Economic Problem:

Finite resources: in any country there is a finite quantity of these resources. Therefore, as there is
only a limited quantity, these resources are scarce.

Unlimited wants: wants are people’s infinite desires for goods and services.

The ‘basic economic problem’ is therefore the allocation of scarce resources between competing
uses representing infinite wants. Different countries have different solutions to the economic
problem. The way in which they attempt to solve it depends on their economic system.

Opportunity Cost:
Opportunity cost: the cost of the next best alternative given up when making a choice.

Resources often have a number of alternative uses: as a result, governments, producers, and
individuals often face the choice of how to use them.

Production Possibility Curves:

A Production Possibility Curve (PPC) shows the different combinations of two goods which an
economy can produce, if all resources are used up. Any point on the PPC represents maximum
output in the economy. A point to the left of the PPC is inefficient, since there are unemployed
resources. A point to the right of the PPC is impossible, since the economy does not have sufficient
resources to produce at that point.

Economic Growth:
At a point in time, an economy cannot produce combinations of goods to the right of the PPC.
However, over time the PPC can move outwards, showing economic growth. This can occur when:

* New technology is introduced which is faster and more reliable. Therefore, more output can be
produced with the same resources.
* Improved efficiency including new production methods allow more efficient use of resources,
allowing more output to be produced with fewer resources.
* Education boosts the productive potential of an economy, since educated workers can carry out
tasks requiring communication, analysis and critical thinking in a more efficient manner.
* New resources discoveries increase the amount of resources available, allowing more goods to be
produced.

‘Negative’ economic growth is represented by a shift in the PPC to the left. Weather patterns,
resource depletion, and migration of skilled workers may result in negative economic growth.

Assumptions:
In the study of economics, several things are assumed.

* Consumers aim to maximise benefit: economists assume that consumers will always choose a
course of action that gives them the greatest satisfaction, since this is rational. This will help them
maximise benefit. For example, if exactly the same product is offered from different suppliers,
consumers will always choose the cheapest option. If different products are offered at the same
price, the consumer will always buy the best quality product.

* Businesses aim to maximise profit: economists assume that business owners will always
maximise profit, since this is also rational. For example if raw materials are available from different
suppliers at the same quality, the owner will always buy the cheapest. If they are available at the
same price then the best quality raw materials will be bought.
Reasons why Consumers may not maximize benefit:
* It is difficult to quantify satisfaction gained from consumption. It may be difficult to measure the
benefit of each alternative use of resources.
* Buying habits, for instance, brand loyalty, developed by consumers may affect their ability to
make rational decisions.
* Consumers may be influenced by the behaviour of others. For instance, young consumers are
often influenced by the buying habits of their parents. Other consumers are influenced by their
peers.
* If consumers do not have access to adequate information, they may be prevented from
maximizing benefit.

Reasons why Producers may not maximize profit:

* Businesses may be influenced by the behaviour of multiple people Not all decisions are made
directly by the owners: they sometimes delegate decision making to others who have different
objectives. For instance, sales department managers often prioritize sales over profit, as their
salaries (commission) are linked to sales levels, which may not result in maximum profit.
* Some producers have alternative objectives. Some businesses focus on customer service, focusing
on producing high quality. This impacts profitability, as they will incur extra training costs.
* Some businesses operate as charities – not-for-profit organizations. They aim to raise money for a
cause: any money they earn is used to fund humanitarian objectives. Therefore, as they have other
aims they do not aim to maximize profit.
* Social enterprises operate commercially, but aim to maximize improvements in human well-
being. They operate to generate revenue, but aim to provide social benefit at the same time.
* If producers do not have access to adequate information, they may be prevented from maximizing
profit.

Demand Curve
Demand is the amount of a good that will be bought at given prices over a period of time.
Effective demand is the amount of a good bought at any given price – it is affected by how much
people can afford to buy and if they would actually buy it at the given price.

The demand curve expresses demand graphically as a curve or straight line, with price on the y-axis
and quantity demanded on the x-axis. Demand and price have an inverse relationship: when price
increases, demand falls and vice versa.

Demand can move along the demand curve when the price changes.

If any other factor, such as income changes, the entire demand curve will shift to the left or to the
right. At any given price, the quantity demanded will be lower or higher.

Factors affecting the demand curve include:

* Advertising: businesses try to influence demand using advertising. While the impact is difficult to
quantify, an increase in advertising expenditure is likely to shift the demand curve to the right.
* Income: when disposable income rises, people can afford more goods and services and can afford
to spend more on wants. Normal goods experience a rise in demand when income increases.
However, inferior goods will experience a fall in demand when income increases, since consumers
will switch to non-inferior goods.
* Fashion / Tastes: over a period of time, changes in consumer tastes cause changes in demand
patterns.
* Price of Substitutes: Many goods sold by businesses have substitutes: goods that are alternatives
but perform the same function. If a good has a lot of close substitutes the prices of them will affect
demand significantly: if the price of the substitute is lower, demand for the good will fall.
* Price of Complements: Some goods (cornflakes and milk) are purchased together as
complements: they are purchased and consumed together. Demand for a good is likely to be
affected by the price of complementary goods: if their price rises, demand may fall.
* Demographic Changes: changes in the structure and size of the population affect demand. For
example, if the average age of the population increases, there will be more demand for products
consumed by the elderly – such as health care or retirement homes.

Supply Curve:
Supply is the amount of goods that sellers are prepared to offer for sale at different prices in a given
period of time. A supply curve is a line drawn on a graph showing the quantity supplied at different
prices. The slope increases from left to right, showing that there is a proportionate relationship
between price and quantity supplied.

When the price changes, there is a movement along the supply curve. Any other changes in factors
will cause a shift in the supply curve: at a given price, quantity supplied will be lower or higher.

If supply is fixed in the short term, the supply curve will be vertical. No matter what the price is, no
more can be supplied.

Factors affecting the supply curve include:

* Costs of production: If the production costs (wages, raw materials, energy, etc) rise, and price is
fixed, supply is likely to fall. A rise in costs causes a shift in the supply curve to the left. A shortage
in factors of production – land, labour, and capital – could cause production costs to rise.
* Indirect taxes: taxes on spending such as VAT or duties affect supply, causing a shift in the supply
curve to the left. They represent a cost to firms: as a result, quantity supplied falls.
* Subsidies: money given to businesses in the form of a grant will increase supply, since costs are
reduced.
* Changes in technology: over time, new technology is likely to become available which is more
efficient, therefore reducing the costs of production. This will result in an increase in supply due to
lower costs.
* Natural factors: the production of certain goods, especially agricultural products, is impacted by
natural factors. Good growing conditions will increase crop yields, therefore shifting the supply
curve to the left.

Market Equilibrium:
The price at which quantity supplied and quantity demanded are equal is the equilibrium price. The
amount supplied is completely bought up: the market is cleared.

Total revenue at the equilibrium price is equal to: TR = Price X Quantity

The equilibrium price changes when there are changes in supply or demand. If demand rises, the
price will rise. If supply rises, the price will fall. If both supply and demand change, then the effect
on the equilibrium price is dependant on how much supply and demand shift.

If the price charged in a market is below the equilibrium price, demand will be greater than supply:
there will be excess demand. If the price is above the equilibrium price, supply will be greater than
demand: there will be excess supply. Disequilibrium in a market is restored by changing price or
changing supply available on the market.
Price Elasticity of Demand:
PED is a measure of the responsiveness of demand to a change in price. The flatter the demand
curve, the more responsive a good is to a change in price.

PED = % change in quantity / % change in price

A perfectly vertical curve has perfectly inelastic demand, where PED = 0.

A perfectly horizontal curve has perfectly elastic demand, where PED = ∞.

A curve where PED = -1 has unitary elasticity: total revenue is the same at each point. The change
in demand is different at each point on the curve.

If the absolute value of PED is greater than 1, demand is elastic. If the absolute value of PED is less
than 1 (a fraction or decimal), demand is inelastic.

Factors affecting PED:

* Availability of substitutes: goods with a lot of close substitutes tend to have elastic demand:
customers can easily switch from one good to another. Goods with few substitutes tend to have
inelastic demand.
* Necessity: goods that are considered essential will have inelastic demand: no matter the price,
customers cannot significantly reduce the amount they purchase. This includes habit-forming
goods. However, non-essential goods tend to have elastic demand.
* Proportion of income spent on a product: if consumers spend a large proportion of income on a
product, demand will be more elastic. Goods that cost very little (postage stamps, etc) tend to have
inelastic demand, since they are a small proportion of income.
* Time: in the short term, goods have inelastic demand, since it takes time for consumers to find
alternatives. In the long term, demand is more elastic, since consumers can search for alternatives.

PED and Income:

Price Elasticity Abs. Value of Price Change Effect on TR

PED
Inelastic <1 Decrease Fall
Inelastic <1 Increase Rise
Elastic >1 Decrease Rise
Elastic >1 Increase Fall

Price Elasticity of Supply:

The responsiveness of the quantity supplied of a good to a change in price is price elasticity of
supply. The steeper the supply curve, the more inelastic supply is.

PES = % change in quantity supplied / % change in price

If PES is less than 1, supply is inelastic. If it is greater than 1, supply is elastic. If PES = 0, supply is
perfectly inelastic (vertical curve). If PES = ∞, supply is perfectly elastic (horizontal curve). If PES
= 1, supply has unitary elasticity.
Factors influencing PES:
Generally, PES is influenced by whether supply can be increased easily or not.

* Factors of production: if factors are easily accessed, then production can be boosted as necessary,
and supply will be elastic. If the production factors are mobile (can be switched to other uses
easily), then supply will also be more elastic.
* Availability of stocks: if producers can hold stocks of goods, supply will be elastic. However,
when it is too expensive to do so or goods are perishable, then supply will be inelastic.
* Spare capacity: if producers have spare capacity, producers can respond to price changes easily. If
firms are running at full capacity, then supply will be more inelastic, since output cannot be
increased at short notice.
* Time: The speed with which producers can react to price changes will affect PES. Over time most
producers can adjust output. Where it is impossible to increase supply quickly, supply will be
inelastic.

Primary goods are likely to be supply inelastic. This is because it takes a long time to react to a
price change: it may take up to a year to change supply of agricultural products, for example. The
supply of resources such as precious metals, is likely to be inelastic, since there are very few
sources available, and the production is expensive and time-consuming.

Income Elasticity:
Income elasticity of demand is a measure of the responsiveness of demand to a change in income.

IES = % change in quantity demanded / % change in income

If IES is between +- 1, demand is income inelastic. If IES is greater than +- 1, then demand is
income elastic.

Necessities are income inelastic. Luxury goods (which are optional) are price elastic. Normal goods
have positive income elasticity, while inferior goods have a negative income elasticity.

Elasticity and businesses:

Price elasticity allows firms to predict the effect of a price change on total revenue. Income
elasticity allows firms to respond to predicted changes in income.

Elasticity and governments:

* Taxes: governments tend to tax goods that have few substitutes or are necessities. Most do not
target goods essential to human survival, but popular targets include alcohol and petrol, which are
very price inelastic.
* Subsidies: governments can only give subsidies to price inelastic goods, as otherwise the subsidy
will have very little effect on reducing price. Often subsidies are given to farmers, which helps keep
food prices low.

The Mixed Economy:

The public sector is government organizations that provide goods and services in the economy.
The private sector is composed of individuals and groups of individuals that provide goods and
services in the economy.

Private Sector:
Goods and services are provided by businesses owned and controlled by individuals. Consumer
gods are often provided by the private sector. Examples include sole traders, partnerships,
multinationals, or small companies (where shareholders own the business)
Aims in the private sector are:
* Survival: new private sector organizations may find it difficult to make a profit in highly
competitive markets. Therefore, the initial aim is often to survive.
* Profit maximization: the owners of most firms are in business to make a profit. Therefore, the
firm will aim to maximize profit.
* Growth: many firms aim to grow, since bigger businesses can exploit economies of scale.
Furthermore, this means that profits will be higher in the future.
* Social responsibility: many firms also wish to please a wide range of stakeholders, including
environmentalists, residents, consumers, etc, aiming to be good corporate ctiizens.

Public sector:
Firms in the public sector are owned and controlled by local or central governments. They include:
* Central government departments – e.g. government ministries. They are usually controlled by
boards led by a government minister.
* State-owned enterprises are owned by the government, run through a board of directors. They are
state-funded and the government is responsible for key policies.
* Local authority services such as fire or policing
* Other – e.g. the Post Office or Bank of England are run by a board, led by an experienced expert
selected by the govermnent.

Aims:
* Services: public sector organizations aim to provide a service. They generally aim to improve the
quality of their service.
* Minimizing costs: it is important that waste is minimized: therefore, governments aim to cut costs
in all areas.
* Allow for social costs and benefits: since they do not aim to make a profit, decisions can take into
account the needs of a wider range of stakeholders.
* Profit: some state owned enterprises operate as commercial businesses, with the aim of making a
profit.

Types of Economy:
Different economies have different approaches to providing goods and services.
* A command economy relies entirely on the public sector. All resources belong to the government,
and the government is responsible for planning and coordinating the production process. Goods are
sold through state-owned shops at a price set by the government.
* A market economy relies least on the public sector: the vast majority of goods and services are
provided by the private sector. Market forces determine the allocation of resources. The public
sector is limited usually to a monetary system, a legal system, and key state services such as
defence.
* A mixed economy balances both the public and private sectors to provide goods and services.

In a mixed economy, the public sector tends to provide goods and services that the private sector
might fail to provide in sufficient quantities. Some services such as transport and infrastructure are
provided most efficiently by the public sector due to market failure in the private sector, where
markets lead to inefficiency.
Market failure can occur due to:
* Externalities: firms may not take into account the social cost of production
* Lack of competition: if there is little competition, an oligopoly exists: the dominant firm may
exploit customers
* Missing markets: some goods and services, called public goods (e.g. defence or policing), are not
provided by the private sector. Other goods, called merit goods (e.g. education and healthcare), are
under provided by the private sector, since they tend to be expensive.
* Lack of information: customers and producers may not have adequate information leading to
inefficiency.
* Factor immobility: the factors of production may be immobile (unable to move freely between
uses). The more specialized a factor of production is, the more immobile it is.

Governments may have to intervene to prevent market failure:

* Businesses that cause externalities may be heavily regulated or fined
* Anti-monopoly legislation can prevent businesses from dominating markets
* Public goods and merit goods can be provided free of charge by the state
* Legislation can force firms to provide more information about products

Public goods have non-excludability and non-rivalry. This means that no individual consumer can
be prevented from consuming a good. For example, an individual cannot be excluded from the
protection provided by the police service. The consumption of a public good by one individual does
not reduce the amount available to others.

Governments have to provide public goods, since if the private sector provided them, there would
be a free rider problem: many people would enjoy the benefits of things like street lighting or
policing without paying for them.

Privatisation:
Privatisation is the transferring of public sector resources to the private sector. This has been a
growing trend. It takes the form of:
* Sale of nationalized industries: industries such as British Airways or British Telecom were public
sector industries, since they were natural monopolies and would be more efficient under state
control. However, they were later sold off to become private sector businesses owned by private
shareholders.
* Contracting out: many local authority services have been contracted out to private sector
businesses.
* Sale of land and property: many people renting council-owned properties were given the chance
to buy their homes with generous discounts. This transferred ownership from the state to
individuals.

Reasons for privatisation are:

* To generate revenue: the sale of state assets generates income for the government.
* Inefficiency: some nationalised industries were inefficient and made losses. Privatisation would
force them to be more efficient, since they would have to make a profit.
* To reduce political interference: in the private sector, the government could not interfere in the
running of the business, making it more stable.

The impact of privatisation on different groups includes:

* Businesses are under pressure to become efficient and provide good quality products at a
reasonable price. This benefits customers, since this will usually cause lower costs and better
service.
* After privatisation to reduce costs many people are made redundant, in order to cut costs and
improve efficiency. This causes higher unemployment, especially regional unemployment,
negatively impacting workers.
* Businesses’ objectives change: for most firms, profit has become their most important objective.
Many firms have increased investment to remain competitive. Also, some companies have merged,
while others have diversified.
* The government generates a huge amount of revenue from the sale of state assets. However, a lot
of money has been spent on advertising the sales, meaning that revenue has not been maximized.

Externalities:
Some production results in costs incurred by third parties. These external costs are spillover effects
of production. The consumption of certain goods also can have positive spillover effects. These are
called external benefits and are enjoyed by third parties.

Examples of external benefits include:

* Healthcare: individuals that consume healthcare will benefit in their own personal health.
However, they will also benefit others, as they can work more effectively, making greater
contributions to the economy and paying more taxes, thus benefiting the wider society. People who
receive vaccinations against an infectious disease will benefit others, since it reduces the likelihood
of others contracting the disease.
* Education: people who receive more education will benefit from a higher quality of life. However,
they will be more productive, improving the economy and paying more taxes, and will increase
standards of living for society as a whole.

Production or consumption will have costs that will be divided into private costs and external costs.
Private costs are costs to individuals and firms, while external costs are costs to society at a whole.
Social cost = Private Costs + External Costs.

Production and consumption will also have benefits that will be divided into private benefits and
external benefits. Private benefits are costs to individuals and firms, while external benefits are
costs to society. Social Benefit = Private Benefit + External Benefit

Governments can deal with externalities using various methods:

* Taxation: taxation can be used to reduce external costs of production. Taxes raise production
costs, thus forcing prices to rise. This lowers demand for the product, and therefore reduces the
negative externality. Taxes can also be used to reduce external costs of consumption – e.g. a tax on
cigarettes will reduce supply, raising the price, causing the demand to fall. However, this depends
on the product being price elastic.
* Subsidies: subsidies can be used as an incentive to reduce external costs and raise external
benefits. For instance, a subsidy can be used to lower the price of a product that causes an external
benefit, increasing demand and increasing the social benefit. However, subsidies have a high
opportunity cost.
* Fines: fines can be used to reduce external costs. For example, fines can be imposted on those that
damage the environment.
* Regulation: regulation can be used to protect the environment, aiming to reduce the external costs
of production.
* Pollution permits can be issued to companies, giving them the right to discharge a certain amount
of pollution. These are tradeable: i.e. if a company manages to reduce their pollution under that
limit, they can sell their permit to another company that is struggling to limit their pollution,
increasing their revenue, and therefore incentivising companies to reduce pollution.