CIE IGCSE Economics 0455 Section 1 - Units 1 to 3

Section 1 – Basic Economic Problem: Choice and the Allocation of Resources UNIT 1 – SCARCITY Economics is defined as, "The study of the production, distribution and consumption of wealth in human society" (Dictionary of Economics, The Economist) The purpose of economic activity The central purpose of economic activity is the production of goods and services to satisfy our ever-changing needs and wants.

Economic problem Scarcity is the basic economic problem because scarce resources (finite) are available to satisfy the unlimited wants. Scarcity exists because wants grow at a faster rate than goods that can be produced. Thus, scarcity leads to choice, we need to decide how to allocate our resources in economic systems.

Choices are made by consumers, businesses and governments. For example, thousands of people travel into Toronto each day and they make decisions about when to travel, whether to use the bus, the subway, to walk or cycle or work from home. Businesses have to decide how much to produce, and what price to sell, how much labour to employ or how much to invest.

Making a choice normally involves a trade-off, meaning that choosing more of one thing can only be achieved by giving up something else in exchange. Every choice involves opportunity cost; it is the next best alternative foregone when a choice is made. Money is no solution to the economic problem. It simply provides the means of rationing or allocating goods between consumers.

Resource Allocation Answers Three Questions:  What goods and services to produce?

What to produce means what kind of goods and services and how much quantity should be produced. Does the economy uses its resources to build more infrastructures, hospitals, schools or luxury hotels? Do we make more smartphone or doubleespressos? Should we provide free health care for our citizens?  How best to produce goods and services?

How to produce means what kind of method of production (technology) should be used for production, e.g. capital intensive or labour intensive technology.  Who is to receive goods and services?

For whom to produce means to which section of the people is should be produced and distributed. Who will get expensive hospital treatment - and who not? Should there be a minimum wage? Or perhaps a living wage? What are the causes and consequences of poverty in societies across the globe?

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UNIT 2 – FACTORS OF PRODUCTION These are the inputs in the production process and are used for the production of goods and services.  Land - All natural resources that are locked up in the earth surface, including minerals, fossil fuels, forests timber and oil. The basic nature of land is its supply is fixed. The reward paid for the owner of land is rent.  Labour - Any kind of human effort, manual and non-manual, skilled and unskilled that are provided by the workforce is called Labour. Labour can be considered as the human resources available, example: doctors, accountants, technicians, teachers, coal miners and factory workers which include both skilled and unskilled workers. The amount of workers that are ready to work is the workforce. The quality of workforce depends on the education and training provided. The reward received for labour is wage, which is determined by the demand and supply of labour.  Capital - Capital consists of all man-made resources, which help in the production of other goods and services, example: machinery, tools. There are two types of capital, working capital and fixed capital. The capital that varies according to the production is called working capital, an example is a firm that uses more capital to increase output, e.g. raw materials, fuel, etcetera. The capital goods that do not change with production are called fixed capital, e.g. building, machine, etcetera. The reward for capital is interest.  Entrepreneur - Enterprise is the process of managing and deciding how factors of production should be used in order to make profits. The entrepreneur is someone who undertakes risks, innovates and takes the responsibility of opening a new business. An entrepreneur’s reward is the profit earned from enterprise.

The role of Enterprise in a modern economy Entrepreneurs takes the risk and organise other factors of production. He/she plans the production, i.e., the combination of different factors of production required to produce goods/services to satisfy the needs and wants of the consumers. The entrepreneur generate ideas and stimulate the onset of innovation. He/she has the inspirational leadership or vision for the workers and the firm. Entrepreneurs have the skills to increase revenue or reduce costs and generate profit as his/her reward.

Enterprise can create wealth and jobs in the economy.

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UNIT 3 – OPPORTUNITY COST Opportunity Cost Opportunity cost measures the cost of any economic choice in terms of the next best alternative forgone. It is usually expressed in terms of the goods which we gave up rather than in terms of money.

Every time we make a choice, there is a certain value we place on that choice. We might not know it or think about it, but every choice has a value to us. When we choose one thing over another, it essentially means we value this more than another choice we had. The basis of choice gives a good its price and changes it from a free good to an economic good.

The opportunity cost of a choice is what we gave up to get it. If you have two choices, either to go to college and get further education or to start working right away that will pay good amount of money – and you choose college, then your opportunity cost is the option to be in the workforce that you could have chosen but didn’t. You gave up the opportunity to work in order to pursue further education. In this way, opportunity cost is the value of the opportunity lost.

Value has two components. It has benefits as well as costs. If you choose education over work, maybe education costs less, or maybe you enjoy it more. So, looking at choice in terms of benefits and costs helps you make better economic decisions. To make a good economic decision, we want to choose the option with the greatest benefit to us but with the lowest cost.

Example of Monetary Value John has recently graduated from University and he has two job offers, he has to choose either of the two jobs. He can either work for IBM or Google. IBM promises to pay him $20 an hour, while Google offers to pay him only $15. Based on this information alone, of course most people would choose IBM. Because IBM is paying a higher salary. But when we look at this kind of a choice in only dollar terms, we're only seeing it from the perspective of the benefits. But what if we analyse further and consider the costs?

John discovers that working in IBM requires him to buy a suit that will cost him $500. He realizes that the job with the higher salary may not be worth it to him. Now he is starting to think economically. We're thinking economically when we look at the value of a choice in terms of both benefits and costs.

Whatever we choose, the opportunity cost is the value of the choice we could have had. For John, the opportunity cost of working for IBM is the value of what he gave up to take the job. He gave up the value of working for Google, so that is the opportunity cost of choosing to work for Google. In this example, we focused more on the monetary costs. The problem is, most of us get stuck evaluating choices only in monetary terms, but there is another side of the coin to consider.

The value of a choice maybe in terms of time or in terms of the enjoyment we hope to experience.

There is a famous saying in Economics that “there is no such thing as a free lunch”. Even if we get to consume a good or a service for free, there must be some opportunity cost © Niaz Mahmud

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associated with it, like the scarce resources that are used to produce it - the next best alternative that might have been produced using those resources.

Examples of opportunity cost  The opportunity cost of deciding not to work is the lost wages forgone.  The opportunity cost of spending money for a foreign vacation is the lost opportunity to buy a home appliance or the chance to enjoy two short vacations inside Bangladesh.  The opportunity cost of the government spending Tk. 10 billion on interest payments to service national debt is the money it could have allocated to the National Education Board.  The opportunity cost of an economy investing its resources in new capital goods is the forgone current production of consumer goods.  The opportunity cost of using arable farm land to produce wheat is that the land cannot be used in that production period to harvest potatoes.

The Economic Agents There are three economic agents which are found in every society and engaged in making economic choices.

1. Consumers - Consumers must consider their limited income (budget) and their wants as distinct from their needs when making choices. A need is something essential to man's survival; anything else qualifies as a want. Wants must be translated into effective demand before they have any effect on the economy.

2. Producers - Producers/Firms are organisations involved in the production of wealth and in our economy it is motivated by the consideration of profit. The business or the firm is responsible for the production of wealth and the creation of all the goods and services which we want as individuals.

3. Governments - The role of government varies depending on the views of those currently elected. Left wing governments believe in greater government intervention than right wing governments.

Production Possibility Curve The Production Possibility Curve (PPC) is the graph that shows maximum attainable combinations of two goods or services that can be produced in an economy when all resources (scarce) are fully and efficiently employed, at a given state of technology. The following diagram depicts how PPC can be used to show opportunity cost.

Consumer Goods

A movement from A to B on the diagram below illustrates that increasing the quantity of Defense goods has an opportunity cost of reduction in capital goods.

Defense Goods © Niaz Mahmud

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The reason why PPC has a curve shape and not linear line is because of the law of diminishing marginal returns, i.e., the opportunity cost of producing more Defense goods increases, in terms of the lost units of consumer goods that could have been produced.

Production at points A, B and C are the most efficient combinations of output on the PPC. Production at C produces more Defense goods than consumer goods, incurs an opportunity cost of producing more consumer goods.

Point X: The economy can exist at this point but it is being inefficient. Point X Is considered inefficient as resources are idle. This could mean that workers are unemployed or unmotivated, machines are idle or that factories are half used.

Point Y: Point Y is unattainable as the economy doesn’t have enough resources to produce both of the products.

Shifts in the Production Possibility Curve Rightward Shift (Economic Growth)

Leftward shift (Economic Recession)

Reasons for rightward shift:

Reasons for leftward shift:

 The quantity and quality of resources

 Less resources available.

available for production can increase e.g. labor can increase if there is an increase in population.

 The PPC can also shift inwards to the left due to war or natural disasters, which reduce a country’s resources.

 Increase in the capital, where more

machines, factories and tools are produced.  The quality of resources might have

improved.

Changes in the slope of the PPC If there is a change in the quantity and quality of resources, which are specific to the production of one type of good, then the entire PPC will not shift to the right, but only the slope will change.

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E.g. Technological improvement in the production of product B has caused the maximum number of product B to increase, but the maximum number of product A doesn’t change. It can also be the other way around i.e. where the slope moves vertically upwards indicating an increase in the maximum number of product A. Important Points to Remember about PPC  Moving along the PPC is different to shifting the PPC. Moving along the PPC uses the same resources and technology to move production from more consumer goods to more defense goods, for example, which incurs an opportunity cost.  Shifting the PPC outwards, for example, uses either more resources or resources of a greater quality. This reduces the opportunity cost of producing either defense goods or consumer goods, since more goods can be produced overall.  If the PPC is a straight line, the marginal opportunity cost is constant. This is because the amount of one good given up to produce the other does not change, which is unrealistic since resources are not fully adjustable to produce both consumer goods and defense goods.  The concave shape of the PPC shows increasing opportunity cost. This is more realistic than the straight line because at each end of the curve producing more of that good decreases the relative output of that good and leads to a relatively higher loss of the output of the other good.

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