Definitions, drawing and interpretation of diagrams, advantages and disadvantages of subsidies

0455 IGCSE Economics – Core Notes

1. The Basic Economic Problem

• Scarcity: Unlimited wants but limited resources.
• Factors of Production:

  • Land (natural resources)
  • Labour (human effort)
  • Capital (machinery, buildings, tools)
  • Enterprise (risk‑taking, organisation)

• Opportunity Cost: The next best alternative fore‑gone when a choice is made.
  

  Formula: OC = Value of best alternative not chosen.

• Production Possibility Curve (PPC):

  • Shows maximum output combinations of two goods when resources are fully and efficiently used.
  • Points on the curve = efficient; inside = under‑utilisation; outside = unattainable.

  How to draw in the exam:

  1. Axes: Good A (horizontal) and Good B (vertical).
  2. Draw a bowed‑out curve from the origin.
  3. Label a point on the curve (e.g., P) and a point inside (e.g., I).
  4. Explain opportunity cost as the slope (ΔB/ΔA) between two points.

2. Allocation of Resources

2.1 Demand and Supply (AO1)

• Demand: Quantity of a good consumers are willing and able to buy at each price, ceteris paribus.
• Supply: Quantity producers are willing and able to sell at each price, ceteris paribus.
• Equilibrium = intersection of D and S (price = P_e, quantity = Q_e).

2.2 Shifts vs. Movements (AO1)

2.3 Price Elasticity of Demand (PED) (AO1‑AO2)

• Definition: % change in quantity demanded ÷ % change in price.
• Formula: PED = (ΔQ / Q) ÷ (ΔP / P).
• Interpretation:

  • |PED| > 1 → elastic (large response).
  • |PED| = 1 → unit‑elastic.
  • |PED| < 1 → inelastic (small response).

• Determinants:

• Diagram tip: A flatter demand curve = more elastic; a steeper curve = more inelastic.

2.4 Market Failure & Government Intervention (AO1‑AO3)

• Public goods – non‑excludable & non‑rival (e.g., street lighting).
• Merit goods – generate positive externalities (e.g., education).
• Demerit goods – generate negative externalities (e.g., cigarettes).
• Externalities – costs or benefits to third parties not reflected in market price.

2.5 Mixed Economic System – Allocation of Resources

A mixed economy combines market mechanisms with selective government intervention to correct market failure, provide public/merit goods and achieve equity.

3. Government Intervention Tools (AO1‑AO3)

4. Subsidies – Detailed Study (AO1‑AO3)

4.1 Definition

A subsidy is a government payment to producers or consumers designed to lower the market price of a good or service, encouraging its production or consumption.

4.2 Diagram – Producer (or Firm) Subsidy

Sketch checklist (exam):

1. Axes: Price (vertical) – Quantity (horizontal).
2. Draw the original upward‑sloping supply curve S and downward‑sloping demand curve D.
3. Mark initial equilibrium (P₁, Q₁) where S meets D.
4. Shift the supply curve down/right by the per‑unit subsidy amount s; label the new curve S′.
5. New equilibrium is (P₂, Q₂) where S′ meets D.
6. Label:

   • Consumer price = P₂.
   • Producer price = P₂ + s = P₁.

7. Shade the rectangle between P₁ and P₂ up to Q₂ – this is the total government outlay.
8. If the question asks for efficiency, add the dead‑weight loss (DWL) triangle between the demand curve and the original marginal‑cost curve beyond the socially optimal output.

4.3 Interpretation of the Diagram

1. The subsidy reduces producers’ marginal cost, shifting supply rightward.
2. Quantity supplied and demanded rises from Q₁ to Q₂.
3. Consumers benefit from a lower price P₂; producers receive the higher effective price P₁.
4. Government expenditure equals the shaded rectangle: Outlay = s × Q₂.
5. If Q₂ exceeds the socially optimal quantity, the small triangle between demand and original MC represents a dead‑weight loss – an efficiency loss.

4.4 Mathematical Expression

If the per‑unit subsidy is s, the supply (or marginal‑cost) equation becomes:

P = MC – s or MC = P + s

4.5 Advantages of Subsidies (AO2)

4.6 Disadvantages of Subsidies (AO2)

4.7 Evaluation Checklist (AO3)

1. Does the subsidy move the market toward the socially optimal output? (Efficiency)
2. Who benefits – consumers, producers, specific regions? Who pays – taxpayers? (Equity)
3. Is the fiscal cost sustainable in the long run? (Fiscal sustainability)
4. Does the policy encourage self‑sufficiency or create dependence? (Long‑term effects)
5. Are there any unintended side‑effects (e.g., market distortion, WTO challenge)?

5. Micro‑Economic Decision‑Makers (AO1‑AO2)

5.1 Households

• Decide how much to spend on consumption vs. saving.
• Influenced by income, interest rates, consumer confidence.

5.2 Firms

• Goal: maximise profit (Total Revenue – Total Cost).
• Key concepts: marginal cost (MC), marginal revenue (MR), profit‑maximising output where MR = MC.
• Diagram – ATC & MC:

  1. Draw ATC (U‑shaped) and MC (U‑shaped, intersecting ATC at its minimum).
  2. Show price line (P) from market; profit = rectangle (P – ATC) × Q.

5.3 Labour Market

• Wage determination through supply of labour (workers) and demand for labour (firms).
• Minimum wage = price floor → potential surplus of labour (unemployment).

5.4 Money & Banking (AO1)

• Money – medium of exchange, store of value, unit of account.
• Central bank – controls money supply, sets policy interest rate.
• Commercial banks – accept deposits, provide loans, create money through fractional reserve banking.

6. Government & the Macro‑Economy (AO1‑AO3)

6.1 Fiscal Policy

• Uses government spending (G) and taxation (T) to influence aggregate demand (AD).
• Expansionary: ↑ G or ↓ T → AD ↑ → higher output & employment (possible inflation).
• Contractionary: ↓ G or ↑ T → AD ↓ → lower inflation but risk of higher unemployment.

6.2 Monetary Policy

• Tools: policy interest rate, open‑market operations, reserve requirements.
• Expansionary: ↓ interest rate → cheaper borrowing → AD ↑.
• Contractionary: ↑ interest rate → borrowing falls → AD ↓.

6.3 Supply‑Side Policies

• Improve long‑run productive capacity.
• Examples: investment in education & training, infrastructure, tax incentives for R&D, deregulation.

6.4 Key Macro Indicators (AO1‑AO2)

7. Economic Development (AO1‑AO2)

• Living standards – measured by real GDP per‑head, household income, consumption levels.
• Human Development Index (HDI) – combines life expectancy, education and per‑capita income.
• Poverty:

  • Absolute poverty – cannot meet basic needs (e.g., $1.90/day).
  • Relative poverty – income far below the median of a society.

• Policies to raise development:

  • Progressive taxation & welfare transfers.
  • Investment in health & education.
  • Infrastructure projects (roads, electricity).
  • Trade‑opening measures to access larger markets.

8. International Trade & Globalisation (AO1‑AO3)

8.1 Benefits of Trade

• Specialisation according to comparative advantage → higher global output.
• Access to a wider variety of goods at lower prices.
• Technology transfer and economies of scale.

8.2 Trade Restrictions

8.3 Balance of Payments (BOP)

• Records all economic transactions between residents and the rest of the world.
• Current account (trade in goods & services, income, transfers) + Capital/Financial account = Overall balance.
• Surplus → net inflow of foreign currency; Deficit → net outflow (may need financing).

9. Drawing & Interpreting Key Diagrams (Exam Checklist)

1. Label axes clearly (price, quantity; or price level, real GDP, etc.).
2. Mark equilibrium points and label them (e.g., P₁, Q₁).
3. Use arrows to show direction of shifts (right/left, up/down).
4. Shade areas that represent:

   • Consumer/producer surplus.
   • Government outlay (subsidy rectangle).
   • Dead‑weight loss (triangle).

5. Write a concise caption (1‑2 sentences) stating what the diagram shows.
6. Check that any numerical data given in the question is reflected accurately in the sketch.

10. Summary (Key Points for Revision)

• Scarcity → choice → opportunity cost; PPC illustrates trade‑offs.
• Demand & supply determine price & output; shifts reflect changes in underlying factors.
• Elasticities measure responsiveness; crucial for tax/subsidy impact analysis.
• Market failure (public/merit/demerit goods, externalities) justifies government intervention.
• Mixed economy blends market efficiency with equity‑oriented state action.
• Subsidies: shift supply right, lower consumer price, raise output, cost government; evaluate on efficiency, equity, fiscal sustainability.
• Fiscal & monetary policies influence aggregate demand; supply‑side measures affect long‑run potential output.
• Economic development measured by GDP per‑head, HDI; policies focus on health, education, infrastructure.
• International trade brings gains through comparative advantage but may be restricted by tariffs, quotas, etc.; BOP records the net flow.
• Always support answers with a labelled diagram and a brief evaluation using AO2/AO3 criteria.