O Level Economics Notes by readandwrite.marketing

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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the Publisher. Title

O-Level Economics Notes

Author

Imran Latif Cell: +923004410900 Email: imranlatifmalik@gmail.com

Published by

Read and Write Publications

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Composed by

Rashid Mehmood, Muhammad Salman

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Edition:

2017 – 18 Edition

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Contents UNIT 1

BASIC ECONOMIC PROBLEM .........................................................................................................................14

BASIC ECONOMIC PROBLEM ................................................................................................................................................... 14 PRODUCTION POSSIBILITY CURVE............................................................................................................................................. 17 UNIT 2

DEMAND, SUPPLY AND EQUILIBRIUM ..........................................................................................................24

DEMAND............................................................................................................................................................................ 24 SUPPLY .............................................................................................................................................................................. 30 EQUILIBRIUM ...................................................................................................................................................................... 35 INTERDEPENDENT MARKETS & PRICES ...................................................................................................................................... 38 UNIT 3

ELASTICITY ....................................................................................................................................................42

INTERPRETING THE ELASTICITY FIGURES..................................................................................................................................... 42 ELASTICITY OF DEMAND......................................................................................................................................................... 43 PRICE ELASTICITY OF SUPPLY (PES) .......................................................................................................................................... 52 UNIT 4

PRODUCTION AND COST ..............................................................................................................................60

COST OF PRODUCTION .......................................................................................................................................................... 62 REVENUE, PROFIT, LOSS & BREAK EVEN ................................................................................................................................... 65 SPECIALIZATION ................................................................................................................................................................... 67 RETURNS TO SCALE............................................................................................................................................................... 68 ECONOMIES OF SCALE........................................................................................................................................................... 69 DIFFERENT SIZE OF FIRMS AND INTEGRATION ............................................................................................................................ 71 UNIT 5

TYPES OF BUSINESS ORGANISATIONS ..........................................................................................................76

MULTINATIONAL CORPORATIONS (MNC) ................................................................................................................................. 76 UNIT 6

MARKET STRUCTURES AND BUSINESS OBJECTIVES .....................................................................................82

OBJECTIVES OF FIRMS ........................................................................................................................................................... 82 MARKET STRUCTURES........................................................................................................................................................... 85 ARE MONOPOLIES ALWAYS BAD FOR CONSUMERS? ................................................................................................................... 88 UNIT 7

ECONOMIC SYSTEMS & ALLOCATION OF RESOURCES ...................................................................................92

TYPES OF INDUSTRIES IN AN ECONOMY ..................................................................................................................................... 92 BASIC ECONOMIC QUESTIONS & ALLOCATION OF RESOURCES ........................................................................................................ 92 ECONOMIC SYSTEMS............................................................................................................................................................. 93 UNIT 8

MARKET FAILURE .........................................................................................................................................96

MARKET FAILURE:................................................................................................................................................................ 97 USING AND CONSERVING RESOURCES ..................................................................................................................................... 101 PUBLIC EXPENDITURE VERSUS PRIVATE EXPENDITURE ............................................................................................................... 101 COMPARISON OF EXPENDITURES BY PUBLIC AND PRIVATE SECTORS ............................................................................................. 102 UNIT 9

LABOUR MARKET ....................................................................................................................................... 104

WAGE DETERMINATION ...................................................................................................................................................... 104 TRADE UNION ................................................................................................................................................................... 108 ROLE OF TRADE UNION IN AN ECONOMY ................................................................................................................................. 111 WAGE DIFFERENTIALS ......................................................................................................................................................... 111 TYPES OF LABOUR EARNINGS ................................................................................................................................................ 114 FACTORS AFFECTING CHOICE OF OCCUPATION ........................................................................................................................ 115 CHANGES IN THE EARNINGS OF INDIVIDUALS OVER TIME ........................................................................................................... 117

UNIT 10

SPENDING, SAVING AND BORROWING ................................................................................................... 120

INCOME ........................................................................................................................................................................... 120 SPENDING/CONSUMPTION .................................................................................................................................................. 120 SAVINGS .......................................................................................................................................................................... 122 BORROWING ..................................................................................................................................................................... 123 DIFFERENCES IN EXPENDITURE PATTERNS OF DIFFERENT INCOME GROUPS...................................................................................... 124 UNIT 11

GOVERNMENT MICROECONOMIC INTERVENTION ................................................................................. 126

1. TAXATION..................................................................................................................................................................... 126 2. SUBSIDIES ..................................................................................................................................................................... 129 3. REGULATIONS................................................................................................................................................................ 130 THE GOVERNMENT AS A PRODUCER AND AN EMPLOYER ............................................................................................................ 132 NATIONALIZATION AND PRIVATIZATION .................................................................................................................................. 132 THE GOVERNMENT AS AN EMPLOYER .................................................................................................................................... 134 UNIT 12

MONEY AND BANKING ........................................................................................................................... 136

MONEY............................................................................................................................................................................ 136 BANKING.......................................................................................................................................................................... 138 STOCK EXCHANGE .............................................................................................................................................................. 139 UNIT 13

NATIONAL INCOME, AD & AS ................................................................................................................. 142

SECTORS AND TYPES OF ECONOMIES: .................................................................................................................................... 143 AGGREGATE DEMAOD (AD): ................................................................................................................................................ 143 AGGREGATE SUPPLY (AS) .................................................................................................................................................... 147 INTERACTION OF AGGREGATE DEMAND AND AGGREGATE SUPPLY AND NATIONAL INCOME EQUILIBRIUM .............................................. 148 CHANGES IN NATIONAL INCOME EQUILIBRIUM ......................................................................................................................... 149 BUSINESS (TRADE) CYCLE .................................................................................................................................................... 150 UNIT 14

INFLATION .............................................................................................................................................. 154

MEASUREMENT OF INFLATION / VALUE OF MONEY / COST OF LIVING.......................................................................................... 155 THE CAUSES OF INFLATION ................................................................................................................................................... 157 THE CONSEQUENCES OF INFLATION........................................................................................................................................ 159 CAUSES AND CONSEQUENCES OF DEFLATION ........................................................................................................................... 163 UNIT 15

EMPLOYMENT AND UNEMPLOYMENT ................................................................................................... 166

THE CAUSES OF UNEMPLOYMENT .......................................................................................................................................... 166 FULL-EMPLOYMENT / NATURAL RATE OF UNEMPLOYMENT (NRU) .............................................................................................. 168 THE CONSEQUENCES OF UNEMPLOYMENT ............................................................................................................................... 168 POLICIES TO CORRECT UNEMPLOYMENT .................................................................................................................................. 169 THE PATTERN AND TRENDS IN (UN)EMPLOYMENT ..................................................................................................................... 169 UNIT 16

ECONOMIC GROWTH .............................................................................................................................. 172

COSTS AND BENEFITS OF GROWTH ......................................................................................................................................... 174 UNIT 17

POPULATION .......................................................................................................................................... 176

SIZE OF POPULATION .......................................................................................................................................................... 176 POPULATION PYRAMIDS ...................................................................................................................................................... 180 AGEING POPULATION.......................................................................................................................................................... 182 UNIT 18

ECONOMIC DEVELOPMENT AND STANDARD OF LIVING ........................................................................ 184

GDP AND STANDARD OF LIVING ............................................................................................................................................ 185 ECONOMIC DEVELOPMENT .................................................................................................................................................. 187 INCOME AND WEALTH INEQUALITY ....................................................................................................................................... 189

THE NATURE AND CAUSES OF POVERTY .................................................................................................................................. 189 UNIT 19

INTERNATIONAL TRADE: ......................................................................................................................... 192

THEORIES OF INTERNATIONAL TRADE: .................................................................................................................................... 192 PROTECTIONISM ................................................................................................................................................................ 192 THE ARGUMENTS IN FAVOUR OF FREE TRADE AND AGAINST PROTECTIONISM .................................................................................. 195 THE ARGUMENTS IN FAVOUR OF PROTECTIONISM AND AGAINST FREE TRADE .................................................................................. 196 UNIT 20

EXCHANGE RATE ..................................................................................................................................... 200

DEFINITIONS AND MEASUREMENT OF EXCHANGE RATES ............................................................................................................. 200 EXCHANGE RATE SYSTEMS.................................................................................................................................................... 200 CAUSES OF EXCHANGE RATE DEPRECIATION ............................................................................................................................ 204 CAUSES OF EXCHANGE RATE APPRECIATION ............................................................................................................................ 206 EFFECTS OF DEPRECIATION/DEVALUATION ............................................................................................................................. 208 EFFECTS OF APPRECIATION/REVALUATION............................................................................................................................... 209 ADVANTAGES AND DISADVANTAGES OF EXCHANGE RATE SYSTEMS: .............................................................................................. 211 THE TERMS OF TRADE ......................................................................................................................................................... 214 UNIT 21

BALANCE OF PAYMENTS ......................................................................................................................... 218

COMPONENTS OF THE BALANCE OF PAYMENTS ......................................................................................................................... 219 BALANCE OF PAYMENT DISEQUILIBRIUM ................................................................................................................................. 222 CAUSES OF BALANCE OF PAYMENT DISEQUILIBRIUM .................................................................................................................. 222 CONSEQUENCES OF A CURRENT ACCOUNT DEFICIT AND A CURRENT ACCOUNT SURPLUS .................................................................... 223 UNIT 22

GOVERNMENT MACROECONOMIC INTERVENTION ................................................................................ 226

GOVERNMENT MACROECONOMIC AIMS: ................................................................................................................................ 226 CONFLICTS AMONG MACROECONOMIC AIMS: .......................................................................................................................... 227

Preface The idea of writing notes for Cambridge O-level Economics came to me in 2003, when, having already taught for a year, I realized that no single economics book available in the local and international markets covered all the topics with the depth and perspective required by the CIE syllabus. Both students and teachers had to consult 3 to 4 different books to find all the material that they neededâ&#x20AC;&#x201D;private candidates and new teachers had it even worse. Furthermore, it was really difficult for students to keep having to refer through different books when the exams were close and they were starved for time. I took on the challenge and decided to write a comprehensive text that explicitly followed the syllabus and exam pattern of the CIE. A year and a half later, in the middle of 2004, I had finally written and published O-level economics notes. Part of them had been handwritten, and part of them had been typed. Soon, word of their usefulness spread, and they were bought all over Pakistan. The notes had served their purpose well till the end of 2014. Till that point, there had only been minor changes in the syllabus. But now, there was a dire need to update them, for the new syllabus for the 2016 examination introduced some significant changes in course content. I hope my efforts will help to contribute both to the learning of the student, as well as to the inquisitiveness of any teachers of A-level economics, effectively. Your suggestions will help me improve the quality of the content for later editions and will be highly appreciated.

Imran Latif Cell: 0092-300-44-10-900 Email: imranlatifmalik@gmail.com

References 1. Economics, 6th Edition / Sloman, J. 2. Principles of Economics, 10th Edition / Karl E. Case, Ray C Fair and Sharon C Oster 3. Economics, 18th edition / Mcconnell Brue 4. Economics, 9th Edition / Arnold 5. Principles of Economics / N. Gregory Mankiw 6. Cambridge International IGCSE / O-level Economics, Grant, Susan 7. Comprehensive economics guide / Hashim Ali. 8. Stanlakeâ&#x20AC;&#x2122;s Introductory Economics/ Susan Grant 9. Penguin Dictionary of Economics / Bannock, Graham et al (eds) 10. Economics: A Studentâ&#x20AC;&#x2122;s Guide / Beardshaw, J 11. Essentials of Economic 5th edition / Sloman, John 12. Economics, 9th edition / Begg, David et al 13. Economics, 11th edition / Michael Parkin 14. www.tutor2u.net 15. www.s-cool.co.uk 16. www.wikipedia.com

Review Board 1. Lahore: Mr. Aslam Tariq, Mr. Mian Mumtaz, Mr. Saeed Afzal, Mr. Kamran Malik , Mr. Shahid Saghir , Mr. Faisal Saeed, Mr. Muhammad Rafi, Mr. Arshad Chudhary, Mr. Ahmed Bilal, Mr. Waqar Khan, Mr. Waqas Iqbal, Mr. Azar Anjum, Mr. Arshad Farooqi, Mr. Rizwan-ur-Rehman, Mr. Irteza Rehman, Mr. Ahmed Javed Paracha, Mr. Ali Rana, Mr. Mazahar Abbas, Mr. Rasheed Kahloon, Mr. Mazhar Muneer, Mr. Mumtaz Ahmad, Miss Nosheen Jamal, Mr. Muhammad Rizwan, Mr. Azeem Qaisar, Mr. Waqas Biag and Mr. Asghar Ali Malik. 2. Islamabad and Rawalpindi Mr. M. Zulfiqar, Mr. Hamood Rehman, Mr. Abdul Salam, Mazhar Hameed Khan, Mr. Ali Yasir, Mr. Asad Ali, Mr. Naveed Iqbal, Mr. Umar Khan, Mr. Sadaqat Ali, Mr. Hamood Ur Rahman and Mian Tahir Siddique, Mr. Saeed Khan. 3. Fisalabad and Jhang Mr. Anwar-ul-Haq, Mr. Aamir Jahangir, Mr. Ahmed Kamal , Mr. Muhammad Sakhi Ahmad, Mr. Javed Iqbal, and Miss Kiran.

4. Sialkot and Gujranwala Mr. Imran Aslam and Mr. Sarwar Imtiaz.

5. Karachi and Multan M. Asif farooq, Miss Shafaq Ahmed, Mr. Siddique Ansari , Mr. Zai, Mr. Munawar Ghazi, Mr. Abdul Kareem Lakhani, Mr. Ali Anwerzada, Miss Khalida Afsar, Miss Amna Basir, Hanah Iqbal Mirza and Mr. Kamran Butt.

Unit 1

Basic economic problem

O-Level Economics 2281 Syllabus overview (2015-17) Section 1. Basic economic problem: choice and the allocation of resources

2. The allocation of resources: how the market works; market failure

3. The individual as producer, consumer and borrower

4. The private firm as producer and employer

5. Role of government in economy

Topics •

economic problem

•

factors of production

•

opportunity cost

•

resource allocation

•

choice

•

production possibility curves.

•

market and mixed economic systems

•

demand and supply analysis

•

price elasticity

•

market failure

•

social and private costs and benefits.

•

functions of money

•

exchange

•

central banks, stock exchanges and commercial banks

•

labour market

•

motives for spending, saving and borrowing.

•

types and sizes of business organisation

•

demand for factors of production

•

costs and revenue

•

profit maximisation and other business goals

•

perfect competition

•

monopoly

•

advantages and disadvantages of increased scale.

•

government as a producer and an employer

•

aims of government economic policy

•

fiscal, monetary and supply-side policies

•

types of taxation

•

possible policy conflicts

•

government's influence on private producers.

•

price indices

•

inflation and deflation

•

employment and unemployment

•

GDP, economic growth and recession

•

GDP and other measures of living standards.

6. Economic indicators

Unit 1

7. Developed and developing economies: trends in production, population and living standards

Basic economic problem

•

developed and developing countries

•

absolute and relative poverty

•

alleviating poverty

•

population growth

•

differences in living standards.

•

specialisation

•

current account of the balance of payments

•

current account deficits and surpluses

•

exchange rate fluctuations

•

protectionism and free trade.

8. International aspects

O-Level Economics 2281 Syllabus Contents Details (2015-17) Section 1

Basic economic problem: choice and the allocation of resources

Basic Economic problem:  define the nature of the economic problem (finite resources and unlimited wants)  define the factors of production (land, labour, capital, enterprise)  define opportunity cost and analyse particular circumstances to illustrate the concept  demonstrate how production possibility curves can be used to illustrate choice and resource allocation  evaluate the implications of particular courses of action in terms of opportunity cost.

Section 2

The allocation of resources: how the market works; market failure

Economic Systems 

describe the allocation of resources in market and mixed economic systems; describe the terms primary, secondary and service (tertiary) sector in an economy

Demand, supply and equilibrium  

demonstrate the principle of equilibrium price and analyse simple market situations with changes in demand and supply describe the causes of changes in demand and supply conditions and analyse such changes to show effects in the market

Elasticity  

define price elasticity of demand and supply and perform simple calculations demonstrate the usefulness of price elasticity in particular situations such as revenue changes, consumer expenditure

Market Failure     

evaluate the merits of the market system describe the concept of market failure and explain the reasons for its occurrence define private and social costs and benefits and discuss conflicts of interest in relation to these costs and benefits in the short-term and long-term through studies of the following issues: conserving resources versus using resources public expenditure versus private expenditure.

Unit 1

Section 3

Basic economic problem

The individual as producer, consumer and borrower

Money and Banking:  

describe the functions of money and the need for exchange describe the functions of central banks, stock exchanges, commercial banks

Labour Market:    

identify the factors affecting an individual's choice of occupation (wage factors and non-wage factors) describe likely changes in earnings over time for an individual describe the differences in earnings between different groups of workers (male/female; skilled/unskilled; private/public; agricultural/manufacturing/services) describe trade unions and analyse their role in an economy

Spending, borrowing and saving   

describe the benefits and disadvantages of specialisation for the individual analyse the different motives for spending, saving and borrowing discuss how and why different income groups have different expenditure patterns (spending, saving and borrowing).

Section 4

The private firm as producer and employer

Types of business organisations    

describe the type of business organisation in the public and private sectors: sole trader (proprietor), public limited companies, multinationals, cooperatives, state-owned enterprises (public corporations) discuss the effects of moving firms from the public sector to the private sector and vice versa describe and evaluate the effects of changes in the structure of business organisations describe what determines the demand for factors of production

Production and cost        

distinguish between labour-intensive and capital-intensive production define productivity and recognise the difference between productivity and production define total and average cost, fixed and variable cost and perform simple calculations analyse particular situations to show changes in total and average cost as output changes define total and average revenue and perform simple calculations describe the main reasons for the different sizes of firms (size of market, capital, organisation) describe and evaluate integration, economies and diseconomies of scale discuss the advantages and disadvantages of monopoly

Market Structures and Business objectives   

describe the principle of profit maximisation as a goal and recognise that business organisations may have different goals describe the characteristics of perfect competition and monopoly describe pricing and output policies in perfect competition and monopoly

Section 5

Role of government in an economy

Macroeconomic Policies and objectives 

describe the government as a producer of goods and services and as an employer

Unit 1

     

Basic economic problem

describe the aims of government policies, such as full employment, price stability, economic growth, redistribution of income, balance of payments stability explain fiscal, monetary and supply-side policies analyse the use of fiscal, monetary and supply-side policies discuss the possible conflicts between government aims describe the types of taxation (direct, indirect, progressive, regressive, proportional) and the impact of taxation discuss the government's influence (regulation, subsidies, taxes) on private producers.

Section 6

Economic indicators

National income  

define Gross Domestic Product (GDP) define the term recession

Inflation   

describe how a consumer prices index/retail prices index is calculated discuss the causes and consequences of inflation discuss the causes and consequences of deflation.

Employment and unemployment  

describe the changing patterns and levels of employment discuss the causes and consequences of unemployment.

Economic growth 

describe and have a general understanding of the causes and consequences of economic growth

Section 7 Developed and developing economies: trends in production, population and living standards Population   

describe the factors that affect population growth (birth rate, death rate, fertility rate, net migration) and discuss reasons for the different rates of growth in different countries analyse the problems and consequences of these population changes for countries at different stages of development describe the effects of changing size and structure of population on an economy

Economic development and standard of living:      

describe why some countries are classified as developed and others are not describe the difference between absolute and relative poverty recognise and discuss policies to alleviate poverty describe and evaluate measures and indicators of comparative living standards, such as GDP per head, Human Development Index (HDI) discuss differences in standards of living within countries and between countries, both developed and developing.

Unit 1

Section 8

Basic economic problem

International aspects

International Trade   

describe the benefits and disadvantages of specialisation at regional and national levels describe methods of trade protection discuss the merits of free trade and protection

Exchange rate  

define exchange rates discuss the causes and consequences of exchange rate fluctuations

Balance of payments  

describe the structure of the current account of the balance of payments discuss the causes and consequences of current account deficits and surpluses

Unit 1

Basic economic problem

Unit 1

Basic economic problem

Unit 1 Syllabus 2015 – 17 Basic Economic problem:

Basic Economic Problem

O Level Economics Notes Imran Latif Cell: 0300-44-10-900 Imranlatifmalik@gmail.com

    

define the nature of the economic problem (finite resources and unlimited wants) define the factors of production (land, labour, capital, enterprise) define opportunity cost and analyse particular circumstances to illustrate the concept demonstrate how production possibility curves can be used to illustrate choice and resource allocation evaluate the implications of particular courses of action in terms of opportunity cost.

Unit 1

Basic economic problem

Economy is an area where goods and services are produced and consumed. Economics is the social science that studies human behaviour between unlimited wants and limited resources with their alternative uses. In other words, it is a social science that studies how we can make the best use of what we have in order to satisfy our needs and wants. Or, simply, economics is the study of the economy. Production and consumption Resources are combined in the process of production to create goods and services. Goods and services have the capacity to satisfy wants. The process through which individuals use up goods and services to satisfy wants is known as consumption. Some goods, such as a chocolate bar, are quickly used up to satisfy our wants and are known as consumer perishables. Other things satisfy wants over a longer period. These are called consumer durables. Examples of consumer durables include television sets, refrigerators and vehicles.

Basic economic problem The limitedness of resources to satisfy all human needs and wants in the society is known as the basic economic problem, fundamental economic problem or problem of scarcity. From an individual to a whole society, everyone faces the problem of scarcity. The problem of scarcity arises due to two reasons: 1. Limited nature of resources 2. Unlimited nature of wants The Limited Nature of Resources

Resources

Economic resources

Free resources

- limited in supply

- unlimited in supply - e.g. Air, Sunlight

Land (N)

Labour (L)

Capital (K)

Entrepreneurship

Resources are all those materials and efforts which can be used to produce goods and services, e.g., agricultural area, labor, machines, tools, etc. Resources are of two types: A. Unlimited resources or free resources B. Limited resources or scarce resources Unlimited Resources or Free Resources: Resources which are unlimited in supply, e.g. sunlight and sea water. Free resources are not of much concern to economists.

Unit 1

Basic economic problem

Limited Resources or Scarce Resources    i.

Resources which are limited in their supply, e.g., agricultural area that a country can have are limited, number of machines, buildings, oil-reserves, and labor force are limited in supply. Scarce resources are also known as factors of production. There are four major types of factors of production, i.e., land, labor, capital, and entrepreneurship.

Land (natural resources):  All natural and god-gifted resources which can be used to produce goods and services are collectively known as land, e.g., agricultural area, oil-reserves, gas-reserves, rivers, lakes, minerals, coal, metals, natural forests, etc.  If a factor owner lends its factor of production to someone else for use of specific period, the benefit that factor owner will receive for parting with the use of factor he owns, is known as factor reward, return of factor of production or factor income.  Reward for land is known as rent.

ii. Labor (human resource): All human efforts (physical or mental) used to produce goods and services are termed as labor. Labor refers to the efforts used in the production process and is not the same as workers. Workers Doctor Teacher Engineer Security guard Labor = No. of workers   

Labor Medical service Teaching services Engineering services Security Services average work hours

Reward of labor is wages and salaries. Salaries are offered to permanently appointed staff and paid usually monthly or weekly. Wages are offered to the labor hired for a specific period or on task-basis.

iii. Capital (man-made resource):  All these resources which are man-made and can be used to produce goods and services  e.g., machines, building, tools, furniture, roads and vehicles, etc.  Reward of capital is interest.

Capital

Financial Capital Amount of money invested by the owner

Used in Accounting Terms

Physical Capital All those man-made resources used to produce goods and services Used in Economics Terms

Unit 1

Basic economic problem

iv. Entrepreneurship:  Entrepreneur is the person who combines all three factors of production and takes the risk of loss.  Combining all factors function may be shared with managerial labor but risk-taking is exclusive function of entrepreneur.  Entrepreneurship is the service of entrepreneur.  Reward for entrepreneurship is known as profit. LAND

LABOR

CAPITAL

ENTREPRENEURSHIP

Symbol

–

Definition

Limited natural resources

Human efforts measured in number of hours.

Man-made resources

 combines all factors of production  takes the risk of loss.

 Roads  Buildings  Machines  Microsoft word

 Sole-trader's services  Partners’ services  Shareholder's services

interest

Profit

Examples

 Medical services  Teaching services  Banking services  Labor services

 Agricultural area  Oil  Minerals  River

Reward

Rent

Wages or salary

Unlimited Nature of Wants    

Wants are all those desires which give us pleasure. Those desires without which we cannot live are known as needs. e.g., food, clothing, shelter, etc However, those desires which provide us pleasure but we can survive without then are termed as wants. Needs are limited but wants are unlimited.

Individuals, firms, or a society have diverse and wide range of wants. 

Individuals may desire better food, luxurious housing, high incomes, better working conditions, and so on.  Firms may desire for more and more profits, expansion, market-share, and monopoly power.  Society may desire for improved infrastructure, low un-employment, low inflation, high economic growth, and high standard of living. There is no limit of wants people, firms, and societies have. This limited nature of resources and unlimited nature of wants leads to the existence of basic economic problem at all levels. Scarcity means inability to satisfy all of the wants with the given level of limited resources.

are satisfied by Unlimited

goods & services

are produced by

Basic Economic Problem ( Scarcity )

Limited

Relationship between scarcity, choice, and opportunity cost The existence of scarcity forces people, firms, and societies to choose some of their wants that can be satisfied and other wants to be left unsatisfied. Economics helps us to make wise choices to achieve the

Unit 1

Basic economic problem

highest possible satisfaction. Hence, economics is a science of making best choices in order to satisfy our needs and wants. Where there is scarcity, there is choice, and every choice has its opportunity cost. If there is no scarcity, there is no choice and no opportunity cost, i.e., free goods.  

Choice means selection of something for consumption or production. Every “choice” is accompanied by opportunity cost. Opportunity cost is the benefit of the next best alternative sacrificed due to the current choice having been made.

Examples: 

At an individual level An individual faces the basic economic problem if he has Rs.20 and wants to buy a Pepsi and chips with prices of Rs.15 and Rs.10, respectively. He is unable to buy both due to his limited income; hence, is forced to make a choice. If he chooses Pepsi, the benefit he could have from consumption of chips is his opportunity cost.  At a firm’s level A firm may have to choose either an advertising campaign or instalment of new machinery in the factory because it does not have enough resources to do both. Choice of advertising campaign will have the opportunity cost of new machinery.  At the country’s level A society may face basic economic problem when it does not find enough resources to develop a school network in rural areas as well as wants to strengthen its defence system. Choice of strong national defence will lead to the sacrifice of the benefit she could have from improved education.   

Opportunity Cost is even present between the choice of present or future. If a society chooses high standard of living in future, it must invest more today to reap high in future. More investment today means less consumption and lower standard of living in the present. Present consumption is the opportunity cost of investment and better future living standards.

Problem of scarcity and its link with choice and opportunity can be best explained through a Production Possibility Curve (PPC).

Production possibility curve The Production possibility curve (PPC) is a curve that shows all maximum possible combinations of two goods and services which a country can produce using all available resources with efficient technique of production at a given state of technology. Assumptions of PPC  Suppose there are only two goods produced in a country: Guns and Roses.  Suppose the economy is working at full employment. All available resources are utilized to produce goods and services and quantity of resources is fixed.  Assume that country is using best available technique of production, i.e., Productive Efficiency (a situation where it is impossible to produce more of one good without sacrifice of other.)  Finally to construct PPC and make it comprehendible, it is assumed that state of technology will not change in the given time constraint. Following diagram shows the production possibility curve of a country producing guns and roses assuming that all available resources are fully employed in the most efficient way at present state of technology.  If all resources are allocated in guns production the economy will be at point ‘A’  If all resources in roses production the economy will be at point ‘B’ 

A curve joining ‘A’ and ‘B’ is PPC as shown below

Unit 1

Basic economic problem

Good y

Good x

Points 'A' and 'B' may be joined by a straight line as shown below: Good y

Good y

Good x

PPC and opportunity cost calculations According to the following diagram: Guns

20 15

a d e

b 0

  

4 Roses Opportunity cost of 4 units of roses is 20 units of guns or opportunity cost of 20 units of guns is 4 units of roses Opportunity cost of 15 units of guns is 2 units of roses or opportunity cost of 2 units of roses is 5 units of guns Opportunity cost of increase in roses from 2 units to 3 units is fall in production of guns from 15 to 10 units, i.e.,5 units of guns and vice-versa

Unit 1

Basic economic problem

Points below, on, and beyond the PPC

According to figure Attainable Desirable Employment of Resources Productive Efficiency Opportunity Cost

Points on the PPC a,b,d, and e  

Points below the PPC S  

Points beyond the PPC U  

Full-employment

Unemployment

–

 

 

– –

Guns

20 15 10

a d e

b 0 3 2 4 Roses Points on the PPC  Point “a” represents the maximum production of guns if all resources are employed in the production of guns and no roses are produced.  Point “b” represents the maximum production of roses when no guns are produced.  A curve joining these two extreme points (may be outward bending, inward bending, or a straight line) is the PPC.  At any point along the curve, such as “d” and “e”, there is a trade-off between two goods.  The production of roses can only be expanded by taking resources away from the production of guns.  When an economy moves from point “d” to “e”, to have an extra unit of roses it must sacrifice “5” units of guns (opportunity cost). Points below the PPC  Point “S” or any other points below the PPC show that the economy is either under-utilizing its scarce resources (i.e., unemployment) or it is using an inefficient technique of production.  Economy is capable of moving to point “d” without sacrificing roses; more guns can be produced by either employing idle resources or replacing inefficient techniques with efficient ones. It is also possible to produce more roses without sacrificing guns, as shown through a movement from point “S” to point “e” on the PPC.  This movement of an economy from a point below the PPC to the any of the points on the PPC is also known as actual economic growth. Points beyond the PPC  Point “U” is unattainable within the current time frame and production capacity. It can be achieved in the long run when some of the assumptions of the PPC are relaxed, e.g., an increase in quantity of land, labor, and capital or an improvement in technology.

Unit 1

Basic economic problem

Shifts in the PPC The production possibility curve can shift parallel inward or outward: Good y

C A E

Good x

Causes of Shifts in the PPC There are three major causes of shifts in the PPC: 1. A change in the quantity of resources. 2. A change in the productivity (quality) of existing resources. 1. A Change in the Quantity of Resources Land:  Land may increase because of:  Discovery of oil, metal or mineral reserves by active search.  Eroded, water-logged land may be made usable for agricultural purposes (Reclamation of land) -It shifts the PPC outward.  Land may decrease because of:  Depletion of non-renewable natural resources .e.g., oil-reserves may exhaust by over utilization.  Erosion caused by deforestation will reduce agricultural land.  Water-logging may reduce agricultural usage of land.  Natural disasters (floods, earthquakes, etc.) may reduce the quantity of land for a country. -It shifts the PPC inward.

Unit 1

Basic economic problem

Labor: Population

Dependent age group (Below 16 yearsand Above 65 years)

Working age group or Adult Population (16-65 years)

Active Population

Inactive Population

Employed

Unemployed

Those who are employed on some job and those who are self-employed

Those who are willing and able to work but have no job

Those who ar e either not willing to work or unable to work e.g.  university students  housewives  disables  on training

Labour Force or Work Force or Working Population

     

i. Labor may increase by: Increase in total population, especially in the working population. Change in structure of population from less dependent population to more working population, even without an increase in total population. Immigration is greater than emigration. Increased women-participation in jobs. Lower school-leaving age. Higher retirement age. -It shifts PPC outwards.

     

ii. Labor may decrease by: Decrease in total population, especially in the working population. Change in structure of population from working population to more dependent, population even without a decrease in total population. Emigration is greater than immigration. Decreased women-participation in jobs. Higher school-leaving age. Lower retirement age.

-It shifts PPC inwards. Capital:  Capital stock means total value of capital goods (buildings, factories, roads, bridges, etc.) at a point in time.  An increase in capital stock by more investment will shift the PPC outward and voice versa. 2. Change in Quality (Productivity) of Resources: Productivity is the efficiency of factors of productions used. Productivity is defined as output per unit of input (per unit of time).

Unit 1

Productivity =

Basic economic problem

Output Labor

Example: If ‘5’ workers produce 10,000 goods in ‘5’ hours, then: Q. What is total production? Ans: 10,000 Q. What is the productivity of labor?

10,000 2000 5 = = 400 goods per worker per hour Ans: 5 5 Determinants of the productivity of labor:  Wage rate  Education and training  Technology  Work conditions  Length of working hours  Fringe benefits\perks\non-monetary benefit\ non-pecuniary benefits  Bonuses and commissions  Promotional opportunities  Health Determinants of the productivity of capital:  Technology  Skilled labor  Depreciation, etc. Determinants of the productivity of land:  Technology  Skilled labor  Fertility rates, etc. Determinants of productivity of entrepreneurship:  Communication  Management techniques, etc Improved technology makes capital more productive and increases the productive capacity of a country. Education and training contributes to human capital (labor) and improves their productivity. Educated and skilled labor also uses capital more efficiently. Research and development (R&D) also contributes towards the productivity of land. Better technique of extraction, improved methods of farming and fishing, development of new breeds of plants and animals, and the use of fertilizers can enhance the productivity of existing land, shifting the PPC outwards. Better technology can also help the entrepreneurial abilities of a country. Improved communication, transportation, and new management techniques can contribute a lot towards the productivity of entrepreneurship. The PPC will shift outwards in this case.