IGCSE ECONOMICS

NOTES 0455
SECTION 1
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.
• 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 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 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.

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.

SECTION 2
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:

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 demandfor a product
is the total (aggregate) demand for the product, or the sum of all individual demands of
consumers).
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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.
 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. •
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 aproduct due to the changes in other factors (excluding
price) causes a shift to the right.
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

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 for it
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.
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.
• 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 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.
• 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 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.
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.
• 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.

2.11 – 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.
• 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.
• 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.
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.

SECTION 3
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 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.
• 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)

HOUSEHOLDS
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:

• 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. 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.
• 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.
WORKERS

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.
• 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.
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. 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 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.
`
• 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 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
• 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.
• 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.

TRADE UNIONS
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
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.
• 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.

FIRMS

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.
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.
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
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.
• 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, 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
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 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.
• 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.

Demand for Factors of Production

Some factors that determine the demand of factors of production:

• The demand for the product: if more goods and services are demanded by
consumers, more factors of production will be demanded by firms to produce and
satisfy the demand. That is, the demand for factors of production is derived demand,
as it is determined by the demand for the goods and services (just like labour
demand).
• The availability of factors: firms will also demand factors that are easily available and
accessible to them. If the firm is located in a region where there is a large pool of
skilled labour, it will demand more labour as opposed to capital.
• The price of factors: If labour is more expensive than capital, firms will demand
more capital (and vice versa), as they want to reduce costs and maximize profits. •
 The productivity of factors: If labour is more productive than capital, then more
labour is demanded, and vice versa.
Labour-intensive and Capital-intensive production Labour-intensive
production is where more labourers are employed than other factors, say capital.
Production is mainly dependent on labour. It is usually adopted in small-scale industries,
especially those that produce personalised, handmade products. Examples: hotels and
restaurants.
Advantages:

• Flexibility: labour, unlike most machinery can be used flexibly to meet changing
levels of consumer demand, e.g., part-time workers.
• Personal services: labour can provide a personal touch to customer needs and wants.
• Personalised services: labourers can provide custom products for different
customers. Machinery is not flexible enough to provide tailored products for
individual customers.
• Gives feedback: labour can give feedback that provides ideas for continuous
improvements in the firm.
• Essential: labour is essential in case of machine breakdowns. After all, machines are
only as good as the labour that builds, maintains and operates them..
Disadvantages:

• Relatively expensive: in the long-term, when compared to machinery, labour has

higher per unit costs due to lower levels of productivity.
• Inefficient and inconsistent: compared to machinery, labour is relatively less
efficient and tends to be inconsistent with their productivity, with various personal,
psychological and physical matters influencing their quantity and quality of work.
• Labour relation problems: firms will have to put up with labour demands and
grievances. They could stage an overtime ban or strike if their demands are not met. Capital
refers to the machinery, equipment, tools, buildings and vehicles used in production. It also
means the investment required to do production. Capital-intensive production is where
more capital is employed than other factors. It is a production which requires a relatively
high level of capital investment compared to the labour cost. Most capital-intensive
production is automated (example: car-manufacturing).
Advantages:

• Less likely to make errors: Machines, since they’re mechanically or digitally

programmed to do tasks, won’t make the mistakes that labourers will.
• More efficient: machinery doesn’t need breaks or holidays, has no demands and
makes no mistakes.
• Consistent: since they won’t have human problems and are programmed to repeat
tasks, they are very consistent in the output produced.
• Technical economies of scale: increased efficiency can reduce average costs
Disadvantages:

• Expensive: the initial costs of investment is high, as well as possible training costs. •
Lack of flexibility: machines need not be as flexible as labourers are to meet changes in
demand.
 • Machinery lacks initiative: machines don’t have the intuitive or creative power that
human labour can provide the business, and improve production.

Production and Productivity

A firm combines scarce resources of land, labour and capital (inputs) to make (produce)
goods and services (output). Production is thus, the transformation of raw materials
(input) to finished or semi-finished goods and services (output).
In other words, production is the adding of value to inputs to create outputs. It is the
production that gives the inputs value.
Some factors that influence production:

• Demand for product: the more the demand from consumers, the more the
production.
• Price and availability of factors of production: if factors of production are cheap
and readily available, there will be more production.
• Capital: the more capital that is available to producers, the more the investment in
production.
• Profitability: the more profitable producing and selling a product is, the more the
production of the product will be.
• Government support: if governments give money in grants, subsidies, tax breaks
and so on, more production will take place in the economy.
Productivity measures the amount of output that can be produced from a given amount
of input over a period of time.
Productivity = Total output produced per period / Total input used per period
Productivity increases when:

• more output or revenue is produced from the same amount of resources •

the same output or revenue is produced using fewer resources.
(Labour productivity is the measure of the amount of output that can be produced by each
worker in a business).

Factors that influence productivity:

• Division of labour: division of labour is when tasks are divided among labourers.
Each labourer specializes in a particular task, and thus this will increase productivity. •
Skills and experience of labour force: a skilled and experienced workforce will be
more productive.
• Workers’ motivation: the more motivated the workforce is, the more productive they
will be. Better pay, working conditions, reasonable working hours etc. can improve
productivity.
• Technology: more technology introduced into the production process will
increase productivity.
• Quality of factors of production: replacing old machinery with new ones, preferably
with latest technologies, can increase efficiency and productivity. In the case of
labour, training the workforce will increase productivity.
• Investment: introducing new production processes which will reduce wastage, increase
speed, improve quality and raise output will raise productivity. This is known as lean
 production.

Costs of Production
Fixed costs (FC) are costs that are fixed in the short-term running of a business and have to
be paid even when no production is taking place. Examples: rent, interest on bank loans,
telephone bills. These costs do not depend on the amount of output produced.
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Output

Variable costs (VC) are costs that are variable in the short-term running of a business and
are paid according to the output produced. The more the production, the more the variable
costs are. Examples: wages, electricity bill, cost of raw materials.
Average Variable Cost (AVC) = Total Variable Costs (TVC) / Total Output

Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)
 This is a simple graph showing the
relation between TC, FC and VC. The gap between the TC and TVC indicates the TFC
Average cost or Average total Cost (ATC) is the cost per unit of output. Average Total
Cost (ATC) = Total Cost (TC) / Total Output or
Average Cost (AC) = Average Variable Cost (AVC) + Average Fixed Cost (AFC)

(Remember ‘average’ means ‘per unit’ and so will involve dividing the particular cost by the
total output produced. In the graphs above you will notice that the average variable costs and
average total costs first fall and then start rising. This is because of economies of scale and
diseconomies of scale respectively. As the firm increases its output, the average costs decline
but as it starts growing beyond a limit, the average costs rise).

Let’s calculate some costs in an example:

Suppose, a TV manufacturer produces 1000 TVs a month. The firm’s fixed costs in rent is
$900, and variable cost per unit is $500. What would its TFC, TVC, AVC, AFC, AC and TC
be, in a month?
No. of units of TVs produced = 1000

Total Fixed Costs for one month = $900

Average Fixed Cost = $900 / 1000 = $0.9 per unit

Variable Cost of producing one unit of TV = $500

Total Variable Costs for producing 1000 TVs in a month = $500 * 1000 = $500,000
Average Variable Cost = $500,000 / 1000 = $500 (AVC is the same as VC per unit!)

Total Costs = Total Fixed Costs + Total Variable Costs ==> $900 + $500,000 = $500,900
Average Costs = Total Costs / Total Output ==> $500,900 / 1000 = $500.9 or Average
Costs = AFC + AVC ==> $0.9 + $500 ==> $500.9

Revenue
Revenue is the total income a firm earns from the sale of its goods and services. The
more the sales, the more the revenue.
Total Revenue (TR) = No. of units sold (Sales) * Price per unit (P)
Average Revenue = Total Revenue (TR) / No. of units sold (Sales) (= Price per unit (P)!)
Suppose, from the example above, a TV is sold at $800 and the firm sells all the units it
produces, what is the firm’s Total Revenue and Average Revenue, for a month? No. of units
sold (Sales) in a month = No. of units produced in a month = 1000 Total Revenue = Sales *
Price ==> 1000 * $800 = $800,000
Average Revenue = Total Revenue / Sales = $800,000 / 1000 = $800

Total Revenue – Total Cost = Profit

Objectives of Firms
Objectives vary with different businesses due to size, sector and many other factors.
However, many business in the private sector aim to achieve the following
objectives.

• Survival: new or small firms usually have survival as a primary objective. Firms in a
highly competitive market will also be more concerned with survival rather than any
other objective. To achieve this, firms could decide to lower prices, which would
mean forsaking other objectives such as profit maximization.
• Profit: profit is the income of a business from its activities after deducting total costs
from total revenue. Private sector firms usually have profit making as a primary
objective. This is because profits are required for further investmentinto the business
as well as for the payment of return to the shareholders/owners of the business.
Usually, firms aim to maximise their profits by either minimising costs, or
maximising revenue, or both.
 • Growth: once a business has passed its survival stage it will aim for growth and
expansion. This is usually measured by value of sales or output. Aiming for business
growth can be very beneficial. A larger business can ensure greater
jobsecurity and salaries for employees. The business can also benefit from
higher market share and economies of scale.
• Market share: market share can be defined as the sales in proportion to total market
sales achieved by a business. Increased market share can bring about many benefits to the
business such as increased customer loyalty, setting up of brand image, etc.
• Service to the society: Some operations in the private sectors such as social enterprises
do not aim for profits and prefer to set more social objectives. They aim to better the
society by aiding society financially or otherwise.
A business’ objectives do not remain the same forever. As market situations change and as
the business itself develops, its objectives will change to reflect its current market and
economic position. For example, a firm facing serious economic recession could change its
objective from profit maximization to short term survival.

Competitive Markets
Firms compete in the market to increase their customer base, sales, market share and profits.

Price competition involves competing to offer consumers the lowest or best possible prices
of a product. Non-price competition is competing on all other features of the product
(quality, after-sales care, warranty etc.) other than price.
Informative advertising means providing information about the product to consumers.
Examples include advertising of phones, computers, home appliances etc. which include
specific information about their technical features.
Persuasive advertising is designed to create a consumer want and persuade them to buy the
product in order to boost sales. Examples include advertisements of perfumes, clothes,
chocolates etc.
Pricing Strategies
What can influence the price that producers fix on a product?

• Level and strength of consumer demand.

• The amount of competition from rival producers in the market.
• The cost of production and the level of profit targeted.
Price skimming: When a new and unique product enters the market, its producers charge a
very high price for it initially as consumers will be willing to pay more for the new product.
As more competitors begin to launch similar products, producers may lower prices. Apple’s
iPhones are good examples – they are very expensive at launch and get cheaper overtime.
Penetration pricing: when producers set a very low price which encourages consumers to
try the product, helping expand sales and increase loyalty. This way, the product is able to
penetrate a market, especially useful when there are a lot of existing rival products.
Netflix,
when it first started out as a DVD rental service, used penetration pricing ($1 monthly
subscription!) to encourage customers to try their service which helped it create a large
customer base.
Destruction pricing (predatory pricing): prices are kept very low (lower than the cost of
production per unit) in order to ‘destroy’ the sales of existing products, as consumers will
turn to the lowest priced products. Once the product is successful, it can raise prices and
cover costs. India’s Reliance Jio, a telecom company, was accused of predatory pricing
during its initial launch years. Predatory pricing is illegal in many countries as it creates a
non-competitive business environment and encourages monopoly practices. Price wars
happen when competing firms continually trying to undercut each other’s prices.
Cost-plus-pricing: this involves calculating the average cost of producing each unit of output
and then adding a mark-up value for profit.
Price = (Total Cost/Total Output) + Mark-up
This ensures that the cost of production is covered and that each unit produces a

profit. Perfect Competition

In a perfectly competitive market, there will be many sellers and many buyers – a lot of
different firms compete to supply an identical product.
As there is fierce competition, neither producers nor consumers can influence market
price – they are all price takers. If any firm did try to sell at a high price, it would lose
customers to competitors. If the price is too low, they may incur a loss. There will also be a
huge amount of output in the market.
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Advantages:

• High consumer sovereignty: consumers will have a wide variety of goods and
services to choose from, as many producers sell similar products. Products are also
likely to be of high quality, in order to attract consumers.
• Low prices: as competition is fierce, producers will try and keep prices low to attract
customers and increase sales.
• Efficiency: to keep profits high and lower costs, firms will be very efficient. If they
aren’t efficient, they would become less profitable. This will cause them to raise
prices which would discourage consumers from buying their product. Inefficiency
could also lead to poor quality products.
Disadvantages:
• Wasteful competition: in order to keep up with other firms, producers will duplicate
items; this is considered a waste of resources.
• Mislead customers: to gain more customers and sales, firms might give false and
exaggerated claims about their product, which would disadvantage both customers
and competitors.

Monopoly
Dominant firms who have market power to restrict competition in the market are called
monopolies. In a pure monopoly, there is only a single sellerwho supplies a good or service.
Example: Indian Railways. Since customers have no other firms to buy from, monopolies can
raise prices – that is they are able to influence prices as it will not affect their profitability.
These high prices result in monopolies generating excessive or abnormal profits. Monopolies
don’t face competition because the market faces high barriers to entry – obstacles preventing
new firms from entering the market. That is, there might be high start-up costs (sunk costs),
expensive paperwork, regulations etc. If the monopoly has a very high brand loyalty or
pricing structures that other firm couldn’t possibly compete with, those also act as barriers to
entry.
Disadvantages:
• There is less consumer sovereignty: as there are no (or very little) other firms selling
the product, output is low and thus there is little consumer choice.
• Monopolies may not respond quickly to customer demands.
• Higher prices.
• Lower quality: as there is little or no competition, monopolies have no incentive to
raise quality, as consumers will have to buy from them anyway. (But since they make
a lot of profit, they may invest a lot in research and development and increase
quality).
• Inefficiency: With high prices, they may create high enough profits that, costs due to
inefficiency won’t create a significant problem in their profitability and so they can
continue being inefficient.
Why monopolies are not always bad?
• As only a single producer exists, it will produce more output than what
individual firms in a competition do, and thus benefit from economies of scale. •
They can still face competition from overseas firms.
• They could sell products at lower price and high quality if they fear new firms may
enter the market in the future.

SECTION 4
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
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 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.
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.

FISCAL POLICY
Budget: a financial statement showing the forecasted government revenue and expenditure in
the coming fiscal year. It lays out the amount the government expects to receive as revenue in
taxes and other incomes and how and where it will use this revenue to finance its various
spending endeavours. Governments aim for its budgets to be balanced.

Government spending
Governments spend on all kinds of public goods and services, not just out of political and
social responsibility, but also out of economic responsibility. Government spending is a part
of the aggregate demand in the economy and influences its well-being. The main areas of
government spending includes defence and arms, road and transport, electricity, water,
education, health, food stocks, government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

• To supply goods and services that the private sector would fail to do, such as public
goods, including defence, roads and streetlights; merit goods, such as hospitals and
 schools; and welfare payments and benefits, including unemployment and child
benefits.
• To achieve supply-side improvements in the economy, such as spending on
education and training to improve labour productivity.
• To spend on policies to reduce negative externalities, such as pollution controls. • To
subsidise industries which may need financial support, and which is not available from
the private sector, usually agriculture and related industries.
• To help redistribute income and improve income inequality.
• To inject spending into the economy to aid economic growth.
Effects of government spending

• Increased government spending will lead to higher demand in the economy and thus
aid economic growth, but it can also lead to inflation if the increasing demand
causes prices to rise faster than output.
• Increased government spending on public goods and merit goods, especially in
infrastructure, can lead to increased productivity and growth in the long run. •
Increased government spending on welfare schemes and benefits will increase living
standards, and help reduce inequality.
• However too much government spending can also cause ‘crowding out’ of private
sector investments – private investments will reduce if the increase in government
spending is financed by increased taxes and borrowing (large government borrowing
will drive up interest rates and discourage private investment).

Tax
Governments earn revenue through interests on government bonds and loans, incomes from
fines, penalties, escheats, grants in aid, income from public property, dividends and profits on
government establishments, printing of currency etc; but its major source of revenue comes
from taxation. Taxes are a compulsory payment made to the government by all people in
an economy. There are many reasons for levying taxes from the economy:
• It is a source of government revenue: if the government has to spend on public goods
and services it needs money that is funded from the economy itself. People pay taxes
knowing that it is required to fund their collective welfare.
• To redistribute income: governments levy taxes from those who earn higher
incomes and have a lot of wealth. This is then used to fund welfare schemes for the
poor.
• To reduce consumption and production of demerit goods: a much higher tax is
levied on demerit goods like alcohol and tobacco than other goods to drive up its
prices and costs in order to discourage its consumption and production. Such a tax on
a specific good is called excise duty.
• To protect home industries: taxes are also levied on foreign goods entering the
domestic market. This makes foreign goods relatively more expensive in the domestic
market, enabling domestic products to compete with them. Such a tax on foreign
goods and services is called customs duty.
• To manage the economy: as we will discuss shortly, taxation is also a tool for demand
and supply side management. Lowering taxes increase aggregate demand and supply
in the economy, thereby facilitating growth. Similarly, during high inflation, the
government will increase taxes to reduce demand and thus bring down prices. More
on this below.
Classification of Taxes
Taxes can be classifies into direct or indirect and progressive, regressive or proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person or
individual responsible for paying it.
• Income tax: paid from an individual’s income. Disposable income is the income left
after deducting income tax from it. When income tax rise, there is little disposable
income to spend on goods and services, so firms will face lower demand and sales,
and will cut production, increasing unemployment. Lower income taxes will
encourage more spending and thus higher production.
• Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is
increased, businesses will have lower profits left over to put back into the business
and will thus find it hard to expand and produce more. It will also cause
shareholders/owners to receive lower dividends/returns for their investments. This
will discourage people from investing in businesses and economic growth could
slow down. Reducing corporate tax will encourage more production and investment.
• Capital gains tax: taxes on any profits or gains that arise from the sale of assets held
for more than a year.
• Inheritance tax: tax levied on inherited wealth.
• Property tax: tax levied on property/land.
Advantages:

• High revenue: as all people above a certain income level have to pay income taxes,
the revenue from this tax is very high.
• Can reduce inequalities in income and wealth: as they are progressive in nature –
heavier taxes on the rich than the poor- they help in reducing income inequality.
Disadvantages:

• Reduces work incentives: people may rather stay unemployed (and receive govt.
unemployment benefits) rather than be employed if it means they would have to pay a
high amount of tax. Those already employed may not work productively, since for
any extra income they make, the more tax they will have to pay.
• Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs to set
up new firms, as a good part of the profits they make will have to be given as tax. • Tax
evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus tax
revenue falls and the govt. has to use more resources to catch those who evade taxes.
Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods and
services and it is paid while purchasing the good or service. It is called indirect because it
indirectly takes money as tax from consumer expenditure. Some examples are:
• GST/VAT: these are included in the price of goods and services. Increasing these
indirect taxes will increase the prices of goods and services and reduce demand and in
turn profits. Reducing these taxes will increase demand.
• Customs duty: includes import and export tariffs on goods and services flowing
between countries. Increasing tariffs will reduce demand for the products. • Excise Duty:
tax on demerit goods like alcohol and tobacco, to reduce its demand. Advantages:

• Cost-effective: the cost of collecting indirect taxes is low compared to collecting

 direct taxes.
• Expanded tax-base: directs taxes are paid by those who make a good income, but
indirect taxes are paid by all people (young, old, unemployed etc.) who consume
goods and services, so there is a larger tax base.
• Can achieve specific aims: for example, excise duty (tax on demerit goods) can
discourage the consumption of harmful goods; similarly, higher and lower taxes on
particular products can influence their consumption.
• Flexible: indirect tax rates are easier and quicker to alter/change than direct tax rates.
Thus their effects are immediate in an economy.
Disadvantages:

• Inflationary: The prices of products will increase when indirect taxes are added to it,
causing inflation.
• Regressive: since all people pay the same amount of money, irrespective of their
income levels, the tax will fall heavily on the poor than the rich as it takes more
proportion of their income.
• Tax evasion: high tariffs on imported goods or excise duty on demerit goods can
encourage illegal smuggling of the good.
Progressive Taxes are those taxes which burdens the rich more than the poor, in that the
rate of taxation increases as incomes increase. An income tax is the perfect example of
progressive taxation. The more income you earn, the more proportion of the income you have
to pay in taxes, as defined by income tax brackets.
For example, a person earning above $100,000 a month will have to pay a tax rate of 20%,
while a person earning above $200,000 a month will have to pay a tax rate of 25%.
Regressive Taxes are those taxes which burden the poor more than the rich, in that the rate
of taxation falls as incomes increase. An indirect tax like GST is an example of a regressive
tax because everyone has to pay the same tax when they are paying for the product, rich or
poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns $500 dollars a
month, this tax will amount to 0.2% of his income, while for a richer person who earns
$50,000 a month, this tax will amount of just 0.002% of his income. The burden on the
poor is higher than on the rich, making its regressive.
Proportional Taxes are those taxes which burden the poor and rich equally, in that the rate
of taxation remains equal as incomes rise or fall. An example is corporate tax. All
companies have to pay the same proportion of their profits in tax.
For example, if the corporate tax is 30%, then whatever the profits of two companies, they
both will have to pay 30% of their profits in corporate tax.
Qualities of a good tax system (the canons of taxation):
• Equity: the tax rate should be justifiable rate based on the ability of the taxpayer. •
Certainty: information about the amount of tax to be paid, when to pay it, and how to
pay it should all be informed to the taxpayer.
• Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t
exceed the tax revenue itself.
• Convenience: the tax must be levied at a convenient time, for example, after a person
receives his salary.
• Elasticity: the tax imposition and collection system must be flexible so that tax rates
can be easily changed as the person’s income changes.
• Simplicity: the tax system must be simple so that both the collectors and payers
understand it well.
Impacts of taxation
Taxes can have various direct impacts on consumers, producers, government and thus, the
entire economy.
• The main purpose of tax is to raise income for the government which can lead to
higher spending on health care and education. The impact depends on what the
government spends the money on. For example, whether it is used to fund
infrastructure projects or to fund the government’s debt repayment.
• Consumers will have less disposable income to spend after income tax has been
deducted. This is likely to lead to lower levels of spending and saving. However, if
the government spends the tax revenue in effective ways to boost demand, it shouldn’t
affect the economy.
• Higher income tax reduces disposable income and can reduce the incentive to work.
Workers may be less willing to work overtime or might leave the labour market
altogether. However, there are two conflicting effects of higher tax:
• Substitution effect: higher tax leads to lower disposable income, and
work becomes relatively less attractive than leisure – workers will prefer
to work less.
• Income effect: if higher tax leads to lower disposable income, then a
worker may feel the need to work longer hours to maintain his desired
 level of income – workers feel the need to work longer to earn more.
• The impact of tax then depends on which effect is greater. If the
substitution effect is greater, then people will work less, but if income
effect is greater, people will work more
• Producers will have less incentive to produce if the corporate taxes are too high.
Private firm aim on making profits, and if a major chunk of their profits are eaten away by

taxes, they might not bother producing more and might decide to close shop. Fiscal
Policy
Fiscal policy is a government policy which adjusts government spending and taxation
to influence the economy. It is the budgetary policy, because it manages the government
expenditure and revenue. Government aims for a balance budget and tries to achieve it using
fiscal policy.
A budget is in surplus, when government revenue exceed government spending. While this is
good it also means that the economy hasn’t reached its full potential. The government is
keeping more than it is spending, and if this surplus is very large, it can trigger a slowdown of
the economy.
When there is a budget surplus, the government employs an expansionary
fiscal policy where govt. spending is increased and tax rates are cut.
A budget is in deficit, when government expenditure exceeds government revenue. This is
undesirable because if there is not enough revenue to finance the expenditure, the government
will have to borrow and then be in debt.
When there is a budget deficit, the government employs contractionary fiscal policy,
where govt. spending is cut and tax rates are increased.
Fiscal policy helps the government achieve its aim of economic growth, by being able to
influence the demand and spending in the economy. It also indirectly helps maintain price
stability, via the effects of tax and spending.
Expansionary fiscal policy will stimulate growth, employment and help increase prices.
Contractionary fiscal policy will help control inflation resulting from too much growth. But
as we will see later on, controlling inflation by reducing growth can lead to increased
unemployment as output and production falls.

MONETARY POLICY
The money supply is the total value of money available in an economy at a point of
time. The government can control money supply through a variety of tools including open
market operations (buying and selling of government bonds) and changing reserve
requirements of banks. (The syllabus doesn’t require you to study these in depth) The
interest rate is the cost of borrowing money. When a person borrows money from a
bank, he/she has to pay an interest (monthly or annually) calculated on the amount he/she
borrowed. Interest is also be earned on the money deposited by individuals in a bank. (The
interest on borrowing is higher than the interest on deposits, helping the banks make a
profit).
Higher interest rates will discourage borrowing and therefore, investments; it will also
encourage people to save rather than consume (fall in consumption also discourage firms
from investing and producing more).
Lower interest rates will encourage borrowing and investments, and encourage people to
consume rather than save (rise in consumption also encourage firms to invest and produce
more).
The monetary authority of the country cannot directly change the general interest rate in the
economy. Instead, it changes the interest rates of borrowing between the central bank and
commercial banks, as well as the interest on its bonds and securities. These will then
influence the interest rate provided by commercial banks on loans and deposits to individuals
and businesses.

Monetary Policy
Monetary policy is a government policy controls money supply (availability and cost of
money) in an economy in order to attain growth and stability. It is usually conducted by
the country’s central bank and usually used to maintain price stability, low unemployment
and economic growth.
Expansionary monetary policy is where the government increases money supply by
cutting interest rates. Low interest rates will mean more people will resort to spending
rather than saving, and businesses will invest more as they will have to pay lower interest on
their borrowings. Thus, the higher money supply will mean more money being circulated
among the government, producers and consumers, increasing economic activity. Economic
growth and an improvement in the balance of payments will be experienced
andemployment will rise.
Contractionary monetary policy is where the government decreases money supply by
increasing interest rates. Higher interest rates will mean more people will resort to saving
rather than spending, and businesses will be reluctant to invest as they will have to pay high
interest on their borrowings. Thus, the lower money supply will mean less money being
circulated among the government, producers and consumers, reducing economic activity.
This helps slow down economic growth and reduce inflation, but at the cost of possible
unemployment resulting from the fall in output.

SUPPLY SIDE POLICY

Supply side policies are microeconomic policies aimed at increasing supply and
productivity in the economy, to enable long-term economic growth. Some of these policies
include:
• Public sector investments: investments in infrastructure such as transport and
communication can greatly help the economy by making the flow of resources quick
and easy, and facilitate faster growth.
• Improving education and vocational training: the government can invest in
education and skills training to improve the quality and quantity of labour to increase
productivity.
• Spending on health: accessible, affordable and good quality health services will
improve the health of the population, helping reduce the hours lost to illnesses and
increasing productivity.
• Investment on housing: as more housing spaces are built, the geographical mobility
of the population will increase, helping increase output.
 • Privatization: transferring some public corporations to private ownership will
increase efficiency and increase output, as the private sector has a profit-motive
absent in public sector.
• Income tax cuts: reducing income tax will increase people’s willingness to work
more and earn more, helping increase the supply in the economy.
• Subsidies are financial grants made to industries that need it. More subsidies mean
more money for producers to produce more, thereby increasing supply. • Deregulation:
removing or easing the laws and regulations required to start and run businesses so they
can operate and produce more output with reduced costs and hassle, encouraging
investments.
• Removing trade barriers: the govt. can reduce or withdraw import duties, quotas
etc. on imports so that more resources, goods and services may be imported to
increase productivity and efficiency in the domestic economy. It can also reduce
export duties to increase export of resources, goods and services to other nations,
thereby encouraging domestic firms to increase production.
• Labour market reforms: making laws that would reduce trade union powers would
reduce business costs and increase output. Minimum wages could be reduced or done
away with to allow more jobs to be created. Welfare payments like unemployment
benefits could be reduced so that more people would be motivated to look for jobs
rather than rely on the benefits alone to live. These will not only increase the incentive
to work but also increase the incentive to invest.
For example, India, in the early 1990’s undertook massive privatisation, liberalisation and
deregulation measures; abolishing its heavy licensing and red tape policies, allowing private
firms to easily enter the market and operate, and opening up its economy to foreign trade by
reducing the excessive trade tariffs and regulations. This led to a period of high economic
growth and helped India become the emerging economy it is today.

Supply-side policies have the direct effect of increasing economic growth as the productive
capacity of the economy is realised. In doing so, it can also create more job opportunities and
help reduce unemployment. Trade reforms will also enable to it to improve its balance of
payments.
However, the reliance on public expenditure and tax cuts mean that the government may run
large budget deficits. Deregulation and privatisation will also reduce government intervention
in the economy, which may prompt market failure.
ECONOMIC GROWTH
Economic growth is an increase in the amount of goods and services produced per
head of the population over a period of time.
The total value of output of goods and services produced is known as the national output.
This can be calculated in three ways: using output, income or expenditure. GDP (Gross
Domestic Product): the total market value of all final goods and services provided within
an economy by its factors of production in a given period of time. Nominal GDP: the value
of output produced in an economy in a period of time, measured at their current market
values or prices is the nominal GDP.
Real GDP: the value of output produced in an economy in a period of time, measured
assuming the prices are unchanged over time. This GDP, in constant prices, provides a
measure of the real output of a country.
GDP per head/capita: this measures the average output/ income per person in an economy.
Since this takes into account the population, it provides a good measure of the living
standards of an economy.
GDP per capita = GDP / Population
An increase in real GDP over time indicates economic growth as goods and services
produced have increased. It indicates that the economy is utilizing its resources better or its
productive capacity has increased. On a PPC, economic growth will be shown by an outward
shift of the PPC, which is also called ‘potential growth’. ‘Actual growth’ occurs when the
economy moves from a point inside the PPC to a point closer to the PPC.

This diagram shows

‘actual growth’ as the economy realizes its potential growth. In order to experience potential
economic growth, the PPC would have to shift outwards.
Causes of economic growth
• Discovery of more natural resources: more resources mean more the production
capacity. The discovery of oil and gas reserves have enabled a lot of economies
(Norway, Saudi Arabia, Venezuela etc.) to grow rapidly.
• Investment in new capital and infrastructure: investment in new machinery,
buildings, technology etc. has enabled firms and economies to expand their
production capacities. Investment in modern infrastructure such as airports, roads,
harbours etc. have improved access and communication in economies, helping in
achieving quicker and more efficient production.
• Technical progress: New inventions, production processes etc. can increase the
productivity of existing resources in industries and help boost economic growth. •
Increasing the quantity and quality of factors of production: A larger and more
productive workforce will increase GDP. More skilled, knowledgeable and productive
human resources thus help increase economic growth. Similarly, good quality capital, use
of better natural resources, innovative entrepreneurs all aid economic growth in the long
run.
 • Reallocating resources: Moving resources from less-productive uses to more
productive uses will improve economic growth.
The benefits of economic growth:

• Greater availability of goods and services to satisfy consumer wants and needs. •
Increased employment opportunities and incomes.
• In underdeveloped or developing economies, economic growth can
drastically improve living standards and bring people out of poverty.
• Increased sales, profits and business opportunities.
• Rising output and demand will encourage investment in capital goods for further
production, which will help achieve long run economic growth.
• Low and stable inflation, if growth in output matches growth in demand. •
Increased tax revenue for government (as incomes and spending rise) that can be
invested in public goods and services.
The drawbacks of economic growth:

• Technical progress may cause capital to replace labour, causing a rise in

unemployment. This will be disastrous for highly populated underdeveloped and
developing economies, pulling more people into poverty
• Scarce resources are used up rapidly when production rises. Natural resources may
get depleted over time.
• Increasing production can increase negative externalities such as pollution,
deforestation, health problems etc. Climate change is a consequence of rapid global
economic growth.
• If the economy produces over its productive capacity and if the growth in demand
outstrips the growth in output, economic growth may cause inflation
• Economic growth has also been accused of widening income inequalities in
developing economies, because rich investors and businessmen gain more than the
working class and poor during growth – the benefits of growth are not evenly
distributed. This will cause relative poverty to rise.
Governments aim for sustainable economic growth which refers to a rate of growth which
can be maintained without creating significant economic problems for future generations,
such as depletion of resources and a degraded natural environment.

Recession
Recession is the phase where there is negative economic growth, that is real GDP is falling.
This usually happens after there is rapid economic growth. High inflation during the boom
period will cause consumer spending to fall and cause this downturn. Workers will demand
more wages as the cost of living increase, and the price of raw materials will also rise,
leading to firms cutting down production and laying off workers. Unemployment starts to
rise and incomes fall.
Causes of recession:
• Financial crises: if banks have a shortage of liquidity, they reduce lending and this
reduces investment.
• Rise in interest rates: increases the cost of borrowing and reduces demand. • Fall in
real wages: usually caused when wages do not increase in line with inflation leading to
falling incomes and demand.
 • Fall in consumer/business confidence: reduces both supply and demand. • Cut in
govt. spending: when government cuts spending, demand falls. • Trade wars:
uncertainty in markets, and thus businesses will be reluctant to invest during a trade
war, causing supply to fall.
• Supply-side shocks: e.g. rise in oil prices cause inflation and lower purchasing
power.
• Black swan events: black swan events are unexpected events that are very hard to
predict. For example, COVID-19 pandemic in 2020 which disrupted travel, supply
chains and normal business activity, as well consumer demand, has caused recessions
in many countries.
Consequences of recession:
• Firms go out of business: as demand falls, firms will be forced to either reduce
production to a level that is sustainable or close shop.
• Unemployment: cuts in production will cause a lot of people to lose work. •
Fall in income: cuts in production also causes fall in incomes.
• Rise in poverty and inequality: unemployment and lack of incomes will pull a lot of
people into poverty, and increase inequality (as the rich will still find ways to earn). • Fall
in asset prices (e.g. fall in house prices/stock market): recessions trigger a crash in the
stock markets and other asset markets as investors’ and consumers’ confidence in the
well-being fall of the economy during a recession. The shares owned by investors will be
worth less.
• Higher budget deficit: due to falling consumption and incomes, the government will
see a fall in tax revenue, causing a budget deficit to grow.
• Permanently lost output: as firms go out of business and employment falls, it results
in a permanent loss of output, as the economy moves inwards from its PPC.

If the economy was

producing at A on its PPC, a recession will cause production to fall to B. Policies to

promote economic growth Expansionary fiscal and monetary
policies (demand-side policies) and supply-side policies described in the previous sections
can be employed to promote economic growth, depending on the nature of the problems that
are holding back the economy from growing. For example, if it is the poor quality of human
capital (labour) that is preventing the economy from achieving its maximum productive
capacity, the government should invest in education and vocational training centres to
improve the quality of the labour force and increase productivity. If it is a lack of effective
demand causing slow growth, the government should focus on cutting income taxes, indirect
taxes and interest rates to boost spending. Effectiveness of such policies:
• Demand-side policies that increase the rate of growth above the long-run trend rate
will cause inflation and quickly lead to a recession if not controlled.
• Supply-side policies can take considerable time to take effect. For example, if the
government invested in better education and training, it could take several years for
this to lead to higher labour productivity.
• In a recession, supply-side policies won’t solve the fundamental problem of
deficiency of aggregate demand. Increasing the flexibility of labour markets and
encouraging investment may help to some extent, but unless there is sufficient
demand, firms will be reluctant to increase production and make new
investments.

EMPLOYEMENT AND UNEMPLOYMENET

Some terms to be familiar with while we’re discussing employment:

Labour force – the working population of an economy, i.e. all people of working age who
are willing and able to work.
Dependent population – people not in the labour force and thus depend on the labour force
to supply them with goods and services to fulfill their needs and wants. This includes students
in education, retired people, stay at home parents, prisoners or similar institutions as well as
those choosing not to work.
Employment is defined as an engagement of a person in the labour force in some occupation,
business, trade, or profession.
Unemployment is a situation where people in the labour force are actively looking for jobs
but are currently unemployed.
All governments have a macroeconomic objective of maintaining a low unemployment rate.

Full Employment is the situation where the entire labour force is employed. That is, all the
people who are able and willing to work are employed – unemployment rate is 0%.
Changing patterns and level of employment Over
time, patterns and levels of employment change. It could be due to the effects of the business
cycle that every economy goes through from time to time (growth and recession). It could be
due to the changes to the demographics (population- age and gender) of the country. It could
also be due to structural changes (dramatic shifts in how an economy operates). Let’s look at
some ways in which this happens:

As an economy develops, it undergoes a structural change as output and employment shifts

from primary sector to manufacturing and then to the tertiary (services) sectors. This
can be seen in rapidly developing countries like India where there employment in agriculture
and allied industries are rapidly falling and people are moving towards the fast-growing
service sector, especially IT and retail.
In the same way, employment moves from the informal sector (formally unrecognised
trades such as street vending- output is not included in GDP and incomes are not taxed) to
the formal sector (recognised – included in GDP and taxes) as economies develops. People
who previously worked as street vendors may work in registered firms, as the economy
develops.
Overtime, as an economy develops, the labour force also sees an increase in the proportion
of female labour. As social attitudes become progressive and women are encouraged to
work, more women will enter the labour force and contribute to growth. Similarly, as the
country develops, the proportion of old people may increase in proportion to young and
working people (because death and birth rates fall). This will cause the labour force to shrink
and cause a huge burden on the economy. Japan is now facing this problem as their birth
rates are falling and it is up to a shrinking labour force to support a growing dependent
senior population.
As economies become more market-oriented (government enterprises and interventions
decline), the economy will naturally see a large proportion of the labour force shift to
the private sector.
Measuring unemployment
Economies periodically calculate the number of people unemployed in their economies, to
check the unemployment rate and see what policies they should implement to reduce it if it is
too high. They can do this in two ways:

• Claimant count: unemployed people can file for unemployment claims

(benefits/allowances provided to the unemployed job seekers) by the government. The
government can count the total number of unemployment claims made in the
economy to measure unemployment.
• Labour surveys: economies conduct surveys among the entire labour force to collect
data about it. This will include data on the number of people unemployed.

Unemployment rate = number of people unemployed / total no. of people in the labour

force There are some problems with measuring employment.

Under-employment: people may be officially classed as employed but they may be working
fewer hours than they would like. For example, they may have a part-time job, but want a
full-time job. This is considered as unemployment because they may not fulfil the working
hours needed to be considered employed.
Inactivity rates: the long-term unemployed may become discouraged and leave the labour
market completely. In effect they are not working, but they are classed as economically
inactive rather than unemployed. So, the unemployment rate can be understated. The
causes/types of unemployment
• Frictional unemployment: this occurs as a result of workers leaving one job and
 spending time looking for a new one. This type of unemployment is short-lived. •
Cyclical unemployment: this occurs as a result of fall in aggregate demand due to an
economic recession. When demand falls, firms will cut their production and workers will
lose their jobs. There will be a nation-wide rise in unemployment.
• Structural unemployment: this occurs due to the long-term change in the structure of
an economy. Workers end up having the wrong skills in the wrong place – causing them
to be unfit for employment. This can be explained by dividing it further:
• Technological unemployment: this has rose in recent times as industrial
robots, machinery and other technology are being substituted for labour,
leaving people jobless.
• Sectoral unemployment: unemployed caused as a sector/industry declines
and leave its workers unemployed.
• Seasonal unemployment: this occurs as a result of the demand for a product being
seasonal. For example, the demand for umbrellas will fall in non-monsoon seasons,
and so workers in umbrella manufacturing firms will become unemployed over those
seasons.
• Voluntary unemployment: when people choose not to work for various reasons – they
want to pursue higher education, would like to take a break etc. Because they’re not
actively looking for work, voluntarily unemployed people do not belong to the
labour force!
The consequences of unemployment
• People will lose their working skills if they remain unemployed for a long time and
may find it even harder to find suitable jobs. As people remain unemployed, their
incomes will be low, and living standards will fall.
• Unemployment will also lead to poverty, homelessness and ill health and encourage
people to steal and commit other crimes to make money– crime rates will rise. • People
losing skills is not just detrimental to the unemployed individuals but also to firms who
may employ these people in the future. They will have to retrain these workers.
• Firms will have to pay redundancy payments to workers they lay off.
• Workers will be demotivated as they fear they could lose their jobs, especially in a
recession.
• As firms lay off workers, they will be left with spare capacity- unutilised machinery,
tools and factory spaces, leading to higher average costs.
• Due to low incomes, people’s purchasing power/consumption will fall,
causing demand to fall.
• People will need to rely on charity or government unemployment benefits to support
themselves. These benefits are provided from tax revenue. But now, as incomes have
fallen tax revenue will also fall. This might mean that people remaining in work will
have to pay more of their income as tax, so that it can be distributed as
unemployment benefits to the unemployed. The burden on tax-payers will rise.
• Public expenditure on other projects such as schools, roads etc. will have to be cut
down to make way for benefits. There is opportunity cost involved here. • The
economy doesn’t reach its maximum productive capacity, i.e., they are economically
inefficient on the PPC. The economy loses output.
Policies to reduce unemployment
Both demand-side policies and supply-side policies help reduce unemployment. Demand-side
policies will address the unemployment caused by demand deficiency (cyclical) while the
supply-side measures will curtail structural and frictional unemployment.

• Expansionary policies to increase demand: expansionary fiscal policies like cutting

down taxes and increasing government spending (which also creates jobs) and
expansionary monetary policies like cutting interest rates will help boost demand in
the economy, to keep production and employment high. However these will take
effect only with a time lag. Cutting tax rates won’t help if people don’t have
confidence in the economy and prefer to save. Similarly, cutting interest rates will
also be ineffective if banks are unwilling to lend to businesses, due to low confidence
in the economy.
• Depreciate the exchange rate: as the currency depreciates, the country’s exports will
become cheaper and so export demand from abroad will increase, helping boost
production and employment in the export industries.
• Control inflation: higher inflation causes firms to lay off workers to reduce costs. So if
the government tries to control inflation via monetary tools, it will help reduce firm
costs and increase employment. But there is also the argument that as unemployment
rises, incomes will also rise, driving up prices again.
• Cutting unemployment benefits to provide incentive to work: many people don’t
work because they are comfortable living off the unemployment benefits provided by
the government. Cutting down on these benefits, will persuade them to look for work
and earn. But this would of course, go against the welfare principle of the
government.
• Restricting imports and encourage exports: a lot of unemployment occurs when good
quality and cheaper foreign products put domestic industries out of business.
Controlling imports using import tariffs and quotas will encourage domestic firms to
emerge and increase production and thus increase employment. Similarly, easing
controls on labour-intensive export industries will open up new job opportunities.
However such protectionist measures can harm the country in the long-run as efficient
competition from abroad reduces.
• Cutting down minimum wages: minimum wages increase firms’ labour costs and so
they will lay off workers. Lowering the minimum wages will encourage firms to
employ more labour.
• Remove labour market regulations: letting the market have a free hand in the
labour market – abolishing maximum working weeks, minimum wages, making it
easier to hire and fire workers – will improve the labour market flexibility, can
improve imperfections in the labour market. However, this can cause temporary
unemployment and cause greater job insecurity.
• Training/Retraining: structural employment issues can be eliminated by retraining
the unemployed in skills required in modern industries. This will also improve
occupational mobility. This is very expensive when done on a large scale across the
economy, requiring training centres to be built, and trainers to be employed. The
benefits of providing skills and training will only be reaped in the long-term.
• Promote industries in unemployed areas: a lot of employment is created when
government provide subsidies and tax breaks for new industries which set up shop in
certain backward regions.
• Increase geographical mobility of labour: frictional unemployment is caused
because people can’t move around to find good jobs. The government can improve
labour mobility by investing in transport and housing services.
 • Provide information: frictional unemployment can be eliminated to an extent by
making information available about job vacancies to the unemployed through job
centres, newspapers, government websites etc.

Inflation
Inflation is the general and sustained rise in the level of prices of goods and services
in an economy over a period of time.
For example, the inflation rate in UK in 2010 was 4.7%. This means that the average price of
goods and services sold in the UK rose by 4.7% during that year.
Inflation is measured using a consumer price index (CPI) or retail price index
(RPI). The consumer price index is calculated in this way:
• A selection of goods and services normally purchased by a typical family or
household is identified.
• The prices of these ‘basket of goods and services’ will then be monitored at a
number of different retail outlets across the country.
• The average price of the basket in the first year or ‘base year’ is given a value of
100.
• The average change in price of these goods and services over the year is
calculated.
• If it rises by an average of 25%, the new index is 125% * 100 = 125%. If in the next
year there is a further average increase of 10%, the price index is 110% * 125 = 137.5%.
The average inflation rate over the two years is thus 137.5 – 100 = 37.5% Causes of
Inflation
• Demand-pull inflation: inflation caused by an increase in aggregate demandis
called demand-pull inflation. This is also defined as the increase in price due to
aggregate demand exceeding aggregate supply. Demand could rise due to higher
incomes, lower taxes etc. The demand curve will shift right, causing an extension in
supply and a rise in price.
• Cost-push inflation: inflation caused by an increase in cost of production in the
economy. The cost of production could rise due to higher wage rate, higher indirect
taxes, higher cost of raw materials, higher interest on capital etc. The supply curve
will shift left causing a contraction in demand and a rise in price.
• A lot of economists agree that a rise in money supply in contrast with output is the
key reason for inflation. If the GDP isn’t accelerating as much as the money supply, then
there will be a higher demand which could exceed supply, leading to inflation. The
consequences of inflation
• Lower purchasing power: when the price level rises, the lesser number of goods and
services you can buy with the same amount of money. This is called a fall in the
purchasing power. When purchasing power falls, consumers will have to make
choices on spending.
• Exports are less internationally competitive: if the prices of exports are high, its
competitiveness in international markets will fall as lower priced foreign goods will
rival it. This could lead to a current account deficit if exports lower (especially if they
are price elastic).
• Inflation causing inflation‘: during inflation, the cost of living in the economy rises as
you have to pay more for goods and services. This might cause workers to demand
 higher wages increasing the cost of production. If the price of raw materials also
increase, the cost of production again increases, causing cost-push inflation.
• Fixed income groups, lenders, and savers lose: a person who has a fixed income will
lose as he cannot press for higher wages during inflation (his/her real wages fall as
purchasing power of his/her wages fall). Lenders who lent money before inflation
and receive the money back during inflation will lose the value on their money. The
same amount of money is now worth less (here, the people who borrowed gain
purchasing power). Savers also lose because the interest they’re earning on savings in
banks does not increase as much as the inflation, and savers will lose the value on
their money.
Policies to control inflation
• Contractionary monetary policy that will reduce demand: contractionary monetary
policy is the most popular policy employed to curtail inflation. Raising interest rates
will discourage spending and investing (as cost of borrowing rises) and reduce the
money supply in the economy, helping cut down on demand. But this depends a lot on
the consumer and business confidence in the economy. Spending and investing may
still continue to rise as confidence remains high. There is also a considerable time lag
for monetary policy to take effect.
• Contractionary fiscal policy that will reduce demand: raising taxes will discourage
spending and investing and cutting down on government spending will reduce
aggregate demand in the economy, helping bring down the price level. However, this
is an unpopular policy only employed when inflation is severe.
• Supply side policies: supply-side policies such as privatisation and deregulation hope
to make firms competitive and efficient, and thus avoid inflationary pressures. But
this is a long-term policy only helping to keep the long-term inflation rate stable.
Sudden surges in inflation cannot be addressed using supply side measures
• Exchange rate policy: Appreciating the domestic currency can lower import prices
helping reduce cost-push inflation arising from expensive imported raw materials. It
also makes export more expensive, helping lower the export demand in the economy as
well as creating incentives for exporting firms to cut costs to remain competitive.

Deflation
Deflation is the general fall in the price level.
Deflation is also measured using CPI, but instead of showing figures above 100, it will
show an index below 100 denoting a deflation. For example, a drop in the average prices of
the basket of goods in a year is 10%, the deflation will be 100 – (90% * 100 = 90%) = 10%.
Causes of deflation
• Aggregate supply exceeding aggregate demand: when supply exceeds demand,
there is an excess of output in the economy not consumed, causing prices to fall. •
Demand has fallen in the economy: during a recession, a fall in demand in the
economy causes general prices to fall and cause a deflation.
• Labour productivity has risen: higher output will lead to lower average costs, which
could reflect as lower prices for products.
• Technological advance has reduced cost of production, pulling down cost-push
inflation.
Consequences of deflation
• Lower prices will discourage production, resulting in unemployment. • As demand
and prices fall, investors will be discouraged to invest, lowering the output/GDP.
 • Deflation can cause recession as demand and prices continue to fall and firms are
forced to close down as enough profits are not being made.
• Tax revenue of the government will fall as economic activity and incomes falls.
They might be forced to borrow money to finance public expenditure.
• Borrowers will lose during a deflation because now the value of the debt they owe is
higher than when they borrowed the money.
• Deflation will increase the real debt burden of the government as the value of debt
money increases.
Policies to control deflation
• Expansionary monetary policy to revive demand: cutting interest rates will encourage
more spending and investment in the economy which will stimulate prices to rise.
However, if interest rate is already at a very low point where decreasing it any further
won’t increase spending, because people still prefer to save some money and pay off
debts, and banks are not willing to lend at a very low interest rate, (this situation is
called a liquidity trap), then cutting interest rates will have no effect on spending.
• Expansionary fiscal policy to revive demand: increasing government spending in the
economy, especially in infrastructure will help raise demand, along with cuts in direct
taxes. The money for this expenditure can be created via quantitative easing (selling
government bonds to the public).
• Devaluation: devaluing the currency through selling domestic currency and/or
increasing the money supply will cause export prices to fall, encouraging production
of exports, resulting in higher demand; and also increase prices of imported products
which will raise costs and prices for products in the economy.
• Change inflation expectations: when a deflation is expected, businesses won’t
increase wages and consumers won’t pay higher prices (because they expect prices to
fall in the future). This will cause the deflation they expected. But if the monetary
authorities indicate that they expect higher inflation, firms will pay their workers
more and consumer will spend more now, avoiding a deflation.
LIVING STANDARDS
Living standards or standards of living refer to all the factors that contribute to a
person’s well-being and happiness
Measuring Living Standards
• GDP per head/capita: this measures the average income per person in an economy.
Real GDP per capita = Real GDP / Population
Merits of using GDP per capita to measure living standards:

• GDP is a useful measure of the total production taking place in the country, and so
indicates the material well-being of the economy
• it also takes population into consideration, adding emphasis on the goods and services
available to individuals
• since it is calculated on output, is a good indicator of the jobs being created •
GDP data is readily available so is population data

Limitations of using GDP per capita to measure living standards:

 • it takes no account of what people can buy using their incomes. A country with a
high GDP per head may be no better off than a country with a low GDP per head, if
there are far fewer products to choose from
• similarly, GDP doesn’t consider changes in technology that can have a large
impact on living standards. People might have had more income in the last decade
but they couldn’t benefit from all the technology available today
• distribution of income is very unequal in reality, so the GDP per head isn’t
accurate. Some people might be very rich while others very poor, but the GDP per
head will only give the average incomes
• real GDP excludes the unpaid work people do for charities and voluntary
organizations etc. Thus, it understates the total output
• GDP also doesn’t differentiate between the positive and negative values economies
place on different output/expenditure. For example, if the output rises because the
sales of tobacco, alcohol or pornographic materials, it might show in the records as
a rise in GDP per head but might not actually make people better off. Similarly,
GDP might rise if the government has to rebuild after a natural disaster, which
doesn’t mean living standards have risen
• the official GDP figures can be overstated due to technical errors or by political
manipulation to look good, and give a wrong picture of living standards • this
measure doesn’t consider leisure activities, health and education levels,
environmental quality- all that determines people’s happiness and well-being • in
order to effectively compare GDP per head across countries, they need to be
converted to a common currency and adjusted for differing purchasing power in
different countries
• comparing GDP per head can also be unreliable as GDP accounting methods can be
different for different countries.
• Human Development Index (HDI): used by the United Nations to compare living
standards across the globe, the HDI combines different measures into one to give a
HDI value from 0 (lowest) to 1(highest). These are:
• Income index, measured using the average national income – GNI per
head adjusted for differences in exchange rate and prices in different
countries (purchasing power parity)
• Education index, measured by how many years on average, a person aged
25 will have spent on education (mean years of schooling) and how many
years a young child entering school can now be expected to spend in
education in his entire life (expected years of schooling)
• Healthcare index: measured by average life expectancy at birth
The benefits of using HDI to measure living standards:

• it takes into account some major indicators of living standards

• recognises that it is not just output or income that determines living standards, but
also social factors
• it is a useful method to compare global living standards– it shows clear patterns of
living standards
• it is very useful and reliable measure since its produced by the UN and is thus also
widely used and recognised
The limitations of HDI to compare living standards:
 •
• it combines a set of separate indicators into one, so a country with good
literacy rates and living standards but poor life expectancy can have a low
HDI value
• there are wide divergences in HDI within countries
• GNI per head doesn’t say anything about inequalities in income and
wealth within countries
• it doesn’t consider other factors such as environmental quality, access to
safe drinking water, political freedom, crime rates etc. which are also
important indicators of living standards
• the HDI information for all countries may not be available such as
war-struck countries where civilisation has been disrupted
In the 2019 HDI index published by the UN, Norway comes first with an HDI index of 0.954
while Niger comes last with an index of just 0.377 owing to very low levels of education and
GNI per head. See the full list at http://hdr.undp.org/en/content/2019-human-development
index-ranking

Reasons for differences in living standards and income distribution within and between
countries

These have been discussed above in the merits and limitations of using GDP per capita and
HDI. More will be discussed in the coming chapters. Some other reasons are discussed
below

Difference in living Standards within a country: there can be variations in living standards
within a country. An excellent example of this is the high living standards of the Indian state
of Kerala (where IGCSE AID is based!) which has a HDI index of 0.779 while the poorest
state of Bihar stands at 0.567 (2018).

• Regional variances in income and consumption

• Major type of sectors/jobs: manufacturing and services heavy regions will have
higher incomes, education and health services compared to agricultural regions •
Local government provisions of education and health
Difference in living Standards between countries:
• Productivity of industries: more productive industries yield more output and
incomes
• Major industries: what makes countries like Qatar and Norway achieve some of the
world’s highest per capita incomes is that their income comes mostly from petroleum
industries that are scare and highly demanded internationally
• Population: dense population lower per capita income and put pressure on scarce
resource
• Ability of citizens pay taxes: higher tax-base and taxable incomes allow
governments to invest in infrastructure and welfare programmes
• Provision of health and educational facilities
• Variety of goods/services produced: if citizens can choose from a wide variety of
 products, living standards rise. Western countries like US enjoy this
• War, crime and natural disasters: war-struck countries of Asia, the high crime rates of
Latin America and frequent natural disasters in island countries, drive down their
living standards as they damage infrastructure and put people into hardship

POVERTY
Absolute poverty: the inability to afford basic necessities needed to live (food, water,
education, health care and shelter). This is measured by the number of people living below a
certain income threshold (called a poverty line).
Relative poverty: the condition of having fewer resources than others in the same society. It
is measured by the extent to which a person’s or household’s financial resources fall below
the average income level in the economy. Relative poverty is basically a measurement of
income inequality since a high relative poverty should indicate a higher income inequality.
Causes of poverty
• Unemployment: when people are unemployed and have to go without income for a
long time, they may end up having to sell their possessions, consume less and go and
into poverty.
• Low education levels: this means that people are uneducated, unskilled and unable to
find better jobs, keeping them in poverty.
• The size of family: more family members with only a few people earning, means
more costs of living, pulling the family into poverty if they’re not earning much. •
Age: older people are likely to have more health problems and be less suitable for
further employment, causing poverty. Young people are still employable and may
find ways to earn an income.
• Poor government support for basic services.
• Poor health: ill mental and physical health is both a cause and result of poverty. •
Overpopulation: high population density will put pressure on scarce resource and the
economy may not be able to produce and provide for everyone, causing poverty.
• Minority group/ethnicity/migrants: will face discrimination from bureaucrats,
employers and the society at large and so won’t be able to access and enjoy all
services. E.g.: African-Americans in the US tend to be poorer than their white
counterparts.
• Gender: women usually face discrimination, especially in employment and end up
being poorer than men.
Policies to alleviate poverty
• Introduce measures to reduce unemployment: an expansionary fiscal/monetary
policy will increase aggregate demand and increase employment opportunities.
Income and standards of living will rise.
• Impose progressive taxes: income taxes are progressive, that is, they increase as
income increases. Imposing these will mean that people on higher incomes will pay a
large percentage of their incomes as tax and help reduce relative poverty.
• Introduce welfare services: money from taxes can be provided as income support to
people with very low incomes. It can also be used to provide free or low-cost homes,
healthcare and education.
• Introduce minimum wage legislation to raise the wage of low-paid employees. •
 Increase the quantity and quality of education.
• Attract and invite inward investments from firms abroad to provide jobs and
incomes for people.
• Overseas aid could be gained from foreign governments and aid agencies. This will
include food aid, financial aid, technological aid, loans and debt relief.

POPULATION
Population is the total number of people inhabiting a specific area. Two-hundred years ago,
the world population was just over a billion, now it is about 7.7 billion, with China and India
having populations above 1 billion each! It is projected to hit 10 billion by 2056.

Factors that affect population

• Birth rates: the average number of children born in a country each year compared to
the total population of an economy is known as the birth rate. This is usually
expressed as the number of births for every 1000 people in the population. Why do
different countries have different birth rates?
• Living standards: improved quality and availability of food, housing, clean
water and medical care result in fewer babies dying. Countries where
children often die due to poor living standards have higher birth rates
(people have more children fearing that some of their children might die.
These children can then work to produce food and earn incomes).
• Contraception: increased use of contraception and legalisation of abortion
have reduced birth rates in developed countries.
• Customs and religion: many religious beliefs don’t allow the use of
contraceptive pills, so birth rates in those communities rise. In developed
economies it is now less fashionable to have large families, so birth rates
have fallen.
• Changes in female employment: more females in developed countries
entering the labour force has resulted in falling birth rates since they do
not want motherhood to affect their careers.
• Marriage: in developed countries, people are tending to marry later in life,
so birth rates have reduced.
• Death rates: the number of people who die each year compared to every 1000 people
of the population is the death rate of an economy.
Reasons for differing death rates in different economies:
• Living standards: just as birth rates, death rates also tend to be very high in
less-developed economies due to lack of good-quality food, shelter and
medical care. Malnutrition remains the major cause of high death rates in
these countries. In developed countries, the major causes of death include
lifestyle diseases, mostly caused by unhealthy diets.
• Medical advances and heath care: lack of medical care and infrastructure
in less-developed countries continue to be a cause for high death rates.
• Natural disasters and wars: hurricanes, floods, earthquakes and famine
due to lack of rain and poor harvests, and wars and civil conflicts increase
 death rates.
• Net Migration: migration refers to the number of people entering (immigration) and
leaving (emigration) the country. Net migration measures the difference between the
immigration and emigration to and from an economy. A net inward migration will
increase the working population of the economy, but can put pressure on
governments finances as demand for housing, education and welfare increase. A net
outward migration may increase the income per capita (if the emigrants send money
to families back home) and thus the HDI, but can result in loss of skilled workers.
Reasons for differing net migration in different economies:
• Living standards: people move to countries where living standards are
high which they can benefit from.
• Employment/wages: people migrate mainly to seek better job
opportunities. Widespread unemployment and low wages in the home
country will cause people to move to countries with better employment
opportunities and higher wages.
• Climate: very cold or very warm countries/regions will face more
emigration than other countries.

Population structure
The structure of a population can be analyzed using:

• Age distribution: the number of people in each age-group.

Falling birth and death rates mean that the average age in developed countries are
rising whereas in developing and less-developed economies, high death and birth rates
result in low average ages. The median age in developed Monaco is highest at 53.1
while in under-developed Niger it is just 15.3. Dependency ratio is the ratio of the
dependent population (those outside the labour force – children and senior citizens –
who depend on the labour force to supply them with goods and services by paying
taxes) to the total population in an economy. A high dependency population, such as
in Japan, put pressure on the government to increase taxes rates in order to raise more
revenue to support the dependents, putting pressure on the labour force. Consequences
of an ageing population:
• The workforce will decline and there will be much dependence on the tax
paying population to fund the welfare of old people.
• Increase in demand for products for old people including healthcare.
• The government will have to spend more on housing, old age welfare
schemes etc.
• Old people are less mobile and so the economy will be slow to adapt to
new technologies.
• Gender distribution: the balance of males and females. The sex ratio measures the
no. of males to the no. of females (the global sex ratio is 101:100; while Arab
countries have sex ratios as high as 2.87, island countries register low sex ratios).
Since the average female lives longer than the average male, there are more females
in the older age-groups than males. Gender imbalance is an excess of males or
females and is caused by
• Wars killing many young males
• Violence towards females (honour killings, rapes)
 • Sex-specific immigration – more males immigrate to a country looking for
work
Consequences of changes in the gender distribution:
• having more females will encourage birth rates to rise and increase
population growth
• more females in employment will increase productivity
• more females in education and employment will increase living standards • a
more balanced gender distribution can aid better social equality as social
attitudes towards women in education and employment become
progressive
Population pyramids display the age and gender distribution of an economy. The vertical
axes show the age groups and the horizontal axes show the gender groups- males on the
left and females on the right.

• Geographic distribution: where people live. 90% of the world population live in
developing countries. This puts a lot of pressure on scarce resources in these
countries. About half of the world population live in urban areas, and this continues to
rise, which has helped increase production and living standards but resulted in rapid
consumption of natural resources and high levels of pollution and congestion.
• Occupational distribution: what jobs people work in. In developed economies, more
people work in the service sector while in less-developed economies, most people work
in agriculture. In developing economies, there is a huge migration of workers
from primary production to manufacturing and service sectors. Female employment
and self-employment are also rising, which will add to production and higher living
standards.
An optimal population is one where the output of goods and services per head of the
population is maximised. An economy is underpopulated when it does not have enough
labour to make the best use of its resources; and it is overpopulated when the population is
too large given the resources it has.
Effects of increasing population size
• Increases size of the home market and thus potential for increase in aggregate
demand in the long-run.
• Higher demand and incomes will lead to more economic growth and expansion. •
Increased supply of labour.
• Puts more pressure on already scarce resources, especially land.
• More capital goods will have to be produced to sustain and satisfy the needs and
wants of the enlarged population.
• Fall in rate of productivity in line with the law of diminishing returns – too many
people working on limited resources means low productivity.
• Shift of employment and output from the primary sector towards the services
sector because land for primary activities is fixed, but want for services is practically
infinite as population grows, and the emergence of mechanisation and technologies
will force people out of the primary sector.
• Congestion of urban centres: as population and incomes rise, people will move to
cities and towns which will become crowded. There will be need for heavy transport,
communications, housing, waste management infrastructure spending.

DEVELOPED AND LESS DEVELOPED

ECONOMIES
Economic development refers to the increase in the economic welfare of people through
growth in productive scale and wealth of an economy. Governments aim for their countries to
expand from developing economies to developed economies.
Developed countries are characterised by high GDP per capita, high life expectancy, high
literacy rate, a stable or dwindling population growth, excellent infrastructure, high levels of
foreign investments, excellent healthcare, high productivity, and a relatively large tertiary
sector. Example: Japan
Under-developed economies or less-developed economies are characterised by very low
GDP per capita, high population growth, poor infrastructure, healthcare and education, low
literacy rates, low levels of foreign investments, poor productivity, and a relatively large
primary sector.
Example: Somalia
Developing economies are countries that are becoming more developed through expansion
of the industrial sector and fewer people suffering the extremes of poverty. They may attract
high levels of foreign investments and will be undergoing major economic shifts towards the
tertiary sector. However they may still have a low standard of living, owing to high
population growth. Example: India
The reasons for low economic development
• Over-dependence on agriculture: farming is the most common work in less
developed economies. Most people work to feed themselves and their families and
sell off any surplus. This means that there is little or no trade happening , which
results in poor incomes, no economic growth or development.
 • Domination of international trade by developed economies: the more wealthier
developed economies have exploited poorer countries by buying up their natural
resources at low prices and selling products made from them in international markets
at higher prices. Rich countries also protect their industries by paying subsidies to
domestic producers, increasing global supply, and in turn, lowering prices. Poor
economies cannot compete with these very low prices, and they lose their jobs and
incomes.
• Low levels of savings because of low incomes and widespread poverty. • Lack of
capital: low incomes in under-developed economies lead to a lack of savings that could
be invested in industries.
• Poor investment in infrastructure: good infrastructure in transport, health and
education is essential for growth and development.
• High population growth: rapidly expanding populations (due to high birth rates) in
less-developed countries will reduce the real GDP/income per head.
• Wars and conflicts deplete resources: there is little scope for development when the
country is a war zone.
• Corrupt and/or unstable governments: causes neglect of economy and citizens’
welfare
The opposites are true for developed economies.

Some development indicators that are used to measure how developed an economy are:
GDP per capita, population living on less than $1 a day, life expectancy at birth, adult literacy
rate, access to safe water supplies and sanitation, proportion of workers in different sectors of
production etc.

SECTION 6
Specialisation is when a nation concentrates its productive efforts on producing a limited
variety of goods and services in which they’re really efficient and productive at and
have an advantage over other economies in.
For example, due to the existence of vast oil and gas reserves in the region, Middle-Eastern
countries concentrate their production on petroleum and have made a fortune off of it.

Specialisation is determined on the basis of either resource allocation or of cost of

production.

Absolute advantage: when one country can produce more efficiently than another either
by producing more of a good or service with same amount of resources or producing the
same amount of a good or service with fewer resources.
For example, India has an absolute advantage in operating call centres because of its
abundant and cheap labour force, compared to western countries.
Comparative advantage: when one country can produce a good at a lower opportunity
cost (in terms of other goods and services being forgone) than another country. It takes into
account the opportunity cost incurred in producing each good.
For example, India may have an absolute advantage in operating call centres (against
Philippines), but it has lower opportunity costs in other IT industries, than Philippines. Thus,
Philippines has, in recent years, seen a growing call centre industry while India has seen
theirs decline.
Note: you are not required by the syllabus to know the terms ‘absolute advantage’ and
‘comparative advantage’, but only the principles.
Advantages of international specialisation:

• Economies of scale and efficiency: just like specialisation by individuals, countries

can specialise in what they do best, and this leads to efficiency and economies of
scale. It can therefore increase output while reducing costs. When more countries
specialise, world output increases.
• Job creation: specialisation leads to increased output and therefore it could lead to
more investment and thus jobs are created. Moreover, it requires skilled labour and
thus earnings are higher.
• Allows more international trade to take place. Therefore goods and services
produced under the most efficient conditions can be traded and all countries can
benefit from them.
• Revenue to the government: as income increases and more trade takes place, it can
increase government revenue from taxes.
• Wider markets: specialisation and trade allow firms to sell their products to
international markets, helping them build international brands and increase market
shares and profits.
• Consumer sovereignty: consumer across the globe will now be able to buy cheap and
high quality products from around the world. Because of specialisation and trade, we
now can get the best chocolate from Switzerland, the best coffee from Ghana and
Colombia, cheap IT services from India, oil from the Middle East, and budget cars
from Japan.
Disadvantages of international specialization:

• Structural unemployment: even though national level specialisation usually creates

more jobs, there is a risk that certain types of structural unemployment might occur.
As the country moves towards specialisation, the workers in the declining industries
will be put out of work.
• Over-exploitation of resources: output maybe increased by over-exploiting Today,
international specialization and trade is causing rapid depletion of non-renewable
resources like oil and coal. Middle Eastern countries are depleting their oil resources so
quickly, they are now building new industries to sustain them in the future.
• Threat of foreign competition: non-specialised industries of a country will face
fierce competition from the foreign countries that specialise in them.
• Risk of over-specialisation: because of more international dependence on other
countries for trade (they will have to sell their specialised products to other countries
and buy other products they need from abroad), any global economic change will
greatly affect highly specialised countries. For example, petroleum-exporting
countries have seen their revenues dip when oil prices fall. They are now trying to
diversify into other products like tourism to sustain them.
• Strategic vulnerability: relying on other countries for vital goods and services makes a
country dependent on those countries. Political or economic changes abroad may
impact the supply of goods or services available to the country.
GLOBALISATION, FREE TRADE AND
PROTECTION
Globalisation is a process of interaction and integration among the people, companies, and
governments of different nations, a process driven by international trade and investment and
aided by information technology [definition by: www.globalization101.org)

Multinational Corporations (MNCs)

Businesses which have their operations, factories and assembly plants in more than one
country are known as multinational businesses. Examples include Starbucks, IKEA, Toyota,
Adidas etc. The country they are based in is called the home country, and the countries they
operate in are called host countries.
Advantages to home country:

• MNCs create opportunities for marketing the products produced in the home
country throughout the world.
• They create employment opportunities to the people of home country, both at home
and abroad.
• It aids and encourages the economic growth and development of the home country. •
MNCs help to maintain favourable balance of payments of the home country in the
long run as they export their products abroad.
Advantages to host country:

• Provides significant employment and training to the labour force in the host
country.
• Transfers of skills and expertise, helping to develop the quality of the host labour
force.
• MNCs add to the host country’s GDP through their spending, for example with local
suppliers and through capital investment.
• Competition from MNCs acts as an incentive for domestic firms in the host country
to improve their competitiveness and efficiency.
• MNCs extend consumer and business choice in the host country.
• MNCs bring with them efficient business practices, technologies and standards
from across the world, which can influence the industries in the home country.
• Profitable MNCs are a source of significant tax revenues for the host economy (for
example on profits earned as well as payroll and sales-related taxes).
Disadvantages to home country:

• MNCs transfer capital from the home country to various host countries causing
unfavourable balance of payments.
• MNCs may not create employment opportunities to the people of home country if it
employs labour from other countries, perhaps due to lower costs or better skills. • As
investments in foreign countries is more profitable, MNCs may neglect the home
 country’s industrial and economic development.
Disadvantages to host country

• Domestic businesses may not be able to compete with MNC’s efficiency, low costs,
low prices and brand image, and may be forced to close shop.
• MNCs may not act ethically or in a socially responsible way, especially by taking
advantage of weak countries who gain a lot from the MNCs presence in their country.
For example, exploiting workers with low wages and poor working conditions in a
country where labour laws are weak.
• MNCs may be accused of imposing their culture on the host country, perhaps at the
expense of the richness of local culture.
• Profits earned by MNCs may be remitted back to the MNC’s home country rather
than being reinvested in the host economy.
• MNCs may make use of transfer pricing and other tax avoidance measures to reduce

the profits on which they pay tax to the government in the host country. Free
Trade and Protection
Free trade is when there are no restrictions for trade between
economies. The advantages of free trade:

• Allows countries to benefit from specialisation: if there was no international trade,

then countries wouldn’t be able to specialise – that is, they would have to become
self-sufficient by producing all the goods and services they require themselves. Total
output would lower and costs would rise. With specialization and free trade, output,
incomes and living standards will improve.
• Increases consumer choice: consumers can now enjoy a variety of products from
around the globe.
• Increases competition and efficiency: international trade means that there will be
more competition among firms in different countries. This would help increase
efficiency.
• Creates new business opportunities: free trade will allow businesses to produce and
sell goods for overseas consumers and expand and grow their operations by doing so.
Profits and revenue would rise.