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

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

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

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)

3.7 Types of markets (Syllabus 3.7)

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.