= private benefit + external benefit.
Example of cost-benefit analysis: some of the costs and benefits of choosing to drive to school by car.
The individual will only consider the private cost and benefits when making his/her choices. This can result in resources being allocated in ways that are not necessarily in society’s best interest because any externalities are not taken into consideration.
The Factors of Production
Factor of production = one of the limited resources that exist to produce goods and services to satisfy our unlimited wants.
The factors of production include
Land = any natural resource, except humans, used in production – eg minerals, fossil fuels, livestock, crops, rivers.
Labour = the human input to production by muscle or brain, skilled or unskilled.
Capital = man-made items which help in the production of other goods and services – eg tools, machines, factories, etc.
Enterprise = the entrepreneur is the decision maker and risk taker in a business. He/she is responsible for putting the money up to start the business and organising the other factors of production within it.
Most big businesses today are run by companies in which the entrepreneur’s jobs are split between the shareholders, who take the risk, and the managing directors, who make the decisions.
The importance of capital
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Capital goods increase the productivity of the land and labour so that more output can be produced from the same amount of land and labour. This allows more wants to be satisfied, making us richer.
- To get capital goods, resources must be diverted away from producing goods and services for consumption. Consumption is the opportunity cost of capital.
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Each time a capital good is used, depreciation occurs so that the good will eventually need to be replaced.
Productivity = the amount of output produced in a firm by a given amount of factor input.
Depreciation = the fall in value of a capital good as a result of its use in production over time.
Types of capital
Fixed capital = items like tools and machines that can be used in production many times over. With each use these goods depreciate a little.
Working capital = these are stocks of raw materials that are carried by businesses. They represent capital because like a tool or machine, the stocks increase productivity/efficiency of the producer. Stocks can only be used once in production.
Social overhead capital = infrastructure like roads is available for all producers and society to use in assisting the production of goods.
The production process
Goods = physical items that can be packaged and carried.
Consumer goods = goods that satisfy a consumer’s want when they are used.
Consumer durable goods = goods that satisfy a want over and over again – eg cars, computers, furniture, clothes.
Consumer non-durable goods = goods that satisfy a want once – eg cakes, sweets, drinks.
Capital goods = goods that are used to assist in the production of other goods – eg tools and machines.
Services = tasks that are performed to satisfy a consumer’s want. They are not physical items that can be packaged and carried – eg haircut, holiday, school lesson.
Production Possibility Curves
Production possibility curve = a graph showing the maximum combinations of goods that an economy is able to produce using all its available resources and technology most efficiently.
Example – an economy has 100 units of resources. Using the technology available most efficiently, 1 unit of resources can produce 10 consumer goods or 5 capital goods each week. The table below gives the maximum possible output combinations of consumer goods and capital goods that the economy can produce each week.
If these output combinations are plotted on a graph, the production possibility curve of the economy is obtained (line AB).
The production possibility curve can be used to illustrate several important economic ideas.
- The economic problem of scarcity – people may want a combination of goods that gives them 1000 consumer goods and 500 capital goods (point C). However, the economy’s scarce resources limit production to the line AB, which does not reach point C.
- The opportunity cost of a choice – if the economy is at point E producing 600 consumer goods and 200 capital goods, and chooses to increase its production of capital goods to 300, it will have to move to point F, sacrificing 200 consumer goods. The opportunity cost of the 100 extra capital goods is 200 fewer consumer goods. The gradient of the curve reveals the opportunity cost.
- The problem of unemployment – if the economy is at point G (500 consumer goods and 200 capital goods) beneath the curve, it must mean that either some resources are not being used (are unemployed) or that technology is not being used efficiently.
- The economic growth of the economy – it may be possible to shift the production possibility curve to the right by achieving economic growth. If this happens, line AB will move to line JK. This growth can be caused by
- more resources becoming available
- better quality resources becoming available
- improved technology becoming available
The curve may shift left if resources are lost or destroyed (eg in a war).
Economic Systems
An economy or economic system is a decision-making system designed to tackle the three key choices or decisions that stem from the economic problem of scarcity. These decisions are
- What to produce? The consumption decision
- How to produce? The production decision
- For whom to produce? The distribution decision
There are four types of economic system designed to cope with these problems.
- A command or planned economy
The basic aim of any economic system is to allocate the scarce resources available, thus answering the three key questions above, while minimising any waste of resources.
Possible sources of waste include
- producing goods that people do not want
- producing goods that people want inefficiently
- producing goods that people want efficiently, but failing to get them to the people that want them
A Subsistence Economy
This economy is organised on a self-sufficiency basis, like Crusoe on his desert island. The individual/family has a set of resources and decides what to produce from them, how this is done and who gets what share of the goods produced.
As a system, it has the appeal of complete independence for the individual/family, but several drawbacks. For example, there will probably be a limited range of goods produced to a rather poor quality because the individual/family will possess a limited range of skills, talent and resources. Some vital products may not be produced at all.
As the name suggests, people can just about survive or subsist satisfying some of their basic needs and wants. Such a system exists in the most primitive economies and forms the basis for the development of more advanced systems.
A Free Market Economy
(Capitalist, laissez-faire economy)
In a free market economy, the consumption, production and distribution decisions are solved by the operation of market forces and the price mechanism. The system has the following features
- All factors of production are privately owned
- People make decisions to maximise their own self interest
- The government does not have a role in the economy
The consumption decision is made in the markets for goods and services. People spend their money on the goods they want most, thus registering votes. Popular goods attract more votes, sell quickly and rise in price. Unpopular goods attract few votes, remain unsold and fall in price. Producers respond to these price changes in order to make profits. They expand the output of popular goods and cut back output of unpopular goods, thus allocating resources in a way consistent with what consumers want.
Producers in competition with each other make the production decision. They will produce goods as efficiently as possible to keep their costs to a minimum. This allows them to keep prices low to compete with other firms, and to make maximum profits on the goods they sell.
The distribution decision is made in the markets for factors of production. People own various factors and they sell the services of these factors to producers. The price that they receive for the factors will be their income, which in turn determines how many goods and services they can afford to buy, and hence their share of the economy’s output.
Advantages of a free market economy
- Competition in markets promotes an efficient use of resources.
- Competition produces a greater variety of goods and hence more choice for consumers.
- Risk taking and initiative are encouraged by the profit motive, and these are likely to promote economic growth.
- The price mechanism adjusts quite quickly to changing economic conditions so that resources are not wasted producing unwanted goods or being unemployed.
Disadvantages of a free market economy
- Competition may break down, causing market failure, such as monopolies, which charge higher prices for fewer goods.
- Markets may not operate efficiently causing some resources to be unemployed.
- Public goods, like streetlights, will not be provided in markets because ‘free riders’ can enjoy the benefits of the goods without paying, so nobody will pay and firms cannot make profits.
- Merit goods, like education and health services, can be provided at a price in markets, but some people may choose not to buy them, so they will be under consumed to the detriment of society – the workforce will deteriorate in quality.
- Decisions are made solely on private costs and benefits, thus ignoring external costs, like pollution, and external benefits. As a result, resources may not be allocated in a way that is not in society’s best interests.
- An unequal distribution of income occurs because some people own factors of production, which are scarcer than others and are paid more. These richer people can divert resources into making luxuries at the expense of necessities for the poor.
A Planned Economy
(Command economy)
In a panned economy, the consumption, production and distribution decisions are made by a group of planners appointed by the government/state. The system has the following features
- All factors of production are owned by the state
- Planners make decisions to maximise the common good
- The government plays the central role in the economy
The consumption decision is made by planners who collect information on what the economy and its consumers want.
The production decision is made by planners who set output targets for firms and allocate resources to them so that these targets can be achieved.
The distribution decision is made by planners who can use ration cards and distribution centres to share out the economy’s output. Alternatively, they can pay factors of production fixed prices, and fix the prices of goods and services in the shops, so they can decide how much the factor owners can afford to buy.
Advantages of a planned economy
- All industries are state owned monopolies so there is less chance of consumer exploitation.
- Planners can ensure that public goods are available.
- Planners can ensure that people have sufficient levels of merit goods.
- Planners can take externalities into consideration when making their decisions.
- Planners can ensure that there is a job for all so unemployment is not a problem.
- Planners can distribute goods equally or fairly if they wish, so there is less chance of income inequality.
Disadvantages of a planned economy
- Resources used in planning are not available to produce goods and services to satisfy wants.
- Planners may get the plan wrong causing gluts and shortages of goods.
- Once in operation it is difficult to adjust the plan to cope with changing economic conditions.
- There is limited choice and variety of goods for consumers.
- There is little incentive to work hard or to take risks because the state owns all resources and planners decide on the distribution of goods. The economy is likely to grow more slowly and technology may lag behind others.
- Planners may be corrupt in their decision making.
A Mixed Economy
A mixed economy contains elements of both a market economy and a planned economy. The key decisions of what? how? and for whom to produce? are partly answered by market forces and partly by government planners.
The aim of a mixed economy is to get the best of both systems without too many of the disadvantages. All countries have mixed economies, but the strength of the mixture varies. In the UK, about 60% is determined by market forces and 40% by planners.
The functions of the government in the UK economy include
- The provision of public goods.
- The provision of an adequate level of merit goods.
- The redistribution of income from rich to poor.
- The control of externalities and consumption of demerit goods.
- The protection of individuals against powerful market influences like monopolies.
- The management of the economy to achieve
- a healthy balance of payments
