Basic Economic Ideas and Resource Allocation
Chapter 1: Introducing economies
(PPC graphs in separate notes)
AS Level Economics (9708)
The basic economic problem
We have unlimited wants and limited resources. This creates scarcity and therefore not
all wants and needs can be satisfied. We are then forced to make a choice. This gives
rise to opportunity cost.
Opportunity cost: the cost of a choice is the value of the next best alternative forgone.
Examples of opportunity cost: the government needs to choose between investing in
education and healthcare. If the government chooses to invest in healthcare there is an
opportunity cost of education.
Scarcity: A situation that arises because people are faced with unlimited wants but have
limited resources.
The coordination problem
The problem associated with bringing different economic activities to produce economic
value. In other words, these are the complications that arise when deciding which type
of economy (free market, mixed, planned) to implement.
To help with the coordination problem we ask the three economic questions:
1. What to produce
2. How to produce it
3. For whom to produce
Free market economy: Market forces are allowed to guide the allocation of resources
within a society.
Economic questions in a free market:
1. What to produce: Determined by consumer preferences
2. How to produce it: As producers aim to make a profit, producers will attempt to
produce the good at a low cost
3. For whom to produce: Whoever has the greatest purchasing power
Advantages and disadvantages of a free market
Advantages
● Firms are likely to be efficient because they produce goods demanded by
consumers
● There is no government intervention
Disadvantages
● Only benefits the wealthy
● Allows for the creation of monopolies, which exploit the market by overpricing
goods
● Overconsumption of demerit goods
● Public service goods such as police services are not provided in a free market
Planned economy: The government allocates all scarce resources in an economy
where there is greater need.
Economic questions to in a planned economy:
1. What to produce: Determined by government preference
2. How to Produce: Produced by government and government employees
3. For whom to produce: Government decides whom its produced for
Advantages and disadvantages of a planned economy
Advantages
● Easier to control resources in a time of crisis such as war
● Government can compensate for market failures by reallocating resources
● Ensures that everyone has basic needs met
● Reduces inequality
● Abuse of monopoly power can be prevented
Disadvantages
● Limits democracy and personal freedom
● Does not cater to consumer preferences
● Government failure
Mixed economy: resources allocated partly through price signals and partly on the basis
of direction by government.
Economic questions in a mixed economy
1. What to produce: Determined by both consumer and government preference
2. How to produce it: Determined by producers making profit and government
3. For whom to produce: Both government preference and the purchasing power of
individuals
Ceteris paribus: Latin term used by economists to refer to a situation where other things
remain equal.
Decision making at the margin: A small change in one economic variable will lead to
further small changes in other variables.
Examples of decision making at the margin: A consumer may decide whether the extra
benefit of consuming an additional can of cola is worth the price to be paid for it
Economic theory suggests that each unit of a good or service consumed gives the
consumer less utility. This is the law of diminishing marginal returns.
Utility: Total satisfaction received from consuming a good or service.
The time dimensions (short run, long run and very long run)
Short-run: In the short run, at least one factor of production is fixed. i.e This is the time
period in which it is possible to change only some inputs.
In the short run, a firm may hire more workers and this may be able to increase output.
Long run: In the long run, all factors of production are variable. i.e. It’s possible for all
factors of production to change.
In the long run, firms may improve the quality and quantity of their capital.
Very long run: The firm's factors of production are variable as are the inputs beyond
their control.
In the very long run factors of production are variable as well as government regulations
and technology.
Positive and normative statements
Positive statement
● A statement about facts
● Uses words such as “will” and “is”
● Can be tested, the result can be examined and statement can be rejected or
accepted
● e.g. A fall in supply of petrol will lead to an increase in its price
Normative statements
● Based on opinion
● These are value judgements
● A subjective statement on what should happen
● Used words such as “should”
● It suggests one action is more credible than another
● They influence economic decisions and policies as different economists make
different judgements from the same statistic
● e.g. Working citizens should not pay for healthcare
Factors of production
● Resources used in the production process used to create a useful product
The four factors of production
● Land: Natural resources
● Labour: Human capital
● Enterprise: Managerial ability
● Capital: Goods that can be used in the production process, machines and
buildings; or semi-finished consumer goods.
Specialisation and division of labour
Specialisation: The process whereby individuals, firms and economies concentrate on
producing goods and services that they have an advantage over others.
Division of labour: Where a manufacturing process is split into a sequence of individual
tasks.
Advantages of specialisation
● High output and potentially higher quality
● Greater variety of goods and services provided for consumers
● Increased competition gives incentive for firms to lower their costs, this keeps
prices down.
Disadvantages of specialisation
● Workers get demotivated by repetitive work
● Increased structural unemployment
Functions of money
● Medium of exchange
● Measure of value
● Store of value
● Method of deferred payment
Classification of goods and services
Public good: A good that is non-exclusive and non-rivalrous. Consumers cannot be
excluded from consuming the good and consumption by one person does not affect the
amount of the good available for others to consume.
● Public goods are not available in a free market economy
● Due to the non-excludable nature of goods, this gives rise to the free-rider
problem
Private good: A good that once consumed by one person cannot be consumed by
someone else, such good has excludability and is rivalrous
Non-excludable: No one is prevented from consuming the good
Non-rival: The benefit of the good does not diminish if more people consume the good
Merit good: A good that brings unanticipated benefits to consumers such that society
believes that it will be under-consumed in a free market economy.
Demerit good: A good that brings less benefit to consumers than they expect such that
too much will be consumed by individuals in a free market.