1. The Basic Economic Problem
1.1 Scarcity and Choice
- Human wants are unlimited, but resources (land, labour, capital, entrepreneurship) are limited → scarcity.
- Scarcity forces individuals, firms and governments to make choices about what to produce, how to produce and for whom to produce.
1.2 Factors of Production and Their Rewards
| Factor | Reward |
|---|
| Land (natural resources) | Rent |
| Labour (human effort) | Wages |
| Capital (machinery, buildings, tools) | Interest |
| Entrepreneurship (organisation, risk‑taking) | Profit |
1.3 Opportunity Cost
The value of the next best alternative that is foregone when a choice is made.
- Consumer example: spending £50 on a concert ticket means giving up the chance to buy a new pair of shoes.
- Firm example: using a factory to produce cars means the opportunity cost is the profit that could have been earned by producing motorcycles instead.
- Government example: allocating budget to defence means less is available for education.
1.4 Production Possibility Curve (PPC)
- Shows the maximum combinations of two goods that can be produced with existing resources and technology.
- Key points to label on a diagram:
- Axes – quantities of the two goods.
- Efficient points – on the curve (full utilisation of resources).
- Inefficient points – inside the curve (under‑utilisation, unemployment).
- Unattainable points – outside the curve (insufficient resources/technology).
- Economic growth – outward shift of the curve (more resources or better technology).
- Economic decline – inward shift (natural disaster, war).
2. Allocation of Resources – Price Determination
2.1 The Role of Markets
- A market brings together buyers and sellers of a good or service.
- Resources are allocated through the price mechanism: interaction of demand and supply determines the price and the quantity exchanged.
- Key functions:
- Facilitate exchange.
- Provide information (prices signal scarcity and preferences).
- Coordinate production decisions.
2.2 Demand
2.2.1 Definition
The quantity of a good that consumers are willing and able to buy at a given price, ceteris paribus (all other factors unchanged).
2.2.2 Individual vs. Market Demand
- Individual demand – one consumer’s willingness to buy.
- Market demand – the sum of all individual demands at each price.
2.2.3 Law of Demand
When price falls, quantity demanded rises (and vice‑versa), ceteris paribus.
2.2.4 Movements Along the Demand Curve
A change in the price of the good itself causes a movement up or down the same demand curve.
2.2.5 Shifts of the Demand Curve
Any change in a non‑price factor shifts the whole curve.
| Factor that shifts demand | Direction of shift |
|---|
| Increase in consumer income (normal good) | Right (↑) |
| Decrease in consumer income (normal good) | Left (↓) |
| Increase in consumer income (inferior good) | Left (↓) |
| Change in tastes/fashions | Right if preference rises, left if falls |
| Price of substitutes rises | Right (↑ demand) |
| Price of complements falls | Right (↑ demand) |
| Number of buyers increases | Right (↑ demand) |
| Expectations of higher future prices | Right (↑ demand) |
2.3 Supply
2.3.1 Definition
The quantity of a good that producers are willing and able to sell at a given price, ceteris paribus.
2.3.2 Individual vs. Market Supply
- Individual supply – one firm’s willingness to sell.
- Market supply – the sum of all individual supplies at each price.
2.3.3 Law of Supply
When price rises, quantity supplied rises (and vice‑versa), ceteris paribus.
2.3.4 Movements Along the Supply Curve
A change in the price of the good itself causes a movement up or down the same supply curve.
2.3.5 Shifts of the Supply Curve
Any change in a non‑price factor shifts the whole curve.
| Factor that shifts supply | Direction of shift |
|---|
| Improvement in technology | Right (↑ supply) |
| Increase in input prices | Left (↓ supply) |
| Expectations of higher future prices | Left (↓ current supply) |
| Number of sellers increases | Right (↑ supply) |
| Taxes on production increase | Left (↓ supply) |
| Subsidies to producers | Right (↑ supply) |
| Regulation that raises compliance costs | Left (↓ supply) |
2.4 Demand and Supply Schedules
Schedules give the numerical relationship between price and quantity demanded or supplied.
| Price (P) | Quantity Demanded (Qd) |
|---|
| $10 | 90 |
| $12 | 80 |
| $14 | 70 |
| $16 | 60 |
| $18 | 50 |
| $20 | 40 |
| Price (P) | Quantity Supplied (Qs) |
|---|
| $10 | 30 |
| $12 | 40 |
| $14 | 50 |
| $16 | 60 |
| $18 | 70 |
| $20 | 80 |
These schedules can be expressed algebraically as:
$$Q_d = a - bP$$
$$Q_s = c + dP$$
where a, b, c, d are constants reflecting consumer preferences and producer costs.
2.5 Market Equilibrium
- Equilibrium occurs where quantity demanded equals quantity supplied (Qd = Qs).
- From the tables above, equilibrium price Pₑ = $16 and equilibrium quantity Qₑ = 60 units.
- Diagram conventions:
- Label the vertical axis “Price (P)” and the horizontal axis “Quantity (Q)”.
- Draw the demand curve (downward sloping) and the supply curve (upward sloping).
- Mark the intersection as point E and write Pₑ and Qₑ on the axes.
- Shade the area above Pₑ (if price is higher) to illustrate a surplus; shade the area below Pₑ for a shortage.
2.6 Disequilibrium – Surplus and Shortage
- Surplus (Excess Supply): P > Pₑ → Qs > Qd. Sellers will tend to lower price.
- Shortage (Excess Demand): P < Pₑ → Qd > Qs. Buyers will tend to bid price up.
2.6.1 Interpreting Disequilibrium Using the Schedules
- Locate the chosen price in both tables.
- Read the corresponding quantities Qd and Qs.
- Compare:
- If Qs > Qd → surplus → downward pressure on price.
- If Qd > Qs → shortage → upward pressure on price.
- Predict the direction of price movement until the market returns to equilibrium.
2.6.2 Worked Example – Government Price Ceiling
Suppose the government imposes a maximum legal price (price ceiling) of $12.
| Price (P) | Qd | Qs | Result |
|---|
| $12 | 80 | 40 | Shortage of 40 units |
| $14 | 70 | 50 | Shortage of 20 units |
| $16 | 60 | 60 | Equilibrium |
| $18 | 50 | 70 | Surplus of 20 units |
- At $12, demand (80) exceeds supply (40) → shortage, putting upward pressure on price.
- The ceiling prevents the price from rising, so the shortage persists unless the government intervenes (rationing, subsidies, or removal of the ceiling).
2.7 Government Intervention in Markets
2.7.1 Price Controls
- Price ceiling (maximum price) – set below the equilibrium price → shortage.
- Price floor (minimum price) – set above the equilibrium price → surplus (e.g., minimum wage, agricultural price support).
2.7.2 Tax
- Imposed on producers (excise) or consumers (sales tax).
- Graphically: shifts the supply curve leftward (tax on producers) or the demand curve leftward (tax on consumers) by the amount of the tax.
- Result: higher price for consumers, lower price received by producers, and a dead‑weight loss (inefficiency).
2.7.3 Subsidy
- Payment from government to producers (or consumers).
- Shifts the supply curve rightward (producer subsidy) or the demand curve rightward (consumer subsidy).
- Result: lower price for consumers, higher price received by producers, and an increase in equilibrium quantity.
2.7.4 Regulation, Quotas & Licences
- Regulation can set standards (e.g., safety, environmental) that raise production costs → leftward shift of supply.
- Import quotas limit the quantity of a good that can be imported → reduce supply, raise price.
- Licences (e.g., taxi licences) restrict the number of sellers, shifting supply left.
2.7.5 Privatisation & Nationalisation
- Privatisation – transfer of state‑owned enterprises to private ownership; aims to increase efficiency via profit motive.
- Nationalisation – transfer of private firms to state ownership; used to achieve social objectives (e.g., universal service).
2.8 Price Elasticity of Demand (PED)
2.8.1 Definition & Formula
Percentage change in quantity demanded divided by the percentage change in price.
$$\text{PED} = \frac{\%\Delta Q_d}{\%\Delta P}
= \frac{\Delta Q_d / Q_d}{\Delta P / P}$$
2.8.2 Interpretation & Terminology (as required by the syllabus)
- Elastic demand (|PED| > 1) – quantity changes proportionally more than price.
- Inelastic demand (|PED| < 1) – quantity changes proportionally less than price.
- Unitary elastic demand (|PED| = 1) – proportional change.
- Perfectly elastic demand (|PED| = ∞) – horizontal demand curve; any price increase eliminates all sales.
- Perfectly inelastic demand (|PED| = 0) – vertical demand curve; quantity demanded does not change as price changes.
2.8.3 Determinants of PED
| Determinant | Effect on Elasticity |
|---|
| Availability of close substitutes | More substitutes → more elastic |
| Proportion of income spent on the good | Higher proportion → more elastic |
| Nature of the good (luxury vs. necessity) | Luxuries more elastic |
| Time horizon | Long‑run > short‑run elasticity |
2.8.4 Worked Calculation (using the schedule)
Calculate PED between $14 and $16:
- ΔP = $16 – $14 = $2
- Average price = ($16 + $14)/2 = $15
- ΔQd = 60 – 70 = –10
- Average quantity = (60 + 70)/2 = 65
- $$\text{PED} = \frac{-10/65}{2/15} = \frac{-0.154}{0.133} \approx -1.16$$
- Since |PED| > 1, demand is **elastic** over this price range.
2.9 Price Elasticity of Supply (PES)
2.9.1 Definition & Formula
Percentage change in quantity supplied divided by the percentage change in price.
$$\text{PES} = \frac{\%\Delta Q_s}{\%\Delta P}
= \frac{\Delta Q_s / Q_s}{\Delta P / P}$$
2.9.2 Interpretation & Terminology
- Elastic supply (PES > 1) – producers can increase output quickly when price rises.
- Inelastic supply (PES < 1) – output changes little with price.
- Unitary elastic supply (PES = 1).
- Perfectly elastic supply (PES = ∞) – horizontal supply curve; producers are willing to supply any quantity at a given price.
- Perfectly inelastic supply (PES = 0) – vertical supply curve; quantity supplied is fixed regardless of price.
2.9.3 Determinants of PES
| Determinant | Effect on Elasticity |
|---|
| Time period | Long‑run more elastic |
| Availability of inputs | Easier access → more elastic |
| Production flexibility (technology) | More flexible → more elastic |
| Storage capacity | Ability to store → more elastic |
2.9.4 Worked Calculation (using the schedule)
Calculate PES between $14 and $16:
- ΔP = $2, average price = $15
- ΔQs = 60 – 50 = 10, average quantity = 55
- $$\text{PES} = \frac{10/55}{2/15} = \frac{0.182}{0.133} \approx 1.37$$
- Supply is **elastic** over this range.
2.10 Using Elasticities to Predict Revenue and Policy Impact
- If demand is elastic, a price rise reduces total revenue; a price fall increases revenue.
- If demand is inelastic, a price rise increases total revenue; a price fall reduces revenue.
- Governments consider elasticity when designing taxes (higher revenue from inelastic goods) or subsidies (greater impact on elastic goods).
3. Micro‑Economic Decision‑Makers
3.1 Households (Consumers)
- Make consumption choices to maximise utility subject to income and prices.
- Factors influencing demand: income, tastes, expectations, prices of related goods, number of buyers.
- Budget constraint: Income = Σ (Price × Quantity).
3.2 Workers (Labour Suppliers)
- Decide how many hours to work based on wages, working conditions, alternative leisure activities, and expectations of future wages.
- Labour supply curve is generally upward sloping, but can be backward‑bending at high wages.
3.3 Firms (Producers)
3.3.1 Production & Costs
- Fixed costs (FC) – do not vary with output (e.g., rent).
- Variable costs (VC) – vary with output (e.g., raw materials).
- Total cost (TC) = FC + VC.
- Average cost (AC) = TC / Q; Marginal cost (MC) = ΔTC / ΔQ.
- In the short run, MC typically falls, reaches a minimum, then rises (U‑shaped).
3.3.2 Revenue
- Total revenue (TR) = P × Q.
- Average revenue (AR) = TR / Q (equals price in perfect competition).
- Marginal revenue (MR) = ΔTR / ΔQ.
3.3.3 Profit Maximisation
Firm produces where MR = MC. In perfect competition, this is also where P = MC.
3.3.4 Market Structures (Cambridge IGCSE focus)
| Structure | Key Characteristics | Price‑Setter? |
|---|
| Perfect competition | Many sellers, identical product, free entry/exit, perfect information | No – price taker |
| Monopoly | Single seller, unique product, high barriers to entry | Yes – price maker |
| Monopolistic competition | Many sellers, differentiated products, low barriers | Some – price‑setter within a narrow range |
| Oligopoly | Few large sellers, inter‑dependent, may collude | Partial – strategic pricing |
3.4 Money & Banking
- Functions of money: medium of exchange, unit of account, store of value.
- Characteristics: acceptability, divisibility, durability, portability, uniformity.
- Banks accept deposits and provide loans; the interest rate is the price of borrowing.
- Central bank (e.g., Bank of England) controls the money supply and influences interest rates.
4. Macro‑Economic Decision‑Makers
4.1 Government (Fiscal Policy)
- Uses taxation and government spending to influence aggregate demand.
- Expansionary fiscal policy: increase spending or cut taxes → shifts AD right → higher output and employment (but may raise inflation).
- Contractionary fiscal policy: decrease spending or raise taxes → shifts AD left → lower inflation (risk of higher unemployment).
- Objectives: economic growth, low unemployment, price stability.
4.2 Central Bank (Monetary Policy)
- Controls the money supply and interest rates.
- Expansionary monetary policy: lower interest rates, increase money supply → AD shifts right.
- Contractionary monetary policy: raise interest rates, reduce money supply → AD shifts left.
- Tools: open‑market operations, reserve requirements, policy interest rates.
4.3 International Sector
- Balance of payments (BOP) records all transactions with the rest of the world.
- Current account – trade in goods & services, income, transfers.
- Capital account – financial flows (investment, loans).
- Exchange rate regimes:
- Fixed (pegged) – government/bank intervenes to maintain a set rate.
- Floating – market determines the rate.
- Trade policies:
- Tariffs – tax on imports (raises domestic price, protects local industry).
- Quotas – limit the quantity of imports.
- Subsidies – support domestic producers.
5. Market Failure
- Occurs when the free market does not allocate resources efficiently.
5.1 Public Goods
- Non‑rival and non‑excludable (e.g., street lighting, national defence).
- Market under‑provides them → government provision.
5.2 Merit and Demerit Goods
- Merit goods – socially desirable (e.g., education, vaccination); often under‑consumed.
- Demerit goods – socially undesirable (e.g., cigarettes, alcohol); often over‑consumed.
5.3 Externalities
- Positive externality – third‑party benefit (e.g., beekeeper’s bees pollinating nearby crops).
- Negative externality – third‑party cost (e.g., factory pollution).
- Government remedies: taxes on negative externalities, subsidies on positive externalities, regulation.
5.4 Information Failure
- When buyers or sellers lack full information (e.g., hidden defects), market outcomes may be inefficient.
- Possible solutions: labelling laws, consumer protection agencies.
5.5 Monopoly Power
- Single seller can restrict output and raise price above marginal cost → dead‑weight loss.
- Remedies: antitrust legislation, price regulation, encouraging competition.
6. Mixed Economic System
- Definition: An economy that combines a market system with government intervention to correct failures and achieve social goals.
- Characteristics:
- Private ownership of most resources.
- Government provides public goods, regulates externalities, and may run key services (health, education).
- Use of fiscal and monetary policy to stabilise the economy.
- Advantages (AO3 evaluation points):
- Efficient allocation of many goods through the price mechanism.
- Government can address market failures and promote equity.
- Provides a safety net (unemployment benefits, pensions).
- Disadvantages:
- Potential for government failure (inefficient bureaucracy, wrong policy choices).
- Higher taxes may discourage investment and work effort.
- Risk of over‑regulation reducing incentives for innovation.
7. Summary of Key Diagram Conventions (for exam answers)
- Always label axes (Price – P, Quantity – Q).
- Mark equilibrium point E and write Pₑ and Qₑ.
- Indicate surplus (excess supply) above Pₑ and shortage (excess demand) below Pₑ.
- When showing a price ceiling/floor, draw a horizontal line at the imposed price and shade the resulting shortage or surplus.
- For taxes/subsidies, show the parallel shift of the relevant curve and label the amount of the tax/subsidy.
- Elasticity diagrams: use a steep demand curve for inelastic demand, a flat curve for elastic demand; similarly for supply.