ECONOMICS

Combination of different topics

Guide note of different topics to help pass your economics IGCSE

Economics is the social science that describes the factors that

determine the production, distribution and consumption of
goods and services.”
(Source: Wikipedia)

The Nature of the Economic Problem

Resources: are the inputs required for the production of goods
and services.
Scarcity: a lack of something (in this context, resources).
The fundamental economic problem is that there is a scarcity of
resources to satisfy all human wants and needs. There are finite
resources and unlimited wants. This is applicable to consumers,
producers, workers and the government, in how they manage
their resources.

Economic goods are those which are scarce in supply and so can
only be produced with an economic cost and/or consumed with
a price. In other words, an economic good is a good with an
opportunity cost. All the goods we buy are economic goods,
from bottled water to clothes.
Free goods, on the other hand, are those which are abundant in
supply, usually referring to natural sources such as air and
sunlight.
The Factors of Production

Resources are also called ‘factors of production’ (especially in

Business). They are:

• Land: all natural resources in an economy. This includes the surface

of the earth, lakes, rivers, forests, mineral deposits, climate etc.
• The reward for land is the rent it receives.
• Since, the amount of land in existence stays the same,
its supply is said to be fixed. But in relation to a country or
business, when it takes over or expands to a new area, you
can say that the supply of land has increased, but the supply
is not depended on its price, i.e. rent.
• The quality of land depends upon the soil type, fertility,
weather and so on.

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Guide note of different topics to help pass your economics IGCSE

• Since land can’t be moved around, it is geographically

immobile but since it can be used for a variety of economic
activities it is occupationally mobile.
• Labour: all the human resources available in an economy. That is,
the mental and physical efforts and skills of workers/labourers.
• The reward for work is wages/salaries.
• The supply of labour depends upon the number of workers
available (which is in turn influenced by population size, no.
of years of schooling, retirement age, age structure of the
population, attitude towards women working etc.) and the
number of hours they work (which is influenced by number
of hours to work in a single day/week, number of holidays,
length of sick leaves, maternity/paternity leaves, whether
the job is part-time or full-time etc.).
• The quality of labour will depend upon the skills, education
and qualification of labour.
• Labour mobility can depend up on various factors. Labour
can achieve high occupational mobility (ability to change
jobs) if they have the right skills and qualifications. It can
achieve geographical mobility (ability to move to a place for
a job) depending on transport facilities and costs, housing
facilities and costs, family and personal priorities, regional
or national laws and regulations on travel and work etc.
• Capital: all the man-made resources available in an economy. All
man-made goods (which help to produce other goods – capital
goods) from a simple spade to a complex car assembly plant are
included in this. Capital is usually denoted in monetary terms as the
total value of all the capital goods needed in production.
• The reward for capital is the interest it receives.
• The supply of capital depends upon the demand for goods
and services, how well businesses are doing, and savings in
the economy (since capital for investment is financed by
loans from banks which are sourced from savings).
• The quality of capital depends on how many good quality
products can be produced using the given capital. For
example, the capital is said to be of much more quality in a
car manufacturing plant that uses mechanisation and
technology to produce cars rather than one in which manual
labour does the work.
• Capital mobility can depend upon the nature and use of the
capital. For example, an office building is geographically

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immobile but occupationally mobile. On the other hand, a

pen is geographically and occupationally mobile.
• Enterprise: the ability to take risks and run a business
venture or a firm is called enterprise. A person who has enterprise is
called an entrepreneur. In short, they are the people who start a
business. Entrepreneurs organize all the other factors of production
and take the risks and decisions necessary to make a firm run
successfully.
• The reward to enterprise is the profit generated from the
business.
• The supply of enterprise is dependent on entrepreneurial
skills (risk-taking, innovation, effective communication etc.),
education, corporate taxes (if taxes on profits are too high,
nobody will want to start a business), regulations in doing
business and so on.
• The quality of enterprise will depend on how well it is able
to satisfy and expand demand in the economy in cost-
effective and innovative ways.
• Enterprise is usually highly mobile, both geographically and
occupationally.

All the above factors of productions are scarce because the time
people have to spend working, the different skills they have, the
land on which firms operate, the natural resources they use etc.
are all in limited in supply; which brings us to the topic of
opportunity cost.

Opportunity Cost
The scarcity of resources means that there are not sufficient
goods and services to satisfy all our needs and wants; we are
forced to choose some over the others. Choice is necessary
because these resources have alternative uses- they can be
used to produce many things. But since there are only a finite
number of resources, we have to choose.

When we choose something over the other, the choice that was
given up is called the opportunity cost. Opportunity cost, by
definition, is the next best alternative that is sacrificed/forgone in
order to satisfy the other.
Example 1: the government has a certain amount of money and
it has two options: to build a school or a hospital, with that

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money. The govt. decides to build the hospital. The school, then,
becomes the opportunity cost as it was given up. In a wider
perspective, the opportunity cost is the education the children
could have received, as it is the actual cost to the economy of
giving up the school.
Example 2: you have to decide whether to stay up and study or
go to bed and not study. If you chose to go to bed, the
knowledge and preparation you could have gained by choosing
to stay up and study is the opportunity cost.
Production Possibility Curve Diagrams (PPC)

Because resources are scarce and have alternative uses, a

decision to devote more resources to producing one product
means fewer resources are available to produce other goods. A
Production Possibility Curve diagram shows this, that is, the
maximum combination of two goods that can be produced by an
economy with all the available resources.

The PPC diagram above shows the production capacities of two

goods- X and Y- against each other. When 500 units of good X
are produced, 1000 units of good Y can be produced. But when
the units of good X increases to 1000, only 500 units good Y can
be produced.

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Guide note of different topics to help pass your economics IGCSE

Let’s look at the PPC named A. At point X and Y it can produce

certain combinations of good X and good Y. These are points on
the curve- they are attainable, given the resources. Th economy
can move between points on a PPC simply by reallocating
resources between the two goods.
If the economy were producing at point Z, which is inside/below
the PPC, the economy is said to be inefficient, because it is
producing less than what it can.
Point W, outside/above the PPC, is unattainable because it is
beyond the scope of the economy’s existing resources. In order
to produce at point W, the economy would need to see a shift in
the PPC towards the right.
For an outward shift to occur, an economy would need to:
• discover or develop new raw materials. Example: discover new oil
fields
• employ new technology and production methods to increase
productivity
• increase labour force by encouraging birth and immigration,
increasing retirement age etc.
An outward shift in PPC, that is higher production possibility,
will lead to economic growth.

In the same way, an inward shift can occur in the PPC due to:
• natural disasters, that erode infrastructure and kill the population
• very low investment in new technologies will cause productivity to
fall over time
• running out of resources, especially non-renewable ones like oil or
water
An inward shift in the PPC will lead to the economy shrinking.

How is opportunity cost linked to PPC?

Individuals, businessmen and the government can calculate
the opportunity cost from PPC diagrams. In the above example, if
the firm decided to increase production of good Y from 500 to
750, it can calculate the opportunity cost of the decision to be
250 units of good X (as production of good X falls from 1000 to
750). They are able to compare the opportunity cost for different
decisions.

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Guide note of different topics to help pass your economics IGCSE

Economy: an area where people and firms produce, trade and consume goods
and services. This can vary in size- from your local town to your country, or the
globe itself.

Microeconomics and Macroeconomics

Microeconomics is the study of individual markets. For example: studying the
effect of a price change on the demand for a good. Microeconomic decision
makers are producers and consumers (who directly operate in markets)

Macroeconomics is the study of an entire economy, as a whole. Examples

include studying the total size of the economy or the unemployment rate, among
other things. Macroeconomic decisions are made by the government of the
particular economy – a town, state or country)

The Role of Markets in Allocating Resources

Resource allocation: the way in which economies decide what goods and
services to provide, how to produce them and who to produce them for.
These questions- what to produce, how to produce, and for whom to produce –
are termed ‘the basic economic questions’. In short, resource allocation is the
way in which economies solve the three basic economics questions.

Market is any set of arrangement that brings together all the producers and
consumers of a good or service, so they may engage in exchange. Example: a
market for soft drinks.

Goods and services are bought and sold in a market at an equilibrium price
where demand and supply are equal. This is called the price mechanism. It helps
answer the three basic economic questions. Producers will produce the good
that consumers demand the most, it will be produced in a way that is cost-
efficient, and will be produced for those who are willing and able to buy the
product. More on these topics below:

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Demand
Demand is the want and willingness of consumers to buy a good or services at a
given price. Effective demand is where the willingness to buy is backed by the
ability to pay. For example, when you want a laptop but you don’t have the
money, it is called demand. When you do have the money to buy it, it is called
effective demand.
The effective demand for a particular good or service is called quantity
demanded.
(Individual demand is the demand from one consumer, while market demand
for a product is the total (aggregate) demand for the product, or the sum of all
individual demands of consumers).

The law of demand states that an increase in price leads to a decrease

in demand, and a decrease in price leads to an increase in demand (it’s an
inverse relationship between price and demand. However it’s worth noting that
an increase in demand leads to an increase in price and a decrease in demand
leads to a decrease in price. The law of demand is established with respect to
changes in price, not demand, hence the difference).

This is an example of a demand curve for Coca-Cola.

Here, a decrease in price from 80 to 60 has increased its demand from 300 to
500.
The increase in demand due to changes in price (without changes in other
factors) is called an extension in demand. Here the extension in demand is from
A to B.

In the above example, an increase in price from 60 to 80, will decreased the
demand from 500 to 300. The decrease in demand due to the changes in price
(without changes in other factors) is called a contraction in demand. Here the
contraction in demand will be from B to A.

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In this example, there is a rise in the demand of Coca-Cola from 500 to 600,
without any change in price. A rise in the demand for a product due to the
changes in other factors (excluding price) causes the demand curve to shift to
the right (from A to B).

In this example, there is a fall in demand of Coca-Cola from 500 to 400, without
any change in price.
A fall in demand for a product due to the changes in other factors (excluding
price) causes the demand curve to shift to the left (from A to B).

Factors that cause shifts in a demand curve:

Consumer incomes: a rise in consumers’ incomes increases demand, causing a

shift to right. Similarly, a fall in incomes will shift the demand curve to the left.
Taxes on incomes: a rise in tax on incomes means less demand, causing a shift
to the left; and vice versa.
Price of substitutes: Substitutes are goods that can be used instead of a
particular product. Example: tea and coffee are substitutes (they are used for
similar purposes). A rise in the price of a substitute causes a rise in the demand
for the product, causing the demand curve to shift to the right; and vice versa.
Price of complements: Complements are goods that are used along with another
product. For example, printers and ink cartridges are complements. A rise in the
price of a complementary good will reduce the demand for the particular
product, causing the demand curve to shift to the left; and vice versa.
Changes in consumer tastes and fashion: for example, the demand for DVDs
have fallen since the advent of streaming services like Netflix, which has caused
the demand curve for DVDs to shift to the left.
Degree of Advertising: when a good is very effectively advertised (Coke and
Pepsi are good examples), its demand rises, causing a shift to the right. Lower
advertising shifts the demand curve to the left.
Change in population: A rise in the population will raise demand, and vice
versa.

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Guide note of different topics to help pass your economics IGCSE

Other factors, such as weather, natural disasters, laws, interest rates etc. can also
shift the demand curve.

Supply
Supply is the want and willingness of producers to supply a good or services at
a given price. The amount of goods or services producers are willing to make
and supply is called quantity supplied.
(Market supply refers to the amount of goods and services all producers
supplying that particular product are willing to supply or the sum of individual
supplies of all producers).

The law of supply states that an increase in price leads to a increase in supply,
and a decrease in price leads to an decrease in supply (there is a positive
relationship between price and supply. However it’s also worth noting that, an
increase in supply leads to a decrease in price and a decrease in supply leads to
an increase in price. The law of supply is established with respect to changes in
price, not supply, hence the difference).

This is an example of a supply curve for a product.

Here, an increase in price from 60 to 80, has increased its supply from 500 to
700.
The increase in supply due to changes in price (without changes in other factors)
is called an extension in supply.

A decrease in price from 80 to 60, will decreased the supply from 700 to 500.
The decrease in supply due to changes in price (without the changes in other
factors) is called a contraction in supply.

In this example, there is a rise in the supply of a product from 500 to 700,
without any change in price. A rise in the supply for a product due to the
changes in other factors (excluding price) causes a shift to the right.

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A fall in supply from 500 to 300, without any changes in price is also shown. A
fall in the supply for a product due to the changes in other factors (excluding
price) causes a shift to the left.

Factors that cause shifts in supply curve:

Changes in cost of production: when the cost of factors to produce the good
falls, producers can produce and supply more products cheaply, causing a shift
in the supply curve to the right. A subsidy*, which lowers the cost of production
also shifts the supply curve right. When cost of production rises, supply falls,
causing the supply curve to shift to the left.
Changes in the quantity of resources available: when the amount of resources
available rises, the supply rises; and vice versa.
Technological changes: an introduction of new technology will increase the
ability to produce more products, causing a shift to the right in the supply curve.
The profitability of other products: if a certain product is seen to be more
profitable than the one currently being produced, producers might shift to
producing the more profitable product, reducing supply of the initial product
(causing a shift to the left).
Other factors: weather, natural disasters, wars etc. can shift the supply curve
left.
Market Price
The market equilibrium price is the price at which the demand and supply
curves in a given market meet.

In this diagram, P* is the equilibrium price.

Disequilibrium price is the price at which market demand and supply curves do
not meet, which in this diagram, is any price other than P*.

Price Changes

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In this diagram, two disequilibrium prices are marked- 2.50 and 1.50.
At price 2.50, the demand is 4 while the supply is 10. There is excess supply
relative to the demand. When the price is above the equilibrium price, a surplus
is experienced. (Surplus means ‘excess’).

At price 1.50, the demand is 10 while the supply is only 4. There is excess
demand relative to supply. When the price is below the equilibrium price, a
shortage is experienced.
(This shortage and surplus is said in terms of the supply being short or excess
respectively).

Price Elasticity of Demand (PED)

The PED of a product refers to the responsiveness of the quantity demanded to
changes in its price.

PED (of a product) = % change in quantity demanded / % change in price

For example, calculate the price elasticity of demand of Coca-Cola from this
diagram.

PED= [(500-300/300)*100] / [(80-60/80)*100]

= 66.67 / 25 = 2.67

In this example, the PED is 2.67, that is, the % change in quantity demanded
was higher than the % change in the price. This means, a change in price makes
a higher change in quantity demanded. These products have a price elastic
demand. Their values are always above 1.

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When the % change in quantity demanded is lesser than the % change in price,
it is said to have a price inelastic demand. Their values are always below 1. A
change in price makes a smaller change in demand.

When the % change in demand and price are equal, that is value is 1, it is called
unitary price elastic demand.

When the quantity demanded changes without any changes in price itself, it is
said to have an infinitely price elastic demand. Their values are infinite.

When the price changes have no effect on demand whatsoever, it is said to have
a perfect price inelastic demand. Their elasticity is 0.

What affects PED?

No. of substitutes: if a product has many substitute products it will have an

elastic demand. For example, Coca-Cola has many substitutes such as Pepsi and
Mountain Dew. Thus a change in price will have a greater effect on its demand
(If price rises, consumers will quickly move to the substitutes and if price
lowers, more consumers will buy Coca-Cola).
Time period: demand for a product is more likely to be elastic in the long run.
For example, if the price rises, consumers will search for cheaper substitutes.
The longer they have, the more likely they are to find one.

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Proportion of income spend on commodity: goods such as rice, water

(necessities) will have an inelastic demand as a change in price won’t have any
significant effect on its demand, as it will only take up a very small proportion
of their income. Luxury goods such as cars on the other hand, will have a high
price elastic demand as it takes up a huge proportion of consumers’ incomes.
Relationship between PED and revenue and how it is helpful to producers:

Producers can calculate the PED of their product and take a suitable action to
make the product more profitable.

Revenue is the amount of money a producer/firm generates from sales, i.e., the
total number of units sold multiplied by the price per unit. So, as the price or the
quantity sold changes, those changes have a direct effect on revenue.

If the product is found to have an elastic demand, the producer can lower prices
to increase revenue. The law of demand states that a price fall increases the
demand. And since it is an elastic product (change in demand is higher than
change in price), the demand of the product will increase highly. The producers
get more revenue.
If the product is found to have an inelastic demand, the producer can raise prices
to increase revenue. Since quantity demanded wouldn’t fall much as it is
inelastic, the high prices will make way for higher revenue and thus higher
profits.

Price Elasticity of Supply (PES)

The PES of a product refers to the responsiveness of its quantity supplied it to
changes in its price.

PES of a product= %change in quantity supplied / %change in price

Similar to PED, PES too can be categorized into price elastic supply, price
inelastic supply, perfectly price inelastic supply, infinitely price elastic supply
and unitary price elastic supply. (See if you can figure out what each supply

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elasticity means using the demand elasticities above as reference, and draw the
diagrams as well!)

What affects PES?

Time of production: If the product can be quickly produced, it will have a price
elastic supply as the product can be quickly supplied at any price. For example,
juice at a restaurant. But products which take a longer time to produce, such as
cars, will have a price inelastic supply as it will take a longer time for supply to
adjust to price.
Availability of resources: More resource (land, labour, capital) will make way
for an elastic supply. If there are not enough resources, producers will find it
difficult to adjust to the price changes, and supply will become price inelastic.

Market Economic System

In a market economic system or free market economic system, all resources are
allocated by the market – private producers and consumers; that is, there is no
or very little government intervention in resource allocation. (There are virtually
no economies in the world that follow this system – there is a government
control everywhere, although Hong Kong and Singapore do come close – check
out the Index of Economic Freedom to see the ranking of economies on the
basis of how market-friendly they are ).

Features:

All resources are owned and allocated by private individuals.

Government refrains from regulating markets. It instead tries to create very
business-friendly environments and any intervention is mostly limited to
protecting private property. The demand and supply fixes the price of products.
This is called price mechanism.
What to produce is solved by producing the most-demanded goods for
which people spend a lot, as their only motive is to generate a high profit.
How to produce is solved by using the cheapest yet efficient combination of
resources – capital or labour- in order to maximise profits.

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For whom to produce is solved by producing for people who are willing and
able to pay for goods at a high price.
Advantages:

A wide variety of quality goods and services will be produced as different

firms will compete to satisfy consumer wants and make profits. Quality is
ensured to make sure that consumers buy from them. There is consumer
sovereignty.
Firms will respond quickly to consumer changes in demand. When there is
a change in demand, they will quickly allocate resources to satisfying that
demand, so as to maintain profits.
High efficiency will exist. Since producers want to maximise profits, they
will use resources very efficiently (producing more with less resources).
Since there is hardly any government intervention (in the form of regulations,
extra fees and fines etc. for example), firms will find it easy and inexpensive to
start and run businesses.
Disadvantages:

Only profitable goods and services are produced. Public goods* and some merit
goods* for which there is no demand may not be produced, which is a
drawback and affects the economic development.
Firms will only produce for consumers who can pay for them. Poor people
who cannot spend much won’t be produced for, as it would be non-profitable.
Only profitable resources will be employed. Some resources will be left
unused. In a market economy, capital-intensive production is favoured over
labour- intensive production (because it’s more cost-efficient). This can lead
to unemployment.
Harmful (demerit) goods may be produced if it is profitable to do so.
Negative impacts on society (externalities) may be ignored by producers, as
their sole motive is to keep consumers satisfied and generate a high profit.
A firm that is able to dominate or control the market supply of a product is
called a monopoly. They may use their power to restrict supply from

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other producers, and even charge consumers a high price since they are the only
producer of the product and consumers have no choice but to buy from them.
Due to high competition between firms, duplication of products may take place,
which is a waste of resources.
*Public goods: goods that can be used by the general public, from which they
will benefit. Their consumption can’t be measured, and thus cannot be charged
a price for (this is why a market economy doesn’t produce them). Examples are
street lights and roads.
*Merit goods: goods which create a positive effect on the community and ought
to be consumed more. Examples are schools, hospitals, food. The opposite is
called demerit goods which includes alcohol and cigarettes
*Subsidies: financial grants made to firms to lower their cost of production in
order to lower prices for their products.

Before we dive into what market failure is, let’s get familiar with some terms
related to market failure:

Public goods: goods that can be used by the general public, from which they
will benefit. Their consumption can’t be measured, and thus cannot be charged
a price for (this is why a market economy doesn’t produce them). Examples
include street lights and roads.

Merit goods: goods which create a positive effect on the society and ought to be
consumed more. Examples include schools and hospitals. The opposite is called
demerit goods which include alcohol and cigarettes.

External costs (negative externalities) are the negative impacts on society (third-
parties) due to production or consumption of goods and services. Example: the
pollution from a factory.

External benefits (positive externalities) are the positive impacts on society due
to production or consumption of goods and services. Example: better roads in a
neighbourhood due to the opening of a new business.

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Private costs are the costs to the producer and consumer due to production and
consumption respectively. Example: the cost of production.

Private benefits are the benefits to the producer or consumer due to production
and consumption respectively. Example: the better immunity received by a
consumer when he receives a vaccine.

Social Costs = External costs + Private Costs

Social Benefits = External benefits + Private benefits

Market Failure
Market failure occurs when the price mechanism fails to allocate resources
effectively. This is the most disadvantageous aspect to the market economy.
Causes of market failure are:

When social costs exceed social benefits (especially where negative

externalities (external costs) are high).
Over-provision of demerit goods like alcohol and tobacco: the external costs
arising from demerit goods are not reflected in the market and so they are
overproduced.
Under-provision of merit goods such as schools, hospitals and public transport,
since the external benefits of these goods are not reflected in the market, they
are underproduced.
Lack of public goods such as roads, bus terminals and street lights: since their
consumption cannot be measures and charged a price for, they are not produced
by the private sector.
Immobility of resources: when resources cannot move between their optimal
uses and thus are not used to the maximum. For example, when workers
(labour) don’t have occupational or geographic mobility.

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Information failure: when information between consumers, producers and the

government are not efficiently and correctly communicated. Example: a
cosmetics firm advertises its products as healthy when it is in fact not. The
consumers who believe the firm and use its products might suffer skin damage.
Abuse of monopoly* powers: monopolistic businesses may use their powers to
charge consumers a high price and only produce products they wish to, since
they know consumers have no choice but to buy from them.

*Monopoly: a single supplier who supplies the entire market with a particular
product, without any competition. Example: public utilities like water, gas and
electricity in many countries are provided by their respective governments with
no other producer allowed in the market.

Mixed Economic System

In a mixed economic system, both the market and government intervention co-
exist. Examples include almost all countries in the world (India, UK, Brazil
etc.). This is because it overrides all the disadvantages of both the market and
planned (govt. only) economies. It identifies the importance of the price
mechanism in operating an efficient resource allocation and also the role of the
government in correcting (any) market failures.

Features:

both the public and the private sector exists

planning and final decisions are made by the govt. while the market system can
determine allocation of resources owned by it, along with the public
organizations.
Advantages:

The govt. can provide public goods, necessities and merit goods. The private
businesses can provide profitable and most-demanded goods (luxury goods,
superior goods). Thus, everyone is provided for.

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The govt. will keep externalities, monopolies, harmful goods etc. in control.
The govt. can provide jobs in the public sector (so there is better job security).
The govt. can also provide financial help to collapsing private organizations, so
jobs are kept secure.
Disadvantages:

Taxes will be imposed, which will raise prices and also reduce work incentive.
Laws and regulations can increase production costs and reduce production in the
economy.
Public sector organizations will still be inefficient and will produce low quality
goods and services.
The specific ways in which the government, in a mixed economic system, can
correct market failures of the market:

Legislation and regulation – the government can make laws that regulate market
activity, for example, prohibit smoking in public (which would cause a negative
externality). One important kind of legislation the govt. can undertake is price
controls – setting a minimum price or maximum price on goods.
Minimum price or price floor is set to control a decreasing tendency of price.
The minimum wage laws in many countries are an example of minimum price.
The government sets the minimum wage above the existing market equilibrium
wage, to ensure that all workers get a basic minimum wage to sustain them. But
even as low-income workers now get better wages, the higher wage will cause
the demand for labour to contract, as shown in the diagram to the left. There
will also be higher supply of labour (workers who want work) because of higher
wages. A reduced demand and increased supply will cause excess supply of
labour i.e., unemployment.
Maximum price or price ceiling is set to control an increasing tendency of price.
It is usually set on rent (this is called rent control), to ensure that low-income
tenants can afford to rent homes. But as a result of the lower rent, landlord will
stop renting more homes, causing supply to contract, as shown in the diagram to
the left. At the same time, lower rent will increase the demand for homes. A
reduced supply of homes and higher demand for them will cause a shortage of
supply in relation to demand.

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Direct provision of merit and public goods – since there is little incentive for the
price mechanism to supply these goods, governments usually provide them. For
example, free education, free healthcare, public parks. One way the govt. can do
this is by nationalising certain products it considers essential to be provided by a
governing authority, rather than the market. For example, in India, the
government operates the only railway network because only it can provide
cheap services to its millions of poor, daily passengers.
Taxation on products – imposing a tax on products (indirect taxes) with
negative externalities can discourage its production and consumption. For
example, a tax on tobacco will make it expensive to produce and consume. In
the diagram below, a tax has been imposed on a product, causing its supply to
shift from S to S1. The price rises from P to P1 because of the additional tax
amount, and the quantity traded in the market falls from Q to Q1.

Subsidies – a subsidy is a grant (financial aid) on products that have a positive

externality. Subsidising, for example, cooking gas for the poor, will increase the
living standard of the population. In the diagram below, a subsidy has been
imposed on a good, causing its supply to shift from S to S1. It results in a fall in
price from P to P1 and subsequently, an increase in the quantity traded in the
market from Q to Q1.

*Note: movements along a demand or supply curve of a good only happen as a

result of a direct change in price of the good; changes caused by any other
factor, tax and subsidy included, is represented by a shift in the curves.
Tradable permits – firms will have to buy permits from the government to do
something, for example, pollute at a certain level, and these can be traded
among firms. Since permits require money, firms will be encouraged to pollute
less.
Extension of property rights – one of the main reasons for pollution in public
spaces is that it is public – it does not harm a specific private individual – the
resource is the government’s who cannot charge compensations easily. So the
government can extend property rights (right to own property) of public places
to private individuals. This will effectively privatise resources, create a market
for these spaces and then individuals can be fined for polluting
International cooperation among governments – governments work together on
issues that affect the future of the environment.

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As you can see, market failure can be corrected by governments in a variety of

ways and the presence of a government is quite indispensable in any modern
economy. Planned (government-only) economies are too inefficient and free
market (no government) economies result in market failures. So a mixed
economic system tries to balance both sides. That being said, there are certain
drawbacks to government intervention in an economy.

Political incentives: this occurs when there is a clash between political and
economics (because a government is a political entity with political incentives).
For example, even though mining companies cause a lot of environmental
damage, the government may encourage and promote their activities to garner
political and financial support from them.
Lack of incentives: in the free market, individuals have a profit incentive to
innovate and cut costs, but in the public sector, such an incentive is absent since
the government will pay them salaries regardless of their performance. So, even
as the government provides certain public and merit goods directly to the people
at low costs, they tend to be very inefficient.
Time lags, information failure: these are some of the government failure arising
because of a lack of incentive. Government offices and employees don’t have an
incentive to provide timely services or give accurate information and this leads
to very inefficient systems.
Welfare effects of policies: government policies such as taxation and welfare
payments distort the market. This means that such policies will influence
demand and supply in the economy and cause markets to move away from the
efficient points produced by a market system. For example, high corporate taxes
will deter companies from expanding their operations and making more profits
or deter new enterprises from entering the market. Unemployment benefits
given out by the government may cause people to stay unemployed and receive
free benefits instead of working.

Money
What is money?
A medium of exchange of goods and services.
Why do we need money?
We need money in order to exchange goods and services with one another. This

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is because we aren’t self-sufficient – we can’t produce all our wants by

ourselves. Thus, there is a need for exchange.
In the past, barter system (exchanging a good or service for another good or
service) prevailed. This had a lot of problems such as the need for the double
coincidence of wants (if the person wants a table and he has a chair to exchange,
he must find a person who has a table to exchange and is also willing to buy a
chair), the goods being perishable and non-durable, the indivisibility of goods,
lack of portability etc.
Thus the money we use today is in the form of currency notes and coins, which
are durable, uniform, divisible (can be divided into 10’s, 50’s , 100’s
etc), portable and is generally accepted. These are the characteristics of what
is considered ‘good money’.
The functions of money:
• Money is a medium of exchange, as explained above.
• Money is a measure of value. Money acts as a unit of account, allowing
us to compare and state the worth of different goods and services.
• Money is a store of value. It holds its value for a long time, allowing us
to save it for future purposes.
• Money is a means of deferred payment. Deferred payments are
purchases on credit – where the consumer can pay later for the goods or
service they buy.
Banking
Banks are financial institutions that act as an intermediary between borrowers
and savers. It is the money we save at banks that is lent out as loans to other
individuals and businesses.
Commercial banks are those banks that have many retail branches located in
most cities and towns. Example: HSBC. There is also a central bank that
governs all other commercial banks in a country. Example: The Reserve Bank
Of India (RBI).
Functions of a commercial bank:
• Accept deposits in the form of savings.
• Aid customers in making and receiving payments via their bank accounts.
• Give loans to businesses and private individuals.
• Buying and selling shares on customers’ behalf.
• Provide insurance (protection in the form of money against damage/theft
of personal property).
• Exchange foreign currencies.
• Provide financial planning advice.
Functions of a central bank:
• It issues notes and coins of the national currency.
• It manages all payments relating to the government.

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• It manages national debt. Central banks can issue and repay public debts
on the government’s behalf.
• It supervises and controls all the other banks in the whole economy, even
holding their deposits and transferring funds between them.
• It is the lender of ‘last resort’ to commercial banks. When other banks are
having financial difficulties, the central bank can lend them money to
prevent them from going bankrupt.
• It manages the country’s gold and foreign currency reserves. These
reserves are used to make international payments and adjust their
currency value (adjust the exchange rate).
• It operates the monetary policy in an economy.(This will be explained in
a later chapter)

Disposable income is the income of a person after all income-related taxes and
charges have been deducted.

Spending (Consumption)
The buying of goods and services is called consumption. The money spent on
consumption is called consumer expenditure.

People consume in order to satisfy their needs and wants and give them
satisfaction.

Factors affecting consumption:

1
Disposable income: the more the disposable income, the more people consume.
Wealth: the more wealthy (having assets such as property, jewels, company
shares) a person is, the more he spends.
Consumer confidence: if consumers are confident of keeping their jobs and their
future incomes, then they might be encouraged to spend more now, without
worries.
Interest rates: if interest rates provided by banks on saving are high, consumers
might save more so they can earn interest and thus consumer expenditure will
fall.

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Saving
Saving is income not spent (or delaying consumption until some later date).
People can save money by depositing in banks, and withdraw it a later date with
the interest.

Factors affecting saving:

Saving for consumption: people save so that they can consume later. They save
money so that they can make bigger purchases in the future (a house, a car etc).
Thus, saving can depend on the consumers’ future plans.
Disposable income: if the amount of disposable income people have is high, the
more likely that they will save. Thus, rich people save a higher proportion of
their incomes than poor people.
Interest rates: people also save so that their savings may increase overtime with
the interest added. Interest is the return on saving; the longer you save an
amount and the higher the amount, the higher the interest received.
Consumer confidence: if the consumer is not confident about his job security
and incomes in the future, he may save more now.
Availability of saving schemes: banks now offer a variety of saving schemes.
When there are more attractive schemes that can benefit consumers, they might
resort to saving rather than spending.
Borrowing
Borrowing, as the word suggests, is simply the borrowing of money from a
person/institution. The lender gives the borrower money. The lender is usually
the bank which gives out loans to customers.

Factors affecting borrowing:

Interest rates: interest is also the cost of borrowing. When a person takes a loan,
he must repay the entire amount at the end of a fixed period while also paying
an amount of interest periodically. When the interest rates rise, people will be
reluctant to borrow and vice versa.

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Wealth/Income: banks will be more willing to lend to wealthy and high-income

earning people, because they are more likely to be able to repay the loan, rather
than the poor. So even if they would like to borrow, the poor end up being able
to borrow much lesser than the rich.
Consumer confidence: how confident people feel about their financial situation
in the future may affect borrowing too. For example, if they think that prices
will rise (inflation) in the future, they might borrow now, to make big purchases
now.
Ways of borrowing: the no. of ways to borrow can influence borrowing.
Nowadays there are many borrowing facilities such as overdrafts, bank loans
etc. and there are more credit (future payment) options such as hire purchases
(payment is done in installments overtime), credit cards etc.
Expenditure patterns between income groups
The richer people spend, save and borrow more amounts than the poor.
The poor spend higher proportions of their disposable income, especially on
necessities, than the rich.
The poor save lesser proportions of their disposable income in comparison with
the rich.

Labour Market
Labourers need wages to satisfy their wants and needs.

Payments for labour:

Time-rate wage: wage given based on the no. of hours the employee has
worked. Overtime wages are given to workers who have worked extra no. of
hours, which will usually be 1.5 times or even twice the normal time rate.
Piece-rate wage: wage given based on the amount of output produced. The more
output an employee produced, the more wage he/she earns. This is used in
industries where output can be easily measured and gives employees an
incentive to increase their productivity.
Salary: monthly payments made to workers, usually managers, office staff etc.
usually in non-manual jobs.

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Performance-related payments: payments given to individual workers or teams

of workers who have performed very well. Commissions given to salespersons
for selling to a targeted no. of customers is a form of performance-related pay.
What affects an individual’s choice of occupation?

Wage factors: the wage conditions of a job/firm such as the pay rate, the
prospect for performance-related payments and bonuses etc. will be considered
by the individual before he chooses a job.
Non-wage factors: This will include:
hours of work
holiday entitlements
promotion prospects
quality of working environment
job security
fringe benefits (free medical insurance, company car, price discounts on
company products etc.)
training opportunities
distance from home to workplace
pension entitlement

Labour demand is the number of workers demanded by firms at a given wage

rate. Labour demand is called ‘derived demand’, since the level of demand of a
product determines that industry’s demand for labour. That is, the higher the
demand for a product, the more labour producers will demand to increase
supply of the product.
When the wage increases, the demand for labour contracts (and vice versa).

Labour supply is the number of workers available and ready to work in an

industry at a given wage rate. When the wage rate increases, the supply of
labour extends, and vice versa.

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We also know that as the number of hours worked increases, the wage rate also
increases. However, when a person get to a very high position and his
wages/salary increases highly, the number of hours he/she works may decrease.
This can be shown in this diagram, called a backward-bending labour supply
curve. CEOs and executive managers at the top of the management tend to have
backward-bending labour supply curves.

Just like in a demand and supply curve analysis, labour demand and supply will
extend and contract due to changes in the wage rate. Other factors that cause
changes in demand and supply of labour will result in a shift in the demand and
supply curve of labour.

Factors that cause a shift in the labour demand curve:

Consumer demand for goods and services: the higher the demand for products,
the higher the demand for labour.
Productivity of labour: the more productive labour is, the more the demand for
labour.
Price and productivity of capital: capital is a substitute resource for labour. If
the price of capital were to lower and its productivity to rise, firms will demand
more of capital and labour demand will fall (labour demand curve shifts to the
left).
Non-wage employment costs: wages are not the only cost to a firm of
employing workers. Sometimes, employment tax, welfare insurance for each
employee etc. will have to be paid by the firm. If these costs increase, firms will
demand less labour.
Factors that cause a shift in the labour supply curve:

Advantages of an occupation: the different advantages a job can offer to

employees will affect the supply of labour- the people willing to do that job.

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Example: if the number of working hours in the airline industry increases, the
labour supply there will shift to the left.
Availability and quality of education and training: if quality training and
education for a particular job, say pilots, is lacking, then the labour supply for it
will be low. When new education and training institutes open, the labour supply
will rise (labour supply curve shifts to the right).
Demographic changes: the size and age structure of the population in an
economy can affect the labour supply. The labour supply curve will shift to the
right when more people come into a country from outside (immigration) and
when the birth rate increases (more young people will be available for work).
Why would a person’s wage rate change overtime?

As a beginner, the individual would have a low wage rate since he/she is new to
the job and has no experience. Overtime, as his/her experience increases and
skills develop, he/she will earn a higher wage rate. If he/she gets promoted and
has more responsibilities, his/her wage rate will further increase. When he/she
nears retirement age, the wage rate is likely to decrease as their productivity and
skills are likely to weaken.

Wage Differentials
Why do different jobs have different wages?

Different abilities and qualifications: when the job requires more skills and
qualifications, it will have a higher wage rate.
Risk involved in the job: risky jobs such as rescue operation teams will gain a
higher wage rate for the risks they undertake.
Unsociable hours: jobs that require night shifts and work at other unsociable
hours are paid more.
Lack of information about other jobs and wages: Sometimes people work for
less wage rates simply because they do not know about other jobs with higher
wage rates.
Labour immobility: the ease with which workers can move between different
occupations and areas of an economy is called labour mobility. If labour

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mobility is high, workers can move to jobs with a higher pay. Labour
immobility causes people to work at a low wage rate because they don’t have
the skills or opportunities to move to jobs with a higher wage.
Fringe benefits: jobs which offer a lot of fringe benefits have low wages. But
sometimes the highest-paid jobs are also given a lot of fringe benefits, to attract
skilled labour.

Why do wages differ between people doing the same job?

Regional differences in labour demand and supply: for example, if the demand
in an area for accountants is very high, the wage rate for accountants will be
high; whereas, in an area of low demand for accountants, the wage rate for
accountants will be low. Similarly, a high supply of accountants will cause their
wages to be low, while a low supply (scarcity) of accountants will cause their
wages to be high. It’s the law of demand and supply!
Fringe benefits: some firms which pay a lot of fringe benefits, will pay less
wages, while firms (in the same industry) which pay lesser fringe benefits will
have higher wages.
Discrimination: workers doing the same work may be discriminated by gender,
race, religion or age.
Length of service: some firms provide extra pay for workers who have worked
in the firm for a long time, while other firms may not.
Local pay agreements: some trade unions may agree a national wage rate for all
their members – therefore all their members (labourers) will get a higher wage
rate than those who do the same job but are not in the trade union. This depends
on the relative bargaining power of the trade union.
Government labour policies: wages will be fairer in an economy where the
government has set a minimum wage policy. The government’s corporate tax
policies can also influence the amount of wage firms will be willing to pay out.
Other wage differentials:

Public-private sector pay gap: public sector jobs usually have a high wage rate.
But sometimes public sector wages are lower than that of the private sector’s

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because low wages can be compensated by the public sector’s high job security
and pension prospects.
Economic sector: workers in primary activities such as agriculture receive very
low wages in comparison to those in the other sectors because the value of
output they produce is lower. Further still, workers in the manufacturing sector
may earn lesser than those in the services sector. But it comes down to the
nature of the job itself. A computer engineer in the manufacturing sector does
earn more than a waiter at a restaurant after all.
Skilled and unskilled workers: Skilled workers have a higher pay than unskilled
workers, because they are more productive and efficient and make lesser
mistakes.
Gender pay gap: Men are usually given a higher pay than women. This is
because women tend to go for jobs that don’t require as much skill as that
is required by men’s jobs (teaching, nursing, retailing); they take career breaks
to raise children, which will cause less experience and career progress (making
way for low wages); more women work part-time than full-time. Sometimes,
even if both men and women are working equally hard and effectively,
discrimination can occur against women.
International wage differentials: developed countries usually have high wage
rates due to high incomes, large supply of skilled workers, high demand for
goods and services etc; while in a less-developed economy, wage rates will be
low due to a large supply unskilled labour.
Division of Labour/Specialisation
Division of labour is the concept of dividing the production process into
different stages enabling workers to specialise in specific tasks. This will help
increase efficiency and productivity. Division of labour is widely used in
modern economies. From the making of iPhones (the designs, processors,
screens, batteries, camera lenses, software etc. are made by different people in
different parts of the world) to this very website (where notes, mindmaps,
illustrations, design etc. are all managed by different people).

Advantages to workers:

Become skilled: workers can get skilled and experienced in a specific task
which will help their future job prospects

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Better future job prospects: because of the skill and training they acquire,
workers will, in the future, be able to get better jobs in the same field.
Saves time and expenses in training
Disadvantages to workers:

Monotony: doing the same task repetitively might make it boring and lower
worker’s morale.
Margin for errors increases: as the job gets repetitive, there also arises a chance
for mistakes.
Alienation: since they’re confined to just the task they’re doing, workers will
feel socially alienated from each other.
Lower mobility of labour: division of labour can also cause a reduced mobility
of labour. Since a worker is only specialised in doing one specific task(s), it will
be difficult for him/her to do a different job.
Increased chance of unemployment: when division of labour is introduced,
many excess workers will have to be laid off. Additionally, if one loses the job,
it will be harder for him/her to find other jobs that require the same
specialisation.
Advantages to firms:

Increased productivity: when people specialise in particular tasks, the total

output will increase.
Increased quality of products: because workers work on tasks they are best
suited for, the quality of the final output will be high.
Low costs: workers only need to be trained in the tasks they specialise in and
not the entire process; and tools and equipment required for a task will only be
needed for a few workers who specialise in the task, and not for everybody else.
Faster: when everyone focuses on a particular task and there is no need for
workers to shift from one task to another, the production will speed up
Efficient movement of goods: raw materials and half-finished goods will easily
move around the firm from one task to the next.

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Better selection of workers: since workers are selected to do tasks best suited
for them, division of labour will help firms to choose the best set of workers for
their operations.
Aids a streamlined production process: the production process will be smooth
and clearly defined, and so the firm can easily adapt to a mass production scale.
Increased profits: lower costs and increased productivity will help boost profits.
Disadvantages o firms:

Increased dependency: The production may come to a halt if one or more

workers doing a specific task is absent. The production is dependent on all
workers being present to do their jobs.
Danger of overproduction: as division of labour facilitates mass production, the
supply of the product may exceed its demand, and cause a problem of excess
stocks of finished goods. Firms need to ensure that they’re not producing too
much if there is not enough demand for the product in the first place.
Advantages to the economy:

Better utilisation of human resources in the economy as workers do the job

they’re best at, helping the economy achieve its maximum output.
Establishment of efficient firms and industries, as the higher profits from
division of labour will attract entrepreneurs to invest and produce.
Inventions arise: as workers become skilled in particular areas, they can
innovate and invent new methods and products in that field.
Disadvantages to the economy:

Labour immobility: occupational immobility may arise because workers can

only specialise in a specific field.
Reduces the creative instinct of the labour force in the long-run as they are only
able to do a single task repetitively and the previous skills they acquired die out.
Creates a factory culture, which brings with it the evils of exploitation, poor
working conditions, and forced monotony.

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Trade Unions are organizations of workers that aim at promoting and protecting
the interest of their members (workers). They aim on improving wage rates,
working conditions and other job-related aspects.

The functions of a trade union:

Negotiating improvements in non-wage benefits with employers.

Defending employees’ rights.
Improving working conditions, such as better working hours and better safety
measures.
Improving pay and other benefits.
Supporting workers who have been unfairly dismissed or discriminated against.
Developing the skills of members, by providing training and education.
Providing recreational activities for the members.
Taking industrial actions (strikes, overtime ban etc.) when employers don’t
satisfy their needs. These are explained later in this topic.
Collective bargaining: the process of negotiating over pay and working
conditions between trade unions and employers.

When can trade unions argue for higher wages and better working conditions?

Prices are rising (inflation): the cost of living increases when prices increase and
workers will want higher wages to consume products and raise their families.
The sales and demand of the firm has increased.
Workers in other firms are getting a higher pay.
The productivity of the members has increased.

Industrial disputes

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When firms don’t satisfy trade union wants or refuse to agree to their terms, the
members of a trade union can organize industrial disputes. Here are some:

Overtime ban: workers refuse to work more than their normal hours.
Go-slow: workers deliberately slow down production, so the firm’s sales and
profits go down.
Strike: workers refuse to work and may also protest or picket outside their
workplace to stop deliveries and prevent other non-union members from
entering. They don’t receive any wages during this time. This will halt all
production of the firm.
Trade union activity has several impacts:

Advantages to workers:

Workers benefit from collective bargaining power by being able to establish

better terms of labour.
Workers feel a sense of unity and feel represented, increasing morale.
Lesser chance of being discriminated and exploited.
Disadvantages to workers:

Workers might get lesser wages or none if they go on strike – as the output and
profits of the firm falls and they refuse to pay.
Advantages to firms:

Time is saved in negotiating with a union when compared to negotiating with

individuals workers.

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When making changes in work schedules and practices, a trade union’s

cooperation can help organise workers efficiently.
Mutual respect and good relationships between unions and firms are good for
business morale and increases productivity.
Disadvantages to firms:

Decision making may be long as there will be need of lengthy discussions with
trade unions in major business decisions.
Trade unions may make demands that the firm may not be able to meet – they
will have to choose between profitability and workers’ interests.
Higher wages bargained by trade unions will reduce the firm’s profitability.
Businesses will have high costs and low output if unions organise agitations.
Their revenue and profits will go down and they will enter a loss. They may
also lose a lot of customers to competing firms.
Advantages to the economy:

Ensures that the labour force in the economy is not exploited and that their
interests are being represented
Disadvantages to the economy:

Can negatively impact total output of the economy.

Firms may decide to substitute labour for capital if they can’t meet trade unions’
expensive demands, and so unemployment may rise.
Higher wages resulting from trade union activity can make the nation’s exports
expensive and thus less competitive in the international market
In modern times, the powers of trade unions have drastically weakened.
Globalisation, liberalisation and privatisation of economies are making markets
more competitive. Firms have more incentive to reduce costs of production to a
minimum in order to remain competitive and profitable. Therefore, it is much
harder for unions to force employers to increase wages. Most unions operating
nowadays are more focused on bettering working conditions and non-monetary
benefits.

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Classification of Firms
Firms can be classified in terms of the sectors they operate in and their relative
sizes.

Firms are classified into the following three categories based on the type of
operations undertaken by them:

Primary: all economic activity involving extraction of raw natural materials.

This includes agriculture, mining, fishing etc. In pre-modern times, most
economic activity and employment was in this sector, mostly in the form of
subsistence farming (farming for self-consumption).
Secondary: all economic activity dealing with producing finished goods. This
includes construction, manufacturing, utilities etc. This sector gained
importance during the industrial revolution of the 19th and 20th centuries and
still makes up a huge part of the modern economy.
Tertiary: all economic activity offering intangible goods and services to
consumers. This includes retail, leisure, transport, IT services, banking,
communications etc. This sector is now the fastest-growing sector as consumer
demand for services have increased in developed and developing nations.
Firms can also be classified on the basis of whether they are publicly owned or
privately owned:

Public: this includes all firms owned and run by the government. Usually, the
defence, arms and nuclear industries of an economy are completely public.
Public firms don’t have a profit motive, but aim to provide essential services to
the economy it governs. Governments do also run their own schools, hospitals,
postal services, electricity firms etc.
Private: this includes all firms owned and run by private individuals. Private
firms aim at making profits and so their products are those that are highly
demanded in the economy.

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Firms can also be classified on their relative size as small, medium or large
depending on the output, market share, organisation (no. of departments and
subsidiaries etc).

Small Firms
A small firm is an independently owned and operated enterprise that is limited
in size and in revenue depending on the industry. They require relatively less
capital, less workforce and less or no machinery. These businesses are ideally
suited to operate on a small scale to serve a local community and to provide
profits to the owners.

Advantages of small businesses:

Independence: owner(s) are free to run the business as he/she pleases.

Control: the owner(s) has full control over the business, unlike in a large
business where multiple managers, departments and branches will exist.
Flexibility: small businesses can adapt to quick changes as the owner is more
involved in the decision-making.
Better communication: since there are fewer employees, information can be
intimated easily and quickly.
Innovation: small businesses can tend to be innovative because they have less to
lose and are willing to take risks.
Disadvantages of small businesses:

Higher costs: small firms cannot exploit economies of scale – their average
costs will be higher than larger rivals.
Lack of finance: struggles to raise finance as choice of sources of acquiring
finance is limited.
Difficult to attract experienced employees: a small business may be unable to
afford the wage and training required for skilled workers.
Vulnerability: when economic conditions change, it is harder for small
businesses to survive as they lack resources.

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Small firms still exist in the economy for several reasons:

Size of the market: when there is only a small market for a product, a firm will
see no point in growing to a larger size. The market maybe small because:
the market is local – for example, the local hairdresser.
the final product maybe an expensive luxury item which only require small-
scale production (e.g. custom-made paintings)
personalised/custom services can only be given by small firms, unlike large
firms that mostly give standardised services (e.g. wedding cake makers).
Access to capital is limited, so owners can’t grow the firm.
Owner(s) prefer to stay small: a lot of entrepreneurs don’t want to take risks by
growing the firm and they are quite satisfied with running a small business.
Small firms can co-operate: co-operation between small firms can lead them to
set up jointly owned enterprises which allow them to enjoy many of the benefits
that large firms have.
Governments help small firms: governments usually provide help to small scale
firms because small firms are an important provider of employment and
generate innovation in the production process. In most countries, it is the
medium and small industries that contribute much of the employment.
Growth of Firms
When a firm grows, its scale of production increases. Firms can grow in to
ways: internally or externally.

Internal Growth/Organic Growth

This involves expanding the scale of production of the firm’s existing

operations. This can be done by purchasing more machinery/equipment,
opening more branches, selling new products, expanding business premises,
employing more workers etc.

External Growth

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This involves two or more firms joining together to form a larger business. This
is called integration. This can be done it two ways: mergers or takeovers.

A takeover or acquisition happens when a company buys enough shares of

another firm that they can take full control. The firm taken over loses its identity
and becomes a part of what is known as the holding company. A well-known
example would be Facebook’s acquisition of Whatsapp in 2014.

A merger occurs when the owners of two or more companies agree to join
together to form a firm.

Mergers can happen in three ways:

Horizontal Integration: integration of firms engaged in the production of the

same type of good at the same level of production. Example: a cloth
manufacturing company merges with another cloth manufacturing company.
Advantages:

Exploit internal economies of scale: including bulk-buying, technical

economies, financial economies.
Save costs: when merging, a lot of the duplicate assets including employees can
be laid off.
Potential to secure ‘revenue synergies’ by creating and selling a wider range of
products.
Reduces competition: by merging with key rivals, the two firms together can
increase market share.
Disadvantages:

Risk of diseconomies of scale: a larger business will bring with a lot of

managerial and operational issues leading to higher costs.

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Reduced flexibility: the addition of more employees and processes means the
need for more transparency and therefore more accountability and red tape,
which can slow down the rate of innovating and producing new products and
processes.
Vertical Integration: integration of firms engaged in the production of the same
type of good but at different levels of production (primary/secondary/tertiary).
Example: a cloth manufacturing company (secondary sector) merges with a
cotton growing firm (primary sector).
Forward vertical integration: when a firm integrates with a firm that is at a later
stage of production than theirs. Example: a dairy farm integrates with a cheese
manufacturing company.
Backward vertical integration: when a firm integrates with a firm that is at an
earlier stage of production than theirs. Example: a chocolate retailer integrates
with a chocolate manufacturing company.
Advantages:

It can give a firm assured supplies or outlets for their products. If a coffee brand
merged with coffee plantation, the manufacturers would get assured supplies of
coffee beans from the plantation. If the coffee brand merged with a coffee shop
chain, they would have a permanent outlet to sell their coffee from.
Similarly, one firm can prevent the other firm from supplying materials or
selling products to competitors. The coffee brand can have the coffee plantation
to only supply them their coffee beans. The coffee brand can also have the
coffee shop chain only selling coffee with their coffee powder.
The profit margins of the merged firm can now be absorbed into the merging
firm.
The firms can increase their market share and become more competitive in the
market.
Disadvantages:

Risk of diseconomies of scale: a larger business will bring with a lot of

managerial and operational issues leading to higher costs
Reduced flexibility: the addition of more employees and processes means the
need for more transparency and therefore more accountability and red tape,

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which can slow down the rate of innovating and producing new products and
processes
It’s a difficult process: The firms, when vertically integrated, are entering into a
stage of production/sector they’re not familiar with, and this will require staff of
either firm to be educated and trained. Some might even lose their jobs. It can
be expensive as well.
Lateral/Conglomerate integration: this occurs when firms producing different
type of products integrate. They could be at the same or different stages of
production. Example: a housing company integrates with a dairy farm. Thus, the
firm can produce a wide range of products. This helps diversify a firm’s
operations.
Advantages:

Diversify risks: conglomerate integration allows businesses to have activities in

more than one market. This allows the firms to spread their risks. In case one
market is in decline, it still has another source of profit.
Creates new markets: merging with a firm in a different industry will open up
the firm to a new customer base, helping it to market its core products to this
new market.
Transfer of ideas: there could be a transfer of ideas and resources between the
two businesses even though they are in different industries. This transfer of
ideas could help improve the quality and demand for the two products.
Disadvantages:

Inexperience can lead to mismanagement: if the firms are in entirely different

industries and have no experience in the other’s industry, cooperating and
managing the two industries may be difficult and could turn disastrous.
Lose focus: merging with and focusing on an entirely new industry could cause
the firm to lose focus of its core product.
Culture clash: as with all kinds of mergers, there could be a culture clash
between the two firms’ employees on practices, standards and ‘how things are
done’.

Scale of Production

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As a firm’s scale of production increases its average costs decrease. Cost saving
from a large-scale production is called economies of scale.

Internal economies of scale are decisions taken within the firm that can bring
about economies (advantages). Some internal economies of scale are:

Purchasing economies: large firms can be buy raw materials and components in
bulk because of their large scale of production. Supplier will usually offer price
discounts for bulk purchases, which will cut purchasing costs for the firm.
Marketing economies: large firms can afford their own vehicles to distribute
their products, which is much cheaper than hiring other firms to distribute them.
Also, the costs of advertising is spread over a much large output in large firms
when compared to small firms.
Financial economies: banks are more willing to lend money to large firms since
they are more financially secure (than small firms) to repay loans. They are also
likely to get lower rates of interest. Large firms also have the ability to sell
shares to raise capital (which do not have to be repaid). Thus, they get more
capital at lower costs.
Technical economies: large firms are more financially able to invest in good
technology, skilled workers, machinery etc. which are very efficient and cut
costs for the firm.
Risk-bearing economies: large firms with a high output can sell into different
markets (even overseas). They are able to produce a variety of products
(diversification in production). This means that their risks are spread over a
wider range of products or markets; even if a market or product is not
successful, they have other products and markets to continue business in. Thus,
costs are less.

External economies of scale occur when firms benefit from the entire industry
being large. This may include:

Access to skilled workers: large firms can recruit workers trained by other
firms. For example: when a new training institution for pilots and airline staff

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opens, all airline firms can enjoy economies of scale of having access to skilled
workers, who are more efficient and productive, and cuts costs.
Ancillary firms: they are firms that supply and provide materials/services to
larger firms. When ancillary firms such as a marketing firm locates close to a
company, the company can cut costs by using their services more cheaply than
other firms.
Joint marketing benefits: when firms in the same industry locate close to each
other, they may share an enhanced reputation and customer base.
Shared infrastructure: development in the infrastructure of an industry or the
economy can benefit large firms. Examples: more roads and bridges by the
govt. can cut transport costs for firms, a new power station can provide cheaper
electricity for firms.

Diseconomies of scale occur when a firms grows too large and average costs
start to rise. Some common diseconomies are:

Management diseconomies: large firms have a wide internal organisation with

lots of managers and employees. This makes communication difficult and
decision-making very slow. Gradually, it leads to inefficient running of the
firms and increases costs.
Too much output may require a large supply of raw materials, power etc. which
can lead to shortage and halt production, increasing costs.
Large firms may use automated production with lots of capital equipment.
Workers operating these machines may feel bored in doing the repetitive
tasks and thus become demotivated and less cooperative. Many workers may
leave or go on strikes, stopping production and increasing costs.
Agglomeration diseconomies: this occurs when firms merge/acquire too many
different firms producing different products, and the managers and owners can’t
coordinate and organise all activities, leading to higher costs.
More shares sold into the market and bought means more owners coming into
the business. Having a lot of owners can lead to a lot of disputes and
conflicts among themselves.

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A lot of large firms can face diseconomies when their products become too
standardised and less of a variety in the market. This will reduce sales and
profits and increase average costs.
A firm that doubles all its inputs (resources) and is able to more than double its
output as a result, experiences increasing returns to scale.
A firm that doubles all its inputs and fails to double its output as a result,
experiences a decreasing or diminishing returns to scale.

The Role of Government

The public sector in every economy plays a major role, as a producer and
employer. Governments work locally, nationally and internationally. Here are
the roles they play in the economy:

As a producer, it provides, at all levels of government:

merit goods (educational institutions, health services etc.)
public goods (streetlights, parks etc.)
welfare services (unemployment benefits, pensions, child benefits etc.)
public services (police stations, fire stations, waste management etc.)
infrastructure (roads, telecommunications, electricity etc.).
As an employer, it provides at all levels of government, employment to a large
population, who work to provide the above mentioned goods and services. It
also creates employment by contracting projects, such as building roads, to
private firms.
Support agriculture and other prime industries that need public support.
Help vulnerable groups of people in society through redistributing income and
welfare schemes.
Manage the macroeconomy in terms of prices, employment, growth, income
redistribution etc.
Governments also manage its trade in goods and services with other countries
by negotiating international trade deals.
Government Macroeconomic Aims

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The government’s major macroeconomic objectives are:

Economic Growth: economic growth refers to an increase in the gross domestic

product (GDP), the amount of goods and services produced in the economy,
over a period of time. More output means economic growth. But if output falls
over time (economic recession), it can cause:
fall in employment, incomes and living standards of the people
fall in the tax revenue the govt. collects from goods and services and incomes,
which will, in turn, lead to a cut in govt. spending
fall in the revenues and profits of firms
low investments, that is, people won’t invest in production as economic
conditions are poor and they will yield low profits.
Price Stability: inflation is the continuous rise in the average price levels in an
economy during a time period. Governments usually target an inflation rate it
should maintain in a year, say 3%. If prices rise too quickly it can negatively
affect the economy because it:
reduces people’s purchasing powers as people will be able to buy less with the
money they have now than before
causes hardship for the poor
increases business costs especially as workers will demand higher wages to
support their livelihood
makes products more expensive than products of other countries with low
inflation. This will make exports less competitive in the international market.
Full Employment: if there is a high level of unemployment in a country, the
following may happen:
the total national output (goods produced) will fall
government will have to give out welfare payments (unemployment benefits) to
the unemployed, increasing public expenditure while income taxes fall –
causing a budget deficit
large unemployment causes public unrest and anger towards the government.
Balance of Payments Stability: economies export (sell) many of their products
to overseas residents, and receive income and investment from abroad; they also

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import (buy) goods and services from other economies, and make investments
in other countries. These are recorded in a country’s Balance of Payments
(BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
All economies try to balance this inflow and outflow of international trade and
payments and try to avoid any deficits because:
if it exports too little and imports too much, the economy may run out of foreign
currency to buy further imports
a BoP deficit causes the value of its currency to fall against other foreign
currencies and make imports more expensive to buy, while a BoP surplus
causes its currency to rise against other foreign currencies and make its exports
more expensive in the international market.
Income Redistribution: to reduce the inequality of income among its citizens,
the government will redistribute incomes from the rich to the poor by imposing
taxes on the rich and using it to finance welfare schemes for the poor. All
governments struggle with income inequality and try to solve it because:
widening inequality means higher levels of poverty
poverty and hardship restricts the economy from reaching its maximum
productive capacity.
Conflict of Macroeconomic Aims
When a policy is introduced to achieve one macroeconomic aim, it tends to
conflict with one or more other aims. In other words, as one aim is achieved,
another aim is undone. Let’s look at some conflicts of government
macroeconomic aims.

Full Employment v/s Price Stability

Low rates of unemployment will boost incomes of businesses and workers. This
rise in incomes, mean higher demand and consumption in the economy, which
causes firms to raise their prices – resulting in inflation. This is probably the
most prominent policy conflict in the study of Economics.

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Economic Growth & Full Employment v/s BoP Stability

Once again, as incomes rise due to economic growth and low unemployment,
people will import more foreign products and consume relatively less domestic
products. This will cause a rise in imports relative to exports and a deficit may
arise in the balance of payments.

Economic Growth v/s Full Employment

In the long run, when economic growth is continuous, firms may start investing
in more capital (machinery/equipment). More capital-intensive production will
make a lot of people unemployed.

The Balance of payments is a record of all the monetary transactions between

residents of a country and the rest of the world over a given period of time. It is
divided into three main accounts: the current account, the capital account and
the financial account.

(In the explanation below, we’ll look at the balance of payments from the point
of view of the UK)

The Current Account

The Current account records the following:

The visible trade (in goods)

The invisible trade (in services)
Net income received or made in payment for the use of factors of production (
also called net primary income):
income debits (outflows) include wages paid to overseas residents working in
the UK, interests, profits and dividends paid out to overseas residents and firms
who have invested in the UK

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income credits (inflows) include wages paid to UK residents working overseas,

interests, profits and dividends earned by UK residents and firms on
investments they have in other countries
income received – income paid = net income received
Net current transfers, which include payments between governments for
international co-operation and other transactions that involve payments for non-
productive activities (also called net secondary income):
debits (outflows) will include financial aid, donations, pension payments etc.
paid to overseas residents and foreign governments, and tax and excise duties
paid by UK residents on foreign purchases
credits (inflows) will include financial aid, donations, grants, pension payments
etc. received from overseas residents and foreign governments, and tax and
excise duties paid by overseas residents on UK purchases
transfers received – transfers paid = net transfers

A current account example:

Item

$ (billion)
Visible exports (Xv)

784.2
Visible imports (Mv)

1230.4
Balance of trade (Xv – Mv =A)

-446.2
Invisible exports (Xi)

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286.4
Invisible imports (Mi)
219.9

Balance on services (Xi – Mi =B)

66.5

Net primary income (C)

21.0

Net secondary income (D)

-58.6

Current account balance (A + B + C + D)

-417.3

Current Account Deficit

When the financial outflows in the current account exceed the financial inflows,
the current account is in deficit.

Causes:

Higher exchange rate: if the currency is overvalued, imports will be cheaper and
therefore there will be a higher quantity of imports. Exports will become
uncompetitive and therefore there will be a fall in the quantity of exports.
Economic growth: if there is an increase in aggregate demand and national
income increases, people will have more disposable income to consume goods.
If producers cannot meet the domestic demand, consumers will have to imports

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goods from abroad. Thus faster economic growth enables the possibility of a
current account deficit developing.
Decline in competitiveness: if export industries are in decline and cannot
compete with foreign countries, the exports fall, ushering in a deficit. This is a
major reason for many countries today experiencing current account deficits.
Inflation: this makes exports less competitive and imports more competitive
(cheaper).
Recession in other countries: if the country’s main trading partners experience
negative economic growth then they will buy less of the country’s exports,
worsening the current account.
Borrowing money: if countries are borrowing money from other countries to
finance their expenditure and growth, current account deficits will develop.
Consequences:

Low growth: a deficit leads to lower aggregate demand and therefore slower
growth.
Unemployment: deficit can lead to loss of jobs in domestic industries as demand
for exports is low and demand for imports is high.
Lowers standard of living: in the long run, persistent trade deficits undermine
the standard of living as demand and income fall, especially if the net incomes
and transfers show a negative balance.
Capital outflow: currency weakness can lead to investors losing confidence in
the economy and taking capital away.
Loss of foreign currency reserves: countries may run short of vital foreign
currency reserves as more foreign currency is being spent on imports and
foreign currency revenues from exports is falling.
Increased Borrowing: countries need to borrow money or attract foreign
investment in order to rectify their current account deficits. In addition, there is
an opportunity cost of debt repayment, as the government cannot use this
money to stimulate economic growth.
Lower exchange rate: a fall in demand for exports and/or a rise in the demand
for imports reduces the exchange rate. While a lower exchange rate can mean
exports becoming more price-competitive, it also means that essential imports

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(such as oil and foodstuffs) will become more expensive. This can lead to
imported inflation.
The severity of these consequences depends on the size and duration of the
deficit. Persistent deficits can harm the economy in the long-run as low export
growth causes unemployment.

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Do nothing because a floating exchange rate should correct it: if there is a trade
deficit, a depreciation will occur as more currency is being spent than received.
Depreciation will make imports more expensive and exports cheaper. As a
result, domestic demand for imports will fall and foreign demand for exports
will rise, reducing the deficit.
Use contractionary fiscal policy: a government can cut public expenditure and
increase taxes to reduce total demand in the economy, which will reduce
demand for imports and improve the trade balance. However, a fall in demand
may affect firms in the economy who may cut output and employment in
response.
Use contractionary monetary policy: a higher interest rate will attract more
direct inward investments and nullify the trade deficit. Higher interest rates will
also make borrowing from banks more expensive and increase the incentive to
save, thus discouraging consumers from spending. The govt. can also devalue
the exchange rate to improve export competitiveness and demand.
Protectionist measures: these measures reduce the competitiveness of imports,
thereby making domestic consumption more attractive. For example, tariffs
raise the price of imports while quotas limit the amount of imports in the
economy.

Current Account Surplus

When the financial inflows in the current account exceed the financial outflows,
the current account is in surplus.

Causes:

Improved competitiveness: exports may have become more price-competitive in

the international market, due to perhaps, better labour productivity or low
prices.
Growth in foreign countries: export demand may have risen due to trading
partners experiencing growth and higher incomes.
High foreign direct investment: strong export growth can be the result of a high
level of foreign direct investment.
Depreciation: a trade surplus might result from a currency depreciation .

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High domestic savings rates: high levels of domestic savings and low domestic
consumption of goods and services cause more products to be exported and
imports to fall.
Closed economy: some countries have a low share of national income taken up
by imports, perhaps because of a range of tariff and non-tariff barriers.
Consequences:

Economic growth: net exports is a component of GDP, so a rise in exports and

incomes will cause economic growth.
Appreciation: as exports increase, the demand for the currency increases and
therefore the value of the currency increases, which will make exports more
expensive and cause its demand to fall.
Employment: since exports have increased, jobs in the export industries will
have increased too.
Better standards of living: higher net incomes, transfers and export revenue
make the country’s citizens better off.
Inflation: higher demand for exports can lead to demand-pull inflation. This can
diminish the international competitiveness of the country over time as the price
of exports rises due to inflation.
Correcting a current account surplus:

Do nothing because a floating exchange rate should correct it: if there is a trade
surplus, an appreciation will occur as more currency is being demanded. An
appreciation will make imports cheaper and exports expensive. As a result,
foreign demand for exports will fall and domestic demand for imports will rise,
reducing a trade surplus.
Use expansionary fiscal policy: increasing public expenditure and cutting taxes
can boost total demand in an economy for imported goods and services.
Use expansionary monetary policy: lower interest rates will make borrowing
from banks cheaper and increase the incentive to spend, thus encouraging
consumers to spend on imports and correct a trade surplus.
Remove protectionist measures: reducing tariffs and quotas cause imports to
rise and close a surplus in the current account.

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