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IGCSE
ECONOMICS
0455

1: The basic economic problem

2: The allocation of resources
3: Microeconomic decision makers

Name :

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1. The basic economic problem
1.1 The Nature of the Economic Problem
1.1.1 Finite resources and unlimited wants

• The (basic / central) economic problem:

Scarcity – Resources are limited (finite) in relation to unlimited human wants.
This necessitates choices and thus incurs opportunity costs.

• Consumers, workers, producers, and governments all face scarcity. What are examples for each?

• Scarcity ≠ Shortage
Scarcity is when resources in nature are not freely available at zero price.
Shortage is a market condition occurring at a specific price at which demand exceeds supply.

• The study of economics involves examining how to best use scarce resources to satisfy as many of
our needs and wants as possible to maximise economic welfare.

• All people have the same basic needs, but people usually want far more than just that.

• Needs – G&S that are essential for decent living, e.g. food, shelter, clothing

• Wants – G&S in addition to basic needs and for comfortable living (not essential for living), e.g.
designer clothing, luxury cars, overseas holidays, latest smartphone models

• Note:
o “Products” refer to both goods and services (products = G&S)
o These terms are sometimes interchangeable:
“Firms” = “Producers” = “Sellers” → represent “supply”
“Consumers” = “Buyers” → represent “demand”

1.1.2 Economic and free goods

Economic Goods Free Goods
Goods that are scarce (i.e. in limited supply) and Goods that are not scarce (i.e. in unlimited supply /
have a price (require effort to be obtained) abundance) and obtained for free

Incurs an opportunity cost in consumption Available at NO opportunity cost + can be consumed

(i.e. something is required, to be sacrificed / paid, as much as needed without reducing its availability to
e.g. money, labour, time) others
Can be valued and traded Available for free and cannot be traded
E.g. books, cars, food, clothes, phones E.g. sunshine, air, water

When is it NOT a free good?

• Water becomes an economic good when its consumption starts incurring opportunity costs, e.g. in dry
environments where it is not in abundance, or in a city with a high population density where more
water is taken than can be replenished

• Goods given away for free are NOT necessarily free goods! E.g. “Free” toys given away by a business
still incur an economic cost as it requires time and materials to make. The business could have
otherwise reduced their product prices, made more profit, etc. (i.e. handing out the “free” toys incurs
an opportunity cost)
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(Not explicitly in syllabus)
Terms
• Rival / Rivalrous: a good whose consumption by one consumer prevents simultaneous consumption
by other consumers (i.e. consuming it redeuces its availability for other consumers)
• Non-rival: benefits available for next user will not diminish once consumed by first user
• Excludable: a good for which it is possible to prevent people from consuming it
• Non-excludable: a good for which it is impractical / difficult to exclude others from consuming it

Other Types of goods & services: public/private, merit/demerit, consumer/capital

Public Goods Private Goods

Are non-excludable and non-rival (i.e. goods that can be Are excludable and rival(rous) (i.e.
consumed simultaneously by everyone and from which no one goods for which consumption is rival
can be excluded), e.g. streetlights, national defence, flood and from which consumers can be
control system excluded)

- Provided free at the point of consumption - Consumers generally have to pay

- Funded by general taxation (or other general form of to enjoy its benefits
charge, e.g. a licence fee) - Are scarce economic resources, so
there is competition to obtain it

• Public goods give rise to the free-rider problem:

o Because it is difficult to charge people for benefitting from public goods
o May lead to the under-provision of certain G&S for which no one has the incentive to pay and
which profit-driven private firms will NOT provide
o Free rider – someone who enjoys the benefits of a good without paying for it

Merit Goods Demerit Goods

Confer significant external benefits (creates positive Creates negative externalities when
externalities) when consumed consumed and are socially undesirable
Tend to be under-consumed if consumption depends on ability Tend to be over-produced in a free
to pay for it (i.e. in a free market / provided solely by private market (no government intervention)
firms) as their benefits tend to be underestimated as their costs tend to be
underestimated
Important and ought to be subsidised / provided free at the E.g. cigarettes, alcohol, drugs
point of consumption by the government, e.g. healthcare,
education

• Consumer goods:
o Good & services that satisfy consumer needs and wants
o Consumer durables last a long time, e.g. televisions, furniture, cars, electronic devices
o Non-durables are perishable or used up quickly, e.g. bread, vegetables, petrol, matches
o Consumer services, e.g. services of a doctor, teacher, insurance agent, window cleaner

• Capital goods:
o Man-made resources that assist in further production or provision of other goods & services
o Wanted not for themselves but for what they can help to produce or provide

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o The buying of capital goods is known as investment, which increases production and boosts
economic growth.
o E.g. machinery, screwdrivers, trucks, roads, bridges, power stations
1.2 The Factors of Production
1.2.1 Definitions of the factors of production and their rewards

• Factors of production (FOP) – productive resources used to produce goods &services

1. Land:
▪ Natural resources used to produce goods & services
▪ E.g. farmland, oil, marine life, forest trees, minerals
2. Labour:
▪ Human resources, i.e. number of workers available to make products
▪ Refers to people who provide the physical and mental effort to produce goods & services
▪ Factors that determine the quantity + quality of the output of goods & services:
a – Size of labour force
b – Ability of labour force (e.g. educated/skilled OR uneducated/unskilled)
3. Capital:
▪ Man-made resources used to assist in the further production or provision of other products
▪ E.g. technology, buildings, factories, and machinery
4. Enterprise:
▪ The skill and risk-taking of entrepreneurs in organising factors of production and producing
goods & services
▪ E.g. opening and operating a new restaurant, starting and running a new business
▪ Entrepreneurs: people who organise the factors of production and take risks to produce goods &
services, e.g. the founders and owners of restaurants, businessmen and businesswomen
▪ When risk is correctly taken, entrepreneurs will be rewarded with profits.

• The FOPs are scarce and limited and have alternative uses. For example,
land can be used for either agricultural, residential, industrial, or commercial
purposes. Skilled labour is limited, and people only have 24 hours a day.

• Land = natural resources

Labour = human resources
Capital = man-made resources
Enterprise brings all 3 resources together for the
production and provision of G&S.

• Other resources: energy, time, expertise, management, etc.

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1.2.2 Mobility of the factors of production

1.2.3 Quantity and quality of the factors of production
The causes of changes in the quantity and quality of the various factors

• An increase in the quantity or quality of the FOPs can lead to an increase in the production capacity
of the economy (see 4.6.4 Causes of economic growth)

Quantity (examples)
• Land:
o Discovery of new resources, e.g. oil, arable land
• Labour:
o Influx of migrants (net inward migration)
o Increase in size of population
o Increasing retirement age
o Movement towards full employment
o All these result in an increase of the size of labour force
• Capital:
o Invest in new and more advanced capital equipment & infrastructure results in an increase in
economy’s productive potential

Quality (examples)
• Land:
o Improved fertilisers and irrigation techniques help to increase farm yield
• Labour:
o Improved education, training, and healthcare would increase skills, knowledge, and productivity
• Capital:
o R&D leads to technological advancements, which increase efficiency of capital and the
productivity of existing resources

1.3 Opportunity Cost

1.3.1 Definition of opportunity cost

• Resources are scarce and have alternative and competing uses.

• Human wants are infinite.
• The economic problem of scarcity necessitates choice and thus incurs opportunity costs.
• A choice has to be made for the resources to be best utilised.

• Opportunity cost (of a course of action) – the benefit of the next best alternative forgone to take that
course of action

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1.3.2 The influence of opportunity cost on decision making
Decisions made by consumers, workers, producers, and governments when allocating their resources

• All economic agents, i.e. the consumers, producers/firms, and government, face OC.
• OC arises when deciding how to allocate scarce resources to produce, provide, or buy different goods
& services.

Consumer:
Scarce resource: money (only $10)
Choice: Coffee or sandwich? Decides to buy coffee.
OC of choice to buy coffee: the benefits from sandwich he could have enjoyed

Producer/Firm:
Scarce resource: funds, labour, baking supplies, time, etc.
Choice: cakes or muffins? Decides on cakes.
OC of choice to bake cakes: the benefits from baking muffins

Producer/Firm:
Scarce resource: funds, human resource, materials, time, etc.
Choice: develop new product or extend current product life cycle? Decides on new product.
OC of choice to develop new product: the benefits from extending the current product life cycle

Government:
Scarce resources: funds, labour (builders, engineers, etc.), building supplies, time, etc.
Choice: Public investment in a hospital or a school? Decides on the school.
OC of choice to invest in a school: the benefits of the hospital

Others:
Workers can make a choice as to who they wish to work for, what they wish to do with their time and
effort, how long they wish to work, etc.
E.g. use time to volunteer, work for a big urban college instead of a small rural primary school, early
retirement

Note: A choice can have many benefits! E.g. enjoyment, health benefits, sales, customer loyalty, joy and
satisfaction, status, free time, flexibility, convenience, maintain friendships / social connections,
leadership and promotion opportunities, positive externalities (like employment, increased skill of future
workforce, increased health and productivity of workers, reduced crime rates, etc.)

1.4 Production Possibility Curve Diagrams (PPC)

1.4.1 Definition of PPC
Definition, drawing, and interpretation of appropriate diagrams

• Production possibility curve – shows the maximum production capacity an economy can achieve
when all resources are fully and efficiently employed, at a given time period and at the current level of
technology
(i.e. shows various combinations of the amounts of two goods which can be produced with the given
resources and technology, given that the resources are fully and efficiently utilised per unit time)

• Assumptions:
1. Only 2 goods produced
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2. Technology is constant
3. Full employment

• AKA production possibility frontier (PPF) / boundary (PPB)

• The PPC reflects OC, choices, and scarcity:

o OC and choices
OC is reflected by the negative gradient (i.e. the PPC is downward sloping), which indicates that
an  in the production of one good will lead to a  in the production of the other good. Because
resources are scarce and have alternative and competing uses, a decision to devote more resources
to producing one product means fewer resources available to produce another. A choice has to be
made of what combination of the amounts of the 2 goods to produce.

o Scarcity
Scarcity is reflected by the unattainable points that lie outside the PPC.

• Shapes of the PPC:

o Concave to the origin: This means OC increases as more of a good is produced (i.e. near the axes
/ near the ends of the curve) because the resources used become less suitable for producing that
good. Most PPCs are concave as resources are not equally suited or adaptable to alternative uses.
The law of increasing OC states that as the production of one good rises, the OC of producing that
good increases.

o Linear: OC remains constant (because gradient remains constant).

o Convex to the origin: This means OC decreases as more of a good is produced.

Note: Be careful! Watch for the units along the axes of a PPC (and all other graphs). If it says “tonnes of
wheat per week”, then answer by writing 80 tonnes of carrots per week, not 80 carrots.

1.4.2 Points under, on, and beyond a PPC

The significance of the location of production points

Which point shows scarcity?

Point E (point beyond the PPC). Resources are limited, which
means it is not possible to produce the combination of G&S at
that point. E is unattainable with the current level of resources
and technology.

Which point/points show concept of choices?

Points A, B, D, F (points on the PPC)

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Point C (point under the PPC): A rational person will not choose point C (though it’s attainable) because
resources are not fully utilized at this point, which means unemployment and inefficiency exist.

Illustrate the concept of OC through movement along the curve.

As economy moves from point B to D, for example, to increase 10 units of good X, 5 units of good Y has
to be sacrificed.

1.4.3 Movements along a PPC

Movements along a PPC and opportunity cost

• Outwards: When a point moves from inside the curve to a point on the curve / still inside but closer
to the curve, there is no OC as the economy was not operating efficiently at the point inside the curve.

• Inwards: A recession causes the economy to move to a point inside the PPC (from a point on the
PPC, assuming all resources are fully and efficiently employed initially).

• Along the PPC: The movement of a point along the curve shows choice, OC, and the allocation of
scarce resources. (Elaborate this answer based on previous points given in 1.4 PPC.)

1.4.4 Shifts in a PPC

The causes and consequences of shifts in a PPC in terms of an economy’s growth

• An outward shift of the PPC is due to economic growth. It is caused by an  in the quantity and/or
quality of the FOPs, which leads to an  in the production capacity of the economy. This results in
a decrease in scarcity as some points previously unattainable will have become attainable. (Note: a
decrease in investment expenditure would slow down the outward shift of the PPC)

• An inward shift of the PPC occurs due to the destruction of resources (FOPs), or the fall in the
quantity and/or quality of the FOPs, e.g. when the amount of new capital falls below the level
necessary to replace the amount of worn-out capital

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2. The Allocation of Resources

2.1 Microeconomics and Macroeconomics
MICROECONOMICS MACROECONOMICS
Examines the behaviour and decisions of individual Examines the performance, structure, behaviour,
agents within the economy, such as households, and decisions of an economy as a whole and of
consumers, producers, companies, and workers countries and governments
Studies individual markets and agents within an Studies economies on the national, regional, and
economy international / global scales
Terms – firms/companies/businesses, consumers, Terms – countries, governments, international,
producers, households, workers, employers, choice, aggregates, GDP, unemployment, inflation,
demand, supply, price, wage differentials, costs of national income, net exports, fiscal and monetary
production policies
Graph + Terms Used
➔ Price VS Quantity (Q) ➔ Price level VS Real GDP (Y)
➔ SS and DD graphs ➔ AS and AD graphs
➔ Label on x-axis = Q ➔ Label on x-axis = Y
Remember: aggregates

2.2 The Role of Markets in Allocating Resources

• In an economy, people and firms produce, exchange & consume goods & services.

2.2.1 The market system

How a market system works; including buyers, sellers, allocation of scarce resources, market equilibrium,
and market disequilibrium

Market System
Goods & services are freely exchanged through a market between buyers and sellers without the need for
government intervention (as economic decisions are made by the buyers and sellers). Prices signal the
preferences of the buyers and thus the profitability of a good or service to the profit-driven sellers, who
will only produce the types and amounts of goods & services that are in demand and profitable as
signalled by prices. Through the price mechanism of a free market, the interaction of buyers and sellers
establishes an equilibrium price and quantity and thus determines the allocation of scarce resources. This
also means that profits will encourage the reallocation of resources to the production of goods & services
that are more profitable.

• The market for any goods & services is made up of 2 agents:

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o Buyers (represented by demand) – consumers willing and able to buy the product
o Sellers (represented by supply) – producers willing and able to make and supply the product

• In economics, a market is any set of arrangements that brings together all the buyers and sellers
(producers and consumers) of a good or service so they may engage in exchange. A market in
economics does NOT refer to a particular location where G&S are traded.

• Markets can be spread over a small or large area. Some goods & services are exchanged all over the
world (i.e. international or global markets), like the markets for crude oil and aircraft.

2.2.2 Key resources allocation decisions

2.2.3 Introduction to the price mechanism

• The central economic problem of scarcity creates 3 fundamental questions about determining resource
allocation (which all economies face, regardless of size and state of development) → what, how, and
for whom to produce

• The answers to the 3 fundamental economic questions is related to:

o Price mechanism
o Efficiency (determines whether the objective of the 3 questions is achieved)
o Economic system (see 2.9 Market Economic System)

2 types of efficiency:

1. Productive efficiency:
The economy is productively efficient when it is impossible to increase the production of one good
without reducing the production of other goods, given the quantity and quality of the FOPs in the
economy. In other words, the economy is producing on the PPC, or production occurs through the
least-cost method. It is a necessary condition for allocative efficiency.

2. Allocative efficiency:
The economy is allocatively efficient when it is impossible to change the allocation of resources in a
way that will make someone better off without making anyone else worse off. In other words, the
economy is producing the combination of G&S that maximises the welfare of society or that is most
desired by society, which is determined by tastes and preferences.

The 3 key allocation questions that arise due to the central economic problem of scarcity:

1. What (and how much) to produce → resource allocation

• Price mechanism – refers to the system where the market forces of demand and supply interact to
determine the prices of goods and services

The types & amounts of goods & services to produce (and which wants to satisfy with scarce resources)
are jointly determined by consumers and firms (producers) through the price mechanism. Profit-driven
firms only produce what consumers are willing and able to pay for, and so prices signal the types &
amounts of goods and services that are in demand and their profitability. This signalling role of prices is
the essence of the price mechanism.

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2. How to produce → production technique

The profit motive means businesses will choose the least-cost method to produce any amount of output.
Relative factor (FOP) prices determine the ways in which goods & services are produced (i.e. the least-
cost method). E.g. if labour is cheaper than capital, then businesses will opt for labour-intensive
production

Production techniques → refer to: ~ (method of) production / processes / or industries

• Capital-intensive – where the proportion of capital used is greater relative to the other factors of
production in the production process, e.g. telecommunications, automobile industry, oil refineries
• Labour-intensive – where the proportion of labour used is greater relative to the other factors of
production in the production process, e.g. nursing, retail, handicraft industry

China is labour-abundant while Germany is at the forefront of technology. Which methods of production
is each most likely to employ?

3. For whom to produce → distribution of G&S

The market system distributes goods to consumers with the ability and willingness to pay for the goods &
services, which is determined by their preferences and income levels.

Determining who will get the final goods & services produced involves making a value judgement (as the
answer depends on the opinions of society, with no right or best answer).

(Note: A value judgement is the subjective judgement of the rightness, wrongness, or usefulness of
something or someone based on your principles/beliefs/priorities. In other words, it is an opinion about
how good or bad something or someone is. There is no right or wrong answer.)

2.3 Demand
2.3.1 Definition of demand
2.3.3 Individual and market demand
The link between individual and market demand in terms of aggregation

• Demand – the willingness and ability of consumers to buy a good or service at each price

• Effective demand – willingness to buy backed by purchasing power (i.e. ability to pay)
(Latent demand is when the willingness of consumers is not backed by the ability to pay)

• Individual demand – the demand of an individual buyer at each price

• Market demand – the horizontal summation of all the demand by all buyers in a market
→ it represents the aggregate (i.e. total) of all individual demand

• Quantity demanded (Qd) – the quantity of G/S consumers are willing to buy at a given price, over a
certain period of time, e.g. litres of petrol per week

Change in Demand Change in Quantity Demanded

Represented by Shift of the demand curve Movement along a demand curve

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Caused by Change in one of the determinants of Change in price (the price factor)
demand (non-price factors)
Terminology Increase and decrease in demand Extensions and contractions in demand
Note Change in demand ≠ Change in quantity demanded
A change in demand is a change in quantity demanded at every price.

• Law of demand:
Keeping all other factors constant (ceteris paribus), there is an inverse relationship between price (P)
and quantity demanded (Qd), i.e. when price increases, quantity demanded decreases, and vice versa.

• The demand curve is downward sloping due to the inverse relationship between P and Qd.

Advertising (2 Types)

• Effects of advertising on DD and PED:

o Increases / Boosts demand
o Makes demand more price inelastic (i.e. reduces PED)

• Advertising boosts demand + promotes customer loyalty + makes demand more inelastic by:
o Creating consumer wants
o Influencing consumer preferences
o Creating positive and powerful brand images

• Benefits of customer brand loyalty to a business:

o Repeat purchases leads to steady revenue
o Protects sales & market share from competition
o Customers may continue to buy the brand even at a higher price

1. Informative advertising: Provides information about a product and its features to a consumer
o Increases product credibility & creates a good reputation for a business
o E.g. bus timetables, menus, ingredients on food packaging
o Government organisations often use this method to tell people about new regulations or increase
awareness of personal health and safety issues.
2. Persuasive advertising: Creates consumer wants and boosts demand and hence sales

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o Brand switching may occur, which is when a brand loses a loyal customer to a competitor.

2.3.2 Price and demand

A demand curve to be drawn and used to illustrate movements along a demand curve with appropriate
terminology, e.g. extensions and contractions in demand

Price Factor
• Price of the product itself (P) determines quantity demanded (Qd) according to the law of demand
(inverse relationship). It does NOT determine demand. Movement along the curve is due to changes in
the price of the product itself (P).
• Extension in demand (movement DOWN the demand curve) – when Qd rises due to a fall in P
• Contraction in demand (movement UP the demand curve) – when Qd falls due to a rise in P

A to B: extension in demand
A to C: contraction in demand

2.3.4 Conditions of demand

Causes of shifts in a demand curve with appropriate terminology, e.g. increase and decrease in demand

Determinants of Demand (Non-Price Factors)

• These non-price determinants of demand cause a shift in a demand curve, i.e. a change in quantity
demanded at every price

D to D1: increase in demand

D to D2: decrease in demand

Mnemonic → SPRITE:
- 5 Seasonality
- 6 Population
- 1 Related goods
- 2 Income of consumers
- 3 Tastes and preferences
- 4 Expectations of the future

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1. Price of related goods

Substitute Goods (or Substitutes) Complementary Goods (or Complements)

Alternative goods that perform the same functions or Goods that are jointly consumed and are in
satisfy the same wants joint demand
E.g. Sunway and INTI, 100 PLUS and Revive, Nike E.g. car and petrol, iPhone and iPhone cases,
and Adidas, iPhone and Xiaomi, margarine and butter marker pen and refill ink, ice cream and cones
A rise in the price of a good results in a fall in demand A rise in the price of a good results in a fall in
for it and a rise in demand for its substitutes demand for both it and its complements
Extra: The info on changes in prices + quality of competing (substitutes) and complementary (complements)
products of rival producers is useful to firms as any changes can affect their own sales, revenues, and profits.

2. Income of consumers

• In general, an  in consumer income would  the demand for many G&S, which is what happens
during an economic boom.

• Normal goods – goods for which demand rises as consumer income rises (and vice versa)
• Inferior goods – goods for which demand falls as consumer income rises (and vice versa)
• As incomes rise, more people switch from train travel to air travel for long distances, and hence long-
distance train travel appears to be an inferior good in consumer preferences.

3. Tastes and preferences

• Demand for G&S can change dramatically because of changing consumer preferences.
• Tastes and preferences can be changed, such as through advertising (more effective if carefully
planned and based on market research).
Examples:
• Negative news about mad cow disease leads to a decrease in demand for beef
• Increasing number of consumers are switching to eco-friendly goods and healthier foods due to
increased education and awareness campaigns on health and the environment.
• In the recent years, spectacles have become a popular fashion accessory and not just something for the
visually impair, e.g. South Korean celebrities wear and popularise the round-framed glasses

4. Expectations of the future prices

• If consumers anticipate an  in prices in the near future, demand is likely to  now.

E.g. demand for cars increase before the introduction of the GST (goods and services tax).
• If consumers anticipate a  in prices in the near future, demand is likely to  now. This is called
delayed spending, which may lead a vicious circle called a deflationary cycle.
• Future price changes could be caused by the changes in taxation, supply of raw materials, etc.

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5. Seasonality

• The need for goods varies by time of year, such as the 4 seasons, holiday seasons, festivals, etc.
Examples:
• A hot summer can boost the demand for ice, cold drinks, and ice cream.
• There is a major increase in demand for CNY cookies a few months before Chinese New Year.
• Demand for winter clothing peaks in autumn and falls in spring. Prices will change accordingly (price
mechanism). (Tip: This is why it is best to shop for winter clothes during end-of-season winter sales.)

6. Population changes (or demographic changes)

• In general, as population size increases  (i.e. number of buyers ), the demand for many G&S .
• However, the changes in demand are usually not spread out equally among all G&S as the changes in
population size may only occur more significantly in certain categories of a population.
Examples:
• The fall in birth and death rates in Western countries results in an aging population (= change in age
distribution). This may increase demand for treatments and drugs for arthritis, dementia, cancer, etc.
• If birth rates suddenly skyrocketed, the demand for baby products would also increase.

There are other factors that affect demand as well.

Changes in laws, e.g. illegal to ride motorbikes without a helmet, illegal to smoke in public places

2.4 Supply
2.4.1 Definition of supply
2.4.3 Individual and market supply
The link between individual and market supply in terms of aggregation

• Supply – the willingness and ability of producers to produce and sell a good or a service at each price

• Individual supply – the supply of an individual producer at each price

• Market supply – the horizontal summation of all individual supplies of all producers in a market
→ it represents the aggregate (i.e. total) of all individual supplies (of all producers competing to
supply that product)

• Quantity supplied (Qs) – the quantity of G/S that producers are willing and able to produce and sell
at a given price over a certain period of time, e.g. tonnes of flour per month

• (Change in) Supply ≠ (Change in) Quantity Supplied

• Law of supply:
Keeping all other factors constant (ceteris paribus), there is a direct relationship between price (P)
and quantity supplied (Qs), i.e. when price increases, quantity supplied increases, and vice versa.

• The supply curve is upward sloping due to the direct relationship between P and Qs.
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2.4.2 Price and supply

A supply curve to be drawn and used to illustrate movements along a supply curve with appropriate
terminology, e.g. extensions and contractions in supply

Price Factor
• Price of the product itself (P) determines quantity supplied (Qs) according to the law of supply
(direct relationship). It does NOT determine supply. Movement along the curve is due to changes in
the price of the product itself (P).

• Prices signal the demand for + profitability of a good / service to producers.

• Extension in supply (movement UP the supply curve) – when Qs rises due to a rise in P
• Contraction in supply (movement DOWN the supply curve) – when Qs falls due to a fall in P

A to B, B to D, etc: extension in supply

D to A, C to B, etc: contraction in supply

2.4.4 Conditions of supply

Causes of shifts in a supply curve with appropriate terminology, e.g. increase and decrease in supply

Determinants of Supply (Non-Price Factors)

• These non-price determinants of supply cause a shift in a supply curve, i.e. a change in quantity
supplied at every price

S to S1: decrease in supply

S to S2: increase in supply

1. Production costs / Costs of production

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• Lower production costs imply higher profits, which would encourage profit-motivated producers to
increase supply, and vice versa.
• Note:
o Production costs are mainly the costs of factors of production (FOP).
o E.g. raw material costs, labour costs (wages), rental costs (for machinery, buildings, land, etc.),
maintenance costs

2. Technology

• Technological advancements lead to improved productivity and efficiency, e.g. improved machinery
with shorter production times and reduced wastage
• This would increase output while lowering production costs, thus leading to increased supply and
higher profits.

3. Number of sellers in a market

• The more sellers/producers/firms in the market/industry, the greater the market supply of the product,
and vice versa.

4. Expectations of future prices

• Higher prices signal higher demand and profitability to producers. If producers expect future prices to
be higher, they will try to hold on to their stock for sale in the future to capture higher prices, thus
reducing supply in the short run.
•
5. Government policies and regulations

• Governments can make policies and regulations that impact (boost or reduce) supply, such as by
providing subsidies or imposing taxes.
Examples:
• Subsidies and Taxation (see Subsidies and Indirect Taxes)
• Quotas – Restricting the maximum quantity of imported wheat through quotas would reduce the
supply of wheat and of other products that require wheat in their production, such as bread.
• Land development scheme – In the late 1950s, a land development scheme (FELDA scheme) was
launched to combat poverty by assigning the poor to settlements to cultivate oil palms. This greatly
reduced poverty while also increasing the supply of palm oil, making Malaysia a top palm oil
producer (second largest).
• Others – increased food labelling regulations, more stringent quality control, etc.

6. Other Factors

• The production of agricultural products is influenced by weather conditions, e.g. crop yields decrease
due to bad weather.
• Other factors affecting supply: extended strikes (disrupt production), floods and natural disasters,
political instability, war, etc.

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Subsidies

• Subsidy – a financial grant from the government to producers to reduce production costs and
encourage production ( SS)
• Subsidies allow producers to keep prices low (i.e. keep products more price competitive).
• Uses → e.g. encourage consumption of merit and public goods, make exports and domestic products
more price competitive against foreign products
• Note: the SS curve shifts down vertically by the amount of subsidy

Explanation:
A subsidy is a financial grant from the government to producers to reduce production costs and encourage
production. Hence, SS  from S1 to S2, and price  (from P1 to P2), thus encouraging consumption.

Indirect Taxes

• Indirect tax – tax imposed on goods & services

• Imposing or increasing direct taxes (such as in an expansionary fiscal policy) would reduce production
costs and reduces post-tax profits. This acts as a disincentive to producers and thus decrease SS.
• The tax burden / incidence falls on producers but can be passed on to consumers through higher prices

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Types of indirect taxes
1. Specific tax (a per unit tax):
o A fixed amount per unit of a good or service,
e.g. tobacco tax

o Causes SS curve to shift upwards parallel to the

original curve (i.e. shift upwards the same amount
at each price)

2. Ad-valorem tax (a percentage tax):

o A fixed percentage on the price / value of the good or service (i.e. the amount of the tax depends on
the value of the good or service), e.g. GST, sales tax

o Causes SS curve to shift upwards but more so at

higher price levels

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2.5 Price Determination
2.5.1 Market equilibrium
2.5.2 Market disequilibrium
Definition, drawing, and interpretation of demand and supply schedules and curves used to establish
equilibrium price and sales in a market and to identify disequilibrium prices and shortages and surpluses

• Market equilibrium:
o Occurs when the 2 opposing forces of supply and demand are equal, which is at the equilibrium
price and equilibrium quantity

• Market disequilibrium:
o Occurs at a disequilibrium price and quantity, at which supply does NOT equal demand, leading
to either shortages or surpluses
o Shortage – when demand exceeds supply (disequilibrium price below equilibrium price)
o Surplus – when supply exceeds demand (disequilibrium price above equilibrium price)
o A surplus / shortage is the difference between the Qs and Qd at a disequilibrium price

2.6 Price Changes

2.6.1 Causes of price changes
Changing market conditions as causes of price changes

2.6.2 Consequences of price changes

Demand and supply diagrams to be used to illustrate these changes in market conditions and their
consequences for equilibrium price and sales

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2.7 Price Elasticity of Demand (PED)
2.7.1 Definition of PED
2.7.2 Calculation of PED
Using the formula and interpreting the significance of the result
Drawing and interpretation of demand curve diagrams to show different PED

• Price elasticity of demand – a measure of the responsiveness of demand to a change in price

𝑄𝑑,2 − 𝑄𝑑,1 𝑄𝑑,2 − 𝑄𝑑,1

× 100%
%𝚫 𝐢𝐧 𝑸𝒅 𝑄𝑑,1 𝑄𝑑,1 𝑸𝒅,𝟐 − 𝑸𝒅,𝟏 𝑷𝟏
𝑷𝑬𝑫 = = = = ×
%𝚫 𝐢𝐧 𝐏 𝑃2 − 𝑃1 𝑃2 − 𝑃1 𝑸𝒅,𝟏 𝑷𝟐 − 𝑷 𝟏
𝑃1 × 100% 𝑃1

• (Except for goods that do not conform to the law of demand, like Veblen goods)
Most products have a negative PED coefficient due to the inverse relationship between price and
quantity demanded according to the law of demand. However, by convention, elasticities are
interpreted as positive numbers, so we take the absolute value of the result.

2.7.4 PED and total spending on a product / revenue

Relationship between PED and total spending on a product/revenue, both in a diagram and as a calculation

2.8 Price elasticity of supply (PES)

2.8.1 Definition of PES
2.8.2 Calculation of PES
Using the formula and interpreting the significance of the result

• Price elasticity of supply – a measure of the responsiveness of supply to a change in price

𝑄𝑠,2 − 𝑄𝑠,1 𝑄𝑠,2 − 𝑄𝑠,1

%Δ in 𝑄𝑠 𝑄𝑠,1 × 100% 𝑄𝑠,1 𝑄𝑠,2 − 𝑄𝑠,1 𝑃1
𝑃𝐸𝑆 = = = = ×
%Δ in P 𝑃2 − 𝑃1 𝑃2 − 𝑃1 𝑄𝑠,1 𝑃2 − 𝑃1
× 100%
𝑃1 𝑃1

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5 Degrees/Types of PED
Note → all PED is in absolute value!

1 2

Elastic demand Inelastic demand

1 < PED < ∞ 0 < PED < 1
A change in price will lead to a more than A change in price will lead to a less than
proportionate change in quantity demanded. proportionate change in quantity demanded.
ΔP < Δ𝑄𝑑 ΔP > Δ𝑄𝑑

3 4

Perfectly elastic demand Perfectly inelastic demand

PED = ∞ PED = 0
A slight change in price will lead to an infinitely A change in price will lead to no change in
large change in quantity demanded. quantity demanded (i.e. quantity demanded
remains constant whatever the price).

Unitary elastic demand

5 PED = 1
A change in price will lead to a proportionate
change in quantity demanded.
ΔP = Δ𝑄𝑑

The DD curve is a rectangular hyperbola

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2.7.3 Determinants of PED (Price Elasticity of Demand)

1. Proportion of income spent

• Direct relationship → the smaller the proportion of income spent on the product, the smaller the PED
and the less elastic the demand (i.e. more inelastic).

Goods with inelastic demands – paper clips, newspapers, matches

Goods with elastic demands – cars, houses, flight tickets

2. Time period

• If prices increase, consumers tend to source for cheaper substitutes, which may be difficult in the short
run. The longer consumers have to look for cheaper substitutes, the more likely they are to find one.
Hence, demand tends to be more elastic in the long run than the short run.

3. Degree of necessity

• The demand for necessities tends to be inelastic as consumers need them for basic survival and living,
e.g. certain food products like rice, oil, and salt
• Luxury goods tend to have elastic demands, e.g. overseas holiday packages

4. Addictiveness

• Goods such as alcohol and tobacco have demands that are price inelastic due to their addictive nature.
Consumers are likely to continue consumption even if price increases.

5. Availability (and closeness) of substitutes

• The more substitutes there are for a product in the market, the more elastic the demand because
consumers.
• If no close substitutes are available, people tend to still buy it even when prices rise.
• The greater the possibility of substitution of a product, the greater the price elasticity of demand for it.
• If a good has more substitutes, demand is likely to be more elastic, e.g. demand for a specific
medicine with no substitutes will likely have an inelastic demand.

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5 Degrees/Types of PES

1 2

Elastic supply Inelastic supply

1 < PES < ∞ 0 < PES < 1
A change in price will lead to more than A change in price will lead to a less than
proportionate change in quantity supplied. proportionate change in quantity supplied.
ΔP < Δ𝑄𝑠 ΔP > Δ𝑄𝑠

3 4

Perfectly elastic supply Perfectly inelastic supply

PES = ∞ PES = 0
A slight change in price will lead to an infinitely A change in price will lead to no change in
large change in quantity supplied. quantity supplied (i.e. quantity supplied remains
constant whatever the price).

Unitary elastic supply

5 PES = 1
A change in price will lead to a proportionate
change in quantity supplied.
ΔP = Δ𝑄𝑠

The SS curve is a straight line that passes through

the origin.

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2.8.3 Determinants of PES (Price Elasticity of Supply)

1. Existence of spare capacity

• If there is plenty of spare capacity, i.e. if firms are not producing near / at full capacity, then the firms
can more easily increase output to take advantage of rising prices. Hence, supply will be more elastic.
• Supply is very elastic during a recession, when there is plenty of spare labour and capital resources
(i.e. spare productive resources) available for use in production.

2. Time period

• Supply is more elastic in the long run than the short run as there is more time for firms to expand
production (e.g. buy more land, hire more workers) and more time for new firms to enter the market.

3. Level of stock

• If there is plenty of stock available for sale, a firm is more able to respond quickly to a sudden
increase in price, and hence supply is more elastic.

4. Production times

• Shorter production times allow firms increase output more quickly when prices rise.

Long production time – inelastic supply – examples:

• Agricultural crops such as pineapples and rubber trees (require many months and years to grow)
• Massive vehicles such as cruise ships (require many months to manufacture)
• High-quality luxury goods that undergo stringent quality control

Short production time – elastic supply – examples:

• Mass-produced goods such as clothing and bread (firms can mass-produce thousands of pieces a day)
• Some inferior goods (due to the limited focus on quality)

5. Factor mobility

• How easily the FOPs can be substituted or moved from one use to another would affect PES.
• The higher the factor mobility, the greater the elasticity of supply because firms can quickly reallocate
resources to raise or reduce output in response to changes in product prices.
Examples:
• A sweatshop manufacturing clothes can easily hire new unskilled workers to increase output when
prices rise. The supply of unskilled sweatshop labour is more elastic than the supply of highly skilled
workers in technological industries, who are more immobile as they require long periods of training.

• It is easier for primary school teachers to switch between teaching different subjects than university
professors, who require longer periods of education. Thus, the supply of primary school math teachers
is more elastic than the supply of math professors.

• A printing press can switch easily between printing greeting cards and magazines as both require
similar equipment, materials, and skill sets to produce, so the supply of greeting cards and magazines
are relatively price elastic due to the high mobility of the factors of production used.

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6. Number of firms in the market/industry

• The more firms in the market, the more elastic the supply.
• If one firm cannot respond quickly to a rise in price, there are other firms that can.

7. Unemployment rate

• If unemployment rate is high, supply is more price elastic as there are more human resources are
available, so it is easier for firms to expand production when prices rise.

2.7.5 Significance of PED and PES

2.8.4 Significance of PES
The implications for decision making by consumers, producers, and government

The Use of PED

• PED is closely linked to revenue changes. (If DD is price inelastic, then when P is raised, there is a
less than proportionate contraction in DD, so total revenue rises. Thus, increasing P would raise
revenue. If DD is price elastic, the P has to be lowered in order to boost sales and revenue.)

• PED is also useful to governments in increasing tax revenue, their main income source. Indirect taxes
increase cost of production and thus increase P. This would cause Qd to fall. Thus, if the government
wants to increase revenue from indirect taxes, it should do so for goods with a price inelastic demand.

Limitations of PED
• Data used in these calculations may be irrelevant, outdated, or unreliable. Respondents may not be
truthful, and some data may be outdated as the determinants of demand may have changed over time.

• The assumption of ceteris paribus made in calculations is an unrealistic assumption and unlikely to
hold in reality. In reality, many factors and determinants are changing simultaneously.

• Due to the omission of total cost, PED may only be useful to increase total revenue but not
necessarily to increase total profit. Changes in total profit depend on whether or not total cost changes
by a larger extent than Qd.

Limitations of PED and PES

• Data on PED and PES are merely estimates. They can change and become outdated over time as
consumption patterns change. In practice, businessmen do not rely solely on PED and PES but have to
consider other factors in business, like their rivals’ marketing strategies, consumer preferences, and so
on. PED and PES are very useful, but it is not the only useful knowledge for use in business.

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2.9 Market economic system
2.9.1 Definition of market economic system
Including the roles of the private sector (firms and consumers) and the public sector (government)

• An economic system is the way an economy decides what, how, and for whom to produce G&S,
which varies in terms of the degree of government intervention in making those fundamental
economic decisions. (See 2.2 The role of markets in allocating resources)

• The 3 economic systems:

o Free market economy / Laissez-faire economic system
o Command economy / Planned economy
o Mixed economy

Free market economy: Adam Smith, a famous economist, was a strong advocate of the free market
economy. He stated that resources should be allocated by the “invisible hand” principle, i.e. through the
interaction of the market forces of DD and SS. The private sector (firms and consumers) make all
economic decisions and determine resource allocation (what, how, and for whom to produce).

Command economy: The public sector (government) plays a very important economic role in deciding
what, how, and for whom to produce to maximise society’s welfare. There is a central committee that
controls all economic activities and allocate resources to where they deem fit and necessary.

• Advantages of a command system:

o Theoretically, it creates a classless society. Inequality is reduced, ands society’s welfare is
maximised as everyone has access to basic necessities, and the government determines wages and
ensures an equal distribution of income.

o Government intervention prevents the abuse of monopoly power.

o The government provides public and merit goods for free.

• Disadvantages of a command system:

o Information failure may occur as the government is not fully aware of consumer preferences,
resulting in the misallocation of resources. There may be large surpluses and shortages of certain
G&S. Planning is difficult and accurate forecasts almost impossible as planners do not have perfect
knowledge.

o The major role of the government in the economy limits democracy and the freedom of choice and
enterprise.

o The lack of incentive to produce and innovate limits economic progress. Firms are generally
inefficient due to the absence of the profit motive, and innovation and technological developments
are reduced.

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Free market economies Command economies
All resources are privately owned by individuals and All resources are owned by the government, i.e.
firms, i.e. private ownership. public ownership.
There is minimum government intervention in Economic decision-making is fully controlled
economic activities. The role of the government is by the government (i.e. centralised). The
restricted to mainly issuing currency and ensuring an government sets the prices and determines the
adequate legal framework for the economy to operate allocation of resources (what, how, and for
smoothly. Resources are allocated through the price whom) that maximises society’s welfare. There
mechanism, i.e. the interaction of demand and supply. is no freedom of enterprise.

Consumer sovereignty is upheld. Consumers decide

what, how, and for whom to produce, and firms will
respond to stay in business.
Competition exists in all economic activities: No competition exists.
- Firms compete for resources and sales
- Consumers compete for G&S
Pursuit of self-interest: Private individuals and firms cannot pursue self-
- Producers seek to maximise profit interest.
- Consumers seek to maximise satisfaction / utility
- Government seeks to maximise society’s welfare
Firms aim to maximise profit. Profits act as an Governments aim to maximise the welfare of
incentive to profit-motivated firms to increase the society.
production of a G/S.
Possible problems: income inequality, market failure
Possible problems: inefficiency, disequilibrium
(see disadvantages of free market economy) (shortages and surpluses), reduced choice and
freedom, reduced incentives
Examples: Hong Kong and Singapore are among the Examples: North Korea, Cuba
freest in the world (but not 100%) (China is a now a mixed economy.)

2.9.2 Advantages and disadvantages of the market economic system

Including examples of how it works in a variety of different countries

Advantages of the Free Market Economic System

1. A wide variety of G&S is produced as many producers will compete to improve on price, quality, and
design due to the profit motive. This benefits consumers and increases consumer surplus.

2. Producers are quick to respond to changing market conditions and consumer spending patterns in
order to survive and maximise profit. They will reallocate resources from unprofitable ranges of G&S
to produce whatever is profitable and in demand according to consumer preferences. Also, consumer
sovereignty is upheld.

3. The free market system encourages innovation and efficiency. Firms are likely productively efficient
as they use the least-cost production method and also allocatively efficient as they produce the
combination of G&S most desired by society. Profit-motivated firms carry out R&D to develop new
and more efficient processes and technologies, which would help to reduce costs and maximise profit.

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Note: Disadvantages/Drawbacks of the free market economic system are market failures.

2.10 Market Failure

2.10.1 Definition of market failure

• Market failure – occurs when the free market is left unregulated and fails to allocate resources
efficiently

Social = Private + External

Costs: SC = PC + EC
Benefits: SB = PB + EB

• Private costs/benefits – costs incurred by / benefits received by the individuals who are directly
involved in the economic activity of production or consumption (that led to those costs/benefits)

• External costs/benefits – costs incurred by / benefits received by a third party who is not directly
involved in the economic activity of production or consumption (that led to those costs/benefits)

• Externality – an external cost or benefit

External costs = negative externalities
External benefits = positive externalities

• Why does EC exist in the equation SC = PC + EC?

EC exists because SC is higher than PC, i.e. SC is more than PC.
A negative externality (i.e. an external cost) exists if the social cost of an economic activity is higher
than the private cost, and vice versa for a positive externality.

• An economic use of resources will raise economic welfare because SB > SC (VS. an uneconomic use
of resources). However, private firms are only interested in profits (PB), so their production decisions
tend to ignore externalities (EC and EB). When private firms are in complete control of all scarce
resources, it’s possible that society will be worse off and SC > SB, and market failure occurs.

Examples
1. Education
o PC – tuition fees
o PB – higher wages, social status
o EC – negligible
o EB – a more productive labour force, which contributes to economic growth
2. Smoking
o PC – cost of a pack of cigarettes, health problems
o PB – stress relief
o EC – health problems caused by inhaling second-hand smoke
o EB – negligible
3. Pollution (chemical processing plant dumping industrial wastes into river)
o PC – total costs of production (including labour wages, rent, loan interests, etc.)
o PB – revenue generated
o EC – pollution of water, aquatic life harmed, adverse health effects on people who use the water
o EB – employment (jobs) created

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Disadvantages of the Free Market Economic System (Market Failures)

1. Public goods not provided at all:

Public goods, such as national defence, are not provided at all because they are non-rival and non-
excludable, which gives rise to the free-rider problem. Private profit-motivated firms will fail to
provide public goods since it is impossible to charge for their usage.

(All consumers automatically benefit from the provision of public goods, and market systems cannot
prevent people who refuse to pay from benefitting, so consumers will withhold payment to enjoy the
benefits for free.)

2. Merit goods underprovided:

Merit goods, such as education and healthcare services, are underprovided and under-consumed in the
market system (i.e. less than the socially optimal level). One of the reasons is information failure as
individuals are not fully aware of the long-term benefits from merit goods. Consumption of merit
goods would generate significant positive externalities (e.g. healthcare services make the labour force
healthier and thus increase labour productivity, which contributes to economic growth).

3. Demerit goods overprovided:

Demerit goods, such as tobacco, will be overprovided and overconsumed in the market system if left
entirely to market forces (i.e. charged at market price). People tend to underestimate their costs and
harmful effects.

4. Occurrence of negative externalities:

Negative externalities, such as pollution, occur as private producers disregard the effects of their
production activities on the environment. Pollution is a form of market failure as those not directly
involved in production still suffer from the pollution and its adverse effects on health. Pollution is an
external cost (i.e. negative externality), which occurs when social costs exceed private costs.

5. Emergence of monopolies:
In reality, the market tends to be dominated by a few large sellers and subjected to their exploitation in
terms of high prices and lower output, which undermines consumer welfare. The presence of
monopolies leads to productive and allocative inefficiencies. Producer sovereignty is upheld instead.
Producers have the ability to set prices and decide what, how, and for whom to produce. Producers
also use aggressive advertising to influence consumers.

6. Unequal distribution of income and wealth:

In a free market economy, there is an unequal distribution of income and wealth. Income earned
depends on the value of resources owned by individuals, and prices of resources are determined by the
price mechanism. There is a wide income disparity between the high-income earners, or owners of
highly valued resources, and the low-income earners. The rich starts off rich and gets richer while the
poor remain poor.

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Conservation or Commercialisation

• Natural resources are scarce. Should they be conserved, or should they be used / commercialised?

• Conservation of resources
o Avoids rapid resource depletion and environmental damage, which are more common in
commercialisation
o Prevents the loss of natural resources that may beneficial and useful in the future, such as a species
with medicinal properties, or areas of natural beauty that can potentially generate revenue from
tourism
o More sustainable growth in the long run
o More of a long-term strategy

o Evaluation → However, the benefits of conservation may be occurring at the expense of current
growth, employment, and standard of living.

• Commercialisation / Use of resources

o Raises output, income, and employment, leading to economic growth and higher standard of living
o If resources are exported, BOP position would improve
o Resources can also potentially be used to achieve social, economic, and environmental goals
instead of being left idle
o More of a short-term measure

o Evaluation → However, commercialisation of resources, if extreme and uncontrolled, leads to

rapid resource depletion, such as overfishing and deforestation. It also harms the environment and
its plants and animals, leading to problems such as pollution, global warming, and extinction.

2.11 Mixed Economic System

2.11.1 Definition of the mixed economic system

• A mixed economy comprises both the public sector (government) and private sector (consumers and
firms). Economic decisions, including what, how, and for whom to produce, are made by both sectors.

Basically, the characteristics of the free market system are present but partially restricted by the
government, e.g. competition, pursuit of self-interest.

• In reality, due to the flaws of the free market and command systems, all economies in the world are a
mixture of both economic systems.

Command-oriented economies, e.g. North Korea, rely on the market system to some extent, and
market-oriented economies, e.g. Singapore, have some degree of government intervention.

• Characteristics of the mixed economic system:

o Public and private sectors work together in economic activities (consumers, firms, government)
o Resources are partly state-owned and partly owned by the private sector
o Resources are largely controlled by the price mechanism
o Government intervenes where necessary to overcome the market failures in a free market system,
e.g. provide public goods, subsidise merit goods, impose taxes on demerit goods, introduce laws
that protect the environment, regulate or break up monopolies

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2.11.2 Government intervention to address market failure
Definitions, drawing, and interpretation of appropriate diagrams showing the effects of three government
microeconomic policy measures: maximum and minimum prices in product, labour, and foreign exchange
markets; indirect taxation; and subsidies

• Government failure – occurs when government intervention leads to net welfare loss

1. Political self-interest:
The pursuit of self-interest among politicians and civil servants can often lead to a misallocation of
resources. The pressure of an upcoming election or the influence exerted by a special interest group
may lead to inappropriate public spending and tax decisions, such as by increasing welfare spending
in the run-up to an election to boost popularity.

2. Policy myopia:
Politicians tend to resort to myopic decision-making and look for short-term solutions for difficult
economic problems rather than making long-term considerations and addressing structural economic
problems, e.g. a decision to build more roads may simply increase traffic congestion in the long run.

3. Regulatory capture:
Regulators, such as government agencies, should act in the interest of the public and consumers, but
when they work very closely with the producers and industries under their control, they may begin to
promote the producer’s interest instead. Problems such as corruption and inefficiencies may occur.

4. The law of unintended consequences:

The actions, regulations, and policies of governments may have unintended consequences, whether
adverse or beneficial. For example, the government may implement a maximum price policy on an
essential good such as rich with the goal to keep it affordable for all, especially lower-income groups.
However, this policy may lead to shortage as quantity demanded exceeds quantity supplied.
Additionally, those who do not have the good may resort to the black market to get their supply at
higher prices, and trading in the informal sector means a loss of government tax revenue through tax
evasion. Also, enforcement costs have to be incurred when administering the maximum price policy.

5. Disincentive effects:
High tax rates, with the aim to fund public spending and reduce income inequalities, may reduce
incentives among people to work longer hours, seek better pay, or set up and run businesses. This is
because profits, which are the rewards for work and risk-taking, are reduced after deducting the tax.

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3. Microeconomic Decision Makers
3.1 Money and Banking
History of Money

• Barter – exchanging one good or service for another

Problems with the barter system

1. Double coincidence of wants: Before two people can barter, a double coincidence of wants is
required, i.e. they must both want the good that the other person is offering.

2. Fixing a rate of exchange: The value of each and every good must be expressed in terms of every
other good. E.g. 1 kg oranges = 0.5 kg cheese, 1 lamb leg, 1 clay pot, …

3. Trying to save: Bartering is a very inefficient method of exchange as saving would be a problem, e.g.
a pig farmer cannot store her meat for very long to barter in the future without a refrigerator

Specialisation increases wealth and surplus in a society as individuals or groups concentrated in the
production of G&S they are best at. Trade (or exchange) allows society to move from being self-sufficient
to being specialised.

Trade through bartering is difficult, e.g. an expert pin-maker may not be able to find people willing to
swap G&S at a fair exchange rate in a barter system. However, money is a single commodity that
everyone was willing to accept in exchange for their labour and all other G&S. Trading with money
overcomes the problems of the barter system.

3.1.1 Money (forms, functions, characteristics)

• Functions of money:
o Money serves as a medium of exchange as it is generally acceptable to everyone as a means of
payment for most G&S. This overcomes the need for a double coincidence of wants.

o Money serves as a unit of account (measure of value). The price of each item can be expressed in
monetary terms (i.e. how many units of currency it is worth), which allows buyers and sellers to
agree on what each good is worth relative to another.

o Money serves as a store of value as it can hold its value over time. Hence, money can be saved for
future use.

o Money serves as a standard for deferred payment as it is durable and holds its value over time. It
allows goods to be bought on credit terms or money to be loaned or borrowed, and payment can be
made at a later date.

• Characteristics of a good money:

o Accepted by everyone
o Durable → which allows it to act as a store of value
o Portable → lightweight and easy to carry around
o Divisible → to make small purchases or give change without it losing value
o Scarce → so people will value it as a good to be used in exchange
o Homogeneous → consistent in quality and mass when representing a certain value
o Difficult to forge

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3.1.2 Banking

Functions of a commercial bank

1. Loans / Lending
• Many individuals and firms borrow from banks for a variety of purposes, e.g. taking out a mortgage to
buy a house, buying cars through hire purchase. Interest is charged on the loan principal.
• Commercial banks also provide overdraft facilities, which allow customers to withdraw and using an
amount more than what they have in their accounts. Interest is charged on the amount borrowed.
• (Credit cards provide a short-term loan to fund spending.)

2. Accept deposits
• Commercial banks provide savings and fixed deposit accounts that pay interest to savers.
o Savings accounts: have low interest rates as interest is calculated on a daily basis and savers can
withdraw at any time.
o Fixed deposit accounts: are given a higher interest rate as money has to be kept in the bank for a
minimum period of time, e.g. 1 month, 6 months, 12 months.

3. Means of payment
• Commercial banks help customers make payments, such as through credit cards, which offer a short-
term loan.
• Commercial banks also provide current accounts (a deposit account), which allow customers to make
and also receive payment through cheques and debit cards.

4. Exchanging foreign currencies

• Commercial banks also facilitate the buying and selling of foreign currencies, which is needed by
customers for international trade and investments, as well as travelling or studying abroad. Customers
can make payments to other people or firms overseas in the currency of that country.

Functions of a central bank

1. Issue notes and coins – A central bank can issue the notes and coins of a country’s currency.

2. Government’s banker – A central bank serves as the government’s banker as it operates an account
for the government through which it manages payment to and from the government.

3. Lender of last resort – A central bank acts as a lender of last resort to the banking system as it lends
money (loans) to commercial banks that encounter financial difficulties.

4. Interest rates and monetary policy – A central bank can set interest rates and control monetary
policy to influence inflation, employment, and growth in the economy. Changing interest rates would
influence the level of borrowing, saving, and spending by consumers and firms.

For example, extremely low interest rates (r) during a recession may increase borrowing and reduce
savings too much, leading to high consumer and investment spending (C and I) and high growth. This
causes high inflation. A central bank may need to curb the inflationary pressures by setting a higher
interest rate (r).

Central Bank Commercial Bank

Issue notes and coins Usually not allowed to issue notes and coins
Customers: commercial banks and the government Customers: people and firms
Controls and implements monetary policy Affected by monetary policy
Government-owned Usually in the private sector
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3.2 Households
3.2.1 The influences on spending, saving, and borrowing

• There are many factors that influence spending/consumption + saving + borrowing between different
households and over time, including:
o Incomes
o Interest rates
o Confidence
o And many more ☺

Incomes (Spending Patterns)

Rich households have higher incomes compared to poor households. They spend on luxuries as well as
higher quality necessities. For example, their necessities may include iPhones, Nike shoes, and French
hams while a private jet and a million-dollar bag may be considered a luxury.

Poor households have low incomes and can only afford basic food, clothing, and housing. Examples
include simple home-cooked meals, unbranded items, or cheap brands like Ayamas and Bata, and some
can only afford rented accommodation. They may not have much or any money left for luxuries.

Example (Per Month)

Rich Poor
Income: $100 000 Income: $2 000
Total spending: $50 000 Total spending: $1 800
% of income spent: 50% % of income spent: 90%

• Marginal propensity to consume (MPC) and to save (MPS):

∆ 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ∆ 𝑆𝑎𝑣𝑖𝑛𝑔𝑠
𝑀𝑃𝐶 = 𝑀𝑃𝑆 =
∆ 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 ∆ 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒

• As income increases, total spending will increase too but less than proportionately. That is why
richer households with higher incomes have higher total spending BUT a lower MPC compared to
poorer households.

• Richer households with higher incomes also have higher total savings and a higher MPS compared to
poorer households. Poorer households may have little or no savings at all. Sometimes, they may resort
to dissaving (which means spending more than the income earned) as they take from their past
savings or resort to borrowing during financial difficulties.

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Factors that affect spending / consumption
1. Income (and wealth)
2. Consumer confidence
3. Interest rates → affect saving and borrowing → and thus affect spending / consumption

Motives for saving

1. High interest rates
o Savings generate interest income.
o The higher the interest rate, the higher the returns from saving and the more rewarding it is to save.
o Note: Interest rate is the price of money + cost of borrowing + reward for parting with liquidity

2. Low consumer confidence

If consumer confidence is low, such as due to concerns about job security, then consumers would tend
to save more and spend less.

3. Save for big ticket (expensive) items

E.g. cars, houses

4. “Save for a rainy day” (emergencies)

E.g. unexpected medical bills, flat tyres

5. Availability of saving schemes

Banks nowadays offer many attractive saving schemes, which motivate people to save. The more and
longer people are willing to save without withdrawing, the higher the interest rate they can get. Some
saving schemes also offer tax-free returns.

Motives for borrowing

1. Low interest rates
When interest rate is low, cost of borrowing is low, and thus people will borrow more.

2. To purchase big ticket items

People who plan to buy expensive items usually take up loans to finance their purchase as most would
not have sufficient funds to pay in cash. E.g. car loan (hire purchase), housing loan (mortgage)

3. For emergencies
Emergencies may require people to resort to borrowing. E.g. after your car has been destroyed in an
accident, you may have to borrow to buy a new one to ensure that you can continue working in order
to earn a living and to work the repayments into your cash flow

4. To finance education or training

Borrowing to finance education or training is a valid reason because improving qualifications and
skills is likely to increase earning potential (i.e. more likely to obtain higher incomes in the future).

5. To start or expand a business

Borrowing to start or expand a business is a good idea if a thorough business plan and cash flow
projection has been carried out. This is likely to increase future incomes.

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3.3 Workers
3.4 Trade Unions
3.3.1 Factors affecting an individual’s choice of occupation → wage (1) and non-wage factors (2 to 8)

• Wages – payment made to workers for their labour and services

1. Wages
o The fundamental motivational factor for a worker to seek employment
o Other monetary rewards include bonuses, commissions, and overtime claims

2. Career prospects
o Occupations or firms with more opportunities for promotion are preferred. E.g. people may not
want to become janitors or work in firms that remain small due to low chances of promotion.

3. Fringe benefits (non-monetary benefits)

o E.g. company car, staff discounts for company products, medical insurance

4. Job security
o People generally do not prefer jobs in which they are likely to be laid off.
o Jobs as civil servants in the public sector usually offer greater job security as the public sectors is
not just profit-driven but also concerned for the welfare of workers.
o Larger firms are usually stronger financially and perceived as more stable and offering greater job
security. Thus, employment in larger firms is usually preferred over jobs in smaller firms.

5. Travelling distance
o Workplaces closer to home are preferred as workers can save on travelling time and costs.
o (Note: The more geographically mobile the worker is, the more choices of occupation he/she has.)

6. Qualifications and skills required

o Workers can only choose the jobs and occupations in which they can meet the minimum
qualifications. (Note: The level and types of qualifications and skills workers have affects
occupational mobility.)
o Certain occupations also require lengthy periods of study or training that incur huge costs and take
many years, which may put many people off, e.g. neurosurgery. However, they usually have much
higher earning potentials compared to jobs that require little to no training, e.g. office cleaner.

7. Holiday entitlements
o More generous holiday entitlements will be more appealing to workers

8. Job satisfaction
o Some people may opt to pursue a career in which they could directly help people and gain high
satisfaction but which may not offer very high pay, e.g. teaching, nursing

Limiting factors: Most people would prefer a well-paid and highly satisfying job with good working
conditions, generous holiday entitlements, good career prospects, high job security, and a convenient
location. However, in practice, people’s choice of occupation is limited by a variety of factors:
• Their level of qualifications
• Skills they have
• Experience they have
• The place they live

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3.3.2 Wage determination
Influences of DD and SS, relative bargaining power, and government policy, including minimum wage
3.3.4 Division of labour / specialisation
Advantages and disadvantages (of specialisation / division of labour) for workers, firms, and the economy

• There is a labour market for every type of occupation (just as there is a market for every G&S).

• Factors that influence wages:

o DD and SS
o Relative bargaining power
o Government policies, e.g. minimum wage

Labour mobility
• Labour mobility – the ease with which workers can move between different jobs in the economy

• 2 main factors:
o Occupational mobility – the ability of a worker to move from one occupation to another
→ occupational immobility occurs due to a lack of transferable skills.

o Geographical mobility – the ability of a worker to move from one geographical region to another
→ geographical immobility occurs due to regional differences, such as differences in house prices,
family ties, transportation networks, language, etc.

• Labour mobility affects:

o Choice of occupation: The higher the occupational and geographical mobility of the workers, the
wider the choices of occupation available to them.
o Demand for labour: The higher the labour mobility, the higher the demand for labour.

Specialisation
• Specialisation – concentration by individuals, firms, regions, or countries on the production of
specific goods and services

• Benefits:
o Specialisation allows individuals to make the best use of their talents and skills.
o Specialisation increases labour productivity through repetition. Productivity gains would offset
production costs, thus allowing firms to make more profits
o Workers can command higher wages because demand for their services is greater due to their
increased labour productivity and efficiency from specialisation.

• Disadvantages:
o The repetitive nature of specialised jobs may lead to boredom. This may reduce labour
productivity. This may also reduce product quality and result in more rejects.
o Workers may be unemployed if their skills and qualifications become outdated / obsolete due to
changes in consumer demand or technology.
o The introduction of industrial robots, computer-integrated manufacturing (CIM), etc. may cause
some workers, especially low-skilled ones, to lose their jobs.

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3.3.3 Reasons for differences in earnings

Wage differentials exist within the same occupation and across occupations for various reasons.

1. Economic factors
• DD for labour (demand factor):
o Demand for labour is a derived demand as it is based on what the worker can do or contribute in
the production process.

o Demand for labour depends on productivity, which depends on work experience, education level,
training, and so on, e.g. compared to a GP, a neurosurgeon commands higher wages because he/she
is more productive.

o Demand for labour also depends on the demand for the goods & services that the labour can
produce, e.g. during the Covid-19 epidemic, there is high demand for workers that manufacture
masks

o Factors affecting DD for labour:

▪ Consumer demand for goods & services
▪ Productivity of labour (affected by many factors, including skilled/unskilled)
▪ Skilled or unskilled labour
▪ Price and productivity of capital
▪ Non-wage employment costs

• SS for labour (supply factor):

o Wage level is also determined by the supply of labour. If labour is scarce, e.g. professional football
players, then the employees can command higher wages compared to those in jobs that have an
abundant supply of labour, e.g. clerks.

o The nature of the job also affects labour supply. E.g. because construction workers have dangerous
jobs and are exposed to weather conditions such as the hot sun, labour supply is limited, and thus
they are compensated with higher wages (aka compensating wage differentials, due to
undesirable job features / working conditions). Clerks work in safe and comfortable office
environments and are thus paid less as many are willing to work in such pleasant conditions.

o Factors affecting SS of labour:

▪ Net advantages of an occupation
▪ Provision and quality of education and training
▪ Demographic changes (changes in population)

• Price Elasticity of DD and SS:

o The price elasticity of both the demand and supply of labour also affects wage level.

o Skilled labour, e.g. doctors, command higher wages than unskilled labour, e.g. janitors, as both the
demand and supply for skilled labour is inelastic compared to unskilled labour.

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3.4.1 Definition of a trade union, 3.4.2 Role of trade unions in the economy
3.4.3 The advantages and disadvantages of trade union activity
From the viewpoint of workers, firms, and the government

2. Trade unions
• Trade union – an organised group of workers with the aim of increasing wages and improving
working conditions by means of collective bargaining

• Trade unions negotiate with employers on behalf of the employees to improve wages, fringe benefits,
working hours, and working conditions.

Functions of a trade union

• Improve working conditions (e.g.):
o Ensuring employers observe health and safety guidelines
o Help employees secure better working hours
• Improve wages and non-monetary benefits (e.g.):
o Higher wages and bonuses
o More generous holiday entitlements
o Greater medical insurance coverage
• Protect job security and rights of employees:
o Trade union leaders serve as legal representatives in the event of industrial disputes.
o Ensure that employers honour the employment contracts, observe labour laws, only dismiss
workers with a valid reason, etc.
• Develop the skills of the union members:
o By providing training and education courses
o Boost labour productivity, efficiency, and employability
o Thus help employees to command higher wages
• Influence government policy:
o Some trade unions can use their power to influence government policies and employment laws to
be more favourable to their members or to workers in general.

Factors determining a trade union’s bargaining power / strength

1. PED of goods produced: Demand for labour is a derived demand as it depends on the demand for
G&S that the workers can produce / provide. Bargaining power will be greater if demand for the G&S
produced is inelastic.
2. Representation: If a large proportion of workers in a firm or industry are members of a trade union,
then the bargaining power of that trade union will be greater.
3. Wage costs as a % of total production cost: If wage costs constitute a large proportion of total
production cost, then the trade union would have less bargaining power.
4. Profitability of a firm: A profitable firm is more likely to give in to demands to increase wages, and
thus the trade union’s bargaining power is higher.

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3. Public VS private sector workers

• Governments are major employers for many economies and thus have the ability to hold down wage
levels, causing public sector employees in general to receive lower wages compared to their
counterparts in the private sector. However, the lower pay is compensated by greater job security (as
civil servants don’t lose jobs due to falling consumer demand), better pension entitlements, and more
generous non-monetary benefits. The public sector also aims to increase employee welfare, and not
just maximise profit.

• However, this varies with country, e.g. in general, public sector workers in Singapore receive
relatively higher wages compared to those in the private sector.

Other reasons, including:

4. Government policy (e.g. national minimum wage laws aim to protect the interests of and prevent the
exploitation of the lowest-paid workers, but it could increase unemployment / surplus of labour)

5. Male VS female workers

6. Skilled VS unskilled workers

7. Primary VS secondary VS tertiary sector workers

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3.5 Firms
3.5.1 Classification of firms
In terms of primary/secondary/tertiary sectors and private/public sector, and the relative size of firms
(NOT required: detailed knowledge of different types of structure of a firm)

Criteria
1. Ownership
2. Finance
3. Liability / Risk
4. Control → making decisions, profits and losses, risks and responsibilities

Control → can be used as advantages and disadvantages, for example:

• Keeping all profits alone VS sharing profits
• Sharing risks, responsibilities, and losses VS bearing them all alone
• Making decisions alone can be good or bad. You could have full control and follow your ideas and
plans, but you may not have ideas and advice that other people may have (in group decision making).

Sole Trader /Sole Proprietor

Ownership 1 owner
Finance Owner’s own savings, loans from friends and relatives
Liability / Risk Owner and business are a single entity
Unlimited liability = High risk
Control Sole owner makes all decisions, keeps all profits, and bears all risks and
responsibilities

Advantages
• Easy to set up
o Very few legal formalities
o Low start-up capital
o Technological advancements have also reduced initial set-up costs significantly.
• Personalised services
o Owner knows the preferences of his/her regular customers
o This promotes customer loyalty
• Full control of business
o Makes all decisions by himself/herself
o Keeps all profits to himself/herself

Disadvantages
• Unlimited liability
o From a legal perspective, the owner and the business are the same entity.
o Owner can lose all personal possessions to pay off business debts if for example the business goes
bankrupt, i.e. the owner is personally liable for business debts and damages
• Full responsibility
o Owner assumes full responsibility for running the business and thus has longer work hours
o E.g. planning, keeping accounts, recruiting and managing workers, deal directly with customers,
marketing and advertising, liaising with suppliers
• Lack of capital
o Source of finance is limited, i.e. only from owners’ savings and from friends and family
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o Hard to secure bank loans as sole traders are considered high-risk
Partnerships

Ownership 2 – 20 partners
Finance From partners
Liability / Risk General partnerships: unlimited liability, high risk; owners and the business are a
single entity
Limited liability partnership (LLP): limited liability; owners and the business are
separate legal entities
Control Partners make decisions together and share all profits / losses, risks, and responsibilities

Advantages
• Relatively easy to set up
o Few legal requirements in drawing up partnership agreements
• More resources
o Partners with different skills and ideas will contribute to the growth of the firm
o Partners share responsibilities in running the business
o Partners can consult each other when making decisions
• More capital
o Partners need to contribute capital to enter the business
o Each partner can help financing start-up costs and day-to-day business expenses

Disadvantages
• Disagreements and conflicts
o Partners may disagree, which slows down decision making
o Some partners may be lazy, causing other partners to suffer
• Shared profits
o Profits will have to be shared among partners based on the percentage of what each put into the
business
• Unlimited liability
o General partners (only in general partnerships) have joint unlimited liability and could lose all their
personal possessions if for examples the business goes bankrupt. (This is NOT the case in limited
liability partnerships / LLPs.)
o Partners are personally liable to the percentage of ownership in the business
• Limited capital
o Source of finance is only from partners

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Private Limited Company

Ownership 2 – 50 shareholders
Finance Capital is raised through the issuance of shares among a closed group of
shareholders, i.e. shares are sold privately
Liability / Risk Shareholders and the company are separate entities
Limited liability
Control Shareholders elect a board of directors
Directors run the business
Shareholders receive profits in the form of dividend

• Private limited companies are required to publish annual financial accounts for reasons of
transparency and accountability.

Advantages
• Limited liability
o Shareholders and companies are separate legal entities
o The liability of the shareholder is limited to the his/her investment in the company
• Management
o Shareholders have management responsibility and can appoint directors to run the business
• More capital
o More capital can be raised through the issuance of shares
o Selling shares as a source of finance is cheaper than taking out bank loans

Disadvantages
• Limited capital
o Shares can only be sold privately to a closed group of shareholders, and so capital is limited
• Financial accounts
o Private limited companies are required to publish financial accounts every year for reasons of
transparency and accountability

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Public Limited Company

Ownership Minimum 2 shareholders (no maximum / upper limit)

Finance Capital is raised through the sale of shares on the stock market to the public
Liability / Risk Shareholders and the company are separate entities
Limited liability
Control Shareholders elect a board of directors
Directors run the business
Shareholders receive profits in the form of dividend

• Public limited companies are required to publish annual financial accounts and to hold AGMs (annual
general meetings).

• Divorce of ownership from control occurs because though the company is owned by its shareholders
(ownership), it is controlled by the board of directors / management (control). Many of the thousands
of shareholders hold a very small number of shares and have limited voting power. They are usually
unable or unwilling to attend AGMs and thus are mostly not in control of the company they own and
its day-to-day decisions. After being elected in an AGM, usually by large shareholders, the directors
and management, who are in control, may pursue business strategies that are in their own interest
rather than what is best for shareholders (owners).

Advantages
• Raise huge capital
o Huge capitals can be raised as shares can be sold publicly
• Safeguard interest of shareholders
o Public limited companies are required to publish detailed financial statements each year, which will
ensure transparency and safeguard the interest of the shareholders.

Disadvantages
• Expensive and complex to set up
o Expensive to set up
o Complex legal requirements, involving investigations, advertising shares in mass media,
developing a prospectus
• Vulnerable to takeovers
o Original owner may lose control if the company is taken over by another company that buys
enough shares in the ownership of this company
• Management diseconomies
o Large companies may have problems in communication, control, and coordination
o Managers and owners may disagree
o Decision making may be slow

Functions of the stock exchange

• Enables stocks and shares to be bought and sold:
o Allows public limited companies to sell their stocks to raise finance and fund expansion
o Helps the public to buy such stocks
• The composite index of a stock exchange can be used to indicate the general value of stocks and
shares. This will show how an economy is doing.
• Share prices are an indication of how well a particular firm is doing.
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Multinational Corporations (MNCs)

• Multinational corporation (MNC) – a large company that has operations worldwide (in other host
countries) but its headquarters in one country (home country)

• MNCs are most likely public limited companies, e.g. Nestle, Amazon, Lenovo, Kia Motors, Petronas

Advantages of being an MNC

• Consumer base
o MNCs have a large geographical base of consumers, which means that they reach many more
consumers globally and can thus sell much more of their G&S than other types of businesses
• Minimise cost
o MNCs can minimise cost of production by moving their businesses to strategic locations
o Locating near the supply of raw materials and near key overseas consumer markets would reduce
transport costs
o Operating in low-wage economies would reduce labour costs
• Avoid trade barriers
o MNCs can avoid trade barriers such as tariffs (tax on imports) and quotas (quantity restrictions on
imports) by setting up their operations in the country that impose those trade barriers
• EOS
o MNCs tend to benefit from economies of scale and have reduced average costs due to their large
scale of production

Positive impacts of MNCs on host nations

• Bring in FDI
o MNCs are a foreign direct investment (FDI) that benefits the host country
o They invest in new premises, modern equipment, cutting edge technologies, etc.
o This increases the productive capacity of the economy of the host country
• Employment
o MNCs create employment and increase incomes for locals
• Knowledge and skills
o MNCs bring in new knowledge, skills, and technologies into a country
o This boosts the productivity and efficiency of domestic firms and workers of the host country
• Large tax revenue
o MNCs contribute large tax revenues from their profits to the government of the host country
• Exports sector
o MNCs can export their huge output and thus boost the exports sector and increase the export
earnings of the host nation through international trade
o This also helps in improving the BOP position of the host nation

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Negative impacts of MNCs on host nations

• Exploitation of workers
o MNCs can take advantage of the lax labour laws, lack of enforcement, and lower health and safety
standards of less-developed economies
o May exploit workers in low-wage economies, such as by paying them much less to do more work
compared to employees in more-developed economies
• Exploit the natural resources and environment
o MNCs can take advantage of lax environmental laws and lack of enforcement in some developing
countries
o May exploit and deplete natural resources
o Pursue production and other activities that lead to environmental degradation
• Avoiding taxes
o MNCs may move their profits from their business units to countries with the lowest taxes
o Tax evasion may also occur some in less-developed economies with poor tax-collection and legal
systems

Cooperatives

• Cooperative – a business organisation owned and controlled by a group of people to undertake an

economic activity for their mutual benefit

• Examples:
o A farming cooperative is a group of farm owners who work together to grow, market, and sell crops
and farm animals.
o A workers’ cooperative gives workers the opportunity to learn how to do business and take part in
decision making.

• Features:
o Members are the owners / shareholders
o Members work together and share profits
o Cooperatives exist for the benefit of its members
o Each member has one vote, i.e. there is equal voting that is not based on size of shares held
o Usually limited liability, i.e. members can only lose what they have invested in the cooperative

• Advantages:
o All members have an equal say in making decisions as each member has one vote only. For
example, in a workers’ cooperative, workers have the opportunity to learn how to do business and
take part in decision making. This may make them work harder.
o Workers share the profits made by the cooperative. Profits are paid out as dividends, either an equal
share for each member or according to how much money each invested into the cooperative.

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3.5.2 Small firms

Advantages and disadvantages of small firms; challenges facing small firms; reasons for their existence

Reasons for the existence and survival of small firms

1. Personalised service
o Owners of small firms can give personal attention to details like colour, texture, design, and taste.
o Some G&S can even be custom-made to cater to individual preferences.
o A personal touch may be required in certain industries that offer personal services or specialised
products.
o E.g. tailors offering made-to-measure suits, carpenters offering furniture that are made to order

2. Small local market

o Population is small, so demand for G&S is limited and the market size is small, and thus only small
firms are set up.
o That small firm may become a local monopoly.
o E.g. a clinic in a small town

3. Niche market
o Some firms cater to a niche market and are thus small.
o A firm may provide G&S exclusively for a handful of rich people, e.g. a jeweller selling very
expensive jewellery

4. Limited capital
o Huge capital is needed to expand the scale of production because modern technology and advanced
capital equipment are expensive.
o The owners may have insufficient savings and incomes and may find it hard to obtain an affordable
loan to finance expansion.
o Thus, some firms may remain small due to a lack of capital.

5. Government assistance
o Small and medium enterprises (SMEs) are the largest contributor to employment
o Government assistance may be financial or in the form of technical know-how
o Small firms would thrive in the industry that the government supports
o E.g. giving tax rebates or exemptions to reduce cost of production to the furniture industry would
allow small firms to thrive in that industry

6. Supplying components to big firms

o Some small firms supply components and parts to big firms, e.g. a contractor for a large housing
developer

7. Personal choice
o Expanding a business may be time-consuming and stressful and require management skills
o The owner may want to keep full control of the business and know all employees and customers
personally. Taxes are also lower for smaller firms with lower profits.
o The owner may think the profit is enough and reasonable and thus there is no need for expansion

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3.5.3 Causes and forms of the growth of firms

• The size of a firm can be measured by:

o Number of employees:
▪ Simple measure of size
▪ However, not all big firms have many employees, such as capital-intensive firms.
o Market share:
▪ Market share (of a firm) – the share of total market sales that firm is able to capture
▪ However, not all markets are large, e.g. a local hairdressing salon may be a very small
business in terms of number of employees and capital employed, but it may have a very large
share of the small, local market it serves because it is the only salon in the small town.
o Organisation:
▪ The size of an organisation may be judged by how it is organised internally
▪ Larger firms tend to be divided up into different departments specialising in particular
functions, e.g. marketing, purchasing, IT, HR, finance. Larger firms may also have different
offices, factories, and outlets in different locations.
▪ In smaller firms, owners and employees tend to carry out all the various functions themselves.
o Paid-up capital:
▪ Paid-up capital (financial, not physical capital) is the amount of money a company has
received in payment from shareholders in exchange for its shares.
▪ Companies that have greater paid-up capital may be regarded as larger companies.

Types of growth
1. Internal growth / Organic growth:
o Internal / Organic growth – involves a firm expanding its own existing operations
o Happens naturally as a business becomes successful
o Easier to manage than external growth
o Example: a firm may experience internal growth through increased market share as it opens new
outlets in different locations
o A profitable firm can afford to reinvest its profits into financing its growth. Also, a firm with a good
track record will find it easier to obtain finance through loans. With these additional financial
resources, the firm can purchase additional capital equipment, hire more workers, rent larger
premises, and so on to support the growth and expansion that arise due to an increase in demand
for its G&S, which may occur due to effective marketing campaigns.

2. External growth:
o External growth – involves integration through mergers or takeovers
o Integration – when two or more business join, either through a merger or a takeover
o Merger – when two or more firms agree to join to form a new, larger enterprise
o Takeover (aka acquisition) – when one company buys enough shares in the ownership of another
company (i.e. more than 50% of shares) and so obtains overall control over that company
(In this way, the firm being taken over loses its identity, becoming part of the other company.)

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3.5.4 Mergers
Examples, advantages, and disadvantages of different types of mergers: vertical, horizontal, conglomerate

Vertical
• Vertical merger – when two or more firms in the same industry but at different stages of production
merge

• 2 types of vertical mergers:

o Forward vertical merger – a merger with another firm in a later stage of production (i.e. closer to
customers), e.g. a sugar farm merges with a candy factory
o Backward vertical merger – a merger with another firm at an earlier stage of production, e.g. a car
manufacturer merges with a tyre manufacturer

• Advantages:
o (General) This may enable a firm to benefit from economies of scale and save costs, e.g. financial
economies, where larger firms can secure bank loans more easily and at better rates due to being
deemed as more credit-worthy.
o (Forward) This allows the firm to be in control of a distribution network. This ensures there are
outlets available and products can get to market. This also ensures the products are well-displayed
and promoted.
o (Backward) For a manufacturer, merging with a supplier ensures a steady supply of raw materials /
component parts at a reasonable price.

Horizontal
• Horizontal merger – when two or more firms in the same industry and at the same stage of
production merge, e.g. when two car manufacturers such as Toyota and Honda merge

• Advantages:
o New firm benefits from economies of scale and thus enjoys cost savings due to their larger
combined size, e.g. price discounts on raw materials from bulk buying, reduced staff and other
costs from the merging of their administration departments.
o Reduced number of competitors
o Larger market share

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Conglomerate
• Conglomerate merger – when two or more firms in different industries merge, e.g. a beverage
company merging with a watch manufacturer

• A conglomerate merger is a form of diversification, which means having activities in a variety of

industries.

• A conglomerate merger creates firms known as conglomerates, which are corporations that produce a
wide range of different and unrelated products. Famous conglomerates include Sime Darby (= motors,
healthcare, insurance, etc.) and Samsung (= smartphones, construction, food processing, retail, etc.)

• Advantages:
o Diversification spreads and reduces risk. Businesses that diversify have a lower risk of being
greatly affected by falling consumer demand for any of its products as it can still fall back to
another of its product ranges, e.g. Sime Darby can still depend on sales from its motors division
even when income from its hospitals have fallen
o Sharing of ideas and innovations between different businesses, e.g. an insurance firm taking over an
advertising agency could benefit from newer ideas and better promotion of its insurance products

3.5.5 Economies and diseconomies of scale

How internal and external economies and diseconomies of scale can affect a firm/industry as the scale of
production changes

• Economies of scale (EOS) – advantages of cost savings arising from large-scale production that leads
to falling long run average cost (LRAC)

• Internal EOS – advantages of lower average costs that a firm can gain from its own growth in size

• External EOS – advantages of lower average costs that firms can gain from the growth in the size of
their entire industry

• Diseconomies of scale (DOS) – cost disadvantages arising from large-scale production, resulting in
higher long run average cost (LRAC)

Note: DOS occur when the scale of production increases beyond the optimum scale.

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Internal economies
1. Purchasing economies:
Large firms can buy raw materials in bulk and benefit from price discounts.

2. Financial economies:
Larger firms can secure larger loans more easily and at lower interest rates. This is because they are
usually more financially secure and can offer more assets as collateral against the risk of default and
are thus deemed to be more credit-worthy and less risky by lenders.

3. Marketing economies:
The fixed costs of advertising, transportation, and promotions are spread over higher outputs, and
larger firms are also more able to spend more to have wider and more effective marketing campaigns.

4. Managerial economies:
Large firms are able to employ specialised and skilled staff and managers that are more productive
and able to increase sales. This is because they are structured with specialised departments and are
also able to attract and retain specialists as they can offer better wages and other perks. The fixed costs
of the salaries of managers are spread over larger outputs.

5. Technical economies:
Large firms can afford to invest in large-scale and specialised efficient equipment that is more
efficient, which would produce higher outputs and lower average costs. Large firms are also
structured with specialised departments and use specialised equipment, both of which allow them to
employ highly specialised and skilled labour, which is more efficient as well.

6. Risk-bearing economies:
Larger firms may have diversified into different product ranges and consumer markets. Diversification
spreads and reduces risks, such as falling consumer demand for one of its products. E.g. Unilever is
famous for its soap and detergent products but also has interests in food, skincare, plastics, tropical
plantations, etc.

Internal diseconomies
1. Management diseconomies:
When firms become too large, it may lead to inefficient management and coordination. They may
experience communication breakdowns and disagreements. Also, it may take longer to make decisions
and for employees to act on them. These time lags may make the firms slower in responding to
changing market conditions.

2. Labour diseconomies:
Large firms may automate production processes, and workers may become bored and demotivated due
to repetitive tasks. Also, lack of the personal touch with managers in large firms may also demotivate
employees. Low motivation may lead to low productivity. These also lead to poor industrial relations,
which increases the likelihood of industrial action, such as strikes, which increase cost of production.

3. Financial diseconomies:
When the loan principal is too large, the risk of default is very high. To protect their interests, banks
may charge higher interest rates.

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External economies
1. Ancillary firms:
Ancillary firms develop and locate in areas where there are many firms of a particular industry to
provide them with the specialised components, equipment, and services they need, e.g. specialist
training, specialised machinery, specialist transport services

2. Shared infrastructure:
When many firms of a particular industry develop and are clustered together in an area, it may
encourage other industries or the government to invest in new infrastructure in that area, such as new
airports and new roads. The firms of that industry and area all benefit from improved transport and
communication links and other infrastructure.

3. Skilled labour:
Firms may benefit from the increased availability of skilled labour when their industry grows. An area
with many firms of a particular industry would attract many specialised and skilled workers, which
reduces recruitment and training costs. Also, the firms can recruit workers trained by other firms in the
same industry.

4. Joint marketing benefits:

When firms in the same industry cluster in an area well-known for producing high-quality products,
they may share an enhanced reputation. Also, this attracts many customers of that industry to that area.

External diseconomies
1. Competition:
An increase in the number of firms in an expanding industry would increase competition for scarce
resources, such as raw materials and skilled labour. Shortages of factors of production would increase
their prices, e.g. labour shortages would push up wages. This would increase costs of production.

2. Congestion:
An increase in economic activity and number of firms in an area may place high pressure on the
infrastructure in that region. This may lead to external costs like traffic congestion, which leads to
transportation delays. This would increase costs of production.

3. Pollution:
The growth of an industry in an area increases pollution, which is an external cost, in that area, thus
increasing the social costs. Pollution is harmful to the health of workers and may reduce their
productivity, leading to rising costs of production.

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3.6 Firms and Production

3.6.1 Demand for factors of production
Influences, to include demand for product, price of different FOP, their availability, and their productivity

3.6.2 Labour-intensive and capital-intensive production

Reasons for adopting the different forms of production and their advantages and disadvantages

Methods of production
1. Capital-intensive – where the proportion of capital used is greater relative to the other factors of
production in the production process, e.g. telecommunications, automobile industry, oil refineries

2. Labour-intensive – where the proportion of labour used is greater relative to the other factors of
production in the production process, e.g. nursing, retail, handicraft industry

3.6.3 Production and productivity

Differences between and influences on production and productivity

• Production – the process of converting input into output

• Productivity – value of output per input in a given period of time

𝑇𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 =
𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑝𝑢𝑡
𝑇𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 =
𝑇𝑜𝑡𝑎𝑙 𝑛𝑜. 𝑜𝑓 𝑤𝑜𝑟𝑘𝑒𝑟𝑠
Theory of production
• Note: factors = factors of production = input

• Time period:
o Short run – a time period that has at least one fixed factor
o Long run – a time period long enough where all factors can be varied

• Factors (inputs):
o Fixed factor – a factor that does not vary with the level of output
o Variable factor – a factor that varies with the level of output

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Short-run production theory: the law of diminishing (marginal) returns

• Diminishing returns occur in the short run, when there is at least one fixed factor

• The law of diminishing (marginal) returns states that as the amount of a variable factor of production
is increased while holding all other factors constant (ceteris paribus), the change in total output will at
first rise and then decline (i.e. there comes a point where the marginal increase in output begins to
decrease)

• This is because the combination of variable and fixed factors would become less and less efficient and
effective, e.g. if capital / land is fixed, hiring extra workers will eventually cause them to get in each
other’s way of trying to increase production, so output increases but at a decreasing rate.

Long-run production theory → the law of returns to scale

• Both returns to scale and EOS describe what happens when scale of production increases in the long
run (i.e. when all FOP are variable), but returns to scale relates input and output only while EOS
shows the effect of the increased output on average cost.

• The law of returns to scale describes the changes in output when all the factors (inputs) are increased
in the same proportion.

• Types of returns to scale:

o Constant returns to scale → % change in output = % change in input
o Increasing returns to scale → % change in output > % change in input
o Diminishing returns to scale → % change in output < % change in input

Note: The symbols (K) and (L) denote (capital) and (labour) respectively.
Amos Beryl Cadbury
Initial 100L + 100K 200L + 250K 300L + 200K
Total output = 100 000 Total output = 200 000 Total output = 300 000
Total costs = $100 000 Total costs = $200 000 Total costs = $300 000
AC = $1 AC = $1 AC = $1
Final: 200L + 200K 400L + 500K 600L + 400K
initial input Total output = 200 000 Total output = 500 000 Total output = 500 000
×2 Total costs = $200 000 Total costs = $400 000 Total costs = $600 000
AC1 = $1 AC1 = $0.80 AC1 = $1.20
AC remains unchanged. AC decreases. AC increases.
Reason for lower LRAC = Reason for higher LRAC =
reaps benefits of EOS suffers from DOS
Doubling the input causes Doubling the input causes the Doubling the input causes the
the output to exactly double output to increase but more output to increase but less than
→ there is constant than double → there is double → there is decreasing
returns to scale increasing returns to scale returns to scale

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3.7 Firms’ Costs, Revenue, and Objectives

3.7.1 Definition of costs of production
3.7.2 Calculation of costs of production
Calculations of TC, ATC, FC, VC, AFC, and AVC; definition, drawing, and interpretation of diagrams
that show how changes in output affect costs of production

• Total cost (TC):

o Total cost = Fixed cost + Variable cost

• Average total cost (ATC)

• Fixed cost (FC):

o A cost incurred by fixed factors and does not vary with the level of output
o E.g. rent, machinery hire charges, loan interest

• Variable cost (VC):

o A cost incurred by variable factors and varies with the level of output
o E.g. raw material costs (e.g. fabric costs in a clothing factory), packaging costs, sales commissions

• Average fixed cost (AFC)

• Average variable cost (AVC)

3.7.3 Definition of revenue

3.7.4 Calculation of revenue
Calculations of TR and AR; the influence of sales on revenue
NOT required: marginal revenue

• Total revenue (TR) = Price x Quantity Traded (PQ)

• Average revenue (AR)= TR/Quantity

3.7.5 Objectives of firms

Survival, social welfare, profit maximisation, growth

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3.8 Market Structure

3.8.1 Competitive markets
Effect (of having high no. of firms) on price, quality, choice, and profit
3.8.2 Monopoly markets
Characteristics, advantages, and disadvantages
(NOT required: diagrams; the theory of perfect and imperfect competition)

Market Structure

Perfect Competition Monopolistic Oligopoly Monopoly

Competition

Criteria of perfect competition and monopolies

Difference Perfect Competition Monopoly
No. of sellers in the Many buyers Many buyers
market / industry Many sellers ONE seller
Types of goods Products made by firms in perfect Products are unique and may not be
produced competition are homogenous / identical homogenous
Influence on market Price takers (Reason: The individual Price setters (Reason: Monopolies are
price (ability in price firm is relatively small in size and hence characterised by a lack of competition
setting) has no influence on market price.) and have very significant market share
and power.)
Freedom of / Barriers Perfect freedom of entry and exit High barriers to entry and exit
to entry and exit
Level of profits in the Firms in perfect competition can only Monopolies are able to make abnormal
long run make abnormal profits in the short run. profits even in the long run.
In the long run, they can only make
normal profits.
Examples - Agricultural industry / markets Public utilities (companies that provide
- Stock market essential services to the public, e.g.
electricity, water, telecommunications)

Perfect Competition / Competitive Market

• Advantages:
o There are many firms, so there are more choices of products, leading to higher consumer
satisfaction.
o Prices are kept low and competitive, which increases consumer surplus.
o Firms strive to keep cost low and achieve productive efficiency.

• Disadvantages:
o Products are homogeneous / identical, leading to low consumer satisfaction.
o Firms only make normal profit in the long run, and so there is no incentive to innovate and improve
on product quality or design.

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Monopoly

• Monopoly:
o Only one seller (textbook definition)
o Captures 25% of market share (legal definition)

• Monopolies are characterised by a lack of economic competition.

• Barriers to entry (monopoly), such as:

o Legal barriers, e.g. patents, copyrights, trademarks
o Cost barriers, due to economies of scale

• Note: abnormal profits = supernormal profits

• Advantages:
o A monopoly earns supernormal profits even in the long run. They can plough back their post-tax
profits for reinvestment and R&D to achieve dynamic efficiency and to produce products of higher
quality and better design.
o A monopoly can reap the benefits of EOS and are thus able to price their products at lower prices
compared to competitive markets.
o Some monopolies are natural monopolies due to very high fixed costs, which make it naturally
efficient to only have one seller in the market. An example is in a public utility in electricity
production. EOS would allow the monopoly to produce at a lower average cost.

• Disadvantages:
o Monopolies may exploit consumers in terms of higher price and lower output, reducing consumer
surplus.
o There is x-inefficiency, which arises from organisational slack and leads to unnecessarily high
costs (i.e. higher than they should be). (This is due to a lack of competition, which means less
incentive for the monopoly to cut costs.)
o Allocative inefficiency occurs because price is greater than marginal cost.
o Productive inefficiency occurs because a monopoly does not produce at the minimum average cost.

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