Unit 1: Fundamental Concepts in Economics

By the end of this unit you will be able to:

 define the term social science

 define, give examples of, and distinguish between, goods and services

 define needs and wants; economic goods and free goods

 define opportunity cost and understand its link to relative scarcity and choice

 explain the basic economic questions: “What to produce?”, “How to produce?”, and “How much
to produce?”

 describe the factors of production

 explain, illustrate, and analyse production possibility curves

 distinguish between microeconomics and macroeconomics; positive economics and normative

economics; private sector and public sector

 explain that economists are model builders and that they employ the assumption of “ceteris
paribus”

 explain and illustrate a basic model of an economy

 distinguish between different rationing systems

 compare and contrast the advantages and disadvantages of planned and free market economies

 distinguish between economic growth and economic development

 define sustainable development.

Vocabulary

Term Explanation
Economics Is the study of choices leading to the best possible use of scarce resources in
order to best satisfy unlimited human needs and wants.
Resources The inputs used to make goods and services.
Factors of production Resources- usually divided into four categories, land, labour capital and
enterprise.
Goods Tangible (physical) objects used to satisfy our needs and wants
Services Intangible activities used to satisfy our needs and wants.
Need Goods and services necessary for survival
Wants Goods and service we would like to have.
Scarcity Resources (factors of production) are finite and wants are infinite.
Land Physical land and the gifts of nature.
Labour Human effort

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Capital Human made resources used in production
Enterprise The skill of combining the other factors of production to produce goods and
service. Involves innovation and risk.
Allocate Share-distribute.
Opportunity cost The cost of the next best alternative forgone when making a choice.
Free goods Goods that are plentiful relative to needs and wants and therefore do not
command a price.
Economic Goods Goods that are scarce relative to needs and wants and therefore command a
price.
Values Core beliefs that shape the way we act.
Positive statement. A statement of fact.
Normative statement. A statement of opinion.
Economic growth. Changes to the size of the economy.
Economic development Raising the standard of living and well-being of people
Sustainability Leaving the same amount and quality of resources for future generations.
Command decision. Government intervention in the economy.
Equity Treating people fairly.
Equality Treating people the same.
Economic Efficiency Producing the best combination of resource with the least waste at the lowest
possible price.
Marginal The next or the last. If the marginal unit is smaller than the average the
average will fall and if it is higher the average will rise.
Assumptions The rules for a model.
Ceteris paribus An important assumption for all economic models. It means holding all things
equal. (We only change the variable we want to and hold all others the same.)
Economic cost The opportunity cost
Accounting cost The cost in money.
Resource allocation Choosing to assign factors of production to competing alternatives.
Distribution of income How much income different groups in society receive
Public sector Parts of the economy under the ownership of the government.
Private sector Parts of the economy under the control of private individuals or groups of
individuals.
Production Efficiency Refers to any point on the production possibility frontier where the maximum
amount of goods and services is produced at the lowest possible price.
Allocative efficiency Refers to the point on the production possibility frontier where the maximum
amount of goods and services is produced at the lowest price in a combination
that best meets societies need. You can’t make anyone better off without
making someone else worse off.

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What is economics?

Economics is the study of how scarce resources are allocated (shared out). Resources (factors of
production) have to be shared out because they are scarce relative to our needs and wants. There are
not enough resources to satisfy all of society’s needs and wants. Choices have to be made and
resources have to be shared. Economics explains the way our system of sharing works.

Human beings have infinite needs and wants but limited means, time and money. Therefore, they have
to choose. When you accumulate all human beings together you can say that it is not possible for
society to produce all the goods and services humans want because resources are scarce, relative to
needs and wants. This is the economic problem and it is the foundation of the study of economics.

The economic problem is that resources are limited but needs and wants are unlimited. This means that
we have to choose which resources we use.

Another way of saying this is that means (time, money and skills) are limited but wants are unlimited
therefore we have to choose.

Economics therefore is the study of choices leading to the best possible use of scarce resources in order
to best satisfy unlimited human needs and wants.

This gives rise to the three basic economic questions.

1. What to produce?
2. How to produce?
3. For whom to produce?

What to produce- all economies must choose what particular goods and service and what quantities of
these goods and services they wish produce.

How to produce-all economies must choose how they combine resources to produce. They can for
example choose to be labour intensive or capital intensive.

For whom to produce-how are the goods and services distributed among the population.

The first two questions relate to resource allocation whilst the third relates to the distribution of
resources and income.

Questions

1 Define what is economics

Economics is the study of how rare and limited resources are shared out, and is the study of
choices leading to the best possible use of scarce resources order to satisfy unlimited human
needs and wants.

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 2 Use the word scarcity to explain why choices have to be made.

Scarcity means rare and limited. Resources and goods are limited, while human needs and
wants are unlimited. Therefore, we have to makes choices.

3 Outline the three basic economic questions.

What to produce?
How to produce?
For whom to produce?

As previously stated resource are inputs used to produce goods and services. They are known as factors
of production and divided into four categories. These are land, labour capital and enterprise. Land
includes physical land as well as gift of nature like naturally occurring resources- oil and gas etc. Labour
is human effort, both physical and mental. Capital consists of human –made resources (factors of
production) used to create goods and services. Examples could include machinery in a factory, roads
and harbours… Enterprise is the special skill some human beings possess to combine the other three
factors of production to produce goods and services. This requires innovation but always carries the risk
of failure.

A further note on capital.

Sometimes the term capital is used in different seemingly unrelated contexts. But when you look at
them carefully you will see that they all relate to the basic meaning of being human produced resources
employed I the production process. Therefore, our description above refers to physical capital. Human
capital is human skills and knowledge related to a productive process. Natural capital or environmental
capital expands the definition of land to include the whole biosphere. Financial capital refers to
investments in stocks and bonds- that money is then employed in the productive process.

Questions
4 Define each of the four factors of production.

The factors of production are land, labour capital and enterprise. Land includes physical land
as well of nature like resources for an example, oil, gas, etc. Labour is work that includes
both physical and mental work of humans. Capital consists of human made resources used
to create goods and services.

5 Some countries favour labour intensive production and others capital intensive production.
Why do you think this is and what advantages and disadvantages do both methods have?

Labour intensive production:

Advantages

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  Staff(labour), unlike machinery can be used flexibly to meet changing levels of consumer
demand, e.g. temporary workers.
 Can provide a ‘personal touch’ and be more in-tune with customer needs and wants.
 Can provide tailor made products / services for different customer needs and wants. Machinery
is not flexible enough to provide custom made products / services for individual customers.
 Labour can provide feedback, that provides ideas for continuous improvement. Workers can
adapt to introduce new ideas.
 Labour is always required to takeover in any event of breakdown of machinery.

Disadvantages
 Relatively expensive in the long-term when compared to machinery – higher per unit costs due
to lower levels of productivity.
 Relatively inefficient and inconsistent levels of effort.
 Labour relation problems, e.g. may go on strike.
 There could be a shortage of skilled labour, unlike machinery.
 Problems in personal life could easily affect the performance at work.

Capital intensive production:

Advantages
 Reduces human error – more accurate production.
 Greater speed (efficiency) and uniform effort / output.
 Technical economies of scale – increased efficiency which could reduce average cost.
 No problems with labour shortages / planning labour.

Disadvantages
 Initial high costs of investment and possible training costs.
 Lack of flexibility in responding to a change in demand. In contrast, labour can be used flexibly,
e.g. using temporary workers.
 Machinery lacks initiative, e.g: it is unlikely to be innovative, provide ideas on how to improve
production or take on extra responsibilities.

(source: http://www.economicsguide.me/?page_id=986)

Production is the act of making goods and services.

Productivity is the ratio of output to input. For example, if we had 100 square metres to mow, twenty
people could mow it by hand. Eight could mow it with simple machines whilst one could mow it with a
ride on lawn mower. The ratios of labour to output are therefore 20:100, 8:100 or 1:100. Clearly this is
the advantage of being capital intensive.

Opportunity Cost.
When we are spending our money or deciding what to do with our time we usually have a list of things
we want. We mentally go through the list ranking what we want and chose the best alternative. This is

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our choice. Our second choice is termed the opportunity cost. To an economist, the opportunity cost,
the cost of the next best alternative forgone, is the cost of any choice we make.

Consequence.
When we make a choice there is also a consequence. This is something that arises from our choice. It
should not be confused with opportunity cost. The example we used in class was if we choose to eat
chocolate instead of the next best alternative broccoli, broccoli is the opportunity cost. A consequence
might be that we put on weight! Another theme that occurs in economics is the unforeseen
consequence.
Example
Bob has only $10 to spend. He could buy fish and chips, drinks, topping up his phone or downloading
some music videos. He ranks his choices mentally as follows.

1 Download
2 Phone top up.
3 Fish and chips
4 Drink.
His choice is the download. It costs him the phone top up. This is the opportunity cost as it is the next
best alternative forgone. A consequence of him listening to the music might be he forgets to do his
homework as he is too busy listening to the music.

Free goods and economic goods.

Some goods are free. They are free because they are plentiful relative to our needs and wants. This is
why air is a free good. The price of a good doesn’t come from how badly we need or want it but rather
from how scarce it is. Economic goods are scarce relative to our needs and wants. This is why they
command a price. The scarcer a good or service the higher the price it commands. Free goods do not
command a price because they do not have an opportunity cost. Economic goods command a price as
they have an opportunity cost.

Values.
A value is a core belief that affects our decision making. We gain our beliefs from our family upbringing,
our friends, our religion our race etc. Everyone has different influences on them and this is why so many
people make different choices.

Questions
6 Write a scenario that explains the concept of opportunity cost and consequence.
7 Distinguish between production and productivity. Ensure that you use the word “whereas’” in
your answer.
8 Distinguish between the terms free and economic goods. Ensure that you use the word
“whereas’” in your answer.
9 Explain why water is generally cheaper than diamonds.

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10 Use the term values to explain why different people and societies make different economic
decisions.

Models
In economics models are used all the time. A model is used to simplify something complicated. Human
thought and decision making is complicated. Models are used to simplify it and make it easy to
understand. Every model has a set of assumptions, these are rules for the model.

A model used to describe the economic problem is the production possibility curve. It operates on four
assumptions:
1. There are two goods or services.
2. You can switch from the production of one good to the other
3. A fixed level of resources
4. A fixed level of technology

It is a good model because it illustrates:

1. Scarcity
2. Choice
3. Opportunity cost.
And in some cases
4. Diminishing returns.

Scarcity
The graph below illustrates scarcity. The points inside the curve are possible whereas the points outside
the curve are impossible because resources are scarce

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As you move from one point to another on a P.P. Frontier there is an opportunity cost. As you move to
produce more units of pizza you have to pay for it with lost calzone production. The rate of movement
is known as the marginal rate of transformation. The straight line P.P. Curve has a constant marginal
rate of transformation. For every unit of calzone given up a unit of pizza is gained. This illustrates
opportunity cost. It shows costs as being constant

The concave P. P. Curve below is perhaps the most accurate. It illustrates each unit of robots gained
costs more and more. This illustrates how difficult it would be to shift all resources from pizza to robot
production. Some resources are after all quite specialised. Thus it illustrates increasing costs.

As stated earlier a point outside the frontier is not possible given the current level of resources unless
international trade takes place. The diagrams above illustrates how trade enables economies to
specialise in what they make best then trade to gain a level of goods and services they could not
produce themselves.

Capital versus Consumer Goods

A nation that produces relatively more capital goods will make more gains long term as their production
possibility frontier moves out further. Such is the case with Japan in 1965. It produced 1/3 capital
goods compared with the USA which produced 1/5. As a result by 1990 the Japanese curve had moved
out further.

Questions
11 How does the production possibility curve represent the concept of scarcity?
12 How does the production possibility represent the concepts of choice and opportunity cost?
13 On the first graph what is the marginal rate of transformation between points B and C.
14 According to the first graph what do two million pizzas always cost us?
15 On the second curve what does point E represent? Point F?
16 What is the cost of moving from point A-B? C-D?
17 What is happening to costs and why?

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Production Possibility for Country A

Knives Forks

A 500 0

B 400 450

C 300 700

D 200 800

E 100 1000

F 0 1100

18 Draw and full label an axis and graph the information from the table. Label each point with the
given letter.
19 Use the PP curve to explain the concept of scarcity.
21 What four assumptions are PP curves based upon?
22 This PP Curve is Concave. Explain the difference between a concave and straight line PP curve.
23 What generalisation can you make about the mobility of resources between knife and fork
production (based on evidence in the curve above.)
24 Mark a point G with 300 knives and 800 forks. How could this situation arise?
25 Mark a point Z with 250 knives and 600 forks. What does this point signify?
26 What is the opportunity cost of moving from point Z to point C? Explain.
27 What is the opportunity cost of moving from point C to point D.
28 Sketch on the graph the impact of increased technology levels in knife production.

Economics is a Social Science

Social sciences deal with human society and social relationships. Because economics deals with how
society organises the allocation of scarce resources it is definitely in this category. Therefore, we use the
social scientific method when studying it.

Step 1: Make observations of the world around us and select an economic question we want to answer.
Step2: Identify the variables we think are important.
Step 3: Make a hypothesis on how the variables are related.

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Step 4: Make assumptions so that the variables are related.
Step 5: Test the hypothesis
Step 6: Compare the predictions with real world outcomes.
As stated before models are used widely in economics Models are used to explain theories, establish
laws, simplify concepts and isolate variables. There are two common assumptions for economic model
building. The first is ceteris paribus. This is a Latin phrase meaning other things equal. It means that we
hold all other potential variables unchanged in the model apart from the ones we are examining. The
second assumption is rational economic decision making. This means we assume that individuals and
societies will act out of self-interest and maximise the amount of satisfaction they get.
Economists make both positive and normative statements. A positive statement is one of fact. For
example, 5% of the population is unemployed. A normative statement is a values based statement like
the unemployment rate is too high. Related to this economic growth refers to changes in the size of the
economy. Economic development refers to raising the standard of living and well-being of people.
Economist often disagree on how economic growth and development should come about. There are
some very common points of disagreement.
1. Sustainability-where an economy grows without leaving fewer or lower quality resources for
future generations.
2. The level of government intervention. When goods and services are provided by free enterprise
it is referred to as the market method. When it is supplied by the government it is referred to as
the command method. In mixed economies governments can provide health services, public
good as well as legislation to protect the economy or redistribute income.
3. The trade-off between equity and efficiency. Efficiency is making the best use of resources and
eliminating waste. It is producing the best combination of goods and services at the lowest
price. Equity is fairness. It should not be confused with equality. In some countries it is
considered equitable to redistribute income by taxing higher income levels at a higher rate. The
revenue provides basic services to the poor.

The three basic types of economies.

Economics basically describes different ways of rationing. Rationing literally means sharing out and
different people have different ideas about the best way of rationing. (This addresses the whole What,
How and for whom questions) The free market economy is designed to let the price mechanism do the
rationing. This means that people with more money gain access to more goods and services. Resources
are allocated according to what rewards the entrepreneur the best. Price dictates the what, how and for
who questions. A centrally planned economy allocates goods and services based upon governmental
decision making. The government owns all factors of production and so makes the what, how and for
who decisions. Non price rationing is a feature of these economies. Mixed economies have both a
public and private sector and rations with a mixture of price and non-price rationing. The what, how
and for who questions are made by both the price mechanism and the government.

29 Complete the table below

Criteria Market Economy Centrally Planned (Command) Economy

Who makes the In a market economy, the producer gets
economic to decide what to produce, how much
decisions to produce, what to charge customers
for those goods, and what to pay
employees.
In a centrally planned economy,
major economic decisions are made by
a central authority.
(source:

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How are goods
and services
rationed?
How is income
distributed?
Describe how the
what, how and for
whom questions
are answered.

30 What are the advantages and potential disadvantages of each type of economy?

Questions
31 Define ceteris paribus.
32 Define rationality in the economic context.
33 Define sustainability.
34 Define the command method.
35 What is the difference between equity and efficiency? (Use the word whereas in your answer)

Read the following

A spokesman from the labour department said that unemployment has reached 7% of the population.
This is according to leading politicians unacceptably high. It does however provide incentives for firms
to expand production to fully utilize resources. A government spokesperson said that it is the task of
government to ensure that unemployed people had the support they needed. This should include a
living wage, the opportunity of retraining and support with housing. Opposition politicians said that the
market and not the government should decide on these outcomes.

36 Find examples of normative and positive statements.

37 Find examples of market and command interventions.

38 Is there an equity/efficiency trade off evident in this article-explain

How to prepare for the unit assessment

To be ready for the assessment for this unit you need to ensure you have covered to following.
1 Check each achievement objective. Do you understand what it means and can you articulate in
your own words?
2 Have you memorised all the definitions? It is important that you can give the correct definition
for the correct.
3 Practice using the DEDE process shown below.
4 Predict the types of question you are likely to be asked from the learning objectives.

The first test will be in the style of paper 1 which is compulsory for both SL and HL. The paper always
consists of two essays, a ten mark and a fifteen-mark essay. For this assessment we will focus upon the

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ten-mark essay. For this essay you will be given a title. To score well you should adopt the following
phrase: DEDE

D Define the key terms, clearly and explicitly.

E Explain the key concepts.

D Draw diagrams (connect to the essay and include figures or data).

E Example (Use real world appropriate examples).

Marking Key for Section A and B 10 mark essays.

Level Level Descriptor Marks

0-10
0 The work does not reach a standard described by the descriptors below.
1 There is very little understanding of the specific demands of the question. 1-3
Relevant economic terms are not defined.
There is very little knowledge of relevant economic theory
There are significant errors
2 There is some understanding of the specific demands of the question. 4-6
Some relevant economic terms are defined.
There is some knowledge of relevant economic theory
There are some errors.
3 There is understanding of the specific demands of the question. 7-8
Relevant economic terms are defined.
Relevant economic theory is explained and defined.
Where appropriate, diagrams are included and applied.
Where appropriate, examples are used.
There are few errors.
4 There is clear understanding of the specific demands of the question. 9-10
Relevant economic terms are clearly defined.
Relevant economic theory is clearly explained and defined.
Where appropriate, diagrams are included and applied effectively.
Where appropriate, examples are used effectively.
There are no significant errors.

Practice

Explain why economies have to make choices about the goods and services that they produce.

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