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978-1-316-63809-5 — Cambridge International AS plus A Level Economics Revision Guide

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Basic economic ideas and resource

Chapter 1

allocation
Learning summary
After you have studied this chapter, you should be
able to:
deine the fundamental economic problem explain the role of the factor enterprise in a
modern economy
explain the meaning of scarcity, opportunity
cost and the basic economic questions draw and interpret production possibility
curves
deine ceteris paribus
explain how constant and increasing
recognise the importance of decision making at
opportunity cost determine the shape of the
the margin
production possibility curve
distinguish between positive and normative
explain the functions and characteristics
statements
of money
outline the characteristics of factors
distinguish between money and barter
of production
deine liquidity
distinguish between the rewards and the
factors of production explain free goods, economic goods, private
goods and public goods
deine specialisation
distinguish between merit goods and
assess the advantages and disadvantages of
demerit goods
division of labour
compare different economic systems

1.01 The fundamental 1.02 Meaning of scarcity and

economic problem the inevitability of choices at
The fundamental economic problem is that there are all levels
never enough resources to produce all the products
people would like to have. As there is scarcity of resources, choices have to
be made. Consumers have to decide what to buy,
Resources are limited in supply (inite) whilst wants are workers – which jobs to do, irms – what to produce,
unlimited (ininite). governments – what to spend tax revenue on.

Progress check A
Will the economic problem ever be solved?

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1.03 Opportunity cost 1.05 Decision making at

Chapter 1 Basic economic ideas and resource allocation

Having to select one option involves an opportunity cost. the margin
Opportunity cost is the best alternative forgone.
Individuals, households, irms and governments often
Due to the economic problem of wants exceeding have to make marginal decisions. These involve
resources, economies have to decide what to considering whether to make slight changes. For
produce, how to produce it and who will receive instance, whether to buy one more apple, produce
what is produced. one more car or to reduce the number of teachers
What to produce, how to produce and who will employed in state schools.
receive what is produced are sometimes referred to
as the three basic questions which all economies have
to answer. 1.06 Positive and normative
statements
TERM
A positive statement is a statement of fact. It can be
tested to assess whether it is right or wrong.
Opportunity cost: the best alternative sacriiced
when an option is selected. A normative statement is a statement based on
opinion. It is a value judgement and, as such, cannot be
proved right or wrong.
There are both positive and normative statements in
Opportunity cost is a concept that you
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economics. ‘The unemployment rate in a country is 6%’

can use in analysing and evaluating a
is a positive statement. In contrast, ‘the government’s
signiicant number of topics, e.g. whether key priority should be reducing unemployment’ is a
a government should spend more on normative statement.
healthcare.
Much of what you write will be based
TIP

on positive statements. In coming to a

conclusion in an answer you may, however,
1.04 Ceteris paribus be making a value judgement e.g. on
Ceteris paribus means other things being equal. what might be the most appropriate
government policy measure to reduce
Economists often make use of ceteris paribus to unemployment. The conclusion should be
consider the possible effects of a change in one variable based on economic analysis and not on
on another variable. For instance, an increase in real uninformed opinion.
disposable income would be expected to lead to an
increase in demand for gold watches, on the assumption
that the other influences on demand for gold watches
are not changing.
TERMS
TERM Marginal decision: whether to make slight changes.
Positive statement: a fact that can be tested.
Ceteris paribus: other things being equal.
Normative statement: a value judgement based
on opinion that cannot be tested.

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Susan Grant
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1.07 Characteristics of
Section 1: AS Level

TERMS
factors of production and
their rewards Factors of production: resources used to produce
goods and services.
Factors of production are resources used to produce Land: natural resources both on the surface and
goods and services: beneath the earth.
• Land covers all natural resources – for example, the Labour: human effort used in production.
surface of the earth, the sea, rivers, minerals below
the earth. Most land is geographically immobile but Capital: goods used to produce other goods.
occupationally mobile. The reward to land is rent. Enterprise: organising the factors of production
• Labour is human effort, mental or physical, used and bearing the risks of producing a product.
in the production of goods and services. Labour
may be geographically immobile due to differences
in housing costs and because of family ties. It
may be occupationally immobile if workers lack Revision activity A
education and training. Spending on education and
a Identify an example of each factor of
training increases human capital. Wages are the
production that is employed in the ilm industry.
reward to labour.
b Give an example of a capital intensive industry
• Capital is human made goods used to produce other
and a labour intensive industry.
goods and services. Investment is spending on capital
goods. Net investment occurs when irms purchase c What factors influence the supply of labour to
more capital goods than are needed to replace a particular occupation?
those capital goods which have become obsolete d Explain the link between enterprise and
– gross investment exceeds depreciation. Capital opportunity cost.
varies in its occupational and geographical mobility.
A photocopier, for instance, can be used in most e Why is the rent on land in city centres usually
types of industries and can be moved from one part higher than that on land in rural areas?
of the country to another. In contrast, an operating
theatre is likely to be occupationally immobile and a
gold mine is geographically immobile. The reward for
The two factors of production that
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capital is interest.
students most commonly get confused
• Enterprise is the willingness and initiative to about are land and capital. Remember land
organise the other factors of production and, is any natural resource and not just land as
crucially, to bear the uncertain risks of producing a soil, and capital refers to capital goods i.e.
product. Entrepreneurs are the people who have human-made goods and not money.
the willingness and initiative to make decisions and
to take the risks involved in production. In a public
limited company, the role of the entrepreneur is
divided between the managers (who make the
business decisions) and shareholders (who bear 1.08 Specialisation
the risks). Entrepreneurs tend to be relatively,
occupationally and geographically mobile. The reward Specialisation involves concentrating on particular tasks
for enterprise is proit. or products. Workers, irms, regions and countries can
concentrate on producing one product.
Specialisation can increase output but there are risks
attached. For instance, if a irm makes only one product
and demand for that product falls, the irm would be
in dificulty.

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1.10 Different economic

Chapter 1 Basic economic ideas and resource allocation

TERM
systems
Specialisation: concentration on a particular task
An economic system is a way of allocating resources
or product.
to answer the three fundamental questions of what to
produce, how to produce it and for whom.
There are three main types of economic systems:
1.09 Division of labour • a market economy
Division of labour involves breaking down the • a planned economy
production into separate tasks and having each worker • a mixed economy
concentrate on a particular task.
One of the irst economists to describe division of TERMS
labour was Adam Smith. In his book An Enquiry into
the Nature and Causes of the Wealth of Nations (often
Market economy: resources are allocated by the
shortened to The Wealth of Nations), he described the
price consumers are willing to pay for products.
18 separate processes involved in producing a pin.
Planned economy: government decides how
Advocates of division of labour claim that it increases
resources are allocated.
output and reduces the average cost of production.
This is because it enables workers to concentrate on
what they are best at, increases their skill (‘practice
makes perfect’), reduces the time it takes to train them,
reduces the equipment needed, cuts back on the time
Market economies
involved in moving from one activity to another and A market economy is one in which resources are
makes it easier to mechanise the process. allocated by means of the price mechanism. Consumers
indicate what they are willing and able to buy through
Critics of division of labour, in contrast, argue that it the prices they are prepared to pay. Private sector irms
may reduce output and increase the average cost of respond to changes in consumer tastes by altering what
production. They claim that workers can get bored, they produce. Property is privately owned and the
doing the same task time after time. Boredom can lead government’s role in the economy is minimal.
to workers making mistakes and leaving the irm after
a short time. In addition, division of labour may mean Among the advantages claimed for a market
that a irm does not ind out what task a worker is best economy are consumer sovereignty, incentives for
at and may mean that a irm will ind it dificult to cover workers and irms to be eficient and innovative, and a
for workers who are absent from work due to illness or lack of bureaucracy.
because they are undergoing training. The possible disadvantages of a market economy
include an inequitable distribution of income, a risk of
unemployment of resources, under-consumption of
Progress check B merit goods, over-consumption of demerit goods, lack
of provision of public goods, information failure, and
In what way do schools engage in division of labour?
abuse of market power.

TERM
TERM
Public good: a product that people cannot be
Division of labour: breaking down production stopped from consuming even if they are not
into separate tasks to be carried out by separate willing to pay for it and once used can still be used
workers. by others.

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• Inflation may rise when price controls are removed.

Section 1: AS Level

TERMS • It may take time to build up entrepreneurial skills,

to develop a inancial sector (including a stock
Merit good: a product the government considers exchange) and implement a social welfare network.
people undervalue.
• The removal of government support and trade
Demerit good: a product the government restrictions can result in some enterprises going out
considers people overvalue. of business and can cause unemployment.

Planned economies 1.11 The role of the factor

A planned economy is one in which the government enterprise in a modern economy
makes most of the decisions on how resources are
allocated. Property is largely state owned and most In many countries enterprise is playing an increasing
workers are employed in state owned enterprises role. As the size of the private sector increases
(SOEs). The private sector’s role in the economy relative to the size of the public sector, there is more
is minimal. opportunity for new businesses to be set up.

The advantages of a planned economy include: Enterprise can encourage invention, innovation and
competition. Such effects can increase output and
• full employment of resources improve living standards.
• avoidance of wasteful duplication
• an equitable distribution of resources Revision activity B
• consideration of externalities Complete Table 1.01.
• provision of merit goods and public goods
A comparison of a market economy and
• discouragement of demerit goods a planned economy
• long term planning and support for vulnerable groups Features Market Planned
economy economy
Among the possible disadvantages of a planned
Allocative State directives
economy are slow responses to changes in consumer
mechanism
demand, too much bureaucracy, a lack of incentives, and
too much concentration on capital goods. Key sector Private
Key decision Consumers
makers
Mixed economies Other names Centrally planned,
In a mixed economy, both the private and public sectors collectivist,
play a key role. Resources are allocated using both the command, state
price mechanism and state planning. owned
Example Hong Kong
A mixed economy seeks to gain the advantages of both
a market and a planned economy whilst seeking to Ownership of State owned
avoid the disadvantages. How successful it is depends means
on the effectiveness of government policies and how Provision of
eficient the private sector is. public goods
In the late twentieth and early twenty-irst century, a The proit Present
number of economies moved from a planned towards a motive
market economy.
Table 1.01
There are a number of problems that can arise when
central planning in an economy is reduced:

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1.12 Production possibility

Chapter 1 Basic economic ideas and resource allocation

Revision activity C
curves Look at Figure 1.01 and answer the questions
A production possibility curve (PPC) shows the which follow.
maximum output of two types of products that can be a What does a straight line production
produced with existing resources and technology. possibility curve (PPC) such as AB indicate?
A production point on the curve represents full use of b What does the movement of the PPC from
resources, a production point inside the curve indicates AB to AC show?
unemployed resources and a production point outside
the curve is currently unattainable. c Why may the PPC have shifted from AB to DE?

A shift to the right of a PPC is caused by an increase Capital

goods
in the quantity or quality of resources. A change in the
A
slope of a PPC will occur if the ability to produce only
one of the two products alters. D

TERM
Production possibility curve (PPC): a diagram
showing the maximum output of two types of
O E B C Consumer
products that can be made with existing resources
goods
and technology.

Figure 1.01

The shapes of production

possibility curves
A straight line PPC indicates a constant opportunity cost. 1.13 The functions and
A PPC which is bowed out indicates an increasing characteristics of money
opportunity cost. In this case, as more capital goods, for
example, are produced, more consumer goods have to Money covers any item which carries out the functions
be sacriiced. This reflects the fact that the resources of money. The four functions of money are:
which are most suited to producing capital goods are 1 a medium of exchange
used irst.
2 a store of value

In drawing PPC curves make sure that 3 a unit of account

TIP

you draw the curve/line all the way to 4 a standard of deferred payments
each axis – do not leave a gap. Also when
Probably the best known function of money is as a
drawing the PPC as a curve, make sure it
medium of exchange. Money makes it easy for people
is continuing to rise when it touches the to buy and sell products. In the absence of money,
vertical axis – do not have it turning down. people would have to engage in barter.
A store of value means that money enables people
to save. Money can be saved in a range of inancial
institutions to be used in the future.
Money acts as a unit of account, or a measure of value,
as it permits the value of goods, services and assets to
be compared.

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A standard of deferred payments allows people to agree Liquidity

Section 1: AS Level

prices of future payments and receipts.This enables

payments to be made and received in the future and Liquidity means the ability to turn an asset into cash
allows people, irms and governments to lend and borrow. quickly and without loss. Cash is obviously the most
liquid asset. Current (checking) accounts at commercial
To act as money, an item has to be generally acceptable. banks are more liquid than deposit (savings) accounts.
An item may have all the other characteristics needed
for it to act as money but if people are not prepared A commercial bank keeps some liquid assets to meet
to accept it in exchange for products and in its other their customers’ demand for cash.
capacities, it will not act as money.The other characteristics
money should possess are durability, recognisability,
divisibility, portability, limited in supply, stability in value and
TERM
uniformity.There are links between the characteristics. For
instance, to be stable in value it should be limited in supply. Liquidity: being able to turn an asset into cash
quickly without a loss.

TERMS
Money: any item that acts as a medium of
exchange, store of value, unit of account or
Revision activity D
standard of deferred payments. Fit the following terms into the sentences, using
each term only once:
Barter: direct exchange of products.
1 medium of exchange
2 store of value
Near money 3 unit of account
Near money is a term for inancial assets that can be 4 standard of deferred payments
converted into money relatively quickly. While such
5 general acceptability
assets are not currently carrying out the essential
function of money, that is acting as a medium of 6 durability
exchange, they have a high degree of liquidity. Examples 7 liquid
of near money include treasury bills and short term
government bonds. Commercial banks hold a range of 8 cheques
these assets as they can be quickly turned into cash and 9 divisible
so count in their liquidity ratios.
a . . . . are not money. They are a means of
transferring a bank deposit from one person
Money and barter to another.
Barter is the direct exchange of products. Money has a b The function of money which allows products
number of advantages over barter. The key one is that it to be bought on credit is a . . . .
makes it easier and quicker to buy and sell products. As c To act as a . . . . money has to be . . . . in order
a result, money can encourage specialisation and trade. that payments of different values can be made
Money also makes it easier for people to save, value and change can be given.
products, borrow and lend. A system of barter would d A sight deposit (current account) is more . . . .
involve uncertainty as to which products other people than a time deposit (deposit account).
will be prepared to accept and how they will value them.
e The . . . . and . . . . of money allows it to act as
a ....
Progress check C f Money acts as a . . . . when the value of
Why do apples not act as money? products is compared.

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1.14 Economic goods and instance, one more person walking down a street will

Chapter 1 Basic economic ideas and resource allocation

not reduce the beneit other people receive from the
free goods street lighting.
Two other characteristics of a public good are non-
The vast majority of goods and services are what
rejectability and zero marginal cost. It is not possible for
economists call economic goods. An economic good is
people to reject public goods such as defence. It is also
one which takes resources to produce it. As a result, its
often the case that once provided, it will not cost any
production involves an opportunity cost.
more to extend the beneit of a public good such as
Free goods are rare. They do not involve the use of sea defence to another person.
resources to produce them and so they do not have an
As it is not possible to charge people directly for public
opportunity cost. Examples include sunlight and air.
goods, private sector irms lack the inancial incentive
to provide them. As a result, the provision of public
Progress check D goods has to be inanced out of taxation. The
government can produce them or pay private sector
A irm gives a present of a free cake to its irms to provide them.
customers just before a public holiday.
Explain whether the cake is a free good or an A quasi-public good is a product which possesses some
economic good. of the features of a public good. For instance, it may
be dificult to restrict entry to a beach, making it non-
excludable, but if it is crowded it may be rival. Some
economists refer to products which are non-excludable
but rival, such as a beach and ish in the ocean in some
TERMS cases, as common resources.

Economic good: takes resources to produce. It can be dificult for a government to determine the
quantity of a public good to provide. This is because
Free good: no resources are used to produce it. preferences are not revealed via the price mechanism.

TERM
1.15 Private goods and
Quasi-public good: has features of public and
public goods private goods, also called common resources.
Most products are private goods. A private good is
both excludable and rival. It is excludable in the sense
that someone who is not prepared to pay for it can
be prevented from consuming the product. It is rival in Progress check E
that if one person consumes the product, someone else
cannot consume it. As private goods are excludable, Why does the development of electronic road
they can be sold through the market. Private sector pricing suggest that roads are changing from being
irms have an incentive to produce them as they can a public good into a private good?
charge directly for them.
The two key characteristics of a public good are non-
excludability and non-rivalry. It is not possible to stop
non-payers from enjoying the product. As a result,
1.16 Merit and demerit goods
people have no incentive to pay for a public good. Merit and demerit goods are special categories of
Once provided, a public good is available for everyone private goods.
including non-payers. So people can act as free riders,
consuming the product without paying for it. When A merit good is a product that a government considers
people consume a public good, they also do not reduce people undervalue. It has two key characteristics.
other people’s ability to consume the product. For As well as people underestimating the beneit they

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receive from consuming the product, the consumption Governments differ as to what they consider to be
Section 1: AS Level

also provides external beneits. As a merit good is merit and demerit goods. The US government, for
undervalued, it will be under-consumed and so under- instance, believes that people are fully and accurately
produced if left to market forces. Output will be below informed about the beneits and risks of owning guns
the allocatively eficient (socially optimum) level. The and so does not impose many restrictions on gun
existence of information failure and external beneits ownership. In contrast, the UK government makes it
results in market failure. more dificult to own a gun as it thinks information
failure and the negative externalities involved are
To encourage greater consumption of a merit good a
more signiicant.
government may:
• provide it for free
• subsidise it TERM
• set a maximum price combined with some state Private good: a product that people can be
provision stopped from consuming and where one person’s
• provide some information about its beneits consumption does not reduce other people’s
ability to consume it.
If the government thinks it is very important for
people to consume the product, it may make its
consumption compulsory.
A demerit good is a product that the government
considers people overvalue. As with a merit good, Progress check F
a demerit good has two key characteristics. People
fail to appreciate the harmful effects they experience Why may a product be treated as a demerit good
from consuming the product and consumption of the in one country but not in another country?
product generates external costs. As a demerit good
is overvalued, it will be over-consumed and over-
produced if left to market forces. Output will be
above the allocatively eficient level. The existence Take care not to confuse public goods and
TIP

of information failure and external costs results in merit goods. To decide whether a good
market failure. is a public good, the key question is not
To discourage consumption of a demerit good a whether people have to pay to consume
government may: tax it, set a minimum price or it but whether it would be possible to
provide information about its harmful effects. If the charge for them.
government thinks the product is very harmful, it may
ban its consumption.

10

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Mind maps

Chapter 1 Basic economic ideas and resource allocation

A student’s A consumer’s
choice of choice of
Best alternative
forgone A person’s courses what to buy
use of time A worker’s
choice of job

A irm’s
Deinition Application choice of
what to produce
Opportunity cost

Type of goods Production possibility

curves

Economic goods
Free goods Bent outwards Straight line

Have an Increasing Constant

opportunity Do not have
an opportunity opportunity opportunity
cost cost cost
cost

Mind map 1.01: Opportunity cost

Natural Human made

Resources used Resources resources goods Human
Inputs effort
to produce goods
and services Land Capital Organisational
Labour and risk
Deinition Other names taking skills
Types
Enterprise
Factors of production

Causes of an
Causes of increase increase in quality
in factors of Rewards Enterprise of factors of production
production
Enterprise
Land Labour Proit Enterprise
Privitisation Capital
Land Training
Capital Labour Rent Capital
Wages Land Education
Interest
Reclamation Immigration Rise Advances Labour
of land Net in retirement Leaving in technology
investment age land fallow
Rise in Education Training
population

Mind map 1.02: Factors of production

11

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