TABLE OF CONTENTS:

2. The Allocation of Resources

Microeconomic decision makers

Government and the Macroeconomy

Economic Development

International Trade and Globalisation

1. The Basic Economic Problem

1.1: The Nature of the Economic Problem

In every country, resources are limited in supply and decisions have to be made by
governments, firms (businesses) and individuals about how to allocate scarce resources to
satisfy unlimited needs and wants. This leads to the basic economic problem which is how
to allocate scarce resources to satisfy unlimited wants and needs.

Scarcity is the term used when resources are in limited supply as compared with the
demand to use them.

Economic goods are those that are limited in supply and thus command a price when sold.
Eg-oil, wheat, cotton
Free goods are those that are unlimited in supply and available to everyone for free. Their
availability is so abundant that they are not a constraint on economic activity. Eg- sunlight,
air

The main economic agents or decision-makers in the economy are individuals/ households,
firms and the government. They serve as consumers, workers, producers and the
government.

Production is required to produce goods and services that satisfy are wants and needs:

Needs are the essential goods and services required for our survival

Wants are a matter of personal choice and human nature. They are non-essential and simply
desires. These are never satisfied.

Goods are physical and tangible items that meet our wants and needs

Services are intangible as they cannot be touched or felt and are non-physical items that
satisfy our wants and needs.

1.2: The Factors of Production

There are four main factors of production. Factors of production are the resources that are
used to produce goods and services which help us meet our wants and needs. Each factor of
production

receives a factor reward/ payment.

Land: Refers to all the natural resources used in the production process including oil, coal,
water and wood, etc. The factor payment for land is rent.

Labour: Refers to the human resources required in the production process. It refers to the
physical and mental contributions of the employees. The factor reward is wages. Includes
skilled and unskilled labour.

Capital: Refers to the man-made or manufactured resources used in the production process.
Capital is the man-made means of further production. Includes machinery, tools, vehicles,
etc. Factor reward is interest. Interest is paid to people or organisations that supply or
invest capital in firms.

Enterprise: It is the factor that combines and brings together other factors of production to
produce goods or services. Enterprise refers to the ability to take risk. Entrepreneurs are
risk takers. The factor reward for enterprise is profit which is a residual. The surplus an
entrepreneur has left after all their costs are paid is called a profit.

Mobility of Factors of Production:

Factor mobility refers to the ease with which resources or other factors of production can
be moved from one productive activity to another without incurring significant costs or a
loss of output.

Factor mobility is of two types:

Geographical mobility: Ability to move factors of production to different locations

Occupational mobility: Ability to move factors between different productive tasks.

Why are some factors more mobile than the others:

Some factors such as workers may be occupationally immobile because they lack certain
skills or may be only specialised in a certain skill. This means it is difficult for them to
change jobs without being re-trained which can be quite expensive.

Some factors may be geographically immobile such as workers because they are reluctant to
move to different locations due to family ties or because moving homes can be expensive.
However, they are more geographically mobile than other factors because they can move
from one place to another easily.

Land is also often geographically immobile. However, it can be used for various alternate
uses and can be occupationally mobile.
Capital is often geographically immobile and is difficult to move from one place to another
because it is heavy and painstaking to do so.

Quantity and quality of factors of production:

Increasing quantity and quality of factors of production can:

Help firms produce more goods and services

Help firms produce a wider range of goods and services

Help firms improve the quality of their goods and services

Help firms invent new ways of producing them

How can quantity of factors of production be increased:

Land:

Increase in rents

New discoveries of fossil fuels, minerals and other natural resources

Making use of other previously unused resources

Planting and growing more trees and plants

Labour:

Increase in wages

Increase in population of working age

Improvements in health care reduces the number of days people are away from work or
school

Capital:

Movements to capital-intensive methods of production

Increased interest rates will increase investments in capital

Enterprise:

Increase in prices consumers are willing to pay for certain goods or services

How can quality of factors of production be increased:

Use of fertilisers and better land management

Reduced use of harmful chemicals

New technologies to make crops pest and drought-resistant

Using organic and more humane animal farming methods

Training and education

Advances in technology have improved speed and accuracy of modern equipment

More and better advice for young entrepreneurs

More and better training courses for people wanting to become entrepreneurs

1.3: Opportunity Cost

Opportunity cost is the next best alternative that is forgone when a choice is made

Choices have to be made because we have scarce resources that need to be allocated.

When a decision is made, along with a choice a sacrifice is also made.

Opportunity cost is used to assess the real cost of any decision or productive activity.

Decisions involving money or time make use of opportunity cost

Opportunity cost is important:

To prevent undervaluing and

Overuse of resources

Decisions made by consumers, workers, firms and the government all involve an
opportunity cost. Economics aims to find the most efficient resource allocation and thus the
concept of opportunity cost arises.
1.4: Production Possibility Curve Diagrams (PPC)

A PPC is used to depict the concept of opportunity cost and scarcity. It shows the different
quantities or combinations of two goods or services that can be produced by fully utilising
existing resources in a country at a given point of time.

It assumes a two-good world.

It shows that to produce more of a certain good or service, a certain amount of another good
or service has to be sacrificed.

PPC’s are concave to the origin generally because factors of production are not completely
substitutable. This means that the same factors of production cannot be used to produce all
goods and services and thus the opportunity cost of changing production keeps increasing.

Points of Production:

A PPC is a locus of all efficients points of production which fully utilise resources in a
country.

A point inside or below the PPC is an inefficient point of production which under utilizes the
resources available in a country.

A point outside or above the PPC is an impossible point of production which is beyond the
country’s resource endowment. This means that the country does not have enough
resources to produce the given quantity of the goods or services.

Movement along a PPC:

This can be shown by movement from point B to point A.

This basically means that the country is re-allocating more of its resources towards the
production of consumer goods as compared to capital goods while still fully utilising all the
resources in the country.
At point A more consumer goods and less capital goods will be produced compared to
before.

The opportunity cost of this reallocation is the quantity(C2-C1) of capital goods that were
sacrificed to produce more consumer goods(X1-X2).

Shifts in a PPC:

A PPC can either shift inwards or outwards.

Inward Shift:

Decrease in productive capacity of an economy

The entire PPC will shift inwards or towards the left.

This indicates a decrease in economic growth

Can occur due to depletion of natural resources which can be a result of:

War or political conflict

A natural disaster

Corruption in the government

This means that fewer total goods and services can be produced with the existing

resources at every point of production.

Outward Shift:
Increase in productive potential of an economy.

The entire PPC will shift outwards to the right.

This indicates positive economic growth as the total output of the economy is increasing.

A greater total goods and services can now be produced at every point of production with
the existing resources in the country.

Can occur due to:

Discovery of more natural resources

Advancements and improvements in technology

Increased investment in capital goods and infrastructure

Providing education and training to improve the quantity and quality of the workforce.

As shown on the graph we will move from PPC1 to PPC2 and the point of production will
move from A to C.

The Allocation of Resources

2.1: Microeconomics and Macroeconomics

Microeconomics: Study of particular markets and segments of the economy. It looks at
consumer behaviour, individual labour markets and the theory of firms. It looks at supply
and demand in individual markets, individual consumer behaviour and individual labour
markets.

Macroeconomics: Study of the whole economy and how the national economy works. It
involves the interaction between aggregate supply and aggregate demand and how this can
influence output, employment and inflation in an economy. It consists of a large market
consisting of the total demand for all goods and services and the total supply of these goods
and services. We also learn about the main macroeconomic objectives and about
government policies to achieve these aims.

2.2: The Role of Markets in allocating resources

Market system

A market system consists of buyers who want to purchase goods and services and sellers
who want to supply these goods and services.

In a market system allocation of scarce resources is carried out by the market forces which
are the consumers and producers.

Market equilibrium is when the price of a product is such that the amount buyers are
willing and able to purchase is equal to the amount sellers are willing and able to provide.

Market disequilibrium is when the price of a product is such that the amount buyers are
willing and able to purchase is more than or less than the amount sellers are willing and
able to provide.

The basic economic problem leads to three main questions about resource allocation:

What to produce?- Decides which goods and services should be produced in an economy. As
resources are in limited supply, supplies see an opportunity cost in answering this question.

How to Produce?- Methods and processes used to produce desired goods and services.
Producers have to choose how they want to combine different factors of production.
For whom to produce?- About which economic agents should receive the goods or services.

Price Mechanism: (effect on allocating resources)

Makes use of demand and supply. Consumers make the decisions and there is consumer
sovereignty.

An increase in demand will increase price. This will provide a financial incentive and a
profit motive to supply more of the product. Resources are moved away from less popular
products .

An increase in supply will reduce price. This will lead to a rise in demand resulting in more
resources being devoted to the product .

Will encourage firms to use the most cost efficient methods of production e.g. will use
labour intensive methods of production if ready supply of labour .

2.3: Demand

Demand is the willingness backed up by the ability of a consumer to buy a certain good or
service at a given point of time. Often called effective demand.

Quantity demanded is the amount of a good or service demanded at a particular price.

Demand is the different combinations of quantity demanded at different prices.

Individual demand is the demand of one individual or firm for a particular good or service.
On the other hand, market demand is the summation of individual demands for a product. It
is the aggregation of the demand of all consumers for a particular good or service.

Demand curves:

These are downward-sloping.

They show the different quantities of goods and services demanded at different prices.

They are downward sloping due to the law of demand:

The law states that as price increases, the quantity demanded for a particular good or
service decreases and vice-versa, ceteris paribus.

The law of demand holds true mainly due to the income effect. This basically means that as
price increases, the real income of people decreases and thus they will be able to buy a
lower quantity of goods or service at the same price.

Price and demand:

As mentioned before the law of demand demonstrates the relationship between demand
and price.

This can be shown as extensions or contractions along the demand curve.

Extension is when the price of a product falls and the quantity demanded increases and we
will thus move from point B to point A along the demand curve.

Contraction is when quantity demanded falls as price increases. This can be shown as
movement from point A to point B.

Conditions of demand:

Non-price factors affecting demand will cause shifts in the demand curve. An increase in
demand means the demand curve will shift outwards to the right. The consumers will
demand a higher quantity of goods and services at each price. A decrease in demand means
that the demand curve will shift left or inwards. Consumers will demand a lower quantity at
each price.

Factors affecting shifts in demand:

Price of substitutes: These are goods that can be used in place of the given commodity. An
increase in the price of substitutes will cause an increase in demand for the given product
and vice-versa.
Price of complements: These are goods that can be used with one another and are jointly
demanded. A fall in the price of a product’s complements will cause an increase in demand
for the commodity and vice-versa.

Taste and Preference: People’s tastes and preferences change over time. Products that
become fashionable and popular will see an increase in demand while those that become
old-fashioned and boring will see a decrease in demand.

Incomes: As peoples’ incomes increase, their real incomes increase and they will be able to
pay for more goods and services and thus demand will increase and vice-versa.

Advertising: Strong advertising in favour of a product can create consumer wants and
increase demand for the product. However, an advertising campaign discouraging a certain
product can decrease demand.

Age distribution: If a country has a predominantly young population and the commodity is
meant for the youth it will see an increase in demand but if the product is mainly designed
for the elderly it will see a decrease in demand.

Increase in indirect taxes will reduce demand for a particular product while subsidies will
increase demand.

2.4: Supply

Supply is the willingness and ability of firms to produce goods and services at a certain
price.

Quantity supplied is the amount of a good or service that producers are willing and able to
make and provide to the market at a particular price. Supply is the different quantities
which producers supply to the market at different prices.

Individual supply is the amount supplied by an individual producer while market supply is
the total amount supplied by all producers competing to supply the product.

Supply Curves:

These are upward-sloping.

They show the different quantities of goods and services supplied at different prices.

They are upward sloping due to the law of supply:

The law states that as price increases, the quantity supplied for a particular good or service
increases and vice-versa, ceteris paribus.

The law of demand holds true because existing firms can supply more and earn more profits
at higher prices and new firms can cover costs at higher prices.

Price and supply:

As mentioned before the law of supply demonstrates the relationship between supply and
price.

This can be shown as extensions or contractions along the supply curve.

Contraction is when the price of a product falls and the quantity supplied decreases and we
will thus move from point B to point A along the supply curve.

Extension is when quantity supplied increases as price increases. This can be shown as
movement from point A to point B.

Conditions of supply:

Non-price factors affecting supply will cause shifts in the supply curve. An increase in
supply means the supply curve will shift outwards to the right. The producers will supply a
higher quantity of goods and services at each price. A decrease in supply means that the
supply curve will shift left or inwards. Producers will supply a lower quantity at each price.

Factors affecting shifts in supply:

Costs of Production: As COP increases, supply decreases because it is more expensive to
produce goods and services and vice-versa.

Imposition of taxes reduces supply as COP increases while imposition of subsidies increase
supply as they are provided by the government to offset production costs.

Technological Progress makes production faster and more efficient and thus increases
supply.

Price and profitability of other goods and services: Price acts as a signal to producers to
move their resources to the provision of goods and services with greater levels of profit.
Thus, if the price and profitability of other goods and services increase, resources will be
moved to the production of those products and thus the supply of the given commodity will
decrease.

Weather and other natural disasters: Bad weather and natural disasters can hamper and
reduce supply of agricultural output.

Wars and political conflicts can also decrease supply of goods and services.

2.5: Price Determination

The equilibrium price (also known as the market-clearing price) is determined where the
demand for a product is equal to the supply of the product. This means that there is neither
excess quantity demanded nor excess quantity supplied at the equilibrium price. At the
equilibrium price quantity demanded is equal to the quantity supplied.

The disequilibrium price is when the demand for a product is not equal to the quantity
supplied. Quantity demanded is not equal to quantity supplied. There can be excess quantity
demanded(shortages) or excess quantity supplied(excess).

Surplus or excess is when quantity supplied>quantity demanded

Shortages occur when quantity demanded>quantity supplied

2.6: Price Changes

Non-price factors that affect demand or supply can cause changes in equilibrium price and
thus quantity traded.

Changing market conditions are the causes for price changes

For example, if the demand for a particular good or service increases, the demand curve will
shift outwards. This means that there will now be shortages or excess demand at the
original equilibrium price. This will signal producers to bid the price at a higher value. As
price increases, quantity supplied will extend and quantity demanded will contract. These
extensions and contractions will continue until we reach our new equilibrium price which is
higher than the original equilibrium price. Also, at this price the quantity traded will be
more.

Similarly, if the supply increases due to non-wage factors, the supply curve will shift
outwards. This means that there will now be surplus or excess supply at the original
equilibrium price. This will signal producers to bid the price at a lower value. As price
decreases, quantity supplied will contract and quantity demanded will extend. These
extensions and contractions will continue until we reach our new equilibrium price which is
lower than the original equilibrium price. Also, at this price the quantity traded will be
more.

The same logic can be applied if there is a decrease in supply or demand or if both demand
and supply conditions change in a market.

2.7: Price Elasticity of Demand (PED)

It measures the degree of responsiveness of quantity demanded for a product following a

change in its price. If a unit price change causes less than proportionate change in the
quantity demanded, then demand is said to be price inelastic (PED<1). Demand is said to be
price elastic (PED>1) if there is more than a proportionate change in the quantity
demanded of a product following a unit change in its price.
PED is always a negative value due to the law of demand. Thus, we generally take its
modulus as seen in IGCSE exam papers but in the diagram above the negative values are
given.

There are three special cases for PED which are theoretical possibilities:

If the PED for a product is equal to 0, then demand is perfectly price inelastic: that is, a
change in price has no impact on the quantity demanded. This suggests that there is
absolutely no substitute for such a product, so suppliers can charge whatever price they
like.

If the PED for a product is equal to infinity then demand is perfectly price elastic: that is, a
change in price leads to zero quantity demanded. This suggests that customers switch to
buying other substitute products if suppliers raise their price.

If the PED for a product is equal to 1 (ignoring the minus sign), then demand has unitary
price elasticity: that is, the percentage change in the quantity demanded is proportional to
the change in the price

Factors affecting PED:(determinants of PED)

Number of close substitutes: If a commodity has a lot of close substitutes, the demand for it
will tend to be more price elastic and vice-versa

Percentage of income spent on the commodity: If a product takes up a large part of a

person’s income, then even a small change in price will cause a much larger change in
quantity demanded and thus its demand will tend to be price elastic.

Addictiveness: Demand for goods that are addictive such as cigarettes tend to be more price
inelastic.

Luxury / Necessity: Demand for necessities are generally price inelastic while demand for
luxuries usually tend to be price elastic.

Time: Over a longer time period people’s tastes and preferences and other such factors can
change and thus make demand price elastic. However in the short run demand is price
inelastic.

Durability and cost of switching can also affect PED for a product.
PED and total spending on a product/revenue:

This is useful for businesses to set prices for their products

Graphs can be seen below where the lighter regions indicate gain and the darker regions
indicate losses.

For goods whose demand are price elastic:

As prices increase, total spending and thus revenue will fall

As prices fall, Total spending and thus revenue will increase.

For goods whose demand are price inelastic:

As prices fall, total spending and thus revenue will fall

As prices increase, Total spending and thus revenue will increase.

PED and taxes:

This is useful for the government

Governments prefer to tax goods whose demand is price inelastic so that the majority of the
burden falls on consumers and less on producers.

This can be seen below

2.8: Price Elasticity of Supply (PES)

It measures the degree of responsiveness of quantity supplied for a product following a
change in its price. If a unit price change causes less than proportionate change in the
quantity supplied, then supply is said to be price inelastic (PES<1). Supply is said to be price
elastic (PES>1) if there is more than a proportionate change in the quantity supply of a
product following a unit change in its price.

However, there are three special cases which are theoretical possibilities for PES:

If the PES of a product is equal to 0, then supply is perfectly price inelastic: that is, a change
in price has no impact on the quantity supplied.

If the PES of a product is equal to infinity then supply is perfectly price elastic: that is, the
quantity supplied can change without any corresponding change in price. In reality,supply
curves are likely to be non-linear, so will have a different PES value at different points.
Supply is more elastic at lower prices and more inelastic at higher prices.

If the PES for a product is equal to 1 then supply has unitary price elasticity: that is, the
percentage change in the quantity supplied matches the proportional change in price. The
supply curve is a straight line passing through the origin.

Factors affecting PES:(determinants of PES)

Mobility of Labour and other factors of production: The more mobile they are, there more
elastic is the supply for the particular product because the producers can change between
different areas of production very quickly

Excess capacity: If the producers have excess capacity, the supply for the product will be
elastic. This is because they can quickly increase their production if needed. People
operating at full capacity cannot change their production and thus supply will be price
inelastic.

Storage/ Perishability of product: If product is not perishable, producers can stock up on

these goods or services and quickly increase or decrease the supply depending on prices
and other factors thus making the supply for them price elastic. However, supply for
perishable goods is often price inelastic.

Time: In the short run, most firms are not able to change their factor inputs, such as the size
of their workforce or the fixed amount of capital equipment they employ. Hence, supply is
less responsive to changes in price in the short run. Supply is more likely to be price elastic
in the long run because firms can adjust their levels of production according to price
changes in the market.

Availability of raw materials: If there are more stocks of raw materials available, supply for
the product will be price elastic because it can be changed quickly and vice-versa.

PES significance:

Often used by governments when imposing taxes: They tax goods whose PES<PED.

Also used by businesses as they seek a high PES. They can try to adjust their productive
activities to obtain a high PES.

2.9: Market Economic System

This economic system relies on the market forces of demand and supply to allocate
resources, with minimal government intervention. There is private ownership of resources.
It is driven by consumers and producers and the government only plays a law-enforcement
role.

The private sector which consists of consumers and producers decide on the fundamental
questions of what, how and for whom production should take place.

USA and UK lean towards such a system

Advantages:

Efficiency: There is competition between firms and thus firms will seek to use resources in
the most efficient way possible. They will adhere to the needs and wants of the consumer

and thus there will be less wastage and there will be less overproduction or
underproduction of goods and services.
Profit incentive: The profit motive for firms and the possibility for individuals to earn
unlimited wealth creates incentives to work hard. This helps to boost economic growth and
living standards in the country. This profit incentive will also encourage them to develop
new products and improve the quality of existing ones.

Greater consumer choice: Individuals can choose which goods and services to purchase and
which career to pursue, without being restricted by government regulations.

There are no taxes on income and wealth.

Firms will respond quickly to changes in consumers wants and spending patterns.

Disadvantages:

Environmental issues - There are negative consequences of economic prosperity under the
market system, such as resource depletion, pollution and climate change.

Income and wealth inequalities - In a market system, the rich have far more choice and
economic freedom. Production is geared to meet the needs and wants of those with plenty
of money, thus basic services for the poorer members of society may be neglected.

Social hardship - The absence of government control means the provision of public goods
such as streerlighting, public roads and national defence may not be provided.These are
non-rivalrous and non-excludable. Relief of poverty in society might only be done through
voluntary charities.

Harmful goods may be produced if it is profitable to do so.

Some firms may dominate the market supply for a particular product leading to the
development of a monopoly.

It could lead to lack of merit goods or essentials if it is not profitable to produce them.

2.10: Market failure

Market failure is the inability of the free market to be allocatively and productively efficient.

Market failure occurs when the production or consumption of a good or service causes
additional positive or negative externalities (spillover effects) on a third party not involved
in the economic activity. In other words, the market forces of demand and supply fail to
allocate resources efficiently.

Key terms:

Public goods are non-rivalrous (one person’s consumption does not affect another

person’s consumption) and non-excludable ( everyone has access to them) such as street-
lighting.

Merit Goods are goods or services which, when consumed, create positive spillover effects
in an economy (e.g. education, training and health care).

Demerit Goods: Demerit goods are goods or services which, when consumed, cause negative
spillover effects in an economy (e.g. cigarette smoking, alcohol and gambling).

Free riders are people who take advantage of goods and services produced by the
government although they do not contribute to government revenue by paying taxes.

External benefits: are the positive side-effects of production or consumption incurred by

third parties, for which no money is paid by the beneficiaries.

External costs: are the negative side-effects of production or consumption incurred by third
parties, for which no compensation is paid.

Private Costs: of production or consumption are actual costs incurred by an individual, firm
or government from their own action.

Private Benefits: of production or consumption are actual benefits enjoyed by an individual,

firm or government from their own action.

Social Cost: True (or full) costs of consumption or production: that is, the sum of private
costs and external costs.

Social Benefit: True (or full) benefits of consumption or production: that is, the sum of
private benefits and external benefits.
Market failure occurs when social costs are greater than social benefits.

Resources are said to be used efficiently and economically when social benefits are greater
than social costs,

Use of resources is uneconomic when social costs are greater than social benefits

Presence of externalities which are external costs and benefits cause market failure.

Causes and consequences of Market Failure:

Overproduction of goods or services which cause negative side-effects on a third party. For
example, the production of oil or the construction of offices may cause damage to the

environment and a loss of green space. These are called negative externalities.

Under production of goods or services which cause a positive spillover effect on a third
party. An example is training programmes, such as first-aid or coaching skills for employees,
which create benefits that can be enjoyed by others.

Over consumption of goods or services which cause a negative spillover effect on a third
party. Such goods are known as demerit goods and include cigarettes, alcohol, gambling and
driving a car.

Under consumption of goods or services which cause a positive spillover effect on a third
party. Such goods are known as merit goods and include education, health care and
vaccinations.

Failure of the private sector to provide public goods such as street lighting, road signs and
national defence due to a lack of profit motive. It is difficult to get people to pay for them
and thus the private sector is unwilling to pay for them.

The existence of a firm in a monopoly market that charges prices which are too high and
exploits customers. This is abusive monopoly power and can cause market failure.

Factor immobility also causes market failure.

Producers may ignore environmental laws causing environmental degradation and market
failure.

2.11: Mixed Economic System

The mixed economic system is a mix of both free market and planned economies. The
private and public sector both co-exist in such an economy.

Microeconomic policy measures to curb market failure:(Govt. Intervention)

Price floors in product, labour and foreign exchange markets:

Maximum prices: these are price ceilings and ensure that prices of products,

wages or exchange rates cannot exceed a certain limit. These are set below the equilibrium
price.

Minimum prices: these are price floors and ensure that prices of products, wages or
exchange rates do not go below a certain limit. These are set above the equilibrium price.

Indirect taxation: These are used to increase the prices of certain goods or services to
discourage their consumption. They are often placed on demerit goods and other products
that produce negative externalities to curb market failure.

Subsidies: These are grants of money given by the government to a firm to offset their
production costs. Subsidies aim to increase the quantity, improve the quality and increase
accessibility to merit goods and goods and services that create positive externalities.

Regulation: Imposition of rules by government, backed by the use of penalties that are
intended specifically to modify the economic behaviour of individuals and firms in the
private sector.
Privatisation: The transfer of ownership, property or business from the government to the
private sector is termed privatization. The government ceases to be the owner of the entity
or business

Nationalisation: Nationalization refers to when a government takes control of a company or

industry to control and regulate its productive activities.

Direct Provision of goods: Direct provision is a measure used to correct market failures
caused by public goods such as national defence and street lighting. It is also commonly
used to correct market failures caused by positive externalities and imperfect information
about the beneficial effects such as education and healthcare. It is when the government
takes responsibility for the production of certain goods and services and provides them
directly for consumers.

Effectiveness of Government Intervention:

Consumption of the good or service may be reduced.

Awareness of the negative impacts of demerit goods (such as drinking and driving) may
change the behaviour of people in the long term.

Awareness of the positive impacts of consumption of merit goods (such as education) is

raised.

Consumption pattern of households may change as desired by the government

Education and training will improve labour mobility and make them more aware about
implications of consuming demerit goods

Direct provision will directly thrust these merit goods into the market

Taxes, subsidies and price barriers can influence consumption by consumers by directly
altering prices of goods and services.

Problems:
Illegal markets may develop

Bans and laws may not be harsh enough

Taxes may not be sufficient as demerit goods are often very addictive

People may not obey rules and regulations

Spending on subsidies, government provision and other such interventions can raise the
question the question on public expenditure vs private expenditure

It can cause conflicts of interest: There is a conflict between the provision of goods and
services directly to people and asking them to pay for the goods and services.

Raises a question about whether to conserve resources or to use them: Production and
consumption of goods and services uses the Earth's resources and can cause damage to the
environment. It is therefore important that economic development is sustainable.

Education and advertising campaigns may take time to show their effect

There may be free riders as discussed before.

3.1: Money and Banking

Money is any commodity which is acceptable as a medium of exchange for the purchase of
all goods and services

Money enables specialisation and exchange. It allows people to specialise in the production
of those goods and services that they are best suited to. They can then use the money they
earn to buy those goods and services that satisfy their wants and needs.

Today’s money supply consists of notes and coins printed by the Central Bank, additional
deposits stored with banks and other financial institutions and finally gold and other
valuable assets which can serve as near-cash.
Functions of money:

Medium of exchange: Money is widely accepted as a means of payment for all other goods
and services. It avoids the problem of requiring a double coincidence of wants.

Unit of account/ Measure of value: The value of all goods and services can be expressed in
terms of how many units of currency it is worth. It is used to compare and measure the
value of different goods and services and used to express their prices.

Store of Value: Money can be stored and used at a later date in the future. This means that
money must be able to hold its purchasing power over time. However, during periods of
rising inflation cash may not serve as a good store of value and other financial assets may
preserve their value better.

Means of deferred payment: This means that money is used as the standard for future
(deferred) payments of debt. Money makes the concept of credit easier. When people buy
goods and services on credit they have the use of the product immediately but can pay for it
at a later date. In the case of hire purchases, payments can be made in installments over
several months and years.

Characteristics of good money:

Durability: Should be long-lasting and hard-wearing. Should not tear easily.

Acceptability: Should be widely recognised and accepted as a means of payment for all
other goods or services.

Divisibility: Notes and coins should have different face values to buy goods and services
with different prices and to give change.

Portability: Should be easy to carry around. Paper notes are lightweight and small coins can
be easily carried around in your pockets.

Uniformity: Currency within a country should be uniform.

Scarcity: A good money must be limited in supply or scarce if people and firms are to value
it. The supply of money, including banknotes and coins, is regulated by the Central bank so
that the money retains its value.

Central Banks:

The central bank of a country is the monetary authority that oversees and manages the
nation's money supply and banking system. It also controls the nation’s monetary policy
and the interest rates.

Functions:

Prints notes and coins which are legal tender. The central bank is the sole issuer of notes
and coins in an economy. This helps to bring uniformity to, and improves public confidence
in, the country's monetary system.

Controls monetary policy in an economy:

It controls monetary policy by controlling interest rates. It sets the base rate in an economy.
The commercial banks set their lending rate slightly above the base rate set by the central
bank.

It also sets monetary policy by controlling the money supply in an economy by printing
notes and coins and through open market operations:

Printing more legal tender is used to increase the money supply during expansionary
monetary policy.

Money supply can also be increased through quantitative easing. That involves the central
bank buying back government bonds to increase the money in the hands of the people.
During contractionary monetary policy, the central bank will sell government bonds to
reduce the money in the hands of the consumers.

The Central bank is the lender of last resort in an economy. Given that the authorities
require all commercial banks to keep a certain percentage of their cash balances as deposits
with the central bank, these cash reserves can be used by the country's banking system
during financial emergencies. This function helps to build public confidence in the
commercial banking system.
The Central bank also supervises the conduct of the banking system, regulates the conduct
of banks holding their deposits and transferring funds between them. It can set rules and
determine which organisations can become banks.

It manages the nation’s gold and foreign currency reserves. These reserves can be used to
make payments overseas and stabilize the value of the national currency. It ensures that the
value of the country’s national currency does not fluctuate too much.

It manages payments to and from the government. The tax and other revenues of the
government of a country will be held in an account in the central bank.

A central bank can issue and repay public sector debt on behalf of the government.

It also works with the International Monetary Fund(IMF) to manage the world’s banking
system. The IMF can provide support to those countries who need it during national
economic or other emergencies. The central bank will store some of its national currency
with the IMF and can buy it back whenever they need it.

Commercial Bank:

A commercial bank is a retail bank that provides financial services to its customers, such

as accepting savings deposits and approving bank loans.

They are called ‘High-Street Banks’.

Accepting deposits and keeping money safe: Commercial banks accept deposits from their
customers, including private individuals, businesses and governments. Deposit accounts are
any type of bank account in which money can be deposited and withdrawn by the account
holder at any time. Deposit accounts are of two types:

Savings account- Safe place to store your savings. Interest will be added to your savings and
will be paid to you when you withdraw money.

Current account- used by account holders to make payments and everyday transactions.
Wages can be paid here.

Lending money in the form of:

Loans: Several types of loans:

Overdraft: Allows customers to withdraw their account by an agreed amount. It's a

convenient short-time loan.

Personal loan: repaid with interest over a fixed period of time usually more than 6 months.

Commercial loan: loan to businesses to pay for operating costs and the purchase of
materials and machinery.

Mortgage: Long-term loan used by people or firms to buy property. Loan is secured against
property and property has to be sold if loan is not repaid.

Credit Cards

Credit Creation: This describes the process by which banks increase the supply of money in
an economy by making money available to borrowers. Credit allows the borrower (or
debtor) to gain purchasing power (money) now with the promise to pay the lender (or
creditor) at a future time. This is done in the following way: When

banks receive deposits they store some of it in their vaults and lend the rest out to the
public. The people who receive these loans then use the money to pay for goods and
services. The people who earn this money will then save the money with the bank. Thus, the
money supply has been increased in the economy by the creation of credit and additional
bank deposits.

Ancillary services such as the following:

Helping customers make and receive payments- debit cards, cheques, etc

Buying and selling shares for customers

Providing insurance-life, property, etc

Operating pension funds

Providing financial and tax planning advice

Exchanging foreign currencies

Telephone and internet banking services

Storing valuables in vaults

3.2: Households

Disposable Income: This is the income a person has left after income-related taxes and
other charges are deducted. A person’s spending and saving depends on their disposable
income.

Spending or consumption: Exchanging money to buy goods or services that help them
satisfy their wants and needs.

Saving: This is delaying consumption until a later date when people can withdraw and
spend their savings plus interest.

Borrowing: When people receive money from another individual or financial institution
with the intention of paying it back in the future. This enables them to increase their
spending.

Factors affecting spending, saving and borrowing:

Income: As people’s disposable income increases, their ability to spend and save both
increase. Their credibility if they want to borrow also increases and thus their borrowing
might also increase.
Rate of interest: As interest rates fall, the cost of borrowing money decreases and thus
borrowing and spending increase, At the same time as interest rates fall, people’s savings
also fall

Consumer confidence: As consumer confidence increases, people are confident of their

employment and income in the future and thus consumer spending and borrowing will
increase as they will be confident of their ability to repay the debt in the future. Also,
savings might decrease as people spend more and save less.

Other factors include: availability of saving schemes, availability of credit, wealth, age

Why do people save money:

For rainy days

To make large purchases at a later date- purchase capital items.

Why do people borrow money:

To make large purchases- cars, etc

To finance education or training schemes to increase their employability

To start a new business

Take mortgages to buy property and land.

3.3: Workers

Factors affecting an individual’s choice of occupation:

There are wage and non-wage factors that combine to form the net advantages of an
occupation.

Wage Factors:

Wage/Salary: These can be paid weekly and monthly.

Time rate: Amount paid to a worker based on number of hours worked

Piece Rate: A fixed amount paid per output produced or sold

Performance-related payment:

Overtime: This is the number of hours worked in addition to the contracted number of
hours. These hours are paid for at a higher rate. These encourage

workers to work unsocial hours.

Commission: This is generally applicable for sales or retail where people earn a percentage
of the value of products sold or produced

Bonus: These are lump payments given to highly productive individuals to reward them.
These again encourage people to work harder and increase their productivity.

Non-wage factors:

Job Satisfaction: This talks about how happy and satisfied people are with their job

and if they enjoy the work. People are likely to stay in a job for longer and work harder if
they enjoy the job

Career Prospects and training opportunities: Jobs where workers are offered training and
promotional opportunities are likely to attract them. They feel they can advance to a more
senior position without having the trouble of finding new jobs.
Fringe benefits: These are non-wage perks that nonetheless have monetary value such as
subsidised housing, healthcare, schooling and use of a company car. These often
compensate for comparatively low wages.

Qualifications required for the job

Job security

Working hours- Flexibility

Holiday entitlement

Working conditions

Distance to work

A person’s choice of occupation will depend on all these factors and a person can choose a
job by comparing these factors.

Wage determination-effect of demand, supply, relative bargaining power and govt policy:

Wages are determined by the interaction of demand for labour and the supply of workers in
an industry. The equilibrium wage rate is determined when the wage rate workers are
willing to work for equals the wage rate that firms (employers) are prepared to pay: that is,
the demand for labour is equal to the supply of labour. Changes in the demand for, or supply
of, labour in an industry will therefore change the equilibrium wage rate.

In addition to demand and supply, government policies such as minimum wage can also
influence wage rates. Minimum wage is often set above the equilibrium wage rate. A
national minimum wage (NMW) is the lowest amount a firm can pay its workers, as set by
the government. Any firm that pays workers less than the legal minimum wage is breaking
the law. the quantity of labour supplied to the market increases as more workers are
prepared to work for a higher wage rate.
Relative bargaining power of trade unions can also influence wage rates as trade unions will
seek higher wages for their workers. This can also change, mostly increase, equilibrium
wage rates.

Demand for labour:

The demand for labour is a derived demand . This means that labour is demanded for the
goods and services it produces and not for itself.

An increase in demand for labour will increase wage rates and vice-versa.

Factors affecting demand for labour:

Level of total demand in an economy

Productivity of labour

Price and productivity of capital

Changes in non-wage employment costs

Supply for labour:

The labour supply in an economy consists of people who are of working age and who are
willing and able to work. This does nor include those who are in full-time education or those
who do not work by choice, such as housewives or house husbands.

The backward-bending supply of labour curve occurs when wage rates rise to a high enough
point to allow people to work less and enjoy more leisure hours. This is a work-leisure trade
off where people are satisfied with the wages they are earning.

An increase in supply will decrease wage rates and vice-versa

Factors affecting supply of labour:

Changes in net advantages of an occupation

Changes in provision and quality of education and training

Demographic changes : such as effect of inward migration

Change in earnings over a lifetime:

Entry: young employee will receive low earnings due to lack of work skills and experience;
can become an apprentice or join a management training scheme to become more skilled

Skilled workers: the more skilled a worker is, the more opportunities he has for increasing
his earnings; bonuses will be given and higher rate of overtime paid

End-of-career employees: if workers keep updating skills, they will continue to have
opportunities to increase wages however when they stop this, their demand would fall &
income would diminish, finally reaching a stop when retired.

Difference in earnings:

Skilled vs Unskilled workers: Skilled workers command higher wages for two main reasons:

Skilled workers are generally limited in supply and thus are able to attract higher wages.

They also tend to be productive because they have more skills and thus their employers will
be willing to pay them higher wages

The demand curve for skilled workers tends to be price inelastic as a change in price will
not cause a more than proportionate change in demand for them.

Industrial sectors: People in the tertiary sector generally tend to earn more than people in
the primary and secondary sectors. People in tertiary sector professions tend to have high
earnings because these jobs require plenty of qualifications, skills and years of experience.
The reward for this time and effort is higher wages, which attract people to those
professions. Also, the value of products produced by the tertiary sector are much greater
than the value of products produced by the primary and secondary sectors. Thus, the
revenue they earn from sales is more and will be able to pay their workers more. In general,
as the value of a good or service increases, so does the wage of the person who produces it.

Males vs Females: Males have generally earned more than women over the years for various
reasons:

Difference in occupation distribution of men and women. The professions men work in
usually pay more than the ones women work in such as teaching and nursing.

Then, women often take career breaks to raise children and thus cannot build up skills and
experience making it difficult for them to attract high wages.

Also, women usually take up part-time jobs because they have to take care of the home as
well. Part-time jobs generally pay less as compared to the full-time work men are thought to
do.

However, in recent time equal pay laws have been introduced to prevent discrimination
against women.

Private vs Public Sector: In theory, people in the private sector can earn more than workers
in the public sector. In many countries, salaries in the public sector are typically less than
those which can be earned in the private sector, but public-sector jobs are more secure and
are accompanied by a pension in retirement. This is because private sector firms and
individuals have profit maximisation as one of their goals. However, public sector jobs are
more secure because the government can raise money through taxes to pay for them.
Despite this theory, in many countries, public sector jobs often require highly skilled
individuals who will be able to attract high wages as compared to those in the private
sector. Thus, this is a highly debatable topic which depends greatly on the conditions in a
particular country.

Why are there wage differentials between people in the same occupation:

Regional differences in supply and demand for labour

Local pay agreements

Discrimination

Length of service

Non-monetary agreements

Division of labour/ Specialisation at work:

Production process broken into a series of different tasks with different workers required
to concentrate on one particular task.

Increase in skill of workers: As workers do the same task repeatedly for a long period of
time, they become more skilled at the task. As they become more skilled they become more
productive and can increase their earning potential.

Time saving: Workers do not have to keep moving from one task to another. This means
there is less friction in the production process and productivity of the firm will increase.

Specialisation in best lines: Workers will generally specialize in the task they are most
proficient at. If they do this, they will enjoy the work, and produce better quality products
for consumers.

Use of supporting technology: Only people who are specialised at a particular task will be
able to make use of technology that increases the efficiency of a particular task.This
technology can help lower business costs and increase the profit margin of the firm.

Over-dependence: As workers become specialised at a particular task, they will become

dependent on those around them in the production process. This means that any disruption
in a specific task in the production process will affect everyone thus reducing production
and causing losses to the firm.

Occupational immobility: These specialised workers will only have one particular skill and
if that skill becomes redundant in the future and they lose their job they will have difficulty
finding a new one due to lack of transferable skills.

Boring and repetitive tasks: Workers may become bored and frustrated by doing the same
task again and again. They will lose concentration and become more error-prone. Their
mistakes may disrupt the production process and reduce output. Lack of effort can also lead
to poor quality products for the economy.
Workers may become alienated, especially those in low-skilled work.

3.4: Trade Unions

Is an association of employees designed to promote and protect the interest of their

members with the purpose of improving their wages and working conditions. In return,
members will usually pay a union membership fee to help fund the organisation.

Role of Trade Unions in an economy:

Bargaining with employers for pay rises, better terms and conditions, better working hours
and a better working environment

Ensuring that equipment at work is safe to use

Ensuring their member’s job security.

Ensuring members are given legal advice when necessary

Giving support to members when they are made redundant.

providing financial and legal support to workers who may have been unfairly dismissed or
disciplined

Persuading the government to pass legislation in favour of the workers such as minimum
wage legislations, maximum working hours, pension rights and retirement age.

Trade unions act as a means of communication and negotiation between employers and
employees through a process called collective bargaining. This occurs when a trade union
representative, who is voted into the position by colleagues, negotiates on behalf of the
union's members (the workers) with the employer for better pay and working conditions.
The collective bargaining is more powerful than each worker negotiating individually with
the employer. Trade unions can therefore be an effective means of communication between
the employer and employees.

Factors affecting strength of union:

Whether the union represents most or all of the workers in a firm or industry

They will be more powerful if union members provide products and public services
consumers need for which they are very few close substitutes.

Whether the union is able to support its members financially during strike action

Advantages of trade unions:

Act as a medium of communication between employees and employers and helps settle
disputes and pay claims efficiently

Offers legal support and advice to employees

Raise living standards by negotiating for better pay and working conditions for their
members

Also raise living standards by trying to influence the government to introduce minimum
wage laws.

It provides members with strength in numbers.

It improves the condition of employment for workers.

Disadvantages of trade unions:

Industrial action in the form of strikes, work-to-rule, go-slow or sit-ins can all reduce
productivity of firms. This will cause them to lose output, revenues and profits during
industrial action which can occur when collective bargaining breaks down.
Union members will not be paid their wages or salaries during strike action and lose their
source of income. Some workers may also lose their jobs if employers cut back on their
demand for labour as they lose customers and profits.

Consumers may be unable to obtain the goods and services they require or may have to pay
higher prices if firms pass on the increased costs.

The reputation of the economy as a good place for business may be damaged. In addition to
this, introduction of minimum wage laws means there will be an excess supply of workers
causing unemployment in the economy. The government will have to pay more
unemployment benefits to these people, not allowing them to invest in other important
aspects of the economy.

3.5: Firms

Classification of Firms: Firms can be classified in many ways-

Industrial sector: Firms can be classified based on whether they are located in the primary,
secondary or tertiary sector. Primary sector firms collect and extract natural resources.
Secondary sector firms are responsible for producing manufactured goods from these raw
materials. Tertiary sector firms provide services.

Private/Public Sector: Firms that are owned or controlled by the central or local
government are called public sector firms while those that are owed by an individual or a
group of individuals and work for their own profit are called private sector firms.

Relative size of firms: Firms can either be SME’s(small and medium-sized firms) or they can
be large firms. Small firms are generally those who have less than 50 employees, employ
little capital, have a small market share and do not have many layers of organisation.

Small Firms:

Why do small firms exist:

The size of a firm is often directly related to the size of its market. Therefore, if the size of
the market is small, entrepreneurs will generally set up small firms.

Access to capital: Firms will generally remain small if they have limited access to capital.
Without capital they will find it difficult to expand their scale of production and grow.

New technology has reduced the scale of production needed. Size and cost of technology has
reduced greatly over time and made it possible for small businesses to reach consumers and
suppliers around the world without needing to become large.

Some business owners may simply choose to stay small as they are making a reasonable
profit after tax. Running a large firm can be stressful and time-consuming. Also, some
entrepreneurs might lack the skills required to run and own a large firm

flexibility – can adapt to quick changes as the owner is more involved

personal service – owners are easily accessible to offer customer service

lower wages – no trade unions = employees has weak negotiating powers; owners are able
to impose wages to the legal minimum wage

better communication and easier management – since there are fewer employees,
information can be reached easily. Less chances of arguments between managers.

innovation – faces more pressure to become innovative, hence they are more prepared to
take risk as they have less to lose

These firms are also cheap and easy to set up.

The entrepreneurs also have a greater degree of control over the business and decision-
making occurs faster.

higher average costs – cannot exploit economies of scales; average cost will be higher than
larger rivals = lack of competitive edge

lack of finance and difficult to raise capital – struggles to raise finance as choice of sources is
limited
staff – hard to attract experienced staff as they lack resources (not able to afford the wage,
training required for a specific skill)

vulnerability – when trading conditions fluctuate, it is hard to survive as they lack resources

Often difficult to attract sales and customers as they face immense competition from larger
firms and may be forced to shut down within the first few years of operation.

Growth of firms: Involves a firm increasing the volume and value of its output. This is done
by increasing the scale of production of a firm:

Internal Growth: Also called organic growth. Involves a firm increasing its scale of
production through the purchase of additional equipment, increasing the size of business
premises and hiring more labour if required. To finance this growth, the owners will have to
use the profits of the firm or borrow money from financial institutions. It will aim to
increase its market share.

External growth: Also called inorganic growth. It involves one or more firms joining
together to form a large enterprise. This can happen via integration through merger or
acquisition.

Merger is when owners of one or more firms agree to join together to form a new, large
enterprise.

Acquisition or takeover is when one company buys enough shares in the ownership of
another company that it gains overall control over the company. This does not require the
agreement of the owners.

Types of integration/ mergers:

Horizontal integration: Horizontal integration occurs when two firms in the same sector of
industry integrate together, by either a merger or a takeover.

The two combined businesses can benefit from:

getting an increased market share

gaining skilled employees from one another

operating with fewer employees (as there is no need to hire two finance departments, for
example), so this may reduce costs

taking advantage of economies of scale.

Diversification

However, the potential costs or drawbacks include the following:

There may be duplication of resources and therefore some workers may be made
redundant - that is, Jose their jobs. Redundancies can cause anxiety, lead to demotivated
staff and cause a decrease in productivity.

The newly formed larger firm may fuce increasing costs arising from diseconomies of scale
(see below).

The combined firm may suffer from a culture clash if the two businesses are very different.
This may initially cause communication and organisational problems.

Vertical Integration: Vertical integration occurs when a firm from one sector of industry
merges with, or is taken over by, a firm from another sector of industry. There are two types
of vertical integration: backward and forward.

Forward integration: Forward vertical integration occurs when a firm from the primary
sector of industry integrates with a firm from the secondary sector, or a firm from the
secondary sector integrates with a firm from the tertiary sector.

Backward integration: occurs when a firm from the secondary sector of industry merges
with a firm from the primary sector, or a firm from the tertiary sector merges with a firm
from the secondary sector.

No wastage

Price of raw materials fall

Costs of production will increase.

Conglomerate merger: Conglomerate integration (also known as lateral integration or

diversification) occurs when finns from different sectors industry, which operate in
unrelated areas of business, merge or are taken over by another firm.

Economies of scale

Diversification: So business is more secure even if demand for one of its products falls.

Also helps increase its market share by accessing different consumer bases.

No past experience managing such a large firm

Shift in focus: away from original objectives

Complications

Governance: Management problems

Diseconomies of scale

Economies of Scale: Average costs of production fall as a firm grows or increases output.
Two types:

Internal economies: benefits for the business

Purchasing economies: Large firms buy the raw materials they need in bulk which

means they get discounts from suppliers and get the resources they need at a cheaper price.
Technical Economies: large firms can afford to purchase expensive pieces of machinery and
automated equipment for the manufacturing process.

Financial economies: of scale occur as large firms are able to borrow money from banks
more easily than small firms because they are perceived to be less risky to financial
institutions. They also have more collateral to offer.

Risk-bearing economies of scale occur as large firms tend to produce a range of products
and operate in many locations. This diversity spreads risks as weak sales in one country can
be supported by strong sales in another.

Marketing economies: of scale occur as big firms tend to have a large advertising budget and
therefore can spend large amounts of money on promoting their products.

They also have research and development economies which means it is easier for them to
innovate and create new products.

External economies: benefits due to the location of the firm

Proximity to related firms: This will give it easy access to nearby suppliers and reduce
transport costs

Availability of skilled labour: Conglomeration develops a large pool of highly skilled

workers

Reputation of geographical area improves the firm’s publicity and exposure

Access to transport: Manufacturing firms benefit from being located near to major road
networks, pons and cargo facilities.

They can also benefit from joint marketing benefits.

Diseconomies of scale: Diseconomies of scale arise when a firm gets too large and average
costs of production start to rise:

Management diseconomies: Communication issues may arise when a firm becomes too
large. There may be too many branches to control and communicate with effectively, and
decision making may be slow due to the number of people in the communication chain. This
may lead to increased costs of production.
Labour diseconomies: Workers within a large organisation may find it difficult to fuel part
of a large firm, so this may lead to a lack of motivation and reduced productivity. Thus
average costs will tend to rise.

Agglomeration diseconomies: means that business owners and managers will find it
difficult to coordinate all the activities of a merged firm.

Large firms require vast quantities of materials, components or power for production and
the firm can thus experience shortages which may hold up production.

They sell shares to raise finance which makes them more vulnerable to takeovers.

They may not be able to attract enough workers with the right skills.

3.6: Firms and Production

Demand for Factors of Production: This is a derived demand which means they depend on
the demand for the goods and services they are used to produce. Factors affecting demand
for the different factors of production:

They are a derived demand and thus one factor is the demand for the goods and services
they are used to produce. Higher the demand for the good or service. The greater the
demand for the factors of production.

Cost of different factors of production: The higher the cost of land, labour and capital, the
lower their demand tends to be.

Factor availability: The greater the availability of factors of production, the lower their cost
tends to be, and hence the higher their demand.

Factor productivity: Higher the productivity of the factors, the greater the demand for those
factors of production.

Labour-intensive Production: This method of production involves employing large

workforces to produce personalised goods or services. Used in many service and
agricultural industries.
Consumers pay a premium price for handmade and personalised products.

Labour costs can be kept low if workers are unskilled or on temporary contacts.

Lower risk of losses due to machinery breakdown or power cuts

Workers take more pride in their work and produce finer, better quality products.

Labour is more flexible than machinery.

Product quality is easier to observe, monitor and control at every stage of the production
process.

Wages and employment costs can be high

Firms may find it difficult to find and hire workers with the right skills and may have to pay
higher wages to attract them.

Disputes with trade unions and workers can result in industrial action leading to disruption
in production

Workers may need to be retrained in certain skills

The average cost of producing each item will be much higher.

Capital-intensive Production: Requires far more capital than labour. They are often partially
or fully-automated. They aim to mass-produce similar products faster and cheaper than by
hand.

Mass-production is possible with large markets

Mass-production means that average cost of producing each unit will fall

Wages and employment costs are lower

Less risk of disruption from industrial disputes or shortages of labour.

Automated production is continuous.

There is less risk of human error and product quality is more consistent.

Machines and other equipment could be very expensive to buy or hire

Maintenance costs can be high and may increase overtime as equipment wears out.

Training costs are higher to teach workers how to operate the equipment.

May be difficult to change production

Technological advance is extremely rapid and machines need to be replaced to compete

with newer firms with new equipment.

Breakdowns and power cuts hold up production

Not suitable for production of custom-made or personalised goods.

Production refers to the total amount of output produced in the production process while
productivity refers to the amount of output produced per unit of labour/ or other factors of
production per period of time. Productivity is a measure of the degree of efficiency in the
use of factor inputs in the production process.

3.7: Firms’ costs, revenues and objectives

Fixed Cost(FC): Fixed costs are the costs of production that have to be paid regardless of
how much a firm produces or sells. They do not vary with output. Examples: salaries for
senior managers, insurance payments and rem all have to be paid regardless of the firm's
output level. Average fixed cost(AFC) is the fixed cost divided by the amount of output
produced.

Variable Cost(VC): Variable costs are costs of production that change when the le,eel of
output changes. They vary directly with the level of output. Examples are the costs of raw
materials or components needed to build houses - the more houses that are built, the higher
these variable costs become. Average variable cost(AVC) is equal to the total variable cost
divided by the total amount of output produced.

Total Cost(TC): As the name suggests, the total costs of production are the sum of all fixed
and variable costs. Average cost(AC) is the total cost divided by the total amount of output
produced.

● All graphs:

Formula:

AFC= TFC/ Output

AVC= TVC/ Output

TC = TFC + TVC

AC = TC / Output
Reasons for shape of AC: Law of diminishing returns: A business can not indefinitely keep
adding the variable factor to a fixed factor because the marginal output will initially
increase and then fall to zero and then become negative implying the benefit of each
additional unit of output falls. This means that initially as output increases, the AC will fall
until a certain point after which it will start to increase. This is in the short run.

The LRAC or the long run average cost curve is also u-shaped and is governed by the law of
returns to scale.

Revenue: Revenue refers to the money payable to a business from the sale of its products. It
is also called turnover. Revenue is often referred to as sales revenue or sales turnover. It is
calculated by using the formula :

Total revenue(TR) = price x quantity sold

Average revenue(AR)= TR/ Total quantity sold

Break-even point is where TR=TC and the firm makes no profits.

Profit maximisation is where the difference between TR and TC is the greatest.

Objectives of firms:

Survival: While business survival is a vital objective for new businesses, even well-
established firms will need to focus on this, especially during unfavourable trading times
such as during a recession.

Social Welfare: Social entrepreneurs are people who create firms to address social and
environmental issues rather than to maximise profits. They will use any profit or surplus to
attain social or environmental goals.

Growth: Internal or external growth is a key objective for private sector firms. Growth will
increase the size and productive potential of a firm so that it can enjoy economies of scale.
Growth is easier when demand for goods and services is rising.

Profit maximisation: Profit maximisation is the goal of most private-sector firms. Profits are
maximised when the positive difference between a firm's sales revenues and its costs of
production is at its greatest. Firms must make profits because it is a necessary reward for
risk-taking, profits provide a source of finance for the firm and profits are a good measure of
success and financial stability. Profit is maximised by trying to be both productively and
allocatively efficient.

Other objectives include diversification and satisficing

3.8: Market Structures

This refers to the characteristics of a market, usually on the supply-side, including how
many firms compete for the market, the degree of competition between them, the extent of
their product differentiation and the ease with which new firms can enter the market to
compete with them.

Competitive Markets: Highly competitive markets constitute perfectly competitive markets.

Their characteristics are as follows:

Firms in the market are price takers.

There are many buyers and sellers in the market.

There will be vigorous price and non-price competition between firms.

Firms will supply identical products so not as much choice.

Firms will supply products to the market at the same market price and this market price
will be the lowest price possible without the firm having to go out of business.

In such markets, firms can make super-normal, sub normal or normal profits in the short
run. However, in the long run all these profits are competed away as firms strive to be
productively and allocatively efficient.

There are no barriers to entry or any exit costs.

Both buyers and sellers have perfect knowledge. This means that customers and firms have
access to information about the product and the prices being charged by competitors.
Product quality is high in perfect markets

Monopoly Markets:

Characteristics:

A monopoly exists if only one firm supplies the whole market.

The firm is a price maker- This means it can influence the price of a good or service and
influence the quantity demanded

There is product differentiation- Unique goods are produced

There are huge barriers to entry

There is imperfect knowledge- customers and rivals have imperfect knowledge

Less consumer choice: Restricting competition limits consumer choice.

Less Output and higher prices: Monopolies restrict supply to set a higher market price than
would otherwise occur in competitive markets. Total amount of goods and services
available to consumers would reduce.

Lower product quality: No incentive to increase the quality of their goods and services. They
may even cut quality to reduce costs.

X-inefficiency: Private-sector firms tend to be inefficient in terms of resource allocation. In

pursuit of profit maximisation, the monopolist can result in the output of a product and/ or
charge a higher price for it. This creates a loss in the welfare of consumers
Government needs to spend money to regulate these monopolies and ensure they carry out
their productive activities without producing too many externalities.

A monopoly may be more efficient than smaller firms supplying the same market because of
its large scale of production which means that it can enjoy economies of scale and reduce
the average cost of producing each unit of output.

A monopoly may face competition from overseas firms or firms selling products that satisfy
similar wants.

A monopoly may charge low competitive prices and offer high quality products because it
fears new firms would otherwise be attracted by the high prices to enter the market it
dominates and will compete for its sales. A market is contestable if barriers of entry are low.

A monopoly business may re-invest some of its profits in new inventions and better
products because the profits it could earn will not be competed away.

Natural barriers to entry:

Economies of scale of a large firm

Capital size

Historical reasons

Legal considerations

Artificial barriers of entry:

Restrictions on supplies

Predatory pricing
Exclusive dealing

Full line forcing

4.1: The Role of government

Government plays an important role as a consumer, producer and employer in most

economies.

Public sector organisations include :

National, regional and local government authorities and their administrative departments
and offices

Govt agencies that are responsible for delivery of public goods

Public corporations

Government as a consumer:

It is a major consumer of goods and services in an economy.

Government spending accounts for a large part of total expenditure in an economy

Government spending is of 2 types:

Current expenditure: Spent on goods and services consumed within the current financial
year
Capital expenditure: Investments in long-lived assets that will increase the productive
capacity of the economy.

Government as a producer:

The government is responsible for the production of the following goods or services:

Public goods: Difficult to get people to pay for them and thus private sector firms are
reluctant to produce them. So, the government takes responsibility for producing them.

Merit goods: Produced based on needs of individuals rather than ability to pay

Essential goods and services: These are required for survival so the government ensures
everyone has access to them at affordable prices.

Provision of water and energy because firms supplying these generally tend to monopolise
the market so the government ensures that everyone receives them.

Government as an employer- The government employs many people in various ways:

Some people work directly for the government as civil servants.

Some work for the government’s administrative offices and departments or government
agencies

Some people work in state-controlled businesses or public corporations

Some people work indirectly for the government in public sector services such as
government schools and hospitals.

4.2: The Macroeconomic Aims of Government

Economic Growth: This is a sustained increase in a country’s output or real GDP. Achieving
economic growth brings greater prosperity to an economy and therefore tends to raise the
standard of living for most people. Economic growth can be achieved by increasing the
quantity and/or quality of factors of production, such as through education and training.

Full employment(low unemployment): Unemployment refers to people who are out of

work, but who are of working age, are physically and mentally able to work, and are actively
looking for work. Governments strive to achieve a low and stable rate of unemployment.

Low and stable rate of price inflation: Inflation is defined as a sustained increase in the
general price levels of goods and services in a country from one point in time to another.
Low and sustainable rates of inflation of about 2-3% are vital to achieving economic
stability and social wellbeing.

Reduce poverty and inequalities in distribution of income and wealth: As an economy

grows, the gap between top and bottom income earners tends to widen. A government will
aim to alleviate poverty and reduce inequalities amongst the people.

It will also aim to achieve a stable balance of international trade payments: The balance of
payments is a record of a country's financial transactions with other nations. This includes
the money flowing into and out of a country from the sale of exports and the purchase of
imports. If the money inflows exceed the outflows, then a balance of payments surplus
exists. If the outflows exceed the inflows, the country has spent more than it has earned, so
a balance of payments deficit occurs. Governments therefore tend to aim to achieve a
balance of payments equilibrium as these surplus and deficits can be harmful.

● Conflicts between macroeconomic aims:

Full employment vs stable prices: If full employment is achieved through expansionary

fiscal policy or monetary policy, these will cause an increase in the aggregate demand in the
economy. As AD increases, prices and thus inflation will rise in the economy. On the other
hand, measures to reduce inflation or curb unstable prices could decrease employment as
there may be a fall in AD.

Economic Growth vs Balance of payments stability: Consumer spending and business

investments tend to be high during an economic boom. However, if this is fuelled by a
significant rise in spending on imports relative to exports or investments overseas, this
leads to a worsening trade deficit on the country's balance of payments.

Full employment vs Balance of payments stability: If full employment is achieved, overall

spending in the economy will increase and businesses will seek to expand their business. In
this case, if they increase spending on imports(goods and services or raw materials for
production) this could also worsen the deficit on the country’s balance of payments.

4.3: Fiscal Policy

Budget is the government’s plans for public expenditure and tax and other revenues in the
coming financial year in numbers.

Reasons for government spending:

To provide goods and services that are in public interest such as public goods and merit
goods: prevent market failure

To invest in national infrastructure: increase productive capacity of the economy

To support agriculture and other key industries: boost economic growth

To manage the macroeconomy: fiscal policy

To reduce inequalities in income and to help vulnerable people: achieve macroeconomic

aim

Tax is a compulsory payment backed by law. It is usually levied as a percentage of a certain

value. The proportion of tax taken from the national income measures the tax burden in an
economy. Reasons for taxation:

Main form of public sector revenue

Raise revenue to fund public expenditure on infrastructure and current items

Used to manage the macroeconomy through fiscal policy

Progressive taxes can be used to reduce inequalities in income and wealth

Taxes such as tariffs can be used to discourage spending on imported goods to maintain a
stable balance of payments or prevent a deficit

Discourage consumption and production of harmful products as indirect taxes raise their
prices

Can protect the environment. Activities that cause pollution can be heavily taxed to prevent
people from engaging in them.

Principles of Taxation:

Equity: Should be fair and should affect taxpayers with similar characteristics in the same
way

Non-distortionary: Should not be so high that they distort sensible economic behaviour

Certainty: People and firms should know when a tax should be paid and how much they
need to pay

Convenience: It must be simple and easy for people to pay the taxes they owe on a regular
basis.

Simplicity: Taxes should be easy to understand so that people do not make mistakes when
paying taxes.

Administrative efficiency: Taxes should be cheap and easy to collect. It should not cost more
to collect them than they earn in revenue

Types of Taxes:
Progressive taxes: The proportion of income taken in tax increases as income increases.
People on higher incomes pay a higher proportion of their income in taxes as compared to
people on lower incomes:

Examples:direct taxes generally progressive.

Regressive taxes: The proportion of income taken in tax decreases as incomes increase.
Although people on lower incomes pay a greater proportion of their income in tax in
absolute terms they still pay less than the richer people.

Examples: Indirect taxes generally regressive

Proportional taxes: These taxes take the same proportion of income in tax no matter what
the income. These are also called flat taxes.

Direct Taxes: This type of tax is paid from the income, wealth or profit of individuals and
firms. Taken directly from a person’s income. Burden of paying tax falls directly on those
who are responsible for paying it.

Examples are taxes on salaries, inheritance and company profits.

Indirect taxes: These are taxes imposed on expenditure on goods and services and taken
indirectly from people’s incomes when they are spent on goods and services. They are also
called outlay or expenditure taxes.

Examples include sales tax such as VAT, import tariffs, excise duties and user charges.

Impact of taxation:

Impact on price and quantity - The imposition of sales tax will shift the supply curve of a
product to the left due to the higher costs of production. This will increase the price charged
to customers and reduce the quantity produced and sold.

Impact on economic growth - Taxation tends to reduce incentives to work and to produce.
By contrast, tax cuts can boost domestic spending, thus benefiting businesses and helping to
create jobs. Nevertheless, tax revenues are essential to fund government spending (for the
construction of schools, hospitals, railways, airports, roads and so on), which fuels economic
growth.

Impact on inflation - As taxation tends to reduce the spending ability of individuals and the
profits of firms, it helps to lessen the impact of inflation . By contrast, a cut in taxes boosts
the disposable income of households and firms, thus fuelling inflationary pressures on the
economy.

Impact on business location - The rate of corporation tax and income tax will affect where
multinational businesses choose to locate. As a result, foreign direct investment in these
countries might be lower than otherwise. By contrast, it might be easier to attract workers
in low income tax countries.

Impact on social behaviour - Taxation can be used to alter social behaviour with the
intention of reducing the consumption of demerit goods

Taxes are also used to protect the natural environment by charging those who pollute or
damage it.

Fiscal Policy: Involves varying the overall level of public expenditure and taxation in an
economy to manage aggregate demand and influence the level of economic activity

lf the government manages to balance its revenues and its spending, then a balanced budget
is said to exist.

However, if the government spends more than it collects from its revenues then a budget
deficit exists.

And if there is more government revenue than is spent, the government has a budget
surplus.

Expansionary fiscal policy is used to stimulate the economy, by increasing government

spending

and/or lowering taxes. This type of fiscal policy is used to reduce the effects of an economic
recession, by increasing aggregate demand, boosting gross domestic product and reducing
unemployment. However, this can increase price inflation in an economy.

By contrast, contractionary fiscal policy is used to reduce the level of economic activity by
decreasing government spending and/or raising taxes. This will reduce AD, and thus reduce
growth and employment in the country. However, it can also lead to deflation.
4.4: Monetary policy

Involves varying the money supply and interest rate in an economy to influence the level of
aggregate demand and economic activity. Also used to influence the exchange rate of its
national currency.

Money supply consists of all notes and coins in an economy along with additional bank
deposits stored with financial institutions.

Expansionary monetary policy, also known as loose monetary policy, aims to boost
economic activity by expanding the money supply. This is done mainly by lowering interest
rates. This makes borrowing more attractive to households and firms because they are
charged lower interest repayments on their loans. Money supply can be increased by
printing more notes and coins or through quantitative easing as discussed before. This will
increase AD and stimulate economic activity. It will have the same effects as expansionary
fiscal policy. It can also be used to devalue the national currency as well. As interest rates
fall, less people will invest in the economy, so demand for national currency falls and
exchange rate of national currency will fall.

Contractionary monetary policy, also known as tight monetary policy, aims to reduce
economic activity by reducing the money supply. This is done mainly by increasing interest
rates. This makes borrowing less attractive to households and firms because they are
charged higher interest repayments on their loans. Money supply can be decreased through
contractionary open market operations as discussed before. This will decrease AD and slow
down economic activity. It will have the same effects as contractionary fiscal policy. It can
also be used to appreciate the national currency. As interest rates increase, more people will
invest in the economy, so demand for national currency increases and exchange rate of
national currency will increase.

4.5: Supply-side policies

Supply-side policies aim to increase the productive capacity of the economy by increasing
the aggregate supply of goods and services. They target economic growth by increasing the
quantity and quality of factors of production.
By increasing economic growth they are also able to reduce unemployment while
maintaining a low and stable rate of price inflation. It will also improve the balance of
payments as exports will become more internationally competitive.

Supply side measures include:

Education and training: Supply-side policies are used to improve the quantity and/or
quality of the workforce in the economy. This will make the workforce more productive and
increase the output of a country and help increase AS.

Labour market reforms:

Minimum wages: This is to increase the incentive to work

Reducing power of trade unions: Trade unions force up wage rates and cause
unemployment and disruption to production. Thus, governments seek to reduce the power
of trade unions.

Reducing unemployment and other welfare benefits to increase people’s incentive to find a
job and work

Deregulation: Removing old, unnecessary and costly regulations on business activities to

enable them to increase their productivity.

Privatisation: Privatisation is the policy of selling off state-owned assets (such as property
or public-sector businesses) to the private sector, if they can be run more efficiently. This is
because private -sector firms are motivated by profit and can, in theory, develop better
products and deliver better services. Competition, productivity and efficiency are essential

components of the private sector, which help to boost the productive potential of the
economy.

Lowering direct taxes: This will increase people’s disposable income. Lower taxes can
create incentives for work especially for people on low wage rates. Over time, this can
provide a boost to consumption. Tax cuts can also encourage firms to invest in the economy,
as they strive to maximise profits.
Subsidies: To reduce production costs and help firms fund research and development of
new technologies.

Removing trade barriers: Domestic firms will face greater competition from overseas and
thus will strive to be more efficient and productive. They will aim to increase the quality
and quantity of their products. They can also increase their production by making use of the
best and cheapest raw materials and technology from all over the world.

Competition policy: Regulations that outlaw unfair trading practices by monopolies and
other large, powerful firms.

4.6: Economic Growth

Economic growth is the increase in the level of national output or it can be defined as a
sustained increase in the real GDP of a country over a period of time. That is the annual
percentage change in the real GDP.

GDP is the total market value of all final goods and services produced using the existing
resources in a country over a given period of time. GDP can be calculated by the output,
income or expenditure method as they are all equal to each other in an economy.
Components of GDP are as follows:

Consumer expenditure: total spending on goods and services by individuals and households
in an economy.

Investment expenditure: capital expenditure of firms which is used to further production

and expand the economy's productive capacity.

Government expenditure: total consumption and investment expenditure of the

government.

Net exports= Value of all exports minus value of all imports

Aggregate demand also has the same components as GDP which are mentioned above. This
is useful when trying to find the effect of certain changes on the economy.
The value of total output, income and expenditure in an economy are all equal and
measured at their current market values or prices. This is called the nominal GDP. However,
these values will rise over time due to price inflation. Nominal GDP is therefore often
misleading so nominal GDP is adjusted to exclude the impact of inflation on monetary
values. This is called real GDP and measures change in total output over time assuming
prices are unchanged. Therefore, this GDP in constant prices is used to measure economic
growth in a country. GDP is useful for making better decisions on economic policies, allows
comparisons to be made between living standards in different countries and different areas
and to compare living standards in one year as compared to the next.

GDP per head is calculated by dividing the total GDP by the population of a country. This
gives the average income per person and is a good measure of living standards in a country.

Real GDP per capita is an even better measure than GDP per head.

Economic recession: This is negative economic growth for two consecutive quarters. It is a
significant decline in economic activity spread out across the economy. A recession would
cause the economy to produce at a point inside its PPC because there will be an
underutilization of resources. It will produce at an inefficient point of production. If
recession is persistent it can turn into a depression.

If total demand was to rise, firms would be willing to increase production and demand more
factors of production. As a result the economy would move from an inefficient point of
production to a point on its PPC which is an efficient point of production where the output
being produced is the maximum that can be produced with the existing resources in a
country at a given point of time.

If there is a growth in total output due to an increase in the productive capacity of the
economy, then the PPC for the country itself will shift outwards towards the right where it
is producing more output than before.

Causes of economic growth:

Discovery of more natural resources will increase the quantity of raw materials needed for
production.
Investment in new capital and infrastructure will increase the scale of production of firms,
lower their average costs and enable them to produce more goods and services in the
future. This increases the quantity of capital and thus the productive capacity of the
economy.

Technical progress is improving the quality and productivity of existing factors of

production which means they can produce more and newer goods and services

Increasing the quantity and quality of the human workforce through education and training
programmes is called investment in human capital and provides a larger and more
productive workforce which will increase the productive scale of the economy and boost
economic growth.

Reallocating resources from less-productive uses to more productive uses will boost output
and growth. For example, moving resources from production of consumer to capital goods.

Benefits of economic growth:

Greater availability of goods and services to satisfy consumers needs and wants

Increased employment and income opportunities

Increased sales and profits and thus more business opportunities

If growth in output is matched by a fairly equal growth in demand it can help maintain a low
and stable rate of price inflation.

Increased tax revenues for the government as there are fewer people unemployed so fewer
unemployment benefits to pay

Improved living standards and economic welfare.

Consequences of economic growth:

Environmental consequences - High rates of economic growth can create negative
externalities such as pollution, congestion, climate change and land erosion. This lowers the
quality of life of the people in the long run.

The risk of inflation - If the economy grows due to excessive demand in the economy, there
is the danger of demand-pull inflation

Inequalities in income and wealth- Although a country might experience economic growth,
not c\·eryonc will benefit in the same way. Economic growth often creates greater
disparities in the distribution of income and wealth

Resource depletion - Economic growth often involves using up the world's scarce resources
at rates that are not sustainable.

Technical progress might replace workers with machines causing unemployment

May be achieved by producing more capital goods at the expense of consumer goods.
Although this stimulates economic growth it may result in a lack of goods and services
available to consumers.

The business cycle : Economic growth occurs when there is an increase in the level of
economic activity in a country over time. The term business cycle (also known as the trade
cycle) describes the fluctuations in economic activity in a country over time. These
fluctuations create a long-term trend of growth in the economy.

Policies to achieve economic growth:

Expansionary fiscal policy- inflationary

Expansionary monetary policy- inflationary

Supply-side policies: Take longer time to take effect but can increase the productive scale of
the economy.

4.7: Employment and Unemployment

Employment refers to the use of factors of production, such as labour, in the economy.

Unemployment is when people who are willing and able to work at the going wage rate are
unable to find a job. They are now claiming unemployment benefits from the government.

Full employment is an economic situation in which all available labor resources are being
used in the most efficient way possible. Full employment embodies the highest amount of
skilled and unskilled labor that can be employed within an economy at any given time.

Changes in patterns and levels of employment:

As an economy develops, more people start to get employed in the tertiary sector and the
formal economy. This is because the majority of the jobs are now found in the tertiary
sector and rising costs of living means that more people are now seeking formal paid
employment.

There has been an increase in female participation in the labour force in recent times for the
following reasons:

Increasing real wages has attracted more women into work.

Rising costs of living has also meant that more women have been forced to work.

Changes in social attitudes has made it more acceptable for women to work.

As a country moves towards a market economy, there is a decline in the proportion of

people employed in the public sector.

Unemployment rate is measured during claimant counts or periodic labour force surveys.
Unemployment rate= (Number of unemployed/ Labour force)*100
Unemployment rate is the percentage of the labour force which is unemployed while the
level of unemployment is the number of people who are unemployed.

Causes of Unemployment:

Frictional unemployment is transitional unemployment that occurs when people change

jobs, due to the time delay between leaving a job and finding or starting a new one.
Therefore, frictional unemployment always exists in the economy because it takes time for
the labour market to match available jobs with the people looking for jobs.

Seasonal unemployment is caused by regular and periodical changes in demand for certain
products.

Structural unemployment occurs when the demand for products produced in a particular
industry falls continually, often due to foreign competition. There are structural and Long-
term changes in demand for the products of certain industries. Those who suffer from
structural unemployment usually find it quite difficult to find a new job without retraining.

Voluntary unemployment occurs when workers choose not to work. Voluntary

unemployment usually exists in economies with relatively generous welfare benefits for the
unemployed as well as high rates of income tax, thus creating disincentives to work at
current market (equilibrium) wage rates.

Cyclical unemployment, also known as demand·deficient unemployment, is the most severe

type of unemployment because it can affect every industry in the economy. It is caused by a
lack of aggregate demand, which causes a fall in national income. Demand-deficient
unemployment is experienced during an economic downturn - that is, in recessions and
slumps.

Consequences of Unemployment:

Personal costs:

People lose their incomes and rely on government payments

May lose their working skills if they are unemployed for a long period of time making it
even harder for them to find work

They become depressed putting an even bigger burden on family members.

Unable to meet financial obligations

Failure to meet mortgage payments or rent and may become homeless.

High levels of unemployment can increase crime and cause civil unrest.

Fiscal costs:

Fall in government revenue because fewer people paying taxes

Increased unemployment benefits have to be paid by the government.

Costs to firms:

Pessimism

Loss of output

Relocation

Firms lose out as there are lower levels of consumer spending, investment and profits.
Business failures and bankruptcies are more likely to occur during periods of high
unemployment.
Costs to economy:

Leaving labour unemployed is a huge waste of resources. Country will operate below its
PPC

Can cause total GDP and incomes to fall and slow down economic growth

Migration out of the country.

AD decreases causing a downward multiplier effect on incomes, output and employment.

Reduces international competitiveness of exports.

Policies to reduce unemployment:

Expansionary fiscal and monetary policy- for cyclical unemployment

Other kinds of unemployment require supply-side measures such as education, training, etc.

4.8: Inflation and Deflation

Inflation is a sustained rise in the general price level in an economy over time.

Deflation is a sustained fall in the general price level in an economy over time.

This means that on average prices of goods and services are falling.
Inflation and deflation can be measured using a consumer price index(CPI):

A CPI is a measure of the change over time in the prices of a fixed basket of goods and
services.

The consumer price index (CPI) is a common method used to calculate the inflation rate. It
measures price changes of a representative basket of goods and services (those consumed
by an average household) in the country.

Different weights are applied to reflect the relative importance of each item in the average
household's expenditure.

The statistical weights in the CPI are based on the proportion of the average household's
income spent on the items in the representative basket of goods and services.

Therefore, items of expenditure that take a greater proportion of the typical household's
spending.

A price index is used to indicate the average percentage change in prices compared with a
starting period called the base year.

The CPI compares the price index of buying a representative basket of goods and services
with the base year, which is assigned a value of 100.

To create a weighted price index, economists multiply the price index for each item (in the
representative basket of goods and services) by the statistical weight for each item of
expenditure.

This gives them the weighted average price for each category. These are then added up to
give the total weighted average price which is then applied in the formula below(it is
essentially the cost of market basket in a given year)

Causes of inflation:

Cost-push inflation is caused by higher costs of production, which makes firms raise their
prices in order to maintain their profit margins. If these high costs are passed on to
consumers it is called cost-push inflation.

Demand-pull inflation is caused by higher levels of aggregate demand (total demand in the
economy) driving up the general price level of goods and services. As AD increases this will
put upward pressure on prices.
Monetary causes of inflation are related to increases in the money supply (see Case Study
on Zimbabwe) and easier access to credit, e.g. loans and credit cards. Increase in money
supply could be due to printing of more notes and coins or due to quantitative easing.

Imported inflation occurs due to higher import prices, forcing up costs of production and
therefore causing domestic inflation.

Causes of deflation:

Deflation can be caused by lower levels of aggregate demand in the economy, driving down
the general price level of goods and services due to excess capacity in the economy. This
causes what is known as malign deflation (deflation that is harmful to the economy)

Deflation can also be caused by higher levels of aggregate supply, increasing the productive
capacity of the economy. This drives down the general price level of goods and services
while increasing national income. Such deflation is called benign deflation (non-threatening
deflation).

Consequences of inflation:

Menu costs - Inflation impacts on the prices charged by firms. Catalogues, price lists and
menus have to be updated regularly and this is costly to businesses.

Consumers - The purchasing power of consumers goes down when there is inflation - there
is a fall in their real income because money is worth less than before. Therefore, as the cost
of living increases, consumers need more money to buy the same amount of goods and
services.

Shoe leather costs - Inflation causes fluctuations in price levels, so customers spend more
time searching for the best deals. This might be done by physically visiting different firms to
find the cheapest supplier or searching on line. Shoe leather costs represent an opportunity
cost for customers.

Savers - Savers, be they individuals, firms or governments, lose out from inflation, assuming
there is no change in interest rates for savings. This is because the money they have saved is
worth less than before.

Lenders - Lenders, be they individuals, firms or governments, also lose from inflation. This
is because the money lent out to borrowers becomes worth less than before due to inflation.
Borrowers - By contrast, borrowers tend to gain from inflation as the money they need to
repay is worth less than when they initially borrowed it - in other words, the real value of
their debt declines due to inflation

Fixed income earners - During periods of inflation, fixed income earners (such as
pensioners and salaried workers whose pay do not change with their level of output) see a
fall in their real income. Thus, they are worse off than before as the purchasing power of
their fixed income declines with higher prices.

Low income earners - Inflation harms the poorest members of society far more than those
on high incomes

Exporters - The international competitiveness of a country tends to fall when there is

domestic inflation. In the long run, higher prices make exporters less price competitive, thus
causing a drop in profits. This leads to a fall in export earnings, lower economic growth and
higher unemployment.

Importers - Imports become more expensive for individuals, firms and the government due
to the decline in the purchasing power of money. Essential imports such as petroleum and
food products can cause imported inflation (higher import prices, forcing up costs of
production and thus causing domestic inflation).

Employers - Workers are likely to demand a pay rise during times of inflation in order to
maintain their level of real income. As a result, labour costs of production rise and, other
things being equal, profits margins fall. TThis can create a wage- price spiral whereby
demand for higher wages to keep in line with inflation simply causes more inflation.

Business confidence levels also fall

Benefits of a low and stable rate of price inflation:

Low inflation encourages consumers to buy goods and services sooner rather than later as
delaying will mean they will have to pay more for the same product.

Low inflation also makes it more appealing to borrow money since interest rates are
generally low during periods of low inflation
A low and stable demand-pull inflation will boost profits.

It will even keep wages low as the real cost of employing labour will fall and the demand for
labour will increase.

Exports from a country that has a lower rate of price inflation will be more competitive than
rival products from overseas producers which will boost the demand for exports, creating
additional incomes and employment opportunities. It will also make the balance of
payments for the country more favourable.

Consequences of Deflation:

Unemployment - As deflation usually occurs due to a fall in aggregate demand in the

economy, this causes a fall in the demand for labour - that is, deflation causes job losses in
the economy.

Bankruptcies - During periods of deflation, consumers spend less so firms tend to have
lower sales revenues and profits. This makes it more difficult for firms to repay their costs.
Thus, deflation can cause a large number of bankruptcies in the economy.

Debt effect - The real cost of debts (borrowing) increases when there is deflation. This is
because real interest rates rise when the price level falls.

Government debt - With more bankruptcies, unemployment and lower levels of economic
activity, tax revenues fall while the amount of government spending rises (due to the
economic decline associated with malign inflation). This creates a budget deficit for the
government.

Consumer confidence - Deflation usually causes a fall in consumer confidence levels, as

consumers fear that things will get worse for the economy. Thus, they may postpone their

spending.

Policies to reduce inflation:

Contractionary monetary and fiscal policy

Supply-side policy

Policies to reduce deflation:

Expansionary monetary and fiscal policy

Supply-side policies will not help.

5.1: Living Standards

The two main measures or indicators of living standards are real GDP per head and the
Human Development Index(HDI)

Real GDP per head:

Real GDP per head gives a measure of average income and is found by dividing real GDP by
population/gives an indication of material living standards

Changes in GDP per capita are a better measure of living standards than the annual increase
in GDP because it also takes into account changes in the population of a country. If the
population of a country grows faster than the GDP, the GDP per capita will be falling and
people will become worse off. However, price inflation erodes the real value of people’s
incomes over time. Therefore this is adjusted for by using real GDP as compared to GDP.
This measures the actual increase in goods and services in an economy.

Excludes impact of price inflation on monetary values

Takes the population of a country into account to see how well-off people are on average

Information is fairly readily available

gives an indication of the value of the goods and services available to people

income/output/expenditure is a key determinant of their living standards

the information is available on every country

Doesn’t take into account what people can buy with their income. It doesn’t factor in
consumer choice in the country.

It doesn’t consider inequalities or disparities in the distribution of income and wealth. Some
people may be very rich and some very poor.

Excludes unpaid work people do voluntarily or for charities and therefore understates total
output and well-being.

Takes no account of the impact of growth on the environment.

Accounting techniques may vary

It needs to take into account differences in climate

Composition of output may vary eg: defence vs education

It doesn’t take into account the hidden economy.

Human Development Index:

HDI is a composite index used by the UN that takes into account not only income but also
education and life expectancy
It has three main components:

Standard of living measured by the GNP per capita of a country. Adjusted for different
exchange rates and overseas prices.

Level of education measured by adult literacy rates, number of years a person aged 25 will
have spent in education and how many years a young child entering school can be expected
to spend in education

Level of healthcare measured by life expectancies in the country.

Covers more variables than GDP

living standards are influenced by not only income but also quality of life

For some countries the HDI figure is unavailable

Although it's wider than GDP it does not consider all factors.

For example it does not take account of water quality, pollution, internet access, number of
doctors per head, freedom of speech, etc.

HDI does not take account of inequitable income distribution, thus being less accurate in
measuring living standards for the 'average' person.

The HDI ignores environmental and resource depletion resulting from economic growth.

Reasons For Varying levels of Economic Development between and within countries

Over-dependence on agriculture

Domination on international trade by developed Nations

Lack of capital

Insufficient investment in education, skills & Healthcare

Low levels of investment in infrastructure

Lack of efficient production and distribution systems

High population growth

Other factors like a corrupt govt. or war

5.2: Poverty

Poverty is a state of lacking sufficient resources for living and well-being.

Absolute poverty: Inability to afford basic necessities needed to live successfully such as
food, water, education, healthcare and shelter. The extent of absolute poverty is measured
by the number of people living below a certain level of income, usually $1.95 a day.
However, absolute poverty is not just about income it is also about access to services such
as food, drinking water, sanitation facilities, healthcare, education and information.

Relative poverty: It is a condition of having fewer resources than others in the same society.
It is usually measured by the extent to which a person’s or household’s financial resources
fall below the average income level in an economy. Occurs when people are poor relative to
other people in the same country are unable to participate fully in normal activities of the
society they live in.

Causes of Poverty:
Lack of resources: Any individual who lacks access to sufficient resources to provide an
income, food and place to live, will very likely live in poverty.

Lack of education: People who lack a good education are less employable than others, will
find it difficult to generate an income and are more likely to be in poverty.

Low wages: Some wages are so low that they are insufficient in preventing workers from
being poor and workers may be unable to buy goods and services

Unemployment: The loss of income associated with unemployment is one of the main
causes of relative poverty in developed economies and absolute poverty in many
developing economies.

Old age, disability and illness: All these factors can prevent people from working and
earning an income. State pensions and welfare payments may also not be enough to lift
some people out of poverty.

Vulnerability to climate change and natural disasters: Droughts, floods, hurricanes and
other unexpected climatic and natural events destroy property and cause deaths, illness and
thus poverty due to loss of income.

Wars and internal conflict: The main income earners in many families may be killed or
injured so they are unable to continue working causing the family to land in poverty.

Corruption: While corrupt individuals with political power enjoy a lavish life, millions of
people are deprived of their basic needs like food, health, education, housing and access to
clean water and sanitation.

Policies to alleviate poverty and redistribute income:

Promoting economic growth: Supply-side policies, expansionary fiscal and monetary policy.
Growth creates jobs, increases incomes and living standards.

Improving the quantity and quality of education: WIll lift people out of poverty by
improving their job prospects

Measures to reduce unemployment: same measures as to promote economic growth

Progressive taxes: To reduce income inequality and relative property as people on higher
incomes will pay a greater proportion of their income in tax.

Reducing indirect taxes: This will improve quality of life for the poor.

Welfare services and income support can be provided to people on very low incomes.

Introducing a national minimum wage to raise the wages of the lowest paid employees so
that they can afford basic necessities.

Tax revenues can be used to subsidize the building of free or low-cost homes for poor
families to live in.

5.3: Population

Factors affecting population growth:

Birth rate: average number of live births per 1000 people per year

Death rate: Average number of deaths per 1000 people per year

Net Migration= Number of immigrants- Number of emigrants. The net migration rate
measures the difference between the number of people entering and leaving a country per

thousand of the population in a year.

Immigration is the movement of people from overseas to become residents of a country

Emigration: movement of people to live overseas leaving their home country.

Fertility rate: Average number of children a woman born in a country can expect to have in
their lifetime.

Life expectancy

Social changes - In economically developed countries, women are choosing to have children
at a later age, partly due to the high cost of raising children but also because more women
opt to have a professional career.

Natural disasters, diseases or war

Reasons for different in birth rates:

Living standards

Contraception

Customs and Religion

Changes in female employment

Marriage

Reasons for different death rates

Age distribution: LEDCs have high death rates because of poor living standards. MEDCs
have high death rates because they often have an ageing population.

Living Standards

Medical advances and healthcare

Natural disasters and war

Net migration is influenced by a set of push and pull factors:

Push factors (why people move away from an area or country):

Poverty

Lack of employment or low wages

Little or poor quality health care provision

Little or poor quality education provision

Lack of availability of food

Lack of availability of water

Impacts of government policy (high taxes)

Drought or famine

Natural disasters

Presence of war, fear of persecution, or political instability

Lack of social amenities

Unreliable supply of electricity

Pull factors (why people move to an area or country)

Absence of poverty, presence of money (capital) in country

Many opportunities for employment and higher wages

Plenty good quality health care provision

Plenty good quality education provision

Availability of food

Availability of water

Impacts of government policy (lower taxes)

Free of natural disasters

Sense of security, safety and political stability

Entertainment opportunities and social amenities (bright lights syndrome)

Reliable electricity supplies

The optimum population exists when the output of goods and services per head of the
population is maximised with the existing resources in a country.
A country is under populated if it does not have sufficient labour to make the best use of its
resources. In this situation, GDP per head of the population could be further increased if
there were more human resources. Fertility rates below the replacement level can lead to
under·population, causing potential economic decline.

A country is overpopulated if the population is too large, given the available resources of the
country. Fertility rates above the replacement level can lead to potential overpopulation.
This causes a fall in GDP per capita as there are insufficient resources to sustain the
population.

Characteristics of a population:

Age distribution of a population: how many people are found in the different age groups.

Sex distribution: the balance of males and females in the population

Geographic distribution: Where people live

Occupational distribution: The employment sectors in which people work.

Population pyramids are a graphical representation of the age and gender distribution of a
country's population.

As a country becomes more developed:

The proportion of young dependents decreases and the proportion of elderly dependents
increases. This is due to a fall in birth rates and increase in life expectancy.

Employment shits from the primary and secondary to the tertiary sectors

As development occurs a process called urbanization also occurs where people move from
the suburbs and rural areas to the big towns and cities which changes the occupational
distribution of a country.

Advantages and disadvantages of small population/decrease in population:

A small population may mean that resources will last over a longer time period enabling
economic growth to continue

There may be less environmental damage and less risk of overcrowding

There may be fewer dependents smaller proportion of children and elderly people which
can increase income per head and may reduce the need for some forms of

government spending

May be less imports

This could be the optimum population for the country in which case it can maximise output
per head.

Less money has to be spent on social infrastructure such as education, healthcare, etc

A small population could be below the optimum population implying that the country is
under populated.

High dependency ratio as working population may be small

There may not be enough workers / low labour force to take advantage of resources
resulting in a low output

low tax revenue reduces government ability to spend

The size of the market for the country’s products may not be large enough / low total
(aggregate) demand less ability to take advantage of economies of scale may be less
attractive to MNCs

May be less exports

Fall in population may be due to high death rates due to spread of diseases, war or natural
disasters.

Advantages and disadvantages of an increase in population/ large population

the increase in population leads to an increase in demand and, therefore, supply

jobs can be found for the population

■ if the extra people are well trained, it could lead to an increase in productivity

Could be the optimum population

population growth puts pressure on resources. The population may be much larger than the
optimum population of the country.

can lead to overcrowding

lack of job opportunities can lead to a very high rate of unemployment

Other problems of overpopulation such as :

Poor housing conditions

Poor access to healthcare and educational services

Very rapid depletion of forests and natural resources

Increase in pollution
Lack of sanitation and hygiene

Food shortages

Water shortages

Problems of ageing population:

High dependency as they are not earning so less income from taxes

More pressure on economically active (working) population

Need for more money to be spent on care for elderly care homes and pensions

More taxation needs to be raised leading to higher taxes

Less workforce (less economically active)

Workforce becomes less innovative

Less money spent on education

Pension aged raised

More spending/pressure on healthcare

Less money spent on infrastructure

Country becomes difficult to defend

5.4: Differences in economic development between countries

6. International Trade and Globalisation

6.1: International Specialisation

International specialisation occurs when certain countries concentrate on the production of

certain goods or services due to cost advantages - perhaps arising from an abundance of
resources. International specialisation allows countries to specialize in the production of
those goods and services which make the best use of natural or other factor resources with
which they are most abundantly endowed. This comes under superior resource allocation.
Countries can then use these resources in the most efficient way possible to produce far
more of the goods and services they specialise in and produce them much more cheaply
than producers in other countries with different factor resources. International
specialisation requires and enables international trade to exchange surplus products.

Advantages of international specialisation:

High levels of output: A country can use its resources efficiently and produce chosen goods
and services at scale. Allows more goods and services to be produced at a lower cost per
unit. This is due to efficiency gains

Increased employment and incomes: Increased output, increased business opportunities

and creation of more jobs.

Economic growth and improved living standards: More efficient use of resources, increasing
output and creating more business opportunities will contribute to increased economic
growth and higher living standards. This will increase the productive capacity of the
country.

Opportunities for increased international trade: Benefits of this include:

Firms located in one country are able to sell far more because they have access to much
larger international markets. Firms can enjoy economies of scale.

Consumers in a country will have a much wider variety of goods and services to choose
from domestic and overseas producers.

Increased competition between firms will lead to reduced costs and improved quality of
products.

Labour productivity will also increase as they focus on the production of one good or
service.

Disadvantages of international specialisation:

Structural unemployment: This may occur as a country becomes more specialised. In the
short run there may be structural unemployment as certain industries close down. Low-
skilled and poorly paid workers tend to receive little training, so they may not develop the
necessary skills to find alternative jobs. Again, this can lead to structural unemployment.

Risk of over-specialisation: A country dependent on just one or very few goods and services
can suffer a catastrophic economic shock if there is a prolonged global decline in demand
for its products during an economic recession.

Consumer choice may be limited if a country specialises in a narrow range of products.

Overexploitation of resources: Resources in which a country has a natural advantage may

be used up or depleted at a faster rate to satisfy the demands of the consumers.

Over-reliance on other countries to supply essential goods and services: A country that
specialises in the production of a narrow range of products must trade with other countries
to obtain the other goods and services it needs. Strikes, weather or transportation problems
could hold up supplies.

6.2: Globalisation, free trade and protection

Globalisation is a wide term used to describe economic, social, technological, cultural and
political changes that are increasing interactions and interdependencies between people,
firms and
entire economies all across the globe.

MNC(Multinational Corporations)

Large business organisation that has operations in more than one country. MNC’s have
subsidiaries in other countries which will produce goods and services in those countries.
Headquarters will be generally based in its country of origin.

What factors attract MNCs:

Size of market: if demand for the product/s produced is high in the country higher revenue
may be earned

Costs of production e.g. low wages/low raw material costs may attract multinational
companies (MNCs)

Availability of raw materials: certain raw materials e.g. copper may be found in a small
number of countries

Trade protection MNCs may set up in a country to get around tariffs

Government subsidies and financial help may be given to companies setting up in some
countries

Fewer government and environmental regulations: MNCs may set up in countries with
fewer rules and laws

Skills of workers: highly skilled workers will produce products of a good quality and will
attract MNCs.

What are the benefits of being a MNC:

Reach many more consumers globally than any other business

Avoid trade barriers by locating operations in countries that have import tariffs and quotas

Minimize transport costs by locating in many different countries

Minimize wage costs by operating where wages are low

Raise significant amounts of new capital for business expansion, R&D, and to employ skilled
labour

Reduce the average cost of producing each unit of output.

Advantages of MNC to a host country:

They provide incomes and jobs for local workers

They invest capital in new or expanded business premises, new machinery and modern
equipment.

Capital received from overseas that is directly invested into productive assets into a country
are called foreign direct investment(FDI)

Increased amount and variety of goods and services available to domestic consumers and
will compete with domestic firms thereby offering consumers more choice. Increased
competition will force firms to cut prices and improve quality

Brings new ideas, skills and technology into a country which domestic firms can learn from.

They pay taxes on their profits and purchases which will increase the government’s tax
revenue to fund public expenditure.

Additional output produced by MNCs will increase export earnings of a host country.

Disadvantages of a MNC to a host country:

Will force local competitors out of business as they can enjoy economies of scale. They may
become monopolies
Can repatriate profits to its headquarters or subsidiary company overseas thus avoiding
paying any taxes to the host country.

Use their power to get generous subsidies and tax incentives from the government as they
are important to the economy.

MNCs exploit workers in low-wage economies and their health and safety may be
compromised.

MNCs exploit natural resources and damage the environment. They use up scarce resources,
create pollution and cause significant damage in their host countries.

An open economy is a national economy that engages freely in international trade with
other

economies. Benefits of free trade are as follows:

Allows countries to benefit from specialization: Trade enables economies to specialize in

the production of those goods and services their natural, human and man-made resources
are best able to produce. Output, incomes and living standards will be higher.

Increases consumer choice: Consumers can enjoy a variety of goods and services from
different countries all over the world.

Increases competition and efficiency: Firms will have to compete with goods and services
imported from overseas. This makes them more efficient and consumers will benefit from
lower prices. More competition from imports so firms will improve quality and increase
their productivity. This will cause an increase in the GDP of the country.

Creates additional business opportunities: Firms can increase sales and scales of production
because they are able to sell their products to a much larger number of consumers globally.

Encourages more foreign investments which increases employment / decreases

unemployment and there is increased capital spending which increases innovation

Enables firms to benefit from the best workforces, resources and technology from
anywhere. Therefore firms can access the best and cheapest materials and components
from different producers in other countries.

Free trade increases economic interdependence between countries and promotes peace. It
reduces the potential for conflict. It helps avoid retaliation from other countries.
Problems of free trade:

Domestic producers might be adversely affected and can’t compete with foreign firms who
might be more cost competitive and unemployment increases

Increase imports will increase deficit on the current account of the balance of payment

May become dependent on other countries.

Free trade may involve the removal of tariffs reducing government revenue

Unsafe products/low quality products may be imported

Dumping may occur driving out domestic producers which can raise prices (lower quality in
the long run.

Trade Protection: Involves the use of trade barriers by the government to restrict access to
international markets and competition.

Tariffs -A tariff is an indirect tax on imports.Tariffs increase the costs of production to

importers, thus raising the price of foreign goods in the domestic market and lowering the
amount of products imported

Subsidies: Governments can provide subsidies (lump-sum payments or cheap loans to

domestic producers) to help local firms to compete against foreign imports. Subsidies lower
the costs of production for home firms, thereby helping to protect local jobs and reduce
imports by making domestically produced goods more competitive.

Quotas - An import quota sets a quantitative limit on the sale of foreign goods into a
country. The quota limits the quantity imported and thus raises the market price of foreign
goods making them less attractive to buy.

Embargo- A ban on the importation of a particular product, or on all imports from a

particular country.May be used to limit the importation of dangerous drugs or to exert
political pressure on other countries.

Excess Quality standards and Bureaucracy- Countries often use bureaucratic rules and
regulations as a form of protection. Complying with these rules and regulations consumes a
lot of time, and increases the costs for overseas firms. This will slow down the flow of
imports into a country.

Reasons for Protection:

To protect infant industries: These are sunrise technologies. Trade protection gives these
new firms a chance to develop, grow and become globally competitive. These firms have
great potential.

To protect sunset industries or declining industries. They still employ many people in an
economy and the closure of the firms in these industries could result in high regional
unemployment. Trade barriers slow down the rate of their decline.

To protect strategic industries: Many governments seek to protect their agricultural, energy
and defence industries so they are not entirely dependent on suppliers from overseas.

To protect domestic firms from dumping: Dumping is a type of predatory pricing and unfair
competition. It involves one country ‘flooding’ another with a product at a price below the
market price to increase its sales and force producers in the importing country out of
business. Trade protection can prevent this.

To limit over-specialization: Trade barriers can help a country to maintain a wider range of
different industries that would otherwise be threatened by overseas competition.

To correct a trade imbalance: Cutting spending on imports using tariff and non-tariff
barriers can help to reduce a trade deficit.

Because other countries use trade barriers- A country will impose trade barriers on foreign
goods if other countries do so on its exports

Consequences of Trade Protection:

They restrict consumer choice: Less international trade means consumers will have fewer
goods and services to choose from and fewer raw materials for producers to choose from.

Restrict new revenue and employment opportunities: Trade barriers restrict the ability of
firms to seek out new markets for their products overseas that will allow them to expand
their scale of production and as a result their demand for labour will also fall causing
unemployment. Increased cost of raw materials and restricting their supply will also harm
the domestic firms that use the materials in their production process. This could lead to
higher domestic prices and imported inflation if the demand for these raw materials is price
inelastic.

Government intervention distorts market signals and therefore can lead to a global
misallocation of resources. Domestic consumers may not be able to purchase lower-priced
imports which are of higher quality than those produced domestically. Protected firms and
industries can become too reliant on the government and thus become inefficient

Other countries are likely to react by retaliating and imposing their own trade barriers.
Such actions may hinder global economic growth and prosperity and lead to trade wars.

6.3: Foreign Exchange Rates

The value of one currency in terms of another is called the foreign exchange rate.

Every country has its own national currency and the amount you get in return for your own
national currency is called its exchange rate. Foreign currencies can be bought and sold on a
platform called the global foreign exchange market.

Determination foreign exchange rate:

The equilibrium market price of one currency in terms on another is its exchange rate.

The ER of each currency in terms of another will be determined by the market demand

and supply conditions for each of the currencies.

Just as any other commodity, as demand contracts the exchange rate for a currency will rise
and vice-versa.

SImilarly, as the exchange rate of the currency rises, the quantity supplied will increase and
vice-versa.

Changes in demand and supply for a national currency will cause the exchange rate to
change or fluctuate.
An increase in demand will cause the exchange rate to increase and vice-versa.

An increase in supply will cause the exchange rate to decrease and vice-versa.

An increase in the exchange rate is called an appreciation whereas a fall in the exchange
rate of a currency is called a depreciation.

Causes of foreign exchange rate fluctuations:

Changes in demand for exports: An increase in the demand for exports, perhaps due to
improved quality or successful advertising, will also increase the demand for the country's
currency. Therefore this increases the exchange rate.

Changes in demand for imports -An increase in the demand for imports, perhaps due to an
increase in the competitiveness of foreign firms, will raise the value of the foreign currency
in order to facilitate the purchase of foreign goods and services. This is because as demand
for imports increase, people will need more foreign exchange to pay for them. Thus, the
supply of the national currency will increase in order to buy more of the foreign currency.
As a result, the exchange rate of the national currency will fall.

Prices and inflation - An increase in the price of goods and services caused by domestic
inflation will tend to decrease the demand for exports. This will therefore tend to cause the
exchange rate to full in value.

Interest rates: When a country’s interest rates are high, overseas residents will be keen to
invest and save money in the country. Thus, they will need to buy national currency to do
so. The demand for the national currency will increase and so will its exchange rate. A rise
in interest rates in other countries will have a depreciating effect on the national currency.

Speculation: A foreign currency speculator is someone who makes a profit by buying and
selling different currencies. If speculators feel the value of a currency is about to fall they
will sell their holdings of the currency increasing its supply and thus causing it to depreciate
in value. The opposite can happen.
Entry and arrival of MNCs: Globalisation and the economic activity of multinational
companies mean that investment in overseas production plants requires the use of foreign
currencies. Thus, if a MNC enters a country there will be inward FDI so demand for national

currency will increase and ER will appreciate. On the other hand, departure of an MNC will
mean that there are fewer exports leaving the country so demand for national currency and
thus the exchange rate will fall.

Consequences of Foreign exchange rate fluctuations:

If there is an appreciation in the exchange rate:

Export prices rise

Import prices fall

As export prices rise, they will lose their international competitiveness and thus spending
on exports will fall if the demand for them is price elastic. However, if demand is price
inelastic spending will actually increase.

As import prices fall, if demand for imports is price elastic, spending on imports will
increase as they become cheaper compared to domestically produced goods and services.
This will benefit local producers who use imported raw materials in the production process.

If there is a depreciation in the exchange rate:

Export prices fall

Import prices rise

As export prices fall, their international competitiveness will increase. If demand for them is
price elastic, spending on these exports will increase greatly. As this happens, export
earnings of the country will increase and as AD increases, output and employment in the
country will also increase.
As import prices rise, if demand for imports is price inelastic, spending on imports will
increase. This means that costs of production will increase for domestic producers who use
these imported raw materials in production.If these higher costs are passed on to customers
it is called imported inflation. However, if demand for them is price elastic, then spending
on imports will reduce greatly and it will improve a trade deficit on the balance of
payments.

Floating Exchange Rate:

In the floating exchange rate system, the value of currency is determined by the market
forces of demand for the currency and supply of the currency

In a floating exchange rate system, there is an appreciation in the exchange rate if the
exchange rate is rising against other currencies. By contrast, there is a depreciation of the
exchange rate if its value falls against other currencies.

Automatic stabiliser

Frees internal policy

Can be managed to a certain extent by state intervention to give a managed floating foreign
exchange rate system

Very flexible

Can avoid inflation

Lower reserves

Uncertainty

Lack of investment due to uncertainty

Speculation can influence the exchange rate

Fixed Exchange Rate:

Under the fixed exchange rate system, the government intervenes in foreign exchange
markets to maintain its exchange rate at a predetermined level

In a fixed exchange rate system, there is a revaluation of the exchange rate ifit is rising
against other currencies. By contrast, the exchange rate is devalued under a fixed exchange
rate system if the value of the currency falls against other currencies.

The currency is allowed to fluctuate between a very small range.

Elimination of uncertainty and risk

Speculation deterred

Prevents depreciation of currency

Attracts FDI because both firms and individuals will be certain about future costs and
prices.

Large foreign exchange reserves needed to stabilize exchange rates which are stored with
the central bank. This has a huge opportunity cost.

Restricts international competition.

Doesn’t allow the country to operate monetary policy as it could influence exchange rates.
Harmful during a recession.
Internal objectives sacrificed.

6.4: Current Account of balance of payments

The balance of payments is a financial record of a country's transactions with the rest of the
world for a given time period, usually over 1 year. This includes the country's trade in goods
and services with other countries.

One of the components of the balance of payments is the current account, which is a record
of all exports and imports of goods and services between a country and the rest of the
world.

Components:

The visible trade balance is a record of the export and import of physical goods. It is also
known as the balance of trade in goods. It is the trade in goods, such as raw materials, semi-
manufactured products and manufactured goods. Visible exports are goods that are sold to
foreign customers. Visible imports are goods bought by domestic customers from foreign
sellers. Exports are considered credits and imports are considered debits.

The invisible trade balance is a record of the export and import of services (intangible
products), such as banking, insurance, shipping and tourism. It is sometimes called the
balance of trade in services. Exports are considered credits and imports are considered
debits.

Primary incomes are factor rewards exchanges between residents and non-residents for the
use of each other’s factors of production. Examples include wage and rent. Payments
received from non-residents are considered credits while payments paid to non-residents
are called debits.

Secondary incomes are simply transfers of money or benefits between residents and non-
residents. These are known as current transfers. They include pensions, social contributions
and welfare payments. Current transfers from non-residents are credits while current
transfers to non-residents are debits.
Current account = visible trade balance + invisible trade balance + net income flows
transfers

If Total Credits>Total Debits there will be a surplus on the current account

If Total Debits>Total Credits there will be a deficit on the current account

Current Account Deficit:

Causes:

Lower demand for exports - This could be caused by a decline in manufacturing

competitiveness, perhaps due to higher labour costs in the domestic economy. Another
factor is declining incomes in foreign markets, perhaps due to an economic recession. This
means households and firms have less money available to spend on another country's
exports. A third cause of lower demand for exports is a higher exchange rate

Increased demand for imports - Domestic buyers tend to buy more imports if they are
cheaper or of better quality. Higher exchange rate means the domestic currency can buy
more foreign currency, so this makes it cheaper to buy imports.

Alternatively, domestic inflation means that imports are relatively cheaper, so more
domestic residents and firms will tend to buy foreign goods and services.

Consequences:

Reduced aggregate demand - A trade deficit means the economy is spending more money
on imports than it receives from the export of goods and services. This can cause aggregate
demand in the economy to fall, thus triggering a recession

Unemployment - As the demand for labour is a derived demand a fall in aggregate demand
is likely to cause unemployment in the economy. Workers may also have to take a pay cut in
order to correct the deficit

A fall in demand for exports and/or a rise in the demand for imports (causing the current
account deficit) reduces the exchange rate. While a lower exchange rate can mean exports
become more price competitive, it also means that essential imports (such as oil and
foodstuffs) will become more expensive. This can lead to imported inflation.

As AD falls, demand-pull inflation will decrease. However, a fall in AD will also cause a loss
output because firms will cut back on production as stocks of unsold goods accumulate. This
will cause the country’s GDP to decrease.

Policies to cut deficit:

Introduce trade barriers to reduce imports

Supply-side policies to boost exports

Contractionary fiscal policy and monetary policy to reduce demand for imports

Allow floating exchange rate system to automatically correct any deficit

Current account surplus:

Higher demand for exports - This could be caused by an improvement in manufacturing

competitiveness, perhaps due to higher labour productivity in the domestic economy.
Another factor is higher incomes in overseas markets, meaning that foreign households and
firms have more money to spend on the country's exports. A third cause of higher demand
for exports is a lower exchange rate

Reduced demand for imports - Domestic buyers tend to buy fewer imports if they are more
expensive or of lower quality than those provided by domestic firms. For example, a lower
exchange rate means the domestic currency can buy less foreign currency, so this makes it
more expensive to buy imports. Another reason is that inflation in overseas countries
causes imports to be more expensive, so individuals and firms buy more home-produced
goods and services.

Employment - A sustained current account surplus can be desirable, as higher export sales
help to create jobs. However, a consequence of this is that job losses are created in other
countries
Standards of living - A furnurable current account balance means the country reaches a
higher income because domestic firms have a competitive advantage in the products they
export. This can lead to a higher standard of living

Inflationary - Higher demand for exports can lead to demand-pull inflation Therefore, the
current account surplus can diminish the international competitiveness of the country over
time as the price of exports rises due to inflation.

Higher exchange rate - The higher demand for exports can cause the currency to appreciate
in value. Subsequently, foreign buyers will find it more expensive to import goods into their
countries.

GDP of a country will increase as export earnings increase.

Policies to reduce surplus if ever needed:

Allow floating exchange rate to automatically correct it

Expansionary monetary and fiscal policy to increase spending on imports

Remove trade barriers

IGCSE ECONOMICS

1.1 Nature of the economic problem

Problem: an economy’s finite resources are insufficient to satisfy all human wants & needs

Finite resources can’t meet infinite wants

Decide the best allocation of resources for society as a whole

Resources: Inputs available for production of g/s

Economic goods: scarce resources that have opportunity costs (eg. clothing, food)

A sacrifice must be made to obtain it (eg. money, effort)

Scarce resources: factors of production that are limited in supply

Free goods: an abundant resource that has no opportunity cost (eg. seawater, sunlight)

No sacrifice must be made in order attain it

Purpose of economic activity

Produce goods & service to provide for wants & needs

Become more efficient to maximise economic welfare & satisfaction

Identify what goods should be produced & how/for whom they should be produced

Economic activity isn’t just production for recorded monetary gain

Includes DIY, subsistence farming, charity work, barter & illegal trade

1.2 Factors of production

Known as inputs

Building blocks used to produce output (g/s)

Eg. Creating a farm

Farmland (land)

Farmer’s physical labour (labour)

Tools used- shovels, tractors, ploughs etc. (capital)

Sale of the products in exchange for money; profit (enterprise)

Land

All natural resources & premises

Eg. coal, water, forests, minerals, oil etc.

Fixed supply

Quality

Soil type, fertility, weather etc.

Mobility

Some are geographically immobile; others are difficult (not impossible)

Many types of land have changed their use (occupational mobility)

Reward: rent

Labour

All human resources (mental & physical efforts of labourers)

Eg. farming (physical efforts), lawyer (thinking skills) etc.

Supply

Number of workers available-

Number of hours they work

Influenced by population size, no. of years of schooling, retirement age, structure of

population etc.

Skill, education & qualification of labour

High occupational mobility (ability to change jobs)

Geographic mobility (ability to move to a place for a job)

Reward: wages

Capital

Capital good: Human made good used in production of other g/s

Eg. hammers, computers, delivery vans, conveyor belts etc.

Becomes obsolete (replaced by more modern versions)

Demand for g/s

Success of business

No. of good quality products that can be produced using the given capital

Depends on nature/use of capital

Eg. office building is geographically immobile but occupationally mobile

Occupational mobility (machine can be used for several industries)

Reward: interest

Enterprise

Ability to take risks & run a business venture/firm

Organise all other factors of production & makes the necessary decisions

Risks: failure, losses, bankruptcy, rival producing better product, costs rising

Eg. earning a profit out of a sale of a product/service

Entrepreneurial skill (risk-taking, innovation, effective communication etc.)

Education

Corporate taxes

If taxes on profits are too high, no one will want to start a business

How well it is able to satisfy & expand demand in the economy in cost-effective

Highly mobile (geographically & occupationally)

Reward: profit
1.3 Opportunity Cost

Next best alternative that is forgone when making an economic decision

Cost of goods measured in terms of what must be sacrificed for other goods

Real cost of any economic decision

Main groups in the economy

Consumers

Workers

Producers

Govt

Financial institutions

Eg. Govt. could spend on 2 options: build a school or a hospital

Decides to build a hospital

Opportunity cost: education the children could have received

1.4 Production Possibility Curve (PPC)

A curve showing the maximum output of two types of products that can be produced at a
given time using all the resources available to their maximum potential

All points on PPC shows maximum production efficiency given the resources currently
available

Not possible to achieve output levels outside the PPC

Shows economic problem, opportunity cost, employment, specialisation & economic growth

Position of points

Inside PPC → Inefficient use of existing resources compared with what is possible (A)

Indicates under-utilised assets, unemployment

On the PPC → Efficient (B, D, C)

Outside PPC → Impossible (X)

Shifts along the PPC reflect an opportunity cost

Outward shift (right) → higher production possibility = efficiency

New technology

New resources (gold discovery)

Increases supply of labour (birth rate, migration)

Improved labour force (education, training)

Better use of labour (division of labour & specialisation)

More entrepreneurism

Inward shift (left) → lower production possibility = inefficiency

Natural disasters (ruined infrastructure, loss of population)

Low investment in new technologies (causes productivity to fall over time)

Running out of resources (particularly non-renewables eg. oil/water)

Opportunity cost is measured along the curve in terms of the sacrifice in the quantity of one
good when you choose to allocate more resources to an alternative good

The Allocation of resources

2.1 Microeconomics & Macroeconomics

Microeconomics: study of individual markets

Deals with individual firms, consumers, & markets making individual decisions within the
economy

Eg. effect of a price change on the demand/supply of a good

Macroeconomics: study of the entire economy as a whole

Deals with aggregates (total supply/demand for g/s in an economy at a particular time)

Eg. level of inflation, national spending, national output, economic development etc.

Decisions are made by govt in managing the economy as a whole

2.2 Role of markets in allocating resources

Resource allocation: the way in which markets decide what goods & services to provide,
how to produce them & who to produce them for

Price mechanism

Prices respond to shortages & surpluses

Price rises: consumers ration

Reduces amount they are willing/able to buy

Tells producers there is excess supply in the market

Gives suppliers incentive to decrease supply

Shortages causes price to rise

Surpluses causes prices to fall

Any place where buyers & sellers meet to exchange goods & services

G/s are bought/sold in a market at an equilibrium price

Producers produce goods that consumers demand the most

Market equilibrium

Demand = supply for a good

Demand changes (eg. income rises: people can afford more goods)

Supply changes (eg. weather impacts supply (drought) = decrease in crops)

Market is more likely to be in state of disequilibrium than equilibrium

Demand & supply constantly change

Mixed economy

Decisions are made by a combination of the govt & the private sector (market)

Eg. USA, India, China, Singapore, Japan etc.

2.3 Demand

Want & willingness of consumers to buy a good or services at a given price

Effective demand: willingness to buy is backed by the ability to pay for the purchase

Quantity demand: effective demand for a particular g/s

Eg. Want a phone but don't have the money to buy (demand)

Have the money to buy (effective demand)

Individual demand: demand from one customer

Market demand: total (aggregate) demand; sum of all individual demands of consumers
3

Demand curve

Shows effective demand

Law of demand

Increased price = decreased demand

Decreased price = increased demand

Slopes down from left to right

Demand increases as price falls (vice versa)

Movements are due to change in price

Price rise = contraction along demand curve (less demand)

Price falls = extension along demand curve (more demand)

Reasons for shifts

Consumer incomes
Increased income = people can afford more

Eg. bicycle replaced by motorcycle

Tax on incomes (more/less disposable income)

Rise/fall in the price of substitute (eg. tea & coffee)

Rise in the price of complements (eg. printers & ink cartridge)

Two products used/consumed together

As demand for 1 product increases, demand for other product increases

Successful/unsuccessful advertising

Weather

Legislation

Age distribution

Fashion/trends

Demand varies depending on age group

Eg. trainers are more popular amongst young people

Majority of population is young people = high demand

Example:

Diagram X:

Decreased price (80 to 60) = increased demand (300 to 500)

Extension in demand from A to B

Increase in price (60 to 80) = decrease in demand (500 to 300)

Contraction in demand from B to A

Diagram Y:

Increased demand (500 to 600)

Increased demand due to changes in other factors (excluding price) causes shift to the right
(A to B)

Diagram Z:

Reduced demand (500 to 400) without change in price

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

2.4 Supply

Want & willingness of producers to supply a g/s at given price

Quality supplied: amount of g/s producers are willing to make & supply

Market supply: amount of g/s all producers supplying the product are willing to supply

Supply curve

Slopes down from right to left

Higher supply = increase in price

Shows relationship between the amount offered for sale & the price

Law of supply

Increased price = increased supply

Decreased prices = decreased supply

Increase in price = extension in supply (increase in quantity supplied)

Decrease in price = contraction in supply (reduced quantity supplied)

Change in costs of production (COP)

Producers can produce & supply products cheaply

COP rises = supply falls

Changes in quantity of resources available

Resources rise = supply rises (vice versa)

Technological changes (higher productivity/output)

Profitability of other products

Producers might shift to producing more profitable products (reduces supply of initial
product)

Joint supply

When a product is made as a by-product of another

Regulation/bureaucracy

Increased number of producers in the market

Example

Increased price (60 to 80) = increased supply (500 to 700)

Decreased supply due to changes in price (without changes in other factors) causes a
contraction in supply

Increased supply without change in price (S to S1)

Due to changes in other factors (excluding price)

Decreased supply without change in price (S to S2)

Due to changes in other factories (excluding price)

2.5 Price determination

Market equilibrium price: price at which the demand & supply curve meet

Equilibrium quantity: quality demanded or supplied at the equilibrium price

Marginal benefit = marginal cost

Movements to a new equilibrium

Increased demand (demand curve shifts right)

Increased supply (supply curve shifts right)

Market disequilibrium

Disequilibrium price: price at which market demand & supply curves don’t meet 2.6 Price
changes

Causes: change in supply/demand

Consequences

2.7 Price elasticity of demand (PED)

Responsiveness of quantity demanded to a change in the price of specific item

Enables prediction of the effect on the price & quantity of a shift in the supply curve for the
product

Businesses identify PED to maximise revenues

Revenue = quantity sold × price per item

Govts use price elasticity to set tax rates on goods

Formula: ℎ (%)

ℎ (%)

Normally negative (price rises; demand falls)

Giffen goods (low income, non luxury eg. rice) have positive PED (price & demand rises)

Eg. Bus reduced fares from $1 to 90 cents. Daily demand for tickets rises from 10000 to
10500

1. Calculate % of quantity demanded

10 500−10 000 × 100 = 5%

10 000

2. Calculate % of change in price

100−90100 × 100 = 10%

3. Use formula

ℎ (%)

10%5% = 12 (inelastic demand)

4. Match the answer to the options in the table below

Types of PED

Price increases = Revenue increases

Price decreases = Revenue decreases

Shifts in the supply curve

Shift to left = Increased prices for inelastic goods (petrol) with few substitutes

Determinants of PED

Substitutes

Lack of substitutes = price inelastic (vice versa)

Can’t switch easily to/from rival producers (eg. water)

Due to lack of competition, lack of improved versions

Change in price will have a profound effect on demand

Time period

Short term alternatives aren’t found easily = price inelastic

Eg. price of petrol increases; people drive less, use public transport etc.

Purchase of product can’t be delayed = price inelastic

Eg. damaged roof has to be repaired despite rise in price

Proportion of income spend on commodity

Necessity goods (rice, water) have inelastic demand

Change in price won’t have any significant effect on its demand

Only takes up a small portion of consumers’ income

Luxury goods (cars) will have a PED

Takes up a large proportion of consumers’ income

Demand becomes more price sensitive as price increases (less affordable)

Addictive products (eg. cigarettes) have price inelastic demand

People find it hard to reduce demand if price rises

Importance for govt

Aids estimation of tax revenue (from indirect taxation)

Earn more on products with inelastic demand

Aids estimation of how much subsidy to give

Subsidy will have more impact on quantity if demand is elastic

Aids estimation of success in reducing consumption of a product

More successful if demand is elastic

May influence price govt charges for products it supplies

2.8 Price elasticity of supply (PES)

Responsiveness of the quantity supplied it to changes in its price

Raised prices give producers incentive to supply more

Normally positive (price increases, more supply)

Eg. Rise in price of rice from $1 to $1.20 per bag = increased supply by farmers from 1,000
to 1,300 bags per month

1. 1300−1000 × 100 = 30%

1000

2. 120−100 × 100 = 20%

100

3. 3020 = 1. 5 (elastic supply)

4. Match answer to the options in the table below

Inelastic supply

<1

Supply is relatively unresponsive to a change in demand

Perfectly inelastic supply

Supply doesn’t change as price changes

Supply is fixed

Determinants of PES

Time of production

Short production time = elastic PES

Non-perishables = elastic PES

Products made with raw materials in short supply = inelastic PES

Not enough resources = harder for producers to adjust to price change

Switching between alternative production = elastic PES

Eg. making football shirts for a different team

Spare capacity = elastic PES

Low COP = elastic PES

Ease of entry into the market: barriers to entry

Eg. foreign workers into labour markets

2.9 Market economic system

An economic system where economic decisions & pricing of g/s are guided by private
producers & consumers with little governmental intervention

Private sector

Private enterprises (retail, manufacturing, local services)

Has wider social concerns (eg. providing essential services)

Anticipate customer requirements & respond to signals provided (demand & supply)

Public sector

Govt (national & local)

Jobs: doctors, police, teachers & civil servants

Features

All resources are owned & allocated by private individuals

No govt control exists

Profit incentive
Demand & supply fixes price of products (price mechanism)

Produces most demanded goods for which people spend a lot

Uses cheapest yet efficient combination of resources (capital/labour) to maximise profits

Produce for people who are willing & able to pay for goods at a high price

Examples: China, USA, Japan

2.10 Market failure

When price mechanism fails to allocate resources effectively, social costs are greater than
social benefits

Social costs = private costs + external costs

Total costs to society

Social benefits = private benefits + external benefits

Total benefits to society

Public goods: Goods that can be used by the general public

Consumption can’t be measured/charged for a price (market economy doesn’t produce)

Characteristics

Non-excludability: free rider principle can’t confine benefits to those who have paid for it

Non-rivalry in consumption: consumption by one person doesn’t reduce availability to

another person

Eg. street lights, roads, defence, fire brigade etc.

Merit goods: Goods whose consumption creates a positive effect on the community

Eg. schools, hospitals

Demerit goods: Goods whose consumption creates a negative effect on the community

Eg. drugs, alcohol

External costs: Negative impacts on society due to production/consumption of g/s

Eg. pollution from a factory

External benefits: Positive impacts on society due to production/consumption of g/s

Eg. better roads for society due to opening of a new business

Private costs: costs to the producer/consumer due to production/consumption

Eg. COP, prices

Private benefits: benefits to producer/consumer due to production/consumption

Eg. better immunity received by a customer when he receives a vaccine

Causes

Externalities

Consequences of an economic activity

Net benefit of an economic activity: (private benefits + external benefits) - (private costs +
external costs)

Favourable effect: Positive externalities

New factory provides local jobs

Social benefit = Private benefit + External benefit

Marginal social benefit is less than the marginal private benefit

Unfavourable effect: Negative externalities

Eg. pollution of surrounding crops by bees kept for honey

Social cost = Private cost + External cost

Marginal social cost is more than marginal private cost

10

Occurs outside the market

Affects individuals not directly involved in production/consumption

Results in ‘wrong amount’ of a g/s being produced/consumed

Overprovision of demerit goods

Underprovision of merit goods

Lack of public goods

Risk: wouldn’t be produced at all by public sector

Govt decides what level of public goods to supply to society

Govt estimates social benefit from consumption of public goods

Not normally provided by the private sector (can’t supply for a profit)

Public goods not supplied at all = complete market failure

Immobility of resources

When resources aren’t used to the maximum

Immobility of factors of production

Unequal distribution of income & wealth

High inequality = alienation & encourages crime (negative externalities)

Information failure

Information between consumers, producers & govt aren't efficiently communicated

Consumers don't realise how good something is for them so they under demand

Eg. a cosmetic firms advertises its products as healthy when it is not

Abuse of monopoly powers

Use their powers to charge consumers high prices

Supply is determined by firm not consumers

Consumers have no choice but to buy from them

Social surplus (consumer surplus + producer surplus) is maximised at equilibrium

Monopolist produces below equilibrium = reduced consumer surplus & welfare loss (extra
benefit exceeds extra cost but monopolist doesn’t supply them)

Firms don’t produce at a minimum cost = inefficient use of resources

Loss of economic & social welfare

Inefficient allocation of resources

Overproduction/consumption of demerit goods

Overconsumption of goods with external costs

Activities with spillover effects (eg. pollution) will be overconsumed in a market economy
(misallocation of resources)

Underproduction/consumption of merit goods/goods with external benefits

Overproduction of negative externalities

Underproduction of positive externalities

Inappropriate pricing due to information failure

Market power = high prices & low output

2.11 Mixed economic system

An economy where both elements of the market economy and govt intervention co-exist

Eg. almost every country

Both private & public sector exists

Planning & final decisions are made by govt

Progressive taxes reduces inequality

Govt regulations

Taxes on demerit goods

11
Govt provision of public goods

Market system determines the allocation of resources owned by it

Able to make profit

Freedom to set up business

Prices determined by market forces

Market failure justifies govt intervention

May intervene to break up monopolies by encouraging competitors to enter a market

Use taxes to penalise businesses that abuse the market

Eg. taxing companies that create pollution

Too much govt interference = govt failure

Eg. Taxes are too high; discourages beneficial business activity

Govt microeconomic policies

Maximum prices
Set to control an increasing tendency of price

Maintained below equilibrium

Makes sure price is less than market clearing price

At max price, demand is greater than supply

Leads to ques & consumers unable to buy

Encourages black markets

Govt has to ration g/s; increases supply

Minimum prices

Set to control decreasing tendency of price

Leads to a surplus

Govt needs to buy surplus & store it

Impose quotas on producers to decrease quantity of the good put onto the market

Indirect taxation
Paid by an intermediary (business) who passes the tax to an end payer

Burden/some of burden of tax can be passed on

Levied on g/s (cost to a business)

Eg. VAT, sales tax on alcohol, cigarettes

Sales tax: indirect tax on g/s

Should be designed to support govt objectives without discouraging effort/initiative

Uses

Raise revenue

Discourage/encourage activities

Eg. high taxes on luxury items; low taxes on children’s clothes

Gives consumers greater choice

Takes control of who purchases a certain kind of item

dissuade consumers from buying demerit goods

Incidence of tax

Refers to who pays the majority part of the tax

Depends on product’s PED

PED determines how much revenue govt is able to collect from indirect sales tax

Increased tax = supply curve shifts to the left

Elastic demand means sellers can raise prices

Results of high taxes

Falling sales & income

Rising unemployment

Workers laid off; businesses close

12

Incentive for businesses & individuals to avoid paying taxes

Subsidies
Money granted by govt to keep price of goods down & maintain supply

Incentives provided by govt to individuals/households to carry out desired activities

Ensures availability of necessary g/s for the community

Eg. Govt grants farmers subsidies to purchase seeds & fertilisers

Promotes greater supply of crops

Effect: Pushes supply curve to the right

Price decreases

Quantity traded increases

Advantages

Encourages production of goods of national importance

Encourages development of new products & industries

Provides support for declining industries that are major employers of labour

Protects domestic industries against foreign competition

Disadvantages

Cost to the govt

May encourage firms to be inefficient (rely on govt aid)

Nationalisation

Occurs when govt of the country takes over the ownership/running of industries that were
previously in the private sectors

Sets up a public corporation to run the industry on behalf of the govt

Privatisation

Govt sells off industries & activities previously run by public corporations to the private
sector

Direct provision

Govt provides public & merit goods directly to users for free

Eg. free primary & secondary education

Regulation
Rules imposed by the govt backed up by penalties to influence the behaviour of firms &
individuals

Eg. Setting up a new business

Paperwork, rules protecting shareholders, filing of tax returns

3.1 Money & banking

Money

Anything that is generally accepted for payment

Forms

Past: barter system

Exchanging g/s for another g/s

Problem: double coincidence of wants

2 people each require what the other is offering

1 party may not have enough goods for a fair trade

Present: currency notes, coins & bank cards

Functions

Medium exchange of goods & services

Accepted as a means of payment for most goods

Unit of account (worth)

Price of an item can be measured in terms of how many units of currency it’s worth

Allows for comparison of the worth of the g/s

13

Store of value

Can be saved; keeps its value

Enables future use

Standard for deferred payment

Borrowers are able to borrow money & pay it back at a later date

Acceptability
Everyone must accept it as a form of payment at its set value

Portability

Easily carried

Can’t be bulky/heavy

Durability

Must last a long time/withstand usage without devaluing

Divisible

Must be easily divided in small quantities

Scarcity

Must be limited in supply

Uniform

Homogeneous

Commercial banks
Private sector banks aiming to make a profit by providing a range of banking services

Provides services to businesses & households

Acts as intermediaries between borrowers & lenders

Govt can control the level of bank lending through its central bank

Eg. HSBC

Keeps money safe

Bank’s vaults are more secure than a safe deposit box in a private house

Accepting deposits of money & savings

Savings accounts: designed to encourage regular savings

Interest rates are higher for than for a current account

Aid customers in making & receiving payments

Current accounts: enables an account holder to deposit/withdraw sums

make payments using their bank card

Pays interest on negative balances

Easy & immediate access to money

Giving loans to businesses & individuals

Loans: fixed sum of money advanced to a borrower in return for repayment of the loan with
interest

Overdraft: Taking out more than what has been put into the account

Credit card: enables users to buy goods & pay for them later

Mortgage: borrowing to purchase land/property

Buying & selling shares on customer’s behalf

Providing insurance

Protection in the form of money against damage/theft

Providing financial planning advice

14
Central banks

Govt owned banks that provide banking services to the govt & commercial banks

Eg. Bank of England (UK)

Issues notes & coins for the nation’s currency

Sets the interest rates

Reduction

Borrowers find borrowing cheaper & borrow more

Increased spending

Increase

Savers save more

Borrowers borrow less

Spending falls

Manages all payments relating to the govt (eg. govt tax revenue, price stability)
Manages national debt

National debt: total amount govt owes lenders

Can issue & repay public debts on the govt’s behalf

Helps govt to borrow money

Issues govt bill & bonds

Bonds: official promises to repay money in the future with interest

Supervises & controls all the other banks in the whole economy

Holds their deposits & transferring funds between them

Lender of ‘last resort’ to commercial banks

When other banks are having financial difficulties

Central bank can lend them money to prevent bankruptcy

Manages the country’s gold & foreign currency reserves

Reserves are used to make international payments

Adjusts their currency value (exchange rates)

Country’s gold is deposited & their own currency within the IMF

Operates the monetary policy in an economy

Determines the quantity of money in the economy & the interest rate

Helps the govt to create/manage monetary policy

Helps manage the international financial system

International Monetary Fund (IMF) set up to provide supervision for the world’s banking
system

Lends money to govts to help them during financial crisis

Central banks work with IMF to create financial stability

3.2 Households

Spending (consumption)

Exchanging money for goods

Immediate consumption (eg. food) or consumer durables (eg. furniture)

Motives

Consumption; satisfy needs/wants

Factors affecting consumption

Size of income

Higher disposable income = higher consumption

High income household: Not likely to spend all of their income

15

Middle income household: May spend most of their income

Low income household: Likely to spend all of their income

May not cover all necessities

Consumer confidence

If consumers are confident about job security/future income they may be encouraged to
spend more
Interest rates

High interest rates (provided by banks) are high = consumers spends & borrows less

Saving

Income set aside for a purpose

Motive

Putting money aside to make a purchase at a later date

Factors affecting savings

Saving for consumption

Save money to make bigger purchases in the future (eg. car, property)

Higher disposable income = higher chances of saving

High income household: Able to save some of their income

Middle income household: May be able to save a little

Low income household: Won’t be able to save

Higher interest rates = higher chances of saving

Longer you save; higher the interest received

If the consumer isn’t confident about job security & future income they may save more now

Saving ratio increases

Availability of saving schemes

More attractive schemes that benefit consumers = more savings

Borrowing

When an individual receives money from another individual/financial institution with the
intention of repaying the money

To be able to spend more than you receive in income to meet your wants/needs

Factors affecting borrowing

Interest rates: Cost of borrowing

High interest rates = high reluctance to borrow

Wealth
Banks are more willing to lend to high income earning people

More likely to repay the loan

Poor are able to borrow less

High income household: Unlikely to need to borrow

Middle income household: Likely borrowing to buy some consumer durable items

Low income household: Have to borrow to meet their needs

How confident people feel about the financial situation in the future

Eg. Inflation in the future = more current borrowing to make big purchases in the future

3.3 Workers

Choice in occupation

Wage factors

16

17
● Doctors have a limited inelastic supply ○ Primary/secondary/tertiary

■ Primary sector (agriculture/fishing/forestry) earn the lowest wages ● Majority of

their work is unskilled

● Output has low sales value

■ Tertiary sector (finance/communications/insurance)

● Requires higher levels of education (more skill)

○ Private sector/public sector

■ Earn different wages

■ Public sector (eg. teachers, nurses, police, civil servants)

● Less salary

● Higher job security

● Provides pension

■ Private sector
● Have higher earning potential

○ Private firms strive for profit

maximisation

● Lower job security

○ Gender

■ Gender pay gap = comparison between the wages of men & women (%)

In most countries, men get higher pay than women

Women take career breaks to raise children

Causes less experience & career progress

Most women work part-time than full time

Flexible working hours fits with childcare arrangements

Discrimination at work

Division of labour/specialisation

Division of labour: workers being expert in a particular production process

Eg. Supermarket cashiers, waiters & factory workers who operate machinery

Specialisation of labour: workers being expert in a particular profession

Eg. landscape architect, psychiatric nurse, corporate lawyer

Division of labour for workers

18

Division of labour for the economy

Organisation which aims to protect the interests of its worker members

Eg. terms & conditions of employment, including pay

Aim: improve wage rates, working conditions & other job-related aspects of workers

Members pay subscription fee to finance administrative/legal expenses to operate the

union

Leaders meet regularly with govt officials & employer representatives

Closed shop: an agreement that all workers must be members of the same trade union
Negotiations improvements in non-wage benefits with employers

Defending employees’ rights

Protecting employment

Improving working conditions (eg. better working hours, better working conditions)

Improving pay & other benefits

Supporting workers who have been unfairly dismissed or discriminating

Developing the skills of members by providing training & education

Providing recreational activities for the members

Industrial actions (strikes, overtime ban etc.) when employers don’t satisfy needs

Influencing govt policy

When trade unions argue for higher wages & better working conditions

Prices are rising (inflation)

Cost of living increases when prices increase & workers demand higher wages
Sales & demand of the firm has increased

Workers in other firms earn a higher wage

Increased in the member’s labour productivity

Industrial action

Measures taken by a trade union due to major disagreements/disputes with their employer

Eg. firms don't satisfy trade union’s wants or refuse to agree to their terms

Types of industrial action

Overtime ban: workers refuse to work more than their normal hours

Go-slow: workers deliberately slow down production (firm’s sales & profits decrease)

Strike: workers refuse to work & protest outside their workplace to stop deliveries

Factors affecting strength of trade unions

19

○ Size of membership affects funds available (harder to replace workers)

○ Skills/qualification of workers (more skilled = harder to replace)

○ Elasticity of demand for workers is elastic = unsuccessful in raising wages ○ Wages are
small proportion of total costs = greater bargaining strength

○ Union success in essential industries (can’t afford to be interrupted by industrial

action)

○ Quality of leadership (skilful leaders = effective negotiators)

○ Growth in manufacturing jobs in the country

■ Manufacturing industry is unionised (workers receive low pay & poor working
conditions)

○ Widening wealth gap & higher cost of living

■ Causes workers to petition for higher wages & better working conditions ○ Govt
legislation wanting to reduce trade union influence

○ Growth in part-time employment (less likely to join a trade union)

○ Growing number of firms independently agreeing to fairer terms & conditions

without negotiating with trade unions

■ Part of their corporate social responsibility

○ Low unemployment rate = high demand for workers

○ Increased number of self-employed people (not trade union members)

● Trade union for the workers

20

3.5 Firms

Classification of firms

Chain of production (all interdependent)

Primary

Economic activity involving extraction of raw natural materials

Eg. Agriculture, mining, fishing etc.

Secondary

Economic activity dealing with turning raw materials into finished goods

Eg. Construction, manufacturing, utilities etc.

Tertiary
All economic activity offering intangible goods & services to consumers

Eg. lawyers, financial advisers, doctors etc.

Part of the economy run/managed by the govt

Eg. defence, arms, nuclear industries

Don’t have a profit motive

Aim: provide essential services to the economy it governs

Part of the economy owned by private individuals & organisations

Relates to all firms owned & run by private individuals

Aim: making profit

Their products are those that are highly demanded in the economy

Size

Number of employees

Small business < 50 employees

Market share

Determined by the % of the market the business is responsible for

Market capitalisation of a firm/value of capital employed

Stock market value of a business

Sells shares on stock exchange to raise finance

Govt sells govt bonds on stock exchange to raise finance

Stock exchange provides destination for savings (investment/disposable income)

Encourages MNCs (strong financial sector)

Sales revenue of a firm

Unit price×quantity sold

Small firms

Reasons for existence

Size of the market

When there is a small market for a product, no firms will want to expand

Local market (eg. local hairdresser)

Final product may be expensive items that only require a small-scale production

Access to capital is limited (owners can’t grow the firm)

Owner prefers to stay small (don’t want to take risks by expanding)

Small firms can cooperate

Can lead to setting up jointly owned enterprises

Allows for the similar benefits that a large firm would have

Govts will help small firms

Important providers of employment to the local economy

Eg. some areas, small local shops will provide jobs where larger businesses won’t

Innovations takes place in the production process

21
Challenges facing their existence

Inability to supply on a large scale

Growth of firms

Internal growth (Organic growth)

Expanding scale of production of the firm’s existing operations using their own resources

Eg. franchising, increasing market share, employing more workers

Finance: profits earned & additional capital from the owner

Enables owner to keep control of their business

Can be slow & puts pressure on the owners

External growth (Inorganic growth)

Involves 2 or more firms joining together to form a large business

Integration: businesses joining together in the form of a takeover/merger

Finance: selling shares

Carry out external growth to:

Buy new brands where sales are likely to be high

Acquire new inventions/technologies

Break into new markets (eg. other countries)

Enables rapid expansion

Allows business to gain more skills/knowledge

Risky; existing business may join with others they have little knowledge about

Done by mergers or takeovers

Merger: Owners of 2/more companies agree to join to form a firm

Takeover/acquisition: company buys enough shares of another firm’s that they can take full
control

Can happen without the owner’s agreement

22

Economies & diseconomies of scale

Economies of scale: the advantages of a larger firm over a smaller one

23

Enables larger output and reduces avg costs of production

Internal economies: advantages that a firm gains from its own growth

Purchasing/Commercial advantages

Large firms can buy raw materials in bulks (trade discount)

Technical advantages

Production becomes more efficient

Using large scale capital equipment

Financial advantages

Banks willing to lend money to large firms (more financially secure)

Borrow at lower interest rates

Managerial advantages
Attracts more highly skilled employees (high salaries)

May have access to cheap labour abroad

Risk-spreading advantages

Market diversification: High output; can sell into different markets

Product diversification: producing & selling a variety of products

Supplier diversification: Using several different suppliers in case one is unable to supply on
time

Production diversification: having several different production plants

External economies: advantages gained from the growth & improvement of a firm’s
industry & locality

Access to skilled workers

Firms can recruit workers trained by other firms

Reduces costs; increased efficiency

Ancillary firms
Firms that supply/provide materials/services to larger firms

Reduces costs; services are cheaper than other firms

Proximity to related firms

Indicates they share an enhanced reputation & customer base

Eg. clothing manufacturers will benefit from having firms that produce zippers, buttons,
thread etc.

Shared infrastructure

Development in industry’s infrastructure or economy can benefit large firms

Eg. more roads/bridges can cut transport costs

Diseconomies of scale: When a firm grows too large & avg costs start to rise

Internal diseconomies of scale: All factors that raise a firm’s COP

Managerial diseconomies

More layers of management in a large firm

Takes longer to make decision

Communication problems

Communication may be indirect

Messages may be misinterpreted

Labour diseconomies

Workers have low morale (demotivated)

Reduces labour productivity/efficiency

Poor industrial relations

Industrial action (eg. strikes) due to time taken to address workers’ grievances (more
people to argue with)

Technical diseconomies

24

Large scale production becomes difficult to organise as effectively as smaller scale

productions

Less likely to receive govt support (subsidy)

Higher taxes (adds to avg costs/corporation tax is progressive)

External diseconomies of scale: Costs of production rise due to an industry growing in size
causing negative externalities

Shortage of resources

Land/labour with relevant skills inflated by competition amongst firms to acquire these
resources

Pollution: social costs created due to growth in firms

Firms & production

Demand for factors of production

Influences

Demand

More g/s demanded = more factors of production demanded to satisfy the demand

Price

Higher cost of factors of production = lower demand

Want to reduce costs & maximise profits

Availability

Firms will demand factors that are easily available/accessible

Greater availability = lower cost = higher demand

Productivity

Better quality resources have higher prices

Labour intensive production

Labour intensive production: more labourers are employed than the other factors

Production is dependent on labour

Suitable for producing products that are highly customised (eg. tailor made suits)

Capital intensive production

Production requires a high level of capital investment compared to labour cost

More capital is employed than other factors

Chosen over labour when:

Cost of labour is high

Mass-market production

Enables more output quicker

Unit costs of production is low

25

Technical economies of scale

Increased efficiency can reduce avg costs

No intuitive/creative power to improve production

Production & productivity

Production: total output of goods & services in the production process

Productivity: Measure of efficiency found by calculating amount of output per unit of a

factor input

Factors influencing productivity

Division of labour
When tasks are divided among labourers

Skills & experiences of labour force

More skilled = more productivity

Workers motivation

More motivated workforce = higher productivity

Better pay, better working conditions, reasonable working hours etc.

Quality of factors of productions

Replacing old machinery with new ones = increased productivity

Training the work = increased productivity

Investment

Introducing new production processes

Reduces wastage, increases speed, improves quality & raises output

Competition
Rivalry gives firms more incentive to be efficient/innovative

Firms’ costs revenue & objectives

Fixed & variable costs

Costs of production: payments made by firms in the production process

Eg. wages/salaries, advertising expenses, rent paid

Fixed costs (FC): Any costs a firm has to pay that do not vary with the level of output (eg.
rent, rates)

Variable costs (VC): costs that change as the level of output changes

Higher output = higher total variable costs

Total & avg costs

Total costs: the sum of all fixed & variable costs of production

Avg costs =

Avg fixed costs (AFC): a firm's fixed costs per unit of output
Falls as they are spread over larger quantities of output

TFC: sum of all the different types of fixed costs at different outputs

Avg variable costs (AVC): the variable cost per unit of output

May fall/rise with output

TVC: sum of all the variable costs at different outputs

Revenue

Total income a firm earns from the sale of its g/s

More sales = more revenue

Total revenue (TR): the amount payable to a firm from the sale of its g/s

TR = Quantity sold×Price

26

Avg revenue (AR): typical price received from the sale of a good/service

AR =

AR = price
Objective of firms

Survival

Have to be profitable to survive

To achieve survival

Firms could decide to lower prices

Would have to forsake other objectives (i.e profit maximisation)

Social welfare

Business activity with concerns for the quality of life of those in society

Socially responsible businesses try to improve the treatment of

workers, customers, shareholders & natural environment

Growth

Business will aim for growth/expansion once the business has surpassed its survival stage

Aimed to increase the firm’s sales revenue & market share

Measured by sales/output

Larger businesses can ensure greater job security & salaries for employees

Can benefit from higher market share & economies of scale

Profit maximisation

Profits are required for further investment into the business & payment of return to the
shareholders/owners of the business

The gap between total revenues & total costs is at the greatest

Profit = total revenue - total costs

Provides incentive for entrepreneurs to take risks

Market structure

Competitive markets

Markets with an immense degree of competition

Eg. wet markets in Asia

High degree of competition in a market benefits consumers

Receive higher-quality products & good customer services

Greater choice, higher output & more competitive prices

Factors affecting competition

Firms in competitive markets are price takers

Firms that set their price according to the market price rather than setting their own prices

Products sold may be identical

Some highly competitive firms don’t focus on quality as a form of product differentiation

Choice

Some highly competitive firms focus on producing differentiated products

Eg. firms may use branding, different product designs, colours, quality, slogans etc.

Profit

Both buyers & sellers have easy access to information about the product & prices being
charged by competitors
27

If there are many rivals in the market, profits will be low for each firm

Perfect competition

Many buyers/sellers; no single buyer/seller can influence the price

No barriers to entry/exit

All products are the same; products of different producers are perfect substitutes for each
other

Perfect knowledge; buyers/sellers fully aware of price & profits earned in the market

Monopoly markets

Pure monopoly: only one firm supplies the whole market

Single supplier (eg. Indian Railways)

Sole supplier of a product in a given market

Due to the lack of substitute products caused by barriers to entry into the market

Price marker
The monopolist has significant market power as it controls enough of the market supply

Can charge higher prices & produce lower output than if it faced competition

Imperfect knowledge

Monopolist is able to protect its prestigious position

Consumers & rivals have imperfect knowledge

Result of monopolist’s ability to protect its trade secrets

High barriers to entry

Obstacles prevent other firms from entering the market

Eg. economies of scale of existing firms, ownership of essential resources, existence of

intellectual property rights, legal barriers

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4.1 Role of the Govt

Locally
Establish local business taxes

Provide a number of local services for businesses & citizens

Establishes regulation governing what takes place in local regions

Eg. providing permits & licence to trade/carry out specific business activities

Invests in local infrastructure

Eg. business parks for rent

Taxes local businesses & provides tax incentives

Eg. low tax rates for start up firms

Carries out marketing activities

Nationally

Central govt establish national business taxes

Provides services nationally for businesses & citizens

Responsible for the overall management of their economies through a range of fiscal &
monetary policies
Manager of the national economy

Govt minister is responsible for economic policy

Will work closely with the central govt

Makes decisions about how to achieve its macroeconomic aims

Fiscal policy

How to raise money through tax/other sources

How much of its annual budget to spend

Monetary policy

May instruct the central bank/monetary authority to make decisions about interest rates &
money supply to influence economic activity

Supply-side policies

To increase productivity & efficiency in the economy

Policies to protect the environment

Internationally

Govts engage interactions of an economic nature

Trading interactions

Countries from trading groups (eg. EU, NAFTA)

Enables freer trade to take place within a given group of countries

Borrowing & financing interactions

Countries form international groups (eg. IMF, World Bank)

To make international payments & enable countries to borrow from a central pool to
finance short term/long term debts

Sustainability interactions

Countries work together at inter-governmental level to create treaties & agreements that
support sustainable growth

Eg. Kyoto Protocol - governs poisonous emissions into the environment

4.2 Macroeconomic aims of the govt

● Macroeconomic aims
○ Economic growth

■ An increase in a country’s real GDP over time

■ Recession causes firms revenues to fall, less govt spending & decreases income &
living standards

■ Economic growth rate: 2− 1 × 100 = %

More output = more economic growth

Govt can encourage by helping private businesses grow (eg. low business taxes)

29

Has to be sustainable

Low unemployment

Higher employment leads to a greater GDP

Low unemployment increases the standard of living

Stable prices/low price inflation

Inflation: sustained rise in the general price level in an economy

Measured using consumer price index (CPI)

To control economic activity

Price rises too quickly

Reduces people’s purchasing power (can buy less with the money they have)

Hardships for the poor

Increased business costs

Exports will be less competitive

Local products will be more expensive than foreign goods

Govt can control inflation by reducing spending/raising taxes when prices start to rise

Balance of payments stability (BoP)

A financial record of a country's transactions with the rest of the world for a given time
period

Export their products overseas & receive income & investment from abroad

Exports > Imports = surplus in BoP

Import g/s from other economies & make investments in other countries

Exports < Imports = deficit in BoP

All economies try to balance the inflow/outflow of international trade/payments

Deficits may lead to :

Running out of foreign currency to buy imports

Value of its currency may fall against other foreign currencies

Imports become more expensive

Govt can encourage exports & discourage imports

Redistribution of income

Macroeconomic aim of achieving greater equality in the distribution of income in an

economy

Taking income from one group (rich) and giving it to another group (poor)

Progressive taxes on the rich to finance welfare schemes for the poor
Widening inequality = higher level of poverty

Poverty & hardship restricts the economy from reaching its maximum productive capacity

Conflicts between govt aims

Full employment vs Stable prices

Economy expands & more people are employed

People have more money to spend

May lead to demand-pull inflation

Demand in the economy is higher than supply

May lead to cost-pull inflation

Full employment makes it harder for firms to attract skilled labour

Could lead to wage inflation

Low rates of unemployment will boost incomes of businesses & workers

Rise in income means higher demand & consumption in the economy

30

Causes firms to raise their prices; leads to inflation

Economic growth vs Balance of payments stability

Incomes rise due to economic growth & low unemployment

People will import more foreign products & consume less of domestic products

Cause a rise in imports relative to exports & a deficit may arise in BoP

If economic growth is caused by higher consumer spending, it may cause a deficit in the
country’s BoP

As consumption rises, there tends to be an in expenditure on imports

If economic growth has caused an increase in inflation, making the country's exports less
price competitive

Full employment vs Balance of payment stability

Employment level increases, people become wealthier & buy more imports

Leads to issues with BoP

Wages tend to rise as an economy reaches the level of national income at which there is full
employment

Contributes to cost-push inflation, making the country’s exports less competitive

Full employment is likely to worsen the countries BoP

4.3 Fiscal Policy

Fiscal policy: a govt policy which adjusts govt spending & taxation to influence the economy

Used to redistribute wealth & income

Elements of fiscal policy

Budget: financial plans in terms of planned revenues (eg. tax revenues) and expenditure (eg.
healthcare)

Budget deficit: When govt spends more than it collects from revenues

Budget deficit = Total govt expenditures - total govt income

Budget surplus: When there is more govt revenue than is spent

Budget surplus = Total govt income - total govt expenditures

Balanced budget: When the govt manages to balance its revenues & its spending
Govt spending

Areas

Communications

Debt interest

Defence

Healthcare

Reason for govt spending

Enables direct intervention into the economy

Supply goods & services that the private sector would fail to do

Eg. public goods, merit goods & welfare payments & benefits

Achieve supply side improvements in the economy

Eg. spending on education & training to improve labour productivity

Reduce the negative externalities (eg. pollution controls)

Subsidise industries which may need financial support

Not available from the private sector (eg. agriculture & related industries)

Help redistribute income & improve income inequality

Inject spending into the economy to aid economic growth

Effects of govt spending

Increased govt spending = higher demand in the economy

Aids economic growth but can lead to inflation if increasing demand causes price to rise

31

Increased govt spending on public goods & merit goods

Increased productivity & growth

Increased govt spending on welfare schemes & benefits

Will increase living standards & help reduce inequality

Too much govt spending causes ‘crowding out’ of private sector investments
Private investments will reduce if the increase in govt spending is financed by increased
taxes & borrowing

Classification of taxes

Tax: Govt levy in income or expenditure

Main source of govt revenue

Reason for taxes

Source of govt revenue

Redistribute income

Levy taxes from those who earn higher incomes & have a lot of wealth

Used to fund welfare schemes for the poor

Reduce consumption & production of demerit goods

Higher tax is levied on demerit goods (alcohol) to drive up its prices/costs to discourage its
consumption/production

Protect home industries

Taxes are levied on foreign goods entering the market

Makes foreign goods more expensive in the domestic market enabling domestic products to
compete with them

Manage the economy

Lowering taxes increases aggregate demand & supply

Encourages growth

During inflation, govt will increase taxes to reduce demand & bring down prices

Direct taxes: a tax that is paid from the income, wealth or profit of individuals & firms

Eg. Income tax, corporation tax (tax paid on company profits), inheritance tax

Burden of tax can’t be passed

Indirect taxes: expenditure taxes imposed on spending on goods & services

Eg. VAT (increasing VAT increases the price of goods & reduce demand)

Progressive taxes: a tax where the rich pay a higher proportion of their income than the
poor

Eg. income tax, capital gains tax

Regressive taxes: a tax where the poor pay a higher proportion of their income than the rich

Eg. airport tax takes up a larger portion of a poor person's income when compared to the
rich despite paying the same amount

Proportional tax: the percentage paid stays the same, irrespective of the taxpayer’s level of
income, wealth or profits

Eg. Sales tax (VAT/GST)

Principles of taxation

Equitable (fair)

Be based on the tax payer’s ability to pay

Economical

Be easy & cheap to collect

To maximise the yield relative to the cost of collection

Convenience

Be convenient for the taxpayer (encourage payment)

Certainty

Taxpayer should know what, when, where & how to pay the tax

To limit tax evasion

32

Efficiency

Attempt to achieve its aims without any undesirable side-effects

Eg. higher tax rates may = disincentive to work

Slows down the economy & reduces long-term tax revenues

Flexibility

To adapt to a change in the economic environment without requiring the rewriting of tax
legislation

Impact of taxation on

Have less disposable income after income tax is deducted

May lower levels of spending/saving

May reduce incentive to work if income is low

Will have less incentive to produce if corporate taxes are too high

Raises income for the govt

Depends what govt spends the money on

Eg. healthcare, education, govt debt repayment etc.

Economy

Falling sales & falling income; businesses close

‘Undercover’ economy involving tax evasion

When business & individuals avoid paying taxes

Fiscal policy & govt aims

Expansionary fiscal policy (govt revenue falls)

Stimulates the economy by increasing govt spending or lowering taxes

Boosting GDP & reducing unemployment

Increasing govt spending = more public jobs

Lowering taxes = increased disposable income & consumer spending

Stimulates growth, employment & helps increase prices

Contractionary fiscal policy

Reduces the level of economic activity by decreasing govt spending or raising taxes

Low govt spending = less public jobs

Higher taxes = decreased disposable income & consumer spending

Helps control inflation resulting from too much growth

Budget position Impacts

Economy hasn’t reached its full potential

Reducing the overall level of demand = reduction in supply & output

Use expansionary fiscal policy

Effects of fiscal policy on govt macroeconomic aims

Economic growth

33

Govt capital expenditure on infrastructure will boost investment in the economy

Lower corporation taxes attracts foreign direct investment (FDI) into the country

Increases the economy’s potential output

Low inflation (stable prices)

Lower taxes (higher FDI) can boost the productive capacity of the economy in the long run

Helps to keep the general price level low

Cuts in income tax are used to create incentives for people to seek employment & work
harder

Govt support for start-ups (subsidies/tax concessions) create incentives for entrepreneurs

Healthy BoP

Low tax helps keep domestic firms competitive (benefits exporters)

Govt can subsidise domestic industries to improve their international competitiveness

Use of progressive taxes & govt spending on welfare benefits, education & healthcare

4.4 Monetary Policy

Money supply: the amount of money in the economy at a particular point in time (eg. coins,
banknotes, bank deposits & central bank reserves)

Monetary policy: the use of interest rates, exchange rates & the money supply to control
macroeconomic objectives & to affect the level of economic activity

Interest rates: the price of borrowing money

Expansionary monetary policy

Increase money supply = decreased interest rates & more spending

Boosts economic activity

Contractionary monetary policy

Decrease money supply = increased interest rates & less spending

Slows economic activity

Reduces overspending & limit investment in the economy

Monetary policy measures

Changes in interest rates

Use of interest rates to influence the level of economic activity

Eg. higher interest rates reduce overall spending in the economy

Changes in money supply

Govt can control the money supply in order to influence the level of economic activity

Eg. allowing commercial banks to lend more money will boost consumption & investment
expenditure in the economy

Changes in foreign exchange rates

Foreign exchange market has a direct impact on the domestic money supply

Eg. domestic customers need to purchase foreign currency in order to buy imports

Buying & selling of foreign currencies will affect the economies money supply

Effects of monetary policy on govt macroeconomic aims

Low interest rates can achieve economic growth

Lower savings, more consumption & more investment in the economy

Lower interest rates achieves economic growth

More spending/investment in the economy = more jobs

34

Low inflation

Lower interest rates = higher consumption & investment expenditure

Increase the productive capacity of the economy

Higher interest rates = limit consumption & investment to control inflation

Lower exchange rates = improvement in the international competitiveness of the country

Improves the BoP

4.5 Supply-side policy

Govt attempts to increase productivity & increase efficiency in the economy

PPC shifts outward

Supply-side policy measures

Education & training

Improves the quality & quantity of labour to increase the productive capacity of the
economy

Govt may spend money directly on providing education & training or provide incentives for
private firms to supply these services

Labour market reforms

Making laws that would reduce trade union powers reduces business costs & increases
output

Minimum wages could be reduced/ removed

Allows more jobs to be created

Welfare payments (eg. unemployment benefit) could be reduced to motivate people to look
for jobs rather than rely on benefits alone

Increases incentive to work & invest

Making labour markets more flexible = greater productivity

Lower direct taxes

Creates incentive for work

Higher disposable income = Increased consumption expenditure = increased

GDP

Deregulation

Reduction/removal of barriers to entry to make markets more competitive

Increased competition = lower prices & better quality output of goods & services

Able to operate & produce more output with reduced costs & hassle

Encourages investments

Aim: increases efficiency & competition

Incentive to work

Direct tax cuts encourage people to find work/work harder

Govt could reduce unemployment benefits, creating more of an incentive for them to seek
employment
Incentive to invest

Tax incentives stimulates firms to invest in the economy to maximise profits

Govt may provide firms with subsidies to give them an incentive to invest

Selling off state-owned assets to the private sector for them to be run more efficiently

Private sector has a profit-motive absent in the public sector

Develop better products & deliver better services

Transferring some public corporations to private ownership increases efficiency

output

Effects of supply-side policy on govt macroeconomic aims

35

Used to achieve sustainable economic growth by increasing the productive capacity of the
economy

Increase in the economy’s productive capacity = increased national output

Creates more jobs in the economy

Increase in the productive capacity of the economy without higher prices

Balance of payment stability

Improves national output = improves a country’s balance of payment

Greater investment in education & training + incentives to work benefits low income
earners more than high income earners

4.6 Economic growth

● The annual increase in the level of national output ● Measurement of economic growth

○ Measured using Gross Domestic Product (GDP)

■ GDP: Measures the monetary value of goods & services produced within a country
for a given period of time

○ Nominal gross domestic product (nominal GDP): measures the monetary value of
goods & services produced within a country during a given period of time

■ Components of nominal GDP

● Consumption expenditure (C): total spending on goods & services by individuals &
households in an economy
○ Eg. spending on housing, transport, food, clothing, domestic holidays etc.

● Investment expenditure (I): sum of capital spending by all businesses within a

country

○ Eg. spending on new machinery & technologies

● Govt spending (G): total consumption & investment expenditure of the govt

○ Eg. spending on infrastructure

○ Calculation of govt spending ignores payments made without any corresponding

output (eg. unemployment benefits)

● Export earnings (X): measures the monetary value of all exports sold to foreign
buyers

● Import expenditure (M): measures the monetary value of all payments for imports

■ Country’s GDP formula: C + I + G + (X-M)

● GDP: Consumer expenditure (C) + Investment expenditure (I) + govt spending (G) +
(Export earnings (X) - import expenditure(M))

○ Real GDP: value of national income (GDP) adjusted for inflation ■ True value of
goods & services produced in a given year
● Inflation artificially raises the value of a country’s output ■ Increase in real GDP over time
= economic growth

● Economy is using its resources better

○ GDP per head (capita): measures the avg value of annual GDP per person

Avg national income per person

Large population = lower GDP per head

Problems with GDP

Exclusion of illegal/hidden economy, costs of environmental damage, distribution of

income, individuals’ access to services etc.

Annual increase in the level of national output

36

Increase in the quantity/quality of factors of production

Larger & more productive workforce = increase in GDP

Discovery of more natural resources = more production capacity

Investment in new capital & infrastructure

Allows for expansion of production capacities

Technical progress

New inventions, production processes increases productivity of existing resources

Positive consequences

Improved standards of living

Higher income levels in a country enable people to spend more money to meet their needs

Greater availability of goods & services

Helps eliminate absolute poverty

Higher employment

Raises consumption & encourages further investment in capital

Helps sustain economic growth

Increased spending = increased tax revenues

Increased sales, profits & business opportunities

Rising output & demand will encourage investment in capital goods for further production

Low & stable inflation if growth in output matches growth in demand

Negative consequences

Increase in negative externalities

Pollution, congestion, climate change etc.

Risk of inflation

If excessive demand causes the economy to grow there is a risk of demand-pull inflation

Leads to prices of g/s rising to unstable levels

Inequalities in income & wealth

Creates greater disparities in the distribution income & wealth

Rich get richer, poor get poorer

Resource depletion

Economic growth uses the world’s scarce resources at unsustainable rates

Eg. deforestation & overfishing

Technical resources may cause capital to replace labour (rise in unemployment)

Policies to promote economic growth

Demand-side policies

Demand is too low

Govt can stimulate growth by cutting taxes/increasing govt expenditure

Lower interest rates cuts borrowing costs for consumers & firms

Helps to fund consumer expenditure & business investments

Supply side policies

Can increase the economy’s productive capacity

Increases competition, productivity & innovation

Eg. govt funding to encourage education & training

Effectiveness
Take time to take effect

37

Recession

A period of decline in economic activity (negative growth) & fall in GDP for 2 successive
quarters (6 months)

High unemployment

Financial crisis

If banks have a shortage of liquidity, they reduce lending & this reduces investment

Higher interest rates

Increases the cost of borrowing & reduces demand

Increases demand for savings

Lower rates of disposable income

Fall in consumer spending

Lower levels of govt expenditure

Fall in consumer/business confidence

Reduces supply & demand

Appreciation in exchange rate

Makes export expensive & less competitive

Causes demand to fall

Fiscal austerity

When govt cuts spending & demand falls

Trade wars

Uncertainty in markets = businesses are reluctant to invest

Supply falls

Supply side shocks

Eg. rise in oil prices = inflation & lower purchasing power

Black swan events

Unexpected events that are hard to predict

Eg. COVID-19 pandemic (2020) disrupted travel, supply chains, consumer demand &
normal business activity

Firms go out of business

Demand falls; firms are forced to reduce production/shut down

Unemployment

Cuts in production = unemployment

Fall in income

Cuts in production = fall in income

Rise in poverty & inequality

Unemployment & lack of income = increase in poverty & inequality

Fall in asset prices

Eg. fall in real estate prices/stock market

Crash in stock markets makes shares owned by investors worthless

Higher budget deficit

Falling consumption & incomes = falling tax revenue

Permanently lost output

Firms go out of business & employment falls = permanent loss of output

4.7 Employment & unemployment

Employment: an engagement of a person in the labour force in some occupation, business,

trade or profession

Unemployment: when people of working age are both willing & able to work but cannot find
employment

Full Employment: Everyone in a country who is willing & able to work has a job

Unemployment rate is 0%

38

● Patterns & levels of employment

○ Due to effects of business cycle that every economy goes through from time to time ○
Employment sector

■ Country develops = No. of people employed in the primary sector falls ■ Majority become
employed in the tertiary sector

○ Delayed entry to the workforce

■ Avg age of employees entering the workforce rises (to complete tertiary)

education

○ Ageing population

■ Avg age of the population rises due to lower birth rates & longer life spans in
developed economies

■ Lower labour supply = firms are more willing to employ older employees & people
beyond their retirement age

○ Formal sector employment

■ Officially recorded employment where workers pay incomes taxes & contributes to
the country’s official GDP

■ Economy develops = increase in the proportion of workers employed ○ Female

participation rate
■ Measures the proportion of women who are active in the labour force

■ Country develops = greater proportion of women active in the labour force

● Changes in social attitudes toward women in the economy

● Women choose to have fewer children at a later age in favour of a career

● High costs of raising children

○ Public sector employment

■ More countries move towards a market economy = decline in the proportion of

people employed in the public sector

○ Flexible working patterns

■ Firms need to be more flexible to compete internationally

■ Eg. firms hiring more part-time staff, allowing employees to work from home,
introducing flexible working patterns

● Measuring unemployment

○ Claimant count: Measures the number of people who are out of work & claiming
unemployment benefits
■ Govt can count the total no. of unemployment claims made in the economy ○ Labour force
survey (LFS): Uses the ILO’s standardised household-based survey to

collect work-related statistics

■ ILO measure

○ Formula: . × 100

Causes/types of unemployment

Lack of skills causes occupational immobility

Lack of geographical mobility caused by (eg. difference in house prices) results in regional
unemployment

Technological unemployment: workers replace by machines

Voluntary unemployment: high unemployment benefits reduced incentive to find jobs

Seasonal unemployment: demand for labour falls at certain times of the year

Frictional unemployment: occurs as a result of workers leaving one job & spending time
looking for a new one

Always exists in the economy (lack of information about job vacancies)

Takes time for labour market to match jobs with people looking for jobs
Structural unemployment: Occurs due to long-term change in the structure of an economy

39

Workers end up having the wrong skills in the wrong place causing them to be unfit for
employment

Industry suffers from structural & long-term changes in product demand

Cyclical unemployment: unemployment caused by a lack of demand which causes a fall in

national income

Demand falls = firms cut their production & workers lose jobs

Severe type of unemployment that affects every industry in the economy

Consequences of unemployment

For individuals

Loss of income

Receive unemployment benefits (low)/no income causing poverty

Reduced ability to educate children (reduced chances of finding a job)

Reduced ability to get a job

Lose out on training by not keeping up with advances in technology

Reduced confidence/self worth = harder to find another job

Declined health

Mental health issues/ increase physical illness due to less nutrition & poor housing

For firms

Firms lose out on lower levels of consumer spending, investment & profits

Bank failures & bankruptcies are more likely to occur

For the govt

Govt faces higher expenditure on welfare benefits & healthcare for the unemployed

High unemployment = increased govt debts

Increased reliance on taxpayer’s money to finance unemployment & welfare benefits

For the economy

Economy is less internationally competitive

Falling levels of spending & national output

Policies to reduce unemployment

Expansionary policies to increase demand

Fiscal policy creates jobs

Boosts consumer spending & investment in the economy = increase in

More employment opportunities

Won’t help if people have no confidence in the economy (prefer to save)

Monetary policy boosts demand in the economy to keep production & employment high

Encourages households & firms to spend & invest

Rise in real wages = attracts more labour

Ineffective if banks aren’t willing to lend to businesses (low confidence in the economy)

Depreciate the exchange rate

Currency depreciates = exports become cheaper

Export demand from abroad will increase

Boost production & employment in export industries

Control inflation

Higher inflation causes firms to lay off workers to reduce costs

If govt tries to control inflation by monetary tools, it will reduce firm costs & increase
employment

Protectionist measures (eg. tariffs & quotas)

Used to safeguard domestic jobs from the threat of international competition

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Investment in education & training

Helps unemployed to gain new skills for them to find employment

Helps future generations to become more skilled & employable

Improves occupational mobility

Reduction in trade union powers

Labour unions won't have a strong bargaining position to obtain higher wages

Govt intervention to reduce the influence & power of trade unions can reduce
unemployment

Incentives

Offered to firms for training & hiring the long-term unemployed

Govt can offer tax allowances &/or subsidies to reduce the costs of training & hiring
workers

Firms may be reluctant

Lower productivity & greater risks of hiring the long-term unemployed

Reducing welfare benefits

Gives unemployed people an incentive to find a job rather than rely on state welfare
benefits

4.8 Inflation & deflation

Inflation
Sustained rise in the general level of prices of g/s over time as measured by CPI

Measurement

Consumer price index (CPI)

Measures the price changes of a representative basket of g/s consumed by an avg

household in the country

Includes staple food products, clothing, transport etc.

Used for international comparisons of inflation rates

Wider sample of population when calculating

Benchmark for central banks to set interest rates

Calculation

Avg price of the basket in the base year (starting year) = 100

Eg. rises by 25% the new index is 125% ×100 = 125

If the next year increases by 10% price index = 110%× 125 = 137.5

Avg inflation rate over 2 years: 137.5 -100 = 37.5

Rate of inflation

Eg. 2013: 108.0, 2014: 115.2

115.2 - 108 = 7.2

1087.2 × 100 = 6. 67% (rate of inflation)

Weighted price index

Measure of changes in the price level which takes into account the different proportions
spent on items in a basket of g/s

Cost-push inflation

Increase in prices of factors of production leads to decreased supply of goods

Higher costs of production = firms raise prices to maintain profit margins

Demand-pull inflation

Aggregate demand exceeds aggregate supply

41

Too many dollars chasing too few goods

People try to out bid each other

Higher demand = increase in general price level of g/s

Rises due to higher incomes, lower taxes etc.

Lower purchasing power

Fall in real income; money is worth less than before

Less number of g/s can be bought with the same amount of money = cost of living increases

Shoe leather costs

Fluctuations in price levels = customers spend more time finding the best deals

Opportunity cost for customers

Borrowers

Gain from inflation

Money they need to repay is worth less than when initially borrowed

Real value of their debt declines

Fixed income earners

Eg. salaries workers & pensioners (income doesn't change with their level of output)

Fall in real income

Purchasing power of the fixed income declines with higher prices

Low income earners

Harms the poor more than the rich

Have a high PED for g/s

Savers

Lose out from inflation

Money saved is worth less than before

May act as a disincentive to save = fewer funds available for investment in the economy

Lenders

Money lent out to borrowers is worth less

Firms

Menu costs

Catalogues, price lists etc. have to be updated regularly with new prices

Additional costs for business

Workers demand pay rise = labour COP rise = profit margin falls

Creates wage-price spiral

Demand for higher wages to keep in line with inflation causes more inflation

Exports are less internationally competitive

High export prices = lower price competition = fall in profits

Low export earnings = lower economic growth = higher unemployment

Imports are more expensive

Decline in purchasing power of money

Essential imports (petrol, food) = imported inflation

Higher import prices = higher COP= domestic inflation

42

Inflation causes inflation

Cost of living rises = workers demand higher wages = COP increases = cost-push inflation

Business confidence levels

Causes uncertainty & lower expected real rates of return on investments = less investment
in the economy

Policies to control inflation

Raising taxes/reducing govt expenditure = less economic activity

Discourages spending & reduces aggregate demand = low price level

Only used when inflation is critical

Raising interest rates discourages spending/investing = reduces money supply in the

economy = less demand

Privatisation & deregulation = more competitive & efficient firms to avoid inflationary
pressures
Deflation

Sustained fall in the general price level in an economy over time (ie. the inflation rate is
negative)

Uses CPI

Figures below 100 = deflation

Eg. drop in the avg basket price is 10% = deflation is 90%

Aggregate supply exceeds aggregate demand

Excess output in the economy = prices fall

Demand has fallen due to recession = general prices fall

Labour productivity rises

Higher output = lower avg costs = lower prices for products

Technological advance

Lower COP= less cost-push inflation

Decrease in money supply = fall in prices

Demand increases for money

Reduced demand for goods = increased demand for money = prices fall

Consumer confidence decreases

Fear the economy will worsen = postpones spending

Expects prices to fall/wait until the economy improves

Value of debt is higher than when they borrowed the money

Real interest rates rise when prices fall

Lower prices discourage production = fall in labour demand = unemployment

Money saved is worth more than before

Money lent out to the borrowers is worth more

Forced to close if not enough profits are being made

Difficult to repay costs & liabilities

43

Wealth effect

Reduces wealth of shareholders

Demand & prices fall = less investment in the economy = lower output

Can cause a recession

Govt debt

Economic activity/income falls = govt tax revenue falls

Tax revenues fall; govt spending rises

Causes budget deficit

Needs to borrow money despite the real cost of borrowing rises

Value of debt money increases = govts real debt burden increases

Policies to control deflation

Cutting direct taxes = increased real incomes = higher demand

To revive demand

Cutting interest rates = reduces the exchange rate = fall in import prices = increased
demand for exports

Decreased corporate taxes = increased investment & risk-taking

Devaluation

Devaluing the currency through selling domestic currency or increasing the money supply

Export prices fall = higher demand for exports

Increased import prices = raises costs & prices for products in the economy

Change inflation expectations

Deflation expected = causes deflation

Businesses won’t increase wages

Consumers won't pay higher prices

Expect prices to fall in the future

If monetary authorities indicate that they expect higher inflation = avoid deflation
Forms pay workers more

Consumers spend more

Economic development

5.1 Living standards

Standard of living: social & economic well being of individuals in a country at a particular
point in time

Real GDP per capita

Measures the avg income per person in an economy

Better indicator of standards of living

Components

Higher real GDP = people have more to spend

Inflation decreases GDP (value of money falls)

44
Human development index (HDI)

UN’s composite indicator of living standards in a country comprising of education,

healthcare & income

Measures life expectancy at birth

Better healthcare = greater social & economic well being

Measures the mean years of schooling & the expected years of schooling in the country

Higher avg years of schooling = greater degree of human development

Income levels

GNI per head

Higher national income (GDP) = greater human development

Poor countries = low GDP (vice versa)

Comparing living standards & income distribution

Productivity levels

More productive industries yield more output & incomes

Highly skilled & experienced workers enjoy a higher standard of living

Population

Dense population = lower per capita income

Densely populated cities have higher rents due to limited space & high demand

Ability of citizens pay taxes

45

Higher tax-base & taxable incomes allow govt to invest in infrastructure & welfare
programmes

Provision of health & educational facilities

Variety of g/s produced

More options = higher living standards

War, crime & natural disasters

Puts people into hardship

Role of govt

Govt uses direct taxes to redistribute income in the economy

Fairer distribution of income/wealth = raises living standards for the majority of a

population

Distribution of national income

National income may be high but isn't distributed in a socially desirable way

Regional income & wealth disparities within countries

General price level

Inflation increases cost of living = negative impact on standards of living

Level of education

More educated & well qualified person = higher their earning potential

Direct impact on their living standards

Level of freedom

Eg. civil liberties, political rights, religious freedom & economic rights
5.2 Poverty

Absolute poverty: inability to afford basic necessities needed to live (food, water, shelter
etc.)

Relative poverty: comparative measure of poverty referring to those who have a lower
standard of living in comparison to the avg member of society

Causes of poverty

Unemployed have to go without income for a long time

May have to sell their possessions

Combination of low literacy, lack of skills & poor health

Low wages

Limits consumption & investment in the economy

Illnesses

Lower life expectancy = poorer the country = greater the degree of poverty

Ill mental & physical health is both a cause & result of poverty
Age

Older people are likely to have more health problems & less suitable for further
employment

Living longer with on income to sustain their standard of living

Young people are still employable & will find ways to earn an income

Education levels

46

People are uneducated, unskilled & unable to find better jobs keeping them in poverty

Size of family

More family members with only few people earning = more costs of living

Poor govt support for basic services

Overpopulation

High population density will put pressure on scarce resources

Economy may not be able to produce & provide for everyone

Minority group/ethnicity/migrants

Face discrimination from bureaucrats, employers & the society at large

Eg. African-Americans in the US tend to be poorer than Caucasians

Gender discrimination

Policies to alleviate poverty & redistribute income

Promoting economic growth

Monetary & fiscal policy encourages consumer spending & investment expenditure in the
economy

Creates more jobs = less unemployed = less poverty

Lowering exchange rates encourages export sales = increases GDP

Helps create more jobs & wealth

Can be redistributed to the underprivileged

Improving education
Improving access to education for everyone

Narrows the gap between rich & poor

Persons level of education affects their earnings/earning potential

Improves the human capital & productive capacity of the country

Providing more generous state benefits

Help redistribute income & alleviate poverty by ensuring every citizen has access to basic
necessities

Using progressive taxation to reduce the wealth gap

Introducing/increasing national minimum wage

Improves the standard of living for low-income households

5.3 Population

● Total number of people inhabiting a specific area ● Factors affecting population growth

○ Birth rates

■ Measures the number of live births per thousand of the population in a year
○ Death rates

■ Measures the number of deaths per thousand of the population in a year

Net migration

Measures the difference between immigration & emigration rates for a country

Net migration rate = immigration - emigration

Immigration

When people enter a country to live & work

Emigration

When people leave a country to live & work

Reasons for different rates of population growth in different countries

Birth rates

MEDCs have lower birth rates than LEDCs

Education & access to contraception

Higher costs of raising children

47

Women choosing to pursue careers over motherhood/have less children & at a later stage
in their lives

Death rates

MEDCs have lower death rates than LEDCs

Better quality education

Healthcare, nutrition & sanitation

LEDCs:

Famine

Poor housing

High infant mortality rates & disease

Net migration rate

Has a direct impact on rates of population growth in different countries

Reasons for migration:

Better living standards

Better job opportunities

Avoid civil unrest

Climate

Effects of changes in the size & structure of population on different countries

Optimum population

Exists when the output of goods & services per head of the population is maximised

Underpopulated countries don't have sufficient labour to make the best use of its resources

GDP per capita could increase if there were more human resources

Govt could introduce measures to increase the population size (eg. encouraging
immigrants)

Overpopulated countries are too large given the available resources

Causes a fall in GDP per capita

Insufficient resources to sustain the population

Govt could introduce measures to reduce the population size or boost investment &
productivity in the economy

Increasing population size

Increased size of home market

Higher demand & incomes = more economic growth & expansion

Increased labour supply

Puts more pressure on already scarce resources

More capital goods have to be produced to satisfy the needs of an enlarged population

Too many people working on limited resources = low productivity

Shift of employment/output from the primary sector to the tertiary sector

Land for primary activities is fixed

Want for services is infinite

Congestion of urban centres

Need for heavy transport, communications, housing etc.

Decreasing population size

Population distribution

Composition & structure of a countries population

Gender distribution

No. of males compared to the no. of females in the population

Consequences of changes

More females

Encourages birth rates to rise

Increases population

48
● In employment = increased productivity in the

workforce

● In education & employment = increased living

standards

More balanced distribution

Better social equality

Social attitudes towards women in education & employment become progressive

Number of people in different age groups in the population

Low income countries = larger proportion of younger age groups

Wealthier countries = growing number of people in older age groups

Consequences of ageing population

Workforce decline

Larger dependency ratio

Increase in demand for products for the elderly (eg. elderly)

Govt spending has to focus on housing, old age welfare schemes etc.

Population pyramids

Graphical representation of the age & gender distribution of a country's population

Dependency ratio

Comparison of the number of people who aren’t in the labour force with the number of
people in active paid employment

Dependency ratio =

Dependent population

Ages between 0-14 & 65<

Full-time students & the unemployed

Working population

Active labour force aged 15-65

Willing & able to work

Higher the ratio = greater tax burden on the working population to support those who
aren’t economically active

Increased dependency ratio:

Higher birth rates (LEDCs)

Higher compulsory school leaving age

49

● Raises the no. of people classified as the

dependent population

Social changes

Workers entering the labour force at a later stage

Greater demand for higher education

More people choosing early retirement

Demand for g/s changes with variations in population trends

Customers have different demands based on their age/gender

Demand & supply of labour changes

Benefits from growing population = collect more tax revenues from a larger workforce

Added pressure to provide more public services, welfare benefits & state pensions

Continual population growth puts more pressure on scarce resources

Leads to inflationary pressures

Increase in import demand if the country can’t produce enough to meet the needs of the
whole population

Natural environment

Non-renewable resources are depleted in the production process

More pollution, traffic etc.

5.4 Differences in economic development between countries

Increase in the economic welfare of people through growth in productive scale & wealth of
an economy

Factors affecting the economic development

Differences in income

Higher real GDP per capita = greater economic development

Differences in productivity

Higher output = higher productivity

Low income countries are unable to gain access to the technologies that would improve
efficiency & productivity

Countries that are able to attract foreign direct investment (FDI) = increase in quantity &
quality of physical capital in the economy

Creates jobs

Differences in population growth

Rapid population growth = decrease in GDP per capita

Hinders economic development

Competing pressures on scarce resources (eg. agricultural land)

Differences in size of primary, secondary & tertiary sectors

Economy develops = shift away from primary & secondary

Countries with low GDP per capita = early stages of economic development

Differences in saving & investment

LEDCs: most people are unable to have savings

50

Income barely meets their basic needs

MEDCs: people are able to save

Firms are able to borrow these funds via banks

More savings + investments = economic development

Differences in education

Greater level of education = higher standard of living

Differences in healthcare

Measured by:
Country's annual expenditure on healthcare (% of GDP)

Child mortality rates

International Trade & Globalisation

6.1 International Specialisation

Countries concentrate on their production of certain goods or services due to cost

advantages (eg.superior allocation of resources or cheaper production)

Specialisation at a national level

6.2 Globalisation, free trade & protection

Globalisation

51

The process by which the world’s economies become increasingly interdependent &
interconnected due to greater international trade & cultural exchanges

Increases the exchange of g/s

Increases international trade

Creates wealth & jobs throughout the world

Freer movement of labour, capital, goods & services

Operating on a global scale

Firms enjoy greater economies of scale

Lower costs per unit when operating on a larger scale

Greater choice of g/s for consumers around the world

Greater cultural understanding & appreciation

Greater dependence on the global economy

Widened income & wealth gaps

Role of multinational corporations (MNC)

An organisation that operates in 2 or more countries (eg. Apple, Volkswagen)

Generates more profit by selling to a larger customer base

Face issues when operating in different countries

Eg. different legal systems, tax regulations, environmental guidelines

Size & geographic spread is harder to manage the overall business

Communication is harder: different languages, cultures & time zones

Benefits of free trade

International trade: exchange of g/s beyond national borders

Sale of exports & imports

Free trade: international trade takes place without protectionist measures

52

Allows countries to benefit from specialisation

No international trade = no specialisation

Countries would have to become self-sufficient

Access to resources

Enables producers & consumers to gain access to goods & services that they can’t produce
themselves
Lower prices

Free trade reduces costs of trading

Trade protection increases costs of trading

Firms operating on a larger scale benefit

Cost saving can be passed on to consumers in the form of lower prices &/or kept by the
produces in the form of higher profits

Greater choice

Free trade = consumers & firms access a larger variety of g/s from different producers
worldwide

Increased market size

Enables firms to earn higher revenues & profits

Efficiency gains

Free trade forces domestic producers to improve the quality of their output due to foreign
competition

Protectionist measures give domestic firms a false sense of security & limit their exposure
to fair & genuine competition
Makes domestic firms inefficient

Improved international relations

Absence of trade barriers encourages international trade & cooperation between countries

If a country imposes trade barriers, others are likely to retaliate in the same way

Trade Protection

The use of trade barriers to restrain foreign trade thereby limiting overseas competition

Methods

Tariffs

Tax on imports

Increases the COP to importers

Raises the price of foreign goods in the domestic market

Lowers the quantity of products imported

Import quotas
Quantitative limit of the sale of a foreign good

Limits the quantity imported

Raises the market price of foreign goods

A form of govt financial assistance to help cut production costs of domestic firms, enabling
them to compete against foreign producers

Lowers the COP for home firms

Embargo

A ban on a trade with a certain country

Due to a trade dispute or political conflict

Consumers suffer from lack of choice & higher prices

Reason

To safeguard infant industry from foreign competition

Safeguard domestic jobs

Protection = source of govt revenue

Required to overcome a BoP deficit

53

Restriction of imports helps deal with imbalance

To protect sunset industries (declining industry)

Strategic industry

Includes: agriculture, energy, defence etc.

Safeguard the country from being too dependent on g/s from other countries

Preventing foreign countries from dumping their goods in the domestic economy

Occurs when foreign firms sell their products in large quantities at prices deliberately
below those charged by domestic firms

Domestic firms unable to compete & shut down

Restrict consumer choice

Restrict new revenue & employment opportunities

High import tariffs/quota = increased COP at home & increased prices

Causes cost-push inflation

Protect inefficient domestic firms

Domestic can now become inefficient due to lack of overseas competition

Other countries may retaliate if a country introduces trade barriers to restrict imports from
other

Trade war may develop

Relations between countries will worsen

Lose out on the benefits of free trade

6.3 Foreign exchange rates

Exchange rate: the price of one currency measured in terms of other currencies

Used when countries trade & need to convert money

Floating system

Currency is allowed to fluctuate against other currencies according to market forces

without any govt interaction
Eg. UK, Japan, Sweden etc.

Appreciation: increase in its value relative to another currency operating in a floating

exchange rate system

Depreciation: decreases in its value relative to another currency operating in a floating

exchange rate system

Reserves can be used to import capital goods/other items to promote faster economic
growth

Fixed system

54

Govt intervenes in foreign exchange markets to maintain its exchange at a predetermined

level

Foreign exchange market: marketplace where different currencies can be bought & sold

Monetary authority buys/sells foreign currencies to ensure the value of its currency stays at
the pegged value

Devaluation: price of currency operating in a fixed system is officially & deliberately

lowered

Revaluation: price of currency operating in a fixed system is officially & deliberately

increases
Determination of exchange rates in foreign exchange market

Demand for currency exists as foreign consumer want to buy/import g/s from that country

Overseas companies buy that currency to invest

Currency is high in demand

Supply of currency exists as domestic consumers want to buy/import g/s from other
countries

Domestic companies buy foreign currencies to invest abroad

Currency is high in supply

Equilibrium market foreign exchange rate: price at which demand = supply

Causes of exchange rate fluctuations

Changes in demand for exports

Increased demand for exports = increased demand for the country’s currency

Increased exchange rate

Changes in demand for imports

Increased demand for imports = increased value of the foreign currency to facilitate the
purchase of foreign g/s

Prices & inflation

Increased price of g/s caused by domestic inflation = decreased demand for exports

Decreases the exchange rate

FDI

Inward FDI (entry of MNC) = increased demand for a currency

Outward FDI (exit MNC) = increased supply of a currency

Speculation

Hot money causes fluctuations

Speculators might lack confidence in certain economies & withdraw their investments

Govt intervention

Central bank could sell their reserves to increase supply & cause fall in value
55

● Consequences of foreign exchange rate fluctuation

○ Exchange rate increases (PED < 1)

BoP

Currency appreciation has larger impact on exports than imports

BoP worsens

Strong currency makes it harder for exporters to sell their g/s in overseas markets

Fall in exports & profits = job losses

Lower levels of spending (caused by unemployment) reduces inflation

Higher exchange rate = decreased economic growth

6.4 Current account of BoP

Records the sale & purchase of g/s, investment income earned abroad & other transfers (eg.
donations & foreign aid)

Structure
Trade in goods (Visible balance)

Record of the exports/imports of physical goods

Eg. trade in raw materials, semi-manufactures products, manufactured goods

Visible exports: goods sold to foreign customers with money flowing into the domestic
economy

Visible imports: goods bought by domestic customers from foreign sellers

Trade in services (invisible balance)

Record of the export & import services

Eg. trade in banking, insurance, consultancy etc.

Primary income (investment income)

Record of a countries net income earned from investments abroad

Eg.

Profits earned by subsidiary companies based overseas

Interest received from loans & deposits in foreign banks

Dividends earned from financial investments in foreign companies

FDI of individuals/businesses in overseas businesses

Money sent home by people working abroad

Secondary income (net income transfers)

Shows income transfers between residents & non-residents

Donations to charities abroad

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Foreign aid

Subsidies/grants paid to companies based overseas

Payments of pensions to retired people based overseas

Scholarships paid to students based in universities overseas

Current account = balance of trade + primary income + secondary income

Current account deficit

When a country spends more money than it earns

Negative balance

Lower demand for exports

Decline in manufacturing competitiveness

High labour costs in the domestic economy

Declining incomes in foreign markets

Due to recession

Households & firms have less money available to spend on another country’s exports

High exchange rates

Exports more expensive for foreign buyers = reduces supply & value of exports

Higher demand for imports

Domestic buyers buy more imports if they are cheaper/better quality

Reduced demand

Trade deficit = recession

Workers may have to take pay cut to correct deficit

Lower standards of living

Current account deficit caused by negative balance of net incomes

Capital outflow exceeds capital inflow for the country

Reduction in consumer spending

Increased borrowing

Opportunity cost of debt repayment

Govt can’t use this money to stimulate economic growth

Lower exchange rates

Fall in export demand/ rise in import demand = lower exchange rate

Export becomes more price competitive = imported inflation

Current account surplus

Country exports more than it imports

Positive balance

Higher demand for exports

Improvement in manufacturing competitiveness

Due to higher labour productivity in the domestic economy

High incomes in overseas markets

Foreign households & firms have more money to spend on the country’s exports

Lower exchange rate

Makes exports less expensive for foreign buyers (increases demand)

Reduced demand for imports

Domestic buyers buy less if they are expensive/low quality

Lower exchange rate = domestic currency can buy less foreign currency
More expensive to buy imports

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Inflation overseas = expensive imports

Employment

Sustained currency account surplus = higher export sales = more jobs

Job losses are created in other countries

Standards of living

Favourable current account balance = higher national income

Domestic firms have a competitive advantage in the goods they export = higher standard of
living

Inflationary pressures

Higher demand for exports = demand-pull inflation

Current account surplus decreases international competitiveness as price of exports rises

Higher exchange rate

Higher demand for exports = currency appreciation

More expensive for foreign buyers to import goods

Policies to achieve BoP stability

Floating exchange rate will correct it

To decrease amount of money available to spend on imports

Reduces current account deficit

Higher interest rates reduces import demand

Monetary authority may devalue the exchange rate to improve its competitiveness

To raise the productive capacity of the economy

Protectionist measures

Reduce competitiveness of imports = domestic consumption is more attractive

Paper 1- MCQ

45 minutes, 30 marks
Paper 2 - Structured questions

2 hours 15 minutes, 90 marks

Answer 4 questions

Section A - Question 1

Section B - any 3 questions Question Criteria

2-3 marks

State facts with a short explanation (1 sentence)

4-6 marks

Mention 4 points with 2-3 sentences of explanation for each point

More than 6 marks

Explain each point in detail

Mention 5-6 points with 4-5 sentences of explanation for each

8 marks (Discuss whether….)

Define & explain key terms

3 reasons why the policy proposed might not work

3 reasons why the police proposed will work

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