Examples of the basic economic problem in the context of workers

The Basic Economic Problem – Focus on Workers (Cambridge IGCSE 0455)

1. The basic economic problem

Definition (Cambridge wording): The basic economic problem exists because resources are scarce while human wants are unlimited. Consequently, societies must decide how to allocate a limited amount of factors of production among competing uses.

1.1 Factors of production and the rewards they generate

1.2 Opportunity cost

Definition (Cambridge wording): The opportunity cost of a choice is the value of the next best alternative that is foregone.

Numeric example (workers):

Anna can either (a) take a part‑time job that pays £120 per week or (b) enrol in a one‑year college course that costs £1 200 in tuition.

If she chooses the job, the opportunity cost is the £1 200 tuition she could have paid (plus the future higher earnings the qualification might bring).

If she chooses the course, the opportunity cost is the £120 × 52 = £6 240 of earnings she gives up during the year.

1.3 Production‑possibility curve (PPC) – relevance to workers

• Axes: Quantity of Good X (horizontal) vs. Quantity of Good Y (vertical).
• Points A, B, C illustrate different production combinations.
• Any point on the curve shows the maximum output attainable with the existing stock of land, labour, capital and enterprise and the current technology.
• Shift outward: occurs when the quantity or quality of any factor improves – e.g. more skilled labour through education, new machinery, or discovery of land.
• Shift inward: results from a reduction in a factor – e.g. a pandemic that reduces the effective labour force.
• Movement along the curve represents a trade‑off: producing more of one good requires giving up some of the other – a direct analogue to a worker’s choice between work, leisure, and training.

2. Allocation of resources – Markets

2.1 Product‑market demand and supply

• Demand: quantity of a good or service that consumers are willing and able to buy at each price, ceteris paribus.
• Supply: quantity that producers are willing and able to sell at each price, ceteris paribus.
• Equilibrium is where Q_D = Q_S; the corresponding price is the market price.
• Shifts:

  • Demand right‑shift – rise in consumer income (normal good), change in tastes, population growth, etc.
  • Supply right‑shift – lower input costs, technological progress, more firms entering the market.

2.2 Labour‑market demand and supply (review)

• Firms demand labour to produce output; workers supply labour for wages.
• Equilibrium wage (w*) and quantity of labour (Q*) are where labour‑demand = labour‑supply.
• Elasticities:

  • Price (wage) elasticity of demand for labour = %ΔQ_D / %Δw.
  • Price (wage) elasticity of supply of labour = %ΔQ_S / %Δw.

2.3 Price elasticity of demand (PED) – goods and services

• Definition: PED measures the responsiveness of the quantity demanded to a change in price.
• Formula: ε_D = (%ΔQ_D) / (%ΔP).
• Interpretation:

  • |ε| > 1 → elastic demand (quantity changes proportionally more than price).
  • |ε| = 1 → unit‑elastic.
  • |ε| < 1 → inelastic demand.

• Determinants: availability of substitutes, proportion of income spent, necessity vs. luxury, time‑period for adjustment.
• Example: If the price of a cinema ticket rises from £8 to £10 (25 % increase) and attendance falls from 1 200 to 900 (25 % decrease), ε = –1 (unit‑elastic).

2.4 Price elasticity of supply (PES)

• Definition: PES measures the responsiveness of the quantity supplied to a change in price.
• Formula: ε_S = (%ΔQ_S) / (%ΔP).
• Determinants: spare capacity, time‑period, mobility of factors, nature of the good (perishable vs. storable).
• Example: A 10 % rise in the price of wheat leads farmers to increase output by 5 %; ε = 0.5 (inelastic supply in the short run).

2.5 Market failure

• Monopsony: single large employer can set wages below the competitive equilibrium, causing under‑employment.
• Monopoly: single seller restricts output and charges a price above marginal cost.
• Externalities: costs or benefits that affect third parties – e.g. under‑investment in training (negative externality) or education that raises societal productivity (positive externality).
• Public goods: non‑rival and non‑excludable (e.g. national defence) – market may under‑provide.

2.6 Government intervention in markets

• Price controls

  • Maximum price (price ceiling) – e.g. rent control; can create shortages.
  • Minimum price (price floor) – e.g. minimum wage; can create surpluses (unemployment) if set above equilibrium.

• Taxes – shift supply curve leftward (higher marginal cost); generate revenue but can reduce output.
• Subsidies – shift supply curve rightward (lower marginal cost); encourage production or consumption.
• Regulation – safety standards, environmental limits, licensing.
• Quotas – limit the quantity of a good that can be imported or produced.
• Privatisation / Nationalisation – transfer of ownership between public and private sector; affects efficiency and distribution of profits.

3. Economic systems

4. Micro‑economic decision‑makers

4.1 Households

• Decide how to allocate income between consumption, saving and paying taxes.
• Face budget constraint: Income = Expenditure on goods + Savings + Taxes.

4.2 Workers (labour)

• Choose between work, leisure, education and unpaid caring responsibilities.
• Opportunity cost of work = value of the next best alternative (e.g., leisure).

4.3 Firms

• Goal: maximise profit (or, in the public sector, achieve social objectives).
• Key concepts:

  • Production function: relationship between inputs (L, K, land) and output.
  • Costs: Fixed (FC) vs. Variable (VC); Total Cost (TC) = FC + VC.
  • Average and marginal concepts:

    • Average Fixed Cost (AFC) = FC / Q
    • Average Variable Cost (AVC) = VC / Q
    • Average Total Cost (ATC) = TC / Q = AFC + AVC
    • Marginal Cost (MC) = ΔTC / ΔQ

  • Revenue: Total Revenue (TR) = P × Q; Average Revenue (AR) = TR / Q (equals price in perfect competition); Marginal Revenue (MR) = ΔTR / ΔQ.
  • Profit = TR – TC; profit maximisation where MR = MC (provided MR is falling).

4.4 Money & banking

• Functions of money: medium of exchange, unit of account, store of value, standard of deferred payment.
• Central bank (e.g., Bank of England): issues currency, controls monetary policy (interest rates, reserve requirements), acts as lender of last resort.
• Commercial banks: accept deposits, provide loans, create money through the multiplier effect.
• Interest rate is the price of borrowing; it influences consumer spending, firm investment and the labour market.

5. Types of markets (structure of firms)

• Perfect competition: many buyers & sellers, homogeneous product, free entry & exit, price takers. Outcome – price = MC = MR; firms earn normal profit in the long run.
• Monopoly: single seller, no close substitutes, high barriers to entry. Outcome – price > MC; can earn economic profit in the long run.
• Oligopoly (brief): few large firms, inter‑dependent decision‑making, possible collusion or price competition.

6. Government, macro‑economy and the labour market

6.1 Fiscal policy

• Government changes in spending and taxation to influence aggregate demand.
• Expansionary fiscal policy (higher spending or lower taxes) → raises AD → can reduce unemployment but may increase inflation.
• Contractionary fiscal policy (lower spending or higher taxes) → lowers AD → can curb inflation but may raise unemployment.

6.2 Monetary policy

• Central bank actions that affect the money supply and interest rates.
• Lower interest rates → cheaper borrowing → firms expand → more hiring (lower cyclical unemployment).
• Higher interest rates → opposite effect, used to control inflation.

6.3 Supply‑side (structural) policy

• Measures that increase the productive capacity of the economy – e.g., investment in education, training, research and development, deregulation.
• Result: outward shift of the PPC, lower long‑run unemployment, higher potential output.

6.4 Economic growth

• Increase in real GDP over time; measured by the growth rate of real GDP.
• Drivers: more/lower‑cost factors of production, better technology, higher productivity.

6.5 Unemployment

• Measurement: Unemployment rate = (Number of unemployed ÷ Labour force) × 100.
• Types (Cambridge):

  • Frictional – short‑term job search.
  • Structural – mismatch of skills or geographic location.
  • Cyclical – caused by insufficient aggregate demand.

6.6 Inflation

• Measurement: Consumer Price Index (CPI) – percentage change in the price of a “basket” of goods and services.
• Causes:

  • Demand‑pull (AD > AS).
  • Cost‑push (rising wages or import prices).
  • Built‑in (wage‑price spiral).

7. Illustrative examples of the basic economic problem for workers

• Unemployment: Excess supply of labour at the prevailing wage.
• Skill mismatch: Shortage of skilled workers, surplus of unskilled workers.
• Wage determination: Scarcity of labour forces wages to adjust to equilibrate supply and demand.
• Opportunity cost of work: Choosing employment foregoes leisure, further education or unpaid caring duties.
• Sectoral allocation: Moving workers from agriculture to services raises output in one sector but reduces labour available for the other – a trade‑off.
• Training programmes: Government‑funded courses shift the labour‑supply curve rightward, reducing unemployment but requiring public spending.

8. Comparative table of common choices faced by workers

9. Suggested revision diagrams

• Labour‑market diagram – demand, supply, equilibrium wage, effect of a skill shortage.
• Product‑market diagram – demand & supply, equilibrium price, shift of demand.
• PPC – initial curve and outward shift caused by education/training.
• ATC & MC curves – profit‑maximising output where MC = MR.
• Monopsony diagram – marginal revenue product of labour vs. marginal cost of labour.
• Price floor (minimum wage) and price ceiling (maximum rent) diagrams.
• Perfect‑competition vs. monopoly price‑output outcomes.

10. Summary

The basic economic problem – scarcity of resources versus unlimited wants – forces every economic agent, especially workers, to make choices. These choices involve trade‑offs and opportunity costs and are resolved through markets (product and labour) or government intervention. Understanding demand and supply, elasticity, market failure, the role of different economic systems, and macro‑economic policies equips students to analyse real‑world issues such as unemployment, skill mismatches, wage setting, inflation and economic growth.