“ECONOMICS By the end of this chapter, you should be able to: Define, and give examples of sail sciences Define economies > Understand the 00 > denify the nine ent ature and scope of economics (key) concepts of 8 economics HL. Define, give examples of, and distinguish between needs and wants; goods nd services; and economic goods and free goods HL. Define opportunity cost and understand its link to scarcity and choice HL_ Explain the basic economic questions; ‘What to produce?", “How to produce?” ‘and How much to produce?” HL Distinguish between microeconomics ané macroeconomics HL. Describe, and give examples of the factors of production HL. Explain that economists ate model builders and that they employ the assumption of ‘ceteris paribus" HL Distinguish between positive economics and normative economics HL. Explain, ilustrate, and analyse production possiblities curves in terms of opportunity cost, scarcity, choice, unemployment of resources, efficiency, ‘actual economic growth and growth in production possibilities HL Distinguish between different economic systems: free market economy, planned economy and mixed economy HL Compare and contrast the advantages and disadvantages of planned and free market economies POEL SON nd1. wins Exercise 1.1 Thinking and Communi Make alist of our own, needs 2. Makealistoftheneeds that your grandparents ‘may have had when they were your age. 3. Explainthe reason for any differences between yout lists for pars 1 and 2. 4, Makealistoftheneeds ofaperson the same age a yous living in another continent, 5. Explain the reason forany differences between yout lists for parts 4 and 4 What is economics? Economics is known as a social science. This means that itis the study ‘of people in society and how they interact with each other. Other social sciences include sociology, political science, psychology, anthropology and history. As the discipline of economics has evolved, certain branches ‘of the discipline have incorporated the findings of many of these other social sciences in order to explain economic behaviour better. ‘The Earth is, to all intent and purposes, finite. This means that we only have a finite amount of resources. Since we need to use these resources ‘to produce the goods and services that we need or want, the quantity ‘of goods and services available to us is also finite. Goods are physical “objects that are capable of being touched (tangible), such as mobile phones, vegetables and cars. Services are intangible things that cannot bbe touched, such as mobile-phone repairs, car insurance and haircuts Although the resources used to produce goods and services are finite, ‘human needs and wants are infinite. Needs are things that we must have to survive, such as food, shelter and clothing. Wants are things that ‘we would like to have but which are not necessary for our immediate physical survival, such as televisions and mobile phones. Searcity exists because of the conflict between the finite resources available to the world’s population and its infinite material needs and. ‘wants. This is where economies comes in. Economics isthe socal scence that examines the way that people behave and interact with each other to overcome the problems that arise asa result ofthe basic economic problem of scarcity It should be obvious that because of scarcity, choices have to be made, ‘Therefore, we can say that economics is the study of the choices that people make in overcoming the problems that arise because resources are limited, ‘while needs and wants are unlimited. Needless to say, the choices made by ‘groups of people can have significant impact on other groups of people, and also on the environment. This must be taken into account when ‘examining economic issues. What are the costs of the choices that economic agents make? All economic agents, whether they are consumers, producers or the government, must make choices about how to allocate the scarce esotroes available to them. For erample, in Very simple terms, Consumers have to decide which goods and services to buy. Producers have to decide which products fo produce and how to produce them. Governments have thousands of decisions to make in tying to allocate the resources available to ther, Whenever a choice is made by an economic agent concerning the use of its resources, something is given up, or sacrificed. This leads us to a key economic concept, known as opportunity cost. Opportunitycost is defined as the next best alternative foregone when an economic decision is made. This may sound quite complicated but simply means that opportunity cost is what you give up in order to have something else, For example, if you decided to buy a new sweater for $30 rather than use the $30 to have a meal out, then you have sacrificed the meal ‘out. Therefore, the opportunity cost of the sweater is the meal out that you have gone without, It is not the $30, as opportunity cost is never ‘expressed in monetary terms. When we discuss opportunity cost, we can also use the word “trade-off”. When you choose one option, you are trading it off for the option you do not select. ‘Consider the example of a government with limited revenues that is faced ‘with the decision of whether to spend EUR 900 million on kindergarten {for all children aged 3-6 years old or spend that same amount of money on upgrading its military aircraft fleet. Ifit spends the money ‘on the aircraft, the opportunity cost of that decision is the kindergarten ‘education that is not available to the children. If it spends the money ‘on the kindergartens, the opportunity cost is clearly the improvements to the military aircraft. Obviously this isa very difficult decision for a _government, who will be confronted by political lobbies (special interest ‘groups) from the different sides who are trying to get the government to spend on what they feel is best for the country. This is an example of the interdependence that exists between different groups within an economy; the decisions of one economic agent inevitably impact on other agents. Consider another example of an industrial firm producing toys. At its annual general mecting, the directors must choose between spending. $150,000 on a new technology that will reduce its CO, emissions or spending that money on new machinery that will result in greater efficiency for the firm by allowing more ofits toys to be produced ‘with the same inputs. If the company spends on the technology that favours the environment, the opportunity cost would be new machinery (and the possible additional profits from producing more toys). If it spends on the new machinery, the opportunity cost would be the technology to reduce emissions (and the gains to the environment). ‘These are good examples of the dilemmas that all economic agents face when making choices ~ because resources are limited, we can’t meet our infinite wants and needs. When we decide in favour of one choice, we necessarily sacrifice something else. Trade-offs always have to be made. Again, economics studies how these choices are made. Does everything have a cost in economics? If secondary education is “free” in your country, this simply means that you do not have to pay money to get it. However, education can never be considered free because the resources that go into providing ‘education could be used for something else, and so there is an ‘opportunity cost. Let's say that someone offers you a “free lunch”, because you do not have to pay for it. However, the resources that wentNote The free market system and the planned econemy are discussedinmare depth ‘on pp. 20-22. into that lunch could have been used for something else, and so there is an opportunity cost of those resources. This is why economics is famous for the expression: “There is no such thing as a free lunch’. In economics, the only things that can be considered to be “free” are those things that are so abundant that there is no scarcity. If there is no scarcity of a good, and everyone can have as much of the good as they want, then we cal ita free good. An example of a free good might be ait, since air is everywhere around us and there is no competition for the air. We can have as much as we want. However, if we change the good to “breathable” air, then we might find that itis becoming an economic good. An economic good is one that is scarce and whose use involves an opportunity cost, Breathable air might not be free in many cities where pollution levels make it difficult to breathe, and so breathable air may bbe scarce, This leads to an important question, which is whether the current patterns of consumption and production of today’s populations are threatening air quality for future generations. This isthe issue of sustainability. To what extent are we actually threatening future generations while meeting the wants and needs of current generations? What is the basic economic problem? ‘We have already seen that resources are relatively scarce and wants are infinite, which leads to choices to be made. These choices are often expressed in terms of three questions and represent the basic economic problem: + What should be produced and in what quantities? Using these scarce resources, how many computers should be produced, how many bicycles, how much wheat and how much rilk? This has to be decided for all economic goods. + How should things be produced? ‘There are many different ways of producing things and there are different combinations of resources that may be used in production. Should sports shoes be produced by an automated production line or by manual workers? Should crops be grown with a high usage of fertilizer or grown organically? + For whom should things be produced? Should they go to those who can afford them or be shared out in some “{aix” manner? How will the total income (the national income) of the economy be distributed? Will teachers get higher incomes than nurses? Whatever the system used to allocate resources, these questions need to be answered. There are two theoretical allocation (rationing) systems — the free market system and the planned economy. In reality, all economies are mixed economies, which are a combination of the free market and planning. The extent to which governments should intervene in any economy isa constant source of debate and will be addressed throughout this course book.What is the difference between microeconomics and macroeconomics? Economics can be split up into two main areas: microeconomics and Microeconomics Microeconomics deals with smaller, discrete economic agents, such as consumers and producers, and the choices they make in response ‘to change ina dynamic werld Microeconomies looks atthe way consumers and producers come together inindividual markets. Atthe consumer level, microeconomics examines the way in which people ‘make choices about which goods and services to buy in orderto Improve their well being, given thei budget constrains. When looking at producer behaviour, microeconomics examines how firms make decisions, such as what goods and services to preduce and how to improve efficiency given theirlimited resources. Microeconomics also considers individual industes to see how producers interact and compete with each other and how governmentintervention may affect producers. Macroeconomics looks atthe factors affecting the economy as awhole, such ‘3s economic growth and the way that well beings impacted by economic growth, ‘The economic problems of unemployment (oblessness), inflaton (rising pnces across the econamy) and deflation (falling prices across the economy) are examined inmacroeconomics. Itooks atthe role of official policies, such as taxes and interest rates, in influencing economic activity. talso looks at the way that income is distributed ‘throughout an economy, Governments throughout the world, to varying degrees, intervene in ‘markets and in economies with their government policies. In terms ‘of microeconomics, there are numerous reasons why governments intervene in markets, For example, it may be to make sure that products, ‘meet certain standards in order to protect the economic well being of consumers, it may be to discourage consumers from consuming certain products, it may be to promote sustainability in the way that producers produce their products, or it may be to prevent large firms from abusing their ability to influence markets In terms of macroeconomics, governments may intervene to try to encourage businesses to produce more in order to increase Gross National Income (or Gross National Product); they may intervene to try to make the conditions in the labour market more equitable (fair) for ‘workers; they may try to reduce the level of unemployment to improve the economic well being of workers or raise taxes on high income people to achieve greater equity (fairness). ‘Throughout the course, the debate about the extent to which, governments should intervene in markets or in the economy is a key area for discussion and evaluation. What are the nine central concepts of this IB Economics course? ‘Throughout this course, we will refer to nine central concepts that ‘overarch economic issues. These will be presented in bold letters throughout the course book. Eaceees inking an Look back atthe frstfew pages of this chapterto find references tthe nine central concepts. These aren bold. Without doing any research {and without reading on!) try 0 explain what you think each of ‘these concepts means, in terms of economics.Key concept Searety Choice Seareityisa cenval canceptin economies. Scarcity refers tothe imited avalablityf economic resources relate to society unlimited emanc fr goods and services, Thus, economice may Be defines the scence that studies humsn behaviours relationship bet resources which have atemstive uses ‘ends and saree Since resources ae scarce ecanomicsisa study of choices. is clearthatnat allneeds and wants canbe satisfied This necessitates choie andthe ides oF opportunity cos, Eeanomie decison ‘makers continually have to make choices between competing sltematves.Esonomice studies the consequences ofthese choiees, bth present and futur, Efficiency Ficlency i quantabe concep, determined by the ratio of useful outputo ial mpl Alocativeefciency refers te making te best possible use of scarce resources to produce the combinations of goods and services that ae optimum for society, thus minimizing resource waste, Equity Th contrast to equality which deserbes suatlons in which economic outcomes a similar for dierent peopl or diferent socal groups equity refers tothe concep or idea of faimess. aimess isamormative concept as itmeans diferent things to diferent people. In economics, inequity isoten interpreted referto inequality which may apply tothe disibusonofinceme, weath or economic opportunity Inespectve ofeeanomie system inequity [or inequality] remains ignfcantiseue both wthin and between societies. Economie wellbeing © ®©@ ©: Ecenomic well being ia muli-dimensional concept relating othe level ofprospeiy andthe quality ofiving standards enjoyed by members ofan ezanomy includes 1 present and ture financial security + the abityto meet basieneeds + he ability to make econemie choices permiting achievementet personal tsfaction + the abiltyto maintain adequate income levels ever the long tem. “here are broad disparities in economic wellbeing both within and across nations ‘Sustainability ® ‘Sustainability in economies refers tothe ability ofthe present generation to meet Re needs witout compromising the ability future generations to meetits own needs. refers tolimting the degree towhich the economic actives ofthe current generation ceate harmful environmental outcomes. “These mightinvelve resource depletion or degradation that wil negatively affect future generations Sustainability is proving increasingly importantin all economic analysis as planetary boundaries ae pushedte the limit. ‘An understanding of he concept of changes essentalin economic. The aconomiewordisina continual tate of flax and economists must be aware ofthis and adapt ther thinking accordingly ‘Tha concept change is important bath in ecanomiethaory and inthe empirical word that economies studes.n economic theory, ecenomics focuses not onthe level ofthe variables t investigates, buton their change fom ene stuaton to another Empirically the world thatis studied by economists is always subjectto continuous and profound change at insttutional, structural, technologies, economic and sail levels Interdependence © © Consumers, fms, households, workers and governmens [alleconamie aie) intractwith each other within an nereasngly, across nations in orderte achieve economic goals. The greater ‘the level ofinteracton, the presterthe degre of interdependence. Ins higly interdependent ‘conomie wold, deislans by certain economic actors will generate mang, snd aten Unintended, ‘economic consequences for ther actos. consideration of possible economic consequences of interdependenceis essential when conducting anemic analysis Intervention ® Tnterveon in economies usually eerste governmentinvolvementinihe workings of markets While markets ate conziered the most efficient mechanism to organize economic acti, tle cften recognized that they may fall t achieve catansocetl goals, such as equity, economic well being orsustainablty Falute te achive such goals may be considered tobe suicientreazon for government intervention. Inthe real wold ther is offen disagreement among economists and policymakers onthe need rand extent of, government intervention, ‘A Table 1.1 The nine central concepts in IB Economics, IB Economics Guide (2020), International Baccalaureate OrganisationPee Exercise 1.3 A eee Foreach ofthe following headlines, work in groups to complete the table. One has been done for you as a sample {shown in red). Please note that there is no right answer just think about possible options! line Reflection ‘Which ceneral concept(s) mightbe Do you think thi ie relevant? Why? microeconomics ora macroeconomics sue wou? The carindusty is pressuring | Why do youthink fms might | Intervention definteiyrelevant Ths ie microeconomics, thegovemmenttoremove | wantfewerregulatons? | since the govemment recognises | becauseits dealing with regulation on CO, emissions, thatthe carmarketpasesa threatto_| ane group offrms, the Inbich thesis say is reducing | Me H™*PTCBABIYWARE | a srsnabily carindusty fits. make higher profs - Efficency might be relevant 25 fume tinkthatithe equations ae Firms nether counties done | removed then they wlhave lower havethe same regulations, 22 | costs and be more ecient they have anadvantege, | sustainability defritly relevant. AND Regulations ae often designesto reduce emissions a preven ciate The firms donatcareitheit | enange which will eerainly threaten emissions maybeimeacing | rie genertons tncimate change because it oes notreally afectthem. | Interdependence may be relevant asthe producersinane county ate dependenton the activites of producers in ancthercountry because theyhave fo compete wth them, President Lessinglowers | Why do you tink ower axes Micro ormacre? Income taxes to stimulate | would encourage consumers consumer spending te spend mote? The Nasarewan government | Why da youthink consumers Misroormacre? has blocked amergerbetween | needtobe protected froma ‘thetwolargest mobile service | merger? providers o protect consumers. ‘Unemploymentclimbs ois | Can you suggestiwa problems Mieroormacro? bighestrateintwo yeors. | thatmightaccuras atesut of higher unemployment? Tn2017 leading sof drinks | Whywoulds company Were ormacre? producerreportedthatit spent | spendthis much money on ‘pproximately $4 ilion (USS) | advertising? Tyo thinket on advertizing global possible advantages and disadvantages ofthis Prime Minister Comish has | Can you suggestiwa reasons Depending onthe ‘announced hat he willput | for puting tax on imported reasons forthe taf tis 12 10%tanf tex) onimported | shoes? could bea ict issueot shoes. amacroissue.Fry Note An orange that you pick off the tree in the garden to eatis not a factor of production because it is not being used te produce another good. However, the oranges that ate sold firms from an orange grove in Spain would be considered 3 factor of production because these oranges wll be used to produce orange juice for example. What are the factors of production that are used to produce goods and services? We have already established that scarcity is the fundamental problem. addressed in economics and that humans must make choices about how they are going to allocate their limited resources to meet their unlimited ‘wants and needs. But what are those “resources”? In economics, the resources used to produce goods and services are classified into four categories known as the four factors of production. Land Land includes all the resources provided by nature that are used to produce goods, It includes the soil on which agricultural produets are grown, anything that is grown on the land and used in the production of other goods, and anything that is found under the land, including oil, minerals and elements. It therefore includes all natural resources. This factor of production may be referred to as “natural capital”. Labour Labour includes all the human resources used in producing goods and services, Its the physical and mental contribution of the existing workforce to production. Labour may also be referred to as “human capital” Capital Capital, which may also be referred to as “physical capital” is the factor of production that includes all the buildings, offices, factories, machines, tools, infrastructure and technologies, and buildings that are used to produce goods and services. Anything that has been made by humans, and is used to produce a good or a service, is referred to as capital. When firms spend money on capital, this is known as investment. Entrepreneurship (management) Management is the organizing and risk-taking factor of production, Entrepreneurs organize the other factors of production ~ land, labour and capital - to produce goods and services. They may use their personal money and the money of other investors to develop new ways of doing things and new products, buy the factors of production, produce the goods and services and, hopefully, make a profit. As a profit is never guaranteed and money may be lost, this is the risk-taking part of the role of the entrepreneur,What is the methodology of economics? How do economists build models? Given the complexity of economic relationships, economists aim to simplify such relationships by focusing on a few specific factors at a time and developing a model. A model is a simplification of reality, often expressed in the form of a mathematical analysis and equations or a diagram. We use economic models as the basis for our analysis. It must be pointed out that every model that has been created by ‘economists has been specifically chosen to highlight certain factors. By definition, this means that other factors are left out, or ignored. It ‘must also be acknowledged that in order to simplify complex reality, ‘economists make assumptions. ‘This can help us to understand why there can be significant disagreement between economists. In developing their theories, ‘economists make choices about which relationships they seek to ‘examine and they make assumptions to explain what is likely to happen. ‘These choices and assumptions differ, and so we have contrasting models. In order to make predictions about how economic agents are likely to behave, economists often use the ceteris paribus assumption. This isa Latin term which means “all other things being equal”. When economists want to test the effect of one variable on another, they need to isolate the effect of the one variable by assuming that there is no change in any of the other variables. Let's consider an example. How would you expect people to behave if the price of a product such as ice cream falls? Typically, when the price of a product falls, people wish to buy more of the product because they can afford more. You will see that this is known as the “law of demand” ‘An economist would say. “A decrease in the price of ice cream leads to an increase in quantity demanded, ceteris paribus”. Its necessary to say ceteris paribus, because there are many things that affect the amount of, ice cream - not just the price. Demand for ice cream could be affected by the weather, or current trends in diets. Ice-cream sellers might lower their prices, but if there is very bad weather or a public health campaign against high-calorie foods, then people might not buy more ice cream. By saying ceteris paribus, we assume that nothing else has changed. ‘The ceteris paribus assumption allows economists to use their models to predict how people will behave What is the distinction between positive economics and normative economics? ‘There are two standard ways in which economists approach the world. Positive economics is concerned with describing and analysing ‘economic relationships and making factual and objective claims. Positive Note Inany economics course, ‘heres extensive use of economic models However in many cases, the assumptions behind the rmodels are notunderstood, fornot questioned. inthis course, we want to make ure that you are aware of competing models, and that {you can understand haw ‘he assumptions made by different ecanomists can lead diferent economic theories. You should also grow realise that when ‘economic madels are used to help people make choices, or businesses develop business plans, er governments set policies, theres often an ideological (political) bias due to the framing ofthe madelTowhatextent does the distinction between positive and normative statements cexistin other academic economics uses the scientific method by using logic to make hypotheses and then collecting empirical evidence in order to refute the hypothesis, or develop predictive models and theories. Positive statements are concerned with the facts and what actually is happening, or what will happen. They may be used to explain causal relationships. Examples of positive statements include: + The unemployment rate in Spain is higher than the unemployment rate in Austria. + An increase in income tax will cause a fall in consumer spending, + The burning of coal, natural gas, and oil for electricity and heat is the largest single source of global greenhouse gas emissions. Normative economics is concerned with how things should be, and necessarily involves subjective value judgments. A normative statement may usually be recognised because it includes opinion-based words like “should”, “ought”, “too little” or “too much”, Examples of normative statements include: + “The Spanish government has put too little emphasis on lowering unemployment.” + "Governments should increase the use of renewable energies by putting higher taxes on fossil-fuel based energy.” It is worthwhile to point out that positive statements can be true or false, and can be fact-checked. For example, a newspaper might have a headline stating that the unemployment rate had fallen to 4%, but the data might be incorrect. On the other hand, normative statements cannot bbe true or false, as they are based on subjective judgments. Even when they are correct, positive economic statements may be misleading, and can contain some normative assumptions. For example, assume that the headline about the unemployment rate is actually a fact. At first glance, this would suggest a positive outcome, as the reduction of unemployment is usually seen to be a good thing. However, ifthe unemployment rate decreased because more people were hired into low pay, part-time jobs with no job security, this might result in longer term problems and not be a good thing, on balance, Itis important to recognize that when governments develop their policies, they are using the positive economic statements and theories about what are likely to be the outcomes, but they are heavily influenced by their own values and ideological objectives. And when we judge economic policies, ‘we are also influenced by our own personal viewpoints. As noted earlier, the debate about the extent to which government should. intervene in markets or in the economy is a key area for discussion and evaluation. This is of course an area of normative economics.How can we illustrate the concepts of scarcity, choice, opportunity cost and efficiency? You will now be introduced to the first “model” that economists use, known as the production possibilities curve (PPC). This simple model may be used to illustrate the concepts of searcity, choice, opportunity cost and efficiency. The definition of a production possiblities curve is that itis a curve showing the maximum combinations of two types of ‘output that can be produced in an economy in a given time period, if all the resources in the economy are being used efficiently and the state of technology is fixed ‘The PPC for an imaginary economy is illustrated in Figure 1.1 With the current amount of scarce resources (land, labour, capital and entrepreneurship) that are available in this imaginary economy, it can produce a limited amount of manufactured goods and agricultural products. The PPC itself shows the maximum quantity of both products that can be produced; this is known as the potential output. ‘You should be able to see that the economy could produce 100 kg of agricultural products (point A), but to do so, the economy would. Nanette enes be using all of its resources and so no manufactured goods could “Figure 1.1 Production possibities be produced. Similarly, the economy could produce 1175 units of cue manufactured goods, but then no agricultural output would be able to be produced (point G). More realistically, the economy would allocate its resources to produce somewhere along the curve, for example at point f, producing 50 kg of agricultural products and 800 units of ‘manufactured goods. How can the PPC model be used? Note that the PPC model contains several assumptions ‘+ It is assumed that the economy produces only two goods. ‘+ tis assumed that the resources and state of technology are fixed, + Itis assumed that all the resources in the economy are fully ‘employed. Despite its simplicity, the PPC model is extremely useful in illustrating several key economic concepts. ‘Scarcity: This imaginary economy does not have enough resources to produce as many agricultural products and manufactured goods as it would like. The PPC illustrates this constraint. The economy cannot produce 800 kg of agricultural products and 80 kg of units of ‘manufactured goods because it does not have enough resources. We say that all the points beyond the PPC are unattainable given the current resources and state of technology.Choice: The PPC clearly shows that a choice has to be made between the two types of output that are competing for the economy's resources. If, for example, some of the workers in the economy (labour) are producing agricultural products, then they cannot be used to produce manufactured goods. So choices have to be made as to which combination of output is to be produced using which resources. Opportunity cost: Let’s say that the economy is operating at point D, with 70 kg of agricultural products and 600 units of manufactured goods It would be possible to increase the production of manufactured goods {to 800 units by shifting some of the resources away from agricultural output, but only if the economy sacrificed the production of agricultural products. To move from point D to point EF, the opportunity cost of the extra 200 manufactured goods would be 20 kg of agricultural products. Efficiency: If the economy is using all ofits resources to the fullest extent possible and operating on the PPC, we say that there is productive efficiency. The economy could of course operate at point H, making 50 kg of agricultural products and 400 units of manufactured goods, but this would imply a lack of productive efficiency, as not all resources would be working to the fullest extent possible. It could be that there are unemployed workers or factories not operating in the economy, so not all Iabour and capital are being used to the fullest extent possible. It could also mean that the economy is not making the best use of the available resources. For example, the land on which the factories are built might be used more effectively to produce agricultural output So, point H illustrates unemployment of resources, or inefficient use of resources. By using the factors of production more efficiently, the economy could move closer to the PPC, increasing its output of agricultural output and manufactured goods. Any points underneath the PPC are possible, but would indicate a lack of efficiency, and some waste of resources, A movement from any point inside the PPC towards the PPC means that more output is being produced. This is known as actual economic growth, ‘The PPC only indicates what a hypothetical economy could produce; it says nothing about where the economy should produce, or which point would be in the best interests of society. Furthermore, even though operating on the PPC indicates productive efficiency, and technically there is no waste, this is not necessarily a desirable outcome, Productive efficiency means that the economy is using all ofits factors of production to the fullest extent possible. This could well involve a rate of resource use and extraction that damages the environment and poses a threat to sustainability. This may reduce production possibilities in the future, and certainly impose costs on the future economic well being of societyWhyjis the PPC concave? In moving from point A to point B, the economy produces an additional 200 units of agricultural output at an opportunity cost of 5 kg of agricultural products. In moving from point B to point C, there is again an increase of 200 units of agricultural output, but the opportunity cost of these additional 200 units has risen to 10 kg of agricultural products In moving from point C to point D, the economy again produces an additional 200 kg of agricultural output, but this time, the economy has to give up 15 kg of agricultural products. Using the diagram, we can see that as we move the resources from producing agricultural products to producing manufactured goods, the opportunity cost increases. This accounts for the concave shape of the PPC. ‘The reason why the opportunity cost increases is due to the fact that not all the factors of production used to produce agricultural output are ‘equally suitable for producing manufactured goods. To produce the first 200 manufactured goods, some of the workers and other resources such as the land itself could be reasonably easily re-allocated to producing, ‘manufactured goods. For example, if factories to produce manufactured. goods were built on the less fertile agricultural land, then not much agricultural output would have to be sacrificed. However, to go on increasing the production of manufactured goods, the resources taken away from producing agricultural output would be less and less suitable for producing manufactured goods, and so the opportunity cost of re- allocating them would be higher. Ifthe opportunity cost were constant, with each additional unit of ‘manufactured goods costing the exact same amount of agricultural ‘output, the PPC would be a straight line (as shown in Figure 1.2) In the hypothetical economy shown in Figure 1.2, the choice of output is between oranges and lemons. In this case, we may assume that the factors of production used to produce oranges (agricultural land, climate, farming skills, machinery) are identical to those producing lemons. Therefore, to increase the production of lemons, the factors of production producing ‘oranges could be readily substituted without facing increasing opportunity costs. In moving from point A to point B, producing 1000 kg of oranges incurs an opportunity cost of 1000 kg of lemons. In moving from point B to point C, the same quantity of lemons is sacrificed, and so on. A straight line PPC indicates constant opportunity costs, whereas the concave PPC indicates increasing opportunity costs, Are the unattainable points beyond the PPC always unattainable? Remember that the PPC is drawn on the assumption that the factors of production and the state of technology are fixed. However, these can certainly change. If there is an improvement in the quality or an increase in the quantity of the factors of production, or technological range (1000 Ke! Lemons (1000 ‘A Figure 1.2 Constant opportunity costManutotored ence . Tere uke) A Figure 1.3 An increase in production possisilities Exercise 1.4 Pare ete Come up with as many different ways as you canto explain how the quality orthe quantity ofan ‘economy's factors of production could be increased or improved, ‘Now imagine that you represent the government of your country. Explain what policies you could adoptto increase the production possibilities fr your county, What possible limitations would {you face in puting your policies Ino action? advancements, then the PPC would shift outwards from PPC, to PPC, as shown in Figure 13 This is referred to as a growth in production possibilities. This could come about from hundreds of reasons. For example: ‘changes in the education system could improve the quality of labour ‘policies to increase immigration could improve the quantity and also the quality of labour + a better-educated population could develop improved technologies ‘+ new forms of energy could be found, or developed, increasing the quantity of natural resources. Unfortunately, an economy's PPC could also shift inwards if there is a reduction in the quantity or worsening of the quality of the factors of production. Wars, epidemics and natural disasters could all have a negative impact on all the factors of production, thus reducing an economy's production possibilities ee The choice of agricultural products and manufactured goods is only one ofinfnite pairs of goods that you could choose to illustate the PPC theory. The key thing is that ‘the two tems you choose would bath be using the economy actor of production In effect, they ae "competing" to use the same factors ofpreduction, and ths explains wy there is trade-off Ifthe resources ae used to produce one good, then they cannot be used to produce the other ~a trade-off mustbe made. Other examples you right see in textbooks or onthe Intemet include, + capita goods versus consumer goods + military goods versus cviian goods (often referred to using the metaphor “guns versus bute) + Good X.versus God (tis ecommended that you do netuse tis one Whenever {you draw and expisina diagramin economies, you wantto be abe to"tella story" andweave nan example. Thisis ifculto dof you ae using gener products ke ood Xand Good!) Btonee 4. Consider a hypothetical economy which produces oniytwo types of output— consumer go0és (goods used by consumes) and capital good (goods used by producers). Because resources are scarce they cannot produce as much ofeach ofthese as they woul lke, The fllowing abe ilusraes the possible combinations of consumer goods and capital goods that canbe produced ‘Combination | Consumer goods (units) | Capital goods (units) a ° T 200 8 50 180 € 100) 750 ° 150 700 E 200 °3) Draw diagram tillustrate the economy's production possibilties curve b)_ Use values from te table orthe diagram to explain the concept of opportunity cost. €) Onyour diagram, add a point" thatis inside the curve. Describe how the ‘economy is using its resources at point F. 4) On your diagram, add a point "6 thatis beyond the curve Explain why this pointis curently not attainable. #) Explain what would have te happen forthe economy to reach point G 2. Using a (new) PPC diagram, explain what would happen ifan economy experienced a devastating natural disaster. Be sure to explain your reasoning What is the circular flow of income model? Another model to illustrate how an economy might work is the circular flow of income model. This will be developed further when. ‘macroeconomics is the focus, but at this point itis worthwhile to have an ‘overview of the model, as it can illustrate the interdependence that exists between key economic decision makers. As with the PPC model, there are certain assumptions behind this model. A simple two-sector model of the economy is shown in Figure 1.4 ‘The two sectors are houscholds and firms, In this simplified model, households have two roles: itis assumed that they are the owners of all the factors of production and they are the people who buy the nation’s ‘output of goods and services, Tateanthe pence Units hey ite facts | (a asictan gars stserct 1 and use these acorsto comin facta mae produce the nation's output ‘onoods and. sernes 3) preaacton (1) ites, an tes ereteneom | esis =e {arrow 3}, and receive Firms Sonar Becca icaees ,| and services (arrow 4). [Afi 4 ose ce fone ede The red arows show how the Income flows through the ‘economy between these Wo sectors, andillustrates the interdependence between the households and fms. Households supply their factors of production to ‘the firms (arow 1) and, in ‘urn, they receive income for their factors (arrow 2). (See box atthe top ofthe next page fora summary ofthe factors of production provided and ‘the income received)‘The factors of production provided by households and payments provided by firms are shown below: Factors of production — provided ‘Payments tothe factor = provided by households, by firme Labour Wages Land Rent Capial Interest Enepreneurship Profits This very simple model contains only two sectors. It suggests that all income earned by the households is spent on domestically produced goods and services, Clearly, households and firms are not the only two ‘sectors acting in an economy and consumers do not spend all their incomes on domestically produced goods. We expand on the model by introducing three additional sectors: the government, the financial sector and the foreign sector. Consumers do not spend all their income on domestically-produced goods and producers do not pass on all their income to the domestic households. Income leaves the sector via the three additional sectors. ‘The income that leaves is known as a leakage. There are three leakages: 1. Taxes: some of the income from both households and firms goes to the government sector in the form of taxes. 2. Saving: both households and firms save some of their income in financial institutions. Examples of these include banks, stock markets and pension funds. These make up the financial sector. 3. Imports: both households and firms spend some of their money on forcign goods and services. The foreign producers that receive this income constitute the foreign sector. ‘The three sectors are also responsible for introducing income into the circular flow. The income that comes in is known as an injection. There are three injections. + Government spending, The two sector model includes only the spending by households and firms. Governments at all levels (local district councils to national governments) spend on all kinds of things including education, health care, the maintenance of law and order, infrastructure and salaries for government workers. As you will seein later chapters, governments are able to spend more than they earn in order to deliberately influence the level of leakages and injections in an economy and thereby affect the level of national income. It is important to point out that there isa category of government spending known as transfer payments that are not included as an injection into the circular flow. Transfer payments are payments to individuals that are not the result of an increase in output, They are payments for which no good or service is exchanged. Examples of transfer payments are pensions, unemployment benefits andchild allowance payments. Governments tax the income of some households and transfer this income to others through the payments As itis a transfer of income rather than income in exchange for output, this spending does not represent an injection. + Investment. The financial sector lends money to firms, which they ‘use to start up or expand their businesses by buying capital. This spending by firms on capital is referred to as investment. verment + Exports. Foreign houscholds and firms buy the country’s exports, ss injecting money into the economy. “ail Figure 1.5 shows the circular flow of income — persing ‘model with the five sectors - houscholds, Howse firms, the foreign sector, financial institutions and the government sector — taking into swung —e[ Franc account the leakages and injections, ence ug, ne | Each sector is associated with one leakage °°" pets and one injection. However, there is no h reason to assume that each sector's leakage will be equal to its corresponding injection. Fes “tena Governments are able to spend more money ino, than they earn in taxes by borrowing money (this is known as running Tons 0" 1 budget deficit). Countries can certainly spend more on imports than. coat Foreign ster they earn from their exports and experience trade imbalances. Banks lend more money than they have as savings held in their institutions. AFigure 1.5 Greuarfow of What can the four-sector circular flow of income model tell us? This four-sector model is clearly a simplification of a complex economy, but is used to illustrate some important conclusions. ‘The amount of income flowing in the circular flow can be referred to as, the national income, or Gross National Income (GND). When national income is rising, we say that the economy is growing, If national income is falling, the economy may be in a recession. ‘The economy is said to be in equilibrium when leakages are equal to injections. This means that if leakages and injections remain equal, the economy will not grow or shrink. If leakages rise, without a corresponding increase in injections, then national income will fall to a ‘new equilibrium, as there will be less income circulating. If injections rise with no corresponding rise in leakages, then the economy will grow by moving to a higher level of national income. If it is assumed that ‘economic growth is a key objective for an economy (an assumption we ‘will question later), the circular flow of income model is widely used to explain how growth can occur. This will be developed further in later chapters. ‘The model is also useful in showing the interdependence that exists between the five sectors,Ey Boone Thinking and Communication Draw your own version ofthe circular flow mode, including the five sectors, the leakages andthe injections, Using. {your diagram, explain or iluswate how a decision by the government olower household income taxes might affect the five sectors ofthe circulat flow, Let’s look at some of the ways in which households and the other sectors are interdependent: + Houscholds are dependent on the firms to pay for their labour and to provide them with goods and services, If firms cannot start up and grow to create jobs, then households will not earn money. This will affect their spending on goods and services winich will in turn harm the firms. Reduced incomes will reduce the amount that houscholds pay to the government in taxes, and it will harm foreign producers because they will not be able to afford as many imports + Households are dependent on the financial sector as a place to borrow money to pay for products that their current income does rot allow them to buy and as a place to store their savings safely. Ifthe financial institutions make it too difficult to borrow money, then they may not be able to buy houses or cars or use their credit cards to finance their spending. If the money that they can earn from saving their money (the interest) is low, then their savings will rot grow, and this will damage their ability to spend on goods and services in the future. Because the decisions taken by the financial sector affect households directly, then firms, the government, and the foreign sector will aso be affected. + Households are dependent on foreign producers to provide them with imports that they cannot get at home, or that are better and/or less expensive than the products they can buy at home. They are also dependent on foreign countries as places to travel. The incomes of the foreign producers are dependent on the ability of the country's houscholds and firms to buy their products. + Households are dependent on the government for 2 myriad of things. For example, governments provide law and order, regulations to make people's lives better and safer, education and valuable infrastructure, And clearly governments are dependent on the households to provide tax revenues to finance their expenditure. ‘The circular nature of the flow of income means that decisions taken anywhere on the cycle will have an impact on all other areas of the cycle What are rationing systems? Economics is often referred to as a study of rationing systems. Since the resources in an economy are relatively scarce, there must be some way of rationing those resources and the goods and services that are produced by them. In theory, there are two main rationing systems and we shall look at them now: What is a planned economy? Ina planned economy, sometimes called a centrally planned economy or a command economy, decisions as to what to produce, how to produce, and for whom to produce, are made by a central body, the government.All resources are collectively owned. Government bodies arrange all production, set wages, and set prices through central planning. Did you know? Decisions are made by the government on behalf of the people and, in As aresult of planning ‘theory, in their best interests problems and an emphasis ‘on industial production, there ‘The quantity of decisions to be made, data to be analysed and factors, Sencar ieee] of production to be allocated are immense. This makes central planning | consumer goods nthe USS very difficult. If one then adds the need to forecast future events and queues were apartof accurately in order to plan ahead, the task becomes almost impossible to daily life. tis estimated that achieve with any decent level of efficiency. the average Russian woman would spend two hours every day lining upto buy essential ‘economies, mainly in the USSR and China, These days, there are very few | goods, countries that rely solely on planning. In Eastern Europe, the countries of the old USSR now have clear market segments. The same is true in China, In the 1980s, almost one third of the world’s population lived in planned. What is a free market economy? Ina free market economy, sometimes called a private enterprise ‘economy or capitalism, prices are used to ration goods and services. All production is in private hands and demand and supply are left free to set ‘wages and prices in the economy. The economy should work relatively efficiently and there should be few cases of surpluses and shortages Individuals make independent decisions about what products they ‘would like to purchase at given prices and producers then make decisions about whether they are prepared to provide those products. The producers’ decisions are based upon the likelihood of profits being made. I there are changes in the pattern of demand, then there will be changes in the pattern of supply in order to meet the new demand pattern. For ‘example, let us assume that producers have been making both roller skates and skateboards and find that they are equally profitable in the quantities currently supplied. Now assume that tastes change and skateboards are seen to be more fashionable, There will be an increased demand for skateboards and a fall in the demand for roller skates. Shops: will experience a shortage of skateboards to sell and a surplus of roller skates that are not being sold. In order to rectify this, they will raise the price of skatcboards, reducing the quantity demanded, and lower the price of roller skates in order to clear the surplus. Producers, whose costs have not changed, will realise that there is now more profit to be made in producing skateboards than there is in producing roller skates and will increase their production of skateboards and reduce their production of roller skates. Resources will be moved from producing roller skates to producing skateboards. Thus, we can see that a change in the demand ‘of consumers sends “signals” that bring about a chain of events that re-allocates factors of production and makes sure that the wishes of the consumers are met. The free market system is a self-righting system. ‘When consumers and producers work to their own best interests, the ‘market produces the “best” outcome for both. As the father of modern ‘economics Adam Smith said, "Every individual... generally, indeed, neither intends to promote the public interest, nor knows how much heis promoting it... he intends only his own gain, and he is inthis... led by an invisible hand to promote an end which was no part of his intention.” ‘This is often used as a justification for arguing that there should be ‘minimal government interference in the economy. Ina market economy, itis said that resources will be allocated efficiently. However, sometimes it takes a long time for resources to be reallocated from the production of one good or service to another. This is likely to create negative consequences for the stakeholders involved. How realistic are planned and free market economies? In reality, all economies are mixed economies. What is different is the degree of the mix from country to country. Some countries, such as ‘China, have high levels of planning and government involvement in the economy. Even in the seemingly free economies, such as the USA, the UK or even Hong Kong, government intervention is very much a part of the economic system, Some degree of government intervention is, deemed essential, since there are some dangers that will exist if the free market is left to operate without interference, Some of the disadvantages of pure free markets and planning are shown in Table 1.2. Dissdvantages of pure free markets Disadvantages of planning Demet goods (things that are bad er people, such as drugs or child prsttution) willbe overprevided, driven dyhigh pices and thas ahigh poitmative Tota producto, investment, rad, and consumption, even ina mall economy, ar too complicated plan efficiently and there be misallocation oftesources, shortages and supluses. Ment goods [things that are good for people, such as education and heath care) willbe underptevded since they willonly be produced fr those who cn afford them and ntforal people Resources may be ured up oo quicly snd the environment may be damaged by polation, as fms seek to make high prfts anda ‘Because there i no prise systemin operation, resources wilnot be used efcently Abizary decisions willnat be abe to make the bestuseofresources. Incentives tend tobe distorted Workers wih guaranteed employment and managets who gain no share of pros ate feu to motivate Output and quality may sufer ‘Some members of =ecety wil notbe able tolook afer themselves, such a orphans the sex andthe longterm unemployed, and wi “The dominance ofthe gavemmentmayleadt alos of personal liberty and reedom ofchoee. age firms may iow and dominate industies, leading tohigh prices, alossofefieieney and excessive power Governments may not share the same aims as the majority ofthe population and yet. by power, may implement plans that ae not popular orare even comupt, ‘A Table 1.2 Disadvantages of pure free markets and planning Thinking outside the box Remember that every economic madelis based on certain assumptions. Inher 2017 book, Doughnut Economies: Seven Ways to Think ike @ 24st-Century Economist, Kate Raworth ofthe University of Oxfra's Environmental (Change Institute, provides compeling challenges tothe assumptions presented in the standard circular flow of Income model Atthe raat ofher argumentis the idea thatthe circular flow of income model focuses only on L ‘economic growth 2s the key economic goal. Her analysis shows how the preoccupation with economic growth is ‘the cause ofthe growing social and economic inequalities and massive environmental challenges facing the global community ‘She points out four clear laws related tothe assumptions. ofthe circular flow model: (hips: kateraworth com/2012/07/23/whg ts time-to-vandalize-the-economic- textbooks/] 3Pee lassumes that the economy is independent ofthe environment, witha closed flow ofincome cycling between the five sectors. There is noreferencetto the ‘energy and natural materials tha are necessary for economic activity, and there is no understanding of the environmental treats such as climate change involved in using the energy and other natural resources. Later, you wll se that economists do tyto account forthe costs tothe environment in treating the consequences as something known as “externalities” However, Raworth points out that this type of analysis ‘weats the negative consequences as extemal side effects of economic activity and argues that this thinking a key reason forthe threats to sustainability We are facing As Raworth says, How can t make sense to treat the fundamental resource on which al life depends as a factor external tothe system?" The circular flow of income model includes only incomes that are pai for (ronetized) in formal markets ~such as incomes pat teaches, factory workers, shop workers o bankers. ignores the fact ‘thatthe monetized economy would not function without the unpaid work ofthe “care economy” This includes allthe services provided by parents and cares (largely women) in having and raising chien, ‘managing households, looking after sick people so thatthey ean return ta work and looking afte elderly people. In many lowrincome counties, where people can" afford necessities and governments are unable to provide things which people in richer counties take for granted, such as water supplies, heating materials and food, lions of women and gts spend hours walking miles each day caring huge loads of water, {ood or rewood on ther heads, often with child con their back Al his work done inthe unpaid ("non- monetized") sectors everywhere inthe words ignored inthe ctcuae flaw model. And as Raworth says," we ignore, we ignore many oflifes most valued goods and services, and misunderstand the working Ives of manyaf the wos women” Relatedto the previous point, there are further kinds of non monetized resources and work that are very significantto the working ofthe economy, The ircula flow of income assumes that all work done is compensated forby income received and al natural resources ae exchanged in markets. However, 9 great deal of workis done for objectives not related tearing anincome. This includes all the voluntary work that contributes tothe functioning ofa society, it includes all te work done to contibute tothe word's ‘sharing of knowledge and information, including the common pool af information on the Internet (for ‘example, Wikipedia). Rowarth refers tothe results ‘ofthis non-menetized work as “the commons", and defines its “the shareable resources of nature or society’ that we can all use without eying on a {government or a firm to provide them. The “commons” also includes the natural resources, such asthe sea, that are not formally owned, but which are used fr ‘economic activity 4. Inthe circular flow ofineome, firms pay wages, rent, profit and dividends to households In the “real world the majority of people receive comparatively low wages in comparison tothe very large rents and dividends which goto the relatively fewer wealthy people whe can afford to own land and capita, This has given ise to troubling powerimbalances and growing Social and economic inequalities both nationally and internationally that cannot be ignore. George Monbiot summarizes the criticisms of the circular flow: "i depicts a closed flow of income cycling between households, businesses, banks, government and trade, ‘operating in a social and ecological vacuum. Energy, materials, the natural world, himan society, power, the wealth we holdin common ... all are missing fom the ‘model. The unpaid work of carers — principally women —is Jgnored, though no economy could function without ther.” (he Guardian, 12 April 2017) ‘ne ofthe principal uses ofthe circular flaw modelis to ‘analyse how the economy ean experience economic ‘growth, and t's usually assumed thatthe primary ‘objective of any economy should be to achieve economic ‘growth. For decades, thas been assumed that economic {growth can solve all problems. However, given the massive negative consequences ofthis approach in terms of climate change and other environmental rises, along with the tremendous social and economic hardships faced bby people across the globe, there has been increasing pressure fora new approach to economic theory. Raworth believes that students of economics require 9 ‘more realistic picture” ofthe economy, She presents her ‘model, called the “Embedded Economy” (Figure 1.6) to ‘show that the economy nests within society and within the lving world. This model recognises the diverse ways inwhich the economy can meet people's needs and wants, I'shows that people are much more than simply workers supplying our labour in return for incomes to buy ‘goods and service. Instead, we are members of societies functioning within the Earth's ecosystem. The embeddedee ‘economy shows that households, the state (goverment), markets and the commons st allinterdependent in supplying and ‘consuming the things we need to meet our ‘material and non-material needs and wants ‘Aca time when we are acing tremendous ‘environmental challenges, the embeded ‘economy models valuable in demanstating thatthe ecanemy cannat be examined without considering the extent which ‘economic activity both uses up the worlds natural resources and causes possibly lneparable darnage to global ecosystems ‘A Figure 4.6 The embedded economy, Raworth (2017) oceeea Ane Read the antcle below and answer the questions that fllow: Should we be concerned about the world’s supply of helium and indium? 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Write down defintions ofthe following words, and use the information from the texto illustrate the meaning ofthe terms: 8) Searcy b) Opportunity cost €)SustainabiliyPee es Ge ees ‘The fist examination paper you will writen your final 8 Diploma Programme {economics exam willbe the essay paper, Paper 1. You wil finé more information about this paper in Chapter 32, but we introduce you tothe topichere. Paper 1 consists ofthree essay questions in total and you willbe required to answer one fofthem, The questions may be drawn from any ofthe four areas ofthe syllabus, Introduction to Economics, Microeconomics, Macroeconomics and The Global Economy, Each question has apart (a), worth 10 marks, anda part(), worth 415 marks. You willhave 75 minutes to mite the essay that you choose, In par (a] youwillbe expected to define key terms, flly explain relevant theory, and illustrate the theory with an appropriate diagrams], You should explain how the diagram relates tothe theory, Donat ust stick the diagram atthe end ofthe answer: explant! Although you do not have to give examples, you may find thatit is easier to explain the theory through the real-world examples that you know and itmay also make your understanding mere clea tothe examiner, Please note that the questions do not specifically ask you to draw a diagram. However, fthere are relevant aiagrams, you would be expected to draw them ang use them as part of {your response. Some examples of possible part (a) questions are 2¢ follows: eC Note Each ofthese questions Paper 1, part (a) questions requires a diagram! Explain how an economy might experience a growth in production possibilities. [10 marks] Explain the idea of opportunity cost. [10 marks] Distinguish between constant opportunity cost and increasing marginal opportunity cost. {10 marks]