INTRODUCTION 1

1.1 The foundations of economics

Before we start this course, we must first look at the foundations of economics. We will
discuss what the science of economics actually is and what the scope of this science might
be.

• Economics is a social science on how to deal with scarcity.

• Scarcity is the problem of having infinite wants, or unlimited desires, while having
only finite resources, or limited means, to fulfil these wants.
• A small scale example of scarcity: a person wants to buy a laptop and a phone, but
has only enough money to buy one of the two.
• In general we describe this problem of scarcity as the economic problem.

Nine key concepts that tie together the course material

1 Scarcity The problem of infinite wants while having only limited resources

Since resources are scarce, economic agents need to make choices. Not all wants
2 Choice
can be satisfied, which creates opportunity costs.

3 Efficiency Efficiency measures the ability to make the best possible use of available
resources.
Equity aims at a fair distribution of wealth and resources. It is a normative
4 Equity
concept as what is fair means different things to different people.
Economic Multi-dimensional concept that reflects living standards and the ability to meet
5
well-being basic needs. Economies worldwide differ greatly on economic well-being.
The ability of the present generation to meet its needs without compromising
6 Sustainability
that ability from future generations.
The field of economics is characterized by constant change, and economists need
7 Change
to take this into account when developing new models and refining old ones.
With high national and international economic interaction, choices made by
8 Interdependence
one agent affect the economic state of others.

9 Intervention Government involvement in the organizing of markets and economic activity.

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 INTRODUCTION The foundations of economics

The solution to the economic problem

In order to solve the economic problem, we must make choices between the different
alternatives we are faced with. In a general economy these choices must be made on:

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

In economic analysis, production occurs using four factors of production, which are
characterized as:

• Land
• Labor
• Capital
• Entrepreneurship

In the IB course we will look at the economic problem from different viewpoints and in
different domains.

1.1.1 Opportunity cost

Opportunity cost The value of the next best alternative that is lost while
making a choice.

When a choice is made, an alternative is always foregone. We call this the opportunity cost
of the choice.

For example: A person has only enough money to buy one of three of the following
items: a smartphone, a laptop, a tablet.

• He lists the items in order of how much he or she desires them: (1) laptop,
(2) smartphone, (3) tablet.
• Because he or she desires the laptop the most, the laptop will be chosen.
• The next best alternative, in this case the smartphone which is next on the list, will
be the opportunity cost of the choice.

One way to illustrate opportunity cost is by the Production Possibilities Curve (PPC)
diagram.

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INTRODUCTION The foundations of economics 1

Figure 1.1: Production Possibilities

Curve (PPC). Two goods produced in an economy are
plotted on the x and y axis. The PPC
then shows combinations of the two
Good type y

goods that are efficient to produce at a

given point in time.
With the level of factors of production,
the institutional framework, and the
state of technology fixed:
• Points inside the PPC are
attainable but inefficient.
• Points on the PPC are attainable
and efficient.
• Points outside of the PPC are
efficient but unattainable.
Good type x

Figure 1.2
Good type y

Increases in output are illustrated by a

movement of a point inside the PPC
towards the PPC (Figure 1.1).
Increases in potential output are shown
by a shift of the PPC curve. This shift
y2 can occur in the long-run, and it reflects
growth, as combinations of output that
were previously unattainable become
y1
attainable.

x1 x2 Good type x

Figure 1.3
Good type y

Assumptions of the PPC model:

• Only two goods produced in the
economy
• Resources and technology are
fixed
• All resources in the economy are
used to the highest extent. This is
of course not sustainable.

Good type x

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 INTRODUCTION The foundations of economics

Increasing opportunity cost As we produce extra units of one good,

increasing amounts of the other good have to be sacrificed.

Increasing opportunity cost is illustrated by a concave PPC.

Constant opportunity cost Producing more units of one good always

requires the same amount of the other good sacrificed.

Constant opportunity cost is illustrated by a linear PPC.

1.1.2 Circular flow of income model

Money, goods and services flow through the economy. The circular flow of income
model illustrates the exchange between households and firms:

Figure 1.4: Visualisation of the circular flow of income.

Injections (J) Withdrawals (W)

= Goods and services =
Investment (I) Savings (S)
+ Factors of production
+
Government House
Firms Taxes (T)
spending (G) holds
+ Income +
Exports (X) Import (M)
Consumer Expenditures (C)

Closed economy, no government, no financial sector

Income = Expenditures = Output

Open economy with government, with financial sector

Change in net value of economic activity = J − W

Table 1.1: The factors of production and their respective income.

Factor of production Income Factor of production Income

Capital −→ Interest Land −→ Rent
Enterprise −→ Profit Labour −→ Wage

Some important notices about the circular flow of income model:

12
INTRODUCTION The Economic approach to the world 1

• The middle part of the model is a closed economy (no international trade ⇒ no
imports and exports) that has no government (no taxes, no government spending)
and no financial sector (no investment, no savings).
• In this economy, the income of consumers will always be the same as their
expenditures because saving is impossible and there are no taxes.
• In this economy, the earnings of companies will always be the same as consumer
expenditure because consumers can’t spend their income on products from abroad
(imports).
• In this economy, all earnings of companies will be the same as the value of their
domestic outputs because companies can’t invest parts of their earnings, nor can
they export some of their output.
• Therefore, in a closed economy without a government and financial sector:

Income = Expenditures = Output

• When we add international trade, a government and a financial sector, injections

(value added to the circular flow: investment, government spending and exports)
and withdrawals (value removed from the circular flow: savings, taxes, imports) are
possible.
• In such an economy the change in the value of economic activity can be measured
as:
J − W = (I + G + X) − (S + T + M)

1.2 The Economic approach to the world

1.2.1 The role of positive and normative

economics

Positive economics Positive economics is built around positive statements.

They are objective, factual statements that can be proven true or false
by scientific experiments. Hypotheses, models, theories, assumptions
(like the ceteris paribus assumption), and empirical evidence are all a
part of positive economics.

Normative economics Normative statements are value statements used in

policy making that determine what the economy “should be” or “ought
to be” like.

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 INTRODUCTION The Economic approach to the world

1.2.2 The history of economic ideas

th
18 century: classical economics

Division of labor: Adam Smith, the “founding father” of modern economics,

discovered that by the division of tasks in a workplace, productivity per worker
would increase.
International trade: Countries should specialize in the production of goods in which
they have a comparative advantage, and trade with one another.
Invisible hand: Free markets allocate information between buyers and sellers, and they
are most efficient without any government intervention.

th
Early 19 century: classical microeconomics and classical
macroeconomics

International trade: Ricardo developed the theory of comparative advantage.

Countries should specialize in the production of goods in which they have a lower
opportunity cost, and trade with one another.
Say’s law of markets: Say claimed that there cannot be overproduction of goods,
because supply creates its own demand. The idea can be linked to the circular flow
of income model.

th
Late 19 century: neo classical economics

The marginal revolution: The idea that consuming the first sample of a good will give
the consumer more satisfaction than consuming the second or third sample of the
same good. This is called the law of diminishing marginal utility.
First diagrams to illustrate theories and models: Alfred Marshall was the first
economist to present a visual supply and demand graphical model and illustrate
the determination of prices in the market.

th
20 century: Keynesian economics and monetarist school of
thought

Keynesian revolution: Keynes argued against the free market approach, and believed
that the mass unemployment of the 1920s Great Depression was not going to
disappear without government intervention.
Monetarism (New Classical Economics): Monetarists believe that the main
determinant of economic growth is the amount of money in the economy. The
focus is therefore on monetary policy.

14
INTRODUCTION Structure of the course 1

st
21 century: increased interdependence between Economics and
other social disciplines

Behavioral economics: Aspects of psychology integrated into economic analysis to

understand the motives behind decision-making agents
Nudge theory: The idea that consumers can be “nudged” to voluntarily make choices
that are better for them and better for the society.
Circular economy: Products are designed to be long-lasting, and new products are
repurposed and recycled from old ones. The principles of circular economy are
consistent with many of the Sustainable Development Goals (SDGs).

1.3 Structure of the course

In this course we will study the economic problem in four themes:

1. How can governments help solve the economic problem in different cases?
2. How is sustainability threatened, while people or companies are making an effort
to solve their economic problem?
3. How does efficiency conflict with equity while people or companies are making an
effort to solve their economic problem?
4. How does economic growth conflict with economic development while
companies or governments are making an effort to solve their economic problem?

We will study these questions in each of the following four economic domains:

Microeconomics: the science of choosing on a small scale (individuals, companies).

Macroeconomics: the science of choosing on a big scale (regions, countries).
Global economy: the science of choosing in interaction with other countries
(international economics) and in order to raise living standards (development
economics).

During this economics course we will go through all four domains and discuss the
material you need to understand for your IB exam. This guide contains a summary of the
contents of the course.

15
 INTRODUCTION Structure of the course

16
MICROECONOMICS 2

2.1. Demand and supply 18

In this section the microeconomic laws of Demand and Supply
are discussed. Further, it is explained how Equilibrium is
reached on the market. We will also see that at this
equilibrium point Market efficiency is reached.

2.2. Externalities 28
Before discussing the theory, this section will briefly go over
the most important Definitions. Next the Economics of
externalities will be discussed in general before dividing them
into two categories: Externalities of production and
Externalities of consumption. This section will close with
Other sources of market failure that might exist in the
economy.

2.3. Government intervention 35

The government can try to solve market failures in many
different ways. This sections discusses the solutions of Indirect
taxes, Subsidies and Price controls.

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 MICROECONOMICS Demand and supply

2.1 Demand and supply

2.1.1 Demand

Law of demand When price goes up, ceteris paribus, quantity demanded goes
down. Therefore, a negative relationship exists between price and
quantity demanded.

Ceteris paribus means ‘when all else remains equal’. In this case it means that the law of
demand only holds when everything except price and quantity demanded remains the
same.

The law of demand can also be written as a formula, the formula of the demand
curve, which has the following general form:

QD = a − b P

In this formula:

• Q D = Quantity Demanded;
• P = Price;
• a = intersect; if the a in the formula changes, the demand curve will shift to
the left (if a decreases) or to the right (if a increases);
• b = slope; the higher the b , the higher the slope of the demand curve; in
the case of the demand curve, b will be negative because of the negative
relationship between price and quantity demanded.

Figure 2.1: The demand curve.

A move along the demand curve occurs

Price

when the price of the product changes.

If, for example, the price increases, a
shift along the demand curve may
P2 A
occur from point B to point A.

B A shift of the demand curve occurs in

P1 cases in which any other factor than
price changes.

Q2 Q1 Quantity Demanded

Below the most important of these factors are listed along with their effect on the
demand curve:

18
MICROECONOMICS Demand and supply 2

The income of consumers In general when the income of consumers

increases (decreases), consumers will have more (less) money to spend. Their
demand of the good of which the demand curve is drawn will increase (decrease).
This will shift the demand curve to the right (left).
⇒ The shift above will only happen if the good in question is a normal
good (i.e. any good for which demand increases when income increases).
Most goods on the market are normal goods.
⇒ In the case of inferior goods (i.e. goods for which demand decreases when
income increases) the opposite will happen. When income
increases (decreases), the demand curve will shift to the left (right). An
example of an inferior good is a hamburger from McDonald’s. When the
income of people increases, they will typically use the extra money to buy
better, healthier and more expensive types of food so demand for hamburgers
goes down.
Prices of complementary goods A complementary good is a good that is consumed
along with another good. Examples of complementary goods include cars with
fuel, computers with computer software and Christmas trees with Christmas
decorations.When the price of a good increases (decreases), the demand for the
complementary good will decrease (increase), shifting the demand curve for the
complementary good to the left (right).
Prices of substitute goods A substitute good is a good that is consumed instead of
another good. Examples of substitute goods include iPhones vs. Samsung phones,
Volkswagen vs. Opel cars and match sticks vs. lighters.When the price of a good
increases (decreases), the demand for the substitute good will increases (decreases)
because it is now a relatively less expensive (more expensive) alternative. This will
shift the demand curve for the substitute good to the right (left).
Population When the population increases (decreases) there will be more (less) people
to demand the good. This will increase (decrease) demand, shifting the demand
curve to the right (left).
Taste when taste (e.g. in fashion) changes so will the demand for certain goods. This
depends on the change. If wearing a certain type of shoe suddenly becomes a trend,
the demand for this type of shoe will increase, shifting the demand curve to the
right.
Future price expectations when a consumer expects the price of a good to increase in
the future, they will take advantage of lower prices by demanding more of the
good in the present. This leads to a shift in the demand curve to the right.

2.1.2 Supply

Law of supply Higher prices will, ceteris paribus, increase quantity supplied.
Therefore a positive relationship exists between price and quantity
supplied.

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 MICROECONOMICS Demand and supply

This relationship makes sense, because producers will want to make and sell more
products when the price on the market for these products has increased in order to make
more profit.

Ceteris paribus means ‘when all else remains equal’. In this case it means that the law of
supply only holds when everything except price and quantity supplied remains the same.

The law of demand can also be written as a formula, the formula of the demand
curve, which has the following general form:

QS = c + d P

In this formula:

• QS = quantity supplied;
• P = price;
• c = intersect; if c in the formula changes, the demand curve will shift to the
left (if c decreases) or to the right (if c increases);
• d = slope; the higher the d , the higher the slope of the supply curve; in the
case of the supply curve, d will be positive because of the positive relation-
ship between price and quantity demanded.

Figure 2.2: The demand curve.

A move along the supply curve occurs

Price

when the price of the product changes.

If, for example, the price increases, a
shift along the supply curve may occur
P2 A
from point B to point A.

B A shift of the supply curve occurs in

P1
cases in which any other factor than
price changes.

Q1 Q2 Quantity Supplied

Below the most important factors are listed along with their effect on the supply curve:

Cost of factors of production When the factors of production become more (less)
expensive, the production cost for producers will increase (decrease). This means
they will probably produce less (more) and the supply curve will shift to the
left (right).
Level of technology When technology advances (deteriorates), producers can produce
more (less) efficiently. This means they will probably produce more (less), shifting
the supply curve to the right (left).
Prices of related competitive goods When the prices of competitive goods
increase (decrease), producers will feel more (less) confident about ‘winning’ the

20
MICROECONOMICS Demand and supply 2

competition. They will increase (decrease) production, shifting the supply curve to
the right (left).
Prices of related joint goods When the prices of related goods increase (decrease),
producers will feel less (more) confident about selling their goods along with the
related good. Therefore they will produce less (more) goods, shifting the demand
curve to the left (right).
Indirect taxes When the indirect taxes (i.e. taxes levied on the sale of goods)
increase (decrease) the price of goods will increase (decrease). This will make
producers feel less (more) confident on selling their goods so they will
decrease (increase) their production and supply. Consequently, the supply curve
will shift to the left (right).
Subsidies When subsidies (i.e. government money given to producers)
increase (decrease), producers will decide to produce more (less) of the good. This
will shift the supply curve to the right (left).
Numbers of firms / competitors on the market When there are more (less)
competitors on the market, the producers will face increased (decreased)
competition, decreasing (increasing) their market shares. This causes them to
produce less (more), shifting the supply curve to the left (right).
Change in expectations When expectations change so does the production of
producers. If a producer, for example, expects an economic crisis to occur, he will
probably decrease supply in order to be prepared for a sudden loss in demand.

2.1.3 Equilibrium

Supply and demand interact to produce market equilibrium. This market equilibrium
will be at the intersection of the demand and the supply curve, where supply equals
demand (see Figure 2.3).

At this equilibrium point, you can find the equilibrium quantity (Q∗ ) at the horizontal
axis and the equilibrium price or market price (P∗ ) at the vertical axis.

But in some cases the price is different from P∗ :

• If the price lies above the market price, the quantity supplied will be higher than
the quantity demanded (QS > Q D ). In this case there will be excess supply.
• If the price lies below the market price, the quantity demanded will be higher than
the quantity supplied (Q D > QS ). In this case there will be excess demand.

21
 MICROECONOMICS Demand and supply

Figure 2.3: Equilibrium. Figure 2.4: Excess supply. Figure 2.5: Excess demand.

Price

Price

Price
excess supply
QS QS QS
P2
P∗ P∗ P∗
P1
QD QD excess demand
QD
Q∗ Quantity Q D2 Q∗ QS2 Quantity QS1 Q∗ Q D1 Quantity

In general, price can be said to have two functions on a market:

Signalling function: A high price is a signal to producers that consumers want to buy
the good.
Incentive function: A higher price is an incentive for producers to produce more to
increase profit.

2.1.4 Market efficiency

The efficiency that is achieved on a market can be measured by adding up the consumer
and producer surplus. This gives you the total welfare.

Consumer surplus (CS) The extra satisfaction gained by consumers from

paying a price that is lower than the price they were prepared to pay
→ total welfare gained from being able to consume.

Consumer surplus is measured by calculating the size of the area locked inside
the demand curve; the horizontal line from P∗ and the vertical line from Q∗ .

Producer surplus The excess of actual earnings that a producer makes from
a given quantity of output above the amount a producer would be
willing to accept for that output
→ total welfare gained from being able to produce; equal to producer
profits.

Producer surplus is measured by calculating the size of the area locked inside
the supply curve; the horizontal line from P∗ and the vertical line from Q∗ .

22
MICROECONOMICS Demand and supply 2

Figure 2.6: Consumer surplus and Figure 2.7: Consumer surplus and pro-
producer surplus when market is in ducer surplus when market is not in
equilibrium. equilibrium.
P

P
QS gone! QS
CS
CS P
P∗ PS
PS

QD QD
Q∗ Q QS QD Q

Best allocation of resources is reached at the market equilibrium. At that point the
community surplus (CS + PS) is maximised. (At that point marginal benefit = marginal
cost, see section on market failure).

⇒ to see that this is true, let’s look at a situation where price is not equal to the
market price (see Figure 2.7).
⇒ You can see that CS + PS is smaller than at the equilibrium, the loss in producer
and consumer surplus is marked in the figure.

Elasticities

Elasticities are used to measure the effect a change in some factor (income, price of a
good, price of another good etc.) has on supply and demand of a good. For your IB exam
you must know of four different elasticities which we will discuss here.

Price elasticity of demand ( PE D )

The price elasticity of demand is used to measure the effect a change in price has on the
demand for a certain good. It can be calculated as follows:
% change in Q D
PED =
% change in P
The outcome of PED is typically negative (because there is a negative relationship
between price and quantity demanded) but in economics we do not write the minus
symbol of the PED.

What does the outcome mean? If price increases by a certain percentage, quantity
demanded will decrease by PED × that percentage. (If for example PED = 2 and price
increased by 10%, demand would decrease by 20%).

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 MICROECONOMICS Demand and supply

The outcome of the PED can be placed into one of five categories:

1 PED = 0 Perfectly inelastic demand

The higher the
2 0 < PED < 1 Inelastic demand elasticity, the more
elastic PED is, the
3 PED = 1 Unit elastic demand
more demand will
4 1 < PED < ∞ Elastic demand change when price
changes.
5 PED = ∞ Perfectly elastic demand
P

• elasticity=∞

PED is different at each point of the

elastic demand
demand curve. In the middle it is equal
to 1. Left of the middle of the demand
• elasticity=1
curve PED will be elastic; right of the
middle of the demand curve it will be
inelastic demand inelastic.
elasticity=0
•
Q

There are two exceptions to the rule above:

On a completely horizontal demand On a completely vertical demand curve,

curve, PED = ∞ at every point. PED = 0 at every point.
P

PED = ∞
PED = 0
D

Q Q

When PED is elastic, firms should lower their price to get more revenue because in that
case demand will increase more than the price will decrease. The opposite will be the
case when PED is inelastic. When PED = 1, the firm should leave the price at the
current level; revenue is maximised at this point.

Governments want to tax goods with an inelastic PED because demand changes less than
the price increase due to the tax, so they can make more tax revenue on these goods.

24
MICROECONOMICS Demand and supply 2

The size of the price elasticity of demand is influenced by the following factors:

The number and closeness of substitutes: The more substitutes, the higher PED. If
there are a lot of substitutes, consumers can easily switch to another product when
the price of the product increases.
The degree of necessity: The higher the need for the product, the lower PED.
Consumers will buy goods they need anyway, regardless of the price. Examples
include: food and gasoline.
The time period over which PED is measured: The longer this time period, the
higher PED. In the long run, consumers have more time to look for alternatives /
substitutes for a good. They will switch more often if the price of the good
increases.
The proportion of income spent on the good: The smaller this proportion, the lower
PED. When the proportion of income spent on a good is low, consumers will not
notice or care about a price change and still buy the same proportion of the good.
The type of good: Primary commodities (i.e. materials in raw unprocessed state) have a
lower PED than manufactured commodities. Primary commodities are necessary
for producers in order to produce. They will buy them anyway, regardless of the
price that is asked for them.

Price elasticity of supply ( PES )

The price elasticity of supply is used to measure the effect a change in price has on the
supply for a certain good. It can be calculated as follows:

% change in QS
PES =
% change in P

The outcome of PES is typically positive (because there is a positive relationship between
price and quantity demanded).

What does the outcome mean? If price increases by a certain percentage, quantity supplied
will increase by PES × that percentage. (If for example PES = 2 and price increased by
10%, supply would increase by 20%).

The outcome of the PES can be placed into one of five categories:

1 PES = 0 Perfectly inelastic supply

The higher the
2 0 < PES < 1 Inelastic supply elasticity, the more
elastic PES is, the
3 PES = 1 Unit elastic supply
more supply will
4 1 < PES < ∞ Elastic supply change when price
changes.
5 PES = ∞ Perfectly elastic supply

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 MICROECONOMICS Demand and supply

PES is different at each point of the supply curve, but there are two exceptions to the rule
above:

On a completely horizontal supply On a completely vertical supply curve,

curve, PES = ∞ at every point.
P PES = 0 at every point.

P
S

PES = ∞
PES = 0
S

Q Q

The size of the price elasticity of supply is influenced by the following factors:

Mobility of factors of production: The more mobile factors of production are, the
easier it is for producers to buy and sell them. This means it is easier for producers
to increase or decrease production, therefore the PES will be more elastic.
Unused capacity: When producers have a lot of unused capacity, it will be easier to
increase production if necessary, therefore the PED will be more elastic.
Ability to store stocks: If a firm is able to store high levels of stock of their product,
they will be able to react to price increases with swift supply increases and
therefore the PES for the product will be relatively high.
The time period over which PES is measured: PES will be higher when it is measured
in the long run since companies will have more time to adjust production to price
levels. In the short run producers often can’t change supply by that much.
Type of goods: Primary commodities typically have a low PES while manufactured
commodities often have a high PES. This is due to the higher necessity of primary
goods (in manufacturing and general usage) compared to manufactured goods.

Income elasticity of demand ( YE D )

The income elasticity of demand is used to measure the effect that a change in income of
consumers has on the demand for a certain product. It can be calculated as follows:

% change in Q D
YED =
% change in income

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MICROECONOMICS Demand and supply 2

The outcome of YED can be positive or negative:

+ −

If the outcome of the YED is positive, If the outcome of the YED is negative,
the good of which the YED is the good will be an inferior good.
calculated is a normal good. When When income increases the
income increases, so does consumption consumption of the good will decrease.
of the good.

What does the outcome mean? If the income of consumers is increased by a certain
percentage, the quantity demanded the good will increase by YED × that percentage.
(If, for example, YED = −2 and the income of consumers has increased by 10%, demand
for the good would decrease by 20%).

Goods can also be placed into two categories based on the size of the YED:

1. If YED > 1, YED is said to be income elastic and the good of which YED is
calculated is a luxury good because an increase in income will lead to a spectacular
increase in demand for these goods. Examples of luxury goods include jewelry and
sports cars.
2. If YED < 1, YED is said to be income inelastic and the good of which YED is
calculated is a necessity good because an increase in income won’t change the
demand for these goods that much, consumers will need them anyway. Examples
of necessity goods include food and medicine.

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