

services to satisfy the needs and wants of consumers.

_______ consumer goods, for example many electrical items,

tend to last a long time.

________ involves trade in goods and services between

producers and consumers.
___________ _ is the cost of choosing between
alternative uses of scarce resources. Choosing one use will always mean
giving up the opportunity to use resources in another way, and the loss of
goods and services they might otherwise have produced.
A or
frontier shows the combined maximum possible output of two products
or groups of products a firm or an entire economy, can produce efficiently
with its existing resources and technology.
The problem of________ _ involves
choosing how best to use and combine limited productive resources to
satisfy as many needs and wants as possible.
________ _ is maximized in a society when
as many of its needs and wants as possible are satisfied from using and
combining scarce resources in the most efficient way.
· ·
 The basic economic problem

Choose and then mark your answer 5 The total amount of goods and services that
A, B, C or D to each question. can be produced in the world economy will
be:
A determined by the amount of natural
1 A new dam is built in India to provide
resources
hydroelectric power. What is the opportunity
B unlimited
cost to the Indian economy of the dam?
C just enough to satisfy all consumer wants
A the construction and running costs of the
D less than what consumers want
hydroelectric dam
B the cost to consumers of using the
6 In the diagram below what is the opportunity
electricity
cost of increasing the output of meat from
C other goods and servicesthe resources
640 tonnes to 700 tonnes per month?
used for the dam could have produced
instead
D the cost of loans used to finance the Cereals
building of the dam
10001-----

2 Which of the following resources used in the

production of timber would an economist
500 •••••••••••••••••••••••••••
refer to as land? '
A a saw for cutting wood 380 ·····-·-·····-·-·--····--··t..
''
B a forest used to produce timber
C a truck used to transport timber
D a computer used in a timber merchant's
0 640700800
office
Meat
A 120 tonnes of cereal crops
3 Which of the following statements best
B 380 tonnes of cereal crops
describes the process of production?
C 500 tonnes of cereal crops
A an activity that uses scarce resourcesto
D 1000 tonnes of cereal crops
provide any good or service
B an activity that uses scarce natural
resourcesto make goods and services
Now check your answers against those given
on page 155. How well did you do? Make a
C an activity that uses up scarce resources
note of any you got wrong and make sure you
to make a profit
D an activity that uses scarce resources
understand the reasons why before you continue
to make goods and servicesto satisfy
to the next section.
consumers needs and wants

4 Which of the following is an example of a

capital good?
A a shopping complex
B a pair of fashionable shoes
C a DVD player
D money
2 The allocationof resources

REVISION SUMMARY

An economic system determines A market economy will produce a SYLLABUS

how scarce resourcesare allocated wide variety of goods and services This section will
In a market economic system or if it is profitable to do so but only • describe the allocation
market economythe decisions for those consumers with the of resources in market
of consumers and producers will ability to pay for them and mixed economic
determine what goods and services systems
are produced and who they are Market failures can cause scarce ·describe the concept
of market failure and
produced for es to be allocated to uses
eful, inefficient or
u to people and the
!.· ~~~::::'.:::"';' ' !

st
es that people
introduce laws and regulations to
control harmful activities

increase its price. Producing more

could earn producers more profit

Scarce resourcescan be used in different ways to produce

many different goods and services, but they will never satisfy
all our needs and wants.
Every society must therefore choose how best to allocate
their scarce resourcesto the production of goods and
services.
That is, we must decide what goods and servicesto produce,
how to produce them, and who will get them.
How these decisions are made is called an economic
system.
 The allocation of resources

ECONOMIC SYSTEMS DETERMINE HOW SCARCE RESOURCES

ARE USED

An economy is a system of activities involving the production, consumption

and exchange of goods and services. For example, the Spanish economy is the
national economic system in Spain. In turn, the Spanish economy is part of the
European economy along with other national economies in Europe including
France and Germany. Similarly, all national economies together make up the
global economy.

An economic system determines how scarce resources are used. That is, it
addressesthe problem of resource allocation. This involves providing answers
to three key questions.

Should more resources be What tools and machinery Should people in the
allocated to the production will be needed? How many greatest need get the goods
of consumer goods and workers will be required and and services they require?
services and less to the what skills do they need? Is Or should they be provided
building of roads or the it cheaper to employ more to people who can pay the
provision of health care? labour or more machinery? most for them?

0% < less government involvement more government involvement > 100%

MARKET MIXED PLANNED

ECONOMY ECONOMY ECONOMY

There are three main types of economic system depending on how much
government involvement there is in making decisions about the allocation of
resources.

In a totally free market economy there is no role for government and

therefore no taxes or government spending. However, in reality, all market
economies have a government that will also decide how best to allocate some
scarce resources.

The ownership and allocation of scarce resources in a mixed economic

system is split between the private sector (private firms and individuals)
and a public sector (government organizations). The amount of goods and
services provided by the public sector can vary greatly between different
national economies.

During the 1990s the governments of many countries, including China and
Russia, introduced policies that increased the role of the market system in their
economies.

China and Russia (then as part of the Soviet Union) were formerly planned
economies in which their governments owned or controlled the vast majority
of scarce resources and determined what, how and for whom goods and
services were produced. There were no private firms in these economies many
years ago and very little consumer choice.
Revision guide: Economics

Who decides Producers and consumers Producers, consumers and government

what and how to
produce?

Who owns or The private sector The private sector and public sector
controls most scarce
resources?

How are resource Firms use market price signals to identify Same as market economy but the
allocation decisions what goods and services consumers want government also provides some goods
made? and will make a profit and services to those in greatest need

Who are goods and Consumers with the greatest ability to Same as market economy but the
services produced pay for them government may provide some goods and
for? services to people in need

Main advant Wide variety of goods and services Same as market economy plus
available
- government can intervene to correct
As firms compete with each other for serious market failures
profits it encourages them to develop
new and more efficient products and
processes

Main disadvantages There can be serious market failures Same as market economy plus
including
- taxes can be high
- worthwhile but unprofitable products
will not be provided - public sector provision may be inefficient

- harmful goods may be available to buy

CONSUMERS AND PRODUCERS ALLOCATE SCA

A MARKET ECONOMY

In a market economic system, or market economy, producers and

consumers decide what, how and for whom to produce.

The private sector of private firms and individuals own all the scarce
resources. Every firm aims to make as much profit as it can. Profit is the
amount of money a firm makes from selling its goods or servicesat a price
greater than the cost of producing them.

Firms will therefore produce goods and servicesfor consumers with the
greatest willingness and ability to pay for them.
 The allocation of resources

CHANGES IN MARKET PRICES TELL PRODUCERS WHAT

CONSUMERS WANT

The market for a good or service includes all those producers willing and
able to supply it and all those consumers willing and able to buy it, no matter
where they might be located.

Consider the market for cool air conditioners. Consumer demand is increasing
as summer temperatures rise around the world. Producers are therefore able
to charge higher prices and earn more in profit. The increase in price signals to
other producers that demand for air conditioners is rising and producing them
may be a more profitable use of resources than making, say, electric heaters.

In contrast, if consumers are buying less of a particular good or service, its

market price will tend to fall and profits will be reduced. This will force some
firms to reduce their production of the product or even to close down, and
move their resources into the production of other more profitable goods and
services instead.

This is called the price mechanism. In this way, market forces ensure
consumers get what they want and are willing to pay for. That is, the profit »2.2 How Markets Work
motive of firms and the preferences of consumers determine how resources
are allocated in a market economy.

A market economy has a number of advantages due to the price

mechanism:
• it produces a wide variety of goods and servicesto satisfy consumers
wants
• it responds quickly to changes in consumer wants
• it encourages innovations in products and new, more efficient methods
of production because firms will compete with each other to lower their
costs and increase their sales and profit.

MARKET FAILURES CAN MISALLOCATE SCARCE RESOURCE

REDUCE ECONOMIC WELFARE

A market economic system can also have major drawbacks, or market

failures. These occur when markets fail to produce goods and servicesthat
are worthwhile and when markets result in wasteful or harmful activities.

In a mixed economy a government can intervene in markets to correct

market failures. It can organize resources to provide goods and servicesand » 5.1 Government
Economic Policy
can also introduce laws and a legal system to control harmful activities.

To finance public sector activities, governments levy taxes on incomes, on » 5.2 Types of
wealth and on goods and services. Taxation
Revision guide: Economics

Only goods and services that are profitable It can produce merit goods such as
to make will be provided. For example, a education and health care for people,
market economy will not provide education regardless of their ability to pay for them,
or health care for people who cannot afford because all the economy will benefit from
to pay for these services having a healthy and educated population

Other services, such as street lighting, sea It can provide public goods,such as
and flood defences and national parks, will street lighting, sea and flood defences
not be provided: firms would be unable to and national parks, that would otherwise
charge consumers a price according to how be unprofitable for private sector firms to
much they use them or benefit from them provide

Resources will only be employed if it is The public sector can employ people who
profitable to do so. Some people who may otherwise be unemployed and provide
are willing and able to work may be left welfare benefits and payments to people
unemployed and without an income out of work or on low incomes

Harmful goods, such as dangerous drugs Laws can make the production of harmful
and weapons, may be produced and be goods illegal, and high taxes can be
freely available to c ers who want to imposed on others, such as cigarettes, to
buy them reduce their consumption

Some producers may ignore the harmful Laws and regulations can protect the
effects of roduction
eople'

particular good or service and wil

consumers very high prices. These firms are
described as monopolies

Government decisions can also introduce disadvantages to a mixed economic

system:

• High taxes on profits may reduce enterprise and high taxes on wages can
reduce people's incentives to work. Consumers will also have less money
after tax to spend on the goods and servicesthey want

• Regulations can impose significant costs on firms and as a result they will
produce less goods and services, increase their prices or lower the wages of
their workers

• Public sector provision may be inefficient and produce poor quality goods
and services because public sector organizations are not motivated to make
profits

• Government spending may be politically motivated instead of correcting

market failures and improving economic welfare.
 The allocation of resources

EXAM PREPARATION

Look at the newspaper headlines below. What problems do they describe about resource
allocation in a mixed economic system? Write a brief note on each in the boxes provided.

1
Hig~ corporation tax on profits is
forcing m~lti-national firms out of
Indonesia argues a new report

A hospital chain in the United States has agreed

to pay back more than $800m in what has been 2
described as the largest fraud settlement ever. The
company, HCA,was accused of fraudulent billing
and overcharging Medicare, a US government health
programme that provides for millions of poor and
·-elderly Americans /".__ ---1

3
Is Government regulation strangling small businesses?

The Government has introduced new employment legislation

to strengthen employee rights in the workplace. But employers
are becoming increasingly vocal about the negative impact that
these rights are having on the way they interact
with staff and run their businesses.

4
THE French oil giant Total was yesterday ordered to
pay
. a 375,000 million euro fine and 192 m1·11·ion euros
in compensation after a Paris court found the
c~mp~ny responsible for one of Europe's worst-ever
oil spills

RWE npower Britain's fourth-largest energy 5

supplier, fuelled anger over soaring ~ms
yesterday when it reported a 41.4% mcrease
in annual profits.

Congressmen in the Philippines are seeking an

investigation into the alleged misuse of more than
PSObillion in funds for road maintenance, road 6
safety and pollution control. They said a large
part of the money goes to the pockets of corrupt
government officials and contractors. The funds
whose use or misuse they want the House to look
into are collections from the so-called motor
vehicle user's charge

Example exam questions

s Discussthe advantages and disadvantages of a public sector allocating resources.
• What are the advantages and disadvantages of relying more on the market economy?
REVISION SUMMARY

The market demand for a good If demand does not equal supply a SYLLABUS
or service is the total effective market will be in disequilibrium. This section will
demand of all consumers willing Pri will have to rise to reduce • demonstrate the
and able to buy that product an ess o and or price will principle of equilibrium
Market demand curves are have to fall to sell off an excess of price and analyse simple
downward sloping. As price rises, supply market situations with
anges in demand and

0'••••••••00°onoooo•o•••••uOOo.OoOooouoOooOOOooOOoo000••'
0

Rice price rise Why do the prices of ice creams rise during the summer?

Why are the prices of LCD televisions falling?

Why do the prices of vegetables rise following a poor harvest?

Changes in the market prices of goods and servicesin a

market economy are the result of changes in the pattern of
consumer demand and the amount supplied by producers.
 The allocation of resources

DEMAND IS THE
AND SERVICES

The market demand for a particular good or service is the total effective
demand of all consumers of that product.

Consumers want many things but for their demand to be an effective

demand they must have enough money to buy what they want at different
prices. That is, a consumer must have a disposable income they can use to pay
for goods and services.

Disposable income refers to the amount of income people have left to spend
or save after taxes on their incomes have been paid.
The market demand curve for any good or service therefore shows the total
quantity demanded by consumers in a given period of time at every possible
price.

Price per unit In general, market demand curves are downward sloping.
As prices fall, quantity demanded tends to increase.
01

P1 ----------------
As the price of a good or service changes, consumers tend
to move along the market demand curve.
I
v An extension in demand (increase in quantity demanded)
P2
occurs when price falls.
01
-----~ A contraction in demand (decrease in quantity demanded)
0 01 02 occurs when price rises.
Quantity per period

If the market demand for a good or service changes for any reason other than
a change in price it will cause the market demand curve to shift.
Revision guide: Economics

Price per unit Price per unit

p p

0 Q1 Q2 0 Q2 Q1
Quantity per period Quantity per period

A rise in the market demand for a product may be A fall in the market demand for a product may be
caused by: caused by:
• an increase in consumers' incomes, for example, • a fall in consumers' incomes, for example, due
due to rising employment to rising unemployment

• a reduction in taxes on incomes • an increase in taxes on incomes

• a rise in the price of substitutes • a fall in the price of substitutes

• a fall in the price of complements • a rise in the price of complements

• consumers' tastes or fashions change in favour • consumers' tastes or fashions change in favour
of the product of other products

• increased advertising of the product • product advertising is cut back or banned

• a rise in the population • a fall in the population

• other factors, for example, a hot summer can • other factors, for example, a ban on smoking in
boost demand for cold drinks and summer public places may reduce demand for cigarettes.
clothes.

Demand for a normal good will tend to rise as incomes rise. However,
demand for inferior goods will tend to fall as incomes rise. For example, as
consumers become better off they might prefer to travel by taxi rather than by
bus.

Taxi and bus travel are also substitutes. Goods and servicesare substitutes
if they are similar and compete to satisfy the same consumer demand. For
example, butter and margarine are close substitutes for many consumers. A
rise in the price of one may result in a rise in demand for the substitute.
 The allocation of resources

Complementary goods or servicesare in joint demand. This means they are

consumed together such as cars and petrol, bread and butter, mobile phones
and phone calls. A rise in the price of one will often lead to a fall in demand
for both.

SUPPLY IS THE WILLINGNESS OF PRODUCERS TO PROVIDE GOODS

AND SERVICES

Supply is the amount of a good or service a firm is willing and able to make
and sell to consumers at different prices. The market supply for a particular
good or service is therefore the total quantity supplied by all firms producing
that product.

The market supply curve

Price per unit
for any good or service shows
the total quantity supplied
S1
by firms in a given period of
P2 ---.-- ----- --- ---- --------- ---- time at every possible price.

In general, market supply

P1
curves are upward sloping. As
prices rise quantity supplied
tends to increase. This is
S1 because firms expect to earn
more profits at higher prices.
---~
0 o ca As the price of a good or
Quantity per period service changes, its producers
tend to move along the
market supply curve.

An extension in supply (increase in quantity supplied) occurs when price

rises.

A contraction in supply (decrease in quantity supplied) occurs when price

falls.

If the market supply for a good or service changes for any reason other than a
change in price it will cause the market supply curve to shift.

A rise in supply will shift the market supply curve outwards to the right and
shows that firms will now supply more than they did before at every possible
price.
A fall in supply will shift the market supply curve inwards to the left and
shows that firms will now supply less than they did before at every possible
price.
Revision guide: Economics

Price per unit Price per unit

82 81

p p

0 Q1 Q2 0 Q2 Q1
Quantity per period Quantity per period

A rise in the market supply of a product may be A fall in the market supply of a product may be
caused by: caused by:

• a fall in the cost of employing factors of • a rise in the cost of employing factors of
production, for example, due to falling wage production, for example, due to increased hire
costs or lower prices for materials charges for machinery

• an increase in resources, for example, from new • a fall in the availability of resources,for
sources of raw materials example, a shortage of skilled labour

• technical progress and improvements in • technical failures, such as a cut in power

production processesand machinery supplies or mechanical breakdowns

• an increase in business optimism and profit • a fall in business optimism and profit
expectations expectations become more pessimistic

• the government pays subsidies to producers • the government withdraws subsidies and/or
and/or cuts taxes on profits increasestaxes on profits

• other products become less profitable • other products become more profitable

• other factors, such as a good summer to boost • other factors, such as wars and natural
crops of fruit and vegetables. disasters.

THE MARKET PRICE OF

DEMAND AND SUPPLY

The market price of a good or service will be determined where the market
demand equals the market supply. At this price consumers are willing and able
to buy exactly the same amount of the product that firms are willing and able
to supply.
 The allocation of resources

~.~······················································\
A market is in equilibrium when demand equals supply because the market
price (Pe) and quantity traded (Oe) between consumers and producers will be
TOP TIP
Always label your
stable.
diagrams

Whenever you draw a

The market will be in a disequilibrium at any price above or below the
graph or diagram you
market price because demand will not equal supply and the price will have to
should always label it
change until they do.
clearly with a title, labels
At a price (P1) above the for axes and the units
market price, there will be they use, for example,
Price per unit an excess supply because $(millions) or Number of

the quantity supplied by Employees (thousands),

01 S1
etc.
<excess supply> firms will exceed the quantity
P1 ------------ demanded by consumers.
Price will have to fall to
encourage consumers to buy
Pe -----------------------·
up the excess supply.
At a price (P2) below the
P2 -------------- market price, there will be
.
< excess.demand >
an excess demand because
the quantity demanded by
S1 01 consumers will exceed the
0 Qe
quantity supplied by firms. As
Quantity per period a result the price will have to
rise to contract demand and
encourage firms to extend
their supply.

Market prices will change when changes in market demand or market supply
occur.

Price per unit

01 81 82
81

P1
P2
P2 ---·-·----------
P1

81 82 01
02
0 0 Q1 Q2
01 02 Quantity per period
Quantity per period

As demand rises from D1 to D2, market price rises As supply rises from S1 to S2, market price falls
from P1 to P2 and more is traded at 02. from P1 to P2 and more is traded at 02.
As demand falls from D2 to D1, market price falls As supply falls from S2 to S 1, market price rises
from P2 to P1 but less is traded at O 1. from P2 to P1 but less is traded at 01.
Revision guide: Economics

PRICE ELASTICITY
DEMAND TO PRICE

Firms will want to know what will happen to their revenues from sales of their
goods and servicesfollowing a change in their price. A government will also
wish to know what will happen to tax revenues if they change indirect taxes
such as sales tax and value added tax (VAT) levied on goods and services.
An increase in price may not result in an increase in revenue. This will depend
on what happens to consumer demand.

• If a small change in price causes a larger change • If a small change in price causesa smaller
in the quantity demanded change in the quantity demanded

• If an increase in price causes a decrease in • If an increase in price causesan increase in

revenue revenue

• If the demand curve is relatively flat • If the demand curve is relatively steep

• If PEd greater than 1, e.g. • If PEd less than 1, e.g .

$2.00 800 $1600 $2.00 500 $4800

$2.50 400 $1000 $2.50 400 $5000

% change in quantity = 400 I 800 = 50% % change in quantity = 100 I 500 = 20%
% change in price= $0.50 I $2.00 = 25% % change in price= $0.50 I $2.00 = 25%
PEd = 50% I 25% = 2.5 PEd = 20% I 25% = 0.8

Demand for a product will be price elasticif: Demand tends to be price inelasticif:
• it has a large number of substitutes, such as • it has few substitutes, for example, travel into
different types of detergents city centers by train at peak travel times

• it is expensive, such as many luxury goods • it is a low cost product, such as a newspaper

• consumers do not need to buy it frequently, so • it is a necessaryitem consumers need to

they have the time to search for alternatives if purchase regularly, such as gas and electricity
price rises. supplies and many foods.
 1 ne auocanon or resources

Price per unit Price per unit

D PEd = 50%/25% = 2 D
PEd = 20%/25% = 0.8
$2.50 $2.50

$2.00 '
$2.00 ------------------~------
D
D

0 400 800 0 400 500

Quantity per period Quantity per period

Price D Price Price D

P2 -------------
P2 PEd = 1
PEd = 0 PEd = oo
P1 1----------~ D
P1 -------------
D

0 Quantity per period 0 Quantity per period 0 Quantity per period

A Some special demand curves

PRICE ELASTICITY
PRICE CHANGES

An increase in the market demand for a product wil tend to push up its
market price. As the market price rises, the quantity supplied will extend, but
by how much?
Revision guide: Economics

• If a small change in price causes a much larger • If a small change in price causesa smaller
change in the quantity supplied change in the quantity supplied

• If the supply curve is relatively flat • If the supply curve is relatively steep

• If PEs is greater than 1 • If PEs is less than 1

Price per unit

Price per unit
PEs = 10%/100% = 0.1 8
PEs = 400%/100% = 4
8 $5.00 ---------------------------------
$5.00

$2.50 $2.50

8
8
0 200 1000 0 900 990
Quantity per period Quantity per period

Supply of a product will be price elastic if Supply of a product will be price inelastic if
• the change in supply is measured over a • the time period is too short for producers to
long time period during which producers can make big changes in production
increase or decrease production easily
• there is a shortage of resourcesavailable to
• resourcesare readily available to expand supply expand supply in response to an increase in
in response to an increase in price. price.

A government can levy

an indirecttax on the
Price per unit
price of a good or service
82
to reduce its market
supply. The tax increases $15 -----------------------------
the cost of production
$5 tax
t
and reduces the profits of 81
firms.
$10
The tax is added to price 82
and therefore shifts the
market supply curve up
by the amount of the tax.
This has the same effect 81
as a fall in supply and
market price will tend 0 Q antity per period
to rise. This will contract
demand for the product.
 111!:! auucauon ur resources

A subsidy is a payment to
producers to reduce their costs
of production. This will encourage
them to increase market supply.
The market supply curve
Price per unit
will move down by the 81
amount of subsidy per unit
produced. This is the same $15 - ·1 · -- - - - - - - - - - - - - - - - - - - - - - - -
as a rise in supply. Market $5 subsidy 82
price will tend to fall as
a result and demand will $10
extend.
However, governments
81 t
often use subsidies to keep
costly and inefficient firms
running in their countries 82

to protect employment and

their balance of trade. 0 Quantity per period

90 130 30 50
80 120 40 60
70 110 50 70
60 100 60 80
50 90 70 90
40 80 80 100
30 110
REVISION SUMMARY

Private firms aim to maximize their

profit, measured as the difference
between their private costs of
The total economic benefit to
society of an economic activity,
or social benefit, includes the
(:.:1 : ~: 11
• define private and social
i
production and their private private benefits enjoyed by those costs and benefits
benefits or revenues undertaking it and any external • discuss conflicts of
A private firm may not take benefits it creates for others interest in relation to
account of the external costs An economic use of resources these costs and benefits
of its activities from pollution or will create more social benefits in the short term and
long term through
the destruction of the natural than social costs and increase
studies of the following
environment. Other firms and economic welfare. Society will be
issues:
people incur these costs better off if more resourcesare
- conserving resources
Decisions by c sumers to use used in this way versus using resources
goods and s es can also An uneconomicuse of - public expenditure
impose external costs on others, resources will create more social versus private
for example, if they consume loud costs than social benefits and expenditure.
music or drop litter lower economic welfare. Society "••••••'••••••'•~•••••-•••••••••••~••••••~•••••••••••••uoo••''

of an economic activity, or so
cost, includes the private
incurred by firms and cons
undertaking the activity a
external costs on others

Do you like to play loud music? If you do, imagine the impact
this might have on your neighbours.
Similarly, how would you feel if people threw litter in your
garden or a local firm dumped toxic waste into a nearby river?
All these activities have negative impacts, or external costs on
others.
Producersand consumers often fail to take account of the
external costs of their activities and this can result in an
uneconomic use of scarce resources in an economy.
 The allocation of resources

ECONOMIC ACTIVITIES INCUR BOTH PRIVATE AND EXTER

AND BENEFITS

Imagine a firm making paints. It pumps the waste chemicals and dyes used in
its paints into a nearby river. This kills the fish and the river can no longer be
used for swimming.
The total economic costs and benefits of this decision are listed in the tables
below.

Paint production $million External costs and $million

per year benefits per year
Private costs $10 m Lost revenue of fishing $4 m
- wages industry
- purchases of
materials Detriment to local $1m
- machinery hire residents unable to go
charges swimming
- factory and office
rent Cost of cleaning up the $2m
- costs of electricity, polluted river
insurance,
transport etc Total external costs $7m
Private benefits $15m
- sale Value to other firms $1m
of trained chemical

The firm making and selling the paints aims to maximize its profit. This is the
difference between its private costs of production and its private benefits,
or revenues.
The firm does not pay the external costs it creates, nor does it compensate
the firms or people badly affected by them. They are called external costs
because others must pay them.
Similarly, the firm receives no payment for the external benefits it creates.
Other people and firms enjoy external benefits. The paint maker may have
spent money training its workers to become skilled chemical engineers.
These workers may then leave and work for other firms which become more
productive and profitable as a result.

An external cost arises when the economic activities of one group have a
negative impact on others and when that impact is not taken into account or
paid for by those creating it.
An external benefit arises when the economic activities of one group have
a positive impact on others and when that impact is not taken into account
or paid for by those who benefit.
Revision guide: Economics

THE SOCIAL COST OF AN ECONOMIC ACTIVITY I

PRIVATE AND EXTERNAL COSTS

Notice how the total external costs exceed the profit of the private firm
making paints and the external benefits. The owners of the firm are better off
producing paints because they make a profit but, overall, society is worse off.
That is, economic welfare is reduced by the activity.
A use of resources is uneconomicwhenever its social cost exceeds its social
benefit, as in the example above. Society will be better off - or economic
welfare higher - if the same resourcesare used to produce something else
instead.

Social cost: the total economic cost of an activity to a society, including

private c ·ncurred by firms nsu ers undertaking and
external ing tho olved in th
Social benefit: the total eco it of an activity to a society, is the
sum of its private benefits and external benefits.

Only when the social benefit of an activity exceeds its social cost will that
particular use of resources be an economicuse of resources and worthwhile
for a society. Economic welfare is increased by the activity.
If an economic activity creates significant social benefits, society will be better
off having more of it. For example, a society may benefit from having more
parks and opens spaces, but private firms may not find it profitable to provide
them. Government may provide them instead.

CONSUMERS' DECISIONS ALSO CREATE EXTERN

BENEFITS

The decisions of consumers to enjoy certain goods or servicescan also create

external costs and external benefits for others. For example, smoking cigarettes
can cause health problems for other people, and dropping litter will mean
others have to spend money and time cleaning it up.
Every year billions of tonnes of waste
bottles, cans, paper and food are
discarded by consumers all over the
world. Scarce resourceswill have been
used up producing these products, and
scarce land then has to be used to bury
the waste. Waste therefore involves a
big opportunity cost. The same resources
could have been used to produce
something else instead.
Alternatively, we could create less waste » 1.2 Scarcity and
if we consume fewer goods and services. Opportunity Cost
This will conserve scarce resources but
will satisfy fewer of our needs and wants,
and fewer people may be employed. The
opportunity cost of conserving resources
is the goods and servicesgiven up.
 The allocation of resources

GOVERNMENTS CAN INTERVENE IF AN ACTIVITY CREATES

SIGNIFICANT EXTERNAL COSTS OR BENEFITS

A government can try to encourage more economic uses of resources in the

following ways:
» 2.2 How Markets Work
• Taxes can increase the private costs of activities that create external costs.
For example, some countries have introduced 'green' taxes on waste
disposal and energy. Firms and consumers can avoid paying these taxes if
they cut their waste and energy use. Cigarettes, cars, petrol and air travel
are also taxed in many countries to reduce demand for them
• Subsidies can be paid to firms to encourage them to move resources to
activities that create more external benefits. For example, subsidies are
often paid to firms to train workers and to recycle waste
• Laws and regulations can make some economic activities illegal. Firms
or consumers found breaking these rules may have a to pay a fine or go to
jail. For example, it is illegal in many countries to dump untreated waste,
while others have banned smoking in public places.

EXAM PREPARATION

Each day millions of people all over the world travel to and from their place of work by car. Many could
have used public transport instead. Continue to list and compare the most likely private and external
costs and benefits of these choices. Overall, which mode of travel do you think will use less petrol,
cause less congestion and create fewer harmful emissions?

Spending on petrol

Revenues for bus and train

companies

Example exam questions

• Discuss, using concepts of social costs and social benefits, why a government might wish to
subsidize public transport but tax private motorists.
e Explain what is meant by (i) an opportunity cost and {ii) a social benefit. Discuss whether it is
possible to apply these concepts to the provision of health care by a government.
Revision guide: Economics

A is an economic system in
which the allocation of resources is determind by the actions of firms and
consumers through the exchange of goods and services.

In a market economy, the actions of producers and consumers are guided

by market price signals. This is called the _
---------

------ -------- occur when markets fail to

provide efficient outcomes.

Ina _ the allocation of resources

is determined by the actions of a private sector and a public sector of
government organizations.

A market is in _ where market demand is

exactly equal to market supply.

Products in joint demand are called _

-----

A product that can replace a consumer want for similar product is a

----------
- _ _ _ _ _ is the amount of a product firms are willing and able to
produce at different prices.

----- ----------
of _
measures the responsiveness of demand to a change in the price of a
product.

If a small change in the price of a product causes a much bigger change in

demand for it then demand is relatively price .

The profit of a firm is the difference between the _

_ _ _ _ _ of production and its private benefits or revenue from the
sale of its goods or services.

An is a negative impact of an
economic activity on others that is not paid for by those who created it.

The of an activity, or total economic

cost to society, will include the private costs paid by firms and consumers
undertaking it and any external costs on others.

A use of resources is and will reduce

economic welfare if it creates more social costs than social benefits.
· ·
 The allocation of resources

Choose and then mark your answer A, B, C or D 4 What is an external cost of building houses in
to each question. a city centre 7
A the cost of compensating residents for
1 A mixed economy has: mud on local roads
A an agricultural and an industrial sector B the cost of city centre traffic congestion
B consumer goods and capital goods caused by the building works
C a financial sector and an industrial sector C the cost of obtaining planning permission
D a private sector and a public sector D the cost of building materials

2 During the 1990s many countries in Eastern 5 The diagram shows the market for bananas.
Europe transformed from planned economies The market equilibrium is X. What will be
to more market oriented economies. Which the new market equilibrium if there is a bad
of the following best describes this change? harvest?
A more public sector control of resources Price of bananas
B increased use of the price mechanism to
allocate resources 02 01 81 82 83
C less private sector ownership of resources
D increased use of price controls

3 A firm publishes and sells books. The diagram

shows a shift in the supply curve from S 1 to
52.
0 Quantity of bananas
per period
Price of books
81 82
6 What information will you need to plot a
market demand for a product?
A the equilibrium market price of the
product
B the number of suppliers of the product at
each price
C the number of consumers who would
0 Quantity of books like to buy the product at each price
per period D the quantity each consumer would be
willing and able to buy at each price

What could have caused the shift in supply?

Now check your answers against those given
A a fall in subsidies paid to book publishers
on page 155. How well did you do? Make a
B a fall in the price of paper
note of any you got wrong and make sure you
C a rise in the income of consumers
understand the reasons why before you continue
D a rise in the wages of the firm's workers
to the next section.
3 The individualas producer,consumerand borrower

REVISION SUMMARY

Money is a generally accepted Commercial banks have retail SYLLABUS

medium of exchange and a good branches in most modern shopping This section will
centres. They offer a wide r e of

I banks, stock
es, commercial

· - - ·

Try to imagine a world without money. How would you buy all the
different goods and servicesyou needed or wanted? How would you be
paid for work?
Many years ago before the widespread use of money, most people had to
swap goods and servicesthey produced. This type of exchange is called
barter.
For example, a person who grew a lot of oranges could swap their surplus
oranges with someone who produced a lot of cheese or clothing. But
how many oranges should be exchanged for 1 kg of cheese, or a pair of
trousers? And what if people with spare cheese or clothes didn't want
oranges? No wonder many people either had to go without or be as self-
sufficient as they could.

Barter therefore has a number of problems:

• Fixing a rate of exchange between every different type of good and
services is very difficult
• Exchange can only take place when there is a double coincidence of
wants. That is, two people must each want the good the other person
has.
 The individual as producer, consumer and borrower

Money therefore enables people to specialize in different occupations and

use the money they earn to buy the different goods and services they need
and want from other producers who accept money in exchange.

MONEY MAKES TRADEdFtEXCHANGE ODE RN

ECONOMIES

Money overcomes the problems of barter and allows people, firms,

governments and entire countries to specialize and trade with each other.
However, to do this money must be:
., A widely accepted medium of exchange
Exchange is simple if everyone accepts money in payment for things they
provide. A person can be paid money for their labour and then use this
money to buy goods and services
., A reliable measure of value
Money provides a single measure of value that can be used for all goods
and services. Every type of good or service will have an easily recognized
market price in terms of money
., A good store of value
Many goods or services are difficult to save because they are too big or
perish quickly. Money usually provides a good store of value unless there is 6. 1 Price Inflation
very rapid price inflation. A given amount of money will buy less and less
over time if prices rise quickly
• A means of deferred payment
Because money can be saved and will hold its value, many firms allow their
customers to pay for a good or service in instalments over time or at later
date.
People in different countries at different times in the past have used various
objects as a medium of exchange, including teeth from animals, shells, small
flat stones and gold rings. However, to fulfil the functions above a money must
possessthe following characteristics: