Economics IGCSE – Revision Notes

Teacher ALO

1.1 – Basic Economic Problem: Choice and the Allocation of

Resources

“Economics is the social science that describes the factors that determine the
production, distribution and consumption of goods and services.”
(Source: Wikipedia)

The Basic Economic Problem

Resources: are the inputs available for the production of good and services.
Scarcity: a lack of something (in this context, resources)
The fundamental economic problem is that there is a scarcity of resources to satisfy
all human wants and needs. There are finite resources and unlimited wants.

Factors of Production
Resources are also called ‘factors of production (especially in Business Studies).
They are:

Land: All natural resources in an economy. This includes the surface of the earth,
lakes, rivers, forests, mineral deposits, climate etc. The reward for land is the rent it
receives.

Labour: All the human resources available in an economy. That is, the mental and
physical efforts and skills of workers/labourers. The reward for work
is wages/salaries.

Capital: All the man-made resources available in an economy. All man-made

goods (which help to produce other goods-capital goods) from a simple spade to a
complex car assembly plant are included in this. The reward for capital is
the interest it receives.

Enterprise: The ability to take risks and run a business venture or firm is called
enterprise. A person who has enterprise is called an entrepreneur. In short, they are
the people who start a business. Entrepreneurs organize all the other factors of
production and take the risks and decisions necessary to make a firm run
successfully. The reward to enterprise is the profit generated from the business.

All the above factors of productions are scarce because the time people have
to spend working, the different skills they have, the land on which firms
operate, the natural resources they use everything is limited in supply. Which
brings us to the topic of opportunity cost.

Opportunity Cost
The scarcity of resources means that there are not sufficient goods and services to
satisfy all our needs and wants; we are forced to choose what we want. Choice is
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necessary because these resources have alternative uses- they can be used to
produce many things. But since, there is only finite resources, we have to choose.

When we choose something over the other, the choice that was given up is called
the opportunity cost.

Opportunity cost, by definition, is the next best alternative that is

sacrificed/forgone in order to satisfy the other.

Example 1: the government has a certain amount of money. There are two option: to
build a school or hospital with the money. The govt. decides to build the hospital.
The school, then, becomes the opportunity cost as it was given up. In a wider
perspective, the opportunity cost is the education the children could have received,
as it is the actual cost to the economy of giving up the school.

Example 2: you have to decide whether to stay up and study or go to bed and not
study. If you chose to go to bed, the knowledge and preparation you could have
gained by choosing to stay up and study, is the opportunity cost.

Production Possibility Curves (PPC)

Because resources are scarce and have alternative uses, a decision to devote more
resources to producing one product means fewer resources are available to produce
other goods. A Production Possibility Curve diagram shows this, that is, the
maximum combination of two goods that can be produced by an economy
with all the available resources.

The PPC diagram above shows the production capacities of two goods- X and Y-
against each other. When 500 units of good X is produced, 1000 units of good Y can
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be produced. But when the units of good X increase to 1000, only 500 units good Y
can be produced.

How is opportunity cost linked to PPC?

Individuals, businessmen and the government can calculate the opportunity cost
from PPC diagrams. In the above example, if the firm decided to increase production
of good Y from 500 to 750, it can calculate the opportunity cost of the decision to be
250 units of good X (as production falls from 1000 to 750). They are able compare
the opportunity cost for different decisions.

2.1 – Economic Systems

Economy: an area where people and firms produce, trade and consume goods and
services. This can vary in size- from your local town to your country, or the globe
itself.

Resource allocation: the way in which economies decide what goods and services
to provide, how to produce them and for who to produce them for. These questions-
what to produce, how to produce, and for whom to produce for- are termed ‘the
basic economic questions’. In short, resource allocation is the way in which
economies solve the three basic economics questions.

*(Public sector refers to everything in govt. ownership and control, while private
sector refers to everything owned and controlled by private individuals).

Economic Systems:
There are three main types of economic systems- three ways in which resources are
allocated.

• The Market* Economic System: (a.k.a free market economic system).

Here, all decisions are made by private individuals; that is, there is no
government intervention or involvement in resource allocation. (There are virtually
no economies in the world who follow this-there is a government control
everywhere, though USA does come close).

Features:

1. All resources are owned and allocated by private individuals. No govt.

control exists.

2. Thus, profit is the main motive

3.The demand and supply (covered in the next section) fixes the price of products.
This is called price mechanism.
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4.What to produce is solved by producing the most-demanded goods for

which people spend a lot, as their only motive is to generate a high profit.

5. How to produce is solved by using the cheapest yet efficient combination

of resources– capital or labour- in order to maximise profits.

6. For whom to produce is solved by producing to people who are willing and
able to pay for goods at a high price.

Advantages:

1. A wide variety of quality goods and services will be produced as different

firms will compete to satisfy consumer wants and make profits. Quality is ensured
to make sure that consumers buy from them. There is consumer sovereignty.

2. Firms will respond quickly to consumer changes in demand. When there is

a change in demand, they will quickly allocate resources to satisfying that demand,
so as to maintain profits.

3. High efficiency will exist. Since producers want to maximise profits, they
will use resources very efficiently (producing more with less resources).

4. Since there is no govt. control, there are no taxes on goods and

services and income. So, consumers have more income to consume, and
producers can cheaply produce.

Disadvantages:

1. Only profitable goods and services are produced. Public goods* and
some merit goods* for which there is no demand may not be produced, which is
a drawback and affects the economic development.

2. Firms will only produce for consumers who can pay for them. Poor people
who cannot spend much won’t be produced for, as it would be non-profitable.

3. Only profitable resources will be employed. Some resources will be left

unused. In a market economy, capital-intensive* production is favoured over
labour- intensive* production*(because it’s more cost-efficient). This can lead
to unemployment.

4. Harmful (demerit) goods may be produced if it is profitable to do so.

5. Negative impacts on society (externalities) may be ignored by producers, as

their sole motive is to keep consumers satisfied and generate a high profit.

6. A firm that are able to dominate or control the market supply of a product
is called a monopoly. They may use their power to restrict supply from
other producers, and even charge consumers a high price since they are the
only producer of the product and consumers have no choice but to buy from them.
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7. Due to high competition between firms, duplication of products may take

place, which is a waste of resources.

• Planned Economic System:

Here, all decisions are made by the government. They decide what to produce,
how to produce and for whom to produce. Example: North Korea.

Features:

1. All resources are owned and allocated by the govt. They also fix the prices.

2. Profit is not the main motive- social welfare is.

3. They produce goods that will be most beneficial to the social welfare of
the economy.

4. Efficiency may not be the highest priority as profit isn’t a motive. Thus,
they could use inefficient production methods to produce the goods.

5. Goods will be produced for all people- mainly those with poor incomes.
Rich people may demand for luxury goods, which the govt. might not be interested
in producing.

Advantages:

1. As it’s a welfare-motive economy, it will produce

necessities (food/water/clothes), public goods and merit goods.

2. Negative externalities will be controlled and reduced.

3. Prices are kept low, so it’s affordable for everyone.

4. Low unemployment can exist as the govt. aims at full employment.

5. Since there is no competition, duplication of products is eliminated.

Disadvantages:

1. Consumer sovereignty is low as the govt. decides what to produce.

2. Lack of profit motive may lead to firms being inefficient.

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• Mixed Economic System: Here, both the market and planned economy co-
exist.
Examples include almost all countries in the world (India, UK, Brazil etc). This is
because it overrides all the disadvantages of both the market and planned
economies.

Features:

1. Both the public and the private sector exists.

2. Planning and final decisions are made by the govt. while the market system can
determine allocation of resources along with the public organizations.

Advantages:

1. The govt. can provide public goods, necessities and merit goods. The
private businesses can provide most-demanded goods (luxury goods,
superior goods). Thus, everyone is provided for.

2. The govt. will keep externalities, monopolies, harmful goods etc. in control.

3. The govt. can provide jobs in the public sector (so there is better job security).

4. The govt. can also provide financial help to collapsing private organizations,
so jobs are kept secure.

Disadvantages:
1. Govt. taxes will be imposed, which will raise prices and also reduce
work incentive.

2. Govt. laws and regulations can increase production costs and reduce
production.

3. Public sector organizations will still be inefficient and will produce low quality
goods and services.

Sectors in an economy

Production in an economy can be divided into three types:

Primary sector: this involves the use/extraction of natural resources. Examples

include agricultural activities, mining, fishing, wood-cutting, oil drilling etc.
Secondary sector: this involves the manufacture of goods using the resources
from the primary sector. Examples include auto-mobile manufacturing, steel
industries, cloth production etc.
Tertiary sector: this consist of all the services provided in an economy. This
includes hotels, travel agencies, hair salons, banks etc.
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*Market: any set of arrangement that brings together all the producers and
consumers of a good or service, so they may engage in exchange. Example: a
market for soft drinks.

*Public goods: goods that can be used by the general public, from which they will
benefit. Their consumption can’t be measured, and thus cannot be charged a price
for (this is why a market economy doesn’t produce them). Examples are street lights
and roads.

*Merit goods: goods which create a positive effect on the community. Examples are
schools, hospitals, food. The opposite is called demerit goods.

*Capital- intensive production: where more capital (machinery/equipment) is made

use of rather than labour. An example is a modern car manufacturing plant

*Labour-intensive production: where more labour is made use of rather than

capital. An example is agricultural activity.

2.2 – How Markets Work

Demand:

Demand is the want and willingness of consumers to buy a good or services at

a given price.
Effective demand is where the willingness to buy is backed by the ability to pay.

(For example, when you want a laptop, but you don’t have the money, it is called
demand. When you do have the money to buy, it is called effective demand.) The
effective demand for a particular good or service is called quantity demanded.

*(Individual demand is the demand from one consumer, while market demand for
a product is the total (aggregate) demand for the product).

The law of demand states that an increase in price leads to a decrease

in demand, and a decrease in price leads to an increase in demand

(it’s an inverse relationship between price and demand. However, it’s worth noting
that an increase in demand leads to an increase in price and a decrease in demand
leads to a decrease in price. The law of demand is established with respect to
changes in price, not demand, hence the difference).
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This is an example of a demand curve for Coca-Cola.

Here, a decrease in price from 80 to 60, has increased its demand from 300 to 500.

The increase in demand due to changes in price (without changes in other

factors) is called an extension in demand. Here the extension in demand is from A
to B.

In the above example, an increase in price from 60 to 80, will decreased the demand
from 500 to 300.

The decrease in demand due to the changes in price (without the changes in
other factors) is called a contraction in demand. Here the contraction in demand
will be from B to A.

In this example, there is a rise in the demand of Coca-Cola from 500 to 600, without
any change in price. A rise in the demand for a product due to the changes in
other factors (excluding price), causes a shift to the right (from A to B).
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In this example, there is a fall in demand of Coca-Cola from 500 to 400, without any
change in price.

A fall in demand for a product due to the changes in other factors (excluding
price), causes a shift to the left (from A to B).

Factors that cause shifts in demand curve:

1. Consumer incomes: a rise in incomes increases demand, causes a shift to right.

And vice versa.

2. Taxes on incomes: a rise in tax on incomes, means less demand, causing a shift
to the left. And vice versa.

3. Price of substitutes: Substitutes are goods that can be used instead of a

particular product. Example: Tea and coffee are substitutes (they are used for
similar purposes). A rise in the price of a substitute means, a rise in the demand
for the product, causing a shift to the right. And vice versa.

4. Price of complements: Complements are goods that are used along with
another product. Example: printers and ink cartridges. A rise in the price of a
complementary good, will reduce the demand for a particular product, causing a
shift to the left. And vice versa.

5. Changes in consumer tastes and fashion: For example, the demand for mobile
phones (as opposed to smartphones) have fallen. This will cause a shift to the left.
And vice versa, if demand rises.

6. Degree of Advertising: when a good is very effectively advertised (Coke, Pepsi),

its demand rises, causing a shift to the right. And vice versa, when advertising is
low.

7. Change in population: A rise in the population will raise demand, and vice versa.

8. Other factors, such as weather, natural disasters, laws, interest rates etc.
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Supply:

Supply is the want and willingness of producers to supply a good or services

at a given price.
The amount of goods or services producers are willing to make and supply is called
quantity supplied.

*(Market supply refers to the amount of goods and services all producers supplying
that particular product are willing to supply).

The law of supply states that an increase in price leads to an increase in

supply, and a decrease in price leads to a decrease in supply.

(it’s a positive correlation between the both- moves in the same direction. It’s also
worth noting that however, an increase in supply leads to a decrease in price and a
decrease in supply leads to an increase in price. The law of supply is established
with respect to changes in price, not demand, hence the difference.)

This is an example of a supply curve for a product.

Here, an increase in price from 60 to 80, has increased its supply from 500 to 700.

The increase in supply due to changes in price (without changes in other

factors) is called an extension in supply.

In the above example, a decrease in price from 80 to 60, will decreased the
supply from 700 to 500.

The decrease in supply due to the changes in price (without the changes in other
factors) is called a contraction in supply.
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In this example, there is a rise in the supply of a product from S1 to S2, without any
change in price.

A rise in the supply for a product due to the changes in other factors
(excluding price), causes a shift to the right.

A fall in supply from S1 to S3, without any changes in price is also shown.

A fall in the supply for a product due to the changes in other factors (excluding
price), causes a shift to the left.

Factors that cause shifts in supply curve:

1. Changes in cost of production: when the cost of factors to produce the good
falls, producers can produce and supply more products cheaply, causing a shift in
the supply curve to the right. When cost of production rises, supply falls (can
include subsidies* too, though it usually results in changes in price, causing either
a contraction or extension in supply curve rather than a shift).

2. Changes in the quantity of resources available: when the amount of resources

available rises, the supply rises. And vice versa.

3. Technological changes: an introduction of new technology will be able to

produce more products, causing a shift to the right in the supply curve.

4. The profitability of other products: if a certain product is seen to be more

profitable than the one currently being produced, producers might shift to
producing the more profitable product, reducing supply of the initial product
(causing a shift to the left).

5. Other factors: weather, natural disasters, wars.

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Market Price:

The equilibrium price is the price at which the demand and supply curves meet.
Example:

P* is the equilibrium price.

Disequilibrium price is the price at which market demand and supply curves do not
meet, which in this diagram, is any price other than P*.

In this diagram, two disequilibrium prices are marked- 2.50 and 1.50.
At price 2.50, the demand is 4 while the supply is 10. There is excess supply relative
to the demand.
When the price is above the equilibrium price, a surplus is experienced.
(Surplus means ‘excess’).

At price 1.50, the demand is 10 while the supply is only 4. There is excess demand
relative to supply. When the price is below the equilibrium price, a shortage is
experienced.

*(This shortage and surplus are said in terms of the supply being short or excess
respectively).
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Price Elasticity of Demand (PED)

The PED of a product refers to the responsiveness of the quantity demanded for
it to changes in its price.

PED (of a product) = % change in quantity demanded / % change in price

For example, calculate the price elasticity of demand of Coca-Cola from this
diagram.

PED= [(500-300/300) *100] / [(80-60/80) *100] = 66.67 / 25 = 2.67

In this example, the PED is 2.67, that is, the % change in quantity demanded was
higher than the % change in the price. Which means, a change in price makes a
higher change in quantity demanded.

These products have a price elastic demand. Their values are always above 1.

When the % change in quantity demanded is lesser than the % change in price, it is
said to have a price inelastic demand. Their values are always below 1. A change
in price makes a smaller change in demand.
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When the % change in demand and price are equal, that is value is 1, it is
called unitary price elastic demand.

When the quantity demanded changes without any changes in price itself, it is
said to have an infinitely price elastic demand. Their values are infinite.

When the price changes have no effect on demand whatsoever, it is said to

have a price inelastic demand. Their elasticity is 0.

What affects PED?

1. No. of substitutes: If a product has many substitute products it will have a elastic
demand. For example, Coca-Cola has many substitutes such as Pepsi, 7 Up etc.
Thus, a change in price will have a profound effect on its demand (If price rises,
consumers will quickly move to the substitutes and if price lowers, more
consumers will buy Coca-Cola).
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2. Time period: Demand for a product is more likely to be elastic in the long run. For
example, if the price rises, consumers will search for cheaper substitutes. The
longer they have, the more likely they are to find one.

3. Proportion of Income spend on commodity: goods such as rice, water

(necessities) will have an inelastic demand as a change in price won’t have any
significant effect on its demand, as it will only take up a very small proportion of
their income. Luxury goods such as cars, on the other hand will have a price
elastic demand, as it takes up a huge proportion of consumers’ incomes.

How is PED helpful to producers?

Producers can calculate the PED of their product and take a suitable action to make
the product more profitable.

If the product is found to have an elastic demand, the producer can lower prices
to increase profitability. The law of demand states that a price fall increases the
demand. And since, it is an elastic product (change in demand is higher than change
in price), the demand of the product will increase highly. The producers get more
profit.

If the product is found to have an inelastic demand, the producer can raise
prices to increase profitability. Since quantity demanded wouldn’t fall much as it is
inelastic, the high prices will make way for higher revenue and thus higher profits.

Price Elasticity of Supply (PES)

The PES of a product refers to the responsiveness of the quantity supplied it to

changes in its price.

PES of a product= %change in quantity supplied / %change in price

Similar to PED, PES too can be categorized into price elastic supply, price inelastic
supply, perfectly price inelastic supply, infinitely price elastic supply and unitary price
elastic supply.

What affects PES?

1. Time of production: If the product can be quickly produced, it will have a price
elastic supply as the product can be quickly supplied at any price. For example,
juice at a restaurant. But product which take a longer time to produce, example
cars, will have a price inelastic supply as it will take a longer time for supply to
adjust to price.

2. Availability of resources: More resource (land, labour, capital) will make way for
an elastic supply. If there are not enough resources, producers will find it difficult to
adjust to the price changes, and supply will become price inelastic.
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*Subsidies: a grant (financial aid) given by the government to producers, so they

may reduce their cost of production and lower prices.

2.3 – Social Costs and Benefits; Market Failure

External Costs and Benefits

External costs (negative externalities) are the negative impacts on third parties
due to production or consumption of goods and services. Example: the pollution from
a factory.

External benefits (positive externalities) are the positive impacts on the society
due to production or consumption of goods and services. Example: better roads for
the society due to the opening of a new business.

Private Costs and Benefits:

Private costs are the costs to the producer and consumer due to production and
consumption respectively. Example: the cost of production.

Private benefits are the benefits to the producer or consumer due to production and
consumption respectively. Example: the better immunity received by a consumer
when he receives a vaccine.

Social Costs and Benefits

Social Costs = External costs + Private Costs

Social Benefits = External benefits + Private benefits

Market Failure
Market failure occurs when resources are allocated inefficiently. This is the most
disadvantageous aspect to the Market Economy. Causes of market failure are:

1. When social costs exceed social benefits. (Especially where negative

externalities (external costs) are high).
2. Over-provision of demerit goods (alcohol, tobacco).
3. Under-provision of merit goods (schools, hospitals, public transport).
4. Lack of public goods (roads, bus terminals, streetlights).
5. Immobility of resources. When resources are not used to the maximum.
6. Information failure: When information between consumers, producers and the
government are not efficiently and correctly communicated. Example:
wrong information about a product is given to consumers.
7. Abuse of monopoly* powers: Monopolistic businesses may use their powers to
charge consumers a high price and only produce products they wish to, since they
know consumers have no choice but to buy from them.
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*Monopoly: a single supplier who supplies the entire market, without any
competition. Example: Microsoft is very close to being a total monopoly, with hardly
any competitors.

3.1 – Money and Finance

Money

What is money?

A medium of exchange of goods and services.

Why do we need money?

We need money if we are to exchange goods and services with one another. This is
because we aren’t self-sufficient- we can’t produce all our wants by ourselves. Thus,
there is a need for exchange.

In the past, barter system (exchanging a good or service for another good or
service) prevailed. This had a lot of problems such as the need for the double
coincidence of wants (if the person wants a table and he has a chair to exchange, he
must find a person who has a table to exchange and also is willing to buy a chair),
the goods being perishable and non-durable, the indivisibility of goods, lack of
portability etc.

Thus, the money we use today are in the form of currency notes and coins, which
are durable, non-perishable, divisible (can be divided into 10’s, 50’s, 100’s
etc), portable and is generally accepted.

The functions of money:

1. Money is a medium of exchange, as explained above.

2. Money is a measure of value. Money acts as a unit of account, allowing us to
compare and state the worth of different goods and services.
3. Money is a store of value. It holds its value for a long, long time, allowing us to
save it for future purposes.
4. Money is a means of deferred payment. Deferred payments are purchases on
credit- where the consumer can pay later for the goods or service they buy.

Banks and Stock Exchanges

Banks are financial institutions that act as an intermediary between borrowers and
savers.
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Commercial banks are those banks that have many retail branches located in most
cities and towns. Example: HSBC. While there is only one central bank that governs
all other commercial banks in a country. Example: The Reserve Bank of India (RBI).

Functions of a commercial bank:

1. Accepting deposits of money and savings.

2. Aid customers in making and receiving payments.
3. Giving loans to businesses and private individuals.
4. Buying and selling shares on customer’s behalf.
5. Providing insurance (protection in the form of money against damage/theft of
personal property).
6. Exchanging foreign currencies.
7. Providing financial planning advice.

Functions of a central bank:

1. It issues notes and coins for the nation’s currency.

2. It manages all payments relating to the government.
3. It manages national debt. Central banks can issue and repay public debts on the
government’s behalf.
4. It supervises and controls all the other banks in the whole economy, even holding
their deposits and transferring funds between them.
5. It is the lender of ‘last resort’ to commercial banks. When other banks are having
financial difficulties, the central bank can lend them money to prevent them from
going bankrupt.
6. It manages the country’s gold and foreign currency reserves. These reserves are
used to make international payments and adjust their currency value (adjust the
exchange rate).
7. It operates the monetary policy in an economy. (This will be explained in a later
chapter)

A stock exchange is a business organization that enables individuals, companies

and the government to buy and sell shares* on the global stock market. It is the most
important source of finance for most businesses.
Example: New York Stock Exchange (NYSE).

Functions of stock exchange:

1. It brings together buyers and sellers of stocks(shares)

2. It provides information on the market prices of stocks.
3. It supervises the conduct of firms of brokers that buy and sell shares on behalf of
investors.

*Shares: A unit of ownership in a company. Companies issue shares to the public

through stock exchanges. Individuals can buy these shares through the stock
exchange (invest in the company) and be an owner of the company. The company
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gets more finance (capital) and the individual (shareholder) gets ownership (he will
get part of the profits the company makes-dividends).

3.2 – Occupations and Earnings

Workers need wages to satisfy their wants and needs.

Payments for labour:

1. Time-rate wage: wage given based on the no. of hours the employee has worked.
An overtime rate can be given to workers who has worked extra no. of hours,
which will be usually 1.5 times or even twice the normal time rate.

2. Piece-rate wage: wage given based on the no. of output produced. The more
output an employee produced, the more wage he earns. This is used in industries
where output can be easily measured and gives employees an incentive to
increase productivity.

3. Salary: monthly payments made to workers, usually managers, office staff etc
in non-manual jobs (work that is done with electronic devices and uses mental
skills rather than being physically done with the use of hands).

4. Performance-related payments: payments given to individual workers or teams

of workers who have performed very well. The commission given to salespersons
for selling to a targeted no. of customers comes under performance-related pay.

What affects an individual’s choice of occupation?

1. Wage factors: The wage conditions of a job/firm such as the pay rate, the
prospect for performance-related pay, bonus etc will be considered by the
individual before he chooses a job.

2. Non-wage factors: This will include:

1. Hours of work
2.Holiday entitlement
3. Promotion prospects
4. Quality of working environments
5. Job security
6. Fringe benefits (free medical insurance, company car, price discounts etc)
7. Training opportunities
8. Distance from work to home
9. Pension entitlement
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Labour Market

Labour demand is the demand of labour by firms to produce goods and

services at a given wage rate.

This demand is called a ‘derived demand’, since the level of demand of a product
determines that industry’s demand for labour. That is, the higher the demand for a
product, the more labour producers will demand to increase supply of the
product.

When the wage increases, the demand for labour contracts, and vice versa.

Labour supply is the supply of labour available and ready to work in an

industry at a given wage rate. When the wage rate increases, the supply of labour
extends, and vice versa.

We also know that as the no. of hours worked increases, the wage rate also
increases. However, when a person get to a very high position and his wages/salary
increases highly, his no. of hours may decrease.

Just like in a demand and supply curve analysis, labour demand and supply will
extend and contract due to changes in the wage rate. Other factors that cause
changes in demand and supply of labour will result in a shift in the demand
and supply curve of labour.

Factors that cause a shift in the labour demand curve:

1. Consumer demand for goods and services: The higher the demand of the
product, the higher the demand for labour.
2. Productivity of labour: the more productive the labour is, the more the demand
for labour.
3. Price and productivity of capital: Capital is a substitute resource for labour. If
the price of capital were to lower and its productivity to rise, firms will demand
more of capital and labour demand will fall- shift to the left.
4. Non-wage employment costs: Wages are not the only cost to a firm of
employing workers. Sometimes, employment tax, welfare insurance for each
employee etc will have to be paid. If these costs increase, firms will demand less
labour.

Factors that cause a shift in the labour supply curve:

1. Advantages of an occupation: The different advantages a job can offer to

employees will affect the supply of labour- the people willing to do that job.
Example: If the no. of hours worked in the airline industry increases, the labour
supply there will shift to the left.
2. Availability and quality of education and training: is quality training and
education for a particular job, say pilots, is lacking, then the labour supply for it will
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be low. When new education and training institutes open, the labour supply will
rise- shift to the right.
3. Demographic changes: the size and age structure of the population in an
economy can affect the labour supply. The labour supply curve will shift to the right
when more people come into a country from outside (immigration) and the birth
rate increases (more young people available for work).

Earnings

Why would a person’s wage rate change overtime?

As a beginner, the individual would have a low wage rate since he/she is new to the
job and has no experience. Overtime, as his/her experience increases and skills
develop, he/she will earn a higher wage rate. If he/she gets promoted and has more
responsibilities, his/her wage rate will further increase. When he/she nears
retirement age, the wage rate is likely to decrease as their productivity and skills are
likely to weaken.

Wage differentials

Why do different jobs have different wages?

1. Different abilities and qualifications: when the job requires more skills and
qualifications, it will have a higher wage rate.
2. Risk involved in the job: risky jobs such as rescue operation teams will gain a
higher wage rate for the risks they undertake.
3. Unsociable hours: people who have night shifts and work at other unsociable
hours are paid more than other workers.
4. Lack of information about other jobs and wages: Sometimes people work for
less wage rates simply because they do not know about other jobs with higher
wage rates.
5. Labour immobility: the ease with which workers can move between different
occupations and areas of an economy is called labour mobility. If labour mobility
is high, workers can move to jobs with a higher pay. Labour immobility causes
people to work at a low wage rate because they can’t move to the jobs with a
higher wage.
6. Fringe benefits: jobs which offer a lot of fringe benefits have low wages. But
sometimes, the highest-paid jobs are also given a lot of fringe benefits, to attract
skilled labour.

Why do wages differ between people doing the same job?

1. Regional differences in labour demand and supply: For example, if the labour
demand in an area for accountants is very high, the wage rate will be high,
whereas, in an area of low labour demand for accountants, the wage rates will be
low.
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2. Fringe benefits: some firms which pay a lot of fringe benefits, will pay less wages,
while firms (in the same industry) which pay less fringe benefits will have higher
wages.
3. Discrimination: Workers doing the same work may be discriminated by gender,
race, religion or age.
4. Length of service: Some firms provide extra pay for workers who have worked in
the firm for a long time, while other firms may not. There is a wage differential.
5. Local pay agreements: Some national trade unions may agree a national wage
rate for all their members- therefore all their members (labourers) will get a higher
wage rate than those who do the same job but are not in the trade union.

Other wage differentials:

1. Public-private sector pay gap: public sector jobs usually have a high wage rate.
But sometimes public sector wages are lower than that of private sector’s because
low wages can be compensated by the public sector’s high job security and
pension prospects.
2. Skilled and unskilled workers: Skilled workers have a higher pay than unskilled
workers, because they are more productive and efficient and make lesser
mistakes.
3. Gender pay gap: Men are usually given a higher pay than women. This is
because women tend to go for jobs that don’t require as much skills as that
required by men’s jobs (teaching, nursing, retailing); they take career breaks to
raise children, which will cause less experience and career progress (making way
for low wages); more women work part-time than full-time. Sometimes, even if
both men and women are working equally hard and effectively, discrimination can
occur against women.
4. International wage differentials: developed countries usually have a high wage
rates due to high incomes, large supply of skilled workers, high demand for goods
and services etc; while in a less-developed economy, wage rated will be low due
to a large supply of unskilled workers.

3.3 – The Role of Trade Unions

Trade Unions are an organization of workers that aims at promoting and
protecting the interest of their members (workers).

They aim on improving wage rates, working conditions and other job-related aspects
of workers.

The functions of a trade union:

1. Negotiating improvements in non-wage benefits with employers.

2. Defending employees’ rights.
3. Improving working conditions, such as better working hours and better safety
measures.
4. Improving pay and other benefits.
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5. Supporting workers who have been unfairly dismissed or discriminated.

6. Developing the skills of members, by providing training and educations.
7. Providing recreational activities for the members.
8. Taking industrial actions (strikes, overtime ban etc) when employers don’t
satisfy their needs. These are explained later in this topic.

Collective bargaining: the process of negotiating over the pay and working
conditions between trade unions and employers.

When can trade unions argue for higher wages and better working conditions?

1. Prices are rising (inflation). The cost of living increase when prices increase, and
workers will want higher wages to consume products and raise their families.
2. The sales and demand of the firm has increased.
3. Workers in other firms are getting a higher pay.
4. The labour productivity of the members has increased.

Industrial disputes

When firms don’t satisfy trade union wants, or refuse to agree to their terms, the
members of a trade union can organize industrial disputes. Here are some:

1. Overtime ban: Workers refuse to work more than their normal hours.
2. Go-slow: Workers deliberately slow down production, so the firm’s sales and
profits go down.
3. Strike: workers refuse to work and may also protest, picket, outside their
workplace to stop deliveries and prevent other non-union members from entering.
They don’t receive any wages during this time. This will halt all production of the
firm.

This will cause a lot of problems:

1. Businesses will have high costs and low output. Their revenue and profits will
god own and they will enter a loss. They may also lose a lot of customers to
competing firms.
2. Union members might now get even less wages-or none if the go on a strike–
as the output and profits of the firm falls.
3. Consumers may be unable to obtain goods and services they
need, especially if firms producing necessities have industrial disputes.
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3.4 – Spending, Saving and Borrowing

Disposable income is the income of a person after all income-related taxes and
charges have been deducted.

Spending (Consumption)
The buying of goods and services is called consumption. The money they spend
through consumption is called consumer expenditure.

Why do people consume?

To satisfy their needs and wants and give them satisfaction.

What are the factors affecting consumption in an economy?

1. Disposable income: the more the disposable income, the more people consume.
2. Wealth: the wealthier (assets such as property, jewels, company shares) a person
is, the more he spends.

3. Consumer confidence: If consumers are confident of their jobs and their future
incomes, then they might be encouraged to spend more now, without worries.

4. Interest rates: if interest rates provided by banks on saving is high, consumers

might save more so they can earn interest and consumer expenditure will fall.

Saving

Saving is income not spent or delaying consumption until some later date. People
can save money by depositing in banks, and withdraw it a later date with the interest.

Why do people save? / Factors affecting saving:

1. Saving for consumption: People save so that they can consume later. They save
money so that they can make bigger purchases in the future (house, car etc).
Thus, saving can depend on the consumers’ future plans.
2. Interest rates: People also save so that their savings may increase overtime with
the interest added. Interest is the return on saving; the longer you save an amount
and the higher the amount, the higher the interest received.
3. Consumer confidence: If the consumer is not confident about his job security and
incomes in the future, he may save more now.
4. Availability of saving schemes: Banks now offer a variety of saving schemes.
When there are more attractive schemes that can benefit consumers, they might
resort to saving rather than spending.
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Borrowing

Borrowing, as the word suggests, is simply the borrowing of money from one
person to another. The lender gives the borrower money. The lender is usually the
bank which gives out loans to customers.

Factors affecting borrowing:

1. Interest rates: Interest is also the cost of borrowing. When a person takes a loan,
he must repay the entire amount with an extra amount interest, which is fixed by
the bank. When the interest rates rise, people will be more reluctant to borrow and
vice versa.
2. Wealth: Banks will be more willing to lend to wealthy people, because they are
more likely to be able to repay the loan, rather than the poor.
3. Consumer confidence: How confident people feel about financial situation in the
future may affect borrowing, too. For example, if they think that prices will rise
(inflation) in the future, they might borrow now, so that they can make big
purchases.
4. Ways of borrowing: The no. of ways to borrow can influence borrowing.
Nowadays there are many borrowing facilities such as overdrafts, bank loans etc.
and have more credit (period of payment) options such as hire purchases
(payment is done in stages/instalments overtime), credit cards etc.

Expenditure patterns between income groups

The richer people spend, save and borrow more amounts than the poor.
The poor spend more proportion of their disposable income, especially on
necessities, than the rich.
The poor save less proportion of their disposable income in comparison with the rich.

4.1 – Types of Business Organizations

Sole Trader/Sole Proprietorship

A business organization owned and controlled by one person. Sole traders can
employ other workers, but only he/she invests and owns the business.

Advantages:

1. Easy to set up: there are very few legal formalities involved in starting and
running a sole proprietorship. A less amount of capital is enough by sole traders to
start the business. There is no need to publish annual financial accounts.
2. Full control: the sole trader has full control over the business. Decision-making is
quick and easy, since there are no other owners to discuss matters with. This will
also eliminate possibilities of conflicts among owners.
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3. Sole trader receives all profit: Since there is only one owner, he/she will receive
all of the profits the company generates.
4. Personal: since it is a small form of business, the owner can easily create and
maintain contact with customers, which will increase customer loyalty to the
business and also let the owner know about consumer wants and preferences.

Disadvantages:

1. Unlimited liability: if the business has bills/debts left unpaid, legal actions will be
taken against the investors, where their even personal property can be seized, if
their investments don’t meet the unpaid amount. This is because the business and
the investors are the legally not separate (unincorporated).
2. Full responsibility: Since there is only one owner, the sole owner has to
undertake all running activities. He/she doesn’t have anyone to share his
responsibilities with. This workload and risks are fully concentrated on him/her.
3. Lack of capital: This is a major disadvantage to sole proprietorship. As only one
owner/investor is there, the amount of capital invested in the business will be very
low. This can restrict growth and expansion of the business. Their only sources of
finance will be personal savings or borrowing or bank loans (though banks will be
reluctant to lend to sole traders since it is risky).
4. Lack of continuity: If the owner dies or retires, the business dies with him/her.

Partnerships

A partnership is a legal agreement between two or more (usually, up to

twenty) people to own, finance and run a business jointly and to share all profits.

Advantages:

1. Easy to set up: Similar to sole traders, very few legal formalities are required to
start a partnership business. A partnership agreement/ partnership deed is a legal
document that all partners have to sign, which forms the partnership. There is no
need to publish annual financial accounts.
2. Partners can provide new skills and ideas: The partners may have some skills
and ideas that can be used by the business to improve business profits.
3. More capital investments: Partners can invest more capital than what a sole
trade only by himself could.

Disadvantages:

1. Conflicts: arguments may occur between partners while making decisions. This
will delay decision-making.
2. Unlimited liability: similar to sole traders, partners too have unlimited liability-
their personal items are at risk if business goes bankrupt
3. Lack of capital: smaller capital investments as compared to large companies.
4. No continuity: if an owner retires or dies, the business also dies with them.
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Multinational Corporations (MNCs)

A multinational is a firm that has business operations in more than one

country, but will usually have its headquarters based in its country of origin. They
are all usually joint-stock companies. Example: Wal-Mart Stores Inc.

Advantages:

1. Reach more consumers globally, increasing sales.

2. Avoid trade barriers and import tariffs by setting up operations in countries that
impose them. This will reduce costs.
3. Minimize transportation costs of exporting by locating operations in the
countries where products are sold.
4. Minimize wage costs by locating operation in countries with low wage costs.
5. A large scale of production will lower its average costs (economies of scale,
explained later in the syllabus).

Advantages to host country of MNCs:

1. They increase investments in the country (direct inward investments), which

will contribute to the development and growth of the economy.
2. They provide jobs and incomes for local workers.
3. They bring in new knowledge and skills, which will be beneficial in increasing
productivity of domestic (local) firms.
4. They will have to pay taxes on their profits to the host country, help raising
govt. revenue.

Disadvantages to host country of MNCs:

1. They may exploit workers: In economies with a low wage, multinationals may
pay employees far less than what they do in other countries. They may also
provide poor health and safety measures in less-developed economies.
2. Natural resources may be exploited: As multinational use up more resources for
production, natural resources (land) such as water and wood may get exhausted.
They may even damage the environment.
3. Profits maybe switched to origin countries, to avoid taxation. This is called
repatriation of profits; this will reduce any possibilities of the govt. gaining more tax
revenue from them.
4. They can use their power and reputation to obtain subsidies and tax deductions
form the govt.: Because they provide lots of jobs and incomes, governments
encourage multinationals to locate there. This would be unfair to other local firms.
5. Local competition may be threatened: Domestic firms will find it hard to keep up
with multinationals and they lose a lot of customers to these MNCs, forcing them
to close down.
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Public Sector Organizations (Public Corporation)

All organizations owned and controlled by the government (all of the above are
owned by private individuals). They deliver essential services such as healthcare,
education, streetlights and roads.

They are usually given at low costs or sometimes freely and do not aim to make a
profit. Instead they aim at providing cost-effective services that are funded by tax
revenue. Businesses under the public sector are called public corporation.

Public corporations’ profits are either reinvested into the business for improvement or
used by the government to fund their activities. They also have limited liability in the
sense that when debts exist, the corporation can be sued, but the government can’t,
because they are an incorporated business (has separate legal identity)

Public corporations are run by a board of directors, chosen by a govt. minister to run
and manage the corporation and they are accountable to the minister.

Nationalization and Privatization

Nationalization is the transfer of ownership of an entire industry from the private

sector to the public sector.
Why are private firms nationalized?
• To control large powerful firms, especially those providing essential products, such
as electricity and gas.
• To protect employment in large firms which may be on the verge of closing down.
• To protect public services. Private firms may be charging too high a price for
essential services in order to maintain profits. Nationalized firms can provide these
even at a loss.

Privatization is the transfer of ownership of an entire industry from the public sector
to the private sector.
Why are public firms privatized?
• To increase efficiency of a particular industry, since the private sector is profit-
motive.
• To raise money for other government projects (by selling firms to private
individuals, the govt. gets money)

4.2 – Organizing Production

Production and Productivity
A firm combines scarce resources of land, labour and capital (inputs) to make
(produce) goods and services (output). Production is thus, the transformation of raw
materials (input) to finished or semi-finished goods and services (output).
In other words, production is the adding of value to inputs to create outputs. It is the
production that gives the inputs value.
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Productivity measures the amount of output that can be produced from a given
amount of input over a period of time

Productivity = Total output produced per period / Total input used per period
Productivity increases when:

• more output or revenue is produced from the same amount of resources

• the same output or revenue is produced using fewer resources

Labour productivity is the measure of the amount of output that can be produced
by each worker in a business.

Average Labour productivity = Total output produced per period / Total no of

employees

How to increase productivity?

1. Implement division of labour. Division of labour is when tasks are divided

among labourers. Each labourer specializes in a particular task, and thus this will
increase productivity. For more details on division of labour
2. Training workers to improve their existing skills to increase productivity
3. Rewarding productive workers with bonuses and other performance-related
pay, which will give them and other workers incentive to be productive.
4. Increasing job satisfaction of workers, so they will work productively
5. Replacing old machinery with new ones, preferably with latest technologies, to
increase efficiency and productivity.
6. Introduce new production processes which will reduce wastage, increase
speed, improve quality and raise output. This is known as lean production.

Factors of Production

Labour-intensive production is where more labourers are employed than capital.

Example: hotels.
Capital-intensive production is where more capital are employed than labourers.
Example: Car-manufacturing. Most production here will be automated.

What affects the demand of these factors of production?

1. The amount of goods and service the consumers demand: If more goods and
services are demanded, more factors of production will be demanded by firms.
That is, the demand for factors of production is derived demand, as it is
determined by the demand for the goods and services (just like labour demand).
2. The market prices for labour and capital: If labour is more expensive than
capital, firms will demand for capital and vice versa, as they want to reduce costs
and maximize profits.
3. The productivity of labour and capital: If labour is more productive than capital,
then labour is demanded and vice versa.
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Costs and Revenues

Total Revenue = Total units sold * Price per unit

Average revenue per unit = Total Revenue / Total units sold

Total Costs = Total Fixed Costs + Total Variable Costs

Fixed costs are costs that are fixed in the short-term running of a business and
have to be paid even when no production is taking place. Examples: rent, interest on
bank loans, telephone bills. These costs do not depend on the no. of output
produced.

Variable costs are costs that are variable in the short-term running of a business
and are paid according to the output produced. The more the production, the more
the variable costs. Examples: Wages, electricity bill, cost of raw materials.

Average Costs per unit = Total Cost / Total Output

As output of a firms, increases its average costs will decrease (this is

called economies of scale), simply because fixed costs remain the same whatever
the output and the fixed cost burden is spread over a much larger output.

However average costs may start to rise again as it gets more expensive to increase
output further (diseconomies of scale)

Profit = Total Revenue- Total Costs

Average profit per unit = Average Revenue – Average Costs

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All these can be graphically represented in a break-even analysis graph.

Here, notice that the fixed costs are constant at all outputs; the total cost is the
sum of both the fixed cost and the variable cost; the total revenue is also drawn.

The point at which total revenue = total costs is called the break-even (point)
level of output.

It is the point at which the firm starts to make a profit. This will help firms know how
much they have to produce to generate a profit.

Another way to calculate the break-even level of output without drawing the graph is:

Break-even level of output = Total fixed costs / (Price per unit – Variable cost
per unit)

4.3 – The Growth of Firms

The Size of Firms
The sizes of firms can be measured in a number of ways:

1. Number of employees: The more the no. of workers employed, the larger the
business is likely to be. But this is not true in many cases, especially in capital-
intensive industries, where more capital is used than labourers (and the firm is still
large)
2. Capital employed: this is the money invested in the business in productive assets
(machinery, factory, stock of raw materials, money to pay wages etc) to produce
goods and services and generate revenue. The more the capital employed in a
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firm, the larger their production will be and larger their size. However, labour
intensive industries, where more workers are used than capital can also be large.
3. Market share: Market share is the total market sales a firm is able to capture.
Market share = (Total sales of firm’s product / Total market sales of product)
* 100. (For example, Coca-Cola has the highest market share in the fizzy drinks
market) The higher a firm’s market share, the larger the firm is likely to be. But this
depends on the size of the market itself. For example, a local salon will have a
high market share, since the market is only a local town, but it is still a small
business.
4. Organization: The internal organization- how the departments are organized- can
tell a lot about its size. Large firms will have different specialized departments and
people under them (purchasing, marketing, finance, production etc), while in a
smaller business, the owners and employees share all the work among them.

Other measure such as the total output and profit can also be used to compare the
sizes of different businesses. But, virtually, all these factors individually cannot
determine the size of a business.

Growth of Firms

When a firm grows, it’s scale of production (amount of output) increases. Firms can
grow in two ways: internally or externally.

Internal Growth/Organic Growth

This involves expanding the scale of production of its existing operations. This
can be done by purchasing more machinery/equipment, opening more branches,
selling new products into the market, expanding business premises, employing more
workers etc.

External Growth

This involves two or more firms joining together to form a large business. This
is called integration. This can be done it two ways: mergers or takeovers.

A takeover or acquisition happens when a company buys enough shares of

other firms that they can take full control. This can happen without the owners’
agreement. The firm taken over loses its identity and become a part of what is known
as the holding company. A well-known example would be Facebook’s acquisition of
WhatsApp in 2014.

A merger occurs when the owners of two or more companies agree to join
together to form a firm.
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Integration can happen in three ways:

1. Horizontal Integration: integration of firms engaged in the production of the same

type of good at the same level of production. Example: a cloth manufacturing
company merges with/takes over another cloth manufacturing company.

2. Vertical Integration: integration of firms engaged in the production of the same

type of good but at different levels of production (primary/secondary/tertiary).
Example: an electronics manufacturing company merges with/takes over a
electronic retail business.

Forward vertical integration: when a firm integrates with a firm that is at a later
stage of production than theirs. Example: a dairy farm integrates with a cheese
manufacturing company.

Backward vertical integration: when a firm when a firm integrates with a firm that
is at an earlier stage of production than theirs. Example: a chocolate selling firm
integrates with a chocolate manufacturing company.

3. Conglomerate integration: occurs when firms producing different type of

products integrates. They could be at the same or different sage of production.
Example: a housing company integrates with a dairy farm. Thus, the firm can
produce a wide range of products.

Scale of Production

As discussed in the last topic, as a firm’s scale of production (output) increases its
average costs decrease. Cost saving from a large-scale production is
called economies of scale.

Internal economies of scale are decisions taken within the firms that can bring
about economies (advantages). Some internal economies of scale are:

1. Purchasing economies: Large firms can buy raw materials and components in
bulk because of their large scale of production. Supplier will usually offer price
discounts for bulk purchases, which will cut purchasing costs for the firm.
2. Marketing economies: Large firms can afford their won vehicles to distribute their
products, which is much cheaper than hiring other firms to distribute them. Also,
the costs of advertising are spread over a much large output in large firms when
compared to small firms.
3. Financial economies: Banks are more willing to lend to lend money to large
firms, since they are more financially secure (than small firms) to repay
loans. They are also likely to get lower rates of interest. Large firms
(companies) also have the ability to sell shares to raise capital that do not have to
be repaid. Thus, they get more money at lower costs.
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4. Technical economies: Large firms are more financially able to invest in good
technology, skilled workers, machinery etc which are very efficient and cut costs
for the firm.
5. Risk-bearing economies: Large firms with a high output can sell into different
markets (even overseas). They are able to produce a variety of products
(diversification in production). This means that their risks are spread over a wider
range of products or markets; even if a market or product is not successful, they
have other products and markets to continue business. Thus, costs are less.

External economies of scale occur when firms benefit from the entire industry
being large. They may include:

1. Access to skilled workers: Large firms can recruit workers trained by other firms.
For example: when a new training institution for pilots and airline staff opens, all
airline firms can enjoy economies of scale of having access skilled workers, who
are more efficient and productive and cuts costs.
2. Ancillary firms: They are firms that supply and provide materials/services to
larger firms. When ancillary firms such as a marketing firm locates close to a
company, the company can cut costs by using their services more cheaply than
other firms.
3. Joint marketing benefits: When firms in the same industry locates close to each
other, they may share an enhanced reputation and customer base.
4. Shared infrastructure: A development in the infrastructure of an industry or the
economy can benefit large firms. Examples: More roads and bridges by the govt.
can cut transport costs for the firms, a new power station can provide cheaper
electricity for firms.

Diseconomies of scale occur when a firm grows too large and average costs
start to rise. Some common diseconomies are:

1. Management diseconomies: Large firms have a wide internal organization with

lots of managers and employees. This makes communication difficult and
decision-making very slow. Gradually, it leads to inefficient managerial running of
the firms and increases costs.
2. Too much output may require a large supply of raw materials, power etc. which
can lead to shortage and halt production, increasing costs.
3. Large firms may use automated production with lots of capital equipment. Worker
operating these machines may feel bored in doing the repetitive tasks, and
thus demotivated and less cooperative. Many workers may leave or others
could go on strikes, stopping production and increasing costs.
4. Agglomeration diseconomies: this occurs when firms merge/acquire too many
different firms producing different products, and the managers and owners can’t
coordinate and organize all activities, leading to higher costs.
5. More shares sold into the market and bought means more owners coming into the
business. Having a lot of owners can lead to a lot of disputes and
conflicts among themselves.
6. A lot of large firms can face diseconomies when their products become too
standardized and less of a variety in the market. This will reduce sales and
profits and increase average costs.
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Why do some firms remain small?

1. The size of their market is small: Business like hairdressers, restaurants, cafés,
hotels that provide personalized goods and services, can only supply to a small
market.
2. Access to capital is limited, so owners can’t grow the firm.
3. Owner(s) prefer to stay small: A lot of entrepreneurs don’t want to take risks by
growing the firm and they are quite satisfied with running a small business.

4.4 – Competition and Monopoly

Firms compete in the market to increase their customer base, sales and market
share and profits. All of this will give them a better image and reputation in the
market.

Price competition involves competing to offer consumers the lowest or best

possible prices of rival products.

Non-price competition is competing on all other features of the product (quality,

promotional campaigns, attractive displays, after-sales care, warranty etc) other than
price.

Informative advertising involves providing information about the product to

consumers. Examples include advertising of phones, computers, food ingredients
etc.

Persuasive advertising is designed to create a consumer want and boost sales of

the product. Examples include perfumes, clothes, chocolates etc.

Advertising of a product will increase the demand of the product, causing a shift in
the demand curve to the right, which will cause an increase in the price (from P0 to
P1 in the diagram)
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Perfect Competition

In a perfectly competitive market, there will be many sellers and many buyers– a
lot of different firms compete to supply an identical product to an equally large
customer base.

As there is fierce competitions, producers nor consumers cannot influence

market price- they are all price takers. If any firm did try to sell at a high price, it
would lose customers to competitors. If the price were too low, they may incur a loss.
There will also be a huge amount of output in the market.

Advantages:

1. High consumer sovereignty: consumers will have a wide variety of goods and
services to choose from, as many producers will sell similar products. They are
also likely to be of high quality, in order to attract consumers.
2. Low prices: as competition is fierce, producers will try and keep prices low to
attract customers and increase sales.
3. Efficiency: to keep profits high and lower costs, firms will be very efficient. If they
aren’t efficient, they would become less profitable. This will cause them to raise
prices which would discourage consumers to buy their product. Inefficiency could
also lead to poor quality products.

Disadvantages:

1. Wasteful competition: In order to keep up with other firms, producers will

duplicate items. Similar products are sold by many firms; this is considered a
waste of resources.
2. Mislead customers: To gain more customers and sales, firms might give false
and exaggerated claims about their product, which would disadvantage both
customers and competitors.

Monopoly

Dominant firms who have market power to restrict competition in the market
are called monopolies.

In a pure monopoly, there is only a single seller who supplies a good or service.
Example: Indian Railways. Since, customers have no other firms to buy from,
monopolies can raise prices- that is they are able to influence prices as it will not
affect their profitability. These high prices result in monopolies generating excessive
or abnormal profits.

Disadvantages:

1. There is less consumer sovereignty: as there are no (or very little) other firms
selling the product, output is low and thus there is little consumer choice.
2. Monopolies may not respond quickly to customer demands.
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3. Higher prices
4. Lower quality: as there is little or no competition, monopolies have no incentive to
raise quality, as consumers will have to buy it anyway. (But since they make a lot
of profit, they may invest a lot in research and development and increase quality)
5. Inefficiency: With high prices, they may create high enough revenue that, costs
due to inefficiency won’t create a significant problem in profitability.

Why monopolies are not always bad?

1. As only a single producer exists, it will produce more output than what individual
firms in a competition do, and thus benefit from economies of scale.
2. They can still face competition from overseas firms.
3. They could sell products at lower price and high quality if they fear new firms may
enter the market in the future.

5.1 – Government Economic Policy

The public sector in every economy plays a major role, as a producer and employer.
Here are some functions of the government:

• To provide goods and services that are in the public interest. This will include
public goods and merit goods.
• To invest in national infrastructure (roads, railways, schools etc.)
• To support agriculture and other prime industries
• To manage the macro economy
• To help vulnerable groups of people in the society.

The Macroeconomic Aims

The govt. has five major macroeconomic objectives:

A. A low and stable rate of inflation– Inflation is the continuous rise in the
average price levels. If prices rise too quickly it can negatively affect the
economy because it can:
•
1. Reduce people’s purchasing powers: people will be able to buy less with
the money they have now, than before.
•
2. Cause hardships for the poor.
•
3. Increase business costs especially as workers will demand for more
wages to support their livelihood.
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4. Will make products more expensive than products of other countries with
low inflation. This will reduce exports.

B. A high and stable level of employment. If there is a high level of

unemployment in a country, the following may happen:

1. The total national output (goods produced) will fall.

2. Government may have to give welfare payments (unemployment benefits)

to the unemployed, increasing public expenditure.

C. Stable and good economic growth. Economic growth refers to the gross
domestic product (GDP) per head, i.e., the amount of goods and services
available for every person in the economy. More output means more
economic growth. But if output falls over time (economic recession), it can
cause:

1. Employment, incomes and living standards of the people will fall.

2. The tax the govt. collects from goods and services and incomes will fall,
which will, in turn, lead to a cut in govt. spending.

3. The revenues and profits of firms will fall.

4. New investments will be very low, that is, people won’t invest in new
firms as economic conditions are poor and it will yield low profits.

D. A stable balance of international trade and payment.

Economies export (sell out) many of their products to overseas residents and
receive other incomes and investments from overseas by foreign investors
(inward investments).

This will bring in more incomes and jobs into the economy. At the same time,
economies also import (buy in) goods and services from other economies, and
make investments in other countries, to bring in more goods and services for the
people.

Exports > Imports = Surplus Exports < Imports = Deficit

All economies try to balance this inflow and outflow of international trade and
payments and try to avoid any deficits because:

1. It may run out of foreign currency to buy imports.

2. The value of its currency may fall against other foreign currencies and
make imports more expensive to buy.
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E. Reduced inequality in income and wealth, along with low rates of poverty.

A high rate of poverty will mean:

1. A low standard of living, reflecting on the economy badly.

Macroeconomic Policies
These are policies used by the govt. to influence macroeconomic aims.

Demand-Side Policies:
These policies influence on demand in an economy.

Fiscal Policy: This policy uses govt. spending and taxation to influence
aggregate (total) demand which will eventually result in changes in the economic
aims.

Expansionary fiscal policy is where govt. spending is increased and tax is

cut to increase aggregate demand. More govt. spending means more economic
activity and usage of public and merit goods and less taxation means more money
for consumers to buy products and less prices for products.

All this will raise aggregate demand. Economic growth will rise (as more output is
produced), balance of payments will improve (more goods and services will be
available for exports), inflation will lower (prices lower), employment will rise (more
output, more job opportunities).

Contractionary fiscal policy is where govt. spending is cut and tax

is increased to reduce aggregate demand. Less govt. spending will reduce
economic activity and high taxes will result in higher prices and less disposable
incomes for consumers.

This will make a reduction in aggregate demand. The opposite effects will befall the
economic aims. But why would the govt. reduce economic growth? A high economic
growth usually brings about inflation and in the long-run unemployment. This will be
discussed later.

Monetary Policy: This policy uses interest rates and money supply to influence
aggregate demand and thus make changes in the economic aims.

Expansionary monetary policy is where the govt. increases money supply and
cut interest rates to increase aggregate demand. More money supply will mean
more money being circulated among the govt, producers and consumers, increasing
economic activity. Low interest rates will mean more people will resort to spending
than saving, and businesses will invest in more money, as they will only have to pay
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little interest. Economic growth and an improvement in the balance of payments will
be experienced, employment will rise.

Contractionary fiscal policy cuts the money supply and increases interest
rates to reduce economic growth. The opposite effect will take place- low
economic activity.

Supply-side Policies

These policies affect the supply in an economy, generally to increase output and
thus economic growth They are:

• Subsidies: more subsidies mean more money for producers to produce more,
thereby increasing aggregate demand.
• Improving education and training: to improve the quality and quantity of labour
ad increase output produced.
• Privatization: transferring some public corporations to private ownership will
increase efficiency and increase output.
• Deregulation: removing burdens and unnecessary or difficult laws so that
businesses can operate and produce more output with reduced costs.
• Removing trade barriers: the govt. can reduce or withdraw import duties, taxes
etc. so that more resources/ goods and services may be imported.
• Labour market reforms: making laws that would reduce trade union powers
would reduce business costs and increase output. Also, restrictions on labour
supply could be reduced, so more jobs will be open and increase output. Welfare
payments like unemployment benefit could be reduced so that more people would
be motivated to look for jobs rather than rely on the benefits only.

Policy Conflicts

The above-mentioned macroeconomic policies can be difficult to achieve all at once-

that is they may conflict with one another.

Economic Growth & Full Employment VS Low and Stable Inflation

A high rate of economic growth and low rates of unemployment will boost incomes of
businesses and workers. This rise in income can cause firms to raise their prices-
resulting in inflation.

Economic Growth & Full Employment VS A Balance of Payments

Once again as incomes rise due to economic growth and low unemployment, people
will import more foreign products and consume less of domestic products. This will
cause a rise in import values relative to export values and a margin for deficit may
arise in the balance of payments
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Economic Growth VS Full Employment

In the long run, when economic growth is continuous, firms may start investing in
more capital (machinery/equipment). More capital-intensive production will make a
lot of people unemployed.

5.2 – Taxation
What are taxes?

Taxes are a compulsory payment made to the government by all people in an

economy.

Why Taxes?

Taxes are incurred for several reasons:

• Taxes are a major source of government revenue used to finance all

government expenses.
• To manage the macro economy through fiscal policy (taxes are used in fiscal
policy see Topic 5.1)
• To promote equality in income between the poor and the rich. People with
higher incomes are taxed heavier that people with low incomes.
• To discourage the consumption and production of demerit goods (alcohol,
tobacco). How taxes affect production and consumption will be discussed later in
this topic.
• To protect the environment. More tax can be imposed on firms and products that
create a lot of pollution and environmental damage.

Tax Systems

Progressive Taxes: the proportion of income taken into tax rises as income rises.
That is, people with higher incomes are taxed heavier that people with low incomes.
Regressive Taxes: the proportion of income paid in tax falls as income rises. That is
taxes fall heavily on the poor than the rich.
Proportional Taxes: the proportion of income paid as tax is same whatever the
income.

Direct Taxes: tax on individual or firm’s income or wealth. The burden of tax
payment falls directly on the person or individual responsible for paying it. They
include income taxes (on people’s income), corporation taxes (on a firm’s profits),
capital gain taxes (on property and other valuable assets), and inheritance tax (on
inheritance of valuable assets).

They are progressive taxes as more the income, more the tax levied.
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Advantages:

• High revenue: as all people above a certain income level have to pay income
taxes, the revenue from this tax is very high.
• Can reduce inequalities in income and wealth: as they are progressive in
nature- heavier taxes on the rich than the poor- they help in reducing the
difference between the income levels of the rich and the poor.

Disadvantages:

• Reduce work incentives: people may rather stay unemployed (and receive govt.
unemployment benefits) rather than be employed if it means they would have to
pay a high amount of tax. Those already employed may not work productively,
since any extra income they make, the more tax they will have to pay.
• Reduce enterprise incentives: corporation taxes may demotivate entrepreneurs
to set up new firms, as a good part of the profits they make will have to be given
as tax.
• Tax evasion: a lot of people find legal loopholes and escape having to pay any
tax. Thus, tax revenue falls and the govt. have to use more resources to catch
those who evade the taxes.

Indirect Taxes: taxes on the goods and services sold (it is called indirect because it
indirectly takes money as tax from consumers incomes). Indirect taxes are normally
paid by producers, but they will shift the tax burden onto consumers by fixing higher
prices. They include ad valorem taxes, sales taxes, tariffs and customs duty (on
imported goods and service) and excise duties (on harmful goods such as cigarettes
and alcohol) all added to the price of a product.

They are regressive taxes; even though all consumers pay the same tax, it will take
more proportion of income of the poor, thus falling heavily on them than the rich.

Advantages:

• Cost -effective: the cost of collecting indirect taxes are low compared to direct
taxes.
• Expanded tax-base: directs taxes are paid by those who make a good income,
but indirect taxes are paid by all people (young, old, unemployed etc) who
consume goods and services.
• Can achieve specific aims: for example, excise duty (tax on demerit goods) can
discourage the consumption of harmful goods; similarly, higher and lower taxes on
particular products can influence their consumption.
• Flexible: indirect tax rates are easier to alter/change than direct tax rates. Thus,
their effects are immediate in an economy.

Disadvantages:

• Inflationary: The prices of products will increase when indirect taxes are added to
it, causing inflation.
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• Regressive: since all people pay the same amount of money, irrespective of their
income levels, the tax will fall heavily on the poor than the rich as it takes more
proportion of their income.
• Tax evasion: high tariffs on imported goods or excise duty on demerit goods can
encourage illegal smuggling of the good.

6.1 – Price Inflation

What is inflation?

Inflation is the general and sustained rise in the level of prices of goods and
services in an economy.

For example, the inflation rate in UK in 2010 was 4.7%. This means that the average
price of goods and services sold in the UK rose by 4.7% during that year.

How is inflation caused?

Demand-pull inflation: Inflation caused by an increase in aggregate demand is

called demand-pull inflation. This is also defined as the increase in price due to
aggregate demand exceeding aggregate supply. Demand could rise due to
higher incomes, lower taxes etc. The demand curve will shift right, causing an
extension in supply and a rise in price.

Cost-push inflation: Inflation caused by an increase in cost of production in the

economy. The cost of production could rise due to higher wage rate, higher indirect
taxes, higher cost of raw materials, higher interest on capital etc. The supply curve
will shift left causing a contraction in demand and a rise in price.

A lot of economics agree that a rise in money supply in contrast with output is
the key reason for inflation. If the GDP isn’t accelerating as much as the money
supply, then there will be a higher demand which could exceed supply leading to
inflation.

The consequences of inflation:

• Lower purchasing power: when the price level rises, the lesser number of
goods and services you can buy with the same amount of money. This is called
a fall in the purchasing power. Thus, inflation causes a fall in the purchasing
power of money.
• Exports are less internationally competitive: if the price of exports are high,
its competitiveness in international markets will fall as lower priced foreign
goods will rival it. This could lead to a current account deficit is exports lower,
especially if they are price elastic.
• ‘Inflation causing inflation‘: during inflation, the cost of living in the economy
rises as you have to pay more for goods and services. This might cause
workers to demand higher wages increasing the cost of production. If the price
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of raw materials also increases, the cost of production again increases,

causing cost-push inflation.
• Fixed income groups and lenders lose: a person who has a fixed income will
lose as he cannot press for higher wages during inflation. Lenders who lent
money before inflation and receive the money back during inflation will lose
valuable purchasing power. The same amount of money is now worth less
(here, the people who borrowed gain purchasing power).

How is inflation measured?

Inflation is measured using a consumer price index (CPI)

The consumer price index is calculated in this way:

•
A selection of goods and services normally purchased by a typical family or
household is identified.

• The prices of these ‘basket of goods and services’ will then be monitored at
a number of different retail outlets across the country.

• The average price of the basket in the first year or ‘base year’ is given a
value of 100.

• The average changes in price of these goods and services over the year
is calculated. If it rises by an average of 25%, the new index is
125%*100=125.

• If in the next year there is a further average increase of 10%, the price index
is 110%*125= 137.5.

• The average inflation rate in the two years is thus 137.5-100= 37.5%.

Deflation

Deflation is the general fall in the price level.

Causes of deflation:

• Aggregate supply exceeding aggregate demand: a shift in the supply curve

to the right will cause an extension in the demand, causing a fall in the price.
• Labour productivity has risen: higher output will make for lower average
costs, which could reflect as lower prices.
• Technological advance has reduced cost of production, pulling down cost-
push inflation.
• Demand has fallen in the economy: this could be due to a number of reasons:
higher direct taxes, higher interest rates etc.
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Consequences of deflation:

• Lower prices could demotivate producer and they may reduce production,
resulting in unemployment.
• As demand falls and prices fall, investors will be discouraged to invest,
lowering the output/GDP.
• Deflation can cause recession as demand and prices continue to fall and
firms are forced to close down as enough profits are not being made.
• Tax revenue for the government will fall as economic activity and incomes
falls. They might be forced to borrow money to finance public expenditure.

6.2 – Employment and Unemployment

Labour force – the working population of an economy, i.e. all people of working age
who are willing and able to work

Labour force participation rate – the percentage of the labour force who are either
working or looking for work.

Unemployment rate – the percentage of people in the labour force that are without
work and are thus unemployed.

Dependent population – people not in the labour force and thus depend on the
labour force to supply them goods and services to fulfil their needs and wants.
All governments have a macroeconomic objective of maintaining a low
unemployment rate.

THE CAUSES OF UNEMPLOYMENT

• Frictional unemployment: this occurs as a result of workers leaving one job

and spend time looking for a new one. This type of unemployment is short-
lived.

• Seasonal unemployment: this occurs as a result of the demand for a product

being seasonal. For example, the demand for umbrellas will fall in non-
monsoon seasons, and so workers in umbrella manufacturing firms will
become unemployed over those seasons. However, this is not a problem since
these workers will work somewhere else over that period and will have planned
so.
• More serious causes of unemployment:

• Cyclical unemployment: this occurs as a result of fall in aggregate demand

due to an economic recession. When demand falls, firms will cut their
production and workers will lose their jobs. There will be a nation-wide rise in
unemployment.
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• Structural unemployment: this occurs due to the long-term change in the

structure of an economy. For example, the typewriter’s demand has declined
drastically as more efficient technology has been developed as substitutes. As
a result, typewriter manufacturing firms have shut down and left many workers
unemployed. Now these workers’ skills are no longer wanted, and they lack the
skills required in the modern industry.

• Technological unemployment: this has rose in recent times as industrial

robot, machinery and other technology have substituted for labour.

THE CONSEQUENCES OF UNEMPLOYMENT

• People will need to rely on charity or government unemployment benefits to

support themselves.

• These benefits are provided from tax revenue. But now, as incomes have fallen
tax revenue will also fall. This might mean that people remaining in work will
have to pay more of their income as tax, so that it can be distributed as
unemployment benefits to the unemployed.

• Public expenditure on other projects such as schools, roads etc will have to be
cut down to make way for benefits. There is opportunity cost involved here.

• People will lose their working skills if they remain unemployed for a long time
and may find it even harder to find suitable jobs.

• The economy doesn’t reach their maximum productive capacity, i.e. they
are economically inefficient on the PPC.

IMPERFECTIONS IN THE LABOUR MARKET

The demand and supply conditions will determine the market wages for different
occupations. However, the market isn’t always perfect. Many factors can disrupt the
labour market outcomes and thus the efficient allocation of resources. These
imperfections also cause unemployment.

• Powerful trade unions may force up wages: Trade unions, in an attempt to

improve pay and working conditions of members, will force firms to pay more
wages by restricting the supply to an industry (when supply of labour falls,
wages will rise) or threatening to take industrial action (go slow, overtime-ban,
strikes). However, higher wages will encourage firms to cut their labour force,
increasing unemployment.

• Unemployment benefits may reduce incentive to work: when the

government gives such a benefit, the unemployed will encourage people to
stay unemployed especially if they get more money through the benefit than
by actually working.
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• Lack of information: If those seeking jobs do not have reliable or sufficient

information about jobs available, then they will remain unemployed for a long
time.

• Minimum wage legislation: in countries or occupations where wages are

very low the government will impose a minimum wage that is above the
equilibrium wage in an attempt to increase wages and improve living
standards. However, this can reduce the demand for labour and cause
employers to make their employees redundant, increasing unemployment.

• Labour immobility: If workers aren’t able to travel from one place to another
to look for jobs or work (geographical immobility), due to family
commitments, cost of travelling eta, then unemployment will rise.

When people cannot move from one occupation to another due to lack of skills
(occupational immobility), then unemployment will rise.

6.3 – Output and Growth

Output

The total value of output of goods and services produced is known as the national
output.

The total amount of income earned by factors of production, including entrepreneurs

and workers, in a macro economy, is the national income.

The total spending of firms and individuals on goods, services and resources, in a
macro economy, is the national expenditure.

National Output = National Income = National Expenditure

GDP (Gross Domestic Product): the total market value of all final goods and
services provided within an economy by its factors of production in a given period of
time.

Nominal GDP: the value of output, income and expenditure in an economy

measured at their current market values or prices is the nominal GDP. However,
these values will rise overtime as a result of inflation.

Real GDP: the value of output, income and expenditure in an economy measured
assuming the prices are unchanged over time. This GDP, in constant prices,
provides a measure of the real output of a country. Here, the impact of inflation on
monetary values is excluded.
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Why is measuring GDP important to the government?

• The government will know about the allocation of resources in the economy
and how much they are producing. This will help in making efficient
economic decisions and policies and how they may affect the resource
allocation and production. For example, if the GDP shows that production of
consumer goods largely exceeds that of capital goods, it may try to equalize
this by imposing higher taxes on consumer goods or by providing subsidies for
capital good manufacturers.
• It allows comparisons to be made of the living standards in one year compared
to that of the next. A higher GDP will show a higher living standard.
• It allows comparisons to be made of living standards in different countries or
different areas of the same country.

Economic Growth

An increase in real GDP over time indicates that the economy has grown as goods
and services produced have increased. On a PPC, an economic growth will be
shown by an outward shift in the frontier.

Causes of economic growth

• Discovery of more natural resources: more resources mean more the

production capacity. The discovery of oil and gas reserves have enabled a lot
of economies to grow rapidly.
• Investment in new capital and infrastructure: investment on new machinery,
buildings, technology has enabled firms and economies to expand their
production capacities. Investments in modern infrastructure such as airports,
roads, harbours etc have improved access and communication in an economy,
helping in quicker and efficient production.
• Technical progress: New inventions, production processes etc can increase
the productivity of existing resources in industries and help boost economic
growth.
• Increasing the amount and quality of human resources: A larger and more
productive workforce will increase GDP. More skilled, knowledgeable and
productive human resources thus help increase economic growth
• Reallocating resources: Moving resources from less-productive uses to
more-productive uses will improve economic growth.

The benefits of economic growth:

• Greater availability of goods and services to satisfy consumer wants and

needs.
• Increased employment opportunities and incomes.
• Increased sales, profits and business opportunities.
• Low and stable inflation, if growth in output matched growth in demand.
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• Increased tax revenue for government (as incomes and spending rise) that can
be invested in better public services.
• improved living standards and economic welfare
•

The drawbacks of economic growth:

• Technical progress may replace employees and cause a rise in unemployment.

• Scarce resources are used up rapidly when production rises. Natural resources
may get depleted over time.
• Increasing production can increase negative externalities such as pollution,
deforestation, health problems etc.
• Inflation can rise if growth in demand exceeds growth in output
• Governments aim for sustainable economic growth which refers to a rate of
growth which can be maintained without creating other significant economic
problems, especially for future generations.

The Economic Cycle

Although most governments seek to achieve a long-term stable economic growth, in

reality, it is not so. There are several phases through which an economy passes:

Growth is the phase where the economy is growing. Output, income, employment
are all growing as firms enjoy high sales and profits and new businesses enter the
markets.

Boom refers to the highest point of economic growth. Aggregate demand, sales and
profits peak and as a result demand-pull inflation rises. Interest rates may be raised
by the government to control inflation. A high inflation and interest rate will reduce
consumer confidence and in turn their spending. Shortage of resources will cause
business costs to rise. A shortage of employees will reduce unemployment and
increase wages.

Recession is the phase where there is negative economic growth, that is real GDP
is falling. This usually happens after there is rapid economic growth. The fall in
consumer spending caused by high inflation during the boom period will cause this
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downturn. Sales and profits of firms will decline. Firms will cut back their production
and workers are made redundant. Unemployment starts to rise and incomes fall.

Slump is the lowest point of recession where aggregate demand, output, incomes
and prices are at the lowest.

Recovery is the phase after a slump where the GDP starts to increase, and the
economy recovers. Business and consumer confidence start to increase, and
output and sales experience an increase. The economy starts to expand again and
is on its way to economic growth.

Measuring Living Standards

• GDP per head/capita: this measures the average income per person in an
economy. Since this takes into account the population, it provides a good
measure of the living standards of an economy.

Real GDP per capita = Real GDP per head / Population

However, it is a relatively poor indicator of welfare, because:

1. It takes no account of what people can buy using their incomes. A

country with a high GDP per head may be no better off than a country with a
low GDP per head, if there are far fewer products to choose from.
2. Distribution of income is very unequal in reality, so the GDP per head
isn’t accurate. Some people might be very rich while others very poor.
3. Real GDP per head excludes the unpaid work people do for charities and
voluntary organizations. Thus, it understates the total output.

• Human Development Index (HDI): Used by the United Nations to compare

living standards across the globe, the HDI combines different measures into
one to give a HDI value from 0 to 1.

These are:
1. standard of living, measured by the average national incomes per head
adjusted for differences in exchange rate and prices in different countries.
2. education, measured by how many years on average, a person aged 25
will have spent on education and how many years a young child entering
school can now be expected to spend in education in his entire life.
3. access to healthcare and having a healthy lifestyle, measured by life
expectancy.

The problems with HDI:

1. It combines a set of separate indicators into one, so a country with good

literacy rates and living standards but poor life expectancy can have a low HDI.
2. It doesn’t consider other factors such a environmental quality, political
freedom, crime rates etc.
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7.1 – Developed and less-developed economies

What does economic development mean?

Economic development refers to the increase in the economic welfare of people

through growth in productive scale and wealth of an economy. Governments aim for
their countries to expand from developing economies to developed economies.

Developed countries generally have a good infrastructure and a stable economy

with very high per capita income. The degree of development, industrialization and
general standard of living for its citizens, in terms of education, health and wealth, is
very high. Example: Japan

Under-developed economies or less-developed economies are countries that lag

behind most others in industrialization, infrastructure and standards of living, and
have low income per capita. Example: Somalia

Developing economies are countries that are becoming more developed through
expansion of the industrial sector and fewer people suffer the extremes of poverty.
However, they may still have a low standard of living. Example: India

The reasons for low economic development:

• Over-dependence on agriculture: Farming is the most common work in less-

developed economies. Most people work to feed themselves and their families
and sell off any surplus. This means that there is little or no trade happening,
which results in no economic growth or development.

• Domination of international trade by developed economies: The wealthier

developed economies have exploited poorer countries by buying up their
natural resources at low prices and selling products made from them in
international markets at large prices. Rich countries also protect their
industries by paying subsidies to domestic producers, increasing global supply,
and in turn, lowering prices. Now the poor economies cannot compete with
these very low prices, and they lose their jobs and incomes.

• Lack of capital: Low incomes in under-developed economies lead to a lack of

capital funds that can be invested in industries that can expand production.

• Poor investment in infrastructure, health and wealth.

• High population growth: Rapidly expanding populations (due to high birth

rates) in less-developed countries will reduce the real GDP/income per head.

• Wars deplete resources

• Corrupt and unstable governments

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Some development indicators that are used to measure how developed an

economy is:
GDP per capita, population living on less than $1 a day, life expectancy at birth, adult
literacy rate, access to safe water supplies and sanitation, proportion of workers in
different sectors of production.

Poverty

Absolute poverty: the inability to afford basic necessities needed to live (food,
water, education, health care and shelter). This is measured by the number of
people living below a certain income threshold.

Relative poverty: the condition of having fewer resources than others in the same
society. It is measured by the extent to which a person or household’s financial
resources fall below the average income level in the economy. Relative poverty is
basically a measurement of income inequality since a high relative poverty should
indicate a higher income inequality.

How to reduce poverty?

• Introduce measures to reduce unemployment: An expansionary

fiscal/monetary policy will increase aggregate demand and increase
employment opportunities. Income and standards of living will rise.
• Impose progressive taxes: income taxes are progressive, that is, they
increase as incomes increases. Imposing these will mean that people on
higher incomes will pay a large percentage of their incomes as tax and help
reduce relative poverty.
• Introduce welfare services: money from taxes can be provided as income
support to people with very low incomes. It can also be used to provide free or
low-cost homes, healthcare and education.
• Introduce minimum wage legislation to raise the wage of low-paid employees
• Increase the quantity and quality of education.
• Attract and invite inward investments from firms abroad to provide jobs and
incomes for people.
• Overseas aid could be gained from foreign governments and aid agencies.
This will include food aid, financial aid, technological aid, loans and debt relief.

7.2 – Population
Population is the total number of people inhabiting a specific area.
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What affects population?

Birth rates

The average number of children born in a country each year compared to the total
population of an economy is known as the birth rate. This is usually expressed as the
number of births for every 1000 people in the population.

Why do different countries have different birth rates?

• Living standards: improved quality and availability of food, housing, clean

water and medical care result in fewer babies dying. Countries where children
often die due to poor living standards, have higher birth rates because people
have more families in case some of their children died. These children can then
work to produce food and earn incomes.
• Contraception: increased use of contraception and abortion have reduced
birth rates in developed countries
• Customs and religion: Many religious beliefs doesn’t allow the use of
contraceptive pills, so birth rates in those communities rise. In developed
economies it is now less fashionable to have large families, so birth rates have
fallen.
• Changes in female employment: as more females in developed countries
enter employment have resulted in falling birth rates since they do not want
motherhood to break their careers.
• Marriage: In developed countries, people are tending to marry later in life, so
birth rates have reduced.

Death rates

The number of people who die each year compared to every 1000 people of the
population is the death rate of an economy.

Reasons for differing death rates in different economies:

• Living standards: Just as birth rates, death rates also tend to be very high in
less-developed economies due to lack of good-quality food, shelter and
medical care. Malnutrition remains the major cause of high death rates in these
countries. In developed countries, the cause of death include heart diseases
and cancer caused by unhealthy diets.
• Medical advances and heath care: lack of medical care and infrastructure in
less-developed countries continue to be a cause for high death rates.
• Natural disasters and wars: Hurricanes, floods, earthquakes and famine due
to lack of rain and poor harvests, and wars and civil conflicts have much effect
on death rates.
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Migration

Migration refers to the number of people entering (immigration) and leaving

(emigration) the country. Net migration measures the difference between the
immigration and emigration to and from an economy.

A net inward migration will increase the working population of the economy but can
put pressure on governments on finances as demand for housing, education and
welfare increase.

A net outward migration will increase the income per capita and thus the HDI, but
can result in loss of skilled workers.

Population structure

The structure of population can be analysed using:

• Age distribution: the number of people in each age-group. Falling birth and
death rates mean that the average age in developed countries are rising
whereas in developing and less-developed economies, high death and birth
rates result in low average ages. As the population of children and senior
citizens increase in proportion to working adults, the workforce will decline and
there will be much dependence on the working population.

• Gender distribution: the balance of males and females. The sex ratio
measures the no. of males to the no. of females (the global sex ratio is
101:100). Since the average female lives longer than the average male, there
are more females in the older age-groups than males.

Gender imbalance is an excess of males or females and is caused by

1. Wars killing of many young males
2. Violence towards females (honour killings, rapes)
3. Sex-specific immigration – more males immigrate to a country looking for
work

Population pyramids display the age and gender distribution of an economy. The
vertical axes show the age groups and the horizontal axes show the gender groups-
males on the left and females on the right.
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• Geographic distribution: where people live. 90% of the world population live in
developing countries. This puts a lot of pressure on scarce resources in these
countries. About half of the world population live in urban areas and this
continues to rise which has helped increase production and living standards
but resulted in rapid consumption of natural resources and high levels of
pollution and congestion.
• Occupational distribution: what jobs people work in. In developed economies,
more people work in the service sector while in less-developed economies,
most people work in agriculture. In developing economies, there is a huge
migration of workers from primary production to manufacturing and service
sectors. Female employment and self-employment are also rising, which will
add to production and higher living standards.

8.1 – International Trade and Specialization

International Specialization

Specialization is when a nation or individual concentrates its productive efforts on

producing a limited variety of goods in which they’re really efficient and productive at
and have an advantage over other economies in producing them. For example, due
to the existence of vast oil and gas reserves in the region, Middle-Eastern countries
concentrate their production on petroleum.

Absolute advantage is when a region/country is able to produce a good or service at

a lower average cost than other countries.
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Example:
Music Players produced by 50 Wheat(tonnes)produced by 50
workers workers
Chile 400 35
Taiwan 500 30
Total output 900 65

In the example above, Taiwan has the absolute advantage in producing music
players while Chile has the absolute advantage in producing wheat. When they
specialize, Chile will produce wheat and Taiwan will produce music players. When
this happens, there will be an increase in the total output of both music players and
wheat as shown:

Music Players produced by 50 Wheat (tonnes) produced by 50

workers workers
Chile 0 70
Taiwan 1000 0
Total output 1000 70

Once they specialize, they can now trade between themselves. Chile will need 400
music players from Taiwan (as before specialization) and Taiwan will need 30 tonnes
of wheat from Chile. This trade will occur:

Music Players produced by 50 Wheat(tonnes)produced by 50

workers workers
Chile 400 40
Taiwan 600 30
Total output 1000 70

Comparative advantage occurs when a region/country can produce a good/service

with lesser opportunity cost than other countries.

Example:
Cars Televisions
Japan 100 400
Germany 80 160
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Total output 180 560

Japan has an absolute advantage in both goods. However, Japan would have to
give up 4 televisions to produce 1 car (400/100). In Germany, they only have to give
up 2 televisions to produce 1 car (160/80). That is, the opportunity cost of producing
one car is lower for Germany than Japan. Thus, Germany will have a comparative
advantage in producing cars. In television, Japan has the comparative advantage
(since they only have to give up 0.25 cars to produce 1 TV while Germany will have
to give up 0.5 cars). When they specialize according to comparative advantage, this
will happen:

Cars Televisions
Japan 0 600
Germany 200 0
Total output 200 600
Once they specialize, this trade will occur (Japan will require 100 cars from Germany
and Germany will require 160 televisions from Japan):

Cars Televisions
Japan 100 540
Germany 100 160
Total output 200 600

Through both absolute and comparative advantage, countries gain more products.

Advantages of International Specialization:

• Economies of scale and efficiency: Just like specialization by individuals,

countries can specialize in what they do best, and this leads to efficiency and
economies of scale. It can therefore increase output of the country. When more
countries specialize, world output increases.
• Job creation: Specialization leads to increased output and therefore it could
lead to more investment and thus jobs are created as the output increases.
Moreover, it requires skilled labour and thus earnings are higher.
• Allows more international trade to take place and therefore more goods that
other countries produce can be imported as well. Therefore it increases choice
for the people of the country
• Revenue to the government: As income increases, and as more trade takes
place, it gives the possibility for the government to increase the revenue.
• Improves standard of living: increased choice for the consumers, increased
income, increased output, increased infrastructure means a better quality of life
for the people.
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Disadvantages of International Specialization:

• Unemployment: Even though national level specialisation usually creates

more jobs, there is a risk of certain types of structural unemployment to occur.
As the country moves towards specialisation, the workers in the declining
industries may not find suitable work for them
• Over-exploitation of resources: output maybe increased by over-exploiting
resources. In this case today’s output is increased at the cost of the future
generations.
• Negative externalities/ social cost: There could be external costs like damage
to the environment.

Regional Specialization

Specialization can occur within a country or across borders. one such example of
regional specialization is the Iberian Peninsula which specializes in mining and
tourism.

Advantages of Regional Specialization:

• Efficient use of resources: A region could specialize in a particular industry

due to availability of resources. Therefore, it will be easier to use that resource
efficiently
• Creates jobs to residents: When an industry develops in a particular region, it
helps the residents of that area since they can find work nearby their homes
• Infrastructure development: When a region is specialized in a particular
industry, infrastructure will be built to support that industry, therefore, it
develops the region.

Disadvantages of Regional Specialization:

• Risk of low demand: Even though specialization increases output, its benefits
will not be gained if there is no sufficient demand.
• Rising costs: Costs will increase if labour and raw materials have to be
transported from other regions.
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International Trade

International trade involves the movement and exchange of physical goods,

services, ideas, money and labour across international borders.

Imports are the products and resources bought into (coming into) the country.
Countries import products, that they do not specialize in and thus do not produce, to
satisfy the needs of their consumers.

Exports are the products and resources sold out (going out)of the country.
Countries, after specialization, will export any surplus of products after the needs of
their own consumers are satisfied.

Free Trade and Protectionism

Free trade is when there are no restrictions for trade between economies.

The advantages of free trade

• Allows countries to benefit from specialization: if there was no international
trade, countries wouldn’t be able to specialize, that is, they would have to
become self-sufficient by producing all the goods and services they require.
Total output would lower and costs would rise. With specialization and free
trade, output, incomes and living standards will improve.
• Increases consumer choice: consumers can now enjoy a variety of products
from around the globe.
• Increases competition and efficiency: International trade means that there
will be more competition among firms in different countries. This would help
increase efficiency
• Creates new business opportunities: Free trade will allow businesses to
produce and sell goods for overseas consumers and expand and grow their
operations by doing so. Profits and revenue would rise.
• Enables firms to benefit from the best work-forces, resources and
technologies from the world.
• Increases economic inter-dependency and thus reduces potential for
international conflicts.

The disadvantages of Free Trade

• Free trade reduces opportunities for growth in less-developed economies

and threatens jobs in developed economies. Small businesses in
developing countries may not be able to compete with larger foreign firms.
Established businesses in developed countries may lose much of their market
share as new firms keep entering the market and lose profits and revenue.

• Causes rapid resource depletion and climate change as more resources

are used up by more firms.
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• Exploitation of workers and the environment: free trade has allowed firms to
relocate to countries with lower costs (usually lower wages), where workers
and the environment can be exploited (as health and safety and environmental
laws in such countries are likely to be relaxed).

• Increase the gap between rich and poor: Multinational firms and consumers
have dominated the international supply and demands. This means that the
rich keep getting richer (by buying and selling more products) while the poor
lose out on products and resources.

Protectionism involves the use of trade barriers by governments to restrict

international market access and competition.

Trade barriers include:

• Tariffs: these are indirect taxes on the goods that make them more expensive
to discourage domestic consumers from buying them.
• Subsidies: government allows subsidies to domestic producers so that they
can increase their output and reduce costs and in turn reduce prices, in the
hope that consumers will be encouraged to buy inexpensive domestic goods
rather than expensive imports.
• Quotas: this is a limit on the number of imports allowed into a country each
month a year. Restricting their supply will push up their market prices and
discourage consumption.
• Embargo: this is a complete ban on imports to a country.
• Excessive quality standards: imports may only enter a country after
extensive quality checks which will be costly and so foreign producers will be
discouraged to sell their products in the country, reducing imports.

Arguments in favour of protectionism

• To protect infant industries: trade barriers will help protect infant industries
(industries that are new and slow and are hoping to grow). Lesser competition
from foreign firms will increase their chances of survival and growth.
• To protect sunset industries: sunset industries are those that are on their
declining stage. They would still employ many people and closure of firms in
the industry will result in high regional unemployment. Lesser competition from
foreign firms will decrease their rate of decline.
• To protect strategic industries: Strategic industries will include agriculture,
energy and defence and governments will want to protect these so they are not
dependent on supplies from overseas. If foreign firms supplied these, they
would restrict output and raise prices.
• To limit over-specialization: If a country specializes in the production of too
narrow a range of products and there is a great global fall in demand for one of
them, then the economy is at risk. Protectionism will ensure diversification into
producing more products and reduce this risk.
• To protect domestic firms from dumping: Dumping is a kind of predatory
pricing, that occurs when imports to a country at a price either below the price
charged in the domestic market or below its cost of production, and result in
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domestic firms unable to compete and forces them to go out of business. Once
this happens, the foreign firms will raise their prices. Trade barriers will
eliminate the risk of dumping.
• To correct a trade imbalance: protectionism can reduce the imports coming
into a country and thus reduce expenditure on imports by domestic consumers.
If a country is experiencing a deficit (imports exceeding exports), then
protectionism will correct this imbalance.
• Because other countries use trade barriers.

Arguments against trade barriers

• They restrict consumer choice

• They restrict new revenue and employment opportunities
• They protect inefficient domestic firms: when trade barriers are used to
protect domestic industries, it might include inefficient industries. Protectionism
means that domestic firms can now become efficient due to lack of competition
from overseas.
• Other countries may retaliate: if a country introduces trade barriers to restrict
imports from other countries, the countries that are affected by this will also
impose similar trade barriers. A trade war may develop. Relations between
countries will worsen.

Tip: If you have trouble remembering all the pros and cons listed above, just
remember this: basically, the advantages of free trade are the disadvantages
of protectionism and the disadvantages of free trade are the advantages of
protectionism.

8.2 – Balancing International Payments

The balance of payments

Visible trade involves the trade in physical products (i.e. goods). Visible trade will
include visible exports and visible imports.

Balance in trade = value of visible exports − value of visible imports

Favourable trade balance/ Trade surplus = value of visible exports > value of
visible imports

Unfavourable trade balance/ Trade deficit = value of visible exports < value of
visible imports

Invisible trade involves the trade in services. Invisible trade will include invisible
exports and invisible imports
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Balance in services = value of invisible exports − value of invisible imports

Balance in services surplus = value of invisible exports > value of invisible imports

Balance in services deficit = value of invisible exports < value of invisible imports

The Balance of payments is a record of all the monetary transactions between

residents of a country and the rest of the world over a given period of time. It is
divided into three main accounts: the current account, the capital account and the
financial account.

(In the explanation below, we’ll look at the balance of payments from the point of
view of the UK.)

The Current Account

The Current account records the following:

• The visible trade (in goods).

• The invisible trade (in services).

• Income received or made in payment for the use of factors of production.

i. The income received or made in payment for the use of factors of production.
Income debits (outflows) include wages paid to overseas residents working in
the UK, an interest, profits and dividends paid out to overseas residents and
firms who have invested in the UK.

ii. Income credits (inflows) include wages paid to UK residents working

overseas, any interest and dividends earned by UK residents and firms on
investments they have in other countries.

iii. Current transfers, which include payments between governments for

international co-operation and other transactions that involve no direct
payment or productive activity.

iv. Debits (outflows) will include financial aid, donations, pension payments etc
paid to overseas residents and foreign governments and tax and excise duties
paid by UK residents on foreign purchases

v. Credits (inflows) will include financial aid, donations, grants, pension

payments etc received from overseas residents and foreign governments and
tax and excise duties paid by overseas residents on UK purchases.
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A current account example:

$ billion 2000
Visible exports (X) 784.2
Visible imports (M) 1230.4
Balance of trade (X – M =A) -446.2
Invisible exports (Xi) 286.4
Invisible imports (Mi) 219.9
Balance on services (Xi – Mi =b) 66.5
Balance on income(C) 21.0
Net Current Transfers -58.6
Current account balance (A + B + C + D) -417.3

The Capital Account

The capital account of a country records international capital transfers for the
acquisition, disposal or transfer of non-financial assets including land, factories,
office buildings and machinery, between its residents and the rest of the world.

The Financial Account

The financial account records all international monetary flows related to investments
in business, real estate, bonds, loan stocks and company shares, and the interests
and dividends resulting from these investments. Government owned assets
(reserves like gold, foreign currencies) are also recorded.

A direct inward investment occurs when a foreign firm sets up its operations in the
country.

Net Errors and Omissions

The balance of payments should always balance at the end of the given time
period. When there is a slight imbalance, a figure of net errors and omissions is
included as a balancing item so that it is the balance of payments is balanced.

Exchange Rates

The exchange rate is the value of a currency in terms of another currency. For
example, 60 Indian Rupees= $1. This exchange rate will be used when these
countries trade to convert money. So, if a person were to convert $100 into Indian
rupees, he would get (100*60) 6000 rupees.
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The exchange rate of each currency is determined by the market demand and
supply of the currency.

Demand for a currency, say the US dollar, exists as foreign consumers want to buy
and import goods and services from the US, when overseas companies buy US
dollars to invest in the US etc. Here, the US is gaining in demand and dollars, so the
currency is in high demand.

Supply of a currency, say the US dollar, exists as US consumers want to buy and
import goods and services from other countries, when US companies buy foreign
currencies to invest abroad. Here the US is losing in demand and dollars, so the
currency is in high supply.

Floating Exchange Rate

This is an exchange rate that is determined freely by market demand and

supply conditions, and so will fluctuate regularly.

An increase in the demand for a currency, for example, because consumers are
buying more goods and serviced from that country, will increase its exchange rate
against other currencies. This rise in the value of one currency against others is
known as appreciation in the exchange rate.

A decrease in the demand for a currency, for example, because firms are investing
more overseas and therefore selling their national currency to buy foreign currencies,
will decrease its exchange rate against other currencies. This fall in the value of one
currency against others is known as depreciation in the exchange rate.
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What causes these changes in demand and supply of currencies and influences the
exchange rates?

• Changes in the current account balance: When a country’s import value is

more than its export value (that is a deficit), it means that more of their
currency is being supplied (going out) than being demanded. The exchange
rate for the country’s currency will depreciate. If there is a surplus in the current
account, an appreciation will follow

• Inflation: If the inflation of a country is higher than that of other countries it

trades with, the price of that country’s goods in the international market will be
very high compared to goods from other countries. The demand for the
country’s goods will fall and the so the currency demand will also fall, causing a
depreciation.

• Changes in interest rate: If a country’s interest rate rises, overseas residents

may be keen to save or invest money in that country. The demand for the
currency will rise, and the exchange rate will appreciate. If interest rates fall
below that of other countries, the currency will depreciate as overseas demand
will fall.

Fixed Exchange Rates

A fixed exchange rate is one that is fixed and controlled by the central bank, acting
on behalf of the government of the country. The central bank will intervene in the
market by buying and selling its currency in the foreign exchange market to
maintain a fixed exchange rate.

When the exchange rate rises due to demand and supply conditions, the
government will sell its currency to increase its supply and reduce its value on the
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foreign exchange market. A deliberate fall in the value of a fixed exchange rate is
called a devaluation.

When the exchange rate falls due to demand and supply conditions, the government
will buy up its currency to increase its demand and raise its value on the foreign
exchange market. A deliberate rise in the value of a fixed exchange rate is called
a revaluation.

How to correct a trade deficit

A trade deficit is a problem for the economy, because more is being spent on foreign
goods and services and less on domestic products.

(However, imports of capital goods can be beneficial to the economy as it will be

utilized for domestic production).

When domestic products’ consumption falls, firms may cut back production resulting
in unemployment and low incomes.

A trade deficit will result in depreciation as more currency is being supplied.

This depreciation will make exports more cheaper and imports will become
expensive.

This could cause imported inflation.

So, how do we correct this deficit:

• Do nothing because a floating exchange rate should correct it. If there is a

trade deficit, a depreciation will occur as more currency is being supplied. A
depreciation will make imports more expensive and exports cheaper. As a
result, domestic demand for imports will fall and foreign demand for exports will
rise, causing a trade surplus.
• Use contractionary fiscal policy: a government can cut public expenditure
and increase taxes to reduce total demand in the economy, which will reduce
demand for imports and improve the trade balance. However, a fall in demand
may affect firms in the economy who may cut output and employment in
response.

• Raise interest rates: a higher interest rate will attract more direct inward
investments and balance and nullify the trade deficit. Higher interest rates will
also make borrowing from banks more expensive and increase the incentive to
save, thus discouraging consumers from spending.
• Introduce trade barriers: this will reduce imports and remove a trade deficit.
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How to correct a trade surplus

A trade surplus for one country means a trade deficit for another country, so there
will be pressure from the other country to reduce this country’s surplus so that they
can reduce their deficit.

If exporting firms enjoy large revenue, this income could cause demand-pull inflation
in the economy.

A trade surplus will also mean that appreciation will occur, which will make imports
more cheaper and exports expensive, which will eventually result in a deficit.

So how do we correct a trade surplus:

• Do nothing because a floating exchange rate should correct it. If there is a

trade surplus, an appreciation will occur as more currency is being demanded.
An appreciation will make imports more cheaper and exports expensive. As a
result, foreign demand for exports will fall and domestic demand for imports will
rise, reducing a trade surplus.

• Use expansionary fiscal policy: Increasing public expenditure and cutting taxes
can boost total demand in an economy for imported goods and services.

• Lower interest rates: Lower interest rates will make borrowing from banks
cheaper and increase the incentive to spend, thus encouraging consumers to
spend on imports and correct a trade surplus

• Remove trade barriers: so that imports will rise and reduce the trade surplus.