Nabeel Ismail – Economics ASL Chapter 1.

03008578998

Economics – ASL – CHAPTER 1.

Economics – The study of how to allocate scarce resources in the most effective way.
Economic Problem – How to allocate scarce resources among alternative uses.
Household – A group of people whose spending decisions are connected.
Microeconomics – The study of how households and firms make decisions in markets.
Macroeconomics – The study of issues that affect economies as a whole.
The world’s poorest countries tend to have few or poor Factor Endowments (vice versa).
Factor Endowments Definition - The stock of factors of production, the resources used for
production.
Production Definition -The output of goods and services
Want Definition - Anything you would like, irrespective of whether you have the resources to
purchase it
Scarcity Definition - A situation where there are insufficient resources to meet all wants.
Choice Definition - The selection of appropriate alternatives
Opportunity Cost Definition - The cost of the (next) best alternative, which is forgone when a
choice is made / the next best alternative forgone
Specialisation Definition - The concentration by a worker or workers, firm, region or whole
economy on a narrow range of goods and services
Exchange Definition - The process by which goods and services are trade
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The Basic Economic Problem

The fact that resources are scarce compared to the unlimited wants → Choices having to be made
Goods Definition – Tangible products, i.e. products that can be seen and touched, such as cars,
food and washing machines
Services Definition – Intangible Products, i.e. products that cannot be seen or touched, such as
banking, beauty therapy and insurance

The fundamental economic problem: of scarcity arises due to unlimited human wants of consumption
exceeding finite economic resources for production.
 Consumption: is process by which consumers satisfy their wants.
 Production: is process of creating goods and services in an economy

Needs are necessary, wants are not - Thus, choices have to be made at all levels
 Consumers – maximum satisfaction.
 Producers – maximum profit.
 Governments – maximum benefits.

Choice: is the need to make decision about the possible alternative uses of scarce resources due to scarcity.
It gives rise to the concept of opportunity cost and the 3 basic economic problems.

Opportunity cost: is the cost of choosing something in terms of the benefit derived from the best
alternative forgone.

Economic resources/factors of production: are inputs available for production of finished goods and
services for consumption.
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Factors of Production
Factors of Production Definition – The resource inputs that are available in an economy for the
production of goods and services
The Four Factors:
Land – This is a natural resource. Things such as oil, coal, rivers and the land itself.
Labour – This is the human resource that is available in any economy / the quantity and quality of
human resources
Some economies (generally poor countries) have large populations but lack a skilled workforce and
for other countries like Germany with declining populations, they depend on immigrant workers to
do both skilled and unskilled jobs. Quality of labour is essential for economic progress.

Capital - Man-made aids for production / Goods used to make other goods
It is combined with Land and Labour
MERC - Machines, Equipment, Robots and Computers

Entrepreneurship - The willingness of an entrepreneur to take risks and organise production.

Entrepreneur - Someone who bears the risks of businesses and who organises production.
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Opportunity Cost: Opportunity cost is the cost of missing out on the next best alternative. In other
words, opportunity cost represents the benefits that could have been gained by taking a different decision.

Opportunity cost measures the cost of a choice made in terms of the next best alternative foregone or
sacrificed. Since resources are scarce there is always a tradeoff to be made, when making a decision to
choose what to produce.

Production Possibility Curve

Production Possibility Curve (Firm) – This shows the maximum quantities of different
combinations of output of two products, given current resources and the state of technology.

Production Possibility Curve (Country) – This shows the maximum quantities of different
combinations of output of capital and consumer goods, given current resources and the state of
technology.

Developed Economy – An economy with a high level income per head

Developing Economy - An economy with a relatively low level of income per head
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PPC Graph Information:

Productive Efficiency – Any point on the

curve/ line, a level in which an economy or entity
can no longer produce additional amounts of a
good without lowering the production level of another
product.
Allocative Efficiency – Choosing between two
points. Allocative efficiency is a state of the economy
in which production is aligned with consumer
preferences e.g point A G
Unemployed Resources - Any point inside the
curve e.g Point H (underutilised resources)

Unobtainable – Any point outside the curve, you do not have

enough resources to produce that much. E.g Point I
Bliss Points – Where the curve starts or ends, where total production of either of the goods A or G

Economic Growth – Change in the productive potential of an economy.

Productive Potential – The maximum output that an economy is capable of producing.

PPC Shifters (Right) Economy expands:

1. Changes in the quantity of resources

 The quantity of labour may increase as a result of net immigration of people of
working age, a higher proportion of women entering the labour force or a rise in the
retirement age.
 The purchase of extra capital goods, referred to as net investment, increases the
quantity of capital goods causing the PPC to increase (shift to the right).
 The quantity of enterprise may be increased by a reduction in rules and regulations
placed on firms, privatisations and government incentives to start ups.
2. Changes in the quality of resources
 Improvements in education and training will improve the quality of labour and raise
productivity causing the PPC to increase (shift to the right)
 The quality of capital goods is raised by advances in technology causing the PPC to
shift right.
 The quality of enterprise may be raised by management training and improved
education
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NOTE – The fact that the line isn’t straight for any of the diagrams is because they are imperfect
Substitutes.

Shape 1: Concave
Good Y
A P

0 Good X
B
The slope of the production possibility curve indicates the rate at which one good is being transformed
into another, not physically, but by transferring resources from one good to another good. As we move
along the production possibility curve through points P and Q downwards, slope or steepness of each tangent
through these points increases. Thus, the production possibility curve takes a concave shape, indicating
increasing opportunity cost, that is, the economy is willing to give up more Y for an additional unit of X.
There is increasing opportunity cost because of diminishing returns.
Note: slope of PPC = change in Y = opportunity cost of producing an additional unit of X in change in X
terms of Y.
Shape 2: Convex
Good Y
A

0 Good X
B
As we move downwards from P to Q, the steepness of each gradient falls, i.e, the gradient becomes
flatter. In other words, the slope of the production possibility curve diminishes as we move downwards. This
means the opportunity cost is decreasing (increasing returns). The economy is now willing to give up less
units of Y for the same additional unit of X.
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Shape 3: Linear

Here the slope of the production possibility curve remains constant. The Opportunity
cost is constant or unchanged as we moved downwards the curve from left to right. Thus, the
production possibility curve becomes linear or straight line. This means that the economy is
willing to give up the same amount of Y for the same additional unit of X.

SHIFT OF THE PRODUCTION POSSIBILITY

CURVE:

If the economy’s capacity to produce goods is increasing, the production possibility curve
will be moving outwards over time. This indicates that economic growth has taken place.
Economic growth shifts the boundary outward and makes it possible to produce more of all
goods. Before growth points a and b were on the production possibility curve and point c was
unattainable. After growth, point c is attainable.
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Economics Systems and the Role of the Markets

Economic System – The way in which production is organised in a country or group of countries

An economic system - The term used to describe the means by which a country’s people,
Organisations and government make decisions:

 What goods and services are to be produced?

 How these goods and services are produced?
 Who should receive these goods and services?

Market Economy – An economic system whereby resources are allocated through the market
forces of demand and supply

Price System – A method of allocating resources by the free movement of prices

Command Economy – An economic system in which most resources are state owned and also
allocated centrally

Mixed Economy – An economic system in which resources are allocated through a mixture of
the market and direct public sector involvement
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MARKET ECONOMY:
In a market economy resource allocation is carried out by private individuals only. All factors of
production are privately owned and managed. There is no government intervention and everyone is
free to operate according to his will and desire. The main characteristics of such a system are:
 Price/ market mechanism which manipulates the allocation of resources or tries to
resolve the three fundamental questions of what, how and for whom to produce. In other
words, resources are allocated through changes in relative prices. Adam Smith referred to
it as the “invisible hands” of the market.
 Consumer’s sovereignty exists, that is, consumer is a king because it directs the allocation
of resources to a large extent while satisfying its own needs. His basic aim is to maximise
satisfaction. The consumer’s decision can dictate economic actions as what and how to
produce.
 Producers aim at profit maximisation and rely on higher prices as a “green signal” to
higher production. The foundation is the profit motive. Evidently, the production of
those commodities will be more profitable which are demanded more by consumers.
 Fierce competition among firms exists and basically it is this competition which
encourages technological change, innovation and higher investment.
 Easy mobilization of capital due to profit maximisation and regular innovations.
Obviously, these do encourage industrialization and economic development.

ADVANTAGES OF MARKET ECONOMY:

 There is consumer sovereignty. This means that consumers can influence what goods are
produced directly by their purchase. In fact, they are free to buy whatever goods and
services from which they can derive maximum satisfaction.
 Similarly, the greater use of price mechanism will provide an automatic and quick way to
signal to producers what consumers want.
 The market provides a wide variety of goods and services to meet consumer’s wants.
Indeed, the consumers may have a greater choice of a number of private-sector
producers.
 This increased competition may increase the quality of products since rival producers will
seek to attract new customers by improving the standard of their goods.
 The market system provides incentives to producers in the form of profits and workers in
the form of higher wages. This should encourage entrepreneurs to produce high quality
products and to innovate, and workers to work hard.
 There is greater efficiency. The aim of firms in a market economy is to make maximum
profit. Hence, the market system encourages technological change, that is, the use of new
and better methods and machines to produce goods and services at low cost. Those
firms, which do not produce what people want at low cost and low prices, may go out of
business.
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MARKET FAILURES / IMPERFECTIONS:

In theory the price mechanism can go a long way in efficiently and automatically solving the basic
economic problems. However, in practice it fails in many respects. There are many market failures
such that the price system cannot ensure the best use of scarce resources:

1. No provision for public goods or public utilities:

Public goods are goods produced on a non-profit maximisation basis because they (street- lighting,
defence, roads) aim at maximising socio-economic welfare. Thus, they cannot be produced
through the market. There is no possibility of fixing a price for the product in question and hence
no possibility of making a profit.

2. Divergence between social cost and private cost:

Private cost refers to the cost which is incurred in the production of a certain commodity, for
example, labour cost or cost of raw materials. However, when production process takes place,
there are smokes which come from factory chimneys, and garbage or wastes thrown in rivers,
thereby, creating pollution. Economists evaluate these costs and name them as external costs or
negative externalities. These external costs are never considered by a private producer in a market
economy. This means that nothing much is done to reduce pollution and any other destruction
caused to nature.

3. Harmful products may be produced and consumed:

The absence of a government sector implies the absence of taxes and the free operation of the
market mechanism. Left to the price system, there will be overproduction of certain harmful
products such as drugs, alcoholic drinks and cigarettes. Their high prices initiate higher production
and greater infiltration of these harmful goods which greatly affect the peaceful life.

4. Luxuries in place of necessities:

Since allocation of resources depends greatly on those goods whose prices are high or are rising,
obviously, the private producers will produce more of these goods and less of other goods may be
essential products. Thus, a rise in the demand of cars may encourage producers to produce more
cars and less food which is but an irrational allocation of resources. The system broadly indicates
that only the rich people have the greater say through their expenditure patterns and the poor, on
the hand, remain poor.

5. Unequal wealth distribution / inequalities of income:

Indeed, the laissez-faire capitalism makes the rich richer and the poor poorer. Systematic
exploitation by the capitalists of the poor working class is obvious because they have to maximise
returns and minimise costs, essentially labour costs. The labour cost has to operate at low rates and
be very productive in the production process. In this case, the wealth distribution under this
system can never be reduced.
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6. Persuasive advertising:
Owing to the fierce competition which exists among firms in a pure market system, huge expenses
are made annually on advertising. The advertising which is adopted is meant for product
differentiation. Such expenses are usually against customers’ interests because they are not only
misleading, but also wasteful. Resources used in advertising could have been used somewhere else
for more productive purposes.

7. Cyclical fluctuations:

Cyclical fluctuations are caused by the ever-changing demand and supply conditions. Sometimes,
when producers anticipate a rise in demand for certain goods, they raise investment to produce
more. But if demand actually does not rise, a general glut will occur, that is, stock accumulation.
Consequently, the affected producers will have to reduce investment, dismiss workers to reduce
costs. Both of these have an adverse effect in the economy as a whole. Less investment means
lower production while lower employment means less consumption, lower prices and profits.
These cumulative effects lead to a lower national income.

It can be deduced that price mechanism determines allocation of resources as per what consumers
want more which initially sounds right. However, this system cannot be left to itself because of its
various imperfections which undoubtedly necessitate government intervention.

PLANNED ECONOMY:
A planned economy is the direct opposite of the market economy. Here all the resources are
owned by the government or the public sector which is the central body deciding upon the
allocation of resources. This allocation is however exerted on the following grounds:
 Maximising socio-economic welfare through creation of public utilities.
 Non-profit maximising strategy
 Parliamentary decisions.

However, in real world, command economies seldom exist. Central planners may set the prices of
essential consumer goods, and allow factory managers to set prices of less essential goods.
However, such an economic system has got several demerits which can be discussed as follows:

1. Decisions are based on a parliamentary level:

Since decisions are based on parliamentary level, they are not readily implemented and in this way,
several important decisions concerning socio-economic activities may be delayed.
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A common feature against the public sector is inefficiency and lack of competence. The sector is
generally over-staffed and inefficient. The services are of “Red-Tape” type because of high level
of bureaucracy. In addition, the attitude of a secured job in the government sector makes workers
idle and careless about the quality of services to be provided to the members of the public.

3. Waste of resources:

Very often there is wastage of resources especially when public sector expenditure is analysed.
There is a great abuse on the part of the workers concerning the use of public sector resources
and materials.

4. The absence of competition:

The absence of competition in this economic system does not ensure innovation and constant
improvements in the quality and quantity of products. Owing to the principle of “No profit- No
loss”, huge losses have to be borne at times by the public sector. Therefore, it is difficult to find
out additional resources for innovations.

5. Restriction on consumers’ sovereignty:

Since there is central allocation of resources, consumers may demand what they wish but to a
restricted extent. The production of luxuries is given as the ultimate priority by the government
because of the concept of the welfare state. Priority must be given only to the production of the
most essential products in the society.

MIXED ECONOMY:

In a mixed economic system, resource allocation is influenced both by the private and public
sectors. In other words, in such an economic system, some economic decisions are taken by the
market mechanism and some by the government planning. It has been found that all modern
economies are now, to varying extent, mixed in nature. Many nations have fluttered from
socialism in the course of suggested the superiority of market over planned economies. Thus, in a
mixed economy the price system allocates resources, but on account of market failures, there is
the need for government intervention. In fact, the government has to intervene in order to attain
some important micro and macro-economic objectives.

Role of government planning in a mixed economy:

1. In a modern mixed economy, the government has to intervene to change the wrong
combination of goods. If left to the price system, there will be over-production and over-
consumption of demerit goods like drugs, cigarettes and alcohol. Hence, the government has to
discourage consumption of these demerit goods through taxation.
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2. The government has to provide public goods in a modern mixed economy since
provisions of these goods are difficult and unsuitable in the hands of private sectors. Defence,
roads, street-lightning are provided by the state in every modern mixed economy. Market system
cannot compel payment for public goods since there is no way to prevent a person who refuses to
pay for the good from receiving its services. Thus, the private firms will fail to produce these
goods. The government, by virtue of their power to tax, can provide the services and collect from
everyone.
3. In a view to maximising profits, private firms consider only their private costs and private
benefits. They ignore any external costs and benefits incurred in the production process. Thus,
firms tend to produce more of those goods which cause external costs (pollution), but less of
those goods which cause external benefits. As a result, the government intervention is deemed
necessary to correct the externality by making rules and regulations. The government should
subsidise activities which cause external benefits, while impose taxation to reduce external costs.
4. Most government in modern mixed economy have policies designed to discourage firms
to act as monopoly. In many countries, important legislations are passed to regulate existing
monopolies and prevent informal agreements with the main aim of making profits by exploiting
consumers.
5. Government may aim to promote the general economic welfare of the population by
creating a more equitable distribution of income and wealth. They may aim to achieve this by a
system of progressive taxation, subsidies and transfer payments.
6. Governments have a large number of macro-economic policy instruments which they use
to influence, for example, the level of spending, the amount of investment, level of employment,
rate of inflation and international trade position. Their aim is to ensure a steady rise in output and
improvements in living standards.

ROLE OF PRIVATE SECTOR IN A MIXED ECONOMY:

1. Greater competition in the private sector motivates innovations and improvements in the
quality of goods and services provided by the public sector.

2. Profits may be used as a guide to efficient allocation and this tends to raise competition
and encourage industrialisation.

The advantages of a free market economy / the disadvantages of command economies:

 Choice – Firms will produce whatever consumers are prepared to buy and there is
no restriction on what they produce in the Free Market (FM). Planners are more
concerned that there are enough essentials goods to go around rather than
allocating resources efficiently between all goods.
 Innovation – Firms will look to produce something new in order to be competitive.
Because of property rights (intellectual property rights through patents) there are
incentives for innovation and producing better quality products. Planners do not
have this incentive, they are happy just producing essentials.
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 Higher Economic Growth Rates – Countries with economic systems closer to the
free market tend to have higher economic growth.
 Efficiency – Free markets are very competitive. Most of their industries are assumed
tobe perfectly competitive and so allocative and productive efficiency occur. This is
because decisions about what to produce are made by the consumers rather than
by planners

The advantages of command economy / the disadvantages of free market economies:

 Public, Merit and Demerit Goods - Public goods cannot be provided in the
private sector. Merit goods are likely to be under consumed in the free market and
demerit goods over consumed. In a command economy demerit goods are likely to be
banned or heavily taxed and public goods and merit goods will be provided at
high levels.
 Unequal Distribution of Income – Benefits will be low and health service and school
unaffordable for a lot. Those who are poor are likely to fall to destitution. A command
economy may not allow the successful to make millions but it will at least try to make
sure the poor are not left to destitution so the economy is fairer
 Environment – Free market economies are likely to produce more pollution. Command
economies will attempt to make sure that the level of output is the socially optimal level of
output through things such as taxes and pollution permits although pollution does tend to still
be high
Specialisation / Division of Labour
Division of Labour Definition – The specialisation of labour where the production process is
broken down into separate tasks
The Advantages of Specialisation / Division of Labour to Firm:

 Increased output: With improvement in efficiency and use of machinery output is

increased
 More innovation
 Improved quality
 Increased productivity: Specialised machinery can be used which further increases the
productivity.
 Developing and maintaining a brand image
 Economies of scale

The Disadvantages of Specialisation / Division of Labour to Firm:

 Reliance on a narrow range of products

 Specialist factor inputs are more expensive per unit
 Limited market size
 Reliance on one specialist resources / suppliers or factor immobility
 Reduced flexibility
 Boredom of workers / demotivation.
The Advantages of Specialisation / Division of Labour – TO THE FIRM:
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 Specialist workers become quicker at producing goods

1. Production becomes cheaper per good because of this
2. Production levels are increased
 Each worker can concentrate on what they are good at and build up their expertise
The Advantages of Specialisation / Division of Labour – TO THE WORKER:
 Increased productivity
 Higher pay for specialised work: Improved skills at that job
The Disadvantages of Specialisation / Division of Labour – TO THE FIRM:

 Greater cost of training worker

 Quality of products may suffer if workers become bored by the lack of variety in their jobs
The Disadvantages of Specialisation / Division of Labour – TO THE WORKER:

 Boredom as they do the same job

 Their quality and skills may suffer
 May eventually be replaced by machine

International Specialisation
The Advantages of International Specialisation:
 An increase in the output of goods and services - In comparison to what they
could achieve on their own
 A widening of the range of goods that are available in an economy
 Increased exchange between developed and developing economies

The Disadvantages of International Specialisation:

 Bad weather – It can wipe out a whole years crops
 De-industrialisation – Due to cheap imported goods displacing workers
 Finite Resources – If they run out trouble will ensue, unless the income gained from it has
been wisely invested in the future
 Tastes or needs of consumers may change – Hardship among those producing goods that
are no longer wanted / needed is inevitable
Productivity Definition – Output, or production of a good or service, per worker per period of
time

Positive Statements

Positive statements (and positive reasoning more generally) are objective. As such, they can be
tested. These fall into two categories. One is a hypothesis, like “unemployment is caused by a
decrease in GDP.” This claim can be tested empirically by analysing the data on unemployment and
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GDP. The other category is a statement of fact, such as “It’s raining,” or “Microsoft is the largest
producer of computer operating systems in the world.” Like hypotheses, such assertions can be
shown to be correct or incorrect. A statement of fact or a hypothesis is a positive statement. Note
also that positive statements can be false, but as long as they are testable, they are positive.

Normative Statements

Although people often disagree about positive statements, such disagreements can ultimately be
resolved through investigation. There is another category of assertions, however, for which
investigation can never resolve differences. A normative statement is one that makes a value
judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is
or is not correct. Here are some examples of normative statements in economics:
 We ought to do more to help the poor.
 People in Pakistan should save more for retirement.
 Corporate profits are too high.

These statements are based on the values of the person who makes them and can’t be proven false.

Because people have different values, normative statements often provoke disagreement

Statement Basis Type

Positive Facts Objective
Normative Value judgments Subjective

Marginal decisions in economics

What is the importance of the margin when making choices?

Marginal in economics means having a little more or a little less of something. It refers to the effects
of consuming and/or producing one extra unit of a good or service

Marginal benefit – is the change in total private benefit from one extra unit

Marginal cost – is the change in total private cost from one extra unit

Rational consumers and producers are assumed to calculate the marginal cost and benefit of each
decision. We are never making decisions in a vacuum; rather all decisions are made at the margin.
This means that they represent relative trade-offs based on who we are, what we need and what we
prefer.
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Classification of Goods
1. Economic goods
An economic good is a good or service that has a benefit (utility) to society. Also, economic goods
have a degree of scarcity and therefore an opportunity cost.

2. Free Good
A free good is a good needed by society but available with no opportunity cost. It is a good without
scarcity. For example, air is a free good, because we can breathe it as much as we want. By
breathing, we do not diminish the available resource for other people.

Water is usually another free good. If you live by a river, you can take water without reducing the
amount available to others. Though in some areas, water can become scarce in drought conditions –
then water is no longer a free good.

Note: a good may be given away for no charge (e.g. healthcare is free at the point of use) However,
it is not a free good because there is an opportunity cost – in this case, healthcare is paid for out of
taxes.

The Four Different Types of Goods

In economics, goods can be categorized in many different ways. One of the most common
distinctions is based on two characteristics: excludability and rivalrousness. That means we
categorize goods depending on whether people can be prevented from consuming them
(excludability) and whether individuals can consume them without affecting their availability to
other individuals (rivalrousness).

Based on those two criteria, we can classify all physical products into four different types of
goods: private goods, public goods, common resources, and club goods.

1. Private Goods

Private Goods are products that are excludable and rival. They have to be purchased before
they can be consumed. Thus, anyone who cannot afford private goods is excluded from their
consumption. Likewise, the consumption of private goods by an individual prevents other
individuals from consuming the same goods. Therefore, private goods are also considered rival
goods. Examples of private goods include ice cream, cheese, houses, cars, etc.

2. Public Goods

Public goods describe products that are non-excludable and non-rival. That means no one can
be prevented from consuming them, and individuals can use them without reducing their
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availability to other individuals. Examples of public goods include fresh air, knowledge,
national defence, street lighting, etc.

3. Common Resources

Common resources are defined as products or resources that are non-excludable but rival.
That means virtually anyone can use them. However, if one individual consumes common
resources, their availability to other individuals is reduced. The combination of those two
characteristics often results in an overuse of common resources. Examples of common
resources include freshwater, fish, timber, pasture, etc.

4. Club Goods

Club goods are products that are excludable but non-rival. Thus, individuals can be prevented
from consuming them, but their consumption does not reduce their availability to other
individuals (at least until a point of overuse or congestion is reached). Club goods are
sometimes also referred to as artificially scarce resources. They are often provided by natural
monopolies. Examples of club goods include cable television, cinemas, wireless internet, toll
roads, etc.

Rivalry: refers to extent to which consumption limits availability.

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Excludability: refers to extent to which free-riders can be prohibited from consumption.

Free-rider: is someone who has no incentive to pay for the consumption of a product. For
example, a fisherman may take a high catch and free ride on other fishermen who are more
concerned to preserve sustainable fish stocks.

Reject-ability: refers to extent to which consumers can avoid consumption of a product.

Quasi-public goods: are those which have some but not all characteristics of public goods.
Examples include roads, tunnels and bridges.
Merit Good
A merit good has two characteristics:

1. People do not realise the true personal benefit. For example, people underestimate
the benefit of education or getting a vaccination.
2. Usually, these goods also have a positive externality.

Therefore in a free market, there will be under consumption of merit goods.

Examples of Merit Goods

 Health Care – people underestimate the benefits of getting a vaccination. If people

do get a vaccination, then there will be a personal benefit in protecting against
diseases. Also, there will be external benefits to the rest of society because it will help
reduce the prevalence of disease in the rest of society.
 Museums – the educational benefit of museums may be unappreciated.
 Eating fruit and vegetables – A diet of raw fruit gives health benefits to the
consumers but we may prefer unhealthy food.
 Education – People may undervalue the benefits of studying, and decide to leave
school early or not get good grades.

Demerit Good
A demerit good has two characteristics:

1. A good which harms the consumer. For example, people don’t realise or ignore the
costs of doing something e.g. smoking, drugs.
2. Usually, these goods also have negative externalities. If you smoke you harm yourself,
but also the smoke negatively affects other people.
Therefore in a free market, there will be overconsumption of these goods.
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Examples of Demerit Goods include:

 Smoking – People underestimate health costs or risks of getting addicted.

 Drinking – Health costs to drinkers. Costs to society include more expenditure on
health care and policing.
 Taking drugs – Health costs to drug users – people underestimate risks of getting
addicted. External costs of more crime.
 Dirking sugary soft drinks – which damage teeth and cause obesity.
Value judgement on merit goods

Merit and demerit goods involve making a value judgement that something is good or bad
for you. Classification is not always straightforward. For example:

Cannabis
 Cannabis is widely considered a demerit good – it contributes to lung cancer and can
lead to psychological problems, such as paranoia.
 However, supporters of cannabis might argue cannabis is a harmless drug which can
help people deal with physical pain and enjoy life more.

Social Cost
Definition of social cost – Social cost is the total cost to society. It includes private costs plus any
external costs.

Social Cost = Private + External Cost

Example of driving to work

 Costs of paying for petrol

(personal cost)
 Costs of increased congestion
(external cost)
 Pollution and worse air quality
(external cost)
 The social cost includes all the
above. (Petrol + congestion +
pollution)

Example of social cost – smoking

If you smoke, the private cost is £6 for a packet of 20 cigarettes. But, there are also external costs to
society

 Air pollution and risks of passive smoking

Nabeel Ismail – Economics ASL Chapter 1. 03008578998

 Litter from discarded cigarette butts

 Health costs to society
The social costs of smoking include the total of all private and external costs.

Example of social cost of building airport

Private costs of airport

 Cost of constructing an airport.
 Cost of paying workers to run airport
External costs of airport
 Noise and air pollution to those living nearby.
 Risk of an accident to those living nearby.
 Loss of landscape.

Importance of social cost

Rational choice theory suggests individuals will only consider their private costs. For example, if
deciding how to travel, we will consider the cost of petrol and time taken to drive. However, we
won’t take into consideration the impact on the environment or congestion levels for other
members in society.

Therefore, if social costs significantly vary from private costs then we may get a socially inefficient
outcome in a free market.

Social Benefit
 Social benefit is the total benefit to society from producing or consuming a good/service.
 Social benefit includes all the private benefits plus any external benefits of
production/consumption.
 If a good has significant external benefits, then the social benefit will be greater than the
private benefit.

Social Benefit = Private Benefit + External Benefit

Nabeel Ismail – Economics ASL Chapter 1. 03008578998

If we cycle to work, the private benefits include

 Lower cost of cycling rather than driving

 Health benefits of cycling
 Ability to avoid congestion, and quicker journey to the worker.
But, the social benefit of cycling may also include external benefits, such as:

 Lower congestion for other road users

 Lower pollution levels from a decision to cycle rather than drive
 Better health may lead to lower health care costs.
Therefore, in this case, the social benefit of cycling may be greater than private benefit.

FUNCTIONS OF MONEY:
Money must perform the following functions to overcome the problems with barter.

1. Money must act as a medium of exchange. This means that money allows buying and selling
to run efficiently. An individual can sell his labour service and uses the money to buy other wants.

2. Money acts as a measure of value. This means that the value of all goods and services are
expressed in terms of money. Consumers are able to compare the value of different goods. Similarly,
businessmen keep record of their transactions in forms of money.

3. Money must act as a store of value. This means that members of the public can hold their
wealth in terms of money. An individual can save his money in the bank and use it in the future to
buy goods and services.

4. Money must act as a standard of deferred payment. This means that credit transactions and
hire purchase can take place. People can acquire goods and services now and payment can be made
later.
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Competitive Markets and How They Work

Market – Where or when buyers and sellers meet to trade or exchange products
Sub-Market – A recognised or distinguishable part of a market> Also known as a market segment
Ceteris Paribus – Assuming other variables remain unchanged
Disposable Income – Income after taxes on income have been deducted and state benefits have
been added
Real Disposable Income – Income after taxes on income have been deducted and state benefits
have been added and the result has been adjusted to take into account changes
Normal Goods – Goods for which an increase income leads to an increase in demand
Inferior Goods – Goods for which an increase in income leads to a fall in demand
Substitutes – Competing Goods
Complements – Goods for which there is joint demand

Efficiency - Where the best use of resources is made for the benefit of consumers