AS Economics
Introductory Microeconomics
Sixth Form pre-reading
The economic problem
Economics is a social science which studies how humans behave when
faced by the economic problem of scarcity.
Economic problem/scarcity = human wants for goods and services are
unlimited, but resources for producing goods and services to satisfy the wants
are limited.
There are two aspects to human wants
Needs = the minimum goods and services required for human survival
(limited)
Wants = desire for goods and services = needs + non essential items/luxuries
(unlimited)
Resources at any moment in time are limited because of the restrictions of the
Earth.
Renewable resources = resources that can be replaced (eg vegetation and
people).
Non-renewable resources = resources that can only be used once and will
ultimately run out (eg fossil fuels, mineral ores). Some of these resources can
be recycled.
Free good = a good that is not scarce, so is available in sufficient quantity to
satisfy all human wants – it carries no price because it is not scare (eg air).
Economic good = a good that is scarce so there is not enough to satisfy all
wants for the good – it carries a price that reflects its relative scarcity (eg
milk).
The nature and purpose of economic activity
The central purpose of economic activity is the production of goods and
services to satisfy human needs and wants, thus providing economic
welfare.
Production = any process that takes resources and uses them to make
goods and services.
Production can be undertaken by
• firms for profit – eg Fords produce cars
• individuals for themselves – eg cooking lunch
• government for society – eg the armed forces
Consumption = any process by which goods and services are used to satisfy
human needs and wants – ie giving economic welfare.
Consumption can take different forms
• eating a meal
• watching a film in the cinema
• taking a walk in the countryside
Economic resources
Factor of production = one of the limited resources that exist to produce
goods and services to satisfy our unlimited wants.
The factors of production include
Land = any natural resource, except humans, used in production – eg
minerals, fossil fuels, livestock, crops, rivers.
Labour = the human input to production by muscle or brain, skilled or
unskilled.
Capital = man-made items which help in the production of other goods and
services – eg tools, machines, factories, etc.
Enterprise = the entrepreneur is the decision maker and risk taker in a
business. He/she is responsible for putting the money up to start the business
and organising the other factors of production within it.
Most big businesses today are run by companies in which the entrepreneur’s
jobs are split between the shareholders, who take the risk, and the managing
directors, who make the decisions.
There are three key points to remember about capital
•
capital goods increase the productivity of the land and labour so that
more output can be produced from the same amount of land and labour.
This allows more wants to be satisfied, making us richer.
•
to get capital goods, resources must be diverted away from producing
goods and services for consumption. Consumption is the opportunity cost
of capital.
•
each time a capital good is used, depreciation occurs so that the good
will eventually need to be replaced.
Productivity = the amount of output produced in a firm by a given amount of
factor input.
Depreciation = the fall in value of a capital good as a result of its use in
production over time.
The different types of capital are
Fixed capital = items like tools and machines that can be used in production
many times over. With each use these goods depreciate a little.
Working capital = these are stocks of raw materials that are carried by
businesses. They represent capital because like a tool or machine, the stocks
increase productivity/efficiency of the producer. Stocks can only be used once
in production.
Social overhead capital = infrastructure like roads is available for all
producers and society to use in assisting the production of goods.
The production process
Factor
inputs
Land
Labour
Capital
Enterprise
Production process
with a set
technology
Product
outputs
goods
consumer goods
durable goods
services
capital goods
non-durable goods
Goods = physical items that can be packaged and carried.
Consumer goods = goods that satisfy a consumer’s want when they are
used.
Consumer durable goods = goods that satisfy a want over and over again –
eg cars, computers, furniture, clothes.
Consumer non-durable goods = goods that satisfy a want once – eg cakes,
sweets, drinks.
Capital goods = goods that are used to assist in the production of other
goods – eg tools and machines.
Services = tasks that are performed to satisfy a consumer’s want. They are
not physical items that can be packaged and carried – eg haircut, holiday,
school lesson.
Choice and opportunity cost
As a result of the economic problem of scarcity, people cannot have
everything they want from their limited resources, so they are forced to make
choices about how to use their resources. Each choice that people make
involving scarce resources has an opportunity cost.
Opportunity cost = the next best alternative use for some resources that is
sacrificed by choice.
Free goods have no opportunity cost.
Examples of opportunity cost
•
•
•
•
Choosing to save the rainforest has an opportunity cost of less farm land.
Choosing to install cashpoint machines has an opportunity cost of jobs for
bank cashiers.
Choosing to give one patient a heart transplant has an opportunity cost of
six hip replacements.
Choosing to buy a new coat has an opportunity cost of a pair of shoes.
Economic decision making
There are three main resource allocation decisions/choices arising from the
economic problem of scarcity.
•
What to produce? – The consumption decision
•
How to produce? – The production decision
•
For whom to produce? – The distribution decision
Rational behaviour = people behave in a logical or reasoned way when
making economic choices, seeking the best possible outcome from the
choice.
The different economic agents have different objectives that determine their
choices/behaviours.
Rational consumer behaviour = maximising the utility/satisfaction obtained
from spending the consumer’s limited resources (money).
Rational producer behaviour = maximising the profit obtained from
supplying a product.
Rational government behaviour = maximising social welfare/welfare of the
whole community.
Cost-benefit analysis (CBA) = a process for making economic
decisions/choices that compares the costs (disadvantages) and benefits
(advantages) of the alternative uses for the resources so that they can be
allocated to the use with the maximum net benefit (benefits - costs) for the
decision maker.
Different categories of cost and benefit to consider.
Private cost = any cost of the decision to the decision maker
Private benefit = any benefit of the decision to the decision maker.
External cost = any cost of the decision to people other than the decision
maker (negative externality).
External benefit = any benefit of the decision to people other than the
decision maker (positive externality).
Social cost = the total cost of the decision to the whole of society
= private cost + external cost.
Social benefit = the total benefit of the decision to the whole of society
= private benefit + external benefit.
Example of CBA: some of the costs and benefits of choosing to drive to
school by car.
Private Costs
Private Benefits
•
•
Petrol
Depreciation of car
External Costs
•
•
Convenience
Can listen to radio
External Benefits
•
•
Road congestion
Pollution
•
•
More space on public transport
Greater profit for petrol company
The individual will only consider the private cost and benefits when making
his/her choices. This can result in resources being allocated in ways that are
not necessarily in society’s best interest because any externalities are not
taken into consideration (conflict of individual welfare v social welfare).
The process of CBA
•
•
•
Decide the objective for the decision – what is to be maximised?
Identify all the costs and benefits of the different alternatives.
Forecast future costs and benefits where appropriate.
•
•
Place present monetary values on all costs and benefits.
Make choice between the alternatives.
Problems with CBA include
•
•
•
•
•
Identification of external costs and benefits
Placing monetary values on costs and benefits, especially externalities like
pollution, loss of human life, etc.
Forecasting future costs and benefits.
Discounting future costs and benefits to obtain their present values.
The need to have a margin for error to allow for uncertainties of CBA.
Economic systems as a means of allocating scarce resources
An economy or economic system is a decision-making system designed to
tackle the three key choices or decisions that stem from the economic
problem of scarcity. These decisions are
•
What to produce?
The consumption decision
•
How to produce?
The production decision
•
For whom to produce?
The distribution decision
There are three types of economic system designed to cope with these
problems.
•
A command or planned economy
•
A free market economy
•
A mixed economy
The basic aim of any economic system is to allocate the scarce resources
available, thus answering the three key questions above, while minimising any
waste of resources.
Possible sources of waste include
•
producing goods that people do not want
•
producing goods that people want inefficiently
•
producing goods that people want efficiently, but failing to get them to the
people that want them
A Planned Economy
(Command economy)
In a panned economy, the consumption, production and distribution decisions
are made by a group of planners appointed by the government/state. The
system has the following features
Main economic agents
Factor ownership
Motivation
•
•
•
Government (planners)
Consumers
Workers
All factors of production are owned by the state
Planners make decisions to maximise social welfare
The consumption, production and distribution decisions are made by
planners who collect information on what resources the economy has, and
what its consumers want.
Strengths of a planned economy
•
All industries are state owned monopolies so there is less chance of
consumer exploitation.
•
Planners can ensure that ‘public’ goods such as national defense are
available.
•
Planners can ensure that people have sufficient levels of ‘merit’ goods,
such as health care.
•
Planners can take externalities into consideration when making their
decisions.
•
Planners can ensure that there is a job for all so unemployment is not a
problem.
•
Planners can distribute goods equally or fairly if they wish, so there is less
chance of income inequality.
Weaknesses of a planned economy
•
Resources used in planning are not available to produce goods and
services to satisfy wants.
•
Planners may get the plan wrong causing gluts and shortages of goods.
•
Once in operation it is difficult to adjust the plan to cope with changing
economic conditions.
•
There is limited choice and variety of goods for consumers.
•
There is little incentive to work hard or to take risks because the state
owns all resources and planners decide on the distribution of goods. The
economy is likely to grow more slowly and technology may lag behind
others.
•
Planners may be corrupt in their decision making.
A Free Market Economy
(Capitalist, laissez-faire economy)
In a free market economy, the consumption, production and distribution
decisions are solved by the operation of market forces and the price
mechanism. The system has the following features
Main economic agents
Factor ownership
Motivation
•
•
•
Consumers
Producers
Owners of factors of production
All factors of production are privately owned
Individuals make decisions to maximise individual
welfare
The consumption decision is made in the markets for goods and services.
People spend their money on the goods they want most, thus registering
votes. Popular goods attract more votes, sell quickly and rise in price.
Unpopular goods attract few votes, remain unsold and fall in price. Producers
respond to these price changes in order to make profits. They expand the
output of popular goods and cut back output of unpopular goods, thus
allocating resources in a way consistent with what consumers want.
Producers in competition with each other make the production decision.
They will produce goods as efficiently as possible to keep their costs to a
minimum. This allows them to keep prices low to compete with other firms,
and to make maximum profits on the goods they sell.
The distribution decision is made in the markets for factors of production.
People own various factors and they sell the services of these factors to
producers. The price that they receive for the factors will be their income,
which in turn determines how many goods and services they can afford to
buy, and hence their share of the economy’s output.
Strengths of a free market economy
•
Competition in markets promotes an efficient use of resources.
•
Competition produces a greater variety of goods and hence more choice
for consumers.
•
Risk taking and initiative are encouraged by the profit motive, and these
are likely to promote economic growth.
•
The price mechanism adjusts quite quickly to changing economic
conditions so that resources are not wasted producing unwanted goods or
being unemployed.
Weaknesses of a free market economy
•
Competition may break down, causing market failure, such as monopolies,
which charge higher prices for fewer goods.
•
Markets may not operate efficiently causing some resources to be
unemployed.
•
Public goods, like streetlights, will not be provided in markets because
‘free riders’ can enjoy the benefits of the goods without paying, so nobody
will pay and firms cannot make profits.
•
Merit goods, like education and health services, can be provided at a price
in markets, but some people may choose not to buy them, so they will be
under consumed to the detriment of society – the workforce will deteriorate
in quality.
•
Decisions are made solely on private costs and benefits, thus ignoring
external costs, like pollution, and external benefits. As a result, resources
may not be allocated in a way that is not in society’s best interests.
•
An unequal distribution of income occurs because some people own
factors of production, which are scarcer than others and are paid more.
These richer people can divert resources into making luxuries at the
expense of necessities for the poor.
A Mixed Economy
A mixed economy contains elements of both a market economy and a
planned economy. The key decisions of what? how? and for whom to
produce? are partly answered by market forces and partly by government
planners.
Main economic agents
Factor ownership
Motivation
•
•
•
•
Consumers
Producers
Owners of factors of production
Government
Mixture of private and public ownership
•
•
Private sector individuals make decisions to
maximise individual welfare
Public sector planners make decisions to
maximise social welfare
The functions of the government in the UK economy include
•
The provision of goods that would not be provided by private companies
(such as national defense)
•
The redistribution of income from rich to poor.
•
The control of externalities and consumption of demerit goods.
•
The protection of individuals against powerful market influences like
monopolies.
•
The management of the economy to the macroeconomic policy
objectives
The aim of a mixed economy is to get the best of both systems without too
many of the disadvantages. All countries have mixed economies, but the
strength of the mixture varies. In the UK, about 60% is determined by market
forces and 40% by planners. To what extent are incentives needed to
promote economic growth?
For any economy to move beyond a basic subsistence level, it needs to
produce a surplus above that which is needed to sustain life. Crucial to the
ability to produce a surplus is the idea of Specialisation.
Specialisation
Specialisation = organising scarce resources so that people are not self
sufficient, but concentrate on producing certain goods and services. This
helps to maximise output from these limited resources, helping to resolve the
economic problem more effectively.
Division of labour = specialisation by workers in production. It can take two
forms
 by product = workers specialise in producing a whole good or
service
 by process = workers specialise in one aspect of the production of a
good or service
Benefits of specialisation/division of labour include
 increased labour productivity
 better quality and more consistent quality goods
 talent and ability are utilised more effectively
 time is saved changing tasks, training workers, etc
 the best capital goods can be used because they are in constant use
 practice makes perfect for workers
Costs of specialisation/division of labour include
 worker boredom and monotony of work
 over specialisation makes it difficult for workers to find new jobs when
unemployed
 technological unemployment – machines replace workers in simple tasks
 interdependence – if one specialist link in the production chain breaks, the
whole chain stops
Measures can be taken to overcome these costs – job rotation, worker retraining, etc.
Specialisation operates on several levels
 individual workers
 firms
 towns
 regions
 countries
A consequence of specialisation is that people produce surplus products,
which need to be exchanged. This exchange takes place in markets. Your
Unit 1 AS Level paper is entitled Markets and Market Failure, so how markets
operate is crucial to your understanding of the subject. This will be covered in
detail in your classes.