1. The Economic Problem
The economic problem arises because resources are scarce, but human wants are unlimited. This forces societies to make choices about how to allocate resources efficiently.
Key Economic Questions
- What to produce? - Deciding which goods and services should be produced.
- How to produce? - Choosing the most efficient methods of production.
- For whom to produce? - Deciding how goods and services should be distributed.
Opportunity Cost: The cost of the next best alternative foregone.
Example: If a government spends more on healthcare, it may have to reduce spending on education. The lost education benefits are the opportunity cost.
The Production Possibility Frontier (PPF):
The PPF is a curve that illustrates the maximum possible output combinations of two goods or services an economy can produce, given current resources and technology.
Key Concepts:
- Efficiency: Points on the PPF represent efficient resource allocation.
- Inefficiency: Points inside the PPF show underutilization of resources. Shown on point F
- Unattainable Production: Points outside the PPF are currently impossible unless resources or technology improve. Shown on point E
- Economic Growth: If the PPF shifts outward, it indicates an increase in productive capacity, allowing more goods and services to be produced
2. Economic Assumptions
1. Firms
As economists we assume that firms will aim for profit maximisation. They will do their best to reduce costs and to increase revenue.
However, there are a few reasons where firms may not act according to this:
- Customer care: Firms would rather have a positive relationship with their customers and a better reputation than exploiting these customers to maximise profits.
- Managerial objectives: Business owners often delegate decision-making to others who might have different objectives. For instance, sales managers may focus on increasing sales revenue because their pay increases along with sales. In order to maximise sales they may reduce prices resulting in a decrease in total profit.
- Non-profit organisations: Some commercial enterprises operate as charities. They aim to raise awareness and money for a particular cause. The money they collect is used to fund its humanitarian activities. We can’t say these firms try to maximise profit as they willingly give away most of their revenue.
As economists we cannot argue or assume companies following these patterns will aim to maximise profits.
2. Consumers
As economists we assume that consumers will aim to maximise benefits. They will do their best to minimize expenditure and to find the good with the highest quality.
However, there are a few reasons where consumers may not act according to this:
- Lack of information: Sometimes consumers may not know or may not take the time to know the benefits and costs from each product resulting in decisions with not the highest benefit.
- Bad habit: Sometimes a consumer has a habit of consuming one type of brand of product and will refuse to change it even if they are aware it's less beneficial for them. For example, cigarettes.
- Peer influence: Some people's purchasing choices are influenced by others. Friends may buy the same product as each other and some children learn to buy the product their parents always did regardless of outside information.
3. The Demand Curve
Demand
Demand is the amount of a good or service that a consumer is willing and able to buy during a given period of time.
The demand curve is a graph showing the relationship between the price of a good and the quantity demanded by consumers.
">Law of Demand
As price increases, quantity demanded decreases, and vice versa. This creates a downward-sloping demand curve.
- Law of Demand: Price ↑ → Demand ↓
- Driven by Income & Substitution effects
Why is Demand Downward Sloping?
- Income Effect: As prices fall, consumers’ purchasing power increases, so they are able and willing to buy more. This causes the quantity demanded to increase.
- Substitution Effect: If a product’s price drops, it becomes cheaper than alternatives, so the quantity demanded increases.
4. Factors That May Shift the Demand Curve
Shifts in Demand
A shift in demand means that at every price level, more (or less) is demanded.
">-
Changes in Consumer Income
- Normal Goods: Demand increases as income rises (e.g., cars, vacations).
- Inferior Goods: Demand decreases as income rises (e.g., second-hand clothes, public transport).
-
Prices of Related Goods
- Substitutes: If the price of Coca-Cola increases, demand for Pepsi increases.
- Complementary Goods: If the price of gaming consoles rises, demand for video games falls.
-
Changes in Tastes & Preferences
New trends, health studies, or marketing can shift demand.
Example: Demand for electric cars increases as people become more environmentally conscious. -
Demographic Changes
A growing population → More demand for housing, food, and transportation.
5. Price Elasticity of Supply (PES)
Shifts in Demand
Supply is the amount of a good/service that consumers are willing and able to produce during a certain period of time.
The supply curve is a graph showing the relationship between the price of a good and the quantity supplied by producers.
">Law of Supply
As price increases, quantity supplied increases, and vice versa.
This creates an upward-sloping supply curve.
Why is Supply Upward Sloping?
- Profit Incentive: Higher prices make production more profitable, so firms supply more.
- Production Costs: As more is produced, costs rise, requiring higher prices to cover those costs.
- New Market Entrants: Higher prices encourage new firms to enter the market, increasing supply.
6. Income Elasticity of Demand (YED)
Shifts in Demand
A shift in supply means that at every price level, more (or less) is supplied.
">-
Changes in Production Costs:
- Higher costs (e.g., wages, raw materials) → Supply decreases.
- Lower costs (e.g., automation, efficiency) → Supply increases.
-
Technological Advancements:
Better technology can reduce costs and increase supply.
Example: AI in factories improves production efficiency.
-
Prices of Related Goods:
Substitutes in production: If farmers can earn more from corn than wheat, they will plant more corn, reducing the supply of wheat.
-
Number of Suppliers:
More firms entering the market → Higher supply.
Example: More smartphone companies → Higher smartphone supply.
-
Government Policies:
- Taxes increase costs, shifting supply left (reducing supply).
- Subsidies lower costs, shifting supply right (increasing supply).
7. Market Equilibrium
Equilibrium: The point where supply and demand meet — the market-clearing price.
Key Concepts
- Surplus (Excess Supply): If the price is too high, supply exceeds demand, leading to unsold goods.
- Shortage (Excess Demand): If the price is too low, demand exceeds supply, causing stockouts.
- Price Mechanism: Prices adjust naturally through market forces to restore equilibrium.
">
8. Price Elasticity of Demand (PED)
Price Elasticity of Demand (PED) measures how responsive quantity demanded is to a change in price.
Formula:
PED = (% Change in Quantity Demanded) / (% Change in Price)
Interpretation:
- Elastic Demand (PED > 1): Quantity demanded is highly responsive to price changes.
- Inelastic Demand (PED < 1): Quantity demanded is less responsive to price changes.
- Unitary Elastic Demand (PED = 1): The percentage change in quantity demanded equals the percentage change in price.
Factors Affecting PED:
- Substitutes: More substitutes make demand more elastic.
- Necessity vs. Luxury: Necessities have inelastic demand; luxuries have elastic demand.
- Time: Demand is more elastic in the long run as consumers adjust.
- Proportion of Income: If a good takes a large share of income, demand is more elastic.
9. Price Elasticity of Supply (PES)
Price Elasticity of Supply (PES) measures how responsive quantity supplied is to a change in price.
Formula:
PES = (% Change in Quantity Supplied) / (% Change in Price)
Interpretation:
- Elastic Supply (PES > 1): Quantity supplied is highly responsive to price changes.
- Inelastic Supply (PES < 1): Quantity supplied is less responsive to price changes.
- Unitary Elastic Supply (PES = 1): Percentage change in supply equals percentage change in price.
Factors Affecting PES:
- Time Frame: Supply is more inelastic in the short run, more elastic in the long run.
- Availability of Resources: Easier access to resources increases elasticity.
- Spare Capacity: Firms with spare capacity can increase supply quickly.
- Ease of Storage: Goods that can be stored are more elastic in supply.
10. Income Elasticity of Demand (YED)
Income Elasticity of Demand (YED) measures how responsive quantity demanded is to a change in income.
Formula:
YED = (% Change in Quantity Demanded) / (% Change in Income)
Interpretation:
- Normal Goods (YED > 0): Demand increases as income rises.
- Inferior Goods (YED < 0): Demand decreases as income rises.
- Luxury Goods (YED > 1): Demand increases more than proportionally as income rises.
Implications:
- Businesses use YED to forecast demand changes based on economic trends.
- Governments may tailor policies based on how income changes affect demand for different goods.
11. The Mixed Economy
A mixed economy combines elements of both market economies (private sector) and planned economies (government intervention).
Features:
- Private Ownership: Most resources are owned and controlled by businesses and individuals.
- Government Role: Provides public goods and services like healthcare and education.
- Regulations: The government intervenes to correct market failures and ensure fairness.
Advantages:
- Balances efficiency (private sector) and fairness (public sector).
- Reduces market failures by addressing externalities and monopolies.
- Provides merit and public goods that are underprovided by the market.
Disadvantages:
- Public sector inefficiencies may exist.
- Risk of over-regulation limiting business freedom.
- Free Rider Problem: Some benefit without paying for non-excludable, non-rival goods.
12. Privatisation
Privatisation is the process of transferring ownership of public sector assets or services to the private sector.
Advantages:
- Increases efficiency – private firms aim to reduce costs and boost productivity.
- Reduces strain on public finances.
- Fosters innovation through competition.
Disadvantages:
- Higher consumer prices due to profit motives.
- Essential services may become less accessible for low-income groups.
- Risk of monopolies forming in privatised sectors.
13. Externalities
Externalities are costs or benefits that affect third parties not directly involved in a transaction.
Types of Externalities:
- Negative Externalities: Costs imposed on third parties (e.g., pollution, traffic).
- Positive Externalities: Benefits enjoyed by third parties (e.g., education, vaccines).
Government Solutions:
- Taxes: Discourage negative externalities (e.g., carbon taxes).
- Subsidies: Promote positive externalities (e.g., renewable energy subsidies).
- Regulations: Laws to limit negative effects (e.g., emission limits).
1. The Economic Problem
The economic problem arises because resources are scarce, but human wants are unlimited. This forces societies to make choices about how to allocate resources efficiently.
Key Economic Questions
- What to produce? - Deciding which goods and services should be produced.
- How to produce? - Choosing the most efficient methods of production.
- For whom to produce? - Deciding how goods and services should be distributed.
Opportunity Cost: The cost of the next best alternative foregone.
Example: If a government spends more on healthcare, it may have to reduce spending on education. The lost education benefits are the opportunity cost.
The Production Possibility Frontier (PPF):
The PPF is a curve that illustrates the maximum possible output combinations of two goods or services an economy can produce, given current resources and technology.
Key Concepts:
- Efficiency: Points on the PPF represent efficient resource allocation.
- Inefficiency: Points inside the PPF show underutilization of resources. Shown on point F
- Unattainable Production: Points outside the PPF are currently impossible unless resources or technology improve. Shown on point E
- Economic Growth: If the PPF shifts outward, it indicates an increase in productive capacity, allowing more goods and services to be produced
2. Economic Assumptions
1. Firms
As economists we assume that firms will aim for profit maximisation. They will do their best to reduce costs and to increase revenue.
However, there are a few reasons where firms may not act according to this:
- Customer care: Firms would rather have a positive relationship with their customers and a better reputation than exploiting these customers to maximise profits.
- Managerial objectives: Business owners often delegate decision-making to others who might have different objectives. For instance, sales managers may focus on increasing sales revenue because their pay increases along with sales. In order to maximise sales they may reduce prices resulting in a decrease in total profit.
- Non-profit organisations: Some commercial enterprises operate as charities. They aim to raise awareness and money for a particular cause. The money they collect is used to fund its humanitarian activities. We can’t say these firms try to maximise profit as they willingly give away most of their revenue.
As economists we cannot argue or assume companies following these patterns will aim to maximise profits.
2. Consumers
As economists we assume that consumers will aim to maximise benefits. They will do their best to minimize expenditure and to find the good with the highest quality.
However, there are a few reasons where consumers may not act according to this:
- Lack of information: Sometimes consumers may not know or may not take the time to know the benefits and costs from each product resulting in decisions with not the highest benefit.
- Bad habit: Sometimes a consumer has a habit of consuming one type of brand of product and will refuse to change it even if they are aware it's less beneficial for them. For example, cigarettes.
- Peer influence: Some people's purchasing choices are influenced by others. Friends may buy the same product as each other and some children learn to buy the product their parents always did regardless of outside information.
3. The Demand Curve
Demand
Demand is the amount of a good or service that a consumer is willing and able to buy during a given period of time.
The demand curve is a graph showing the relationship between the price of a good and the quantity demanded by consumers.
">Law of Demand
As price increases, quantity demanded decreases, and vice versa. This creates a downward-sloping demand curve.
- Law of Demand: Price ↑ → Demand ↓
- Driven by Income & Substitution effects
Why is Demand Downward Sloping?
- Income Effect: As prices fall, consumers’ purchasing power increases, so they are able and willing to buy more. This causes the quantity demanded to increase.
- Substitution Effect: If a product’s price drops, it becomes cheaper than alternatives, so the quantity demanded increases.
4. Factors That May Shift the Demand Curve
Shifts in Demand
A shift in demand means that at every price level, more (or less) is demanded.
">-
Changes in Consumer Income
- Normal Goods: Demand increases as income rises (e.g., cars, vacations).
- Inferior Goods: Demand decreases as income rises (e.g., second-hand clothes, public transport).
-
Prices of Related Goods
- Substitutes: If the price of Coca-Cola increases, demand for Pepsi increases.
- Complementary Goods: If the price of gaming consoles rises, demand for video games falls.
-
Changes in Tastes & Preferences
New trends, health studies, or marketing can shift demand.
Example: Demand for electric cars increases as people become more environmentally conscious. -
Demographic Changes
A growing population → More demand for housing, food, and transportation.
5. Price Elasticity of Supply (PES)
Shifts in Demand
Supply is the amount of a good/service that consumers are willing and able to produce during a certain period of time.
The supply curve is a graph showing the relationship between the price of a good and the quantity supplied by producers.
">Law of Supply
As price increases, quantity supplied increases, and vice versa.
This creates an upward-sloping supply curve.
Why is Supply Upward Sloping?
- Profit Incentive: Higher prices make production more profitable, so firms supply more.
- Production Costs: As more is produced, costs rise, requiring higher prices to cover those costs.
- New Market Entrants: Higher prices encourage new firms to enter the market, increasing supply.
6. Income Elasticity of Demand (YED)
Shifts in Demand
A shift in supply means that at every price level, more (or less) is supplied.
">-
Changes in Production Costs:
- Higher costs (e.g., wages, raw materials) → Supply decreases.
- Lower costs (e.g., automation, efficiency) → Supply increases.
-
Technological Advancements:
Better technology can reduce costs and increase supply.
Example: AI in factories improves production efficiency.
-
Prices of Related Goods:
Substitutes in production: If farmers can earn more from corn than wheat, they will plant more corn, reducing the supply of wheat.
-
Number of Suppliers:
More firms entering the market → Higher supply.
Example: More smartphone companies → Higher smartphone supply.
-
Government Policies:
- Taxes increase costs, shifting supply left (reducing supply).
- Subsidies lower costs, shifting supply right (increasing supply).
7. Market Equilibrium
Equilibrium: The point where supply and demand meet — the market-clearing price.
Key Concepts
- Surplus (Excess Supply): If the price is too high, supply exceeds demand, leading to unsold goods.
- Shortage (Excess Demand): If the price is too low, demand exceeds supply, causing stockouts.
- Price Mechanism: Prices adjust naturally through market forces to restore equilibrium.
">8. Price Elasticity of Demand (PED)
Price Elasticity of Demand (PED) measures how responsive quantity demanded is to a change in price.
Formula:
PED = (% Change in Quantity Demanded) / (% Change in Price)
Interpretation:
- Elastic Demand (PED > 1): Quantity demanded is highly responsive to price changes.
- Inelastic Demand (PED < 1): Quantity demanded is less responsive to price changes.
- Unitary Elastic Demand (PED = 1): The percentage change in quantity demanded equals the percentage change in price.
Factors Affecting PED:
- Substitutes: More substitutes make demand more elastic.
- Necessity vs. Luxury: Necessities have inelastic demand; luxuries have elastic demand.
- Time: Demand is more elastic in the long run as consumers adjust.
- Proportion of Income: If a good takes a large share of income, demand is more elastic.
9. Price Elasticity of Supply (PES)
Price Elasticity of Supply (PES) measures how responsive quantity supplied is to a change in price.
Formula:
PES = (% Change in Quantity Supplied) / (% Change in Price)
Interpretation:
- Elastic Supply (PES > 1): Quantity supplied is highly responsive to price changes.
- Inelastic Supply (PES < 1): Quantity supplied is less responsive to price changes.
- Unitary Elastic Supply (PES = 1): Percentage change in supply equals percentage change in price.
Factors Affecting PES:
- Time Frame: Supply is more inelastic in the short run, more elastic in the long run.
- Availability of Resources: Easier access to resources increases elasticity.
- Spare Capacity: Firms with spare capacity can increase supply quickly.
- Ease of Storage: Goods that can be stored are more elastic in supply.
10. Income Elasticity of Demand (YED)
Income Elasticity of Demand (YED) measures how responsive quantity demanded is to a change in income.
Formula:
YED = (% Change in Quantity Demanded) / (% Change in Income)
Interpretation:
- Normal Goods (YED > 0): Demand increases as income rises.
- Inferior Goods (YED < 0): Demand decreases as income rises.
- Luxury Goods (YED > 1): Demand increases more than proportionally as income rises.
Implications:
- Businesses use YED to forecast demand changes based on economic trends.
- Governments may tailor policies based on how income changes affect demand for different goods.
11. The Mixed Economy
A mixed economy combines elements of both market economies (private sector) and planned economies (government intervention).
Features:
- Private Ownership: Most resources are owned and controlled by businesses and individuals.
- Government Role: Provides public goods and services like healthcare and education.
- Regulations: The government intervenes to correct market failures and ensure fairness.
Advantages:
- Balances efficiency (private sector) and fairness (public sector).
- Reduces market failures by addressing externalities and monopolies.
- Provides merit and public goods that are underprovided by the market.
Disadvantages:
- Public sector inefficiencies may exist.
- Risk of over-regulation limiting business freedom.
- Free Rider Problem: Some benefit without paying for non-excludable, non-rival goods.
12. Privatisation
Privatisation is the process of transferring ownership of public sector assets or services to the private sector.
Advantages:
- Increases efficiency – private firms aim to reduce costs and boost productivity.
- Reduces strain on public finances.
- Fosters innovation through competition.
Disadvantages:
- Higher consumer prices due to profit motives.
- Essential services may become less accessible for low-income groups.
- Risk of monopolies forming in privatised sectors.
13. Externalities
Externalities are costs or benefits that affect third parties not directly involved in a transaction.
Types of Externalities:
- Negative Externalities: Costs imposed on third parties (e.g., pollution, traffic).
- Positive Externalities: Benefits enjoyed by third parties (e.g., education, vaccines).
Government Solutions:
- Taxes: Discourage negative externalities (e.g., carbon taxes).
- Subsidies: Promote positive externalities (e.g., renewable energy subsidies).
- Regulations: Laws to limit negative effects (e.g., emission limits).
frequently Asked Questions