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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi

Theme 1 Introduction to markets and market failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Chapter 1 The nature of economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Chapter 2 The nature of demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Chapter 3 The nature of supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Chapter 4 How markets work: price determination and the price mechanism . . . . . . . . . . 53
Chapter 5 How markets work: the price mechanism in action . . . . . . . . . . . . . . . . . . . . . 67
Chapter 6 Market failure and externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Chapter 7 Market failure: public goods and information gaps . . . . . . . . . . . . . . . . . . . . . . 91
Chapter 8 Government intervention and government failure . . . . . . . . . . . . . . . . . . . . . . 101
Theme 1 key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

Theme 2 The UK economy — performance and policies . . . . . . . . . . . . . . . . . . . . . . . . 121

Chapter 9 Measures of economic performance: economic growth . . . . . . . . . . . . . . . . . 122

Chapter 10 Measures of economic performance: inflation, unemployment and the
balance of payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
Chapter 11 Aggregate demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Chapter 12 Aggregate supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
Chapter 13 National income and macroeconomic equilibrium . . . . . . . . . . . . . . . . . . . . . 180
Chapter 14 Economic growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
Chapter 15 Macroeconomic policy objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Chapter 16 Macroeconomic policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Theme 2 key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

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Theme 3 Business behaviour and the labour market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245

Chapter 17 Business growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246

Chapter 18 Revenues, costs, profits and objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Chapter 19 Market structure: perfect competition and monopoly . . . . . . . . . . . . . . . . . . . 275
Chapter 20 Market structure: monopolistic competition and oligopoly . . . . . . . . . . . . . . . 301
Chapter 21 Pricing strategies and contestable markets . . . . . . . . . . . . . . . . . . . . . . . . . . 318
Chapter 22 The labour market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
Chapter 23 Government intervention to promote competition . . . . . . . . . . . . . . . . . . . . . 353
Theme 3 key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

Theme 4 A global perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

Chapter 24 Globalisation and trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

Chapter 25 Trading blocs and restrictions on trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
Chapter 26 The balance of payments and exchange rates . . . . . . . . . . . . . . . . . . . . . . . . 419
Chapter 27 Poverty and inequality in developed and developing countries . . . . . . . . . . . . 446
Chapter 28 Emerging and developing economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
Chapter 29 Strategies influencing growth and development . . . . . . . . . . . . . . . . . . . . . . . 498
Chapter 30 The financial sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
Chapter 31 The role of the central bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
Chapter 32 The role of the state in the macroeconomy . . . . . . . . . . . . . . . . . . . . . . . . . . 548
Theme 4 key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574
Synoptic practice paper: Microeconomics and macroeconomics . . . . . . . . . . . . . 578
Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584

Contents v

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ME 1
THE INTRODUCTION
TO MARKETS AND
MARKET FAILURE

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1 The nature of economics

1.1.1, 1.1.2, 1.1.3, 1.1.4, 1.1.5, 1.1.6

Welcome to economics. Many of you opening this book will be meeting economics
for the first time, and you will want to know what is in store for you as you set out
to study the subject. This opening chapter sets the scene by introducing you to
some key ideas and identifying the scope of economic analysis. As you learn more
of the subject, you will find that economics is a way of thinking that broadens your
perspective on the world around you.

In this chapter
This chapter will introduce you to:
➜ the nature and scope of economic analysis
➜ the role of models and assumptions in economics
➜ positive and normative statements
➜ the importance of scarcity and choice
➜ the concept of opportunity cost
➜ the notion of factors of production
➜ the distinction between renewable and non-renewable resources and the idea of sustainability
➜ the production possibility frontier
➜ the concept of the division of labour
➜ how specialisation can improve productivity
➜ the role of markets and what is meant by a mixed economy
➜ alternative ways of coordinating the allocation of resources in society
➜ the distinction between microeconomics and macroeconomics

What is economics?
As its name suggests, economics deals with all aspects of economic behaviour.
It explores the way that individuals, businesses and governments take economic
decisions. For example, it highlights the factors that influence the decisions made
by households in choosing what to consume, and the decisions made by firms
about what goods and services to produce. It also examines the decisions made by
governments about taxation and expenditure.
All these decisions interact with each other — and human behaviour is not always
easy to understand — so economics faces a substantial challenge in trying to deal
with the complexity of the real world.
If economists are to cope with this complexity, it is essential to simplify reality in
Key term some way; otherwise the task would be overwhelming. Economists therefore work
model a simplified with models. These are simplified versions of reality that are more manageable for
representation of reality analysis, allowing economists to focus on some key aspects of the world.
used to provide insight into
Often this works by allowing them to focus on one thing at a time. A model almost
economic decisions and
always begins with assumptions that help economists to simplify their questions.
events
These assumptions can then be gradually relaxed so that the effect of each one of

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them can be observed. In this way, economists can gradually move towards a more
complicated version of reality.
Chapter 2 considers the demand for a good, and the factors that affect how much of a
good is demanded by consumers. Trying to analyse all the possible influences on these
decisions would be difficult, so it is common to start by exploring how the price of a
good affects the quantity demanded, under the assumption that all other influences stay
the same. This is a common assumption in economics, which is sometimes expressed
by the Latin phrase ceteris paribus, meaning ‘other things being equal’. Given the
complexity of the real world, it is often helpful to focus on one thing at a time.

Economics explores the way

that individuals, businesses
and governments take
economic decisions

To evaluate a model, it is not necessary that it be totally realistic. The model’s

desired objective may be to help in predicting future behaviour, or in testing
empirical evidence collected from the real world. If a model provides insights into
how individuals take decisions, or helps to explain economic events, then it has
some value, even if it seems remote from reality.
However, it is always important to examine the assumptions that are made, and to
ask what happens if these assumptions do not hold.

Test yourself 1.1

What phrase is used by economists when assuming that some variables are to be held constant?

Key terms
Economics as a social science ceteris paribus a Latin
A question that is often raised in relation to economics as a subject is whether it can phrase meaning ‘other
be regarded as a ‘science’, given that it deals with decisions taken by human beings. things being equal’; it is
Economics attempts to study economic aspects of society using a scientific approach, used in economics when
and as such can be seen as a social science. we focus on changes in
one variable while holding
In many physical sciences, investigation can proceed by testing hypotheses in the other influences constant
laboratory through carrying out experiments. Experimental economics is a rapidly
social science a subject
expanding area in the subject, but although this allows economists to improve their
involving the scientific
understanding of individual behaviour, there are still many areas of economics
study of human beings
where it is not possible to rely on experiments to advance knowledge.

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Economists can stage experiments in which they ask a sample of individuals how
they would act in various situations — for example, what they would pay for a good
or service. This can provide insights into economic behaviour. However, there are
situations in which it is simply not possible to set up an experiment. A government
cannot decide to double the rate of income tax to find out what would happen. A
firm would be wary of making a substantial increase in the price of its product just
to see what happens.
Astrophysics faces similar challenges, as it cannot move stars and planets around to
see what happens! Instead it relies on observations to develop its theories. Economics
also relies on observation and assumptions to interpret the way in which economic
Key terms decisions are taken. It then attempts to apply logic and scientific reasoning to build
on assumptions in order to explain behaviour.
positive statement a
statement about what is
(i.e. about facts) Positive and normative economic statements
normative statement a Economics aims to look at the causes and consequences of choices in an objective
statement that involves way. However, some of its subject matter requires careful attention if we are to
a value judgement about remain objective. To achieve this, it is important to be clear about the difference
what ought to be between positive and normative statements.
value judgement a In short, a positive statement is about facts and in principle is testable. A normative
statement based on your statement is about what ought to be. Another way of looking at this is that a statement
opinion or beliefs, rather becomes normative when it involves an opinion or value judgement.
than on facts
Suppose the government is considering raising the tax on cigarettes. It may
legitimately consult economists to discover what effect a higher tobacco tax will
Study tip have on the consumption of cigarettes and on government revenues. This would
Notice that the word be a positive investigation, in that the economists are being asked to use economic
‘positive’ here is not used analysis to forecast what will happen when the tax is increased.
in the sense of being A very different situation will arise if the government asks whether it should raise
opposite to ‘negative’. the tax on cigarettes. This calls for an opinion to be expressed (a value judgement).
A positive statement that For example, a response might be to say that the tax on cigarettes ought not to be
is found to be false is raised because it discriminates against smokers. This would be a normative statement.
still a positive economic There are some words that indicate normative statements, such as ‘should’ or ‘ought
statement, as it is a to’ — watch for these.
statement about facts.
Most of this book is about positive economics. However, you should be aware that
positive analysis is often called upon to inform normative judgements. If the aim
Synoptic link of a policy is to stop people from smoking (which reflects a normative judgement
The effect of a tax on about what ought to happen), then economic analysis may be used to highlight the
cigarettes is examined in strengths and weaknesses of those alternatives in a purely positive fashion.
Chapter 5. Critics of economics often joke that economists always disagree with one another:
for example, it has been said that if you put five economists in a room together,
Test yourself 1.2 they will come up with at least six conflicting opinions. However, although
economists may arrive at different value judgements, and have differences when
Is the following statement
it comes to normative issues, there is much greater agreement when it comes to
a normative or a
positive analysis. Nonetheless, value judgements do influence economic decision
positive statement? ‘The
making and policy because different people — and political parties — may have
government ought to raise
different views about what is desirable for society, even if they agree on how
unemployment benefits.’
policies may work.

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The economic problem

For any society in the world, the fundamental economic problem faced is that of
scarcity. You might think that this is obvious for some societies in the developing
world, where poverty and hunger are rife. But it is also true for relatively prosperous
economies such as those of Switzerland, the USA and the UK.
It is true in the sense that all societies have finite resources, but people have unlimited
wants. A big claim? Not really. There is no country in the world in which all wants
can be met, and this is clearly true at the global level.
There is a difference between wants and needs. Everyone needs to breathe and to
eat, so air and food are necessary for human life. However, there are also things that Test yourself 1.3
people would like to consume, and these are known as wants. Thinking of yourself, give
There are some goods that may be regarded as free goods. An example might be an example of a ‘want’ and
the earth’s atmosphere, which would not normally be regarded as scarce. Goods of a ‘need’.
that are scarce are known as economic goods. Most goods fall into this category.
Talking about scarcity in this sense is not the same as talking about poverty. Poverty Synoptic link
might be seen as an extreme form of scarcity, in which individuals lack the basic The meaning and causes
necessities of life; whereas even relatively prosperous people face scarcity, because of poverty are examined in
resources are limited. Chapter 27, where you will
see that although absolute
Scarcity and choice poverty may only exist
in developing countries,
The key issue that arises from the existence of scarcity is that it forces people to make
relative poverty also exists
choices. Each individual must choose which goods and services to consume. In
in advanced countries
other words, everyone needs to prioritise the consumption of whatever commodities
such as the UK.
they need or would like to have, as they cannot satisfy all their wants. Similarly, at
the national level, governments have to make choices between alternative uses of
resources. Key terms
scarcity a situation that
Test yourself 1.4 arises when people have
Give examples of the ways in which the government spends its funds. unlimited wants in the face
of limited resources
It is this need to choose that underlies the subject matter of economics. Economic free goods goods such
analysis is all about analysing those choices made by individual people, firms and as the earth’s atmosphere
governments. that are not normally
regarded as being scarce
Opportunity cost economic goods goods
that are scarce
This raises one of the most important concepts in all of economic analysis — the
notion of opportunity cost. When an individual chooses to consume one good, poverty a situation in
they do so at the cost of the item that would have been next in their list of priorities. which individuals lack the
For example, suppose you are on a strict diet, and at the end of the day you can basic necessities of life or
‘afford’ either one chocolate or a piece of cheese. If you choose the cheese, the have low incomes relative
opportunity cost of the cheese is the chocolate that you could have had instead. to their fellow citizens
opportunity cost in
This important notion can be applied in many different contexts, because whenever
decision making, the value
you make a decision you reject an alternative in favour of your chosen option. You
of the next-best alternative
have chosen to read this book — when instead you could be watching television or
forgone
meeting friends.

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The notion of opportunity cost is related to an important tool in economics known

Key term
as marginal analysis. This is based on the idea that people take decisions by
marginal analysis an considering small changes that could be made. For example, in choosing whether
approach to economic to read this book, you may consider if the extra (marginal) benefit you will receive
decision making based on from doing so will exceed the additional benefit you would receive from watching
considering the additional television. Firms may also take decisions in this way, perhaps by checking whether
(marginal) benefits and the cost of producing and selling an additional unit of output will exceed the extra
costs of a change in (marginal) return they receive from selling it. This approach will become familiar
behaviour to you as you continue to study economics.

Study tip Exercise 1.1

Opportunity cost is a key Asif has just started his A level courses, and has chosen to take Economics, Mathematics and
concept in economics, and French. Although he was certain about the first two, it was a close call between French and
is important in a variety English. What is Asif’s opportunity cost of choosing French?
of contexts. Similarly,
marginal analysis is a key
As you move further into studying economics, you will encounter this notion of
part of economic thinking,
opportunity cost again and again. A household choosing to buy a new car faces an
so make sure that you
opportunity cost in having to forgo a holiday. A farmer choosing to grow onions
understand these fully
incurs an opportunity cost in not being able to grow potatoes. The need to balance the
from the outset.
relative merits of alternative choices is challenging, but crucial. Economic thinking
helps to explain how such choices are made, and how they could be improved.

Test yourself 1.5

Suppose your school or college wants to build a new sports hall. Identify possible elements of
the opportunity cost of such a project.

Economic agents
In analysing the process by which choices are made, it is important to be aware of
the various economic agents that are responsible for making decisions. In economic
analysis, there are three key groups of decision makers: consumers, producers and
government.
■ Consumers (individuals and households) make choices about their expenditure.
In this role, they are consumers who demand goods and services. In order to be
able to buy goods, consumers need income, so they also take decisions about the
supply of their labour, which is discussed in the next section.
■ Producers (firms or businesses) exist in order to produce output of goods or
services. Producers also make choices, particularly about which goods or services
to produce, and the techniques of production to be used. The prices at which they
can sell are also important in economic analysis. Firms also have a dual role, as
they need to purchase machines and raw materials if they are to produce goods
and services.
■ Government fulfils several roles in society. It undertakes expenditure, and influences
the economy through its taxation and regulation of markets.
Opportunity cost is crucial for each of these economic agents, because they each
face constraints on their choices. As soon as they choose one course of action, they
forgo the possibility of taking an alternative decision.

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Factors of production
People in a society play two quite different roles. On the one hand, they are the
consumers, the ultimate beneficiaries of the process of production. On the other
Key term
hand, they are a key part of the production process in that they are instrumental in factors of production
producing goods and services by supplying labour. The production process requires resources used in the
not only labour but other resources as well. These productive resources are known production process;
as the factors of production. The main types are outlined in Table 1.1. inputs into production,
particularly including
Table 1.1 The factors of production labour, capital, land and
enterprise
Labour The most obvious human resource, labour is a key input into production.
There are many different types of labour, encompassing different skill levels
and working in different ways, from unskilled labourers to web designers or
brain surgeons.
Capital The term ‘capital’ covers inputs such as plant and machinery, transport
equipment and factory buildings.
Enterprise Enterprise is another human resource. An entrepreneur is someone who
organises production and identifies projects to be undertaken, bearing the
risk of the activity. This is an important role in the modern economy, where
firms need to be alert for market opportunities.
Management is also sometimes classified as a human resource, although it
might be seen as a particular form of labour.
Land Land covers the inputs provided by nature — both the land itself and the
natural resources that nature provides in the form of raw materials.

The way in which these inputs are combined in order to produce output is another
key part of the allocation of resources. Firms need to take decisions about the mix of
inputs used in order to produce their output. Such decisions are required no matter
what form of economic activity a firm is engaged in.

The rewards to factors of production

The factors of production need to be rewarded in return for the services that they
provide, as shown in Table 1.2.
Table 1.2 Rewards to the factors of production

Labour Households supply their labour in return for wages and salaries. The wage is
therefore the reward for the labour services that they supply, for which they
must give up their leisure time.
Capital Interest is the return on the use of capital services. It is the return that the
firm gains from using the capital goods in the production process. In doing
this, the firm forgoes the interest that it could have gained from investing in
a financial asset.
Enterprise Profit is the reward for enterprise. By recognising income-earning opportunities
for the firm, the entrepreneur is able to make profit for the business.
Land It is the rental that constitutes the reward for the use of land in production.

Synoptic link
The decisions taken by producers are discussed later, in particular in Chapter 18, but first you
need to understand more about the behaviour of households and firms.

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Test yourself 1.6

How do we refer to
resources such as
labour, land, capital and
enterprise when they are
used in production?

Factors of production — labour

(workers), capital (buildings)
and land

Renewable and non-renewable resources

An important distinction is between renewable resources such as forests, and
Key terms non-renewable resources such as oil or coal.
renewable resources
In the case of renewable resources, there have been many debates in recent years
natural resources that
about the dangers of depleting such resources at too rapid a rate to allow replacement.
can be replenished, such
One example of this has been the stocks of some fish such as cod, where it has been
as forests that can be
argued that overfishing may lead to the extinction of the species. Similar arguments
replanted, or solar energy
have been applied to other resources such as the rainforests. This has highlighted
that does not get used up
the importance of sustainable development, which has been defined as ‘development
non-renewable resources which meets the needs of the present without compromising the ability of future
natural resources that generations to meet their own needs’ (Brundtland Commission, 1987). Applying this
once used cannot be to the case of cod fishing, for example, sustainable fishing would be seen in terms of
replenished, such as coal not catching so many cod that the overall population becomes unsustainable.
or oil
For non-renewable resources, reserves are finite — by definition — so concern has
arisen over their possible exhaustion. Attention has tended to focus on oil, which
is much in demand, especially given rapidly rising car ownership. This has led to a
search for renewable sources of energy (and the development of electric cars), which
would also contribute to sustainability. One economic issue here is whether the prices
of resources such as oil will rise as reserves are depleted. This could then have the
effect of giving incentives to firms to develop alternative, ‘green’ sources of energy. It
could also mean that some reserves of oil that are currently uneconomic may become
viable. This is one example of how prices can be seen to guide resource allocation.

Test yourself 1.7 Exercise 1.2

Name one example of Classify each of the following as human, natural (renewable or non-renewable) or produced
a renewable energy resources:
resource, and one example a timber b the services of a window cleaner
of a non-renewable energy c a combine harvester d a computer programmer who sets up a
source. e a computer company to market their software

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The three key economic questions

By now you should be getting some idea of the subject matter of economics. The
American economist Paul Samuelson (who won the Nobel Prize for Economic Test yourself 1.8
Sciences in 1970) identified three key questions that economics sets out to investigate: What were the three key
questions that Samuelson
1 What? What goods and services should be produced in a society from its scarce
identified for economics?
resources? In other words, how should resources be allocated among producing
smartphones, potatoes, banking services and so on?
2 How? How should the productive resources of the economy be used to produce
these various goods and services?
3 For whom? Having produced a range of goods and services, how should these be
allocated among the population for consumption?

Exercise 1.3
With which of Samuelson’s three questions (what, how, for whom) would you associate the
following?
a A firm chooses to switch from producing laptop computers in order to increase its output of
tablet computers.
b The government reduces the highest rate of income tax.
c Faced with increased labour costs, a firm introduces labour-saving machinery.
d There is an increase in social security benefits.
e The owner of a fish-and-chip shop decides to close down and take a job in a local factory.

Summary: key economic ideas

■ Positive statements are about what is, whereas normative statements are about what ought
to be.
■ The fundamental problem faced by any society is scarcity, because resources are finite but
wants are unlimited. As a result, choices need to be made.
■ Each choice has an opportunity cost — the value of the next-best alternative forgone.
■ The amount of output produced in a period depends on the inputs of factors of production.
■ The rate at which renewable resources are used needs to be seen in the light of the notion
of sustainability.
■ Economics deals with the questions of what should be produced, how it should be
produced, and for whom.

The production possibility frontier

Economists rely heavily on diagrams to help in their analysis. In exploring the notion
of opportunity cost, a helpful diagram is the production possibility frontier
Key term
(PPF). This shows the maximum combinations of goods that can be produced with production possibility
a given set of resources. frontier (PPF) a curve
showing the maximum
First consider a simple example. In an earlier exercise, Asif was studying for his A
combinations of goods
levels. Suppose now that he has got behind with his homework. He has limited time
or services that can be
available, and has five economics questions to answer and five maths exercises. An
produced in a given period
economics question takes the same time to answer as a maths exercise.
with available resources
What are the options? Suppose he knows that in the time available he can tackle either
all of the maths and none of the economics, or all of the economics and none of the
maths. Alternatively, he can try to keep both teachers happy by doing some of each.

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Quantitative skills 1.1

Drawing and interpreting graphs: the production possibility
frontier
An important quantitative skill is to be able to draw and interpret graphs. The diagram showing
the PPF is a good example to introduce this skill.
When you look at Figure 1.1, you may be surprised to see that the ‘curve’ is actually a straight
line. What is important to the economist is that we can use diagrams to show an economic
relationship. Sometimes, this may be a line, but sometimes we might expect a curve. In Figure 1.1,
the ‘curve’ happens to be a straight line.
Figure 1.1 shows the options that Asif faces. He can devote all of his efforts to maths, and leave
the economics for another day. He will then be at point A in the figure, choosing to do 5 maths
exercises (which you read off as the value on the vertical axis), but no economics exercises
(reading zero on the horizontal axis).
Alternatively, he can do all the economics exercises and no maths, and be at point B. The line
joining these two extreme points shows the intermediate possibilities. For example, at C he does
2 economics exercises and 3 maths problems — again you read off the values from the two axes.

Maths 6
problems 5 A

4
C D
3
E
2
1
B
0
0 1 2 3 4 5 6
Economics exercises
Figure 1.1 The production possibility frontier

The line shows the maximum combinations that Asif can tackle — which is why it is called a
‘frontier’. There is no way he can manage to be beyond the frontier (for example, at point D), as
to do 3 maths exercises and 4 economics ones would need more time than he has available.
However, he could end up inside the frontier, at a point such as E. This could happen if he
gives up, and squanders his time by watching television; that would be an inefficient use of his
resources — at least in terms of tackling his homework.
As Asif moves down the line from left to right, he is spending more time on economics and less
on maths. The opportunity cost of tackling an additional economics question is an additional
maths exercise forgone. One way of expressing this is that Asif faces a trade-off between the time
spent on economics and on maths.

A trade-off
In the example discussed in the Quantitative skills box, Asif faces a trade-off
Key term between the time spent on economics and on maths. In other words, Asif can only
trade-off a situation in spend more time on economics by spending less time on maths. He must trade off
which the choice of one one against the other. You will come across many instances of this notion as your
alternative requires the study of economics progresses.
sacrifice of another
Figure 1.2 shows how the PPF provides information about opportunity cost.
Suppose we have a farmer with 10 hectares of land who is choosing between growing
potatoes and onions. The PPF shows the combinations of the two crops that could

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be produced. For example, if the farmer produces 300 tonnes of onions on part of
the land, then 180 tonnes of potatoes could be produced from the remaining land. In
Study tip
order to increase production of potatoes by 70 tonnes from 180 to 250, 50 tonnes of Diagrams are an important
onions must be given up. Thus, the opportunity cost of 70 extra tonnes of potatoes way of explaining economic
is seen to be 50 tonnes of onions. concepts, and being able
to integrate economic
diagrams into your analysis
Why might the PPF be curved? is a good way of improving
Notice that the PPF in Figure 1.2 is drawn as a curve instead of a straight line. This your understanding — and
is because the farmer’s land varies in different plots, with some plots being ideal showing examiners that
for potatoes but others being better for onions. The farmer can choose a balanced you understand!
approach, using each plot of land for the use to which it is suited. However, if he
were to choose to produce only onions (or only potatoes), overall the land would be
less productive. In other words, the more onions that are produced, the higher their Test yourself 1.9
opportunity cost in terms of potatoes (and vice versa), reflected in the way that the If a firm buys a computer
PPF gets steeper moving from left to right. to use in its production
Onions 450 process, is this an example
(tonnes) 400 of a consumer or a capital
350 good?
300
250
200
Key terms
150 capital goods goods
100 used as part of the
PPF
50 production process, such
0 as machinery or factory
0 100 200 250 300 400 500
buildings
180 Potatoes (tonnes)
consumer goods goods
Figure 1.2 Opportunity cost and the PPF
produced for present use
(consumption)
Consumption and investment
To move from thinking about an individual to thinking about an
Capital
economy as a whole, it is first necessary to simplify reality. Assume goods
an economy that produces just two types of good: capital goods and per period
consumer goods. Consumer goods are for present use, whereas capital
B
goods are to be used to increase the future capacity of the economy —
in other words, for investment. K1
A

Figure 1.3 illustrates society’s options in a particular period. Given the C

resources available, society can produce any combination of capital
and consumer goods along the PPF line. Thus, point A represents one
PPF
possible combination of outputs, in which the economy produces C1
consumer goods and K1 capital goods. C1 Consumer
goods per
As with the simpler example, if society were to move to the right period
along the PPF, it would produce more consumer goods — but at the Figure 1.3 Capital and
expense of capital goods. Thus, it can be seen that the opportunity consumer goods
cost of producing consumer goods is forgone opportunities to produce
capital goods. However, as the economy moves towards complete specialisation in
one of the types of good, factors are no longer being best used, and the opportunity
cost changes. For example, if nearly all of the workers are engaged in producing

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consumer goods, it becomes more difficult to produce still more of these, whereas
those workers producing machinery find they have too few resources with which to
work. In other words, the more consumer goods are being produced, the higher is
their opportunity cost.
It is now possible to interpret points B and C. Point B is unobtainable given present
resources, so the economy cannot produce that combination of goods. This applies
Test yourself 1.10 to any point outside the PPF. On the other hand, at point C society is not using its
resources efficiently. In this position there is unemployment of some resources in the
In Figure 1.3, which
economy. By making better use of the resources available, the economy can move
labelled points represent
towards the frontier, reducing unemployment in the process. However, at any point
productively efficient
on the frontier, production is productively efficient in the sense that all resources are
positions?
being fully utilised.

Economic growth or decline

Capital Figure 1.3 focuses on a single period. However, if the economy is
goods producing capital goods, then in the following period its capacity to
per
period produce should increase, as it will have more resources available for
production. How can this be shown on the diagram? An expansion in
the available inputs suggests that in the next period the economy should
be able to produce more of both goods. This is shown in Figure 1.4.

PPF0 PPF1
In the initial period the production possibility frontier is at PPF 0. However,
in the following period the increased availability of capital resources enables
Consumer goods greater production, and the frontier moves to PPF1. This is a process of
per period potential economic growth, an expansion of the economy’s productive
Figure 1.4 Economic growth capacity through the increased availability of inputs. If the economy were
to go into decline, such that less output could be produced, the frontier
Key term would shift inwards.
potential economic Notice that the decision to produce more capital goods today means that fewer
growth an expansion in consumer goods will be produced today to provide more in the future.
the productive capacity of
the economy An increase in the availability of inputs is not the only way in which the PPF could
shift outwards. An increase in the way in which the inputs are used would also allow
the PPF to shift out. Such a change would be known as an increase in productivity.
Test yourself 1.11 This could happen through technical advance, for example.
Suppose that a firm
There could also be a shift inwards of the PPF if there is a reduction in the
devises a new and more
availability of inputs, or a fall in the productivity of inputs. For example, returning
cost-effective production
to the farmer’s production of onions and potatoes, if part of the land is flooded and
method. How would this
becomes unusable, then the farmer would have less land to work. If the land is over-
affect the PPF?
farmed, it could become less productive. In either case, the PPF would shift inwards.

Total output in an economy

Key term Remember that the PPF is a model: a much simplified version of reality. In a real
gross domestic product economy, many different goods and services are produced by a wide range of
(GDP) a measure of the different factors of production — but it is not possible to draw diagrams to show all
economic activity carried of them.
out in an economy over a The total output of an economy like the UK is measured by its gross domestic
period product (GDP).

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By calculating the average level of GDP per person in a country, it is possible to derive a
measure of the average amount of resources per person — or average income per head.

Exercise 1.4
Megan has been cast away on a desert island, Coconuts
and has to survive by spending her time either per day
A
fishing or climbing trees to get coconuts. The PPF
E
in Figure 1.5 shows the maximum combinations
B
of fish and coconuts that she can gather during a
day. Which of the points A to E represents each of D
the following?
PPF
a a situation where Megan spends all her time
fishing C

b an unobtainable position Fish per day

c a day when Megan goes for a balanced diet — Figure 1.5 Fish and coconuts
a mixture of coconuts and fish
d a day when Megan does not fancy fish, and spends all day collecting coconuts
e a day when Megan spends some of the time trying to attract the attention of a passing ship

Summary: the production possibility frontier

■ The production possibility frontier shows the maximum combinations of goods or services
that can be produced in a period by a given set of resources.
■ At any point on the frontier, society is making full use of all resources.
■ At any point inside the frontier, there is unemployment of some resources.
■ Points beyond the frontier are unobtainable.
■ In a simple society producing two goods (consumer goods and capital goods), the choice is
between consumption and investment for the future.
■ As society increases its stock of capital goods, the productive capacity of the economy
increases, and the production possibility frontier moves outwards: this may be termed
‘economic growth’.

Specialisation and the division of labour

How many workers does it take to make a pin? The eighteenth-century economist
Adam Smith figured that 10 was about the right number. He argued that when a Key term
worker was producing pins on their own, carrying out all the various stages involved division of labour a
in the production process, the maximum number of pins that could be produced process whereby the
in one day was 20 — given the technology of his day, of course. This would imply production procedure
that 10 workers could produce about 200 pins if they worked in the same way as the is broken down into a
lone worker. However, if the pin production process were broken into 10 separate sequence of stages, and
stages, with one worker specialising in each stage, the maximum production for a workers are assigned to a
day’s work would be a staggering 48,000. This is known as division of labour. particular stage
The division of labour is effective because individual workers become skilled at
performing specialised tasks. By focusing on a particular stage, they can become
highly adept, and thus more efficient, at carrying out that task. In any case, people
are not all the same, so some are better at certain activities. Furthermore, this
specialisation is more efficient because workers do not spend time moving from one
activity to another. Specialisation may also enable firms to operate on a larger scale
of production. You will see later that this may be advantageous.

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This can be seen in practice in many businesses today, where there is considerable
specialisation of functions. Workers are hired for particular tasks and activities. You
do not see your star striker pulling on the goalkeeper’s jersey at half time because
he fancies a change. Earlier in the chapter, it was argued that ‘labour’ is considered
a factor of production. This idea can be developed further by arguing that there are
different types of labour, having different skills and functions.

Advantages and disadvantages of division of labour

Specialisation therefore means that workers can focus on the tasks that they perform
well and hence become more productive, which could then have a favourable effect
on a firm’s costs of production. Training can also be provided more cost-effectively
when it can be focused on specific tasks that workers need to perform. Furthermore,
working as a team allows more overall output to be produced. However, it is possible
to take specialisation too far. A worker who spends all their time on a narrow and
repetitive task may find that it becomes tedious or that they become bored and
careless. This could then mean that firms face problems of staff turnover. Over-
specialisation may also mean that a team of workers becomes inflexible: if a worker
specialising in a key part of the production process becomes ill, it may be difficult
to find cover.

Employees at a BMW factory. Each worker specialises in a particular task, creating an efficient
assembly line

Specialisation between firms and nations

Although we refer to the division of labour, we can extend these arguments to
consider specialisation among firms. For example, consider car manufacturing. The
process of mass-producing cars does not all take place within a single firm. One firm
may specialise in producing tyres; another may produce windscreens; another may

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focus on assembling the final product. Here again, specialisation enables efficiency
gains to be made.
Specialisation also takes place among nations, simply because some countries are
better equipped to produce some products than others. For example, it would not
make sense for the UK to go into commercial production of pineapples or mangoes.
There are other countries with climatic conditions that are much more suitable for
producing these products. On the other hand, many Formula 1 racing teams have
their headquarters in the UK, and there are benefits from this specialisation.
Specialisation may have disadvantages. A firm that specialises may find that it is
vulnerable in times of recession, or if it supplies another firm that encounters trading
difficulties. If this means that demand for its product falls, it may have to close down.
This might be seen as an incentive to diversify its product range so that it does not
depend so heavily on a particular activity or product.
A nation may face similar issues, especially if it chooses to specialise in a Synoptic link
product that is strategically important. For example, a country that specialises in
The possible gains from
agricultural production may find itself in difficulty if the price of its products falls
specialisation and trade
relative to other goods. If the country is highly dependent on exporting goods, or
are discussed more fully in
on importing key items, then a global disruption of trade could create problems.
Chapter 24 in the context
This was evident during the coronavirus (COVID-19) pandemic and the war in
of international trade.
the Ukraine.

Summary: specialisation and the division of labour Test yourself 1.12

■ Adam Smith introduced the notion of division of labour. Name a possible
■ This suggests that workers can become more productive by specialising in stages of the disadvantage of over-
production process. specialisation in
■ This enables more output to be produced. production.
■ There may be limits to specialisation: in the production process, performing repetitive tasks
may become tedious and induce errors, and for the firm or economy too much specialisation
involves risk.

Markets
You will find that in economics the term ‘market’ is used frequently, so it is
important to be absolutely clear about what is meant by it.
Key term
market a set of
A market need not be a physical location (although it could be — you might regard a
arrangements that allows
local farmers’ market as an example of ‘a set of arrangements that allows transactions
transactions to take place
to take place’). The COVID-19 pandemic accelerated the trend towards online
shopping, meaning that everyone has become accustomed to ways of buying and
selling that do not involve direct physical contact between buyer and seller — so the
notion of an abstract market should not be too alien a concept.
In relation to a particular product, a market brings together potential buyers and
sellers. This is explored in the coming chapters.
Synoptic link
Markets are important in the process of resource allocation, with prices acting as a
The role of prices in
key signal to potential buyers and sellers. If a firm finds that it cannot sell its output
influencing resource
at the price it has chosen, this is a signal about the way that buyers perceive the
allocation is explored more
product. Price is one way that firms find out about consumers and their willingness
fully in Chapter 5.
to pay for a particular product.

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The functions of money

Imagine a world without money. It is lunchtime, and you fancy a banana. In your
bag you have an apple. Perhaps you can find someone with a banana who fancies an
apple? But the only person with a banana available fancies an ice cream. The problem
with such a barter system is that you need to find someone who wants what you have
and who has what you want — a double coincidence of wants. If this problem were to be
faced by a whole economic system, undertaking transactions would be so inefficient
as to be impossible. Hence the importance of money as a medium of exchange.
In order to fulfil this role, money must be something that is acceptable to both
buyers and sellers. Nobody would accept money in payment for goods or services
if they did not trust that they could proceed to use money for further transactions.
Money must thus also act as a store of value: it must be possible to use it for future
transactions. This quality of money means that it can be used as one way of storing
wealth for future purchases.
Money also allows the value of goods, services and other assets to be compared — it
provides a unit of account. In this sense, prices of goods reflect the value that society places
on them, and must be expressed in money terms. So, money is also a measure of value.
A further role for money is that it acts as a method of deferred payment. For example, a
Test yourself 1.13 firm may wish to agree a contract for the future delivery of a good, or may wish to
Name the four key hire a worker to be paid at the end of the month. Such contracts are typically agreed
functions of money. in terms of a money value.
All of these functions of money are important to the smooth operation of markets, and
are crucial if prices are to fulfil their role in allocating resources within society. This
will become apparent as you learn more about economics.

The coordination problem

With so many different individuals and organisations (consumers, firms, governments)
all taking decisions, a major question is how it all comes together. How are all these
separate decisions coordinated so that the overall allocation of resources in a society is
coherent? In other words, how can it be ensured that firms produce the commodities
that consumers wish to consume? And how can the distribution of these products be
organised? These are some of the basic questions that economics sets out to answer.

Market economy
A free market economy is one in which market forces are allowed to guide the
allocation of resources within a society without intervention from government.
Prices play a key role in this sort of system, providing signals and incentives to
producers and consumers. Adam Smith argued that in such a system, resources
would be allocated effectively (and fairly) through the operation of an ‘invisible
hand’. This operates when individuals are free to pursue their own interests. Firms
would produce the goods and services that consumers wish to consume.
Synoptic link
Karl Marx argued that in a capitalist society in which there is private ownership of
The role of prices in
productive resources, the owners of capital would exploit their position at the expense
influencing resource
of labour, eventually resulting in revolution. Although this did not transpire in the way
allocation is explored in
that Marx expected, there was a move in some countries away from private ownership
Chapter 4.
of capital and towards state control of resource allocation through central planning.

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Command economy
A command economy is one in which the government undertakes the coordination
Key terms
role, planning and directing the allocation of resources. Given the complexity of
modern economies, reliance on central planning poses enormous logistical problems. free market economy an
In order to achieve a satisfactory allocation of resources across the economy, the economy in which market
government needs to make decisions on thousands of individual matters. forces are allowed to guide
the allocation of resources
One example of this emerges from the experience of central planning in Russia after
the revolution in 1917. Factories were given production targets to fit in with the overall command economy
plan for the development of the economy. These targets then had to be met by the an economy in which
factory managers, who faced strong incentives to meet those targets. Factories producing decisions on resource
nails were given two sorts of target. Some factories were given a target to produce a allocation are guided by
certain number of nails, whereas others were given targets in weight terms. The former the state
responded by producing large numbers of very small nails; the latter produced a very
small number of very big nails. Neither was what the planners had in mind!
Micromanagement on this sort of scale proved costly to implement administratively.
The collapse of the Soviet bloc in the 1990s largely discredited this approach,
although a small number of countries (such as North Korea and Cuba) continue to
stick with central planning. China has moved away from pure central planning by
beginning to allow prices to be used as signals.

Evaluation of economic systems

An influential economist was Friedrich von Hayek, who came from what became
Study tip
known as the neo-Austrian School. He saw that in the period after the Second
World War, there was a move towards more intervention in the economy by Famous economists
governments which perceived that markets were not working effectively. For such as von Hayek and
example, John Maynard Keynes had argued for a more active government in times Keynes were influential
of high unemployment, such as occurred in many countries in the 1930s. Hayek in developing theories
argued that such intervention would be damaging, because governments are faced that we still rely upon
with imperfect information, especially in a command economy. Markets would be today. Linking your own
more effective because they rely on people responding to signals and incentives. explanations of economic
systems to their ideas can
Free market and centrally planned economies tackle the problem of how to allocate help you to develop your
resources in very different ways, but both extreme forms are seen to experience arguments.
problems. There are situations in which a free market system fails to produce an
outcome that is good for society. On the other hand, the logistical problems facing a
centrally planned economy also create insurmountable difficulties in micromanaging
such a complex economic system.
In a free market system, prices can guide the allocation of resources in line with
consumer preferences. Competition between firms can help to drive innovation
and efficiency in production. However, markets do not always work effectively (as
will be seen later in this Theme). Another disadvantage is that without government
intervention, inequality between groups in society can arise, and the poor may not
always be adequately protected.
In a command economy, there may be more equality across society and the
government may be able to ensure good provision of essential services. However,
inefficiency occurs when the allocation of resources is centrally directed. There may
also be limits to inequality if certain groups are able to corner more than their fair
share of the country’s resources.

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In practice, most economies operate a mixed economy system, in which market

Key term
forces are complemented by some state intervention. This may be important because
mixed economy an free markets can lead to inequality in the distribution of resources in society. It
economy in which has been argued that any such state intervention should be market-friendly: in other
resources are allocated words, when governments do intervene in the economy, they should do so in a
partly through price signals way that helps markets to work, rather than trying to have the government replace
and partly on the basis of market forces. In such an economy, the government plays a minimal role by setting
intervention by the state the framework in which markets can operate.

Incentives
Another important concept that is at the heart of economic analysis is the notion
that individuals respond to incentives. The coordination problem is handled in
Test yourself 1.14 different forms of economy through the operation of different forms of incentive
that influence decision making. In a market economy, prices and profits provide
Name one example of a
incentives, whereas in a centrally planned economy these incentives are replaced by
mixed economy.
state directives.

Microeconomics and macroeconomics

The discussion so far has focused sometimes on individual decisions, and sometimes
Key terms on the decisions of governments, or of ‘society’ as a whole. Economic thinking
microeconomics the is applied in different ways, depending on whether the focus is on the decisions
study of economic taken by individual agents in the economy or on the interaction between economic
decisions taken by variables at the level of the whole economy:
individual economic
■ Microeconomics deals with individual decisions taken by households or firms,
agents, including
or in particular markets.
households and firms
■ Macroeconomics examines the interactions between economic variables at the
macroeconomics level of the aggregate economy.
the study of the
interrelationships between In some ways the division between the two types of analysis is artificial. The same
economic variables at an sort of economic reasoning is applied in both types, but the focus is different.
aggregate (economy-wide)
level Exercise 1.5
Think about the following, and see whether you think each represents a microeconomic or
macroeconomic phenomenon:
a the overall level of prices in an economy
b the price of ice cream
c the overall rate of unemployment in the UK
d the unemployment rate among catering workers in Aberdeen
e the average wage paid to construction workers in Southampton

Summary: free market, mixed and command economies

■ Decisions about resource allocation need to be coordinated within a society.
■ This may happen by allowing markets to guide decisions, through direct intervention by the
state, or through a combination of the two in a mixed economy.
■ Microeconomics deals with individual decisions made by consumers and producers,
whereas macroeconomics analyses the interactions between economic variables in the
aggregate — but both use similar ways of thinking.

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Economics in the real world 1.1

Plantains and coffee
Jacob is a subsistence farmer who lives in Nangare, a village
in the west of Uganda. He lives in a mud hut and owns two
sheep, two chickens and one mattress for his household
of ten people. He farms a small piece of land, on which he
grows plantains (a staple food crop in Uganda, related to
the banana) and some coffee. One of the key decisions that
Jacob faces is how to allocate his land between plantains
and coffee. If he chooses to plant more coffee in his field, he
faces a cost, as growing more coffee means growing fewer
plantains.
A number of factors are likely to influence this decision. For
Plantains or coffee? How will Jacob allocate his land?
example, the prices of plantains and coffee may be important,
and it may be that the costs involved in growing the two crops c Identify a point on the diagram that you drew for part (b) to
are different. Or it may be that some parts of the land are illustrate a situation in which:
more suitable for growing one of the crops. There may also i Jacob uses his land to produce only plantains.
be other crops that could be grown on the land. All of these ii Jacob uses his land to produce a combination of
factors could affect Jacob’s decisions. plantains and coffee.
Follow-up questions iii Jacob does not use all of the land available, but
produces a combination of the two crops.
a With reference to Jacob’s choice between growing plantains
and coffee, explain the concept of opportunity cost.
b Draw a possible production possibility frontier to illustrate
Jacob’s choice of producing plantains and coffee.

Exam-style questions
1.1 Nature of economics
Short-answer questions
1 The production possibility frontier can be used to illustrate the trade-off
between consumer and capital goods. An economy is currently achieving
economic efficiency.
a Economic efficiency is best illustrated by any point:(1)
A On the production possibility frontier
B Where more consumer goods are produced than capital goods
C Within the production possibility frontier
D Where more capital goods are produced than consumer goods
b Draw a fully labelled production possibility frontier diagram to illustrate
the opportunity cost of an economy producing more consumer goods. (4)
2 Economics is an example of a social science.
a As a social science, economics is least likely to involve: (1)
A Making assumptions
B Building economic models
C Making value judgements
D Conducting scientific experiments

1 The nature of economics 19

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Global wind generation rose from 1,587 to 1,814 terawatt hours between
2020 and 2021. However, many environmentalists believe the transition to
renewable energy is too slow.
b Explain what is meant by the term ‘positive statement’. (2)
c Calculate the percentage change in global wind generation between
2020 and 2021. You are advised to show your workings. (2)
Data response question: Government spending on HS2
Extract A: The rising cost of HS2
In February 2020, Boris Johnson confirmed the go-ahead for High Speed 2
(HS2). The controversial high-speed railway aims to reduce journey times
between London and cities in the Midlands and the North of England, as well as
increasing the rail network capacity.
Construction began in September 2020 and will employ 22,000 workers in its
first phase. Division of labour is crucial to the success of the project and will be
aided by the use of the most up-to-date technology. Although many of the jobs
created will be directly in the construction of the railway itself, HS2 will also
employ engineers, architects and designers.
However, there are also concerns about the increased government spending on the
HS2 project, with the cost rising from £32.7 billion in 2012 to £56 billion in 2015.
An independent review says the final bill could be as high as £106 billion. There
have also been delays during the COVID-19 pandemic due to social distancing
requirements, staff absences and problems resulting from global supply-chain
disruption.
3 a With reference to Extract A, explain how increased government
spending on the HS2 project will influence its opportunity cost. (5)
b Assess the likely benefit of using division of labour in the HS2
project. (10)
Essay question
4 According to the Index of Economic Freedom in 2022, Singapore is the
best example of a free market economy in the world. The Singaporean
economy is characterised by low levels of regulation and taxation.
Evaluate the likely benefits of scarce resources being allocated by a
free market economy, such as Singapore. Refer to at least one famous
economist in your answer. (25)

20 Theme 1 Introduction to markets and market failure

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