Introductory Concepts
Introductory Concepts
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Economics tests its ideas against evidence, like any science. But it studies people, and you cannot put a whole economy in a laboratory.
A chemist can heat one test tube and not another, with everything else the same. Any difference must come from the heat. This is a controlled experiment: change one thing, hold the rest still, and compare.
Economists ask the same kind of question. Does a higher minimum wage cost jobs? The clean test would be to raise it in one country, leave an identical copy of that country alone, and compare. But there is no identical copy, and no one can rewind a year and run it again.
Social science: the study of human behaviour and society, using scientific methods to build theories and test them against evidence.
So economists use the evidence history supplies: a period before a change against the period after, or two similar places where only one changed a policy. The second is a natural experiment. It is useful, but never fully controlled, because the two places also differ in other ways.
Real Example: In April 1992 the US state of New Jersey raised its minimum wage from $4.25 to $5.05 an hour, while next-door Pennsylvania stayed at $4.25. David Card and Alan Krueger surveyed 410 fast-food restaurants on both sides and found no fall in jobs in New Jersey. Others, using payroll records, found a fall, and the argument ran for years. Card shared the 2021 Nobel prize in economics for studies like this.
Exam Matters: Define a social science with both halves: what it studies (human behaviour and society) and how (testing theories against evidence). To explain why forecasts fail, give one reason there is no controlled experiment: history cannot be rerun, or other things change at once.
Economists simplify on purpose. A model keeps what matters for one question and assumes the rest away, so it can make a clear prediction.
A metro map is wrong on purpose. It straightens the lines and leaves out the streets, which is exactly why you can find your train in seconds. An economic model works the same way.
Economic model: a simplified representation of how part of the economy works, used to explain and predict behaviour.
To simplify, a model makes assumptions. A model of the rice market might assume that buyers know the price in every shop. That is not quite true, but it lets the model predict what happens when one shop changes its price.
Assumption: a condition that a model takes to be true in order to simplify reality.
An assumption matters only if dropping it would change the conclusion. If buyers do not know every price, a shop that raises its price may lose fewer customers than predicted. So to judge a model, name the assumption and say how the answer changes without it.
Ceteris paribus: the assumption that all other factors stay constant, so that the effect of one change can be studied on its own.
Ceteris paribus is Latin for 'other things being equal'. It lets a model make a clear claim: if the price of rice rises, ceteris paribus, people buy less rice. Incomes and the price of noodles are held still in the model, though in real life they move.
Real Example: In May 2020, with the pandemic spreading and oil prices falling, Saudi Arabia announced it would triple its value added tax (VAT), a tax on most spending, from 5% to 15% on 1 July. A model predicts that, ceteris paribus, a tax that raises prices cuts spending. Yet spending jumped in June, as lockdown ended and shoppers bought before the rise. Neither June's jump nor a fall after July shows what the tax alone did.
Exam Matters: Write 'ceteris paribus' when you set out a chain of cause and effect, to show you are holding other influences constant on purpose. When data seem to contradict a prediction, name what else changed before calling the model wrong.
Some claims can be checked against evidence and some cannot. Telling them apart shows where facts end and value judgements begin.
Two friends argue about the bus fare. One says, 'Since the fare went up, fewer people take the bus.' The other says, 'The fare is too high for students.' Counting passengers could settle the first. No count will settle the second: it depends on what each thinks is fair.
Positive statement: a statement of fact that can be tested against evidence to show whether it is true or false.
Normative statement: a statement about what ought to be, which rests on a value judgement and so cannot be tested against evidence.
Value judgement: a view about what is good or bad, or about what ought to happen, based on beliefs rather than on facts.
Words such as should, ought, fair, too and better are clues to a normative statement. They are not the test. Ask instead: could evidence show this to be true or false?
Real Example: In January 2014 Mexico taxed sugary drinks by 1 peso a litre, about 10% of the price. A study in the BMJ found purchases fell by 6% in the first year and by 12% by December 2014, most among poorer households. Those findings are positive: others can check them. The World Health Organization's advice that such taxes should raise prices by at least 20% is normative: it weighs health against cost.
Exam Matters: Classify a statement by the test, not the word: could evidence show it true or false? In a longer answer, set out what the evidence shows first, then say which outcome you think matters more, and why.
Economists can agree on what a policy will do and still disagree about whether to do it, because they weigh its gains and losses differently.
Your school has money for one project: a new science laboratory, or free lunches for pupils from poorer families. Everyone agrees on what each would do. The argument is about which matters more, and that is a value judgement.
Government decisions work the same way. Evidence can tell a government what a policy is likely to do, and who gains and who loses. It cannot say how much each gain or loss should count. When economists disagree about a policy, it is usually over these weights rather than over the facts.
Four questions show where the value judgements sit in almost any decision.
A strong judgement names the question it puts first, and says why. 'It depends on the government's priorities' is only a start: say which priority leads to which decision.
Real Example: In February 2020 Berlin froze rents on about 1.5 million older flats at their June 2019 level, for five years; flats built from 2014 were left out so that building would continue. An ifo Institute study later found that the number of flats advertised for rent fell by up to 60%. Supporters put sitting tenants first; critics put people still looking for a home first. In April 2021 Germany's top court struck the law down, only because rent rules are for the national government.
Exam Matters: In a Discuss or Evaluate answer, name the aim you put first (the best use of resources, fairness, or now against later) and whose interests you weigh, and give a reason. Say what each priority would decide.
People always want more than there is. Resources run out before wants do, so every society has to choose how to use them.
Think of what your family would buy if money were no object: a bigger home, a car, travel, the best schooling. Once you had them, you would want new things. Human wants have no limit.
The resources used to make goods and services do have a limit: only so much land, so many people able to work, so many machines and buildings.
Factors of production: the resources used to produce goods and services: land, labour, capital and enterprise.
Scarcity: the situation in which wants are unlimited but the resources to satisfy them are finite, so not every want can be met.
Basic economic problem: how to allocate finite resources between unlimited wants, which forces every society to decide what to produce, how to produce it and for whom.
So every economy, rich or poor, has to answer three questions. What should be produced? How should it be produced, with which mix of workers, machines and land? And for whom: who gets what is made?
Real Example: Singapore is one of the world's richest countries per person, and very short of land. It has added about a quarter to its area by reclaiming land from the sea, mostly since the 1960s. Even so, less than 1% of its land is set aside for farming, and it imports more than 90% of its food. Each hectare used for homes, factories or roads cannot grow food: being rich has not removed the choice.
Exam Matters: To define scarcity, give both halves: unlimited wants and finite resources. In a longer answer, say what scarcity forces: a choice between uses, which every economy makes when it decides what to produce, how and for whom.
Some resources grow back and some do not. But a resource that grows back still runs out if you use it faster than it renews.
A mango tree gives fruit every year. A gold mine gives up its gold only once. Both are land, a gift of nature used in production, but they behave very differently when you use them.
Renewable resource: a natural resource that replaces itself over time, such as fish, forests or wind, so it can be used indefinitely if it is not used faster than it renews.
Non-renewable resource: a natural resource that exists in a fixed amount, such as oil, coal or copper, so every unit used leaves less for the future.
The key is the rate of use. A fish stock breeds, but only so fast. If boats take more fish each year than the fish can replace, the stock shrinks year after year, and a renewable resource starts to behave like a non-renewable one.
For a non-renewable resource, every tonne used today is a tonne no one can use later. So deciding how fast to use it is also a decision about future generations.
Real Example: For centuries the cod off Newfoundland, in Canada, seemed endless. Then large factory trawlers arrived, and the catch peaked at about 810,000 tonnes in 1968, far more than the fish could replace. In July 1992 Canada banned cod fishing to let the stock recover, and about 30,000 people lost their jobs. The ban was meant to last two years. The fishery reopened only in 2024, with a limit of 18,000 tonnes.
Exam Matters: When a question asks about a resource running out, compare its rate of use with the rate at which it renews. Calling it renewable is only the start: show, with a figure from the case, that it is used faster than it replaces itself.
Scarcity forces a choice, and every choice gives something up. The cost of a choice is the best option you did not take.
Your family has saved enough for one big purchase: a laptop for your studies, a motorbike for your brother's journey to work, or a new fridge. You cannot have all three, because the savings are limited. Say the family chooses the laptop. What did it really cost?
Not all three things: you could only ever have had one of them. The real cost is the option you would have chosen next, say the motorbike. Economists call this opportunity cost.
Opportunity cost: the value of the next best alternative forgone when a choice is made.
This is how scarcity and choice connect. Because resources are finite, you must choose between their uses, and choosing one use means giving up the next best. The same is true for a firm deciding what to do with a factory, and for a government deciding how to spend its revenue.
Two details matter. First, opportunity cost is the next best alternative: one option, not a list of everything given up. Second, it need not be money. A day spent on one thing costs the next best thing you could have done with that day, even if nobody is paid.
Real Example: In 2018 South Korea beat Japan 2-1 in the Asian Games football final. The gold medal freed Son Heung-min, then playing for Tottenham in England, from the 21 months of military service Korean men then had to complete before turning 28. Had he served, the main cost to him would not have been money. It would have been almost two seasons of top-level football, the next best use of those months.
Exam Matters: When a question asks for the opportunity cost of a decision in a case, name one specific alternative use of the same money, time or resources from the case, and say why it was the next best. Not the price, and not a list.
A good is free only if using more of it costs nothing forgone. Most things you get without paying still used scarce resources.
When you breathe on an open hillside, nobody else has less air, and no resource was used to make it. When your school gives you a lunch without charge, the food, the cook's time and the kitchen could all have been used for something else.
Free good: a good that is not scarce, so it has zero opportunity cost: using more of it takes nothing away from anyone else.
Economic good: a good that is scarce, so producing or using it has an opportunity cost.
So the test is not the price. Ask: would one more unit use resources that could have been used for something else? If so, it is an economic good, even when the user pays nothing, and someone else bears the cost.
Free goods are rare, and a good can stop being free. Air in a polluted city is still there to breathe, but clean air is scarce: cleaning it uses machines, energy and labour.
Real Example: Air to breathe is the textbook free good, but clean air in Delhi is not. In 2023 the Swiss firm IQAir ranked New Delhi the world's most polluted capital, so clean air there has to be produced. In August 2021 the city opened a 24-metre 'smog tower' whose 40 large fans pull air through filters, built for about 200 million rupees. That money, the machinery and the power to run it could all have been used for something else.
Exam Matters: To decide whether a good is free or economic, apply the opportunity-cost test to that good: name the resources one more unit would use and what else they could have done. Say that its price does not decide it.
A country cannot make unlimited amounts of everything. A PPF shows the most it can make, and whether it is wasting what it has.
Imagine a country, Maraya, that makes two kinds of goods: consumer goods, such as food and clothes, which people use up now, and capital goods, such as machines and trucks, which are used to make other things. Its land, workers and machines are limited.
Production possibility frontier (PPF): a curve showing the maximum combinations of two goods or services that an economy can produce in a given period, when all its resources are fully and efficiently used.
Maraya's frontier runs from A, 40 thousand capital goods and no consumer goods, to F, 50 thousand consumer goods and no capital goods. Once every resource is in use, more of one good means less of the other, so the curve slopes down. The model holds resources and technology fixed over one period, such as a year.
Productive efficiency: producing the maximum possible output from the available resources, so that more of one good can only be made by making less of another.
So every point from A to F is productively efficient. At G, Maraya makes 20 thousand of each good, yet with the same resources it could be at C, with 33 thousand capital goods. At G, resources are unemployed or misallocated.
H, 40 thousand consumer goods with 32 thousand capital goods, is unattainable with today's resources: at 40 thousand consumer goods, the frontier allows only 14 thousand capital goods.
Real Example: In April to June 2020, during a national lockdown, India's output was about 24% lower than a year earlier. Its workers, land and machines still existed, so its frontier had not moved: India was producing far inside it. By the end of 2020, output was growing again without any new resources.
Exam Matters: When you draw a PPF, label both axes with the good and its units, bow the curve outward, and label every point the question names, saying what a point inside or beyond the curve means.
Moving along a PPF, you can work out exactly what one more unit of a good costs, and see why that cost keeps rising.
Opportunity cost is the next best alternative given up, and a PPF lets you put a number on it. Economists look at one small step at a time and ask what one extra unit costs: this is marginal analysis.
Opportunity cost on a PPF: the amount of one good that must be given up to produce one more unit of the other good, as an economy moves along its frontier.
Work out each step of 10 thousand consumer goods and the cost climbs: 0.2 capital goods from A to B, 0.5 from B to C, 0.8 from C to D, and more again on every step after that. This is increasing opportunity cost.
Maraya's resources are not equally good at both goods. It first moves the workers and machines least useful for capital goods, so it loses little. Later it must move the ones best at capital goods, so each extra consumer good costs more.
This rising cost is why the frontier bows outward, or is concave to the origin. If every resource were equally good at both goods, the cost would never change and the PPF would be a straight line.
Real Example: From the late 1970s, Saudi Arabia grew wheat in the desert, using water pumped from deep underground stores that rain does not refill. Output peaked at about 4.1 million tonnes in 1992, but each tonne used scarce water on land badly suited to wheat. In 2008 the government decided to end wheat growing by 2016.
Exam Matters: Show both subtractions, then the division, then the answer with its unit. If you are asked why the cost changes, say that resources are not equally suited to both goods.
Some changes alter what an economy chooses to make. Others alter what it is able to make. A PPF shows the two in different ways.
If Maraya decides to make more consumer goods and fewer capital goods, its workers, land and machines are unchanged; only the mix is different. That is a movement along the frontier, such as from C to D.
If its workers become better trained, or it finds a large new copper deposit, it can make more of both goods than before. The whole frontier moves outward, from PPF1 to PPF2: a shift.
Economic growth: an increase in the productive potential of an economy, shown by an outward shift of its production possibility frontier.
Economic decline: a fall in the productive potential of an economy, shown by an inward shift of its production possibility frontier.
A change in what people want to buy does not move the frontier. It only changes which point on it the economy chooses.
Real Example: Guyana announced a large oil find under its seabed in 2015 and began pumping in December 2019. The new resource shifted its frontier outward: in 2022 its output grew by about 62%. Because the find helps make oil far more than other goods, a diagram of oil against other goods shows a pivot along the oil axis.
Exam Matters: First ask: does this change what the economy is able to produce, or only what it chooses to produce? If capacity changes, shift the curve and name the cause; if not, show a movement between two labelled points.
Making machines instead of things to use now means less to enjoy today, but it lets an economy produce more in the future.
A family eats the rice it buys this week. A farmer's tractor is different: nobody wants it for itself, but it helps grow rice season after season.
Consumer good: a good bought by households to satisfy their wants directly, such as food, clothing or a phone.
Capital good: a good used to produce other goods and services, such as machinery, tools, factories and roads.
What counts is how a good is used, not what it is. A motorbike ridden at weekends is a consumer good; the same motorbike used by a delivery rider is a capital good.
Capital goods matter because they let each worker produce more. A farmer who ploughs 1 hectare a day by hand might plough 8 with a tractor.
Productivity: output per unit of input per period of time, such as output per worker per hour.
With the tractor, output per worker per day rises from 1 hectare to 8. When workers across an economy become more productive, it can make more of both goods, so its PPF shifts outward: economic growth.
But capital goods must be made first, with resources that could have made consumer goods. Picture two economies, Kestra and Lumo, that start on the same frontier and choose differently.
Which is better is a value judgement about now against later. In a very poor country, consuming less today can mean real hardship.
Real Example: For most years from the late 1970s to 2000, South Korea put a third or more of its output into capital goods, about 42% in 1991. New factories, ports and machines let each worker produce more, and output per head rose more than four times in real terms between 1980 and 2000.
Exam Matters: Draw two economies on the same frontier, one choosing more capital goods, then their later frontiers, with that one shifted out further. Then weigh it: the sacrifice comes now, and the gain comes later and is not certain.
When each person does one job, far more gets made. But everyone then depends on everyone else, and narrow jobs bring costs of their own.
Think about the shirt you are wearing. One person did not grow the cotton, spin it, weave the cloth and sew it: many people each did one part, and each got good at it.
Specialisation: the concentration by an individual, firm, region or country on producing a limited range of goods or services.
Division of labour: the splitting of the production of a good into separate tasks, with each worker doing one task or a few.
Adam Smith, a Scottish economist, described a pin factory in The Wealth of Nations (1776). Making a pin was divided into about eighteen separate operations. Ten workers sharing them out could make upwards of 48,000 pins a day between them, about 4,800 each.
One worker making whole pins alone, Smith wrote, could perhaps not make twenty in a day. He gave three reasons for the gain: workers grow more skilled by repeating one task, no time is lost switching between tasks, and a simple repeated task is easy to hand to a machine.
Real Example: In late 2011, floods in Thailand shut factories that made about 40-50% of the world's hard disk drives. Computer makers everywhere ran short and drive prices rose sharply, and Toyota and Honda cut car output as far away as North America. Each stage was efficient, and every later stage depended on it.
Exam Matters: Link each of Smith's three reasons to higher output per worker, then to a lower cost per unit. For balance, take one disadvantage as a chain: the narrow task, the risk it creates, and who bears it.
Specialists must swap what they make for everything else they need. Money makes that swap quick and easy.
A rice farmer who grows rice all day still needs a fishing net, clothes and medicine. Without money, she must find someone who has a net and also wants rice.
Barter: the direct exchange of one good or service for another, without using money.
Double coincidence of wants: the situation in which each person in an exchange has what the other wants, and wants what the other has.
Suppose the net maker wants a goat, and the goat herder wants rice. No pair wants each other's goods, so under barter nothing is traded. The more narrowly people specialise, the harder this search becomes.
Money: anything that is generally accepted as payment for goods and services and for settling debts.
Money works only while people trust it to hold its value. When the general level of prices rises very fast, which is high inflation, money fails first as a store of value. In July 2008 Zimbabwe's official inflation rate reached about 231 million per cent a year, and in 2009 the country switched to the US dollar and the South African rand.
Real Example: In March 2007 Safaricom launched M-Pesa in Kenya, so people could pay, be paid and save with a basic mobile phone. A 2016 study found it lifted about 194,000 Kenyan households, about 2%, out of extreme poverty, and helped an estimated 185,000 women move from farming into business.
Exam Matters: Name each function and the barter problem it removes, then link it to specialisation: without money, a specialist would lose hours searching for a double coincidence of wants instead of producing.
Some people have money they do not need yet; others need money now to build or buy something. Financial markets bring them together.
A teacher saves part of her salary each month. A bus company wants ten new buses but does not have the money. Financial markets connect the two, so the teacher's savings do not sit idle.
Financial market: a market that brings together savers and borrowers, in which financial assets such as loans, shares, bonds and currencies are bought and sold.
Forward market: a market in which a price is agreed today for a commodity or currency that will be delivered and paid for on a set date in the future.
Equity (share): a part of the ownership of a company, which gives its owner a share of the profits and can be sold on to someone else.
Real Example: For about 30 years, Ghana's cocoa board has borrowed against its forward sales: banks lend against cocoa that buyers have agreed to take, and the board pays farmers at harvest, $1.13 billion for the 2022/23 crop. When harvests failed in 2023/24, the system broke down, and it raised no such loan for 2024/25.
Exam Matters: Learn the five roles by name. In a data question, say which role a bank, deal or exchange in the text is performing, and what it lets people do that they could not do without it.
Every country must decide what to make, how, and for whom. Economic systems differ in who makes those decisions.
Every economy faces the same three questions: what to produce, how to produce it, and who gets it. Someone has to answer them. In some economies it is millions of buyers and sellers; in others, a government plan.
Free market economy: an economy in which resources are owned by private individuals and firms, and are allocated through markets by the decisions of buyers and sellers, guided by prices.
Command economy: an economy in which the state owns most resources and decides what, how and for whom to produce through a central plan.
Mixed economy: an economy in which resources are allocated partly by markets and partly by the state, with both a private sector and a public sector.
No country is a pure example of either extreme. Picture a line with the free market at one end and the command economy at the other: every real economy sits somewhere between them, so every real economy is mixed.
Hong Kong and Singapore sit near the market end. Sweden sits in the middle, with high taxes paying for health care, schooling and pensions. North Korea sits near the command end.
Real Example: North Korea is the closest thing to a command economy today. Yet after a famine in the 1990s, when the state could no longer feed people, markets grew up to fill the gap, and the state later allowed them. By 2018, satellite images showed at least 436 official markets.
Exam Matters: When a question names a country, place it on the line between the two extremes and give evidence: which decisions are left to markets, and which the state takes.
Markets are good at finding out what people want and making it cheaply. Plans can make sure everyone gets the basics. Each has a cost.
In a free market, firms make what people will pay for, because that is where the profit is. In a command economy, planners decide what people need. Each approach does some things well and others badly.
So the comparison depends on what you care about most. Efficiency, new ideas and choice favour markets; equality and guaranteed essentials favour planning. Deciding which matters more is a value judgement, which is why real economies mix the two.
Real Example: In October 1957 the Soviet Union, a command economy, launched Sputnik 1, the world's first artificial satellite: its planners could pour resources into one national goal. Yet in the late 1980s, Moscow shoppers still queued for everyday goods such as washing powder.
Exam Matters: Weigh strengths against weaknesses criterion by criterion, rather than listing both sides. A strong judgement says when each system does better, such as when competition is real, or when buyers' wants are spread across millions of people.
In a mixed economy, markets do most of the work. The state steps in where markets do badly, but the state can get things wrong too.
Markets leave some things undone. No firm will light a street, because it cannot make people pay for light they get anyway. Markets also leave some people with too little income to buy essentials.
But state action can make things worse. The state may lack information, act slowly, or be swayed by powerful groups.
Government failure: when government intervention leads to a worse allocation of resources than there would have been without it.
So the case for the state doing more needs two things: the market doing badly, and the state being able to do better. How far to go is also a value judgement about how much weight to give fairness against efficiency.
Real Example: In April 2021 Sri Lanka banned imports of chemical fertiliser, to force farmers to switch to organic farming. Farmers had no time to adjust, and rice output fell by about 20% in the first six months. The ban was partly lifted that November, and the state paid about $200 million in compensation to farmers: an intervention that left farming worse off than before.
Exam Matters: Use government failure as your counter-argument, and be specific: name what the state would need to know or do, and why it might not. Then judge how likely that failure is in the case you are given.
Economics tests its ideas against evidence, like any science. But it studies people, and you cannot put a whole economy in a laboratory.
Economists simplify on purpose. A model keeps what matters for one question and assumes the rest away, so it can make a clear prediction.