The Nature of the Economic Problem

Resources: are the inputs required for the production of goods and
services.
Scarcity: a lack of something (in this context, resources).
The fundamental economic problem is that there is a scarcity of
resources to satisfy all human wants and needs. There are finite
resources and unlimited wants. This is applicable to consumers,
producers, workers and the government, in how they manage their
resources.

Economic goods are those which are scarce in supply and so can only
be produced with an economic cost and/or consumed with a price. In
other words, an economic good is a good with an opportunity cost. All
the goods we buy are economic goods, from bottled water to clothes.
Free goods, on the other hand, are those which are abundant in supply,
usually referring to natural sources such as air and sunlight.
The Factors of Production
Resources are also called ‘factors of production’ (especially in
Business). They are:

 Land: all natural resources in an economy. This includes the

surface of the earth, lakes, rivers, forests, mineral deposits, climate
etc.
 The reward for land is the rent it receives.
 Since, the amount of land in existence stays the same,
its supply is said to be fixed. But in relation to a country
or business, when it takes over or expands to a new area,
you can say that the supply of land has increased, but the
supply is not depended on its price, i.e. rent.
 The quality of land depends upon the soil type, fertility,
weather and so on.
  Since land can’t be moved around, it is geographically
immobile but since it can be used for a variety of
economic activities it is occupationally mobile.
 Labour: all the human resources available in an economy. That
is, the mental and physical efforts and skills of workers/labourers.
 The reward for work is wages/salaries.
 The supply of labour depends upon the number of
workers available (which is in turn influenced by
population size, no. of years of schooling, retirement age,
age structure of the population, attitude towards women
working etc.) and the number of hours they work (which is
influenced by
 number of hours to work in a single day/week, number of
holidays, length of sick leaves, maternity/paternity leaves,
whether the job is part-time or full-time etc.).
 The quality of labour will depend upon the skills,
education and qualification of labour.
 Labour mobility can depend up on various factors. Labour
can achieve high occupational mobility (ability to change
jobs) if they have the right skills and qualifications. It can
achieve geographical mobility (ability to move to a place
for a job) depending on transport facilities and costs,
housing facilities and costs, family and personal priorities,
regional or national laws and regulations on travel and
work etc.
 Capital: all the man-made resources available in an economy.
All man-made goods (which help to produce other goods – capital
goods) from a simple spade to a complex car assembly plant are
included in this. Capital is usually denoted in monetary terms as
the total value of all the capital goods needed in production.
 The reward for capital is the interest it receives.
 The supply of capital depends upon the demand for goods
and services, how well businesses are doing, and savings
in the economy (since capital for investment is financed
by loans from banks which are sourced from savings).
  The quality of capital depends on how many good quality
products can be produced using the given capital. For
example, the capital is said to be of much more quality in
a car manufacturing plant that uses mechanisation and
technology to produce cars rather than one in which
manual labour does the work.
 Capital mobility can depend upon the nature and use of
the capital. For example, an office building is
geographically immobile but occupationally mobile. On
the other hand, a pen is geographically and occupationally
mobile.
 Enterprise: the ability to take risks and run a business
venture or a firm is called enterprise. A person who has enterprise
is called an entrepreneur. In short, they are the people who start a
business. Entrepreneurs organize all the other factors of production
and take the risks and decisions necessary to make a firm run
successfully.
 The reward to enterprise is the profit generated from the
business.
 The supply of enterprise is dependent on entrepreneurial
skills (risk-taking, innovation, effective communication
etc.), education, corporate taxes (if taxes on profits are too
high, nobody will want to start a business), regulations in
doing business and so on.
 The quality of enterprise will depend on how well it is
able to satisfy and expand demand in the economy in cost-
effective and innovative ways.
 Enterprise is usually highly mobile, both geographically
and occupationally.
All the above factors of productions are scarce because the time people
have to spend working, the different skills they have, the land on which
firms operate, the natural resources they use etc. are all in limited in
supply; which brings us to the topic of opportunity cost.

Opportunity Cost
The scarcity of resources means that there are not sufficient goods and
services to satisfy all our needs and wants; we are forced to choose some
over the others. Choice is necessary because these resources have
alternative uses- they can be used to produce many things. But since
there are only a finite number of resources, we have to choose.

When we choose something over the other, the choice that was given up
is called the opportunity cost. Opportunity cost, by definition, is the
next best alternative that is sacrificed/forgone in order to satisfy the
other.
Example 1: the government has a certain amount of money and it has
two options: to build a school or a hospital, with that money. The govt.
decides to build the hospital. The school, then, becomes the opportunity
cost as it was given up. In a wider perspective, the opportunity cost is
the education the children could have received, as it is the actual cost to
the economy of giving up the school.
Example 2: you have to decide whether to stay up and study or go to bed
and not study. If you chose to go to bed, the knowledge and preparation
you could have gained by choosing to stay up and study is the
opportunity cost.
Production Possibility Curve Diagrams (PPC)
Because resources are scarce and have alternative uses, a decision to
devote more resources to producing one product means fewer resources
are available to produce other goods. A Production Possibility Curve
diagram shows this, that is, the maximum combination of two goods
that can be produced by an economy with all the available
resources.
The PPC diagram above shows the production capacities of two goods-
X and Y- against each other. When 500 units of good X are produced,
1000 units of good Y can be produced. But when the units of good X
increases to 1000, only 500 units good Y can be produced.

Let’s look at the PPC named A. At point X and Y it can produce certain
combinations of good X and good Y. These are points on the curve- they
are attainable, given the resources. Th economy can move between
points on a PPC simply by reallocating resources between the two
goods.
If the economy were producing at point Z, which is inside/below the
PPC, the economy is said to be inefficient, because it is producing less
than what it can.
Point W, outside/above the PPC, is unattainable because it is beyond the
scope of the economy’s existing resources. In order to produce at point
W, the economy would need to see a shift in the PPC towards the right.
For an outward shift to occur, an economy would need to:
  discover or develop new raw materials. Example: discover new oil
fields
 employ new technology and production methods to increase
productivity
 increase labour force by encouraging birth and immigration,
increasing retirement age etc.
An outward shift in PPC, that is higher production possibility, will lead
to economic growth.

In the same way, an inward shift can occur in the PPC due to:
 natural disasters, that erode infrastructure and kill the population
 very low investment in new technologies will cause productivity to
fall over time
 running out of resources, especially non-renewable ones like oil or
water
An inward shift in the PPC will lead to the economy shrinking.

How is opportunity cost linked to PPC?

Individuals, businessmen and the government can calculate
the opportunity cost from PPC diagrams. In the above example, if the
firm decided to increase production of good Y from 500 to 750, it can
calculate the opportunity cost of the decision to be 250 units of good X
(as production of good X falls from 1000 to 750). They are able to
compare the opportunity cost for different decisions. Economy: an area
where people and firms produce, trade and consume goods and services.
This can vary in size- from your local town to your country, or the globe
itself.
Microeconomics and Macroeconomics
Microeconomics is the study of individual markets. For example:
studying the effect of a price change on the demand for a good.
Microeconomic decision makers are producers and consumers (who
directly operate in markets)
Macroeconomics is the study of an entire economy, as a whole.
Examples include studying the total size of the economy or the
unemployment rate, among other things. Macroeconomic decisions are
made by the government of the particular economy – a town, state or
country)
The Role of Markets in Allocating Resources
Resource allocation: the way in which economies decide what goods
and services to provide, how to produce them and who to produce them
for.
These questions- what to produce, how to produce, and for whom to
produce – are termed ‘the basic economic questions’. In short,
resource allocation is the way in which economies solve the three basic
economics questions.
Market is any set of arrangement that brings together all the producers
and consumers of a good or service, so they may engage in exchange.
Example: a market for soft drinks.
Goods and services are bought and sold in a market at an equilibrium
price where demand and supply are equal. This is called the price
mechanism. It helps answer the three basic economic questions.
Producers will produce the good that consumers demand the most, it will
be produced in a way that is cost-efficient, and will be produced for
those who are willing and able to buy the product. More on these topics
below:

Demand
Demand is the want and willingness of consumers to buy a good or
services at a given price. Effective demand is where the willingness to
buy is backed by the ability to pay. For example, when you want a
laptop but you don’t have the money, it is called demand. When you do
have the money to buy it, it is called effective demand.
The effective demand for a particular good or service is called quantity
demanded.
(Individual demand is the demand from one consumer, while market
demand for a product is the total (aggregate) demand for the product, or
the sum of all individual demands of consumers).
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The law of demand states that an increase in price leads to a decrease
in demand, and a decrease in price leads to an increase in
demand (it’s an inverse relationship between price and demand.
However it’s worth noting that an increase in demand leads to an
increase in price and a decrease in demand leads to a decrease in price.
The law of demand is established with respect to changes in price, not
demand, hence the difference).

This is an example of a demand curve for Coca-Cola.

Here, a decrease in price from 80 to 60 has increased its demand from
300 to 500.
The increase in demand due to changes in price (without changes
in other factors) is called an extension in demand. Here the
extension in demand is from A to B.
In the above example, an increase in price from 60 to 80, will decreased
the demand from 500 to 300. The decrease in demand due to the
changes in price (without changes in other factors) is called a
contraction in demand. Here the contraction in demand will be from B
to A.
 In this example,
there is a rise in the demand of Coca-Cola from 500 to 600, without any
change in price. A rise in the demand for a product due to the
changes in other factors (excluding price) causes the demand curve
to shift to the right (from A to B).
In this example, there is a fall in demand of Coca-Cola from 500 to 400,
without any change in price.
A fall in demand for a product due to the changes in other factors
(excluding price) causes the demand curve to shift to the left (from A
to B).
Factors that cause shifts in a demand curve:
 Consumer incomes: a rise in consumers’ incomes increases
demand, causing a shift to right. Similarly, a fall in incomes will
shift the demand curve to the left.
 Taxes on incomes: a rise in tax on incomes means less demand,
causing a shift to the left; and vice versa.
 Price of substitutes: Substitutes are goods that can be used
instead of a particular product. Example: tea and coffee are
substitutes (they are used for similar purposes). A rise in the price
of a substitute causes a rise in the demand for the product, causing
the demand curve to shift to the right; and vice versa.
 Price of complements: Complements are goods that are used
along with another product. For example, printers and ink
cartridges are complements. A rise in the price of a complementary
 good will reduce the demand for the particular product, causing the
demand curve to shift to the left; and vice versa.
 Changes in consumer tastes and fashion: for example, the
demand for DVDs have fallen since the advent of streaming
services like Netflix, which has caused the demand curve for
DVDs to shift to the left.
 Degree of Advertising: when a good is very effectively advertised
(Coke and Pepsi are good examples), its demand rises, causing a
shift to the right. Lower advertising shifts the demand curve to the
left.
 Change in population: A rise in the population will raise demand,
and vice versa.
 Other factors, such as weather, natural disasters, laws, interest rates
etc. can also shift the demand curve.
Supply
Supply is the want and willingness of producers to supply a good or
services at a given price. The amount of goods or services producers
are willing to make and supply is called quantity supplied.
(Market supply refers to the amount of goods and services all producers
supplying that particular product are willing to supply or the sum of
individual supplies of all producers).
The law of supply states that an increase in price leads to a increase
in supply, and a decrease in price leads to an decrease in
supply (there is a positive relationship between price and supply.
However, it’s also worth noting that, an increase in supply leads to a
decrease in price and a decrease in supply leads to an increase in price.
The law of supply is established with respect to changes in price, not
supply, hence the difference).
 This is an example of a
supply curve for a product.
Here, an increase in price from 60 to 80, has increased its supply from
500 to 700.
The increase in supply due to changes in price (without changes
in other factors) is called an extension in supply.
A decrease in price from 80 to 60, will decreased the supply from 700 to
500. The decrease in supply due to changes in price (without
the changes in other factors) is called a contraction in supply.
In this example, there is a rise in the supply of a product from 500 to
700, without any change in price. A rise in the supply for a product
due to the changes in other factors (excluding price) causes a shift to
the right.

A fall in supply from 500 to 300, without any changes in price is also
shown. A fall in the supply for a product due to the changes in other
factors (excluding price) causes a shift to the left.
Factors that cause shifts in supply curve:
 Changes in cost of production: when the cost of factors to
produce the good falls, producers can produce and supply more
products cheaply, causing a shift in the supply curve to the right. A
subsidy*, which lowers the cost of production also shifts the
supply curve right. When cost of production rises, supply falls,
causing the supply curve to shift to the left.
 Changes in the quantity of resources available: when the
amount of resources available rises, the supply rises; and vice
versa.
 Technological changes: an introduction of new technology will
increase the ability to produce more products, causing a shift to the
right in the supply curve.
 The profitability of other products: if a certain product is seen to
be more profitable than the one currently being produced,
producers might shift to producing the more profitable product,
reducing supply of the initial product (causing a shift to the left).
 Other factors: weather, natural disasters, wars etc. can shift the
supply curve left.
Market Price
 The market equilibrium
price is the price at which the demand and supply curves in a given
market meet.
In this diagram, P* is the equilibrium price.

Disequilibrium price is the price at which market demand and supply

curves do not meet, which in this diagram, is any price other than P*.
Price Changes

In this diagram, two

disequilibrium prices are marked- 2.50 and 1.50.
At price 2.50, the demand is 4 while the supply is 10. There is excess
supply relative to the demand. When the price is above the
equilibrium price, a surplus is experienced. (Surplus means ‘excess’).
At price 1.50, the demand is 10 while the supply is only 4. There is
excess demand relative to supply. When the price is below the
equilibrium price, a shortage is experienced.
(This shortage and surplus is said in terms of the supply being short or
excess respectively).
Price Elasticity of Demand (PED)
The PED of a product refers to the responsiveness of the quantity
demanded to changes in its price.
PED (of a product) = % change in quantity demanded / % change
in price
 For example, calculate the
price elasticity of demand of Coca-Cola from this diagram.

PED= [(500-300/300)*100] / [(80-60/80)*100]

= 66.67 / 25 = 2.67

In this example, the PED is 2.67, that is, the % change in quantity
demanded was higher than the % change in the price. This means, a
change in price makes a higher change in quantity demanded. These
products have a price elastic demand. Their values are always above 1.
When the % change in quantity demanded is lesser than the % change in
price, it is said to have a price inelastic demand. Their values are
always below 1. A change in price makes a smaller change in
demand.

When the % change in demand and price are equal, that is value is 1,
it is called unitary price elastic demand.
When the quantity demanded changes without any changes in price
itself, it is said to have an infinitely price elastic demand. Their values
are infinite.

When the price changes have no effect on demand whatsoever, it is

said to have a perfect price inelastic demand. Their elasticity is 0.
What affects PED?

 No. of substitutes: if a product has many substitute products it will

have an elastic demand. For example, Coca-Cola has many
 substitutes such as Pepsi and Mountain Dew. Thus a change in
price will have a greater effect on its demand (If price rises,
consumers will quickly move to the substitutes and if price lowers,
more consumers will buy Coca-Cola).
 Time period: demand for a product is more likely to be elastic in
the long run. For example, if the price rises, consumers will search
for cheaper substitutes. The longer they have, the more likely they
are to find one.
 Proportion of income spend on commodity: goods such as rice,
water (necessities) will have an inelastic demand as a change in
price won’t have any significant effect on its demand, as it will
only take up a very small proportion of their income. Luxury goods
such as cars on the other hand, will have a high price elastic
demand as it takes up a huge proportion of consumers’ incomes.
Relationship between PED and revenue and how it is helpful to
producers:

Producers can calculate the PED of their product and take a suitable
action to make the product more profitable.

Revenue is the amount of money a producer/firm generates from sales,

i.e., the total number of units sold multiplied by the price per unit. So, as
the price or the quantity sold changes, those changes have a direct effect
on revenue.

If the product is found to have an elastic demand, the producer can

lower prices to increase revenue. The law of demand states that a price
fall increases the demand. And since it is an elastic product (change in
demand is higher than change in price), the demand of the product will
increase highly. The producers get more revenue.
If the product is found to have an inelastic demand, the producer can
raise prices to increase revenue. Since quantity demanded wouldn’t
fall much as it is inelastic, the high prices will make way for higher
revenue and thus higher profits.
Price Elasticity of Supply (PES)
The PES of a product refers to the responsiveness of its quantity
supplied it to changes in its price.
PES of a product= %change in quantity supplied / %change in
price
Similar to PED, PES too can be categorized into price elastic supply,
price inelastic supply, perfectly price inelastic supply, infinitely price
elastic supply and unitary price elastic supply. (See if you can figure out
what each supply elasticity means using the demand elasticities above as
reference, and draw the diagrams as well!)

What affects PES?

 Time of production: If the product can be quickly produced, it

will have a price elastic supply as the product can be quickly
supplied at any price. For example, juice at a restaurant. But
products which take a longer time to produce, such as cars, will
have a price inelastic supply as it will take a longer time for supply
to adjust to price.
 Availability of resources: More resource (land, labour, capital)
will make way for an elastic supply. If there are not enough
resources, producers will find it difficult to adjust to the price
changes, and supply will become price inelastic.
Market Economic System
In a market economic system or free market economic system, all
resources are allocated by the market – private producers and
consumers; that is, there is no or very little government intervention in
resource allocation. (There are virtually no economies in the world that
follow this system – there is a government control everywhere, although
Hong Kong and Singapore do come close – check out the Index of
Economic Freedom to see the ranking of economies on the basis of how
market-friendly they are ).

Features:
  All resources are owned and allocated by private individuals.
 Government refrains from regulating markets. It instead tries to
create very business-friendly environments and any intervention is
mostly limited to protecting private property. The demand and
supply fixes the price of products. This is called price mechanism.
 What to produce is solved by producing the most-demanded
goods for which people spend a lot, as their only motive is to
generate a high profit.
 How to produce is solved by using the cheapest yet efficient
combination of resources – capital or labour- in order to
maximise profits.
 For whom to produce is solved by producing for people who are
willing and able to pay for goods at a high price.
Advantages:
 A wide variety of quality goods and services will be produced as
different firms will compete to satisfy consumer wants and make
profits. Quality is ensured to make sure that consumers buy from
them. There is consumer sovereignty.
 Firms will respond quickly to consumer changes in demand.
When there is a change in demand, they will quickly allocate
resources to satisfying that demand, so as to maintain profits.
 High efficiency will exist. Since producers want to maximise
profits, they will use resources very efficiently (producing more
with less resources).
 Since there is hardly any government intervention (in the form of
regulations, extra fees and fines etc. for example), firms will find it
easy and inexpensive to start and run businesses.
Disadvantages:
 Only profitable goods and services are produced. Public
goods* and some merit goods* for which there is no demand may
not be produced, which is a drawback and affects the economic
development.
  Firms will only produce for consumers who can pay for them.
Poor people who cannot spend much won’t be produced for, as it
would be non-profitable.
 Only profitable resources will be employed. Some resources will
be left unused. In a market economy, capital-intensive production
is favoured over labour- intensive production (because it’s more
cost-efficient). This can lead to unemployment.
 Harmful (demerit) goods may be produced if it is profitable to do
so.
 Negative impacts on society (externalities) may be ignored by
producers, as their sole motive is to keep consumers satisfied and
generate a high profit.
 A firm that is able to dominate or control the market supply of a
product is called a monopoly. They may use their power to restrict
supply from other producers, and even charge consumers a high
price since they are the only producer of the product and
consumers have no choice but to buy from them.
 Due to high competition between firms, duplication of
products may take place, which is a waste of resources.
*Public goods: goods that can be used by the general public, from
which they will benefit. Their consumption can’t be measured, and thus
cannot be charged a price for (this is why a market economy doesn’t
produce them). Examples are street lights and roads.
*Merit goods: goods which create a positive effect on the community
and ought to be consumed more. Examples are schools, hospitals, food.
The opposite is called demerit goods which includes alcohol and
cigarettes
*Subsidies: financial grants made to firms to lower their cost of
production in order to lower prices for their products.

Public goods: goods that can be used by the general public, from which
they will benefit. Their consumption can’t be measured, and thus cannot
be charged a price for (this is why a market economy doesn’t produce
them). Examples include street lights and roads.
Merit goods: goods which create a positive effect on the society and
ought to be consumed more. Examples include schools and hospitals.
The opposite is called demerit goods which include alcohol and
cigarettes.
External costs (negative externalities) are the negative impacts on
society (third-parties) due to production or consumption of goods and
services. Example: the pollution from a factory.
External benefits (positive externalities) are the positive impacts on
society due to production or consumption of goods and services.
Example: better roads in a neighbourhood due to the opening of a new
business.
Private costs are the costs to the producer and consumer due to
production and consumption respectively. Example: the cost of
production.
Private benefits are the benefits to the producer or consumer due to
production and consumption respectively. Example: the better
immunity received by a consumer when he receives a vaccine.
Social Costs = External costs + Private Costs
Social Benefits = External benefits + Private benefits
Market Failure
Market failure occurs when the price mechanism fails to allocate
resources effectively. This is the most disadvantageous aspect to the
market economy. Causes of market failure are:

 When social costs exceed social benefits (especially where

negative externalities (external costs) are high).
 Over-provision of demerit goods like alcohol and tobacco: the
external costs arising from demerit goods are not reflected in the
market and so they are overproduced.
 Under-provision of merit goods such as schools, hospitals and
public transport, since the external benefits of these goods are not
reflected in the market, they are underproduced.
*Monopoly: a single supplier who supplies the entire market with a
particular product, without any competition. Example: public utilities
like water, gas and electricity in many countries are provided by their
respective governments with no other producer allowed in the market.

2.11 – Mixed Economic System

In a mixed economic system, both the market and government
intervention co-exist. Examples include almost all countries in the
world (India, UK, Brazil etc.). This is because it overrides all the
disadvantages of both the market and planned (govt. only) economies. It
identifies the importance of the price mechanism in operating an
efficient resource allocation and also the role of the government in
correcting (any) market failures.
Features:
 both the public and the private sector exists
 planning and final decisions are made by the govt. while the
market system can determine allocation of resources owned by it,
along with the public organizations.
Advantages:
 The govt. can provide public goods, necessities and merit goods.
The private businesses can provide profitable and most-demanded
goods (luxury goods, superior goods). Thus, everyone is provided
for.
 The govt. will keep externalities, monopolies, harmful goods etc.
in control.
 The govt. can provide jobs in the public sector (so there is better
job security).
 The govt. can also provide financial help to collapsing private
organizations, so jobs are kept secure.
Disadvantages:
 Taxes will be imposed, which will raise prices and also reduce
work incentive.
 Laws and regulations can increase production costs and reduce
production in the economy.
  Public sector organizations will still be inefficient and will produce
low quality goods and services.
The specific ways in which the government, in a mixed economic
system, can correct market failures of the market:
 Legislation and regulation – the government can make laws that
regulate market activity, for example, prohibit smoking in public
(which would cause a negative externality). One important kind of
legislation the govt. can undertake is price controls – setting a
minimum price or maximum price on goods.

Minimum
price or price floor is set to control a decreasing tendency of
price. The minimum wage laws in many countries are an example
of minimum price. The government sets the minimum wage above
the existing market equilibrium wage, to ensure that all workers
get a basic minimum wage to sustain them. But even as low-
income workers now get better wages, the higher wage will cause
the demand for labour to contract, as shown in the diagram to the
left. There will also be higher supply of labour (workers who want
work) because of higher wages. A reduced demand and increased
supply will cause excess supply of labour i.e., unemployment.
 Maximum
price or price ceiling is set to control an increasing tendency of
price. It is usually set on rent (this is called rent control), to ensure
that low-income tenants can afford to rent homes. But as a result of
the lower rent, landlord will stop renting more homes, causing
supply to contract, as shown in the diagram to the left. At the same
time, lower rent will increase the demand for homes. A reduced
supply of homes and higher demand for them will cause a shortage
of supply in relation to demand.
 Direct provision of merit and public goods – since there is little
incentive for the price mechanism to supply these goods,
governments usually provide them. For example, free education,
free healthcare, public parks. One way the govt. can do this is
by nationalising certain products it considers essential to be
provided by a governing authority, rather than the market. For
example, in India, the government operates the only railway
network because only it can provide cheap services to its millions
of poor, daily passengers.
 Taxation on products – imposing a tax on products (indirect taxes)
with negative externalities can discourage its production and
consumption. For example, a tax on tobacco will make it expensive
 to produce and consume. In the diagram below, a tax has been
imposed on a product, causing its supply to shift from S to S1. The
price rises from P to P1 because of the additional tax amount, and
the quantity traded in the market falls from Q to Q1.

 Subsidies – a subsidy is a grant (financial aid) on products that

have a positive externality. Subsidising, for example, cooking gas
for the poor, will increase the living standard of the population. In
the diagram below, a subsidy has been imposed on a good, causing
its supply to shift from S to S1. It results in a fall in price from P to
P1 and subsequently, an increase in the quantity traded in the
market from Q to Q1.
 *Note: movements along a demand or supply curve of a good only
happen as a result of a direct change in price of the good; changes
caused by any other factor, tax and subsidy included, is
represented by a shift in the curves.
 Tradable permits – firms will have to buy permits from the
government to do something, for example, pollute at a certain
level, and these can be traded among firms. Since permits require
money, firms will be encouraged to pollute less.
 Extension of property rights – one of the main reasons for
pollution in public spaces is that it is public – it does not harm a
specific private individual – the resource is the government’s who
cannot charge compensations easily. So the government can extend
property rights (right to own property) of public places to private
individuals. This will effectively privatise resources, create a
market for these spaces and then individuals can be fined for
polluting
 International cooperation among governments – governments
work together on issues that affect the future of the environment.
As you can see, market failure can be corrected by governments in a
variety of ways and the presence of a government is quite indispensable
in any modern economy. Planned (government-only) economies are too
inefficient and free market (no government) economies result in market
failures. So a mixed economic system tries to balance both sides. That
being said, there are certain drawbacks to government intervention in an
economy.
 Political incentives: this occurs when there is a clash between
political and economics (because a government is a political entity
with political incentives). For example, even though mining
companies cause a lot of environmental damage, the government
may encourage and promote their activities to garner political and
financial support from them.
 Lack of incentives: in the free market, individuals have a profit
incentive to innovate and cut costs, but in the public sector, such an
incentive is absent since the government will pay them salaries
regardless of their performance. So, even as the government
provides certain public and merit goods directly to the people at
low costs, they tend to be very inefficient.
 Time lags, information failure: these are some of the government
failure arising because of a lack of incentive. Government offices
and employees don’t have an incentive to provide timely services
or give accurate information and this leads to very inefficient
systems.
 Welfare effects of policies: government policies such as taxation
and welfare payments distort the market. This means that such
policies will influence demand and supply in the economy and
cause markets to move away from the efficient points produced by
a market system. For example, high corporate taxes will deter
companies from expanding their operations and making more
profits or deter new enterprises from entering the market.
Unemployment benefits given out by the government may cause
people to stay unemployed and receive free benefits instead of
working.
  Lack of public goods such as roads, bus terminals and street
lights: since their consumption cannot be measures and charged a
price for, they are not produced by the private sector.
 Immobility of resources: when resources cannot move between
their optimal uses and thus are not used to the maximum. For
example, when workers (labour) don’t have occupational or
geographic mobility.
 Information failure: when information between consumers,
producers and the government are not efficiently and correctly
communicated. Example: a cosmetics firm advertises its products
as healthy when it is in fact not. The consumers who believe the
firm and use its products might suffer skin damage.
 Abuse of monopoly* powers: monopolistic businesses may use
their powers to charge consumers a high price and only produce
products they wish to, since they know consumers have no choice
but to buy from them.
Money
What is money?
A medium of exchange of goods and services.
Why do we need money?
We need money in order to exchange goods and services with one
another. This is because we aren’t self-sufficient – we can’t produce all
our wants by ourselves. Thus, there is a need for exchange.
In the past, barter system (exchanging a good or service for another
good or service) prevailed. This had a lot of problems such as the need
for the double coincidence of wants (if the person wants a table and he
has a chair to exchange, he must find a person who has a table to
exchange and is also willing to buy a chair), the goods being perishable
and non-durable, the indivisibility of goods, lack of portability etc.
Thus the money we use today is in the form of currency notes and coins,
which are durable, uniform, divisible (can be divided into 10’s, 50’s ,
100’s etc), portable and is generally accepted. These are the
characteristics of what is considered ‘good money’.
The functions of money:
  Money is a medium of exchange, as explained above.
 Money is a measure of value. Money acts as a unit of account,
allowing us to compare and state the worth of different goods and
services.
 Money is a store of value. It holds its value for a long time,
allowing us to save it for future purposes.
 Money is a means of deferred payment. Deferred payments are
purchases on credit – where the consumer can pay later for the
goods or service they buy.
Banking
Banks are financial institutions that act as an intermediary between
borrowers and savers. It is the money we save at banks that is lent out as
loans to other individuals and businesses.
Commercial banks are those banks that have many retail branches
located in most cities and towns. Example: HSBC. There is also
a central bank that governs all other commercial banks in a country.
Example: The Reserve Bank Of India (RBI).
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Functions of a commercial bank:
 Accept deposits in the form of savings.
 Aid customers in making and receiving payments via their bank
accounts.
 Give loans to businesses and private individuals.
 Buying and selling shares on customers’ behalf.
 Provide insurance (protection in the form of money against
damage/theft of personal property).
 Exchange foreign currencies.
 Provide financial planning advice.
Functions of a central bank:
 It issues notes and coins of the national currency.
 It manages all payments relating to the government.
 It manages national debt. Central banks can issue and repay public
debts on the government’s behalf.
  It supervises and controls all the other banks in the whole
economy, even holding their deposits and transferring funds
between them.
 It is the lender of ‘last resort’ to commercial banks. When other
banks are having financial difficulties, the central bank can lend
them money to prevent them from going bankrupt.
 It manages the country’s gold and foreign currency reserves. These
reserves are used to make international payments and adjust their
currency value (adjust the exchange rate).
 It operates the monetary policy in an economy.(This will be
explained in a later chapter)

Disposable income is the income of a person after all income-related

taxes and charges have been deducted.
Spending (Consumption)
The buying of goods and services is called consumption. The money
spent on consumption is called consumer expenditure.
People consume in order to satisfy their needs and wants and give them
satisfaction.

Factors affecting consumption:

 Disposable income: the more the disposable income, the more
people consume.
 Wealth: the more wealthy (having assets such as property, jewels,
company shares) a person is, the more he spends.
 Consumer confidence: if consumers are confident of keeping their
jobs and their future incomes, then they might be encouraged to
spend more now, without worries.
 Interest rates: if interest rates provided by banks on saving are
high, consumers might save more so they can earn interest and thus
consumer expenditure will fall.
Saving
Saving is income not spent (or delaying consumption until some later
date). People can save money by depositing in banks, and withdraw it a
later date with the interest.
Factors affecting saving:
 Saving for consumption: people save so that they can consume
later. They save money so that they can make bigger purchases in
the future (a house, a car etc). Thus, saving can depend on the
consumers’ future plans.
 Disposable income: if the amount of disposable income people
have is high, the more likely that they will save. Thus, rich people
save a higher proportion of their incomes than poor people.
 Interest rates: people also save so that their savings may increase
overtime with the interest added. Interest is the return on saving;
the longer you save an amount and the higher the amount, the
higher the interest received.
 Consumer confidence: if the consumer is not confident about his
job security and incomes in the future, he may save more now.
 Availability of saving schemes: banks now offer a variety of
saving schemes. When there are more attractive schemes that can
benefit consumers, they might resort to saving rather than
spending.
Borrowing
Borrowing, as the word suggests, is simply the borrowing of money
from a person/institution. The lender gives the borrower money. The
lender is usually the bank which gives out loans to customers.
Factors affecting borrowing:
 Interest rates: interest is also the cost of borrowing. When a
person takes a loan, he must repay the entire amount at the end of a
fixed period while also paying an amount of interest periodically.
When the interest rates rise, people will be reluctant to borrow and
vice versa.
  Wealth/Income: banks will be more willing to lend to wealthy and
high-income earning people, because they are more likely to be
able to repay the loan, rather than the poor. So even if they would
like to borrow, the poor end up being able to borrow much lesser
than the rich.
 Consumer confidence: how confident people feel about their
financial situation in the future may affect borrowing too. For
example, if they think that prices will rise (inflation) in the future,
they might borrow now, to make big purchases now.
 Ways of borrowing: the no. of ways to borrow can influence
borrowing. Nowadays there are many borrowing facilities such as
overdrafts, bank loans etc. and there are more credit (future
payment) options such as hire purchases (payment is done in
installments overtime), credit cards etc.
Expenditure patterns between income groups
The richer people spend, save and borrow more amounts than the poor.
The poor spend higher proportions of their disposable income, especially
on necessities, than the rich.
The poor save lesser proportions of their disposable income in
comparison with the rich.

Labour Market
Labourers need wages to satisfy their wants and needs.

Payments for labour:

 Time-rate wage: wage given based on the no. of hours the
employee has worked. Overtime wages are given to workers who
have worked extra no. of hours, which will usually be 1.5 times or
even twice the normal time rate.
 Piece-rate wage: wage given based on the amount of output
produced. The more output an employee produced, the more wage
he/she earns. This is used in industries where output can be easily
 measured and gives employees an incentive to increase their
productivity.
 Salary: monthly payments made to workers, usually managers,
office staff etc. usually in non-manual jobs.
 Performance-related payments: payments given to individual
workers or teams of workers who have performed very
well. Commissions given to salespersons for selling to a targeted
no. of customers is a form of performance-related pay.
What affects an individual’s choice of occupation?
 Wage factors: the wage conditions of a job/firm such as the pay
rate, the prospect for performance-related payments and bonuses
etc. will be considered by the individual before he chooses a job.
 Non-wage factors: This will include:
 hours of work
 holiday entitlements
 promotion prospects
 quality of working environment
 job security
 fringe benefits (free medical insurance, company car, price
discounts on company products etc.)
 training opportunities
 distance from home to workplace
 pension entitlement
Labour demand is the number of workers demanded by firms at a
given wage rate. Labour demand is called ‘derived demand’, since the
level of demand of a product determines that industry’s demand for
labour. That is, the higher the demand for a product, the more labour
producers will demand to increase supply of the product.
When the wage increases, the demand for labour contracts (and vice
versa).
Labour supply is the number of workers available and ready to
work in an industry at a given wage rate. When the wage rate
increases, the supply of labour extends, and vice versa.
 We also know that as the
number of hours worked increases, the wage rate also increases.
However, when a person get to a very high position and his wages/salary
increases highly, the number of hours he/she works may decrease. This
can be shown in this diagram, called a backward-bending labour
supply curve. CEOs and executive managers at the top of the
management tend to have backward-bending labour supply curves.
Just like in a demand and supply curve analysis, labour demand and
supply will extend and contract due to changes in the wage
rate. Other factors that cause changes in demand and supply of
labour will result in a shift in the demand and supply curve of
labour.
Factors that cause a shift in the labour demand curve:
 Consumer demand for goods and services: the higher the
demand for products, the higher the demand for labour.
 Productivity of labour: the more productive labour is, the more
the demand for labour.
 Price and productivity of capital: capital is a substitute resource
for labour. If the price of capital were to lower and its productivity
to rise, firms will demand more of capital and labour demand will
fall (labour demand curve shifts to the left).
 Non-wage employment costs: wages are not the only cost to a
firm of employing workers. Sometimes, employment tax, welfare
 insurance for each employee etc. will have to be paid by the firm.
If these costs increase, firms will demand less labour.
Factors that cause a shift in the labour supply curve:
 Advantages of an occupation: the different advantages a job can
offer to employees will affect the supply of labour- the people
willing to do that job. Example: if the number of working hours in
the airline industry increases, the labour supply there will shift
to the left.
 Availability and quality of education and training: if quality
training and education for a particular job, say pilots, is lacking,
then the labour supply for it will be low. When new education and
training institutes open, the labour supply will rise (labour supply
curve shifts to the right).
 Demographic changes: the size and age structure of the
population in an economy can affect the labour supply. The labour
supply curve will shift to the right when more people come into a
country from outside (immigration) and when the birth rate
increases (more young people will be available for work).
Why would a person’s wage rate change overtime?
As a beginner, the individual would have a low wage rate since he/she is
new to the job and has no experience. Overtime, as his/her experience
increases and skills develop, he/she will earn a higher wage rate. If
he/she gets promoted and has more responsibilities, his/her wage rate
will further increase. When he/she nears retirement age, the wage rate is
likely to decrease as their productivity and skills are likely to weaken.

Wage Differentials
Why do different jobs have different wages?
 Different abilities and qualifications: when the job requires more
skills and qualifications, it will have a higher wage rate.
 Risk involved in the job: risky jobs such as rescue operation
teams will gain a higher wage rate for the risks they undertake.
 Unsociable hours: jobs that require night shifts and work at other
unsociable hours are paid more.
  Lack of information about other jobs and wages: Sometimes
people work for less wage rates simply because they do not know
about other jobs with higher wage rates.
 Labour immobility: the ease with which workers can move
between different occupations and areas of an economy is
called labour mobility. If labour mobility is high, workers can
move to jobs with a higher pay. Labour immobility causes people
to work at a low wage rate because they don’t have the skills or
opportunities to move to jobs with a higher wage.
 Fringe benefits: jobs which offer a lot of fringe benefits have low
wages. But sometimes the highest-paid jobs are also given a lot of
fringe benefits, to attract skilled labour.

Why do wages differ between people doing the same job?

 Regional differences in labour demand and supply: for
example, if the demand in an area for accountants is very high, the
wage rate for accountants will be high; whereas, in an area of low
demand for accountants, the wage rate for accountants will be low.
Similarly, a high supply of accountants will cause their wages to be
low, while a low supply (scarcity) of accountants will cause their
wages to be high. It’s the law of demand and supply!
 Fringe benefits: some firms which pay a lot of fringe benefits, will
pay less wages, while firms (in the same industry) which pay lesser
fringe benefits will have higher wages.
 Discrimination: workers doing the same work may be
discriminated by gender, race, religion or age.
 Length of service: some firms provide extra pay for workers who
have worked in the firm for a long time, while other firms may not.
 Local pay agreements: some trade unions may agree a national
wage rate for all their members – therefore all their members
(labourers) will get a higher wage rate than those who do the same
job but are not in the trade union. This depends on the relative
bargaining power of the trade union.
 Government labour policies: wages will be fairer in an economy
where the government has set a minimum wage policy. The
 government’s corporate tax policies can also influence the amount
of wage firms will be willing to pay out.
Other wage differentials:
 Public-private sector pay gap: public sector jobs usually have a
high wage rate. But sometimes public sector wages are lower than
that of the private sector’s because low wages can be compensated
by the public sector’s high job security and pension prospects.
 Economic sector: workers in primary activities such as agriculture
receive very low wages in comparison to those in the other sectors
because the value of output they produce is lower. Further still,
workers in the manufacturing sector may earn lesser than those in
the services sector. But it comes down to the nature of the job
itself. A computer engineer in the manufacturing sector does earn
more than a waiter at a restaurant after all.
 Skilled and unskilled workers: Skilled workers have a higher pay
than unskilled workers, because they are more productive and
efficient and make lesser mistakes.
 Gender pay gap: Men are usually given a higher pay than women.
This is because women tend to go for jobs that don’t require as
much skill as that is required by men’s jobs (teaching, nursing,
retailing); they take career breaks to raise children, which will
cause less experience and career progress (making way for low
wages); more women work part-time than full-time. Sometimes,
even if both men and women are working equally hard and
effectively, discrimination can occur against women.
 International wage differentials: developed countries usually
have high wage rates due to high incomes, large supply of skilled
workers, high demand for goods and services etc; while in a less-
developed economy, wage rates will be low due to a large supply
unskilled labour.
Division of Labour/Specialisation
Division of labour is the concept of dividing the production process into
different stages enabling workers to specialise in specific tasks. This will
help increase efficiency and productivity. Division of labour is widely
used in modern economies. From the making of iPhones (the designs,
processors, screens, batteries, camera lenses, software etc. are made by
different people in different parts of the world) to this very website
(where notes, mindmaps, illustrations, design etc. are all managed by
different people).

Advantages to workers:
 Become skilled: workers can get skilled and experienced in a
specific task which will help their future job prospects
 Better future job prospects: because of the skill and training they
acquire, workers will, in the future, be able to get better jobs in the
same field.
 Saves time and expenses in training
Disadvantages to workers:
 Monotony: doing the same task repetitively might make it boring
and lower worker’s morale.
 Margin for errors increases: as the job gets repetitive, there also
arises a chance for mistakes.
 Alienation: since they’re confined to just the task they’re doing,
workers will feel socially alienated from each other.
 Lower mobility of labour: division of labour can also cause a
reduced mobility of labour. Since a worker is only specialised in
doing one specific task(s), it will be difficult for him/her to do a
different job.
 Increased chance of unemployment: when division of labour is
introduced, many excess workers will have to be laid off.
Additionally, if one loses the job, it will be harder for him/her to
find other jobs that require the same specialisation.
Advantages to firms:
 Increased productivity: when people specialise in particular
tasks, the total output will increase.
 Increased quality of products: because workers work on tasks
they are best suited for, the quality of the final output will be high.
 Low costs: workers only need to be trained in the tasks they
specialise in and not the entire process; and tools and equipment
 required for a task will only be needed for a few workers who
specialise in the task, and not for everybody else.
 Faster: when everyone focuses on a particular task and there is no
need for workers to shift from one task to another, the production
will speed up
 Efficient movement of goods: raw materials and half-finished
goods will easily move around the firm from one task to the next.
 Better selection of workers: since workers are selected to do tasks
best suited for them, division of labour will help firms to choose
the best set of workers for their operations.
 Aids a streamlined production process: the production process
will be smooth and clearly defined, and so the firm can easily
adapt to a mass production scale.
 Increased profits: lower costs and increased productivity will help
boost profits.
Disadvantages o firms:
 Increased dependency: The production may come to a halt if one
or more workers doing a specific task is absent. The production is
dependent on all workers being present to do their jobs.
 Danger of overproduction: as division of labour facilitates mass
production, the supply of the product may exceed its demand, and
cause a problem of excess stocks of finished goods. Firms need to
ensure that they’re not producing too much if there is not enough
demand for the product in the first place.
Advantages to the economy:
 Better utilisation of human resources in the economy as workers
do the job they’re best at, helping the economy achieve its
maximum output.
 Establishment of efficient firms and industries, as the higher
profits from division of labour will attract entrepreneurs to invest
and produce.
 Inventions arise: as workers become skilled in particular areas,
they can innovate and invent new methods and products in that
field.
Disadvantages to the economy:
  Labour immobility: occupational immobility may arise because
workers can only specialise in a specific field.
 Reduces the creative instinct of the labour force in the long-run
as they are only able to do a single task repetitively and the
previous skills they acquired die out.
 Creates a factory culture, which brings with it the evils of
exploitation, poor working conditions, and forced monotony.

Trade Unions are organizations of workers that aim at promoting

and protecting the interest of their members (workers). They aim on
improving wage rates, working conditions and other job-related aspects.
The functions of a trade union:
 Negotiating improvements in non-wage benefits with employers.
 Defending employees’ rights.
 Improving working conditions, such as better working hours and
better safety measures.
 Improving pay and other benefits.
 Supporting workers who have been unfairly dismissed or
discriminated against.
 Developing the skills of members, by providing training and
education.
 Providing recreational activities for the members.
 Taking industrial actions (strikes, overtime ban etc.) when
employers don’t satisfy their needs. These are explained later in
this topic.
Collective bargaining: the process of negotiating over pay and
working conditions between trade unions and employers.
When can trade unions argue for higher wages and better working
conditions?
 Prices are rising (inflation): the cost of living increases when
prices increase and workers will want higher wages to consume
products and raise their families.
 The sales and demand of the firm has increased.
 Workers in other firms are getting a higher pay.
 The productivity of the members has increased.
Industrial disputes
When firms don’t satisfy trade union wants or refuse to agree to their
terms, the members of a trade union can organize industrial disputes.
Here are some:

 Overtime ban: workers refuse to work more than their normal

hours.
 Go-slow: workers deliberately slow down production, so the firm’s
sales and profits go down.
 Strike: workers refuse to work and may also protest or
picket outside their workplace to stop deliveries and prevent other
non-union members from entering. They don’t receive any wages
during this time. This will halt all production of the firm.
Trade union activity has several impacts:

Advantages to workers:
 Workers benefit from collective bargaining power by being able to
establish better terms of labour.
 Workers feel a sense of unity and feel represented, increasing
morale.
 Lesser chance of being discriminated and exploited.
Disadvantages to workers:
 Workers might get lesser wages or none if they go on strike –
as the output and profits of the firm falls and they refuse to pay.
Advantages to firms:
 Time is saved in negotiating with a union when compared to
negotiating with individuals workers.
 When making changes in work schedules and practices, a trade
union’s cooperation can help organise workers efficiently.
 Mutual respect and good relationships between unions and firms
are good for business morale and increases productivity.
Disadvantages to firms:
 Decision making may be long as there will be need of lengthy
discussions with trade unions in major business decisions.
  Trade unions may make demands that the firm may not be able
to meet – they will have to choose between profitability and
workers’ interests.
 Higher wages bargained by trade unions will reduce the firm’s
profitability.
 Businesses will have high costs and low output if unions
organise agitations. Their revenue and profits will go down and
they will enter a loss. They may also lose a lot of customers to
competing firms.
Advantages to the economy:
 Ensures that the labour force in the economy is not exploited and
that their interests are being represented
Disadvantages to the economy:
 Can negatively impact total output of the economy.
 Firms may decide to substitute labour for capital if they can’t meet
trade unions’ expensive demands, and so unemployment may
rise.
 Higher wages resulting from trade union activity can make the
nation’s exports expensive and thus less competitive in the
international market
In modern times, the powers of trade unions have drastically weakened.
Globalisation, liberalisation and privatisation of economies are making
markets more competitive. Firms have more incentive to reduce costs of
production to a minimum in order to remain competitive and profitable.
Therefore, it is much harder for unions to force employers to increase
wages. Most unions operating nowadays are more focused on bettering
working conditions and non-monetary benefits.

Classification of Firms
Firms can be classified in terms of the sectors they operate in and their
relative sizes.
Firms are classified into the following three categories based on the type
of operations undertaken by them:

 Primary: all economic activity involving extraction of raw natural

materials. This includes agriculture, mining, fishing etc. In pre-
modern times, most economic activity and employment was in this
sector, mostly in the form of subsistence farming (farming for self-
consumption).
 Secondary: all economic activity dealing with producing finished
goods. This includes construction, manufacturing, utilities etc. This
sector gained importance during the industrial revolution of the
19th and 20th centuries and still makes up a huge part of the
modern economy.
 Tertiary: all economic activity offering intangible goods and
services to consumers. This includes retail, leisure, transport, IT
services, banking, communications etc. This sector is now the
fastest-growing sector as consumer demand for services have
increased in developed and developing nations.
Firms can also be classified on the basis of whether they are publicly
owned or privately owned:

 Public: this includes all firms owned and run by the government.
Usually, the defence, arms and nuclear industries of an economy
are completely public. Public firms don’t have a profit motive, but
aim to provide essential services to the economy it governs.
Governments do also run their own schools, hospitals, postal
services, electricity firms etc.
 Private: this includes all firms owned and run by private
individuals. Private firms aim at making profits and so their
products are those that are highly demanded in the economy.
Firms can also be classified on their relative size as small, medium or
large depending on the output, market share, organisation (no. of
departments and subsidiaries etc).
Small Firms
A small firm is an independently owned and operated enterprise that
is limited in size and in revenue depending on the industry. They
require relatively less capital, less workforce and less or no machinery.
These businesses are ideally suited to operate on a small scale to serve a
local community and to provide profits to the owners.
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Advantages of small businesses:

 Independence: owner(s) are free to run the business as he/she

pleases.
 Control: the owner(s) has full control over the business, unlike in
a large business where multiple managers, departments and
branches will exist.
 Flexibility: small businesses can adapt to quick changes as the
owner is more involved in the decision-making.
 Better communication: since there are fewer employees,
information can be intimated easily and quickly.
 Innovation: small businesses can tend to be innovative because
they have less to lose and are willing to take risks.
Disadvantages of small businesses:

 Higher costs: small firms cannot exploit economies of scale –

their average costs will be higher than larger rivals.
 Lack of finance: struggles to raise finance as choice of sources of
acquiring finance is limited.
 Difficult to attract experienced employees: a small business may
be unable to afford the wage and training required for skilled
workers.
 Vulnerability: when economic conditions change, it is harder for
small businesses to survive as they lack resources.
Small firms still exist in the economy for several reasons:
  Size of the market: when there is only a small market for a
product, a firm will see no point in growing to a larger size. The
market maybe small because:
 the market is local – for example, the local hairdresser.
 the final product maybe an expensive luxury item which
only require small-scale production (e.g. custom-made
paintings)
 personalised/custom services can only be given by small
firms, unlike large firms that mostly give standardised
services (e.g. wedding cake makers).
 Access to capital is limited, so owners can’t grow the firm.
 Owner(s) prefer to stay small: a lot of entrepreneurs don’t want
to take risks by growing the firm and they are quite satisfied with
running a small business.
 Small firms can co-operate: co-operation between small firms
can lead them to set up jointly owned enterprises which allow them
to enjoy many of the benefits that large firms have.
 Governments help small firms: governments usually provide
help to small scale firms because small firms are an important
provider of employment and generate innovation in the production
process. In most countries, it is the medium and small industries
that contribute much of the employment.
Growth of Firms
When a firm grows, its scale of production increases. Firms can grow in
to ways: internally or externally.

Internal Growth/Organic Growth

This involves expanding the scale of production of the firm’s existing
operations. This can be done by purchasing more machinery/equipment,
opening more branches, selling new products, expanding business
premises, employing more workers etc.
External Growth
This involves two or more firms joining together to form a larger
business. This is called integration. This can be done it two ways:
mergers or takeovers.
A takeover or acquisition happens when a company buys enough
shares of another firm that they can take full control. The firm taken
over loses its identity and becomes a part of what is known as the
holding company. A well-known example would be Facebook’s
acquisition of Whatsapp in 2014.
A merger occurs when the owners of two or more companies agree
to join together to form a firm.
Mergers can happen in three ways:

 Horizontal Integration: integration of firms engaged in the

production of the same type of good at the same level of
production. Example: a cloth manufacturing company merges with
another cloth manufacturing company.
Advantages:


 Exploit internal economies of scale: including bulk-
buying, technical economies, financial economies.
 Save costs: when merging, a lot of the duplicate assets
including employees can be laid off.
 Potential to secure ‘revenue synergies’ by creating and
selling a wider range of products.
 Reduces competition: by merging with key rivals, the
two firms together can increase market share.

Disadvantages:


 Risk of diseconomies of scale: a larger business will
bring with a lot of managerial and operational issues
leading to higher costs.
 Reduced flexibility: the addition of more employees and
processes means the need for more transparency and
therefore more accountability and red tape, which can
slow down the rate of innovating and producing new
products and processes.
 Vertical Integration: integration of firms engaged in the
production of the same type of good but at different levels of
production (primary/secondary/tertiary). Example: a cloth
manufacturing company (secondary sector) merges with a cotton
growing firm (primary sector).
 Forward vertical integration: when a firm integrates
with a firm that is at a later stage of production than theirs.
Example: a dairy farm integrates with a cheese
manufacturing company.
 Backward vertical integration: when a firm integrates
with a firm that is at an earlier stage of production than
theirs. Example: a chocolate retailer integrates with a
chocolate manufacturing company.
Advantages:


 It can give a firm assured supplies or outlets for their
products. If a coffee brand merged with coffee plantation,
the manufacturers would get assured supplies of coffee
beans from the plantation. If the coffee brand merged with
a coffee shop chain, they would have a permanent outlet to
sell their coffee from.
 Similarly, one firm can prevent the other firm from
supplying materials or selling products to competitors.
The coffee brand can have the coffee plantation to only
supply them their coffee beans. The coffee brand can also
have the coffee shop chain only selling coffee with their
coffee powder.
 The profit margins of the merged firm can now be
absorbed into the merging firm.
 The firms can increase their market share and become
more competitive in the market.
Disadvantages:


Risk of diseconomies of scale: a larger business will
bring with a lot of managerial and operational issues
leading to higher costs
 Reduced flexibility: the addition of more employees and
processes means the need for more transparency and
therefore more accountability and red tape, which can
slow down the rate of innovating and producing new
products and processes
 It’s a difficult process: The firms, when vertically
integrated, are entering into a stage of production/sector
they’re not familiar with, and this will require staff of
either firm to be educated and trained. Some might even
lose their jobs. It can be expensive as well.
 Lateral/Conglomerate integration: this occurs when firms
producing different type of products integrate. They could be at the
same or different stages of production. Example: a housing
company integrates with a dairy farm. Thus, the firm can produce a
wide range of products. This helps diversify a firm’s operations.
Advantages:


 Diversify risks: conglomerate integration allows
businesses to have activities in more than one market. This
allows the firms to spread their risks. In case one market is
in decline, it still has another source of profit.
 Creates new markets: merging with a firm in a different
industry will open up the firm to a new customer base,
helping it to market its core products to this new market.
 Transfer of ideas: there could be a transfer of ideas and
resources between the two businesses even though they
 are in different industries. This transfer of ideas could help
improve the quality and demand for the two products.
Disadvantages:

 Inexperience can lead to mismanagement: if the firms are in

entirely different industries and have no experience in the other’s
industry, cooperating and managing the two industries may be
difficult and could turn disastrous.
 Lose focus: merging with and focusing on an entirely new industry
could cause the firm to lose focus of its core product.
 Culture clash: as with all kinds of mergers, there could be a
culture clash between the two firms’ employees on practices,
standards and ‘how things are done’.
Scale of Production
As a firm’s scale of production increases its average costs
decrease. Cost saving from a large-scale production is called
economies of scale.
Internal economies of scale are decisions taken within the firm that can
bring about economies (advantages). Some internal economies of scale
are:
 Purchasing economies: large firms can be buy raw materials and
components in bulk because of their large scale of production.
Supplier will usually offer price discounts for bulk purchases,
which will cut purchasing costs for the firm.
 Marketing economies: large firms can afford their own vehicles
to distribute their products, which is much cheaper than hiring
other firms to distribute them. Also, the costs of advertising is
spread over a much large output in large firms when compared to
small firms.
 Financial economies: banks are more willing to lend money to
large firms since they are more financially secure (than small
firms) to repay loans. They are also likely to get lower rates of
interest. Large firms also have the ability to sell shares to raise
 capital (which do not have to be repaid). Thus, they get more
capital at lower costs.
 Technical economies: large firms are more financially able to
invest in good technology, skilled workers, machinery etc. which
are very efficient and cut costs for the firm.
 Risk-bearing economies: large firms with a high output can sell
into different markets (even overseas). They are able to produce a
variety of products (diversification in production). This means
that their risks are spread over a wider range of products or
markets; even if a market or product is not successful, they have
other products and markets to continue business in. Thus, costs are
less.

External economies of scale occur when firms benefit from the

entire industry being large. This may include:
 Access to skilled workers: large firms can recruit workers trained
by other firms. For example: when a new training institution for
pilots and airline staff opens, all airline firms can enjoy economies
of scale of having access to skilled workers, who are more efficient
and productive, and cuts costs.
 Ancillary firms: they are firms that supply and provide
materials/services to larger firms. When ancillary firms such as a
marketing firm locates close to a company, the company can cut
costs by using their services more cheaply than other firms.
 Joint marketing benefits: when firms in the same industry
locate close to each other, they may share an enhanced reputation
and customer base.
 Shared infrastructure: development in the infrastructure of an
industry or the economy can benefit large firms. Examples: more
roads and bridges by the govt. can cut transport costs for firms, a
new power station can provide cheaper electricity for firms.

Diseconomies of scale occur when a firms grows too large and

average costs start to rise. Some common diseconomies are:
  Management diseconomies: large firms have a wide internal
organisation with lots of managers and employees. This makes
communication difficult and decision-making very slow.
Gradually, it leads to inefficient running of the firms and increases
costs.
 Too much output may require a large supply of raw materials,
power etc. which can lead to shortage and halt production,
increasing costs.
 Large firms may use automated production with lots of capital
equipment. Workers operating these machines may feel bored in
doing the repetitive tasks and thus become demotivated and less
cooperative. Many workers may leave or go on strikes, stopping
production and increasing costs.
 Agglomeration diseconomies: this occurs when firms
merge/acquire too many different firms producing different
products, and the managers and owners can’t coordinate and
organise all activities, leading to higher costs.
 More shares sold into the market and bought means more owners
coming into the business. Having a lot of owners can lead to a lot
of disputes and conflicts among themselves.
 A lot of large firms can face diseconomies when their products
become too standardised and less of a variety in the
market. This will reduce sales and profits and increase average
costs.
A firm that doubles all its inputs (resources) and is able to more than
double its output as a result, experiences increasing returns to scale.
A firm that doubles all its inputs and fails to double its output as a result,
experiences a decreasing or diminishing returns to scale.

Demand for Factors of Production

Some factors that determine the demand of factors of production:

 The demand for the product: if more goods and services are
demanded by consumers, more factors of production will be
 demanded by firms to produce and satisfy the demand. That is, the
demand for factors of production is derived demand, as it is
determined by the demand for the goods and services (just like
labour demand).
 The availability of factors: firms will also demand factors that are
easily available and accessible to them. If the firm is located in a
region where there is a large pool of skilled labour, it will demand
more labour as opposed to capital.
 The price of factors: If labour is more expensive than capital,
firms will demand more capital (and vice versa), as they want to
reduce costs and maximize profits.
 The productivity of factors: If labour is more productive than
capital, then more labour is demanded, and vice versa.
Labour-intensive and Capital-intensive production
Labour-intensive production is where more labourers are employed
than other factors, say capital. Production is mainly dependent on labour.
It is usually adopted in small-scale industries, especially those that
produce personalised, handmade products. Examples: hotels and
restaurants.
Advantages:

 Flexibility: labour, unlike most machinery can be used flexibly to

meet changing levels of consumer demand, e.g., part-time workers.
 Personal services: labour can provide a personal touch to
customer needs and wants.
 Personalised services: labourers can provide custom products for
different customers. Machinery is not flexible enough to provide
tailored products for individual customers.
 Gives feedback: labour can give feedback that provides ideas for
continuous improvements in the firm.
 Essential: labour is essential in case of machine breakdowns. After
all, machines are only as good as the labour that builds, maintains
and operates them..
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Disadvantages:

 Relatively expensive: in the long-term, when compared to

machinery, labour has higher per unit costs due to lower levels of
productivity.
 Inefficient and inconsistent: compared to machinery, labour is
relatively less efficient and tends to be inconsistent with their
productivity, with various personal, psychological and physical
matters influencing their quantity and quality of work.
 Labour relation problems: firms will have to put up with labour
demands and grievances. They could stage an overtime ban or
strike if their demands are not met.
Capital refers to the machinery, equipment, tools, buildings and vehicles
used in production. It also means the investment required to do
production. Capital-intensive production is where more capital is
employed than other factors. It is a production which requires a
relatively high level of capital investment compared to the labour cost.
Most capital-intensive production is automated (example: car-
manufacturing).
Advantages:

 Less likely to make errors: Machines, since they’re mechanically

or digitally programmed to do tasks, won’t make the mistakes that
labourers will.
 More efficient: machinery doesn’t need breaks or holidays, has no
demands and makes no mistakes.
 Consistent: since they won’t have human problems and are
programmed to repeat tasks, they are very consistent in the output
produced.
 Technical economies of scale: increased efficiency can reduce
average costs
Disadvantages:

 Expensive: the initial costs of investment is high, as well as

possible training costs.
  Lack of flexibility: machines need not be as flexible as labourers
are to meet changes in demand.
 Machinery lacks initiative: machines don’t have the intuitive or
creative power that human labour can provide the business, and
improve production.
Production and Productivity
A firm combines scarce resources of land, labour and capital (inputs) to
make (produce) goods and services (output). Production is thus, the
transformation of raw materials (input) to finished or semi-finished
goods and services (output).
In other words, production is the adding of value to inputs to create
outputs. It is the production that gives the inputs value.
Some factors that influence production:

 Demand for product: the more the demand from consumers, the
more the production.
 Price and availability of factors of production: if factors of
production are cheap and readily available, there will be more
production.
 Capital: the more capital that is available to producers, the more
the investment in production.
 Profitability: the more profitable producing and selling a product
is, the more the production of the product will be.
 Government support: if governments give money in grants,
subsidies, tax breaks and so on, more production will take place in
the economy.
Productivity measures the amount of output that can be produced
from a given amount of input over a period of time.
Productivity = Total output produced per period / Total input
used per period
Productivity increases when:

 more output or revenue is produced from the same amount of

resources
  the same output or revenue is produced using fewer resources.
(Labour productivity is the measure of the amount of output that can be
produced by each worker in a business).

Factors that influence productivity:

 Division of labour: division of labour is when tasks are divided

among labourers. Each labourer specializes in a particular task, and
thus this will increase productivity.
 Skills and experience of labour force: a skilled and experienced
workforce will be more productive.
 Workers’ motivation: the more motivated the workforce is, the
more productive they will be. Better pay, working conditions,
reasonable working hours etc. can improve productivity.
 Technology: more technology introduced into the production
process will increase productivity.
 Quality of factors of production: replacing old machinery with
new ones, preferably with latest technologies, can increase
efficiency and productivity. In the case of labour, training the
workforce will increase productivity.
 Investment: introducing new production processes which will
reduce wastage, increase speed, improve quality and raise output
will raise productivity. This is known as lean production.