CAIE A-Level Economics

Scarcity and choice

The fundamental economic problem is scarcity: the resources available to produce goods and services (land, labour, capital and enterprise) are limited, while human wants are, for practical purposes, unlimited. Because not every want can be met, a choice has to be made about which ones will be. Scarcity is not the same as shortage. A shortage is a market in which quantity demanded exceeds quantity supplied at the current price, and it can disappear when the price adjusts, whereas scarcity never disappears because resources remain limited however rich a society becomes.

Choices have to be made at every level:

• Individuals (households) choose how to spend limited income and limited time, for example between buying a laptop and saving, or between working extra hours and studying.
• Firms choose how to use limited funds, workers and machinery, for example whether to expand an existing factory or open a new site.
• Governments choose how to use limited tax revenue and borrowing, for example between spending more on healthcare and cutting taxes.

Opportunity cost

Every choice means giving something up. The opportunity cost of a decision is the value of the next best alternative that is forgone. It is not the total of everything that could have been done instead, only the single best alternative, and it is not always measured in money. Time, leisure and satisfaction have opportunity costs too.

A student who spends Saturday afternoon revising instead of earning £40 in a part-time job has an opportunity cost of £40, if the job was the next best use of that time. If the next best use had been a football match with friends, the opportunity cost would be the enjoyment of the match. A government that spends £5 billion on a new motorway gives up the next best use of that £5 billion, such as new schools or lower taxes. A firm that uses its own premises to produce goods gives up the rent it could have earned by letting them to someone else, so that rent is an opportunity cost even though no payment is made.

Opportunity cost is the reason economics treats the cost of anything as what is sacrificed, rather than only the money paid.

The basic questions of resource allocation

Because resources are scarce, every society has to answer three questions.

1. What to produce: which goods and services to make, and in what quantities, out of the many that could be made. Producing more of one good means producing less of another.
2. How to produce: which methods and which combination of resources to use. A good can often be made with more labour and little machinery or with the reverse, and the choice affects cost, employment and the environment.
3. For whom to produce: how the output is shared among the members of society, which depends on how income and wealth are distributed.

Different economic systems answer these questions in different ways, which is why they are compared in terms of resource allocation.

Economic methodology

Economics as a social science

Economics is a social science: it studies how people, firms and governments behave when they make choices, using the scientific method as far as human behaviour allows. Economists observe, build simplified models of how the economy works, derive hypotheses from them and test those against data. A model is a simplification that leaves out detail so that the main relationships can be seen. It is judged by how well it explains and predicts, not by how realistic its assumptions are.

Economics differs from the natural sciences because it cannot run controlled laboratory experiments on whole economies. People change their behaviour in response to being studied and to policy, and conditions are never repeated exactly. This is why economists need an assumption that holds other things constant.

Positive and normative statements

A positive statement is a statement of fact that can in principle be tested against evidence, and it may turn out to be true or false. A normative statement is a value judgement about what ought to be, and it cannot be settled by evidence alone, because it depends on opinions about what is desirable.

A positive statement does not have to be true to be positive. "Cutting interest rates will always reduce inflation" is positive (and false). Policy debate usually mixes the two: the positive part predicts what a policy will do, and the normative part decides whether that outcome is wanted.

Ceteris paribus

Ceteris paribus is Latin for "other things being equal". It is the assumption that every variable other than the ones being studied is held constant. When the effect of a price change on quantity demanded is analysed, income, tastes and the prices of other goods are assumed not to change, so that the effect of price alone can be isolated. In the real world many things change at once, so the assumption is a way of separating causes in a model, and conclusions are therefore conditional on it.

The time period

The effects of an economic change depend on the time allowed for adjustment, and economics uses three broad periods.

• The short run is a period in which at least one factor of production is fixed, so that a firm can change its output only by changing the variable factors, such as labour or raw materials.
• The long run is a period in which all factors of production can be varied, although the state of technology is fixed.
• The very long run is a period in which technology and the other determinants of productive capacity can change as well.

These are not fixed numbers of months or years. The short run for a bakery may be a few weeks, and for a steelworks or an oil refinery it may be several years. The length of the period matters because responses are usually greater with time: consumers find substitutes, firms build new capacity, and workers retrain.