O Level Economics Paper 2

Topical Economics Paper 2 (Solved) (2004-2016) Article # 142

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Title

Economics O-Level P-2 (Solved Topical)

Author

Imran Latif Cell: +92 300 441 0900 Email: imranlatifmalik@gmail.com

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Preface This book provides a thorough exercise of paper 2 for students taking Cambridge International

Examinations

O-Level

Economics.

Structured

essays

from

past

examinations are sorted into relevant chapters which will enable students to practice their understanding systematically.

We appreciate our students and fellow teachers who helped us to improve this book.

Your suggestions and comments will be highly appreciated.

REVIEW BOARD 1. Lahore: Mr. Aslam Tariq , Mr. Zahid Kamal , Mr. Mian Mumtaz and Mr. Asim Ali Bukhari Mr. Ahmed Ali , Mr. Taimur K.Bandey, Saeed Afzal, Mr. Kamran Malik , Mr. Shahid Saghir, Mr. Faisal Saeed, Mr. Muhammad Rafi, Mr. Arshad Chudhary, and Mr. Ahmed Bilal.

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Imran Latif M.A. Economics M.A. Mass Communication Cell: +92 300 4410900 Email: imranlatifmalik@gmail.com

CONTENTS UNIT - 1 BASIC ECONOMIC PROBLEM ......................................................................................8 1.1 1.2 1.3

FACTORS OF PRODUCTION ................................................................................................... 8 OPPORTUNITY COST AND SCARCITY (BASIC ECONOMIC PROBLEM)....................................... 11 PRODUCTION POSSIBILITY CURVE ....................................................................................... 15

UNIT - 2 DEMAND SUPPLY AND EQUILIBRIUM ......................................................................18 2.1 2.2

DEMAND ............................................................................................................................. 18 MARKET EQUILIBRIUM & CHANGES IN EQUILIBRIUM .............................................................. 22

UNIT - 3 ELASTICITY ..................................................................................................................30 3.1 3.2 3.3

PRICE ELASTICITY OF DEMAND (PED) .................................................................................. 30 PRICE ELASTICITY OF SUPPLY (PES) .................................................................................. 40 ELASTICITY AND TAX INCIDENCE.......................................................................................... 41

UNIT - 4 PRODUCTION AND COST ...........................................................................................43 4.1 4.2 4.3 4.4 4.5 4.6 4.7

PRIMARY, SECONDARY & TERTIARY SECTORS ..................................................................... 43 TYPES OF COSTS ............................................................................................................... 44 DIVISION OF LABOUR AND SPECIALIZATION .......................................................................... 47 ECONOMIES & DISECONOMIES OF SCALE ............................................................................ 50 SMALL FIRMS...................................................................................................................... 54 SOURCES OF GROWTH OF FIRMS & INTEGRATION ............................................................... 56 PROFIT MAXIMISATION ........................................................................................................ 59

UNIT - 5 TYPES OF BUSINESS ORGANIZATIONS ...................................................................62 5.1 5.2

TYPES OF BUSINESS ORGANIZATIONS ................................................................................. 62 MULTINATIONALS ................................................................................................................ 65

UNIT - 6 MARKET STRUCTURES ..............................................................................................70 6.1 6.2

MARKET STRUCTURES ........................................................................................................ 70 ARE MONOPOLIES ARE ALWAYS BAD FOR CONSUMERS? ..................................................... 70

UNIT - 7 ECONOMIC SYSTEMS & ALLOCATION OF RESOURCES .......................................74 7.1 7.2 7.3

PRIVATE AND PUBLIC SECTOR ............................................................................................ 74 LABOUR INTENSIVE VS CAPITAL INTENSIVE METHOD ............................................................ 75 ECONOMIC SYSTEMS .......................................................................................................... 76

UNIT - 8 MARKET FAILURE .......................................................................................................83 8.1 8.2 8.3 8.4

SOCIAL COSTS AND BENEFITS............................................................................................. 83 CAUSES OF MARKET FAILURE ............................................................................................. 89 W HY GOVERNMENT PRODUCE GOODS & SERVICES ............................................................. 92 GOVERNMENT POLICIES AND THEIR LIMITATIONS ................................................................. 94

UNIT - 9 LABOUR MARKET......................................................................................................102 9.1 9.2 9.3 9.4 9.5 9.6

FACTORS DETERMINING W AGE RATE................................................................................. 102 W AGE DIFFERENTIALS ...................................................................................................... 103 TRADE UNIONS ................................................................................................................. 110 FACTORS AFFECTING CHOICE OF OCCUPATION ................................................................. 113 TYPES OF PAYMENTS ....................................................................................................... 117 CHANGES IN EARNING IN LIFETIME .................................................................................... 117

UNIT - 10

SPENDING, SAVING AND BORROWING ...........................................................119

10.1 MOTIVES TO SPEND OR SAVE ........................................................................................... 119 10.2 SPENDING PATTERNS ....................................................................................................... 121 UNIT - 11 GOVT. MICROECONOMIC INTERVENTION .............................................................123 11.1 11.2 11.3 11.4 11.5

TYPES OF TAXES SYSTEM AND DISTRIBUTION OF INCOME ................................................. 123 DIRECT & INDIRECT TAXES ................................................................................................ 125 REASONS FOR TAXATION .................................................................................................. 126 OBJECTIVE AND FINANCE OF GOVERNMENT SPENDING ...................................................... 127 GOVERNMENT BUDGET ..................................................................................................... 128

UNIT - 12 MONEY AND BANKING .............................................................................................129 12.1 FUNCTIONS OF MONEY ..................................................................................................... 129 12.2 FUNCTION OF CENTRAL BANK ........................................................................................... 129 12.3 FUNCTION OF COMMERCIAL BANK ..................................................................................... 130 UNIT - 13 NATIONAL INCOME, AD & AS ..................................................................................131 13.1 NATIONAL INCOME ............................................................................................................ 131 13.2 AD AND AS ....................................................................................................................... 131 UNIT - 14 INFLATION ..................................................................................................................132 14.1 14.2 14.3 14.4 14.5

MEANING OF INFLATION .................................................................................................... 132 CAUSES OF INFLATION ...................................................................................................... 132 MEASUREMENT OF INFLATION ........................................................................................... 135 EFFECTS OF INFLATION..................................................................................................... 137 ACTUAL VALUE VS PERCENTAGE VALUE ............................................................................ 138

UNIT - 15 EMPLOYMENT & UNEMPLOYMENT.........................................................................140 15.1 15.2 15.3 15.4

MEANING OF UNEMPLOYMENT........................................................................................... 140 TYPES & CAUSES OF UNEMPLOYMENT .............................................................................. 141 EFFECTS OF UNEMPLOYMENT ........................................................................................... 142 FULL EMPLOYMENT ........................................................................................................... 144

UNIT - 16 ECONOMIC GROWTH ................................................................................................145 16.1 ECONOMIC GROWTH ......................................................................................................... 145 16.2 CAUSES OF ECONOMIC GROWTH ...................................................................................... 147 16.3 MEANING AND MEASUREMENT OF ECONOMIC GROWTH ..................................................... 148

UNIT - 17 POPULATION ..............................................................................................................149 17.1 FACTORS OF GROWTH IN POPULATION .............................................................................. 149 17.2 AGEING POPULATION ........................................................................................................ 151 17.3 TYPES OF POPULATION AND EFFECTS OF GROWTH IN POPULATION ................................... 153 UNIT - 18 ECONOMIC DEVELOPMENT & STANDARD OF LIVING .........................................155 18.1 18.2 18.3 18.4

STANDARD OF LIVING ....................................................................................................... 155 ECONOMIC DEVELOPMENT ................................................................................................ 158 ABSOLUTE VS RELATIVE POVERTY .................................................................................... 166 CAUSES AND POLICIES FOR ECONOMIC DEVELOPMENT & POVERTY ................................... 167

UNIT - 19 INTERNATIONAL TRADE ..........................................................................................170 19.1 REASONS FOR SPECIALIZATION AND TRADE ...................................................................... 170 19.2 METHODS OF PROTECTIONISM .......................................................................................... 170 19.3 ADVANTAGES AND DISADVANTAGES OF FREE TRADE AND PROTECTIONISM ........................ 173 UNIT - 20 EXCHANGE RATE ......................................................................................................178 20.1 20.2 20.3 20.4 20.5

MEANING OF EXCHANGE RATE .......................................................................................... 178 EXCHANGE RATE SYSTEMS ............................................................................................... 178 EFFECTS OF EXCHANGE RATE CHANGES. ......................................................................... 179 ADVANTAGES/DISADVANTAGE OF EXCHANGE RATE SYSTEM .............................................. 180 CAUSES OF EXCHANGE RATE DEPP/APP ........................................................................... 181

UNIT - 21 BALANCE OF PAYMENT ...........................................................................................182 21.1 BOP ACCOUNTS ................................................................................................................ 182 21.2 CAUSES OF BOP DEFICIT/SURPLUS ................................................................................... 182 21.3 EFFECTS OF BOP DEFICIT OR SURPLUS ............................................................................ 184 UNIT - 22 GOVERNMENT MACROECONOMIC INTERVENTION .............................................185 22.1 22.2 22.3 20.4 20.5

MACROECONOMIC AIMS & CONFLICTS ............................................................................... 185 MACROECONOMIC POLICIES FOR CURRENT ACCOUNT DEFICIT ........................................... 188 MACROECONOMIC POLICIES FOR ECONOMIC GROWTH AND EMPLOYMENT .......................... 188 MACROECONOMIC POLICIES FOR INFLATION ...................................................................... 194 MACROECONOMIC POLICIES FOR MULTIPLE AIMS............................................................... 196

UNIT - 23 OTHERS ......................................................................................................................199 SECTION A 202 J04/P2/Q1................................................................................................................................. 202 N04/P2/Q1 DECLINE IN W ORLD SUPPLY OF COTTON .............................................................. 204 J05/P2/Q1 EUROPEAN RECESSION ........................................................................................ 205 N05/P2/Q1 LESOTHO NATIONAL DEVELOPMENT CORPORATION............................................... 207 J06/P2/Q1 DEMAND FOR OIL IN INDIA .................................................................................... 208 N06/P2/Q1 TRADE AND PRODUCTION IN BANGLADESH ........................................................... 210 J07/P2/Q1 AIRLINE INDUSTRY LOSSES .................................................................................. 211 N07/P2/Q1 THE ROYAL MAIL ................................................................................................. 213

J08/P2/Q1 UK RAILWAY OPERATION ..................................................................................... 214 N08/P2/Q1 POPULATION IN BOTSWANA .................................................................................. 216 J09/P2/Q1 ECONOMIC GROWTH IN UGANDA .......................................................................... 218 N09/P2/Q1 ................................................................................................................................ 219 J10/P2/Q1 ECONOMIC DOWNTURN PUTS PRESSURE ON NEW ZEALAND FIRMS TO BE MORE PRODUCTIVE 221 N10/P2/Q1 THE ASIAN DEVELOPMENT BANK MEETS IN INDONESIA .......................................... 223 J11/P2/Q1 THE DHAKA STOCK EXCHANGE IS DOING W ELL .................................................... 225 N11/P2/Q1 THE STRUGGLES OF THE IVORY COAST’S COCOA FARMERS.................................. 226 J12/P2/Q1 CHINA DECIDES TO MOVE TOWARDS A MORE FLEXIBLE EXCHANGE RATE ............. 229 N12/P2/Q1 A NEW CITY IS TO BE BUILT IN GHANA ................................................................. 230 J13/P2/Q1 THE COMMUNICATIONS MONOPOLY IN MEXICO ..................................................... 233 N13/P2/Q1 PRICES RISE FASTER THAN W AGES IN THE UNITED KINGDOM (UK) ....................... 234 J14/P2/Q1 THE CHALLENGES FACING ANGOLA ...................................................................... 236 N14/P2/Q1 FISCAL POLICY AND AN AGEING POPULATION IN JAPAN......................................... 240 J15/P2/Q1 PERU AND PANAMA ............................................................................................. 243 NOVEMBER 2015 PAPER 22 .....................................................................................................247 JUNE 2016 PAPER 22.................................................................................................................259 NOVEMBER 2016 PAPER 22 .....................................................................................................270 JUNE 2017 PAPER 22.................................................................................................................283 NOVEMBER 2017 PAPER 22 .....................................................................................................293

Unit 1

8

Unit - 1 1.1

FACTORS OF PRODUCTION

1

J04/P2/Q2(a)

Basic Economic Problem

Basic Economic Problem

In Zimbabwe a local community markets a tea which grows wild in their area. ‘Communities should be able to manage their natural resources if they are to benefit, especially if they are to gain an economic benefit,’ the leader of the project said.

Q:

Identify the factors of production.

[4]

Ans:

Land, labour, capital and enterprise

2

N05/P2/Q5(c), J08/P2/Q6(c)

Q:

Explain with the use of one example what is meant by a natural resource of a country.

[3]

Ans:

The term natural resource refers to any material or substance occurring in nature which can be exploited for economic gain for e.g. agricultural area is natural resource which can be used to produce crops, vegetables and fruits etc. Resources which are not natural but man-made are known as capital.

3

N05/P2/Q7(b)

Q:

Discuss which factor of production might be most significant in the operation of a luxury hotel.

[4]

Ans:

All four factors of production i.e. land(natural resources), labour(human efforts), capital (man-made resources) and entrepreneurship are used in hotel business. The hotel is a luxury hotel so it is likely to require reasonable amount of capital expenditure even if the hotel itself is not very big. Hotels however are usually labour intensive because of the high need to provide personal service to the customers. Often, though not always, luxury hotels are set in well-kept grounds so land plays an important role too. The owner (entrepreneur) of the hotel will decide upon how the hotel should operate and keep a check upon everything. Labour however, plays the most significant role in the operation of a luxury hotel. This is because the services required by the customers cannot be provided through machines so human force is needed and similarly, land can only be used to locate the hotel, although these factors do matter, customer satisfaction is based heavily upon the services that may be directly related to the workers at the hotel.

4

J06/P2/Q2(a), N10/P2/Q2(a), N11/P2/Q2(b), J13/P2/Q2(a)

Q:

Explain what is meant by the factors of production.

Ans:

Any material or effort used in production of goods and services is a resource or a factor of production. There are four factors of production; land includes all the natural resources used for production for e.g. oil, coal, fish, forests etc. Labour comprises of all the physical and mental efforts of the workers invested into the business for the production of

[4]

Unit 1

9

Basic Economic Problem

goods and services for e.g. educational and engineering services etc. Capital means all the man made resources that are invested into a business for further production of goods and services. Capital includes machinery, tools, equipment etc. Enterprise is the fourth factor of production i.e. the skills and the risk taking ability of an entrepreneur to combine the other three factors of production and produce goods and services e.g. shareholder’s services.

5

J08/P2/Q3(a)

In Ghana local farmers manage small plots of land for subsistence farming. However, some have benefited by selling pineapples at an agreed, fixed price to an exporter. The exporter provides finance, training, fertilizers and machinery and even building materials for the farmers’ homes.

Q:

Identify and explain which factors of production are mentioned above.

[4]

Ans:

The small plots used for subsistence farming is a factor of production known as land that includes all the natural resources used for production. Labour comprises of all the physical and mental efforts of the workers invested into the business. The farmers that work on the crop are providing farming services which is labour. The machinery and fertilizers used are the capital i.e. all the man made resources that are invested into a business for further production of goods and services. Enterprise is the fourth factor of production involved here i.e. the skills and the risk taking ability of an entrepreneur to combine the other three factors of production and produce goods and services that is the exporter here as he provides training and finance etc.

6

J09/P2/Q3(a)

In 2007, it was reported that a trade union of post office workers feared that increased capital investment would mean more automation and job losses. The union demanded that managers allow higher wages and shorter working hours for its members.

Q:

Explain what is meant by the factors of production and identify which factors are involved in the above statement.

[4]

Ans:

All materials or efforts used in production of goods and services are resources or factors of production. There are four factors of production; land includes all the natural resources used for production for e.g. oil, coal, fish, forests etc. Labour comprises of all the physical and mental efforts of the workers invested into the business for the production of goods and services for e.g. educational and engineering services etc. Capital means all the man made resources that are invested into a business for further production of goods and services. Capital includes machinery, tools, equipment etc. Enterprise is the fourth factor of production i.e. the skills and the risk taking ability of an entrepreneur to combine the other three factors of production and produce goods and services e.g. shareholder’s services.

The factors of production involved in the above statement are labour, capital and entrepreneurship.

Unit 1

10

Basic Economic Problem

7

J10/P2/Q3(b)

Q:

Explain three factors of production that are involved in the operation of an airport. [6]

Ans:

All materials or efforts used in production of goods and services are resources or factors of production. There are four factors of production; land includes all the natural resources used for production for Labour comprises of all the physical and mental efforts of the workers invested into the business for the production of goods and services. Capital means all manmade resources that are invested into a business for further production of goods and services. Enterprise is the fourth factor of production i.e. the skills and the risk taking ability of an entrepreneur to combine the other three factors of production and produce goods and services.

Land is important factor of production involved in the operation of an airport because it is used to construct runways and terminals without which flights cannot operate so the purpose of airport cannot be fulfilled. Another factor of production involved is labour; skilled or unskilled, airport operations require workers for almost all the activities. Skilled workers such as pilots are important to run the planes and are responsible for safe travelling of the customers and other skilled workers who are responsible for the pre-flight operations. Whereas unskilled workers are important for the cleanliness of the airports, aero planes etc. The third important factor of production involved in the operation of an airport is capital which includes the equipment and machinery used at the airport without which most workings at the airport would become extremely time consuming and costly.

8

J12/P2/Q2(a)

Q:

Explain, using examples, what is meant by the factor of production called land. [3]

Ans:

The term natural resource refers to any material or substance occurring in nature which can be exploited for economic gain for e.g. agricultural area is natural resource which can be used to produce crops, vegetables and fruits etc. Resources which are not natural but man-made are known as capital. Other examples of land include coal, oil, gas, water, forests, fish, etc.

9

N12/P2/Q2(a)

Q:

Describe, with the use of examples, two factors of production.

Ans:

Labour is a factor of production that comprises of all the physical and mental efforts of the workers invested into the business for the production of goods and services for e.g. medical and law services etc. Capital is another factor that means all the man made resources that are invested into a business for further production of goods and services.

It includes machinery, tools, equipment etc.

10

N13/P2/Q2(a)

Q:

Define the factor of production, enterprise.

Ans:

Enterprise is the factor that takes the risk of bringing together and combining the other three factors of production in order to produce goods and services. Enterprise involves

[4]

[4]

Unit 1

11

Basic Economic Problem

the taking of decision on what to produce, how to produce and for whom to produce. For example shareholder’s services and partner’s services etc.

11

N14/P2/Q2(a)

Q:

Using examples, define the factor of production, ‘capital’.

Ans:

Factors of production are all the resources invested into a business for production. The term capital refers to all man-made resources that aid the production of other goods and services, for e.g. tools and equipment, machinery, furniture etc. New capital is made of existing land, labour, capital and entrepreneurship.

1.2

OPPORTUNITY COST AND SCARCITY (BASIC ECONOMIC PROBLEM)

1

J15/P2/Q2(a)

[4]

Students have to consider the opportunity cost of going to university. University graduates usually earn more than people who have not gone to university. Having more graduates influences a country’s production possibility curve. Some economists suggest that students should pay the full cost of their university courses and accommodation. Others say that the government should pay some or all of the cost.

Q:

Describe a possible opportunity cost of a student going to university.

[2]

Ans:

The term opportunity cost refers to the next best alternative forgone when making a decision. The opportunity cost of a student going to the university could be getting a job and earning a living, otherwise.

3

J06/P2/Q6(a)

Q:

Explain the terms scarcity and opportunity cost.

Ans:

Resources are inputs (materials or efforts) used to produce goods and services. All resources (i.e. land, labour, capital and entrepreneurship) are limited in their availability.

On the other hand it is human nature to keep on desiring more and more and therefore there is no limit to human desires. Due to unlimited wants and limited resources, the resources become insufficient to satisfy all the needs and wants thus leading to scarcity of resources. Scarcity of resources force individuals, firms and societies to make choices and every choice has its opportunity cost. Opportunity cost refers to the next best alternative forgone when making a choice. For example if government provides hospitals it may have an opportunity cost of schools due to its limited budget.

4

J09/P2/Q5(a)

Q:

Explain the term opportunity cost and discuss why an increase in spending on police and armed forces may result in an opportunity cost.

[4]

Ans:

Opportunity cost means the next best alternative forgone when making a choice due to scarcity of resources. Since money is a scarce, an increase in spending on police and

[4]

Unit 1

12

Basic Economic Problem

armed forces involves opportunity cost. The government could either choose to spend this money on health and education or on police and armed forces of the country. Health and education have been forgone thus the opportunity cost of spending on police and armed forces is the benefits that could be derived by spending money on health and education.

5

N10/P2/Q2(b)

Q:

Explain the nature of the economic problem.

Ans:

Resources are inputs (materials or efforts) used to produce goods and services. All resources (i.e. land, labour, capital and entrepreneurship) are limited in their availability.

On the other hand it is human nature to keep on desiring more and more and therefore there is no limit to human desires.

The nature of economic problem is that the wants of the people are unlimited whereas the resources available are insufficient to satisfy the wants are making these resources scarce As a result of this scarcity, the need to make a choice arises. Choice leads to opportunity cost as something has to be forgone when choosing another due to resources limitation. This choice will be in terms of what to produce, how to produce and for whom to produce.

6

N11/P2/Q2(a)

Q:

Why do all countries face the basic economic problem?

Ans:

All countries have a limited amount of resources whereas human needs and wants are unlimited so the resources required to fulfill these needs and wants become scarce, so the need to make a choice arises as everything cannot be produced or consumed.

Choice leads to opportunity cost as something has to be forgone when choosing another due to resource limitation. This choice will be in terms of what to produce, how to produce and for whom to produce. This is why all countries, developing or developed, face the basic economic problem because the resources available are finite.

7

N11/P2/Q2(c & d)

(c)

Define opportunity cost and explain why it is an important concept for economists.

[4]

Ans:

Opportunity cost is the next best alternative forgone when making a choice during the decision making process. Opportunity cost is an important economic principle that affects how individuals, businesses and societies make decisions each day. A consumer may want to buy both a cell phone and laptop but has budget for one only will face basic economic problem and is forced to choose any one between two desires. Selection of cell phone will have opportunity cost of laptop and vice versa. A firm desiring to advertise and open new branch may be able to do one due to limited budget and will make a choice that benefits it most and its alternative will be its opportunity cost. A government may choose between healthcare or educational expenditure and will face opportunity cost. It is important because we continually face tradeoffs and opportunity cost can

[4]

[4]

Unit 1

13

Basic Economic Problem

determine what we do, the decisions we make and how we live. It helps to make allocation of scarce resources efficient. (d)

Discuss whether a government should allocate more resources to education and health care rather than other forms of expenditure.

[8]

Ans:

Spending on education has many benefits for the economy. Higher levels of education mean a better educated and skilled workforce that is more productive. Productivity means output per unit of input here labour.

Productivity of labour =

Output Labour

This means that the demand for labour would increase so the labour prices (wage rates) would rise. This will also create employment in the economy and improve living standards along with reduction in poverty levels. This will also lead to a higher output so GDP would rise. Similarly, spending on health care would mean a healthier workforce that has more potential to work, and because of being so healthy they are more likely to miss out fewer days at work. This will again lead to increased productivity and GDP of the economy, so better living standards.

However spending on education and healthcare has a few drawbacks associated with it.

Even if education increases the productivity of the workers, if there isn’t enough demand for the workers in the market, the resulting labour surplus will drive labour prices (wage rates) down. Or if the rate of unemployment is very high, the government will have to spend huge amounts on education so other important areas in the economy can be neglected or the government might run out of funds. Moreover, spending on health care would reduce death rates and might increase birth rates so population growth rate would increase. This will increase the dependency ratio and put more pressure on the resources of the economy.

Everything has an opportunity cost involved. Because government funds are limited, it cannot be spent on all areas at the same time in order to maximize the advantages of all types of spending and minimize the disadvantages. There are several other types of expenditure that might also have a significant impact on economy, e.g. spending on transport infrastructure or housing. This would generate employment as the construction of houses would require workers or the building up of infrastructure would also need workers. This will also increase GDP of the economy.

8

N12/P2/Q2(b)

Q:

Explain what is meant by the economic problem and why opportunity cost is relevant to the allocation of resources.

[6]

Ans:

The basic economic problem is that the human wants are unlimited while resources are limited so they become insufficient to fulfill all the wants of the society giving rise to the problem of scarcity. Resources means things or efforts used in production activity and they are four i.e. Land (natural resources e.g. agricultural area), labour (human efforts e.g. medical services), capital (man-made resources e.g. machines), and entrepreneurship (risk taking).Opportunity cost on the other hand is the cost of next best alternative forgone when making a decision. Allocation of resources means distribution of economy’s scarce resource (land, labour, capital etc) in production of different goods and services on order to satisfy the needs and wants of society.

Unit 1

14

Basic Economic Problem

Opportunity cost is relevant to the allocation of resources because scarcity gives birth to the need to make a choice. Opportunity cost indicates that if resources are used for one purpose they cannot be used for the other due to their finite nature. As a result, consideration of opportunity cost can result in an efficient allocation of resources which means get best of what we have. For instance, while deciding whether we should use a piece of land for agricultural purpose to grow some crops or establish a new solar park there. A right choice is made once we evaluate the relative benefits of both options and therefore scarce resources of society can only be allocated efficiently if opportunity cost is incorporated in our decision making. Similar can be applied to labour, capital and entrepreneurship.

9

J13/P2/Q2(c)

Q:

Discuss whether more factors of production should be used to build houses.

Ans:

More resources should be used to build houses as it would allow for more houses to be build that will help reduce the number of homeless people in the country. If more houses will be built, the supply of houses will increase which will reduce the price of houses in the market and make them more affordable. Investing more factors to build the houses may also lead to improved quality of these houses. It will also generate more employment as there will be larger number of houses to be built. This will have a multiplier effect on the economy as increased employment would mean more people have the purchasing power to satisfy their needs and wants. This will increase demand and output and not only help the economy to grow as GDP will rise, but also increase the firm profits that may then employ more workers for further production and it will continue to generate more incomes in the economy.

However, if more resources are invested for the building of houses it will involve an opportunity cost as these resources could be devoted for the production of goods and services in other industries or other important areas. The land occupied by extra houses could have other purposes such hospitals or schools could be built or training centers to improve the skills and quality of the working population. The money used for construction could be used to provide the poor with the basic necessities so that the gap between the rich and the poor reduces, or could be used to subsidize firms that produce consumer goods, so that they lower prices and goods become affordable for the poor. The labour and capital could also have several other alternate uses and might help other industries to grow as well. The building of houses will destroy natural land so it may cause a lot of environmental costs, especially if the houses are already in abundance. It might also be that some resources are not suitable for building houses so they will only be wasted if still invested for construction.

Thus, more resources should only be used to build more houses as long as their net social benefits are greater than their alternatives of other important areas in the economy.

10

J14/P2/Q2(a)

Q:

What is meant by the ‘economic problem’?

Ans:

The economic problem is the unlimited wants, while the resources needed to fulfill these wants are limited. Where resources means things or efforts used in production activity and they are four i.e. Land, labour, capital, and entrepreneurship.

[8]

[2]

Unit 1

15

Basic Economic Problem

11

N14/P22/Q2(c)

Q:

Explain why scarcity gives rise to an ‘opportunity cost’.

Ans:

Scarcity is when the human needs and wants are unlimited while the resources needed to satisfy these wants are limited. Since wants are unlimited, the resources become insufficient to produce enough goods and services to satisfy these wants. As a result, the need to make a choice arises. The producer must choose what to produce and the consumer must choose what to consume. This need to make a choice gives rise to opportunity cost. The term opportunity cost refers to the next best alternative forgone, as one thing has to be left when choosing the other. Where there is a scarcity, there is a choice and every choice has its opportunity cost. If there is no scarcity e.g. in case of air, there is no need to make choice and there will not be any opportunity cost.

1.3

PRODUCTION POSSIBILITY CURVE

1

J13/P2/Q2(b)

Q:

Using a production possibility curve, explain what is meant by opportunity cost. [6]

Ans:

The term opportunity cost means the next best alternative forgone as a result of making a decision. Suppose a country produces two goods only; Good A and Good B. The maximum possible combination of these two goods that the country can produce, with the given technology and resources, is shown using the production possibility curve in the diagram below. Suppose the country is initially producing at point ‘x’ where it produces 60 units of Good A and 20 units of Good B. Good A

60

x y

40

0

[4]

20

30 Good B

The country now wishes to produce 30 units of Good B. as the diagram clearly shows, it can only produce 10 more units of Good B if it forgoes 20 units of Good A i.e. point ‘y’ hence opportunity cost is involved. More of one good cannot be achieved without letting go off some units of the other good due to limited resources.

2

J14/P2/Q2(b)

A number of economies are devoting more of their resources to the provision of health care. Due to the economic problem, this involves them having to make difficult choices.

Unit 1

16

Basic Economic Problem

Q:

Using a production possibility curve diagram, explain why choices have to be made as to how to allocate resources.

[6]

Ans:

The term opportunity cost means next best alternative forgone, when making a decision.

Since resources are limited and wants unlimited there is a scarcity of resources. Because of scarcity, all needs and wants cannot be satisfied so choice has to be made. As the diagram shows, a country, for e.g. produces only two types of products: Product A and Product B, the maximum possible combinations of two goods the country can produce within the given technology and full employment of resources is shown using the PPC.

Product A

150 100

0

120

200 Product B

The country currently produces 150 units of Product A and 120 units of product B. It wishes to increase the units of product B to 200. As we can clearly see, it will not be possible without forgoing 50 units of Product A hence, opportunity cost is involved. In order to produce more of product B, the economy will have to allocate fewer resources to the production of Product A as resources are limited.

3

J15/P2/Q2(c)

Students have to consider the opportunity cost of going to university. University graduates usually earn more than people who have not gone to university. Having more graduates influences a country’s production possibility curve. Some economists suggest that students should pay the full cost of their university courses and accommodation. Others say that the government should pay some or all of the cost.

Q:

Using a production possibility curve diagram, analyse what effect an increase in the number of graduates will have on an economy.

[6]

Ans:

Production possibility curve (PPC) shows maximum possible combinations of two goods a country can produce within the given technology and with full-employment of resources and efficiency.

An increase in the number of graduates may increase the skills and productivity of the workers. Productivity means output per unit of input here labour.

Output Productivity of labour = Labour

Unit 1

17

Basic Economic Problem

Thus, the improved quality of the labour will enhance the productive potential of the country leading to economic growth. i.e. an outward shift in PPC from AB to CD as shown in the following diagram.

Good y C A

0

B

D Good x