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.

The Role of Government

The public sector in every economy plays a major role, as a producer and employer.
Governments work locally, nationally and internationally. Here are the roles they play in
the economy:

● As a producer, it provides, at all levels of government:

● merit goods (educational institutions, health services etc.)
● public goods (streetlights, parks etc.)
● welfare services (unemployment benefits, pensions, child benefits etc.)
● public services (police stations, fire stations, waste management etc.)
● infrastructure (roads, telecommunications, electricity etc.).
● As an employer, it provides at all levels of government, employment to a large
population, who work to provide the above mentioned goods and services. It also
creates employment by contracting projects, such as building roads, to private
firms.
● Support agriculture and other prime industries that need public support.
● Help vulnerable groups of people in society through redistributing income and
welfare schemes.
● Manage the macroeconomy in terms of prices, employment, growth, income
redistribution etc.
● Governments also manage its trade in goods and services with other countries
by negotiating international trade deals.

Government Macroeconomic Aims

The government’s major macroeconomic objectives are:

● Economic Growth: economic growth refers to an increase in the gross domestic

product (GDP), the amount of goods and services produced in the economy,
over a period of time. More output means economic growth. But if output falls
over time (economic recession), it can cause:
● fall in employment, incomes and living standards of the people
● fall in the tax revenue the govt. collects from goods and services and
incomes, which will, in turn, lead to a cut in govt. spending
● fall in the revenues and profits of firms
● low investments, that is, people won’t invest in production as economic
conditions are poor and they will yield low profits.
● Price Stability: inflation is the continuous rise in the average price levels in an
economy during a time period. Governments usually target an inflation rate it
should maintain in a year, say 3%. If prices rise too quickly it can negatively
affect the economy because it:
● reduces people’s purchasing powers as people will be able to buy less
with the money they have now than before
● causes hardship for the poor
● increases business costs especially as workers will demand higher
wages to support their livelihood
● makes products more expensive than products of other countries with
low inflation. This will make exports less competitive in the international
market.
● Full Employment: if there is a high level of unemployment in a country, the
following may happen:
● the total national output (goods produced) will fall
● government will have to give out welfare payments (unemployment
benefits) to the unemployed, increasing public expenditure while
income taxes fall – causing a budget deficit
● large unemployment causes public unrest and anger towards the
government.
● Balance of Payments Stability: economies export (sell) many of their products
to overseas residents, and receive income and investment from abroad; they
also import (buy) goods and services from other economies, and make
investments in other countries. These are recorded in a country’s Balance of
Payments (BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
All economies try to balance this inflow and outflow of international trade and
payments and try to avoid any deficits because:
● if it exports too little and imports too much, the economy may run out of
foreign currency to buy further imports
● a BoP deficit causes the value of its currency to fall against other
foreign currencies and make imports more expensive to buy, while a
BoP surplus causes its currency to rise against other foreign
 currencies and make its exports more expensive in the international
market.
● Income Redistribution: to reduce the inequality of income among its citizens,
the government will redistribute incomes from the rich to the poor by imposing
taxes on the rich and using it to finance welfare schemes for the poor. All
governments struggle with income inequality and try to solve it because:
● widening inequality means higher levels of poverty
● poverty and hardship restricts the economy from reaching its maximum
productive capacity.

Conflict of Macroeconomic Aims

When a policy is introduced to achieve one macroeconomic aim, it tends to conflict with
one or more other aims. In other words, as one aim is achieved, another aim is undone.
Let’s look at some conflicts of government macroeconomic aims.

Full Employment v/s Price Stability

Low rates of unemployment will boost incomes of businesses and workers. This rise in
incomes, mean higher demand and consumption in the economy, which causes firms to
raise their prices – resulting in inflation. This is probably the most prominent policy
conflict in the study of Economics.

Economic Growth & Full Employment v/s BoP Stability

Once again, as incomes rise due to economic growth and low unemployment, people
will import more foreign products and consume relatively less domestic products. This
will cause a rise in imports relative to exports and a deficit may arise in the balance of
payments.

Economic Growth v/s Full Employment

In the long run, when economic growth is continuous, firms may start investing in more
capital (machinery/equipment). More capital-intensive production will make a lot of
people unemployed.

4.3 – Fiscal Policy

Budget: a financial statement showing the forecasted government revenue
and expenditure in the coming fiscal year. It lays out the amount the
government expects to receive as revenue in taxes and other incomes and
how and where it will use this revenue to finance its various spending
endeavours. Governments aim for its budgets to be balanced.
Government spending

Governments spend on all kinds of public goods and services, not just out of
political and social responsibility, but also out of economic responsibility.
Government spending is a part of the aggregate demand in the economy
and influences its well-being. The main areas of government spending
includes defence and arms, road and transport, electricity, water, education,
health, food stocks, government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

● To supply goods and services that the private sector would fail to do,
such as public goods, including defence, roads and streetlights; merit
goods, such as hospitals and schools; and welfare payments and
benefits, including unemployment and child benefits.
● To achieve supply-side improvements in the economy, such as
spending on education and training to improve labour productivity.
● To spend on policies to reduce negative externalities, such as
pollution controls.
● To subsidise industries which may need financial support, and which is
not available from the private sector, usually agriculture and related
industries.
● To help redistribute income and improve income inequality.
● To inject spending into the economy to aid economic growth.

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Effects of government spending

 ● Increased government spending will lead to higher demand in the
economy and thus aid economic growth, but it can also lead to
inflation if the increasing demand causes prices to rise faster than
output.
● Increased government spending on public goods and merit goods,
especially in infrastructure, can lead to increased productivity and
growth in the long run.
● Increased government spending on welfare schemes and benefits will
increase living standards, and help reduce inequality.
● However too much government spending can also cause ‘crowding
out’ of private sector investments – private investments will reduce if
the increase in government spending is financed by increased taxes
and borrowing (large government borrowing will drive up interest rates
and discourage private investment).

Tax

Governments earn revenue through interests on government bonds and

loans, incomes from fines, penalties, escheats, grants in aid, income from
public property, dividends and profits on government establishments,
printing of currency etc; but its major source of revenue comes from
taxation. Taxes are a compulsory payment made to the government by all
people in an economy. There are many reasons for levying taxes from the
economy:

● It is a source of government revenue: if the government has to spend

on public goods and services it needs money that is funded from the
economy itself. People pay taxes knowing that it is required to fund
their collective welfare.
● To redistribute income: governments levy taxes from those who earn
higher incomes and have a lot of wealth. This is then used to fund
welfare schemes for the poor.
● To reduce consumption and production of demerit goods: a much
higher tax is levied on demerit goods like alcohol and tobacco than
other goods to drive up its prices and costs in order to discourage its
 consumption and production. Such a tax on a specific good is called
excise duty.
● To protect home industries: taxes are also levied on foreign goods
entering the domestic market. This makes foreign goods relatively
more expensive in the domestic market, enabling domestic products to
compete with them. Such a tax on foreign goods and services is called
customs duty.
● To manage the economy: as we will discuss shortly, taxation is also a
tool for demand and supply side management. Lowering taxes increase
aggregate demand and supply in the economy, thereby facilitating
growth. Similarly, during high inflation, the government will increase
taxes to reduce demand and thus bring down prices. More on this
below.

Classification of Taxes

Taxes can be classifies into direct or indirect and progressive, regressive or

proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly
on the person or individual responsible for paying it.

● Income tax: paid from an individual’s income. Disposable income is the

income left after deducting income tax from it. When income tax rise,
there is little disposable income to spend on goods and services, so
firms will face lower demand and sales, and will cut production,
increasing unemployment. Lower income taxes will encourage more
spending and thus higher production.
● Corporate Tax: tax paid on a company’s profits. When the corporate tax
rate is increased, businesses will have lower profits left over to put back
into the business and will thus find it hard to expand and produce
more. It will also cause shareholders/owners to receive lower
dividends/returns for their investments. This will discourage people
from investing in businesses and economic growth could slow down.
 Reducing corporate tax will encourage more production and
investment.
● Capital gains tax: taxes on any profits or gains that arise from the sale
of assets held for more than a year.
● Inheritance tax: tax levied on inherited wealth.
● Property tax: tax levied on property/land.

Advantages:

● High revenue: as all people above a certain income level have to pay
income taxes, the revenue from this tax is very high.
● Can reduce inequalities in income and wealth: as they are progressive
in nature – heavier taxes on the rich than the poor- they help in
reducing income inequality.

Disadvantages:

● Reduces work incentives: people may rather stay unemployed (and

receive govt. unemployment benefits) rather than be employed if it
means they would have to pay a high amount of tax. Those already
employed may not work productively, since for any extra income they
make, the more tax they will have to pay.
● Reduces enterprise incentives: corporate taxes may demotivate
entrepreneurs to set up new firms, as a good part of the profits they
make will have to be given as tax.
● Tax evasion: a lot of people find legal loopholes and escape having to
pay any tax. Thus tax revenue falls and the govt. has to use more
resources to catch those who evade taxes.

Indirect Taxes are taxes on goods and services sold. It is added to the prices
of goods and services and it is paid while purchasing the good or service. It is
called indirect because it indirectly takes money as tax from consumer
expenditure. Some examples are:
 ● GST/VAT: these are included in the price of goods and services.
Increasing these indirect taxes will increase the prices of goods and
services and reduce demand and in turn profits. Reducing these taxes
will increase demand.
● Customs duty: includes import and export tariffs on goods and services
flowing between countries. Increasing tariffs will reduce demand for
the products.
● Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce
its demand.

Advantages:

● Cost-effective: the cost of collecting indirect taxes is low compared to

collecting direct taxes.
● Expanded tax-base: directs taxes are paid by those who make a good
income, but indirect taxes are paid by all people (young, old,
unemployed etc.) who consume goods and services, so there is a larger
tax base.
● Can achieve specific aims: for example, excise duty (tax on demerit
goods) can discourage the consumption of harmful goods; similarly,
higher and lower taxes on particular products can influence their
consumption.
● Flexible: indirect tax rates are easier and quicker to alter/change than
direct tax rates. Thus their effects are immediate in an economy.

Disadvantages:

● Inflationary: The prices of products will increase when indirect taxes

are added to it, causing inflation.
● Regressive: since all people pay the same amount of money,
irrespective of their income levels, the tax will fall heavily on the poor
than the rich as it takes more proportion of their income.
● Tax evasion: high tariffs on imported goods or excise duty on demerit
goods can encourage illegal smuggling of the good.
Progressive Taxes are those taxes which burdens the rich more than the
poor, in that the rate of taxation increases as incomes increase. An income
tax is the perfect example of progressive taxation. The more income you earn,
the more proportion of the income you have to pay in taxes, as defined by
income tax brackets.
For example, a person earning above $100,000 a month will have to pay a tax
rate of 20%, while a person earning above $200,000 a month will have to pay
a tax rate of 25%.

Regressive Taxes are those taxes which burden the poor more than the rich,
in that the rate of taxation falls as incomes increase. An indirect tax like GST
is an example of a regressive tax because everyone has to pay the same tax
when they are paying for the product, rich or poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns
$500 dollars a month, this tax will amount to 0.2% of his income, while for a
richer person who earns $50,000 a month, this tax will amount of just 0.002%
of his income. The burden on the poor is higher than on the rich, making its
regressive.

Proportional Taxes are those taxes which burden the poor and rich equally,
in that the rate of taxation remains equal as incomes rise or fall. An
example is corporate tax. All companies have to pay the same proportion of
their profits in tax.
For example, if the corporate tax is 30%, then whatever the profits of two
companies, they both will have to pay 30% of their profits in corporate tax.
Qualities of a good tax system (the canons of taxation):

● Equity: the tax rate should be justifiable rate based on the ability of the
taxpayer.
● Certainty: information about the amount of tax to be paid, when to pay
it, and how to pay it should all be informed to the taxpayer.
● Economy: the cost of collecting taxes must be kept to a minimum and
shouldn’t exceed the tax revenue itself.
● Convenience: the tax must be levied at a convenient time, for example,
after a person receives his salary.
● Elasticity: the tax imposition and collection system must be flexible so
that tax rates can be easily changed as the person’s income changes.
● Simplicity: the tax system must be simple so that both the collectors
and payers understand it well.

Impacts of taxation

Taxes can have various direct impacts on consumers, producers, government

and thus, the entire economy.

● The main purpose of tax is to raise income for the government which
can lead to higher spending on health care and education. The impact
depends on what the government spends the money on. For
example, whether it is used to fund infrastructure projects or to fund
the government’s debt repayment.
● Consumers will have less disposable income to spend after income
tax has been deducted. This is likely to lead to lower levels of spending
and saving. However, if the government spends the tax revenue in
effective ways to boost demand, it shouldn’t affect the economy.
● Higher income tax reduces disposable income and can reduce the
incentive to work. Workers may be less willing to work overtime or
might leave the labour market altogether. However, there are two
conflicting effects of higher tax:
 ● Substitution effect: higher tax leads to lower disposable
income, and work becomes relatively less attractive than
leisure – workers will prefer to work less.
● Income effect: if higher tax leads to lower disposable income,
then a worker may feel the need to work longer hours to
maintain his desired level of income – workers feel the need to
work longer to earn more.
● The impact of tax then depends on which effect is greater. If
the substitution effect is greater, then people will work less,
but if income effect is greater, people will work more
● Producers will have less incentive to produce if the corporate taxes are
too high. Private firm aim on making profits, and if a major chunk of
their profits are eaten away by taxes, they might not bother producing
more and might decide to close shop.

Fiscal Policy

Fiscal policy is a government policy which adjusts government spending

and taxation to influence the economy. It is the budgetary policy, because it
manages the government expenditure and revenue. Government aims for a
balance budget and tries to achieve it using fiscal policy.

A budget is in surplus, when government revenue exceed government

spending. While this is good it also means that the economy hasn’t reached
its full potential. The government is keeping more than it is spending, and if
this surplus is very large, it can trigger a slowdown of the economy.
When there is a budget surplus, the government employs an
expansionary fiscal policy where govt. spending is increased and tax rates
are cut.

A budget is in deficit, when government expenditure exceeds government

revenue. This is undesirable because if there is not enough revenue to finance
the expenditure, the government will have to borrow and then be in debt.
When there is a budget deficit, the government employs contractionary
fiscal policy, where govt. spending is cut and tax rates are increased.

Fiscal policy helps the government achieve its aim of economic growth, by
being able to influence the demand and spending in the economy. It also
indirectly helps maintain price stability, via the effects of tax and spending.
Expansionary fiscal policy will stimulate growth, employment and help
increase prices. Contractionary fiscal policy will help control inflation resulting
from too much growth. But as we will see later on, controlling inflation by
reducing growth can lead to increased unemployment as output and
production falls.

Monetary policy
The money supply is the total value of money available in an economy at
a point of time. The government can control money supply through a variety
of tools including open market operations (buying and selling of government
bonds) and changing reserve requirements of banks. (The syllabus doesn’t
require you to study these in depth)

The interest rate is the cost of borrowing money. When a person borrows
money from a bank, he/she has to pay an interest (monthly or annually)
calculated on the amount he/she borrowed. Interest is also be earned on the
money deposited by individuals in a bank.
(The interest on borrowing is higher than the interest on deposits, helping the
banks make a profit).
Higher interest rates will discourage borrowing and therefore, investments; it
will also encourage people to save rather than consume (fall in consumption
also discourage firms from investing and producing more).
Lower interest rates will encourage borrowing and investments, and
encourage people to consume rather than save (rise in consumption also
encourage firms to invest and produce more).

The monetary authority of the country cannot directly change the general
interest rate in the economy. Instead, it changes the interest rates of
borrowing between the central bank and commercial banks, as well as the
interest on its bonds and securities. These will then influence the interest rate
provided by commercial banks on loans and deposits to individuals and
businesses.
Monetary Policy

Monetary policy is a government policy controls money supply

(availability and cost of money) in an economy in order to attain growth
and stability. It is usually conducted by the country’s central bank and
usually used to maintain price stability, low unemployment and economic
growth.

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Expansionary monetary policy is where the government increases money

supply by cutting interest rates. Low interest rates will mean more people
will resort to spending rather than saving, and businesses will invest more as
they will have to pay lower interest on their borrowings. Thus, the higher
money supply will mean more money being circulated among the
government, producers and consumers, increasing economic activity.
Economic growth and an improvement in the balance of payments will be
experienced and employment will rise.

Contractionary monetary policy is where the government decreases

money supply by increasing interest rates. Higher interest rates will mean
more people will resort to saving rather than spending, and businesses will be
reluctant to invest as they will have to pay high interest on their borrowings.
Thus, the lower money supply will mean less money being circulated among
the government, producers and consumers, reducing economic activity. This
helps slow down economic growth and reduce inflation, but at the cost of
possible unemployment resulting from the fall in output.