The difference between economic goods and free goods

Topic: The Basic Economic Problem – Economic Goods and Free Goods

Learning Objectives

• Explain why scarcity creates the basic economic problem.
• Identify the three fundamental economic questions and the factors of production.
• Define opportunity cost and illustrate it with a production‑possibility curve (PPC).
• Distinguish clearly between economic goods and free goods, giving appropriate examples.
• Describe how markets allocate scarce resources and recognise the role of price signals.
• Analyse demand and supply, equilibrium, price elasticity, market structures, market failure and government intervention.
• Understand the decisions of households, workers, firms and the role of money & banking.
• Summarise the main macro‑economic aims and the tools of fiscal, monetary and supply‑side policy.
• Evaluate the measurement of economic development and the policies used to promote it.

1. The Basic Economic Problem (Syllabus 1.1‑1.4)

1.1 Nature of the basic economic problem

• Scarcity: resources (land, labour, capital, enterprise) are limited while human wants are unlimited.
• Result – societies must make choices about how to use scarce resources.
• The three basic questions every economy must answer:
  1. What goods and services should be produced?
  2. How should they be produced?
  3. For whom should they be produced?

1.2 Factors of production and their rewards

Factor	Examples	Reward (income)
Land (natural resources)	Agricultural land, minerals, forests, water	Rent
Labour	Factory workers, teachers, doctors	Wages
Capital	Machinery, factories, computers, software	Interest
Enterprise (entrepreneurship)	Business owners, innovators, risk‑takers	Profit

1.3 Opportunity cost

• Definition: the value of the next best alternative that is foregone when a choice is made.
• Measured in terms of the alternative that is given up (usually in money, units of another good, or time).
• Example: Studying for an exam means giving up the wage you could have earned working a part‑time job.

1.4 Production‑Possibility Curve (PPC)

• Shows the maximum possible output of two goods that can be produced with a fixed amount of resources and a given technology.
• Key points:
  • Inside the curve – resources are under‑utilised; opportunity cost is not fully realised.
  • On the curve – efficient use of resources; moving along the curve entails a trade‑off (opportunity cost).
  • Outside the curve – unattainable with current resources/technology.
• Shifts of the PPC:
  • Outward shift – increase in resources or improvement in technology → economic growth.
  • Inward shift – loss of resources or deterioration in technology.

1.5 Economic goods vs. free goods (Syllabus 1.1.3)

• Economic (scarce) goods: goods that are limited in supply and have a price because the cost of producing them exceeds the resources available.
  Examples: smartphones, wheat, petrol, a cinema ticket.
• Free goods: goods that are abundant relative to demand and are available without a price.
  Examples: air (in most circumstances), sunlight, seawater (in coastal areas).
• Key distinction – only economic goods require allocation through the market; free goods are not subject to scarcity.

2. Allocation of Resources (Syllabus 2.1‑2.10)

2.1 The role of the market

• Markets bring buyers and sellers together.
• Price signals coordinate the allocation of scarce resources.
• When markets work well they achieve allocative efficiency – goods go to those who value them most.

2.2 Demand

• Definition: the quantity of a good or service that consumers are willing and able to buy at a given price, during a given period.
• Law of demand – as price falls, quantity demanded rises (ceteris paribus).
• Determinants of demand: income, tastes & preferences, prices of related goods (substitutes & complements), expectations, number of buyers.
• Movement along the demand curve = change in price; shift of the curve = change in any determinant other than price.

2.3 Supply

• Definition: the quantity of a good or service that producers are willing and able to sell at a given price, during a given period.
• Law of supply – as price rises, quantity supplied rises (ceteris paribus).
• Determinants of supply: input prices, technology, expectations, number of sellers, taxes/subsidies, price of related goods (in production).
• Movement along the supply curve = change in price; shift of the curve = change in any other determinant.

2.4 Market equilibrium and disequilibrium

• Equilibrium: where quantity demanded equals quantity supplied (Q_d = Q_s) – the market price is stable at p*​.
• Surplus: Q_s > Q_d at a given price → downward pressure on price.
• Shortage: Q_d > Q_s at a given price → upward pressure on price.

2.5 The price mechanism

When a shortage exists, price rises, reducing demand and encouraging more supply until a new equilibrium is reached; the opposite occurs with a surplus.

2.6 Price elasticity of demand (PED)

• Formula: PED = (%ΔQ_d) / (%ΔP)
• Interpretation:
  • |PED| > 1 – demand is elastic.
  • |PED| = 1 – demand is unit‑elastic.
  • |PED| < 1 – demand is inelastic.
• Determinants of PED:
  • Availability of close substitutes
  • Proportion of income spent on the good
  • Nature of the good (luxury vs necessity)
  • Time horizon (more elastic in the long run)
• Relevance:
  • Pricing decisions – firms can raise price if demand is inelastic.
  • Revenue – total revenue moves opposite to price when demand is elastic.

2.7 Price elasticity of supply (PES)

• Formula: PES = (%ΔQ_s) / (%ΔP)
• Determinants:
  • Time period (more elastic in the long run)
  • Mobility of factors of production
  • Availability of spare capacity
  • Complexity of the production process
• Policy implication – taxes on goods with inelastic supply cause larger price rises for consumers.

2.8 Types of market system

System	Key Characteristics	Typical Examples
Market (free) economy	Decisions made by households & firms through price signals; limited government role.	United Kingdom, United States (mixed but market‑driven)
Command economy	Central authority decides what, how & for whom to produce; prices often set by the state.	North Korea, former Soviet Union
Mixed economy	Combination of market mechanisms and government intervention to correct failures and achieve social goals.	Most modern economies (e.g., UK, India, Brazil)

2.9 Market failure

• Public goods – non‑rival and non‑excludable (e.g., national defence, street lighting). Free‑rider problem leads to under‑supply.
• Merit goods – socially desirable but under‑consumed if left to the market (e.g., education, vaccinations).
• Demerit goods – socially undesirable but over‑consumed (e.g., cigarettes, alcohol).
• Externalities
  • Positive externality – benefits to third parties (e.g., beekeping, education).
  • Negative externality – costs to third parties (e.g., pollution, noise).
• Monopoly – single seller can restrict output and raise price, causing allocative inefficiency.

2.10 Government intervention

Tool	Purpose	Typical Effect on Market
Price ceiling (max price)	Protect consumers from high prices	Creates shortage if set below equilibrium price
Price floor (min price)	Support producers (e.g., minimum wage)	Creates surplus if set above equilibrium price
Tax	Reduce consumption of demerit goods, raise revenue	Shifts supply curve upward; price to consumers rises, price to producers falls
Subsidy	Encourage consumption/production of merit goods	Shifts supply curve downward; price to consumers falls, producer receives higher effective price
Regulation	Control externalities, ensure safety standards	Can increase costs for firms, altering supply
Privatisation	Transfer public enterprises to private ownership to improve efficiency	Introduces market discipline
Nationalisation	Bring essential services under state control	Eliminates profit motive; may affect efficiency
Quota	Limit quantity of imports/exports	Raises domestic price, protects domestic producers

3. Micro‑economic Decision‑Makers (Syllabus 3.1‑3.7)

3.1 Money and banking

• Functions of money: medium of exchange, unit of account, store of value, standard of deferred payment.
• Banking creates money through the fractional‑reserve system – banks keep a fraction of deposits as reserves and lend out the remainder.
• Interest rate = price of borrowing; influences consumer spending and business investment.

3.2 Households

• Decide how much to consume, save and borrow.
• Budget constraint: Income = Expenditure on goods + Savings.
• Choice between present and future consumption is affected by the real interest rate.

3.3 Workers (Labour market)

• Supply of labour – determined by wages, working conditions, alternative employment opportunities, education and training.
• Demand for labour – derived from the marginal productivity of labour (MPL); firms hire up to the point where MPL = wage.
• Government policies (e.g., minimum wage, trade unions) can shift supply or demand.

3.4 Firms – Types and objectives

• Business organisations: sole trader, partnership, private limited company, public limited company.
• Objectives of firms:
  • Survival (short‑run)
  • Profit maximisation (most common objective)
  • Growth, market share, corporate social responsibility.

3.5 Production and productivity (Syllabus 3.5)

• Production: transformation of inputs (land, labour, capital, enterprise) into outputs.
• Productivity: output per unit of input (e.g., output per hour of labour). Higher productivity can raise real wages and economic growth.
• Factors influencing productivity: technology, skill levels, management techniques, economies of scale.

3.6 Costs, revenue and profit (Syllabus 3.6)

Cost concept	Formula / Description
Total Cost (TC)	TC = Fixed Cost (FC) + Variable Cost (VC)
Average Fixed Cost (AFC)	AFC = FC / Q
Average Variable Cost (AVC)	AVC = VC / Q
Average Total Cost (ATC)	ATC = TC / Q = AFC + AVC
Marginal Cost (MC)	MC = ΔTC / ΔQ (cost of producing one more unit)
Total Revenue (TR)	TR = Price (P) × Quantity sold (Q)
Average Revenue (AR)	AR = TR / Q = P (in a perfectly competitive market)
Marginal Revenue (MR)	MR = ΔTR / ΔQ (revenue from selling one more unit)
Profit (π)	π = TR – TC

3.7 Types of markets (Syllabus 3.7)

Market type	Key characteristics	Advantages	Disadvantages
Perfect competition	Many buyers & sellers, homogeneous product, free entry & exit, price‑taker.	Allocative & productive efficiency; low prices for consumers.	Hard to achieve in reality; firms have little control over price.
Monopoly	Single seller, unique product, high barriers to entry, price‑setter.	Potential for economies of scale; stable profits for the firm.	Allocative inefficiency (price > marginal cost); higher prices, lower output.

4. Government & Macro‑economics (Syllabus 4.1‑4.7)

4.1 Macro‑economic aims

• Economic growth (increase in real GDP)
• Low unemployment
• Low inflation
• Balance of payments equilibrium
• Equitable income distribution
• Environmental sustainability (modern addition to the syllabus)

4.2 Measuring macro‑economic performance

• Real GDP: total value of final goods and services produced, adjusted for inflation.
• GDP per head: real GDP ÷ population – indicator of living standards.
• Consumer Price Index (CPI): measures changes in the price of a typical basket of goods; used to calculate inflation.
• Unemployment rate: (Number of unemployed ÷ Labour force) × 100.
• Balance of payments (BOP): record of a country’s transactions with the rest of the world; current‑account surplus/deficit.

4.3 Fiscal policy (government spending and taxation)

• Expansionary fiscal policy: increase in government spending and/or decrease in taxes – shifts aggregate demand (AD) right, used to combat recession.
• Contractionary fiscal policy: decrease in spending and/or increase in taxes – shifts AD left, used to control inflation.
• Budget deficit = expenditure > revenue; surplus = revenue > expenditure.
• Tax types (relevant for IGCSE): income tax, corporation tax, VAT, excise duties – each influences consumption, investment and government revenue.

4.4 Monetary policy (central bank actions)

• Controlled by the central bank (e.g., Bank of England, Federal Reserve).
• Key tools:
  • Open‑market operations – buying/selling government securities to change the money supply.
  • Bank rate / base interest rate – influences commercial bank rates.
  • Reserve requirements – proportion of deposits banks must hold.
• Expansionary monetary policy: lower interest rates, increase money supply – shifts AD right.
• Contractionary monetary policy: raise interest rates, reduce money supply – shifts AD left.

4.5 Supply‑side (structural) policy

• Aims to increase the productive capacity of the economy (shift the PPC outward).
• Key measures:
  • Education and training – improve labour quality.
  • Investment in infrastructure – reduce production costs.
  • Research & development – foster innovation.
  • Labour‑market reforms – flexible wages, reduce trade‑union power.
  • Deregulation and privatisation – increase competition.

4.6 Economic growth, unemployment and inflation

• Economic growth: sustained increase in real GDP. Measured by the growth rate (%ΔReal GDP).
• Causes – capital accumulation, labour force growth, technological progress, improved productivity.
• Unemployment types:
  • Frictional – short‑term, job‑search.
  • Structural – mismatch of skills/locations.
  • Cyclical – due to downturns in the business cycle.
• Inflation: sustained rise in the general price level (CPI). Measured as %ΔCPI.
• Causes – demand‑pull (excess AD), cost‑push (rising production costs), built‑in (wage‑price spiral).
• Policy responses:
  • To curb inflation – contractionary fiscal or monetary policy.
  • To reduce unemployment – expansionary fiscal or monetary policy, supply‑side measures.

4.7 Balance of payments and exchange rates

• Current account: trade in goods & services, income, transfers.
• Capital account: financial flows – investment, loans, aid.
• Surplus – exports > imports; deficit – imports > exports.
• Exchange‑rate regimes:
  • Fixed (pegged) – government/central bank maintains a set rate.
  • Floating – market determines the rate.
  • Managed float – occasional intervention.
• Impact on macro‑policy – a depreciating currency can improve the trade balance but may raise import‑price inflation.

5. Economic Development (Syllabus 5.1‑5.4)

5.1 Measuring development

• Real GDP per head – basic indicator of average living standards.
• Human Development Index (HDI): composite of life expectancy, education (mean & expected years of schooling) and GNI per capita.
• Gini coefficient: measures income inequality (0 = perfect equality, 1 = maximum inequality).
• Other indicators – poverty rates, infant mortality, access to clean water, gender parity.

5.2 Causes of under‑development

• Low levels of capital, technology and skilled labour.
• Political instability, poor institutions, corruption.
• Unfavourable geography (landlocked, disease‑prone).
• Dependence on primary commodities and vulnerability to price fluctuations.
• Inadequate infrastructure (transport, electricity, communications).

5.3 Strategies for development

• Import substitution industrialisation (ISI): protect domestic industries with tariffs and quotas to develop a manufacturing base.
• Export‑led growth: encourage export of comparative‑advantage goods; liberalise trade, attract foreign direct investment (FDI).
• Foreign aid and loans: financial assistance for infrastructure, health and education.
• Structural reforms: improve governance, property rights, reduce red‑tape, promote private sector.
• Investment in health, education and technology to raise productivity.

5.4 Sustainable development

• Balancing economic growth with environmental protection and social equity.
• Policies: renewable energy, pollution taxes, conservation programmes, corporate social responsibility.
• Link to the macro‑economic aim of environmental sustainability.

Key Summary Diagrams (suggested for revision)

• Production‑Possibility Curve (PPC) – shifts and opportunity cost.
• Demand and supply curves – equilibrium, surplus, shortage.
• Price‑elasticity of demand – steep vs. flat curves.
• Labour‑market diagram with a minimum wage floor.
• ATC and MC curves – profit maximisation in perfect competition.
• Aggregate‑Demand/Aggregate‑Supply (AD/AS) model – impact of fiscal and monetary policy.
• Balance‑of‑payments diagram – current‑account surplus/deficit.
• HDI components and Gini coefficient illustration.