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Economics Study and Revision Guide Third Edition

Economics
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 My revision planner
Countdown to my exams 6
Introduction 7

AS LEVEL TOPICS
1 Basic economic ideas and resource allocation
1.1 Scarcity, choice and opportunity cost 11
1.2 Economic methodology 12
1.3 Factors of production 14
1.4 Resource allocation in different economic systems 17
1.5 Production possibility curves 20
1.6 Classification of goods and services 23
2 The price system and the microeconomy
2.1 Demand and supply curves 27
2.2 Price elasticity, income elasticity and cross
elasticity of demand 35
2.3 Price elasticity of supply 41
2.4 The interaction of demand and supply 43
2.5 Consumer and producer surplus 48
3 Government microeconomic intervention
3.1 Reasons for government intervention in markets 52
3.2 Methods and effects of government intervention in markets 53
3.3 Addressing income and wealth inequality 59
4 The macroeconomy
4.1 National income statistics 62
4.2 Introduction to the circular flow of income 64
4.3 Aggregate demand and aggregate supply analysis 66
4.4 Economic growth 70
4.5 Unemployment 73
4.6 Price stability 76
5 Government macroeconomic intervention
5.1 Government macroeconomic policy objectives 84
5.2 Fiscal policy 84
5.3 Monetary policy 91
5.4 Supply-side policy 93
6 International economic issues
6.1 The reasons for international trade 97
6.2 Protectionism 102
6.3 Current account of the balance of payments 104
6.4 Exchange rates 108
6.5 Policies to correct imbalances in the current account
of the balance of payments 111

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AS Level exam-style questions and answers 113

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 My revision planner

A LEVEL TOPICS
7 The price system and the microeconomy
7.1 Utility 124
7.2 Indifference curves and budget lines 127
7.3 Efficiency and market failure 130
7.4 Private costs and benefits, externalities and social costs
and benefits 134
7.5 Types of cost, revenue and profit, short-run and
long-run production 141
7.6 Different market structures 150
7.7 Growth and survival of firms 159
7.8 Differing objectives and policies of firms 163
8 Government microeconomic intervention
8.1 Government policies to achieve efficient resource
allocation and correct market failure 168
8.2 Equity and redistribution of income and wealth 175
8.3 Labour market forces and government intervention 178
9 The macroeconomy
9.1 The circular flow of income 185
9.2 Economic growth and sustainability 191
9.3 Employment/unemployment 197
9.4 Money and banking 201
10 Government macroeconomic intervention
10.1 Government macroeconomic policy objectives 212
10.2 Links between macroeconomic problems and their
interrelatedness 212
10.3 Effectiveness of policy options to meet all
macroeconomic objectives 214
11 International economic issues
11.1 Policies to correct disequilibrium in the balance
of payments 221
11.2 Exchange rates 224
11.3 Economic development 228
11.4 Characteristics of countries at different levels
of development 234
11.5 Relationship between countries at different levels
of development 237
11.6 Globalisation 241
A Level exam-style questions and answers 245

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 AS LEVEL

Basic economic ideas and

1 resource allocation
1.1 Scarcity, choice and opportunity cost
The fundamental economic problem and scarcity
» Scarcity refers to the fact that at any moment in time, the output that an
economy is able to produce will be limited by the resources and technology KEY TERMS
available. People’s wants and needs, however, will always exceed the resources wants: items that
available to satisfy them — in other words, these wants and needs are unlimited. are not essential for
This is known as the fundamental economic problem. survival (e.g. a new car
» As a result of this condition of scarcity, choices must be made. or television)
» In all economies, therefore, there is an inevitability of choice at all levels of needs: items that are
decision making — at the level of the individual, the firm and the government. essential for survival
(e.g. food or shelter)
This focus on choice stresses the need to recognise the implications not only of
choosing one thing, but also of not choosing something else. Opportunity cost is resources: the inputs
the benefit forgone from not choosing the next best alternative. An example is available to an economy
using a piece of land for farming purposes rather than building a factory on it. for use in the production
of goods and services
economic problem:
STUDY TIP a situation where
It is important that candidates fully understand the difference between a want and a there are not enough
need, and can clearly demonstrate this understanding to the examiner. resources to satisfy all
human needs and wants
opportunity cost: the
KEY SKILL benefit forgone from not
Application: an example of a want would be a new car or television and an example of a choosing the next best
need would be food or shelter. alternative

The need to make choices at all levels

As a result of the condition of scarcity, choices must be made. This could be at the
level of:
» individuals
» firms
» governments

The nature and definition of opportunity cost, arising

from choices
The focus on choice stresses the need to recognise the implications not only of
choosing one thing, but also of not choosing something else. This is known as
opportunity cost.

STUDY TIP
Candidates sometimes define opportunity cost as the benefit that is forgone (or
sacrificed) as a result of taking a decision. But it is not the result of any random choice;
it is the cost of the next best alternative forgone.

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 KEY CONCEPT
Scarcity and choice: the fundamental problem in economics is that resources are
scarce and wants are unlimited, so it is always necessary to make a choice between
competing uses for the resources and there is always an opportunity cost in making
this choice.

The basic questions of resource allocation

The emphasis on choice focuses on three basic economic questions:
» what to produce KEY SKILL
» how to produce Problem solving:
» for whom to produce understanding the
potential missed
opportunities forgone by
STUDY TIP economic agents when
Candidates should emphasise the importance of needing to make a choice as a result choosing one policy
of the condition of scarcity. Although choice can apply to various areas of economic over another allows for
activity, these three economic questions are the most fundamental ones. better decision making.

The three basic economic questions are solved in different ways in various
economies — in other words, resource allocation can be approached through
different systems or mechanisms, as section 1.4 of this chapter shows.

NOW TEST YOURSELF

1 Explain what is meant by the ‘economic problem’.
2 Analyse why ‘opportunity cost’ is such an important concept in economics.

1.2 Economic methodology

Economics as a social science
A social science can be defined as the scientific study of human society. Can
economics be regarded as a social science?
» Economics is social in the sense that it studies different aspects of human
behaviour and, in particular, the choices that humans make.
» Economics is a science in the sense that it uses an organised system of theories
and facts capable of making verifiable predictions.
» Economics can therefore be regarded as a social science because it uses scientific
methods to establish theories that can help explain the behaviour of individuals,
groups and organisations in societies.

NOW TEST YOURSELF

3 Discuss to what extent economics should be described as a ‘social science’.

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 1 Basic economic ideas and resource allocation

Positive and normative statements

It is important in economics to be able to distinguish between two different types
of statements — positive statements and normative statements.
» A positive statement is one that can be checked against the facts to decide KEY TERMS
whether it is true. positive statement: a
» A normative statement, on the other hand, reflects the norms or values of the statement that is factual
person expressing the statement — such a statement will involve a value and objective
judgement and will reflect someone’s personal opinions. Normative statements normative statement:
often include the words ‘should’ or ‘ought to’. The distinction between facts and a statement that
value judgements is therefore very important in economics. is subjective and
expresses a value
judgement
STUDY TIP
Candidates should understand that economics is one of the social sciences, so positive value judgement: an
statements play an important role in the subject, offering an objective approach, opinion that reflects a
whereas, in contrast, normative statements are more subjective and are reflections of particular point of view
value judgements.

REVISION ACTIVITY
Read an economics article in a newspaper or a magazine and select three
positive statements and three normative statements.

The meaning of the term ‘ceteris paribus’

» Although economics is one of the social sciences, with many aspects of the
subject involving scientific analysis, it is not really possible to study human KEY TERMS
behaviour under laboratory conditions. ceteris paribus: a
» However, economic theory does assume that certain aspects of human behaviour Latin term that literally
can be held constant. means ‘other things
» This assumption of ceteris paribus, that other things are equal, means that being equal’
economists can analyse one aspect of human behaviour at a time. For example, in economic law: an
this way it has been possible to put forward economic laws of demand and economic theory put
supply. These economic theories have been put forward in relation to both forward by economists
microeconomics and macroeconomics. (e.g. the laws of demand
and supply)

STUDY TIP microeconomics: the

study of the behaviour
Candidates should appreciate that it is virtually impossible to keep all variables
of relatively small
constant, and this is why economists use the concept of ceteris paribus to indicate the
economic units
idea of ‘everything else being held constant’. This idea can be brought into a number of
(e.g. particular
answers, such as showing the relationship between changes in the price of a product
individuals, households
and changes in the demand for that product. If ceteris paribus applies, all other
or firms)
possible influences, such as changes in income, can be assumed to be constant.
macroeconomics: the
study of economics
at the national and
REVISION ACTIVITY international levels

Consider whether, without the concept of ceteris paribus, it would be possible

to regard economics as a social science.

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 The importance of the time period
Economists, when analysing economic behaviour, distinguish between three
different time periods: KEY TERMS
» Short run: this refers to that time period in which only certain factors of short run: the time
period when it is not
production (factors of production are covered in section 1.3 of this chapter) can
possible to change
change. These are known as ‘variable factors’. In the short run it is not possible all of the factors of
to change the ‘fixed factors’. For example, in the short run it may be possible to production
change labour, but the same capital will need to be used.
long run: the time
» Long run: this refers to that time period when the inputs of all factors of
period when it becomes
production can be changed — for example, it will be possible to vary both possible to change
labour and capital in the long run. It is not possible to define exactly how long all of the factors of
the short run or the long run is because it will vary depending on the particular production
circumstances.
very long run: the time
» Very long run: this refers to that time period when supply conditions can change period when technical
because of technical progress. In both the short run and the long run, technical progress is no longer
progress is assumed to be held constant. In the very long run, however, technical assumed to be constant,
progress can change — for example, as a result of a new invention in a particular as is the case in the
industry — and this will have an effect on the supply conditions in that short run and the long
industry. run, and the conditions
of supply in an industry
can be affected, e.g.
KEY CONCEPT by the impact of a new
Time: economic conditions change in different time periods, such as the short run, the invention
long run and the very long run. Individuals, firms, markets and governments are able
to respond to these changes in different ways depending on the time frame.

1.3 Factors of production

The nature and definition of factors of production
Production in an economy can take place in three sectors:
» Primary sector: this is the extractive sector, where minerals are taken from
the ground, and is concerned with production in areas of an economy such as KEY TERMS
farming, fishing, forestry, mining and quarrying. primary sector:
» Secondary sector: this is the manufacturing and construction sector, working production that takes
place in agriculture,
with the resources that have been extracted in the primary sector, and is
fishing, forestry, mining,
concerned with areas of an economy such as car production and the construction quarrying and oil
of airport runways. extraction
» Tertiary sector: this is the services sector and is concerned with wide areas of
secondary sector:
economic activity such as banking, insurance, tourism, teaching, medicine and
production that takes
the law. place in manufacturing,
construction and energy
NOW TEST YOURSELF tertiary sector:
production that takes
4 Explain, with the aid of examples, why production in an economy consists of place through the
a primary sector, a secondary sector and a tertiary sector. provision of services

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 1 Basic economic ideas and resource allocation

There are four factors of production:

» Land: this refers to all the natural resources that can be used in the process of
REVISION
production. It can include farmland, forests, lakes and rivers and all the mineral ACTIVITY
deposits of a country, such as coal or oil.
» Labour: this refers to all the human input into the process of production. It refers Analyse the changes
not just to the people themselves, but to their skills, training, education and in the primary,
qualifications. It can also be referred to as ‘human capital’ or ‘intellectual capital’. secondary and
» Physical capital: this refers to the human-made aids that can be used in the tertiary sectors as
process of production. It can refer to equipment, machinery and factories. a country becomes
more economically
» Enterprise: this refers to the factor that brings the other factors of production
developed.
together to produce products. The individual who combines the other factors of
production, and takes a risk in doing so, is an entrepreneur.

KEY TERMS
land: the factor of production that includes all the gifts of nature, or natural resources,
that can be used in the process of production (e.g. minerals, forests and the sea)
labour: the factor of production that includes all the human effort that goes into the
process of production, both mental and physical
capital: the factor of production that includes all the human-made aids to production
(e.g. tools, equipment and machinery)
enterprise: the factor of production that refers to taking a risk in organising the other
three factors of production
entrepreneur: the individual who takes a risk in combining the factors of production

REVISION
STUDY TIP ACTIVITY
Candidates often confuse the use of the term ‘capital’ as a factor of production with
another use of the term to refer to money. It is important that these two meanings of Analyse the
the term are carefully distinguished. contribution of
the four factors
of production
to a particular
NOW TEST YOURSELF industry, such as
car production or
5 Analyse why the factor of production, capital, makes such a vital agriculture.
contribution to the process of production.

The difference between human capital and physical

capital
» Human capital refers to the human component of production — that is, the
talent, knowledge, abilities, training, education and skills of the labour force. KEY TERMS
» Physical capital refers to the non-human resources used in the production of human capital: the
goods and services — for example, the tools, equipment, plant, buildings and skills, knowledge and
machinery. experience possessed
by a population in terms
STUDY TIP of their value or cost to a
business or an economy
Candidates often confuse the terms ‘human capital’ and ‘physical capital’. It is
important that these two terms are clearly distinguished. physical capital: the
tangible, human-made
objects that a business
uses to produce
goods and services
(e.g. tools, machinery
and equipment)

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 The rewards to factors of production
The rewards to the factors of production are as follows:
» Rent: the reward to land.
» Wages or salaries: the reward to labour.
» Interest: the reward to capital.
» Profit: the reward to enterprise; many enterprises aim for profit maximisation.

KEY TERMS
rent: the price paid for the use of land
wage: the reward to labour based on the number of hours worked multiplied by an
hourly rate of pay
salary: the reward to labour on an annual basis
interest: the reward for parting with liquidity; the reward to capital for the use of the
human-made aids to production
profit: the reward to enterprise, defined as the difference between total revenue and
total costs

Division of labour and specialisation

Specialisation refers to a process of concentration on a particular aspect of
production: KEY SKILL
Application: Adam
» A car assembly line is a good example of the way in which a manufacturing process Smith pointed out that
can be broken down into a sequence of specific tasks. Workers will concentrate on, the process of producing
or specialise in, these particular tasks, giving rise to a division of labour. pins involved 18 specific
» One of the first studies of this process was by the Scottish economist Adam operations. If one
Smith, who described in his book The Wealth of Nations (1776) how division of person did all of these,
that person would be
labour in a pin factory enabled a great many more pins to be produced than if
able to produce 20 pins a
each worker tried to do everything him- or herself. day. However, if division
The concept of specialisation is also discussed in the context of international trade of labour was applied,
in Chapter 6, section 6.1. it would be possible for
each worker to produce
4,800 pins a day.
KEY TERMS
specialisation: the process whereby individuals, firms and economies concentrate on
producing those products in which they have an advantage
REVISION
division of labour: the way in which production is divided into a sequence of specific
tasks which enables workers to specialise in a particular type of job
ACTIVITY
Adam Smith: one of the founding fathers of economics (1723–90) and author of Discuss whether
The Wealth of Nations, published in 1776 the advantages of
division of labour
always outweigh its
disadvantages.
The role of the entrepreneur in contemporary
economies
Entrepreneurs play a crucial role in contemporary economies, performing two key
functions:
» Organisation: entrepreneurs are responsible for organising and coordinating the other
factors of production — land, labour and capital — to produce goods and services.
» Risk: entrepreneurs take a risk in performing this organisation and coordination
function; this arises from the uncertainty that will be a feature of any initiative
they take. Although there are many famous entrepreneurs in the world, who have

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had success in a number of different business ventures, there are many others
who have failed.
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 1 Basic economic ideas and resource allocation

NOW TEST YOURSELF

6 Assess why it is important that there is one factor of production that is
responsible for organising the other factors.
7 Analyse the role of the entrepreneur in contributing to the development of
contemporary economies.

Contemporary economies have provided many opportunities for the development of

an enterprise culture. This is where people are imaginative and creative, and are
willing to take risks in order to gain profit.
There are a number of ways in which a government could encourage the development
of an enterprise culture, including:
» supporting business start-up programmes
» encouraging venture capital financing (this is where private investors provide
finance to start-up businesses that are believed to have good long-term growth
potential)
» providing grants to support research and development
» policies to promote competition in markets, such as deregulation (this is covered
in Chapter 8, section 8.1)
» development of appropriate education and training to improve the quality of
human capital
» financial support for the development of technology parks and the fostering of
innovation
» favourable tax treatment for start-up businesses in the form of tax incentives
» reducing administrative burdens, such as less ‘red tape’ in the form of excessive
bureaucratic paperwork

KEY TERM
enterprise culture: an economy in which taking a risk in the production of new
products is encouraged in the hope of making a profit

1.4 Resource allocation in different economic

systems
Decision making and resource allocation in market,
planned and mixed economies
An allocative mechanism is needed for deciding how economic goods (see section
1.6 of this chapter) that are scarce are produced and consumed.

KEY TERM
allocative mechanism: a method of taking decisions about the different uses that can
be made of factors of production

STUDY TIP
Although an allocative mechanism is necessary to allocate economic goods, free goods
(see section 1.6 of this chapter) that are in sufficient supply to satisfy demand do not
need an allocative mechanism.

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 There are three different types of allocative mechanism:
» market economies
» planned economies
» mixed economies

STUDY TIP
Candidates should understand that every country in the world (and there are over 200
countries) will allocate its scarce resources in different ways. This range of allocative
mechanisms is so broad that economists have focused on three main types: market
economies, planned economies and mixed economies.

Market economies
In a market economy, the allocation of resources is left to the market forces of
demand and supply, operating through the price mechanism. The advantages and
disadvantages of the market economy are shown in Table 1.1.

KEY TERMS
market economy (or market system): an economy where decisions about the allocation
of resources are taken through the price mechanism
market: a way in which buyers and sellers come together to exchange products

▼ Table 1.1 Advantages and disadvantages of the market economy

Advantages of the market economy Disadvantages of the market economy

• Decisions are made by individual consumers, who act • Some products will be underprovided and
in their own self-interest, i.e. seek to maximise their underconsumed in a market economy; these are known
utility or satisfaction when they consume a product. as merit goods (e.g. education and healthcare). Merit
• Decisions are made by individual producers, who act goods are covered in section 1.6 of this chapter.
in their own self-interest, i.e. seek to maximise their • Some products will be overprovided and
profits. overconsumed in a market economy; these are known
• The use of the price mechanism to allocate resources as demerit goods (e.g. alcohol and tobacco). Demerit
(referred to as ‘the invisible hand’ by the Scottish goods are covered in section 1.6 of this chapter.
economist Adam Smith) means that there is no need • Some products will not be provided or consumed at all
for any government intervention in the allocation of in a market economy because it would be impossible
resources. to charge a market price for them; these are known
• Competition between firms can lead to greater as public goods (e.g. defence and lighthouses). Public
efficiency. goods are covered in section 1.6 of this chapter.
• Income and wealth disparities can be very significant.

Planned economies KEY TERM

Planned economies, also known as command economies, involve the allocation of planned (or command)
scarce resources through government intervention with no (or very little) scope for economy: an economy
market forces to operate. The advantages and disadvantages of planned economies where decisions about the
are shown in Table 1.2. allocation of resources
are taken by the state
▼ Table 1.2 Advantages and disadvantages of the planned economy

Advantages of the planned economy Disadvantages of the planned economy

• Government intervention in the allocation of • A system with such a large amount of government
resources means it can take decisions in the national influence and control will tend to be bureaucratic
interest (e.g. it can prevent the production of socially and, as a result, may be inefficient.
undesirable products such as drugs). • The lack of competition and the lack of the profit
• The government can intervene to bring about a more motive mean that products are often of poor quality

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equitable distribution of income and wealth. with consumers having little choice.

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 1 Basic economic ideas and resource allocation

Mixed economies KEY TERM

A mixed economy combines elements of both market economies and planned mixed economy: an
economies — in other words, there is some degree of state ownership and state economy where the
intervention, but in many areas of the economy market forces will be allowed to allocation of resources
operate. is decided both by
market forces and by
It could be argued that all economies today are, to some extent, mixed economies. the state
However, there are large differences between, say, China, where the government
still plays an important role in the allocation of resources, and the USA, where the
government has only a limited role in the allocation of resources.

KEY SKILL
Evaluation: you need to be able to evaluate the strengths and weaknesses of the
different types of allocative mechanism, coming to a judgement as to which is
preferable and why. For example, a strength of a market economy is that there is no,
or very little, government intervention, but a weakness is that without government
intervention, there are likely to be many examples of market failure. Therefore, if
a market is uncompetitive, or there is a high level of market failure, government
intervention may be necessary to increase the degree of competition and reduce the
level of market failure in the economy. (For more on market failure, see Chapter 3,
section 3.1, and Chapter 7, section 7.3.)

STUDY TIP
Candidates need to demonstrate they understand that the degree of mixture in any
economy is not static. For example, since the credit crunch began in 2007, a number of
banks in many countries have either been brought under complete state ownership or
been given financial assistance by government to remain in business. One bank in the
UK, NatWest, became 84% state owned in 2008 and this bank was still 51% state owned
in 2022.

NOW TEST YOURSELF

8 Discuss whether a market economy is always preferable to a planned
economy.

REVISION ACTIVITY
Evaluate the various advantages and disadvantages of the three types of
economic system. Consider which is of most benefit to a consumer. Justify
your choice.
KEY TERM
transitional economy:
Transitional economic systems an economy that was
previously a command
A number of economies are going through a period of change where the extent of or planned economy and
central planning is being reduced and market forces are being allowed to have a which is now allowing a
greater degree of influence. China and Cuba are examples of such a transitional greater degree of scope
economy. for market forces to
operate
There are, however, possible problems associated with transition, as Table 1.3 shows.

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 ▼ Table 1.3 Problems of transitional economies

Unemployment A planned economy is generally better able to keep down the rate of unemployment in
an economy; when there is a move towards greater reliance on market forces, the rate of
unemployment in an economy is likely to increase because, in a market economy, firms aim to
maximise profits and this may lead them to reduce costs of production, possibly by laying off
some workers.
Inflation In a planned economy, the state controls prices so it is easier to keep down the rate of
inflation; when prices are determined by the free-market forces of demand and supply, it is
more difficult to control prices and so inflation is more likely.
Output In a planned economy, it is possible for the state to support inefficient firms and industries;
when state support is ended, such firms and industries may not be able to compete and so
output could fall.
Welfare A planned economy is able to provide housing and healthcare to everyone; with the
introduction of market forces, there may be a fall in welfare provision and this may have a
detrimental effect on levels of productivity in the economy.

STUDY TIP
Candidates should recognise that transitional economies can vary a great deal,
depending on the degree of change or transition that has taken place. Some of these
economies will still be similar to a planned economy, with only a small degree of
private sector involvement. On the other hand, other economies will have moved
away from a planned economy towards more of a market economy. It should also be
understood that such economies are changing rapidly, and a great deal of change can
have taken place in a short period of time.

NOW TEST YOURSELF

9 Discuss why a country may move from a planned economy towards a
market economy, despite the potential problems involved in this transition.

1.5 Production possibility curves

The nature and meaning of a production possibility
curve (PPC)
A production possibility curve (or production possibility frontier, as it is
sometimes called) shows the different combinations of products that can be
produced if an economy is working at full capacity.

KEY TERM
production possibility curve (or frontier): a graphic representation showing the
maximum combination of goods or services which can be produced from given
resources and with a constant state of technology

The shape of the curve: constant and increasing

opportunity costs
The shape of the curve shows that there are a number of different combinations of
products that can be produced. It is drawn as a curve rather than as a straight line
because not all factors of production are equally efficient. This can be seen in Figure 1.1.

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 1 Basic economic ideas and resource allocation
Capital goods
per period
B
A
K1
C

PPC

C1 Consumer goods
per period
▲ Figure 1.1 A production possibility curve

» The production possibility curve (PPC) in Figure 1.1 shows the combination of
capital goods (shown on the vertical axis) and consumer goods (shown on the
horizontal axis) that an economy can produce in a particular period of time with
the existing economic resources available.
» Point A shows one possible combination of outputs, where the economy produces
K1 capital goods and C1 consumer goods.
» Any movement along the curve from point A shows that the production of more
of one type of good leads to the production of less of the other (thus illustrating
the concept of opportunity cost).
» Point C, which is inside the PPC, shows that the economy is not using its
resources efficiently and there is some unemployment of resources. Output of
both capital and consumer goods is lower than it could be.

KEY CONCEPT
Scarcity and choice: the fundamental problem in economics is that resources are
scarce and wants are unlimited, so a choice is always required between competing
uses for the resources and an opportunity cost in making this choice.

Constant and increasing opportunity costs

» It has already been stated that a production possibility frontier is drawn as a
curve, rather than as a straight line, because not all factors of production are
equally efficient.
» It is therefore necessary to distinguish between constant and increasing
opportunity costs. If it were possible to move from one point on the production
possibility curve to another, with an equal sacrifice of resources, then this would
indicate a situation of constant opportunity costs.
» However, there will come a time when this is not the case. Increasing
opportunity costs mean that an ever-increasing amount of one product will need
to be sacrificed to produce more of the other product.
» The reason is that different factors of production have different qualities. As
a result of this, the production possibility frontier changes shape slightly as it
approaches each axis.
» For example, in Figure 1.1, this is most clearly seen as the PPC gets closer to the
horizontal axis, showing the consumer goods produced per period of time.

KEY SKILL
Analysis: a production possibility frontier is drawn as a curve because of the existence
of the law of diminishing marginal returns (see Chapter 7, section 7.5). This states that
employing an additional factor of production will eventually cause a relatively smaller
increase in output.

KEY CONCEPT
The margin and decision making: the shape of the production possibility frontier as a
curve illustrates the importance of decisions taken at the margin, given that resources

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are not equal substitutes for each other.

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 The causes and consequences of shifts in a PPC
» Point B in Figure 1.1, which is outside the PPC, is unreachable at the present time
given the resources that the economy currently has.
» However, over a period of time it is possible for there to be economic growth
resulting from the availability of more resources and/or the more productive
use of resources, and this would enable point B to be reached. This can be seen
in Figure 1.2.

KEY TERM
economic growth: an increase in the national output of an economy over a period of
time, usually measured through changes in gross domestic product
Capital goods
per period

PPC2
PPC1

Consumer goods
per period
▲ Figure 1.2 Economic growth

Economic growth (see Chapter 9, section 9.2, on the distinction between actual
economic growth and potential economic growth) enables an economy to produce
more of both capital and consumer goods. It refers to a situation where there is
an expansion in the productive capacity or potential output of an economy. This is
shown in Figure 1.2 by a rightward shift of the PPC from PPC1 to PPC2.
Of course, if there were a decrease in the quantity and/or quality of resources in an
economy, this would lead to a leftward shift of a PPC from PPC2 to PPC1.

STUDY TIP
It is important that candidates understand the difference between a movement along,
and a shift of, a production possibility curve:
» A movement along a curve indicates the different combinations of two goods that
could be produced from the given resources in an economy.
» A shift of a curve to the right would indicate an expansion in the productive potential
or capacity of an economy, allowing more of both goods to be produced.

NOW TEST YOURSELF

10 Explain why a production possibility curve is drawn as a curve rather than
as a straight line.

KEY SKILL
Diagrams: it is important that candidates understand the correct labelling of the two axes
of a production possibility curve, especially when compared with the labelling of demand
and supply diagrams in Chapter 2. The two axes of a PPC are labelled as particular goods
or types of goods (e.g. capital goods and consumer goods in Figures 1.1 and 1.2). This is
different from labelling the two axes P and Q in demand and supply diagrams.

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 1 Basic economic ideas and resource allocation

KEY SKILL
Diagrams: it is important that a PPC is drawn so that it touches both axes. This is
because it is assumed that all of an economy’s resources will be used to produce one
or other of the two products shown in the PPC diagram.

The significance of a position within a PPC

» It is important to understand the significance of a position within a PPC.
» As can be seen in Figure 1.1, point A is where an economy is using its resources
efficiently, but point C, within a PPC, is where an economy is using its resources
inefficiently.
» At this point, not all resources are being utilised and the output of both products
is lower than it could be if all resources were being used.

1.6 Classification of goods and services

The nature and definition of free goods and private
goods (economic goods)
Free goods
A free good is one which is consumed by people without a situation of scarcity KEY SKILLS
arising — in other words, there is enough of the good to satisfy everybody. As the Analysis: the situation
good is not scarce, it does not require a market. The supply of the good equals the of scarcity does not
demand for it at zero price. It takes no factors of production to produce a free good apply in the case of a
and so there is no opportunity cost involved. free good because there
is enough of a good to
satisfy everybody.
Private goods
Application: examples
A private good (or economic good) is one which is consumed by an individual for of free goods include air
their own private benefit. This applies to most products in an economy. Private and sunshine.
goods have two important characteristics:
Application: examples
» Excludability: one key feature of a private good is that people can be excluded of private or economic
from consuming it. goods include food,
» Rivalry: another key feature of a private good is that the consumption of it clothing, cars and
smartphones.
by one person reduces its availability for other people; there is rivalry in such
a situation because consumers are in competition with other consumers to
consume a particular product.

KEY TERMS
free good: a good that is not scarce and so does not require a market price to be
attached to it
private good: a good that is bought and consumed by individuals for their own benefit
rivalry: a feature of private goods whereby when a product is consumed by one person,
it cannot be consumed by another
excludability: a feature of private goods whereby people can be excluded from
consuming a good

STUDY TIP
It is important that candidates can clearly distinguish between private goods and public
goods in their examination answers on this topic. The key characteristics of a private
good are rivalry and excludability.

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 The nature and definition of public goods
In contrast to private goods, public goods are provided by society as a whole so
that everyone can benefit from them. KEY SKILL
Public goods have two important characteristics: Application: examples
of public goods include
» Non-excludability: once a public good has been provided for one person, it is street lighting, defence
not possible to stop other people from benefiting from such a good (i.e. no one and police.
is excluded).
» Non-rivalry: as more people consume the public good, the benefit to those
already consuming it is not reduced (i.e. consumption by one person does not
prevent others from consuming it).
These products need to be provided by the state or the public sector because if they
were provided by the private sector, it would be impossible to exclude someone who
had not paid. This gives rise to the free rider problem.
For example, it would not be possible to provide street lighting through the private
sector because it would be impossible to prevent someone who had not paid from
benefiting from the service. When such products are provided by the public sector,
they are part of government expenditure and are financed out of taxation.
In addition to being non-rival and non-excludable, public goods are also non-
rejectable. This means that, even if a person does not want to be protected by their
country’s defence and police system, they are not actually able to reject it.

KEY TERMS
public good: a good that is non-rival, non-excludable and non-rejectable
non-excludability: where the consumption of a product by one person does not exclude
others from consuming the same product
non-rivalry: where the consumption of a product does not prevent its consumption by
someone else
free rider: the idea that it would be impossible to charge people for using a good or
service because it would be impossible to prevent someone who had not paid from
benefiting
government expenditure: the total of all spending by a government
non-rejectability: where individuals cannot actually avoid the consumption of a public
good, even if they want to

STUDY TIP
Whereas key features of a private good are that it involves rivalry and excludability,
candidates need to emphasise in their answers that key features of a public good are
that it is both non-rival and non-excludable.

NOW TEST YOURSELF

11 Explain why a private good, but not a public good, can be provided through
a market.

REVISION ACTIVITY
Analyse what gives rise to the problem of a free rider.

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 1 Basic economic ideas and resource allocation

The nature and definition of merit goods

» A merit good is a particular type of private good. Examples include education
and healthcare.
» Like other private goods, merit goods are both rival and excludable, but what
distinguishes a merit good is that there is information failure which means that
the good is likely to be underprovided and underconsumed if provided through
the private sector.
» For example, people don’t fully appreciate the value of a good education or good
health. This could be regarded as a market imperfection.
» Without government intervention, it is likely that there would be market failure
because the allocation of resources would be sub-optimal.
» Governments therefore intervene by providing such goods through the public
sector, alongside private sector provision, so that those who would not or
could not afford to consume them in the private sector will do so in the
public sector.

KEY TERMS
merit good: a product that is rivalrous and excludable but, if left to a free market,
would be likely to be underproduced and underconsumed
information failure: where people lack the full information that would allow them to
make the best decisions about consumption
market imperfection: a feature of a market which does not perform perfectly
because of a failure to make an optimal use of resources, necessitating government
intervention
market failure: a market imperfection which gives rise to an allocation of scarce
resources which is not as efficient as it might otherwise have been

STUDY TIP
Candidates sometimes get confused and describe merit goods as examples of public
goods. They are not examples of public goods, but of private goods. Like all private
goods, they are rivalrous and excludable.
Candidates also sometimes confuse a merit good with a free good, especially given that
some merit goods are free at the point of consumption, such as entry to a particular
lesson. A free good, however, is something completely different: it is where there is
so much of a product that demand can be satisfied without the need for an allocative
mechanism, and supply will equal demand at zero price (e.g. air).

The nature and definition of demerit goods

» Demerit goods are the opposite of merit goods. Whereas merit goods would be
underprovided and underconsumed in a free market, demerit goods would be
overproduced and overconsumed in a free market.
» A demerit good is socially undesirable in some way: for example, alcohol and
tobacco.
» The overproduction and overconsumption of demerit gods is a result of imperfect
information by consumers. For example, they may not realise that alcohol and
tobacco are bad for their health.
» Without government intervention, it is likely that there would be market failure
because the allocation of resources would be sub-optimal.

KEY TERM
demerit good: a product that is rivalrous and excludable but, if left to a free market,
would be likely to be overproduced and overconsumed

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 STUDY TIP
It is important that candidates indicate clearly how a demerit good is fundamentally
different from a merit good. Whereas a merit good is likely to be underproduced and
underconsumed, a demerit good is likely to be overproduced and overconsumed in a
free market.

NOW TEST YOURSELF

12 Explain why a merit good will be underconsumed and a demerit good
overconsumed in a market.

REVISION ACTIVITY KEY SKILL

Application: examples
Assess how a government could encourage the consumption of merit goods of merit goods
and discourage the consumption of demerit goods. include education and
healthcare. Examples of
demerit goods include
alcohol and tobacco.
SUMMARY Examples of public
goods include street
In this chapter you have learned: lighting and defence.
» the fundamental economic problem of scarcity
» the need to make choices at all levels, including individuals, firms and
governments
» the nature and definition of opportunity cost
» the three basic questions of resource allocation
» the idea of economics as a social science
» to distinguish between positive and normative statements
» the meaning of the term ‘ceteris paribus’
» the importance of the time period in relation to the short run, long run and
very long run
» the nature and definition of the factors of production: land, labour, capital
and enterprise
» the rewards to the factors of production
» the meaning of division of labour and specialisation
» the role of the entrepreneur in contemporary economies
» how decisions are made in market, planned and mixed economies
» how resources are allocated in these three economic systems
» the nature and meaning of a production possibility curve (PPC)
» the shape of the PPC in relation to constant and increasing opportunity
costs
» the causes and consequences of shifts in a PPC
» the significance of a position within a PPC
» the nature and definition of free goods and private (economic) goods
» the nature and definition of public goods
» the nature and definition of merit goods
» the nature and definition of demerit goods

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 AS LEVEL

The price system and the

2 microeconomy
2.1 Demand and supply curves
Effective demand
Effective demand refers to that demand which can be supported by having the
means to pay. In this situation, consumers must not just want a particular product, KEY TERM
but also be willing and able to pay for it. effective demand:
demand for a product
KEY SKILL that is backed by the
Analysis: the characteristics of effective demand need to be made very clear when the ability and willingness
theory of demand is being explained (i.e. the fact that people must be willing and able to pay for it
to buy something at a particular price).

STUDY TIP
It is important that candidates demonstrate in their answers an understanding that
demand needs to be effective demand. It is not enough that consumers want something;
they have to be in a position to pay for it.

Individual and market demand and supply

Individual and market demand
» Demand is the quantity of a product that consumers are willing and able to buy KEY TERMS
at a given price in a given time period. demand: the quantity
» An individual demand curve shows the quantity of a product that a particular of a product that
consumers are willing
consumer is willing and able to buy at each and every price, ceteris paribus
and able to buy at a
(i.e. with all other things unchanged). given price in a given
» The individual demand curve will slope downwards from left to right, indicating period of time
that a consumer is more likely to buy a product at a lower price than at a higher
law of demand: a law
price. This is known as the law of demand.
(or theory) which states
that there is an inverse
Aggregation of individual demand curves to give market relationship between
the quantity demanded
demand of a product and the
» A demand curve can be drawn for every consumer in a society for every product, price of the product,
but in economics it is more usual to focus on market demand curves. ceteris paribus
» Market demand for a product is derived from bringing together (or aggregating)
all the potential buyers of a product. It is the total quantity of a product that all
potential buyers would choose to buy at a given price in a given period of time.
» A demand schedule can be produced for a particular
600
Price of smartphones ($)

product, such as smartphones.

» This schedule can then be plotted to give a market demand 500
curve, as shown in Figure 2.1. The price of smartphones is 400
shown on the vertical axis and the quantity of smartphones 300
bought is shown on the horizontal axis. 200
100 Demand
The demand curve shows the relationship between price and
the quantity demanded. It is downward sloping, indicating an 0
0 20 40 60 80 100 120
inverse relationship between the price of a product and the

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Quantity of smartphones
quantity demanded of a product: that is, as the price falls, the (thousands per period)
demand rises. ▲ Figure 2.1 A demand curve for smartphones

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 Derived demand is where the demand for a component depends upon the final
demand for a product that uses that component. For example, the demand for rubber KEY TERMS
is derived from the demand for car tyres. Derived demand can also be used in demand curve: a curve
relation to the demand for workers — for example, the demand for bus drivers that shows how much
of a good or service
derives from people’s demand for bus transport.
will be demanded by
consumers at a given
NOW TEST YOURSELF price in a given period
of time
1 Explain the nature of the relationship between a change in the price of a demand schedule:
product and a change in the quantity demanded of a product. a table giving the
quantities sold of a
product at different
Individual and market supply prices, enabling a
demand curve to
Individual and market supply curves be drawn from this
Supply is the quantity of a particular product that firms are willing and able to information
sell at each and every price in a given time period, ceteris paribus (all other things derived demand:
unchanged). A firm’s supply curve will slope upwards from left to right, indicating where demand for
that a producer will be more likely to sell a product at a higher price than at a lower the components of a
product or for workers
price. This is known as the law of supply.
arises from demand for
the final product
KEY TERMS
supply: the quantity of a product that producers are willing to sell at a given price in a
given period of time
law of supply: a law (or theory) which states that there is a direct relationship between
the quantity supplied of a product and the price of the product, ceteris paribus

Aggregation of individual firms’ supply curves

KEY TERMS
A supply curve can be drawn for every producer in an economy for every product,
supply curve: a curve
but in economics it is more usual to focus on market supply curves. Market supply of that shows how much of
a product is derived from bringing together (or aggregating) all the potential a good or service will be
suppliers of a product. It is the total quantity of a product that all potential sellers supplied by producers at
would choose to sell at a given price in a given period of time. a given price in a given
period of time
A supply schedule can be produced for a particular product, such as smartphones. This
schedule can then be plotted to give a market supply curve, as shown in Figure 2.2. supply schedule: a table
giving the quantities
sold of a product
Supply
Price

at different prices,
enabling a supply curve
to be drawn from this
information

Quantity per period

▲ Figure 2.2 A supply curve

The price of smartphones is shown on the vertical axis and the quantity of
smartphones sold is shown on the horizontal axis. The supply curve shows the
relationship between price and the quantity supplied. It is upward sloping,
indicating a direct relationship between the price of a product and the quantity
supplied of a product: that is, as the price rises, the supply rises.

NOW TEST YOURSELF

2 Explain the nature of the relationship between a change in the price of a

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 2 The price system and the microeconomy

The determinants of demand

Price
A major influence on the demand for a product is its price. Figure 2.3 shows that KEY TERMS
there is an inverse relationship between a change in the price of a product and change in quantity
the quantity demanded of a product, all other things unchanged (ceteris demanded: where
demand for a product
paribus). changes as a result of
When it is only the price of a product that changes, the resulting change in a change in the price of
quantity demanded can be shown on a demand curve by a movement along the the product; change in
quantity demanded is
curve. This can be seen in Figure 2.3.
shown by a movement
along a demand curve
Price
of DVDs

extension in demand:
when the quantity
P0
demanded of a product
increases as a result
P1 of a fall in the price of
the product, shown by
a movement down the
demand curve
D
contraction in demand:
Q0 Q1 Quantity of when the quantity
DVDs
demanded of a product
▲ Figure 2.3 A movement along the demand curve decreases as a result
of a rise in the price
» When the price of a product is reduced, for example, from P0 to P1, the quantity of the product, shown
demanded goes up from Q0 to Q1. This is represented by a downward movement by a movement up the
along the demand curve, indicated in the diagram by the downwards arrow. This demand curve
is known as an extension in demand.
» If, on the other hand, the price of a product is increased, the quantity demanded
falls and this would be shown as an upward movement along the demand curve.
This is known as a contraction in demand.

The determinants of supply

Movements along a supply curve are determined by changes in the price of a
product. Figure 2.4 shows the direct relationship between the price of a product
and the quantity supplied of that product. This is why the supply curve is upward
sloping. A movement up a supply curve is known as an extension in supply and a
movement down a supply curve is known as a contraction in supply.

KEY TERMS
change in quantity supplied: where the supply of a product changes as a result of a
change in the price of the product; change in quantity supplied is shown by a movement
along a supply curve
extension in supply: when the quantity supplied of a product increases as a result of a
rise in the price of the product, shown by a movement up the supply curve
contraction in supply: when the quantity supplied of a product decreases as a result of
a fall in the price of the product, shown by a movement down the supply curve

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 Causes of a shift in the demand curve
Price is not the only factor that influences demand. If the ceteris paribus
assumption is removed, it is possible to consider all the other factors that were
previously being held constant. These other factors could include:
» a change in the incomes of consumers
» a change in the price of a substitute product (a substitute product is one that
could be used for the same purpose by consumers)
» a change in the price of a complementary product (a complementary product is
one that is directly related to, and used with, another product)
» an advertising campaign
» a change in population
» a change in the tastes and preferences of consumers
» a lowering of interest rates, making borrowing more affordable
» a change in the weather, possibly associated with different seasons
When one of these other factors affects demand, the result is described as a change
in demand and is shown by a shift of the demand curve. This can be seen KEY TERMS
in Figure 2.4. change in demand:
where there is a change
Price
of DVDs

in the conditions of
demand, i.e. something
other than a change in
the price of a product;
this is shown by a shift
of a demand curve
composite demand: the
D0 D1
demand for a product
that can be used for
Quantity of DVDs more than one purpose
▲ Figure 2.4 A shift in the demand curve

In this diagram, there might have been an increase in incomes and/or an effective
advertising campaign. The demand curve shifts to the right, from D0 to D1, as shown
by the rightward arrow.
Composite demand refers to the demand for a product that can be used for more
than one purpose. Stone, for example, could be used for building purposes and could
also be used in the construction of roads; a particular piece of land could be KEY SKILL
demanded to build both shops and houses. Diagrams: it is
important to show
STUDY TIP clearly the direction of a
shift in a demand curve:
Candidates sometimes confuse movements along a demand curve and a shift of a
for example, by labelling
demand curve. It is important that you understand what will cause a movement along
the two demand curves
a demand curve and what will cause a shift of a demand curve. A movement along a
D0 and D1 and by
demand curve can only be caused by a change in the price of a product, whereas a shift of
including an arrow to
a demand curve can be caused by anything other than a change in the price of a product.
show the direction of the
shift.

NOW TEST YOURSELF

3 Analyse why there is sometimes a movement along a demand curve and
sometimes a shift of a demand curve.

REVISION ACTIVITY
Consider all the possible factors that could influence the demand for a motor
vehicle. Explain which of these will cause a movement along the demand curve
for the product and which will cause a shift of the demand curve for the product.

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