STUDENT INDUCTION PACK

Unit 1: Microeconomics

Topic 1 – The Basic Economic Problem

For Intermediate 2 and Higher, you should be able to:

Prelim exam

Final exam
assessment
Internal
explain the basic economic problem.
explain the meaning of scarcity.
explain with examples the meaning of opportunity cost as
it is faced by individuals, firms and governments.
describe the choices (what, how, for whom) faced by
different economic systems.
describe three different types of economic system (see also
Topic 3 in Unit 2: The Role of Government in the Economy).
classify resources/factors of production and describe their
characteristics.
explain the meaning of economic efficiency and why
countries seek to achieve it.
explain the meaning of substitution of resources.
explain the meaning of geographical and occupational
mobility of resources.
describe measures to increase the substitution and mobility
of resources.
and in addition for Higher, you should be able to:
explain how substitution of resources and mobility of
resources may contribute to improved economic efficiency.
explain the term potential output.
draw production possibility curves.
calculate opportunity costs from production possibility
figures or curves.
explain the factors which may shift a production possibility
curve.
explain the term equity.

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UNIT 1

Topic 1: The Basic Economic Problem

1 Scarcity

1.1 The basic economic problem is scarcity. In economics scarcity

means that there are not enough resources to produce all the
goods and services which consumers want. Scarcity arises because
human wants for goods and services are unlimited but the
resources required to produce them are limited.

1.2 Scarce goods and free goods. Scarce goods, also called economic
goods, are those which have a price, i.e. something has to be
sacrificed to obtain them. Free goods are those goods of which
there is enough to satisfy everyone’s wants, e.g. fresh air, sea
water. Free goods have no price. All scarce goods have an
opportunity cost whereas free goods do not.

1.3 Scarcity is not the same as shortage.

• A shortage is when the demand for a product is greater than its

supply.
• Scarcity is when wants for a product are greater than its supply.

Demand means what consumers want and can afford to buy.

Therefore if there is enough of a product to meet the demand of
those consumers who want and can afford to pay the prevailing
price there is no shortage. However the product will remain scarce
because of all those consumers who want the product but cannot
afford to pay the price.

2 Choice and opportunity cost

2.1 Because of the problem of scarcity it follows that choices have to

be made. Consumers must choose what to buy out of their limited
incomes. Producers must choose what to produce with their
limited resources. Governments must choose what services to
provide out of their limited tax revenues.

2.2 Every choice involves a sacrifice and this sacrifice is called

opportunity cost. Opportunity cost is the sacrifice of the next best

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alternative choice. For a consumer the opportunity cost of

choosing a product is the next item on his/her scale of preference.
For a producer the opportunity cost of producing a good is the
next most profitable product which could have been produced
with the resources used. For a government the opportunity cost of
providing a service is the next best service which it could have
provided with the resources used.

2.3 In economics we assume that people are rational, i.e. when faced
with a choice they will always choose the alternative that will give
them the greatest satisfaction. This involves weighing up all the
alternatives and then choosing the one that has the lowest
opportunity cost.

3 Resources: factors of production

3.1 Resources may be classified as natural, human or man-made. They

are sometimes called factors of production and are then classified
as land, labour, capital and enterprise.

3.2 Land refers to all the gifts of nature and includes not only land
itself, but also all the minerals in and on the land, the sea and
everything in the sea, the air, sunlight, etc.

3.3 Labour refers to any human effort (manual or mental), which is

directed to the production of goods or services.

3.4 Capital refers to those man-made resources which are used to

produce goods or services. Capital may be categorised as
industrial, social, private or financial.

• Industrial capital is used by firms, e.g. factories, offices, plant

and machinery, tools, vehicles.
• Social capital belongs to the whole community, e.g. schools,
hospitals, roads.
• Private capital belongs to individuals, e.g. houses.
• Financial capital is money waiting to be used to buy capital
goods. When capital goods are bought this is called investment.
(Note the difference between saving and investment!)

3.5 Enterprise refers to the decision making and risk taking of

entrepreneurs. The entrepreneur decides how many of each factor
is to be used, how they are to be combined to make the most profit
and how the work should be done. He or she also bears the risks

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caused by business uncertainties. An entrepreneur is an organiser

and a risk taker.

4 Mobility of resources

4.1 Modern industrial economies are dynamic. This means that they
are in a continual state of change. Changing consumer demands
and changing production methods mean that some industries will
be growing, e.g. electronics, finance while others are declining,
e.g. coal, shipbuilding. In such a world there is a need for
resources to be mobile – to be able to change their location or
their use. Resources which cannot change either their location or
their use run the risk of becoming unemployed.

4.2 Factor or resource mobility is the speed and ease with which a
resource can move from place to place (geographical mobility) or
can change use (occupational mobility).

4.3 In practice there are obstacles to factor mobility and to ensure that
resources are used efficiently these obstacles need to reduced.

4.4 Land tends to be geographically immobile. Its mineral wealth and

the crops it produces are commonly transported from one area to
another but the great majority of land is used where it is. For this
reason, attention is focused not so much on where it might be
used as on how.

4.5 People may become geographically and occupationally immobile.

Many factors influence people’s mobility. Willingness to move
elsewhere is determined largely by age and by family and cultural
ties. Willingness and ability to do another type of job is closely
linked to age, education and training.

4.6 Capital has varying degrees of mobility. Some capital is highly

specialised. As a result it is difficult to adapt it to other uses. Power
stations and swimming pools are examples, as also are screwdrivers
and staplers. The geographical mobility of capital is determined
largely by its size and weight. Money capital is much more mobile.
It can be moved about the world quickly and cheaply by electronic
means.

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5 Economic efficiency

5.1 All countries have the problem of scarce resources and so should
find ways of making best use of them. Best use of resources is
called economic efficiency.

5.2 Economic efficiency in the use of a country’s resources is achieved

when the following three conditions are met:

(a) when technical efficiency is achieved, i.e. when products

are produced at minimum unit cost, in other words when the
fewest necessary resources are used to produce each
product.

Example
In building a bridge, using the least amount of steel while ensuring
the bridge will not collapse. Building a bridge strong enough to
take 1000-ton lorries would be wasting steel, which could be used
for making other products.

(b) when allocative efficiency is achieved, i.e. when resources

are allocated (used) to produce those goods and services
which consumers most want.

Example
One hundred bridges could be built over the River Don in
Aberdeen in a technically efficient way, but this would be a wasteful
use of resources if consumers don’t want 100 bridges. The
resources could have been used to make products which
consumers want more.

(c) when all resources are employed. Idle resources will result
in lost output.

6 Equity

Equity concerns social justice or fairness. The aim of economic

efficiency can conflict with the aim of equity, e.g. a country with a
free-market economy could be achieving economic efficiency by
satisfying many of the wants of a few rich people at the expense of
a large number of poor people.

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7 Economic systems

7.1 All nations face the problem of scarcity, i.e. they have insufficient
resources to produce all the goods and services which their
citizens need and want. Three basic questions have to be
addressed:

• What goods and services will be produced?

• How will these goods and services be produced? This means
who will do the production and which methods of production
will be used.
• To whom will the goods and services be distributed? This
means who will consume the goods and services after they been
produced – how will it be decided who receives them.

7.2 To address these questions a nation needs an economic system.

There are three different economic systems: the command or
planned economy, the market economy, and the mixed economy.
Each has different ways of allocating resources and of distributing
goods and services to consumers.

8 The command or planned economy

8.1 All decisions about resource allocation are made by government.

The government owns the resources and directs them into the
production of the goods and services decided on. This system is
based on the principle of equity. This was the type of economic
system which used to exist in the communist countries of Eastern
Europe.

8.2 A command economy answers the three questions in the following

ways:

• What to produce? – government planners estimate what their

population need. They fix the quantity of each good to be
produced.
• How to produce? – government sets quotas for each factory and
decides how many resources should be employed in producing
the goods.
• For whom to produce? – prices and incomes are controlled so
that each citizen has an almost equal entitlement to what has
been produced.

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9 Free-market economy

9.1 The features of a market economy are:

• Resources are owned by private individuals.

• Producers are free to produce what they wish.
• Consumers have consumer sovereignty (literally meaning the
consumer is king) and rule the market, i.e. the freedom of
consumers to decide what to buy influences what producers
produce.
• Decisions are made on the basis of self-interest. Producers aim
to maximise profit. Consumers aim to maximise value for money.
• Competition exists between producers and between consumers.
• Resources are allocated by the price mechanism. Price acts as a
signal to producers. Products which consumers demand will rise
in price thus encouraging producers to supply them. Producers
will need more resources. They will attract them by offering
higher incomes to those who own them. Falling demand for
products will result in lower prices and lower rewards to owners
of resources so that they will then be encouraged to move their
resources to where the rewards are greater.

9.2 A market economy answers the three questions as follows:

• What to produce is decided by consumers.

• How to produce is decided by producers using the most
efficient methods of production in order to keep down cost so
that they can compete and maximise profit.
• To whom products is distributed is decided by the buying
power of those consumers who earn the highest incomes from
the resources which they own.

10 The mixed economy

In this system there is a private sector and a public sector. In the

private sector the price mechanism allocates resources but the
public sector, i.e. government, intervenes when the private sector
fails to produce in an efficient way the goods and services which
consumers want. In practice, all economies are mixed – what varies
is the degree of mix. Some are planned rather than free, e.g. North
Korea, while others are more free than planned, e.g. the UK.

Please note that Economic Systems is dealt with in more detail in

Topic 3, The Role of Government in the Economy of Unit 2, The UK
Economy.

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Higher only

11 Production Possibility Curves (PPC)

11.1 Production possibility curves can be drawn (in theory) for a

country or firm to show the possible combinations of goods that
can be produced.

11.2

Capital goods

Consumer goods

On the diagram above, A is the maximum amount of consumer

goods that a country could produce if all resources were devoted
to their production. B is the maximum amount of capital goods
that could be produced. The production possibility curve joins all
the possible maximum combinations of consumer and capital
goods. This maximum output is called the country’s potential
output.

11.3 Points on the curve are possible if all existing resources are being
fully and efficiently employed, i.e. if resources are being used in a
technically efficient way. If the economy is producing at a point
inside the curve then it is producing less than it could. This could
be because some resources are unemployed, or because some
resources are being used inefficiently. Points outside the curve are
not possible because the economy does not have the productive
capacity. Given that any point on the curve represents a technically
efficient use of resources, an economy still has to make the
decision about which combination of goods to produce.
Remember that to use resources in an economically efficient way,
the combination chosen must be that which satisfies most wants.

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11.4 A production possibility curve can be used to show the

opportunity cost of producing a product, e.g. the opportunity cost
of producing OD consumer goods is EB capital goods. The
resources required to produce OD could have been used to
produce more capital goods, i.e. EB.

Capital goods

Consumer goods

11.5 A production possibility curve (PPC) can also show the opportunity
cost of a change in production, e.g. the opportunity cost of
increasing the production of consumer goods from OD to OF is EG
capital goods.

Capital goods

Consumer goods

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11.6 The usual PPC curves outwards from the origin because the
opportunity cost of producing one good usually increases as more
of it is produced. This is because more resources are required to
produce each extra unit. Notice that as more consumer goods are
produced the opportunity cost in terms of lost capital goods
increases.

Capital goods

Consumer goods

11.7 If an economy’s productive capacity increases, the PPC will move

outwards and more of both goods can be produced. This is known
as economic growth This would result from an increase in the
quantity of a country’s resources, e.g. discovery of North Sea oil;
an advance in technology, e.g. the invention of the microchip; or
an increase in the efficiency of resources, e.g. training of workers.

Capital goods

Consumer goods

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