Economics is the study of how scarce resources are used to satisfy unlimited wants. It asks what, how and for whom to produce.
1.1 Scarcity, choice and opportunity cost
Scarcity is the fundamental economic problem: limited resources cannot satisfy unlimited wants, so choices must be made. Needs are essential for survival; wants are desires beyond that.
Choices are made by consumers (maximising satisfaction), producers (maximising profit) and governments (improving welfare). Economic agents are consumers, producers and the government.
Basic questions: what to produce, how to produce it and for whom.
1.2 Economic methodology
| Statement | Meaning | Example |
|---|---|---|
| Positive | can be tested against facts | "A rise in income tax cuts hours worked." |
| Normative | involves value judgements and opinion | "Income tax should be cut." |
Economists build models using ceteris paribus (all other things being equal), to isolate one relationship. Models are simplifications; they use assumptions that may not hold. Economics uses data and theory, and economic policy involves trade-offs and value judgements; economists often disagree.
Economics is a social science: it studies human behaviour using evidence and models but cannot run perfectly controlled experiments. The time period matters: in the short run at least one factor is fixed; in the long run all factors can vary; in the very long run technology and the structure of the economy can change too.
1.3 Factors of production
| Factor | Reward | Examples |
|---|---|---|
| Land | rent | all natural resources: soil, oil, water, forests |
| Labour | wages | human effort, mental and physical |
| Capital | interest | man-made goods used to produce others: machinery, factories |
| Enterprise | profit | organising the other factors and taking risk |
Quantity and quality of each factor affect output; education raises the quality of labour; technology raises the quality of capital. Mobility of factors (how easily they move between uses) matters for adjustment: geographical and occupational mobility of labour.
Division of labour is breaking production into separate tasks, each done by a different worker; specialisation is a worker, firm or region concentrating on what it does best. Together they raise productivity and output (workers get skilled, less time is lost switching tasks), but work can become boring, workers less flexible, and the whole process depends on every link. Human capital is the skills, knowledge and health of workers, built up by education and training; physical capital is man-made equipment and buildings.
1.4 Resource allocation in different economic systems
| System | Who decides | Features |
|---|---|---|
| Market economy | individuals and firms through the price mechanism | private ownership, profit motive, competition |
| Planned (command) economy | the state | public ownership, central plans |
| Mixed economy | both | private and public sectors; the state provides some goods and regulates |
The price mechanism
Prices signal scarcity: a rise shows a good is scarce, encouraging producers to supply more and consumers to buy less; a fall does the reverse. It rations goods and allocates resources to the most valued uses. Advantages of a market: efficiency, consumer sovereignty, choice, incentives and innovation. Disadvantages: market failure, inequality, no provision of public goods, short-termism.
Planned systems: can direct resources to priorities and reduce inequality, but lack price signals, incentives, efficiency and choice, and need much information.
Mixed economies try to combine efficiency with equity; the balance between market and state differs across countries.
1.5 Production possibility curves
A production possibility curve (PPC) shows the maximum combinations of two goods (or goods and services) that can be produced with all resources fully and efficiently employed.
- A point on the curve: productive efficiency, full use of resources.
- A point inside: unemployed or inefficiently used resources.
- A point outside: unattainable now.
- The slope measures opportunity cost: moving along the curve means giving up one good for the other.
- A bowed-out (concave) curve shows increasing opportunity cost because resources are not equally suited to both goods; a straight line shows constant opportunity cost.
Shifts: the PPC shifts outwards with more or better resources, technology or education (economic growth) and inwards with war, disaster or resource depletion.
1.6 Classification of goods and services
| Classification | Meaning |
|---|---|
| Free goods | no opportunity cost: unlimited (air) |
| Economic goods | scarce, with an opportunity cost |
| Private goods | rivalrous (use stops others) and excludable |
| Public goods | non-rival and non-excludable: street lighting, defence: the free-rider problem means the market does not provide them, so the state does |
| Merit goods | under-consumed by the market because people undervalue the benefits: education, healthcare |
| Demerit goods | over-consumed because people undervalue the costs: tobacco, alcohol |
Consumer and capital goods: consumer goods satisfy wants directly; capital goods are used to produce other goods. Durable and non-durable goods differ by lifespan. Goods are tangible; services are intangible.
Merit and demerit goods arise partly because of imperfect information: consumers do not know or ignore the full benefits of a merit good (such as the long-term gain from education) so they under-consume it, and do not appreciate the full harm from a demerit good (such as smoking) so they over-consume it.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.
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