The three basic economic questions which determine resource allocation: who to produce for

The Basic Economic Problem – Resource Allocation Decisions

1. Scarcity and the Three Basic Economic Questions

Because the world’s resources are scarce, societies must decide how to use them efficiently. This gives rise to three fundamental questions (Cambridge IGCSE 0455 1.1‑1.4):

1. What goods and services should be produced?
2. How should they be produced (techniques, organisation, who does the work)?
3. Who should receive the output – i.e. how is the output distributed?

All three are linked: the choice of what and how to produce influences who ultimately benefits.

2. Economic Goods vs. Free Goods (Syllabus 1.1.3)

• Economic goods – scarce; require a choice and have a price (e.g. a loaf of bread).
• Free goods – abundant; no opportunity cost and are available without payment (e.g. air, sunlight).

3. Factors of Production and Their Rewards

4. Opportunity Cost

Opportunity cost = the value of the best alternative that is foregone when a choice is made.

Example: A student can either study for an exam or work a part‑time job earning £50. If she studies, the opportunity cost is £50 (the income she gives up).

5. The Production Possibility Curve (PPC) (Syllabus 1.2‑1.4)

• Axes: Quantity of Good A on the x‑axis, quantity of Good B on the y‑axis.
• Points on the curve: Efficient use of all resources (maximum possible output of both goods).
• Points inside the curve: Inefficient – resources are under‑utilised (unemployment, idle factories).
• Points outside the curve: Unattainable with current resources/technology.
• Shifts of the PPC:

  • Outward/right‑hand shift: More resources or better technology – economic growth.
  • Inward/left‑hand shift: Fewer resources or deteriorating technology – recession or disaster.

Diagram suggestion: Draw a PPC with points A (efficient), B (inefficient) and an outward‑shifted curve PPC′ to illustrate growth.

6. Demand and Supply (Syllabus 2.1‑2.4)

6.1 Demand

• Individual demand: Quantity of a good a single consumer is willing & able to buy at each price.
• Market demand: Horizontal sum of all individual demand curves.
• Movement along the demand curve: Caused by a change in the price of the good itself.
• Shift of the demand curve: Caused by changes in:

  • Consumer income (normal vs. inferior goods)
  • Prices of related goods (substitutes, complements)
  • Preferences, expectations, population

6.2 Supply

• Individual supply: Quantity a single firm is willing & able to sell at each price.
• Market supply: Vertical sum of all individual supply curves.
• Movement along the supply curve: Caused by a change in the price of the good itself.
• Shift of the supply curve: Caused by changes in:

  • Input prices (land, labour, capital, enterprise)
  • Technology (improvements shift supply right)
  • Number of firms, expectations, taxes/subsidies

6.3 Price Determination – Equilibrium

Where the market‑demand curve meets the market‑supply curve:

• Equilibrium price (P_e) – the price at which quantity demanded equals quantity supplied.
• Equilibrium quantity (Q_e) – the quantity bought and sold at P_e.

If the market price is above P_e a surplus occurs → downward pressure on price.

If the market price is below P_e a shortage occurs → upward pressure on price.

Diagram suggestion: Standard demand‑supply graph showing equilibrium, surplus, and shortage.

7. Elasticity (Syllabus 2.5‑2.6)

7.1 Price Elasticity of Demand (PED)

PED formula: \(\displaystyle \text{PED}= \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}\)

• Elastic (>1): Quantity changes proportionally more than price.
• Inelastic (<1): Quantity changes proportionally less than price.
• Unit‑elastic (=1).

Determinants of PED: Availability of substitutes, proportion of income spent, necessity vs. luxury, time‑period.

Worked example: Price falls from £10 to £8 (‑20 %). Quantity demanded rises from 100 to 130 (+30 %).

PED = 30 % / ‑20 % = –1.5 → demand is elastic.

7.2 Price Elasticity of Supply (PES)

PES formula: \(\displaystyle \text{PES}= \frac{\% \text{ change in quantity supplied}}{\% \text{ change in price}}\)

• Elastic supply when producers can increase output quickly (e.g., services).
• Inelastic supply when production depends on fixed factors (e.g., land‑based agriculture).

8. Market Economic System vs. Mixed Economic System (Syllabus 2.8‑2.10)

8.1 Market (Free‑Market) Economy

• Resources allocated mainly by the price mechanism.
• Private ownership of firms.
• Limited government intervention (only to correct market failures).

Advantages: High efficiency, encourages innovation, reflects consumer preferences.

Disadvantages: May produce inequality, can under‑provide public goods, can lead to market failures.

8.2 Mixed Economy

• Combination of market forces and government intervention.
• Government may provide public goods, regulate monopolies, subsidise merit goods, tax demerit goods.

Advantages: Balances efficiency with equity; can correct market failures.

Disadvantages: More complex to manage; risk of policy contradictions; administrative costs.

9. Market Failure and Government Intervention (Syllabus 2.7‑2.10)

• Public goods – non‑rival & non‑excludable (e.g., street lighting). Market under‑provides them → government provision.
• Externalities – third‑party effects.

  • Negative: pollution → tax or regulation.
  • Positive: education → subsidy.

• Merit & demerit goods – merit (under‑consumed, e.g., vaccines) → subsidise; demerit (over‑consumed, e.g., cigarettes) → tax.
• Monopoly power – single seller can set price above marginal cost → regulation or public ownership.

10. Allocation of Output – “Who Should Output be Produced For?” (Syllabus 5.1‑5.3)

10.1 Evaluation Criteria (AO3)

• Impact on equity (distribution of income and wealth).
• Impact on efficiency (maximising output from scarce resources).
• Effect on incentives for producers (innovation, investment, output).
• Ability to correct market failures (public goods, externalities, merit/demerit goods, monopoly).
• Administrative feasibility and cost.
• Political and social acceptability.

10.2 Illustrative Example – Allocation of a Life‑Saving Vaccine

• Market Allocation: Vaccine sold at market price; only those who can afford it receive it.
• Command Allocation: Government distributes it free to high‑risk groups, regardless of income.
• Mixed Allocation: Government subsidises the vaccine, lowering the price so a broader segment can purchase it.

11. Money and Banking (Syllabus 3.1‑3.2)

• Functions of Money: Medium of exchange, unit of account, store of value, standard of deferred payment.
• Types of Money: Commodity money, fiat (paper) money, electronic money.
• Central Bank: Issues currency, controls money supply (e.g., through open‑market operations, reserve requirements), sets policy interest rates.
• Commercial Banks: Accept deposits, provide loans, create money through the multiplier effect.

12. Households (Syllabus 3.3)

• Decisions on consumption, saving and borrowing are influenced by:

  • Current income and wealth
  • Interest rates (cost of borrowing, reward for saving)
  • Consumer confidence and expectations
  • Age, culture, family size

• Households supply labour to firms and receive wages, rent, interest and profit.

13. Workers (Syllabus 3.4)

• Wage determination: Interaction of labour supply and demand; influenced by skills, education, trade‑union power, minimum‑wage legislation.
• Labour‑market diagram: Shows equilibrium wage (W_e) and quantity of labour (L_e); a minimum wage set above W_e creates unemployment (surplus labour).

14. Firms (Syllabus 3.5‑3.6)

14.1 Production and Productivity

• Production function: Relationship between inputs (labour, capital, enterprise) and output.
• Productivity: Output per unit of input (e.g., labour productivity = output ÷ labour hours).

14.2 Costs

Typical cost curves: MC cuts ATC at its minimum; AFC falls as output rises; AVC falls then rises due to diminishing returns.

14.3 Revenue

• Total Revenue (TR) = Price × Quantity.
• Average Revenue (AR) = TR ÷ Q = Price (in a perfectly competitive market).
• Marginal Revenue (MR) = Change in TR from selling one more unit.

14.4 Objectives of Firms

• Profit maximisation (most common objective in market economies).
• Growth, market share, survival, corporate social responsibility – may be secondary goals.

15. Types of Markets (Syllabus 3.7)

16. Government Macro‑Economic Aims (Syllabus 4.1‑4.2)

• Economic growth (increase in real GDP).
• Full employment (low unemployment).
• Low inflation.
• Balance of payments equilibrium.
• Equitable distribution of income.
• Sustainable development (environmental protection).

17. Fiscal Policy (Syllabus 4.3‑4.4)

• Government Budget: Revenue (taxes, duties) vs. Expenditure (public services, welfare, interest payments).
• Budget Deficit: Expenditure > Revenue → borrowing.
• Budget Surplus: Revenue > Expenditure → repayment of debt.
• Tools:

  • Taxation: Direct (income tax) & indirect (VAT); can be progressive or regressive.
  • Government Spending: Infrastructure, education, health – can stimulate demand.

• Effect on Aggregate Demand (AD): Expansionary fiscal policy (higher spending or lower taxes) shifts AD right; contractionary policy shifts AD left.

18. Monetary Policy (Syllabus 4.5‑4.6)

• Conducted by the central bank to influence the money supply and interest rates.
• Instruments:

  • Open‑market operations (buying/selling government securities).
  • Reserve requirements for commercial banks.
  • Policy interest rate (e.g., repo rate).

• Expansionary monetary policy: Lower interest rates → increase borrowing and consumption → AD shifts right.
• Contractionary monetary policy: Higher interest rates → reduce borrowing → AD shifts left.

19. Supply‑Side Policies (Syllabus 4.7)

• Measures aimed at increasing the productive capacity of the economy (shifting the LRAS curve right).
• Examples: improving education and training, reducing regulation, tax incentives for investment, promoting research & development, infrastructure investment.

20. Macroeconomic Evaluation of Policies (AO3)

When assessing any policy (fiscal, monetary, supply‑side, or allocation mechanism) consider:

• Short‑run vs. long‑run effects on growth, unemployment and inflation.
• Distributional impact – who benefits and who may be disadvantaged.
• Time‑lag and feasibility of implementation.
• Potential unintended consequences (e.g., crowding‑out, inflationary pressure).
• Political acceptability and sustainability.

21. Suggested Diagrams (for exam revision)

• PPC with shift (growth) and points A (efficient) & B (inefficient).
• Demand‑supply diagram showing equilibrium, surplus, shortage.
• Elasticity – steep vs. flat demand curves.
• Labour‑market diagram with minimum wage.
• Cost curves (MC, ATC, AFC, AVC) with profit‑maximising output.
• AD‑AS diagram illustrating fiscal or monetary expansion.
• Flow‑chart comparing Market, Command and Mixed allocation mechanisms and their typical effects on equity and efficiency.

22. Key Take‑aways

• Scarcity creates the three basic economic questions; “who should output be produced for?” concerns distribution.
• Understanding factors of production, opportunity cost and the PPC provides the foundation for analysing choices.
• Demand, supply, price‑determination and elasticity explain how markets allocate resources.
• Market failure justifies government intervention; most modern economies adopt a mixed approach.
• Allocation mechanisms, fiscal and monetary policies, and supply‑side measures are evaluated using criteria of equity, efficiency, incentives, feasibility and political acceptability.