Student name: Teacher:

Unit One: An Introduction to Economics

“Who gets what and what are the
consequences?”

Does every choice result in an opportunity cost?

Is the method of resource allocation prescribed by a planned
economic system the best response to the problem of scarcity and
an approach that will promote sustainability?

1
 Contents

Key concepts for the IBDP Economics course, benchmarks Page 1-6
(syllabus strands), sentence starters

Economics as a Social Science and Economic Methodology Page 7-12

The Problem of Choice (FOP, the basic economic problem, , Page 12-17
opportunity cost)

The Problem of Choice: (production possibility curve model) Page 18-22

The Problem of Choice (economic systems) Page 23-32

The Evolution of Economic Thought Page 33-47

Approaches to learning Page 48-49

Notes Page 50

2
Key concepts Understanding their relationship to the course

Scarcity The central concept in economics is scarcity and this refers to the limited
availability of economic resources relative to society’s unlimited demand
for goods and services. Thus, economics is the study of how to make the
best possible use of scarce or limited resources to satisfy unlimited
human needs and wants.

Choice Since resources are scarce, economics is the study of choice. Not not all
needs and wants can be satisfied; this necessitates choice and gives rise to the
idea of opportunity cost. Economic decision-makers continually make
choices between competing alternatives, and economics studies the
consequences of these choices, both present and future.

Efficiency Efficiency is a quantifiable concept, determined by the ratio of useful

output to total input. Allocative efficiency refers to making the best possible
use of scarce resources to produce the combinations of goods and services that
are optimum for society, thus minimizing resource waste.

Equity In contrast to equality, which describes situations where economic outcomes are
similar for different people or different social groups, equity refers to the
concept or idea of fairness. Fairness is a normative concept, as it means
different things to different people. In economics, inequality is often interpreted
to refer to inequality, which may apply to the distribution of income, wealth or
human opportunity. Irrespective of economic system, inequity or inequality
remain significant issues both within and between societies. The degree to
which markets versus governments should, or are able to, create greater equity
or equality in an economy is an area of much debate.

Economic well-being Economic well-being is a multidimensional concept relating to the level of

prosperity and quality of living standards enjoyed by members of an
economy. It includes:
● present and future financial security
● the ability to meet basic needs
● the ability to make economic choices permitting achievements of
personal satisfaction
● the ability to maintain adequate income levels over the long term.
There are broad disparities in economic well-being both within and across
nations.

Sustainability Sustainability in economics refers to the ability of the present generation to

meet its needs without compromising the ability of future generations to
meet their own needs It refers to limiting the degree to which the current
generation’s economic activities create harmful environmental outcomes
involving resource depletion or degradation that will negatively affect future
generations. Sustainability is proving increasingly important in all economic
analysis as planetary boundaries are pushed to the limit.

Change An understanding of the concept of change is essential in economics. The

economic world is in a continual state of flux and economists must be aware of
this and adapt their thinking accordingly. The concept of change is important
both in economic theory and the empirical world that economics studies. In
economic theory, economics focuses not on the level of the variables it
investigates, but on their change from one situation to another. Empirically, the
world that is studied by economists is always subject to continuous and
profound change at institutional, structural, technological, economic and
social levels.

3
Interdependence Individuals, communities and nations are not self-sufficient. Consumers,
companies, households, workers, and governments, all economic actors,
interact with each other within and, increasingly, across nations in order
to achieve economic goals. The greater the level of interaction, the greater will
be the degree of interdependence. In a highly interdependent economic world,
decisions by certain economic actors are likely to generate many, and often
unintended, economic consequences for other actors. A consideration of
possible economic consequences of interdependence is essential when
conducting economic analysis.

Intervention Intervention in economics usually refers to government involvement in the

workings of markets. While markets are considered the most efficient
mechanism to organize economic activity, it is recognized that they may fail to
achieve certain societal goals, such as equity, economic well-being or
sustainability. Failure to achieve such goals may be considered sufficient
reason for government intervention. In the real world, there is often
disagreement among economists and policymakers on the need for, and extent
of, government intervention. There is a considerable debate about merits of
interventions versus the free market.

Benchmarks (Learners should be ABLE TO / learners should KNOW HOW TO):

Economics as a Social Science and Economic Methodology

Define, and give examples of social sciences. AO1

Define economics. AO1

Explain the social nature and scope of economics. AO2

Distinguish between microeconomics and macroeconomics. AO2

Identify the nine central (key) concepts of IB economics: scarcity, choice, efficiency, equity,
economic well-being, sustainability, change, interdependence, intervention AO1

Distinguish between positive economics (use of logic, hypotheses, models, theories, empirical
evidence, refutation) and normative economics (role of value judgements) in policy making.
AO2

Explain the meaning of equity and inequality within the context of normative economics. AO2

Explain that economists are model builders and that they employ the assumption of “ceteris
paribus” when developing economic models. AO2

The Problem of Choice

Describe, and give examples of, the factors of production. AO1

Define, give examples of, and distinguish between needs and wants; goods and services, and
economic goods and free goods. AO1, AO2

Define opportunity cost and explain its link to scarcity and choice. AO1, AO2

Explain the basic economic question; “What to produce?”, “How to produce?” and “How

4
much to produce?” Link to scarcity to sustainability. AO2

Distinguish between different economic systems: free market economy, planned economy and
mixed economy and the means of answering the economic questions: market versus
government intervention. AO2

Explain the advantages and disadvantages of planned and free market economies. AO2

The Production Possibility Curve Model

Explain, illustrate using diagrams, and analyse production possibilities curves in terms of
opportunity cost (increasing and constant), scarcity, choice, unemployment of resources,
efficiency, actual economic growth and growth in production possibilities. AO2, AO4

Explain the assumptions that underpin the PPC curve model. AO2

Economic Thought

Explain the basic ideas of Adam Smith (18th century). AO2

Explain the meaning of laissez-faire economics (18th century). AO2

Explain the evolution of classical microeconomics and macroeconomics thinking through the
nineteenth century (including Says law and Marxist critique of classical thought). AO2

Explain the perspective of Keynesian economics (20th century). AO2

Explain the perspective of monetarist/new classical economics (20th century). AO2

Explain the growing role of behavioural economics (21st century-increasing dialogue with
other disciplines such as psychology). AO2

Explain the concept of a circular economy (21st century-increasing awareness of the

interdependencies that exist between the economy, society and environment and the
compelling reasons for moving toward a circular economy). AO2

Link to chapter/s in student textbook (Blink): Chapter 1 (foundations of economics)

Using Academic Sentence Frames to help you with your writing

INTERPRETING IDENTIFYING CAUSE & EFFECT

✓ The concept of teaches us that ✓ ______ was caused by ……
___________. ✓ The most likely reason for …….was
✓ It really means that ….. because ….. …….
✓ That wasn’t caused by …… because
SEQUENCING ✓ The effects of ______ were …….
✓ ______ was a result of …….
✓ In the first stage/phase, ….
✓ The …...led to…., which then led….
✓ Consequently the _____ began to …..
✓ The change resulted in …..
✓ Following this,......
✓ Following this.......
✓ After….the next step is/was to …..

5
COMPARING/ CONTRASTING ANALYZING
✓ Notice how the two are similar in that ______ and yet ✓ The relationship between
are different and_____ is
✓ At first glance, and may seem ✓ This is important/significant because….
similar; however, ✓ There is a pattern that emerges when
✓ On the one hand we have ; on the other we look at….
hand, we have ✓ Given the evidence, we can deduce that
✓ In the case of , we could argue …..
that_____________. ✓ _________ can be distinguished from
✓ They are similar because ……… _________ based
✓ One similarity between ______ and _______ is on……..
_______. ✓ After a thorough analysis of the
✓ ________ and _______ are similar because they evidence, we can conclude that
both…….. ……….
✓ There is an important difference ……. ✓ This means that..
✓ On the other hand, ……… ✓ _________ is related to
✓ The two differ because one ……. while the other …. _________based on …..
✓ _______ and ______ are different because while ✓ One reason that ..
_______ is ______, _______ is ……..
✓ Whereas ________ is ………., ______ is ……..

JUSTIFYING SOLVING PROBLEMS & EXPLAINING

✓ I have several reasons for arguing this position: SOLUTIONS
✓ A further point is …. ✓ We need to ……
✓ Although not everybody would agree with my ✓ I think that the answer is ______
position, I …. because …..
✓ Even though the issue has two sides, I think I have ✓ In order to solve this problem we must
shown that ….. first ….
✓ Some argue that …. Though we can easily see ✓ We need to identify…..
That….because…. ✓ First, ….
✓ After looking closely at both sides of the issue and ✓ The solution to this problem is ….
the evidence, we can see that ….. because ✓ The solution to this problem requires….
✓ It is also vital to consider ….. ✓ A critical element of the solution to this
✓ Then again…. problem is….
✓ That is a good point, but I think the evidence shows
that …. EXPLAINING
✓ Based on the evidence, we should ….because… ✓ This means that..
✓ We have a duty to ….. ✓ As a result..
✓ Therefore..
✓ This results in...
✓ This causes..
✓ So..

SUMMARIZING, SYNTHESISING & INFORMING EVALUATING/DISCUSSING

✓ On the whole…. ✓ But
✓ The advantages of _____ outweigh the disadvantages ✓ Despite this ...
of _______ in so far as….. ✓ Therefore..
✓ The statistics are misleading because they do/not ✓ On the other hand...
show…. ✓ Unlike..
✓ These (facts/reasons/data) strongly suggest that ….yet ✓ Alternatively …
some would say that … ✓ Whereas..

6
 ✓ However …
✓ Meanwhile..
✓ Equally …
✓ Furthermore..

Contents have been drawn from Blink and Dorton 2020 and IBO teacher support materials.

Economics as a Social Science

Learning objectives:

● Define and give examples of the social sciences. AO1

● Define economics. AO1
● Distinguish between micro and macro economics. AO2
● Explain the social nature and scope of economics. AO2
● Explain that economists are model builders and that they employ the assumption of ceteris paribus when
developing economic models. AO2
● Distinguish between positive and normative economics. AO2
● Identify the nine key concepts related to the IBDP course. AO1

Task: Match the concepts/terms below to the definitions in the table and use the term in a sentence to
demonstrate your understanding.

Economics Social Science Macroeconomics Microeconomics

Ceteris Paribus Positive Economics Normative Economics Economic Models

Concept/term Definition Use the term in a sentence

A science which studies people

in society and how they interact
with each other.

A Latin expression meaning

“other things being equal”.

The study of the behaviour of

individual consumers, firms and
industries, and the
determination of market prices
and quantities of good, services
and factors of production

A social science that studies

human behaviour as a
relationship between ends and
scarce resources which have
alternative uses.

The study of aggregate

economic activity. It investigates
how the economy as a whole
works.

7
 This deals with areas of the
subject that are open to
personal opinion and belief.

Used to simplify relationships

and explain the links between
different variables by focusing
on a few key factors.

Economics is classified as a social science and uses scientific methods to investigate social life. The
social sciences also include anthropology, psychology, sociology, and political science.

Social science Economics and Economists

A science which studies people in society and how The social science that examines the way that
they interact with each other. The study of people behave and interact with each other to
institutions, functions, relationships and the overcome the problems that arise as a result of the
organization of human society is the focus. Data is basic economic problem of scarcity.
collected to establish patterns and create .
hypotheses which are then tested in order to create Economists: Study how choices are made
theories about human behaviour. between competing/alternative uses for resources
Their job is to advise others on how best to allocate
scarce resources to make goods and services to
satisfy as many wants as possible/in a sustainable
way (in some cases). Then it is possible for people
to be better off and enjoy a higher standard of
living.

Microeconomics Macroeconomics

Looks at the way consumers and producers come Looks at the factors affecting the economy as a
together in individual markets. At the consumer whole, such as economic growth and the way that
level, microeconomics examines the way in which well being is impacted by economic growth.
people make choices about which goods and
services to buy in order to improve their economic
well-being given their budget constraints.

When looking at producer behaviour, Examines the economic problems of

microeconomics examines how firms make unemployment (joblessness), inflation (rising prices
decisions, such as what goods and services to across the economy) and deflation (falling prices
produce and how to do so efficiently, given their across the economy).
limited resources.

Considers individual industries to see how Examines the role of official policies, such as taxes
producers interact and compete with each other and interest rates, in influencing economic activity
and how government intervention may affect and the way that income is distributed throughout
producers and consumers. an economy.

Scientific methods: Scientists will use the following method of investigation when analysing the physical
world:

8
Applying scientific methods to the social sciences

This is difficult because it is usually not ethical or possible to study the behaviour of people in a controlled
laboratory situation. It is also difficult to generalise that all people will behave in a certain way, unlike
chemicals would. Therefore, economists usually use phrases such as `this is likely to happen' rather than
`this WILL happen'. Economists will, nevertheless, apply the rigour of the scientific method when
investigating the workings of the economy.

Ceteris paribus The assumption that all other variables within an economic model remain constant
when just one change is being considered. By making this assumption, it makes it
very much easier for economists to explain clearly how the economy works. EG
when explaining the effect of changes in price to changes in either demand or
supply as a result of changes in one variable at a time (eg the impact of advertising
only on demand, not advertising and a change in income together).

Economic models

Economists use theories and models to make sense of the complexity of the social world.

Models

1. Used to simplify relationships (eg between households and firms) and explain the links between
different variables by focusing on a few key factors.

2. It is often expressed in the form of a mathematical analysis and equations and/or in a diagram.

3. In simplifying reality, assumptions are made.

4. Different economists made choices about what to include and leave out of models which leads to
debate amongst them and causes different models to arise.

9
Positive and normative economics

Economists will use two approaches in their discussions about economic phenomena.

Positive economics Normative economics

Deals with scientific or objective explanations of Is concerned with describing what ought to be.
the economy. It describes and analyses economic Such statements will include a subjective value
relationships and makes factual and objective judgement - a personal opinion. (e.g. ‘the
claims (e.g. the when price falls, quantity government has a duty to provide for the poorest
demanded rises). Scientific methods are then people in society’).
applied by using logic to create hypotheses,
empirical evidence is then collected so the
hypothesis can be tested and then accepted or
falsified/refuted.

Many economists are more interested in the normative side of economics and want to find answers to
questions such as `How best can pollution be dealt with?' and "Should society help the poor?'.

Government policy: Usually grounded positive economics and theories as to what likely outcomes will be
although decision re policy are heavily grounded in an elected governments values and ideology. Degrees
of government intervention in economies are contained within the realms of normative economics.

Task: Circle P for positive statements or N for normative statements in the table below.

P N Singapore’s unemployment rate has gone down from 5% to 3%.

P N Inflation will harm the economy more than unemployment will.

P N An indirect taxation on goods and services is the best way to reduce

government budget strain.

P N The escalated trade war will result in higher tariffs and protectionism
measures being placed.

P N An oligopolist cutting prices will trigger a price war.

P N Venezuela's inflation rate will exceed 350,000% by this year.

P N The GST hike will be raised from a current 7% to a 9%.

P N Subsidising healthcare will be more beneficial than education in

increasing human capital

P N A non-regulated monopoly tends to charge the highest possible price.

P N A high GDP means a higher standard of living

10
Key Concepts in Economics

There are nine key concepts that are central to the study of economics. They are listed and explained at the
beginning of this workbook. Complete the task below and you will begin to see how true this is:

Task: With a partner, discuss the headlines listed below and fill in the table.

Headline Reflection Which central Do you think this is a

concept(s) might be microeconomics or
relevant? Why? macroeconomics
issue? Why?

The car industry is Why do you think firms

pressuring the might want fewer
government on CO2 regulations?
emissions, which the
firms say is reducing
profits.

President Lessing Why do you think lower

lowers income taxes to taxes would encourage
stimulate consumer consumers to spend
spending. more?

The Nasarawan Why do you think

government has blocked consumers need to be
a merger between the “protected” from a
two largest mobile merger?
service providers to
protect consumers.

Unemployment climbs to Can you suggest two

its highest rates in two problems that might
years. occur as a result of
higher unemployment?

In 2017, a leading soft Why would a company

drinks producer reported spend this much money
that it spent on advertising? Try to
approximately $4 billion think of possible
(US$) on advertising advantages and
globally. disadvantages of this.

Prime Minister Comish Can you suggest two

has announced that she reasons for putting a tax
will put a 10% tariff (tax) on imported shoes?
on imported shoes.

11
 Stop, reflect and make some connections

Task: Using any of the concepts from the list in the tables below, answer the three conceptual questions
by creating 3 statements that sum up what you understand about this subtopic. You can use some of the
connecting words listed to help you as well if you wish.

CQ: What kinds of information do economists use to understand economic phenomena?

Concepts (you can also chose others):

Normative Microeconomics Macroeconomics Positive

Quantiative data Qualitative data

My sentence (with supporting evidence/an example):

CQ: How do economists view the social world?

Concepts (you can also chose others):

Interdependent Economics Social world/society Dynamic

Governments Connsumers Producers

My sentence (with supporting evidence/an example):

CQ: How do economists explain the relationships between different economic agents?

Concepts (you can also chose others):

Pattern Firms Households Model

Consumers Producers

12
 Connecting words:

Shapes Determines Can be May Needs Requires

Has Produces Results in Drives Structures Establishes

Causes Distorts Consists of Contains In/decreases Such as

Leads to Makes Includes Creates

The Problem of Choice

Factors of Production

Learning objectives:

● Describe and give examples of factors of production. AO1

● Define, give examples of, and distinguish between needs and wants, goods and services. AO1, AO2

Task: Match the concepts/terms below to the definitions in the table and use the term in a sentence to
demonstrate your understanding.

FOP Capital Enterprise Labour

Land Natural Source/Gift of Man-Made resource Human resources

Nature

Production Consumption Goods Services

Concept Definition Use the term in a sentence

One of the 4 FOPs, these are goods

that are used to produce other
goods. Eg. machinery, tools, etc

Land is an example of this.

The four resources that allow an

economy to produce its output: land,
labour, capital and entrepreneurship

13
 Resources that do not occur in the
natural world.

The process of combining the factors

or production to create goods or
services and satisfy consumers
wants and needs.

One of the 4 FOPs. The willingness

and ability of certain individuals to
take risks and mobilise the 4 FOPs.

Labour and entrepreneurship input

into the production of goods and
services

The human factor of production. It is

the physical and mental contribution
of the existing workforce to
production.

Physical objects.

Spending by households on
consumer goods and services over a
period of time.

Actions or activities that one person

performs for another.

The physical factor of production. It

consists of natural resources, some
of which are renewable and some of
which are non-renewable.

Factors of These are resources that are finite and their use incurs an opportunity cost. They
production are the inputs into the production process from which an output is generated (i.e.
goods and services).

Production The process of combining the factors of production to create goods and services to
satisfy consumers wants and needs.

Consumption The process through which individuals use up goods and services to satisfy wants.
Using them up may take time (durable goods) or may happen quickly. (single use
goods)1

The four factors of production

Land The natural resources/natural capital on the planet provided by nature, (‘gifts of
nature’) not only land itself but what lies under it and on top of it. (e.g. fish, oil)

1
Information drawn from Blink and Dorton, Maley and Welker, A Anderton, J Sloman
14
 Labour The human input (physical and mental) to the production process. Not all labour is
of the same quality-some workers are more productive because they have more
experience/skills or have had more training.

HUMAN CAPITAL is made up of the skills and abilities of workers that results from
investing in education and training. The greater human capital of a worker, the
greater their productivity will be.

Capital The stock of man-made resources. It includes roads, machinery, factories, schools
etc that human beings have created in order to produce other goods and
services.

An increase in the CAPITAL STOCK of a nation is called INVESTMENT.

Sometimes capital is called physical capital to distinguish it from labour/human
capital.
● Social capital: This capital is mainly owned by the state and is used to
produce g and s. (e.g. roads, govt schools and hospitals)

● Infrastructure: This is part of capital stock-it is the man made environment.

(e.g. canals, railways, airports)

Entrepreneurship Entrepreneurship refers to the special skills possessed by some people who:
/enterprise ● Organise the other three factors of production.
● Bear the risks of production and set up to trade with the aim of generating
profit from the goods/services they choose to produce.

Factor The blend of resources a country possesses which gives rise to the production of
endowment particular goods and services. The quality/quantity of factors of production differ in
particular economies. (e.g. some countries often have lots of available land and
labour but little capital stock so they may focus on producing agricultural goods).

Payment to factors of production

Land Landlords aim to maximise their rental income.

Labour Wage earners aim to maximise their wages/income.

Capital Investors aim to maximise their returns in the form of interest received.

Entrepreneurship Entrepreneurs aim to maximise their profits.

15
Goods and services

Goods Physical objects such as shoes and shirts. They are tangible (can be touched).

Services Actions or activities that one person performs for another, such as haircuts and
teaching. They are intangible.

The Basic Economic Problem

Learning objectives:

● Define, give examples of, and distinguish between economic and free goods. AO1
● Define opportunity cost and its link to scarcity, sustainability and choice. AO1
● Explain the basic economic problem questions, ‘what, how and how much to produce’. AO2

Task: Match the concepts/terms below to the definitions in the table and use the term in a sentence to
demonstrate your understanding.

Need Want Scarcity Free Goods

Economic Goods Opportunity Cost Finite Infinite

Concept/term Definition Use the term in a sentence

Goods and services that are not

necessary for survival but
individuals wish and desire for.

16
 The few things, such as air and
salt water, that are not limited in
supply and so do not have an
opportunity cost.

The next best alternative foregone

when an economic decision is
made.

Fixed in supply

Goods and services required for

the basis of survival. Eg. food,
shelter, water, etc

Goods and services that require

scarce resources to be sacrificed
in order for them to be produced

This the limited availability of

economic resources relative to
society’s unlimited demand for
goods and services.

Endless

Economics is the study of how people seek to satisfy their needs and wants by making choices.
Because people act individually, as part of groups and through governments, economists must study each
of these groups. The reason people have to make these choices is because of scarcity/the basic economic
problem.

Scarcity
Living in a country with everything you need, you may find it hard to understand scarcity. We have many
goods and services that we need.

Needs These are essential items required for survival.

Wants These are desires for non essential items (not needed for survival) and may
differ from person to person and are INFINITE-everyone wants more than they
can have.

Shortage (not to be When demand > supply. IE the production of a good or service cannot meet
confused with the demand for it/there is excess demand.
scarcity)

Scarcity/the basic A situation where there are insufficient and finite resources in the world to
economic problem satisfy human wants. This would not be a problem if:
● Resources were infinite.
● Human wants were limited.
● If all resources were free and their use did not yield an opportunity cost.

Free goods Any goods that are unlimited in supply and have no opportunity cost. (e.g.
air-although ‘clean’ air could be an economic good’)

17
 Economic goods Goods which are scarce and have an opportunity cost.

Why do people keep wanting more?

Often wants are created in our minds from:

● Pressure from peers/fashion, etc.
● Advertising.

Resource allocation

Because of the basic economic problem and because resources are finite, we are forced to make choices
about how they are used/what and how much of them we can have. (e.g. land-a limited resource-build on it
‘v’ keep it as green land for the pleasure of all) This then gives rise to an opportunity cost.

Resource allocation The way in which factors of production are distributed between/amongst
competing wants.

Opportunity cost The cost of the next best alternative foregone when a decision has to be made
about how resources should be allocated. This is called a REAL COST-it is not
expressed in financial terms but in terms of the competing alternative that was
given up.

Trade offs

All individuals, households, firms and governments make decisions that involve trade offs. Trade offs are all
the alternatives that we give up when we choose one course of action over another. For example, when we
choose to buy a TV or go on holiday. If we choose the TV, the trade off is the holiday.

Individuals Firms Government

We might decide to play football Farmers who grow onions cannot An example that shows this is the
rather than watch a movie, we use that land to grow carrots. “guns or butter” debate. If a
might want to get a job rather A factory that decides to use its country decides to produce more
than study at college. resources to produce chairs military goods, then it has fewer
cannot use the same resources resources to produce consumer
to produce tables at the same goods.
time.

Choices made about resource allocation affect others. EG governments choosing to spend more on
developing their healthcare system than on the military affects others. This is an example of the
interdependence that exists between different groups in an economy or economic agent has an impact on
others. When we think about how to use limited resources to satisfy competing wants, there are three
decisions that have to be made and different countries with different economic systems address these
questions in different ways. We will explore these later in this workbook.

18
Production Possibility Curve Model

Learning objectives:

● Explain and illustrate (using diagrams), production possibility curves in terms of opportunity cost (increasing
and constant), scarcity, choice, unemployment of resources, efficiency, actual economic growth and growth
in production possibilities (in the long run). AO2, AO4
● Explain the assumptions that underpin the PPC curve model. AO2

Task: Match the concepts/terms below to the definitions in the table and use the term in a sentence to
demonstrate your understanding.

Efficiency PPC Actual Growth Potential Growth

Constant Opportunity Increasing Diminishing Returns Consumer Goods

Costs Opportunity Cost

Capital Goods

Concept/term Definition Use the term in a sentence

A curve showing the maximum

19
 combination of goods and
services that can be produced
by an economy in a given time
period, if all the resources in the
economy are being used fully
and efficiently and the state of
technology is fixed.

The point where the benefit

gained from producing the next
unit of output is less than the
costs.

As you continue to increase

production of one good, the
opportunity cost of producing
the next unit increases.

Tangible assets used to produce

other goods/services.

A quantifiable concept,
determined by the ratio of useful
output to total input.

Growth that would be possible

when the quantity or quality of
FOPs in an economy is
increased.

As you continue to increase

production of one good, the
opportunity cost of producing
the next unit remains the same.

This occurs when previously

unemployed factors of
production are brought into use.

Items bought for consumption.

The final result of production.

Production This curve shows the maximum potential level of output possible if an economy
possibility uses all of its resources as efficiently as possible. It represents all of the different
curves/frontiers combinations of two goods at maximum production when all available resources
are used efficiently.

It is assumed that:

1. Only two goods are produced.

2. Resources are fully employed and used efficiently.

20
 3. The quantity and quality of resources available is fixed.

4. The state of technology is unchanged/fixed.

Source

This model can be applied to individuals, firms, governments or to the nation as a whole. It can be used to
illustrate the choices that have to be made between resources allocated towards the production of two
goods and the concept of opportunity cost. If more capital goods are produced when an economy is using
its resources efficiently, some of the production of consumer goods has to be foregone because resources
are finite and must be directed towards producing capital goods, away from consumer goods. It is not
possible to make more capital goods without sacrificing some of the production of consumer goods. The
amount of consumer goods which are given up is the opportunity cost.

Capital goods Tangible assets used to produce other goods/services. (eg machines, tools,
technology)

Consumer goods Items bought for consumption, the final/end result of production/manufacturing.

When the PPF/PPC is drawn, it is assumed that an economy will use all of its resources as fully and as
efficiently as possible. However, if there is unemployed labour or if machinery is lying idle, for example,
production will take place within this curve, not on the PPF/PPC.

Shifts in the PPF/PPC

An outward shift This will happen when there is long run economic growth. This occurs when:

1. The quantity of resources available for production increases. (e.g. new factories are
built-investment)

2. The quality of resources increases. (e.g. education and training will make workers more
productive)

An inward shift This will happen if an economy contracts. (e.g. coal mines become depleted,
there is a war)

21
The shape of the curve:

The curve is concave because it is assumed that not all resources in the economy are as productive in one
use compared to their next best use. (e.g. not all parts of the UK are suitable for producing wheat, they may
be better allocated to nurturing cattle). As wheat production increases, less productive land has to be used
and thus increasing opportunity costs are experienced and more and more land will be used to produce
declining harvests of wheat and causing ‘diminishing returns’ in terms of output produced. This will
create a concave shaped PPC.

Only if opportunity costs were constant would the PPC be linear.

PPC to show actual growth and potential growth

Actual (short run) ● An increase in real income/output overtime. Existing resources are used
growth more efficiently to generate this growth. Usually measured by using GDP.
(gross domestic product over a given time period)

● Illustrated by the movement from a point inside the PPC towards or onto
the PPC.

Potential (long run) ● Growth that would be possible if the quality/quantity of FOPs in an
growth economy increased.

● Illustrated by a shift in the PPC to another curve.

Task: Explain, using PPC diagrams and a real world example:

● Show constant opportunity costs in the first box.

● Label points where resources are used inefficiently, efficiently and a point where production would
not be possible given the resources available
● Show increasing opportunity costs and diminishing returns in the second box.
● Use suitable figures on the axes of both diagrams to help you to do this.
● On both diagrams, illustrate actual and increased potential economic growth.

Diagram: Diagram:

22
Explanation: Explanation:

Evaluation of the usefulness of the PPF/PPC curve model:

1. It shows a range of production possibilities/combinations for two goods if output was maximised
using a fixed amount of resources.

2. It illustrates the phenomenon of increasing opportunity costs.

3. It assumes that only two goods are produced.

4. It indicates what a hypothetical economy could produce, it does not state where they should
produce, or which point would be in the best interests of society.

5. Operating on the PPC at productive efficiency may not be optimal nor involve the sustainable use
of resources and could negatively impact economic well being in the future.

Stop, reflect and make some connections

Task: Using any of the concepts from the list in the tables below, answer the conceptual question by
creating a statement that sums up what you understand about this subtopic. You can use some of the
connecting words listed to help you as well if you wish.

CQ: Why do choices inevitably result in trade offs?

Concepts (you can also chose others):

Economics Choice Scarcity Sustainability Opportunity cost

Resources

My sentence (with supporting evidence/an example):

23
 Connecting words:

Shapes Determines Can be May Needs Requires

Has Produces Results in Drives Structures Establishes

Causes Distorts Consists of Contains In/decreases Such as

Leads to Makes Includes Creates

Economic Systems

Learning objectives:

● Explain the basic economic problem questions, ‘what, how and how much to produce’. AO2
● Distinguish between different economic systems: free market, planned and mixed economies. AO2
● Explain the advantages and disadvantages of planned and free market economies. AO2

Task: Match the concepts/terms below to the definitions in the table and use the term in a sentence to
demonstrate your understanding.

Mixed Economy Free Market Planned Economy Privatisation

Economy

Nationalisation Merit Goods Public Goods Private Sector

Public Sector Government Planning Demand Supply

Market Forces Price Mechanism Market Failure Social Costs

Social Objectives Self Interest Utility

Concept Definition Use the term in a sentence

An economy where the means of

production are collectively owned.
The state determines what/how
much to product, how to produce
and for whom to produce.

The motivation behind the

behaviour of rational economic
agents. Eg. landlords want to
maximize their rental income.

24
This is done by govt officials who
decide upon the allocation of
resources: what to produce, how to
produce and how much to produce

Demand and Supply

Economic activity in this part of the

economy is undertaken by the
government, such as the provision
of defense and public
transportations systems.

A measure of the satisfaction

derived from purchasing a good or
service.

Willingness and ability of

customers to pay a certain price in
a market to obtain a good or
service

An economy that has elements of

planning and elements of the free
market.

Negative spillover effects - costs

incurred by a third party (society) in
an economic transaction for which
no compensation is paid

Willingness and ability of firms to

provide a good or service ast a
given price, per time period

The failure of markets to produce

at the point where community
surplus is maximised.

An economy where the means of

production are privately held by
individuals and firms. Demand and
supply determined what/how much
to produce, how to produce and for
whom to produce.

The manner in which price affects

the demand and supply in a
market. Including the signalling and
rationing fucntions.

When a government takes control

of a company or industry that was

25
 previously owned by the private
sector

Economic activity in this part of the

economy is undertaken by private
firms and households

The transfer of ownership,

businesses and property from the
government (public sector) to the
private sector

Goods or services which would not

be provided at all by the market.
They have the characteristics of
non-rivalry and non- excludability.

Goals of governments that

consider the impact of
actions/policies on the community.

Goods or services considered to

be beneficial for people that would
be underprovided by the market
and so under-consumed.

Scarcity and the problem of resource allocation

All countries share the same basic economic problem. They have limited resources and populations of
people that have infinite wants. Decisions therefore have to be made about what wants to satisfy and how
this will be achieved. This is the basic economic problem which concerns resource allocation.

An economy A system of activities involving the production, consumption and exchange

goods and services. It can occur on a local, national or global scale.

An economic system This is a rationing device that determines how scarce resources are used and
is the method through which a country decides WHAT and HOW to produce,
and for WHOM.

26
There are three types of economic system:

1. The free market system

2. The planned/command system
3. The mixed system

Government intervention

Having said that there are three economic systems, in reality there is no perfect example of any of these
economic systems. In each of these economic systems, the government will intervene to differing degrees.
It could be to promote sustainability, efficiency, equity and/or economic well being at a micro or macro level.
It is the degree of government intervention that is important to recognise in deciding how ‘planned’ or ‘free
market’ a system is.

There are two sectors in any economic system, each of which can differ in size:

Public sector In this part of an economy, the government/state owns resources and engages
in the production of goods and services for their population.

Private sector In this part of an economy, private households own resources which they sell to
private firms who make goods and services that they sell back to households
hoping to make a profit from doing so. (refer back to the work on the circular flow of
income model)

All systems need to address three key questions:

1. What goods and services 2. How should goods and 3. Who should consume the
should be produced? services be produced? goods and services produced?

What economic goods and What is the best way to make Who will we produce goods and
services should be produced? maximum use of resources we services for? Only for those who
Only those that are demanded? have available to produce goods are willing and able to purchase
and services? (using workers/ them? Or allocated by some
machines? Using oil, solar other method?
power, nuclear or coal?,
produced organically or not?)

How these questions are answered depends on the emphasis placed on different economic goals which
include:

Economic efficiency Getting the most output from resources and limiting waste.

Economic freedom Freedom from government in the production and distribution of goods and
services.

Economic security Making sure that goods and services are available, payments are made on time,
and predictability and a safety net will protect individuals in times of economic crisis.

Equity Sharing resources, goods and services out ‘fairly’.

27
 Economic growth Innovation leads to economic growth, and economic growth leads to a higher
and innovation standard of living.

Other goals Eg environmental goals

As a general rule the three key questions are addressed in the following ways::

Free market economy Mixed economy Planned economy

Who Private sector firms and Private sector firms, Government

produces? households. households and the
government

What is The goods and services The goods and services that The goods and services
produced? that consumers demand. consumers demand and that the government
those which the government believes are socially
believe are socially desirable desirable and meet their
and meet their own own ideological
ideological objectives.. objectives.

How is In the most productively Using govt planning and in Using govt planning
production or efficient manner possible. the most productively
organised? efficient manner possible.

For whom? For those who are willing For those who are willing For the general public
and able to purchase and able to purchase goods who receive certain
goods and services at at particular prices and for goods and services that
particular prices. the general public who are socially desirable at
receive certain goods and subsidised prices or free
services that are socially of charge.
desirable at subsidised
prices or free of charge.

Some key terms that are associated with this topic:

Public goods Governments provide these goods. They will not be provided by private firms
because they do not generate revenue or profit as no one would pay for their use. This
is because of the ‘free rider problem’- if one person happened to pay for this type of
good, others would also benefit free of charge. They have two characteristics:
1. The consumption by one person does not reduce the amount available for
consumption by others or the quality of that consumption (they are non rival).
And:
2. All individuals can freely consume a good if they choose to (non excludable).

Merit goods These are goods that are underprovided by private firms and are under consumed.
Some provision can be profitable but to provide such goods to all of those people who
need them, the government has to step in and provide them as well, either free of
charge or at a subsidised rate. The government also provides these goods in greater
quantities as they yield benefits to all in society. (e.g. health care)

Demerit These are over provided and over consumed . (e.g. illegal drugs) The production
Goods and consumption of these goods create social costs such as crime, stress, ill health
and pollution.

28
 Private goods These are goods where consumption by one person results in that good not being
available for consumption by another (excludable) and where that consumption
reduces the amount of and/or quality of consumption for others (rival).

1. The free market system

This type of economic system is capitalist; land and labour and capital (the FOP) are privately owned. All
economic decisions are made by households and firms and it is assumed that they act in their own self
interest.

1. Owners of firms aim to maximise their profits.

2. Consumers aim to maximise their utility.

3. Workers aim to maximise their wages/income.

4. Landlords aim to maximise their rent.

This type of economy originates from the idea that the market/price mechanism is the best way to handle
economic problems. (Adam Smith-‘the invisible hand’) Producers make decisions about what and how to
produce and for whom through the market/price mechanism. Resources are allocated via the price
mechanism through the market forces of supply and demand.

Consumers Make independent decisions about what products they would like to purchase at given
prices.

Producers Make decisions about what goods and services to supply based on the likelihood of
making profit from selling them.

Price acts as a signal for firms to shift their resources out of one industry/market into another. An increase
in price is a signal that there is more profit to be had. A decrease in price is a signal that people do not
want certain goods/services anymore and that resources should be shifted/allocated elsewhere. This is the
PRICE MECHANISM. The market forces of S and D determine prices and solve the problem of how to
allocate resources.

When producers and consumers work to their own best interests, the market produces the ‘best’ outcomes
for both according to Adam Smith. He argued that all economic agents operate out of self interest (and in
so doing he argues for minimal government intervention). In a market economy it is assumed that resources
will be allocated efficiently but sometimes this ‘fails’ to happen (e.g. resources may be used up
unsustainably, production and consumption of goods may occur at levels that are not optimal for society). In
this case market failure occurs.

Advantages of the free market system Disadvantages of the free market system

Firms respond quickly to people’s wants. (i.e. Factors of production will only be employed if it is
changes in demand) profitable to do so. (e.g. this may cause
unemployment of FOP)

Firms provide a wide variety of goods and services G and s (public goods) that do not make profit will
to satisfy people’s wants. not be provided. (e.g. street lights) The government
then has to intervene to provide public goods
financed via taxation.

29
 It encourages the use of new and better methods of There may be over production and consumption
production (improved quality of g/s, innovation) to of harmful goods; demerit goods (e.g. illegal
minimise costs and increase productive efficiency drugs) so sometimes the government has to step in
to maximise profit, otherwise firms will be driven out to stop this with new laws.
of the market.

There is economic freedom. Consumers and Some g/s will be under produced and consumed
producers have free choice (e.g. to buy what they (merit goods e.g. education, vaccinations) so the
are willing and able to, to produce what they think government may intervene to address this and
will be profitable) . encourage/assist with their production and
consumption.

Theoretically, there is intense competition, so much The social effects of production are ignored;
so that no one firm dominates the market. externalises (e.g. pollution) Profit alone is the most
Consumers are offered the lowest prices as firms to important objective for firms. Resources may be
aim to produce as efficiently as possible and to used up unsustainably.
maximise profit and make best use of the use of
their resources. Consumers spend wisely to
maximise their utility, and workers are productive
to establish their own job security. This self interest
helps to solve some of the problems of scarcity.

Consumers are sovereign; they cast their The gap between rich and poor will be
spending votes (demand) to influence what g/s are evident-some have more money to purchase g and
produced. s than others and thus some will be allocated more
g/s than others.This impacts the economic
wellbeing of some.

Competition between firms is often limited. Where

perfect competition does not exist, firms (e.g.
monopolies) can increase prices and make
abnormal profits.

2. The planned/command system

This economic system is associated with socialist or communist countries where land and capital is
collectively owned. The assumption is that consumers, firms and the government are selfless; they operate
for the common good of all in society. Decisions about what, how and for whom to produce are made by the
State. Planners are employed by the government to allocate resources; decide production targets, the
distribution of income, and to plan the long term growth of the economy. They tell organisations which are
owned/regulated/controlled by the government what and how much to produce (production targets) over
fixed time period periods (eg 5 yrs).

Prices are FIXED (not determined by the forces of demand and supply). The government intervenes and
sets maximum and minimum prices which tend to be arbitrary leading to the inefficient allocation of
resources. As prices are often low, increased demand for g/s means that resources are rationed through
some form of queuing to address shortages/excess demand for g/s.

Advantages of the planned system Disadvantages of the planned system

A minimum standard of living is an objective and There is little freedom of choice. Workers can be
thus the government plans for basic goods and ‘directed’ to particular occupations or geographical
services to be accessible to the whole population. areas, consumers have little say in what is
They may decide to share things equally and so will provided, and producers are told what and how
not allow some people to try to purchase more.

30
 Thus the gap between rich and poor is narrower much to produce. Consumers do not necessarily
than in a market economy and this thus affects get the goods and services they want.
economic well being.

In theory, the social costs of production are more There is too much information for planners to
likely to be considered and minimised although handle in order to make resource allocation
negative externalities are often significant as the effective and efficient. Shortages or gluts of goods
government forces producers to focus on output, or services are common.
not the protection of the environment, etc.

There is no incentive to work hard and create

wealth as workers know that they are unlikely to
lose their jobs, and acquiring privately owned
property is not permitted.

There is no incentive for producers to increase

efficiency as often, when government targets are
met, the reward is increased targets being set for
the future.

Without competition, there is no incentive to

change, innovate and improve the quality of
goods and services.

Many countries have experimented with centrally planned economies, but most of these experiments have
failed. Most of these countries have moved to mixed economies over time.

3. The mixed economy

There is no economic system today that is purely based on central planning or the free market. In reality,
economic activity takes place in both the private and public sectors. Mixed systems are based on a market
system but have government intervention. The private and public sectors both own resources and
produce goods and services. Adam Smith tells us that governments should not intervene in economies.
However, it is important for governments to make some decisions because some wants and needs are
difficult to meet in the modern marketplace. How else could the modern marketplace provide for armies and
roads and highways?

Benefits of a mixed economy

1. A free market economy may experience periods of high unemployment (which affects economic
well being) as it may not be profitable at certain times to employ staff whereas in a mixed
economy, the government may create jobs for those that are unemployed thus the swings in this
respect are reduced.

2. The government will intervene and provide goods or services not provided by the private sector
(e.g. defence) and raise funds to do this by taxing income and spending.

3. The government will intervene and provide goods and services that they think that people should
consume (merit goods-e.g. education) for the good of all in society.

4. The government will intervene to create laws to prevent harmful goods and services from being
consumed or may discourage consumption by attaching high taxes to them. (demerit goods)

5. The government may intervene to create laws to protect society/the environment.

31
 6. The government will intervene to provide for its poorest people.2

Comparing Economic Systems

Task: Sort out the words in brackets to either die of the table below:

Free Market Economy Characteristic Planned Economy

Degree of government
interference
(high/low)
Size of public sector
(big/small)
Size of private sector
(big/small)
Who owns factors of production
(households and firms/the state)
Interests of individuals and
organisations
(self interest/to attain social
objectives)
Allocation of resources is done by
…
(government planners/price
mechanism)
Amount of competition
(low/high)
Quality of g/s
(low/high)
Variety of g/s
(broad/limited)
Incentive to innovate
(low/high)
Speed of reaction to consumer
wants (quick/slow)
Amount of free choice
(broad/limited)
Efficiency
(low/high)
How prices are set
(price mechanism/govt planners)
Level of provision of public goods
(provided/not provided)
Level of provision of merit goods
(under provided/provided)
Levels of employment
(high/sometimes unstable)
Social costs
(low/high)

2
Information drawn from Blink and Dorton, Maley and Welker, A Anderton, J Sloman
32
 Stop, reflect and make some connections

Task: Task: Using any of the concepts from the list in the tables below, answer the conceptual question
by creating a statement that sums up what you understand about this subtopic. You can use some of the
connecting words listed to help you as well if you wish.

CQ: How do different societies coordinate the distribution of resources?

Concepts (you can also chose others):

Economic Choice Resources Competing wants Resource

systems allocation

My sentence (with supporting evidence/and example):

Connecting words:

Shapes Determines Can be May Needs Requires

Has Produces Results in Drives Structures Establishes

Causes Distorts Consists of Contains In/decreases Such as

Leads to Makes Includes Creates

The Evolution of Economic Thought

Learning objectives:

● Explain the basic ideas of Adam Smith. AO2

● Explain the meaning of laissez faire economics. AO2
● Explain the evolution of classical micro and macroeconomic thinking through the 19th Century (including
Says law and Marxist critique of classical thought). AO2
● Explain the perspective of Keynesian economics (20th century). AO2
● Explain the perspective of monetarist/new classical economics. AO2
● Explain the growing role of behavioural economics (21st century-increasing dialogue with other disciplines
such as psychology). AO2
● Explain the concept of the circular economy (21st century-increasing awareness of the interdependencies
that exist between the economy, society and environment and the compelling reasons for moving toward a
circular economy). AO2

33
Task: Match the concepts/terms below to the definitions in the table and use the term in a sentence to
demonstrate your understanding.

Classical Economics Mercantilism Capitalism Specialisation

Division of Labour Labour Productivity Labour Theory of Invisible Hand

Value

Laissez-faire Theory Absolute Advantage Comparative Says Law

Advantage

Neoclassical Economics Marginal Decision Keynesian Monetarism

Making Economics

Behavioural Economics Nudge Theory Circular Economy SDG’s

Donut Economics Marginal Utility

Concept/term Definition Use the term in a sentence

A set of goals created as a

universal call to action to end
poverty, protect the planet and
ensure that all people enjoy peace
and prosperity.

The view that markets should be

left alone, with minimal
intervention by the government.

The value of a good is the sum of

the value of the labour of the
inputs involved in producing the
good.

A visual framework of
sustainability balancing the earth’s
boundaries along with social
boundaries.

This is generally used to describe

situations where nudges are used
to improve the life and wellbeing of
people and society.

When private producers are left

alone to decide what to produce
and how to produce it, they are
guided by an unobservable market
force, leading to production based
on consumer wants.

34
The extra utility derived from
consuming one more unit of a
good or service.

This is where a country is able to

produce more output than other
countries using the same input
factors of production.

Represents the total volume of

output produced per unit of labour
during a given time period.

An economic system that looks

beyond the linear
“take-make-dispose” model and
aims to redefine growth, focusing
on society-wide benefits.

This is where a country is able to

produce a good at a lower
opportunity cost of resources than
another country.

A school of economic thought that

believes that the value of a good is
determined by the value that
consumers place on the good,
based on the amount of utility that
it brings them.

The assumptions built into the

neoclassical model, suggesting
that consumers and producers are
believed to behave in a rational
way.

States that the production of

goods creates its own demand.

The separation of tasks in an

economic system so that
participations of that system may
specialize in the particular or a
particular good or service.

An economic system which is

controlled by private firms and
households. The production of
goods.services is based on supply
and demand and the primary
motive of firms is profit.

35
 Theory where the consumers
decide whether to consume the
“next” unit of a good, depending
on how much utility that extra unity
brings them.

A method of production where an

individual or group focuses on the
production of a limited scope of
goods to gain a greater degree of
efficiency in producing that
particular good.

Wealth of a nation is based on the

value of goods and services it
produces.

This is a branch of economic

research that adds elements of
psychology to traditional models in
an attempt to better understand
decision making by economic
actors. It challenged the
assumption that actors will always
make rational choices with the aim
of maximising utility.

A school of economic thought that

believes that demand, as opposed
to supply, determines the overall
level of national income and that
the government has a key role in
managing the level of aggregate
demand in an economy.

Theory that the worth of a nation

was determined by the amount of
gold and silver they accumulated.

A school of economic thought that

believes that the main determinant
of economic growth is the total
amount of money in the economy.

Introduction

There are many different ways of conceptualising and explaining the economy which gives rise to very
different economic theories and models, none of which is “right”. All theories including natural sciences like
physics involve abstraction and thus cannot capture every aspect of the real world. This means that no
theory is good at explaining everything. Each theory possesses particular strengths and weaknesses,
depending on what it highlights and ignores or assumes, how it conceptualises things, and how it analyses
relationships between them. The fact that no one theory is “right” is what should encourage students of

36
economics to adopt a heterodox approach where they consider an issue from a variety of perspectives,
using a range of theories.

Where did “modern” economics begin?

1. 18th Century Economics: Classical economics

Until the beginning of the industrial revolution and the birth of capitalism the prevailing view of economics
was that there was a certain amount of gold and silver in the world, and that the amount of gold and silver a
nation state had was the only measure of its worth. Under this theory of mercantilism, rulers aimed to
accumulate wealth by obtaining more gold and silver through trade. The goal was to maximize exports to
earn more gold and silver, and use barriers to imports such as customs and tariffs to prevent gold and silver
from leaving the economy. The government was heavily involved in controlling aspects of the economy.
Having colonies abroad was one important way in which countries were able to produce and export goods
to accumulate more gold and silver.

In 1776, the first “revolution” occurred in economic thought and the classical school of economics was born.
The “father” of classical economics is Adam Smith, a moral philosopher from Scotland, who published what
is often referred to as the first book on modern economics, “An Inquiry Into the Nature and Causes of
the Wealth of Nation”s, completely changed way that economic activity was understood and became the
backbones of economic theory until later in the nineteenth century. His observations form the basis of
many of the theories we study today and his book is still considered to be extremely influential terms of its
contribution to economic thought.

In comparison to the mercantilist theories that preceded him, Smith observed that the wealth, or prosperity,
of a nation is not based on its accumulation of gold and silver. He proposed that it is based on the value of
the goods and services that it produces, on its Gross National Product. Smith argued that the priority of
government should be to maximize the country’s output, and he wrote about how production and
productivity (output per worker) could be increased.

One of his major contributions to economic theory was his identification of the benefits of specialization and
the division of labour (e.g. through a story about a factory with ten workers making pins). He identifies
approximately eighteen separate steps involved in manufacturing a pin. When tasks were divided up with
each one specializing in one or two of the steps, they could make an average of 4,800 pins per person
instead of 10-20 if undertaking all tasks alone. Labour productivity was about fifty times higher than the
work done if they operate individually and the benefits of the division of labour were significant in explaining
how production and productivity across an economy could grow. As output increases, there are further and
further divisions of labour and increases in productivity, leading to higher profits and the accumulation of
capital to develop even better production technologies and more output. This would result in greater wealth
and prosperity for the nation as a whole. Contrary to earlier thought, the wealth was not increased merely
through trade and the acquisition of more gold and silver; wealth is increased by producing more output.

Another theory introduced by Smith, and developed by other classical economists, is the “labour theory of
value”. According to this theory, the value, or price of a good is the sum of the value of all the labour of
that as used in producing the goods. EG the price of the bushel corn was determined by all the labour costs
of the inputs involved in producing the bushel. Contrary to theories that were developed later, the value of
the product was determined primarily from factors relating to the supply of the product.

One of Smith’s most notable contributions to the discipline of economics was the “invisible hand”. He
observed that when private producers are left alone to decide what to produce and how to produce it, they
are guided by an “invisible hand”. They are not told what to produce by a government or any other authority.
They choose what to produce based on what consumers want.

In pursuing their own “self interest” (ie higher profits for themselves), Smith observed that competition
amongst producers also benefits consumers because it gives them the incentives to come up with better
and cheaper products. So when producers seek to maximize their profits, they also maximize the

37
satisfaction/utility of consumers. And when producers supply the goods that give consumers the most
utility, they create jobs and wealth for the nation as a whole. What was particularly innovative was the
notion that markets are self-regulating, and will lead to an optimum outcome without government
intervention. An economy based on free markets and competition is one which leads to full employment of
resources and greater prosperity for the economy.

In the ‘Wealth of Nations’, Smith also showed how a country’s prosperity grows through trade with other
countries. He advocated that countries specialize in the production of goods which they produce more
efficiently than other countries, export their surpluses to other countries and import goods which other
countries produce more efficiently. This was contrary to previous views under mercantilism where
governments restricted imports from other countries in order to protect their own producers. Smith’s writings
promoted the notion of free trade, or trade without government protectionist policies.

The conclusion that society as a whole prospers from the forces of competition and the invisible hand is the
basis for the laissez-faire theory for which the classical economists are famous.

Laissez-faire theory From French as “let do”, refers to the capitalist economic system where
production, consumption and trade take place in free markets with as little
government intervention and as few regulations as possible.

This does not mean to say that Adam Smith advocated no government intervention whatsoever.
Government responsibilities lay in the areas of defense, universal education, the provision of essential
infrastructure such as roads and bridges, the establishment of legal rights and the punishment of crime. He
wrote extensively about these obligations of governments in facilitating the pursuit of prosperity for nations.

2. 19th Century Economics

How did Classical Economics develop in the nineteenth century?

Classical economics was developed in the nineteenth century through the work of many famous
economists, including David Ricardo, Thomas Malthus, John Stuart Mill and Jean-Baptiste Say.

The classical economist David Ricardo is well known for the work he did on international trade. Similar to
Smith, he agreed that countries should specialize in the production of different goods and trade freely to
increase global output. However, in terms of international trade, Smith focused on the “absolute
advantage” of one country compared with another country, Ricardo developed the law of “comparative
advantage”. This theory is the basis of most international trade theory today, and is one we come across
later in the course.

Much of classical economics is based on the work of Jean-Baptiste Say, who is famous for “Say’s law of
markets”. A Frenchman who was known to be very much in favour of free markets and free trade, Say
was strongly influenced by the writings of Adam Smith.

According to Say’s law, it is production of goods that is actually the source of all demand in an economy:
“supply creates its own demand”. This can be linked to the circular flow model which shows that the
economic activity of production creates incomes equivalent to the value of the output. These incomes are
then used to consume other goods and services. By supplying goods, producers are effectively creating the
purchasing power for consumers to demand other goods. Total demand in the economy comes about as a
result of production.

Importantly, Say’s theory is used to argue that there cannot be any overproduction of goods within the
economy and the economic growth is achieved by focusing on increasing production as a means of
generating further demand for goods. His law, with its focus on the supply side of the economy, is
consistent with classical economics in rejecting government interventions that restrict the operating of
free markets.

38
The Neoclassical school of economics

This emerged in 1870, with the work of William Jevon, Leon Waltras and Carl Menger. These three
economists were working independently in three different countries, yet they shared some common
conclusions and approaches.

A significant difference between the neoclassical and the classical theories relates to the determination of
the value or price of a product. Smith and other classical economists supported the labour theory of value
which concluded that the value of a product is determined by the costs of labour and other inputs in
the production process, so their focus was primarily on the production side. In contrast, the neo
classical economists argued that the value of a good is determined by the value that consumers place
on the good, based on the amount of utility that it brings them. They therefore placed significant
importance on the demand for the product. Neoclassical economists believed that utility could be
measured and given a monetary value. This is one small sign of the increasing importance of
mathematical analysis in the neoclassical school.

The work of Jevons, Menger and Walras introduced the marginal revolution, because of their idea of
“marginal decision-making”. This means that consumers decide whether to consume the “next” unit of a
good depending on how much utility that extra unit brings them; producers decide whether to produce
the “next” unit of a good depending on the extra cost of producing that good. (e.g. the theory of
diminishing marginal utility).

This marginal revolution marked a significant change between the theories of classical economics and the
much more mathematical scientific work of neoclassical economics. Although the classical school
considered both supply and demand, they considered them separately, and placed more importance on
the supply side because of their belief in the labour theory of value. Rejecting the labour theory of value,
neoclassical economists placed more emphasis on the demand side, and developed complex
mathematical functions to explain the interaction between production (supply) and consumption (demand)
decisions to understand how prices were determined and hence how resources are allocated in individual
markets.

Perhaps the most notable contributions to the neoclassical school came from the work of Alfred Marshall,
whom some regard as the founder of the neo classical school. In his ‘Principles of Economics’ (1890),
Marshall was the first to present the visual supply and demand graphical model, which we still use today, to
illustrate how prices are determined in a market. Instead of pages of writing that characterized earlier works
of economics, Marshall’s work was filled with diagrams to illustrate the theories and models. This was
further evidence of the change in the way that economists approached the world, using mathematics and a
much more scientific approach to explain economic behaviour.

In building their models to explain producer and consumer behaviour, it was necessary for neo classical
economists to make assumptions. These assumptions, which continue to underpin contemporary
economic theories, are based on the idea that both consumers and producers are assumed to be
optimizers in seeking the best outcome for themselves; consumers are assumed to want to maximise utility
and producers are assumed to want to maximize their profits.

In maximizing utility, consumers are assumed to behave in a rational way. This means that they are
self-interested (in some interpretations, this is referred to as selfish behaviour). When faced with choices,
it is assumed that consumers have full information about their options and they are assumed to be
able to make judgments instantly about the marginal utility of consuming an extra unit of a product.
Producers are also assumed to be rational when making choices about how to maximize their profits, and it
is assumed that producers are able to calculate accurately the marginal cost of producing an extra
unit of a good. In modern terminology, the assumptions built into the neoclassical model are referred to as
“rational choice theory”.

The neo classical model is consistent with Smith’s notion of the “invisible hand”. When producers are
rationally trying to maximize their profits (acting in their own self-interest), they will compete with each other,
thereby producing the best possible products at the lowest prices in order to give consumers the
39
opportunity to choose their products rationally. According to the model, this process will produce the best
possible outcome from society’s point of view.

Up until the time of the “marginal revolution” and the models presented by the neoclassical economists, the
discipline of economics was formally referred to as “political economy” and the approach to the subject was
largely philosophical. With its heavy reliance on mathematical models, equations and diagrams, neo
classical economics effectively allowed the discipline of economics to be viewed as a science. From this
point on, the discipline became known by its modern term “Economics”. This was part of a move to
remove the subjective normative questions from the study and give it more objectivity and rigour as a
science in comparison with the philosophical approach taken by the classical economists.

3. 20th Century Economics

In the first few decades of the twentieth century, the neo-classical faith in the ability of the free market to
bring about the best outcomes prevailed. Since individual markets were seen to move towards equilibrium
when left alone to the forces of demand and supply, it was believed that the economy as a whole would
move towards a general equilibrium with full employment of resources (in particular, labour), without
government intervention. The “orthodoxor generally accepted view remained that governments need not
intervene prevailed (laissez faire).

Keynesian macroeconomics

In the 1920s and 1930s, the British economist John Maynard Keynes was responsible for the next
“revolution” in economic thinking and “Keynesian economics” emerged as a new school of thought. With
his focus on the workings of the economy as a whole, Keynes is often considered to be the “father of
macroeconomics”. The view for which Keynes is most well-known was published in 1936 in The General
Theory of Employment, Interest and Money.

The governing orthodoxy at the time was that of laissez-faire, which argued that government intervention in
the economy should be carefully limited and focused on the supply side of the economy. This means that
governments did have a role, but in helping create the conditions necessary for maximum production. This
would involve education to create skilled workers, infrastructure to make production and exchange possible,
and the establishment of laws and the maintenance of order in order to guarantee stability.

Keynes put forward the radical idea that it was demand rather than supply that determined the overall level
of national income and more importantly, that governments had a key role to play in managing the level of
total demand ( “aggregate demand”) in the economy. Keynes’ General Theory grappled with the problem of
mass unemployment of the 1920s and he believed that it was not going to disappear if left to market forces,
as the laissez-faire economists believed.

Keynes argued that the problem during the Great Depression was one of insufficient demand in the
economy. The demand from consumers and businesses was not enough to buy up the total output of goods
and services being produced in the economy, resulting in excess supply of goods and services. In such
circumstances, firms would lay off workers, who would then have even less purchasing power to buy goods
and services, resulting in further falls in demand for goods and services, and even less demand for workers.
The solution, as Keynes saw it, was for the government to intervene to increase aggregate demand by
spending more money itself and lowering taxes so households and businesses could also spend more. This
would raise demand and bring the economy out of the depression.

Why was this approach different to that of the neoclassical economists?

1. It went against the notion of automatically stabilizing markets; rather than leaving the economy alone,
Keynes argued that it was an obligation for governments to intervene. Keynes acknowledged that while
market forces might eventually result in full employment of all resources in the long run, this could take an

40
unacceptably long time, with consequences too damaging (in terms of high and prolonged
unemployment) for governments to accept. The policies that Keynes recommended were fiscal policies,
related to government spending and taxation, and monetary policies, related to interest rates and the
money supply.

2. Until the time of Keynes, it was felt that all economic agents (households, firms and the government)
should operate within their means, and not spend more money than they had. Keynes proposed that in
order for governments to stimulate the economy by increasing overall demand, they should go into debt and
“run budget deficits”, spend more money than they earned from taxation revenue by borrowing money to
make up the shortfall. The assumption was that in times when the economy was growing well, the
government would take in more money in taxes and spend less so that the debts could be paid off.

Demand side theory

Keynesian economics is also referred to as “demand-side” theory, or “demand management”.

Economies typically pass through business/trade cycles fluctuating between rapid rates of growth (with low
unemployment and rising inflation) and slow growth or recession (with high unemployment) so Keynes
advocated “countercyclical” government policies.

1. During an economic downturn, or recession, with high unemployment, governments should increase
aggregate demand by using expansionary fiscal policy (increasing government spending and
decreasing taxes) and expansionary monetary policy, operated by the country’s central bank
(increasing the money supply and decreasing interest rates).

2. During a rapidly growing, or booming economy, where an economy risks rapidly rising prices
(inflation) governments should decrease aggregate demand by using contractionary fiscal policy
(decreasing government spending and increasing taxes) and contractionary monetary policy
(increasing interest rates and decreasing the supply of money).

Keynesian economics gained widespread acceptance and became the dominant economic school of
thought until 1970s, when economic realities could not easily be explained by Keynesian theories-eg in the
early 1970’s, many economies faced high unemployment AND high inflation whereas Keynesian
theories spoke of a trade off: high inflation with low unemployment (stagflation), or low inflation with high
unemployment. This cleared the way for a new way of looking at macroeconomics.

What is Monetarism?

Monetarism emerged as the main challenge to Keynesianism in the late 1960s. This school of thought was
made famous by the economist Milton Friedman, who received a Nobel Prize in Economics in 1976.
Monetarists believe that the main determinant of economic growth is the total amount of money in the
economy and so their focus was mainly on monetary policy.

Monetarists were most concerned with the issue of inflation in an economy, and observed that inflation was
caused by too much growth in the money supply. A country’s central bank should NOT use monetary policy
to try to deliberately increase aggregate demand in the economy by increasing the supply of money, as
this would simply lead to higher and higher inflation. Central banks should instead increase the money
supply, but by a strictly controlled steady amount consistent with the rate of growth of national
income. When money supply increases by more than the amount of output, then the economy would face
a situation of “too much money chasing too few goods”. As a result, prices rise rapidly.

The best way to achieve economic growth for monetarists was for the government to avoid demand
management and for the central bank to control the growth of the money supply. Expansionary policies
would only result in inflation.

The new classical school builds on the work of the neo classical school and similarly argues that the
economy will move automatically to a level of national income where all resources are fully employed. The

41
new classical school revives the notion of rationalism through its theory of “rational expectations”. This
assumption leads new classical economists to have similar conclusions about inflation as the monetarists.
When governments employ expansionary policies, households and businesses will anticipate that inflation
will occur and, acting in a rational manner, will behave in a manner that will actually cause wages and
prices to rise. For example, if governments use expansionary policies, workers will rationally expect inflation
to occur and so will demand higher wages. If workers demand higher wages, producers will charge higher
prices to cover their higher costs and inflation occurs.

Economist Robert Lucas Jr. received a Nobel Prize in Economics in 1995 for having “developed and
applied the hypothesis of rational expectations, and thereby having transformed macroeconomics analysis
and deepened our understanding of economic policy”.

Economists in the new classical school of thought are similar to the monetarists in their conclusion that
governments should never try to manage the level of demand in the economy. They argue that the only
way that the government can promote economic growth is by using policies that focus on the supply side
of the economy by creating incentives such as tax cuts for businesses to become more efficient and for
workers to work harder.

Task: Create a timeline that explains the evolution of economic thought from 18th - 20th Centuary.

21st Century Economics (behavioural economics)

The classical approach makes the assumption that consumers behave rationally-they will calculate the
benefit/utility that the consumption of a product will bring them againsts its cost in an intelligent, logical way,
motivated by self interest. In the real world, humans do not necessarily behave in this rational way and are
not able to make these instant cost-benefit analyses.

When faced with the millions of choices that we make on a day-to-day basis, we don't necessarily make
intelligent decisions and certainly do not have perfect information about relative prices of goods and the
utility that each product will give us. We do not always act in a purely self-interested way; we do actually
care about how our choices affect others.

Challenges to the assumptions of consumer rationality have given rise to a branch of economics known as
“behavioural economics”.

42
 Behavioural A branch of economics which incorporates the insights of psychology and recognizes
economics that the choices which consumers make are governed by many factors that are not
consistent with the assumptions behind the neoclassical models.

It aims to understand the decision-making process of actual human beings (rather

than so-called ‘rational’ human beings). It then uses this understanding to help
consumers make better choices and to help governments design policies that will
encourage consumers to make better choices.

Thaler and Sunstein in their book. “Nudge: Improving decisions about health, wealth and happiness”, state
consumers can be “nudged” to make choices voluntarily that are better for them and indeed, better for
society. For example, when governments legislate that processed foods must have the nutritional values
printed on their labels, they are then ‘nudging’ consumers to make healthier eating choices.

The work on nudge theory by behavioural economists has had a big impact on governments and
organisations all round the world, who are now nudging people to make ‘better’ decisions. These have
contributed to improvements in people’s standards of living, their health, their communities and the
environment.

Critique of nudge theory

1. Any form of government intervention may be accused of taking away individual rights.

2. Governments may not actually know what is best for people and so cannot be trusted to choose
how to nudge people.

Government intervention v laissez faire approach

Behavioural economists argue that governments should intervene to shape the behaviour of economic
agents. They challenge the belief that markets operate efficiently on their own and question the assumption
that consumers act rationally. Their vast experimental work shows how the insights from psychology can be
used to select carefully designed and tested interventions to nudge consumers in the right decisions,
without taking away their rights to choose.

The circular economy (a new approach to economics in 21st Century)

There is increasing awareness that tremendous challenges to sustainability are the result of the fact that
economic activity tends to take place within a “linear” economy. This has led to calls for a different
approach to economic activity to a “circular” economy.

The linear economy, a “take-make-waste” approach, is where we take natural resources from the
environment and use them to produce new products. Once used, these products are disposed of into the
environment where they end up in landfill sites or are incinerated, creating even more pollution. This type of
economy is responsible for the overexploitation and degradation of natural resources. Moreover, it is
resulting in unmanageable accumulations of waste with accompanying health and environmental risks. This
presents tremendous challenges to sustainability.

43
 The circular A “regenerative” and “restorative” approach. Products are specifically designed
economy to be long-lasting and the materials for new products come from reusing and
recycling old products. There is much more emphasis on the design, maintenance,
repair, refurbishment and remanufacture of products.

Blink and Dorton 2020

The principles of the circular economy are consistent with many of the Sustainable Development Goals
(SDGs). Throughout the world, governments are increasingly encouraging, or even requiring, the adoption
of circular economy principles. For example, in 2019, the European Union released a comprehensive report
on the implementation of its Circular Economy Action Plan.

For firms, there are greater gains from adopting circular economy models, in terms of cost savings and
compliance with national environmental regulations. Many companies have also adopted principles of
circular economy.

Kate Raworth’s “embedded company” model is another depiction of a circular economy, and the key feature
is the interdependence that exists between the economy, society and the environment. Economic activity
which does not appreciate this interdependence will increase the challenges confronting the globe today.

Blink and Dorton 2020

44
Raworth argues that economics must take a radically different approach that can deal with the challenges
of the twenty-first century. Policies based on traditional economic models have resulted in a narrow focus
on economic growth and a careless disregard for the negative consequences of “extreme inequalities” of
income and wealth and the unprecedented destruction of the living world”. The goal must be changed.

“For the 21st century, a far bigger goal is needed: meeting the human rights of every person within the
means of the planet. Instead of pursuing ever-increasing GDP, it is time to discover how to thrive in
balance”. For Rowarth, this can only happen when one views the economy as operating within society and
within the Earth’s ecosystem.

Raworth’s doughnut model illustrates the challenges that we face and the world that she thinks we need. .

Blink and Dorton 2020

1. The inner ring is the “social foundation”:

1. The ‘basics in life” that we should rightfully demand for everyone: “sufficient food; clean water and
decent sanitation; access to energy and clean cooking facilities; access to education and to
healthcare; decent housing; a minimum income and decent work; and access to networks of
information and to network of social support.”

2. The model shows that people should be entitled to gender equality, social equity, political voice,
peace and justice.

3. Anyone living within this boundary, in the hole in the doughnut, would be in a state of deprivation.

4. These are not radical or unrealistic goals; the UN Sustainable Development Goals (SDGs),
includes all of these, with a view to achieving the goals by 2030.

45
2. The outer ring is the Earth’s environmental limits/boundaries

If we move beyond this outer ring, we are putting the Earth’s ecosystems, and our ability to live within this
ecosystem, under great threat.

The “safe place” is within the two rings, in the doughnut.

It is Raworth’s view that economic goals, models and theories must be adapted to ensure that we operate
within this safe place, working towards a world where people’s human needs and rights are met within the
environmental limits of the earth.

Blink and Dorton 2020

Conclusion re economic thinking

Whilst there have always been debates among different branches of economics and schools of thoughts,
many students of economics have grown increasingly frustrated with the focus and assumptions of
mainstream economics. We are facing growing real-world crises, such as climates change and tremendous
socioeconomic inequities, because businesses and governments have been using narrow economic
theories as the basis on which to make their decisions.

A movement calling for change has grown and spread to many countries across the globe. There are
demands to see the discipline of economics questioning the assumptions made to a greater degree, and
include many more varied schools of thought.

We have looked at several which have gained the status of ‘mainstream’ economics. However, they are
many more including Developmentalist Economics, Feminist Economics, Austrian Economics, Institutional
Economics, Complexity Economics, Cooperative Economics. It is essential that you are aware that a
multitude of approaches exists, and that economics is not all just new classical economics. With the
growing awareness of the importance of circular economics, we may be looking at the next paradigm.

46
 Stop, reflect and make some connections

Task: Using any of the concepts from the list in the tables below, answer the conceptual questions by
creating a statement that sums up what you understand about this subtopic. You can use some of the
connecting words listed to help you as well if you wish.

CQ: How has the study of economics evolved into a respected academic discipline?

Discipline Natural science Social sciences Mathematics

Hypothesis Data collection Human behaviour Conclusion/s

My sentence (with supporting evidence/an example):

Connecting words:

Shapes Determines Can be May Needs Requires

Has Produces Results in Drives Structures Establishes

Causes Distorts Consists of Contains In/decreases Such as

Leads to Makes Includes Creates

47
Approaches to Learning

Thinking about how you have approached your learning, (individual work, homework tasks, group work
such as the healthcare activity, the PPC game and ‘scarce chairs’, and so on) and identify:

1. Two approaches (in bold type) where you think you have been successful. Consider the quality and
frequency with which you have shown these ATLs as we have moved through this unit of work, and the
degree to which you have achieved them independently. Highlight or circle them in the image below.

2. One approach (in bold type) that you think is an area for growth.

48
3. Fill in the table below:

Reflection 1:

Reasons why I have been successful in ATL ATL that is my area for growth: Action plan
1 and 2 with supporting evidence to achieve it

Reflection 2:

Reasons why I have been successful in ATL ATL that is my area for growth: Action plan
1 and 2 with supporting evidence to achieve it

49
Notes:

50