O Level Economics formulas and key terms

The basic economic problem

The nature of the basic economic problem

• Basic economic problem: resources are finite but wants are unlimited
• Scarcity: there are not enough resources to produce everything people want
• What to produce: which goods and services, and how much of each
• How to produce: which mix of resources and methods to use, for example more machines or more workers
• For whom to produce: who receives the goods and services that are made
• Economic good: uses scarce resources, so it has an opportunity cost
• Free good: is not scarce and has no opportunity cost, for example sunlight or air

Factors of production

• Land (natural resources) earns rent
• Labour (human effort, physical and mental) earns wages
• Capital (man-made goods used in production) earns interest
• Enterprise (organising the other factors and taking risks) earns profit
• Quantity of labour rises with population growth, immigration, a higher retirement age or more people willing to work
• Quality of labour rises with education, training and better health care
• Capital grows through investment and falls when worn-out machines are not replaced; land grows when new resources are found or land is reclaimed

Opportunity cost

• Opportunity cost: the next best alternative given up when a choice is made
• It exists because resources (income, time, land, tax revenue) are limited
• Only the next best alternative counts, not all the alternatives added together
• Consumers: buying one product means going without another
• Workers: taking one job means giving up the pay and conditions of the next best job
• Firms: using resources for one product means making less of another
• Governments: spending more on one service means less for another, or higher taxes

Production possibility curve (PPC) diagrams

• PPC: the maximum output combinations of two goods with existing resources and technology
• On the curve: full and efficient use of resources. Inside: unemployed or inefficiently used resources. Outside: unattainable at present
• Movement along the curve: resources are reallocated; the opportunity cost is the output of the other good given up
• Bowed-out curve: opportunity cost rises, because resources are not equally suited to both goods
• Straight-line PPC: opportunity cost is constant
• Outward shift: more or better resources, for example new technology, training, investment or a discovery of resources
• Inward shift: resources lost, for example through war, natural disaster or emigration of workers

The allocation of resources

The role of markets in allocating resources

• Market: any arrangement that lets buyers and sellers trade
• A market needs buyers, sellers, a product and a way to agree a price; it does not need a physical place
• Buyers (consumers) demand products and want low prices
• Sellers (producers) supply products and want high prices and profit
• Product markets trade goods and services; factor markets trade land, labour and capital
• In the labour market, workers are the sellers and firms are the buyers

Demand

• Demand: the willingness and ability to buy a product at a given price
• Market demand = the sum of the quantities all buyers demand at each price
• Price of the product falls: extension of demand (movement down along the curve). Price rises: contraction (movement up along the curve)
• Demand increases (curve shifts right) when income rises for a normal good, a substitute becomes dearer, a complement becomes cheaper, tastes or advertising favour the product, or population grows
• Substitutes are used instead of each other (tea and coffee); complements are used together (tea and sugar)
• The opposite changes decrease demand (curve shifts left)

Supply

• Supply: the willingness and ability to sell a product at a given price
• Market supply = the sum of the quantities all firms supply at each price
• Price of the product rises: extension of supply (movement up along the curve). Price falls: contraction (movement down along the curve)
• Supply increases (curve shifts right) with lower costs of production, better technology, a subsidy, good weather for crops or more firms in the market
• Supply decreases (curve shifts left) with higher costs, an indirect tax, bad weather or natural disasters, or fewer firms
• If another product that uses the same resources becomes more profitable, supply of this product decreases

Price determination

• Equilibrium price: the price at which quantity demanded = quantity supplied
• In a schedule, find the row where the two quantities are equal
• Price above equilibrium: surplus = quantity supplied − quantity demanded; price then falls
• Price below equilibrium: shortage = quantity demanded − quantity supplied; price then rises
• What to produce: firms make the goods consumers will pay a profitable price for
• How to produce: firms choose the cheapest mix of resources to keep costs low
• For whom to produce: goods go to those willing and able to pay the price

Price changes

• Demand increases (shifts right): price rises, quantity rises
• Demand decreases (shifts left): price falls, quantity falls
• Supply increases (shifts right): price falls, quantity rises
• Supply decreases (shifts left): price rises, quantity falls
• If both curves shift, one result is certain and the other depends on the size of each shift
• A higher price with nothing else changed means lower sales, because demand contracts
• Percentage change = (change ÷ original value) × 100

Price elasticity of demand (PED)

• PED = percentage change in quantity demanded ÷ percentage change in price
• Percentage change = (change ÷ original value) × 100
• Size of PED: 0 perfectly inelastic (vertical curve); between 0 and 1 inelastic; 1 unitary; greater than 1 elastic; infinite perfectly elastic (horizontal curve)
• Total revenue = price × quantity sold; this equals the amount consumers spend
• Inelastic demand: price and revenue move in the same direction, so a price rise increases revenue
• Elastic demand: price and revenue move in opposite directions, so a price cut increases revenue
• Unitary demand: revenue stays the same when price changes

Price elasticity of supply (PES)

• PES = percentage change in quantity supplied ÷ percentage change in price
• PES is positive, because the supply curve slopes upwards
• PES values: 0 perfectly inelastic (vertical curve); between 0 and 1 inelastic; 1 unitary; greater than 1 elastic; infinite perfectly elastic (horizontal curve)
• A straight-line supply curve that starts from the origin has PES = 1 at every point
• More elastic: spare capacity, stocks of finished goods, easily available factors, short production time, long run
• More inelastic: full capacity, perishable goods that cannot be stored, long growing or building time, short run

Market economic system

• Market economic system: resources are allocated by the price mechanism, with private ownership and little government intervention
• Advantages: wide consumer choice, competition keeps prices low and quality high, the profit motive encourages efficiency and innovation, quick response to changes in demand
• Public goods (street lighting, defence) are not provided, because firms cannot make non-payers pay
• Merit goods (education, health care) are under-consumed; demerit goods (cigarettes) are over-consumed
• External costs such as pollution are ignored by firms
• Incomes can be very unequal, and those who cannot work may have little or no income
• Firms may grow into monopolies and raise prices

Market failure

• Social cost = private cost + external cost
• Social benefit = private benefit + external benefit
• Public good: non-excludable (people who do not pay cannot be stopped from using it) and non-rival (one person's use does not reduce what is left for others), e.g. street lighting, national defence
• Free rider problem: people can use a public good without paying, so private firms cannot make a profit and do not supply it
• Merit good: more beneficial than people realise, so under-consumed, e.g. education, vaccinations
• Demerit good: more harmful than people realise, so over-consumed, e.g. cigarettes
• Monopoly: a single seller; it may restrict supply, so prices are higher and too few resources go into the good

Mixed economic system

• Maximum price: the highest price sellers may charge. It only has an effect if set below equilibrium, and it causes a shortage (demand greater than supply)
• Minimum price: the lowest price sellers may charge. It only has an effect if set above equilibrium, and it causes a surplus (supply greater than demand)
• Indirect tax: a tax on goods and services. Price usually rises by less than the tax, so consumers and producers share it
• Tax revenue = tax per unit × quantity sold after the tax
• Subsidy: a payment by the government to producers. Cost to the government = subsidy per unit × quantity sold after the subsidy
• Privatisation: selling state-owned firms to the private sector. Nationalisation: taking private sector firms into state ownership
• Regulation: laws and rules, e.g. a ban on smoking in public places. Quota: a limit on quantity, e.g. on the fish that may be caught

Microeconomic decision-makers

Money and banking

• Functions of money: medium of exchange, unit of account (measure of value), store of value, standard for deferred payments
• Characteristics of good money: generally acceptable, durable, portable, divisible, limited in supply, recognisable
• Forms of money: notes, coins and bank deposits. Shares, property and goods are assets, not money
• Commercial bank profit: the interest rate charged on loans is higher than the interest rate paid on deposits
• Central bank functions: issues currency, banker to the government, banker to commercial banks, lender of last resort, carries out monetary policy, holds the country's foreign currency reserves, supervises banks
• Lender of last resort: the central bank lends to a commercial bank that is short of cash and cannot borrow elsewhere, which keeps trust in the banking system

Households

• Saving = disposable income − spending
• Percentage of income saved = saving ÷ disposable income × 100
• Higher income: more spending and more saving in total; a smaller share is spent and a larger share is saved
• Higher interest rate: more saving, less borrowing, less spending. Lower interest rate: the opposite
• Low confidence (fear of unemployment): less spending and borrowing, more saving
• Age: young adults borrow (education, home, car), the middle-aged save most (for retirement), the retired spend their savings
• Culture: traditions and attitudes to debt, e.g. saving for weddings, or avoiding loans that charge interest

Workers

• Demand for labour comes from firms; supply of labour comes from workers
• Demand for labour shifts right when demand for the product or workers' productivity rises: wage and employment both rise
• Supply of labour shifts right when more people qualify for or want the job: wage falls and employment rises
• National minimum wage above equilibrium: the wage rises, demand for labour contracts and supply extends, so there is a surplus of labour (unemployment)
• A trade union is stronger when it has many members, the workers are skilled and hard to replace, and unemployment is low
• Occupational mobility: ability to change to a different job (helped by education and training). Geographical mobility: ability to move to a job in another area (helped by affordable housing, transport and information)
• Division of labour: each worker specialises in one task. Output per worker rises and training is quicker, but the work can be boring and one absence can stop production

Firms

• Horizontal merger: firms at the same stage of production in the same industry, e.g. two banks
• Vertical merger: firms at different stages of the same industry. Backward: with a supplier. Forward: with a firm nearer the customer, e.g. a retailer
• Conglomerate merger: firms in unrelated industries. It spreads risk (diversification)
• Internal economies of scale (the firm grows): buying (bulk discounts), technical, financial, managerial, marketing, risk-bearing
• External economies of scale (the industry grows): pool of skilled labour, specialist suppliers nearby, better infrastructure, shared research
• Diseconomies of scale: internal, e.g. poor communication, slow decisions, low morale; external, e.g. congestion and dearer resources as the industry grows
• Small firms survive because of small local markets, personal service, flexibility and low set-up costs

Firms and production

• Labour productivity = total output ÷ number of workers (or ÷ hours worked)
• Production can rise while productivity falls, if the number of workers rises by a bigger percentage than output
• Demand for a factor rises when demand for the product rises, or when the factor becomes cheaper, easier to get or more productive
• Labour-intensive: chosen where labour is cheap and plentiful or goods are made to order. Flexible, with low set-up costs, but output is slower and quality can vary
• Capital-intensive: chosen for mass production. High output, low average cost and even quality, but high set-up costs, less flexibility and breakdowns stop production
• Investment is spending on capital goods; more or better capital per worker raises labour productivity

Firms’ costs, revenue and objectives

• Total cost = fixed cost + variable cost (TC = FC + VC)
• Average total cost = total cost ÷ output (ATC = TC ÷ Q), and ATC = AFC + AVC
• Average fixed cost = fixed cost ÷ output (AFC = FC ÷ Q)
• Average variable cost = variable cost ÷ output (AVC = VC ÷ Q)
• Total revenue = price × quantity sold (TR = P × Q)
• Average revenue = total revenue ÷ quantity sold (AR = TR ÷ Q), which is the same as the price
• Profit = total revenue − total cost (TR − TC)

Types of markets

• Competitive market: many buyers and sellers, similar products, easy entry and exit, each firm has little influence over price
• Many firms: lower prices, better quality, more choice, lower profit for each firm
• One firm: higher prices, less choice, possibly lower quality, high profits that last
• Pure monopoly: a single firm supplies the whole output of the market
• Barriers to entry: patents and licences, high set-up costs, economies of scale, brand loyalty, control of a vital resource
• For monopoly: economies of scale can lower costs, profits can pay for research, and it avoids wasteful duplication (e.g. one set of water pipes)
• Against very competitive markets: firms are small, so they gain few economies of scale and have little money for research

Government and the macroeconomy

Government macroeconomic intervention

• Economic growth: a rise in the economy's output (real GDP) over time, which can raise living standards
• Full employment: nearly everyone who is willing and able to work has a job. It means low unemployment, not zero
• Stable prices: a low and steady rate of inflation, so money keeps its value and firms and households can plan
• Balance of payments stability: over time, money coming in from abroad roughly matches money going out, with no large, lasting deficit
• Redistribution of income: narrowing the gap between rich and poor through taxes and benefits
• Environmental sustainability: meeting present needs without harming future generations' ability to meet theirs
• Conflicts: full employment against stable prices; economic growth against environmental sustainability; full employment against balance of payments stability

Fiscal policy

• Budget balance = government revenue − government spending. Positive: surplus. Negative: deficit
• Direct taxes: income tax, corporation tax. Indirect taxes: sales tax (GST or VAT), excise duty, tariffs
• Progressive: the percentage of income paid in tax rises as income rises. Proportional: it stays the same. Regressive: it falls as income rises
• Reasons to tax: raise revenue, discourage demerit goods, reduce imports, redistribute income, influence total demand, protect the environment
• Expansionary fiscal policy: cut taxes or raise government spending, so total demand rises
• Contractionary fiscal policy: raise taxes or cut government spending, so total demand falls
• Main spending areas: education, healthcare, defence, infrastructure, welfare benefits, interest on government debt

Monetary policy

• Expansionary monetary policy: lower interest rate, larger money supply or lower exchange rate, so total demand rises
• Contractionary monetary policy: higher interest rate, smaller money supply or higher exchange rate, so total demand falls
• Higher interest rate → less borrowing and more saving → less consumer spending and investment → lower inflation
• A higher interest rate also attracts savings from abroad, which raises demand for the currency and so its exchange rate
• If the money supply grows much faster than output, the result is inflation
• Limit: in a deep recession, low confidence can stop households and firms borrowing even when interest rates are cut
• Fiscal policy uses taxes and government spending; monetary policy uses the interest rate, the money supply and the exchange rate

Supply-side policy

• Supply-side policy = measures to increase total supply by raising the quantity or quality of resources (productive capacity).
• Privatisation = selling state-owned firms or assets to the private sector.
• Deregulation = removing rules that restrict competition or raise firms' costs.
• Labour market reforms = changes that make workers more willing and able to move between jobs, e.g. less trade union power, lower unemployment benefits.
• Lower direct taxes (income tax, corporation tax) raise the reward for working and investing.
• Successful supply-side policy shifts the PPC outwards: more growth, lower unemployment and lower inflation in the long run.
• Limits: slow to work, expensive, and the result is not certain.

Economic growth

• Economic growth = an increase in real GDP over time.
• Real GDP = nominal GDP adjusted for inflation.
• Growth rate (%) = change in real GDP ÷ original real GDP × 100.
• Recession = a fall in real GDP for two consecutive quarters (six months).
• Causes of growth: higher total demand, a greater quantity of resources, a better quality of resources (the reverse of each can cause a recession).
• If nominal GDP and the price level rise by the same percentage, real GDP has not changed.
• Policies for growth: expansionary fiscal and monetary policy (demand), supply-side policy (capacity).

Employment and unemployment

• Unemployment = people who are willing and able to work and actively seeking a job, but without one.
• Labour force = employed + unemployed.
• Unemployment rate (%) = number unemployed ÷ labour force × 100.
• Full employment = everyone willing and able to work at the current wage can find a job; some frictional unemployment still exists.
• Labour force survey = a sample of households is asked whether they have work or have been looking for it.
• Cyclical unemployment = caused by a fall in total demand, as in a recession.
• Structural = a long-term change in industry; frictional = short-term, between jobs; seasonal = at certain times of the year.

Inflation

• Inflation = a sustained rise in the general price level; deflation = a sustained fall in the general price level.
• Inflation rate (%) = change in CPI ÷ original CPI × 100.
• Weighted price index = sum of (weight × price index) ÷ sum of weights.
• CPI of 100 = base year; a CPI of 130 means prices are 30% higher than in the base year.
• Demand-pull: too much total demand. Cost-push: higher costs of production.
• If inflation is above the interest rate, savers and lenders lose real value and borrowers gain.
• Control: higher interest rates, higher taxes or lower government spending for demand-pull; supply-side policy for the long run.

Economic development

Living standards

• Real GDP per head = real GDP ÷ population.
• HDI has three components: life expectancy at birth, years of schooling (mean and expected), and GNI per head.
• HDI runs from 0 to 1; a higher value means higher human development.
• Real GDP per head is an average: it says nothing about the distribution of income.
• A country can have a high GDP per head but a lower HDI if health or education is poor.
• Income differs within a country because of skills, education, type of job, region, ownership of assets and the tax and benefit system.

Poverty

• Absolute poverty = not having enough income to meet basic needs (food, water, clothing, shelter).
• Relative poverty = being poor compared with others in the country; income well below the average.
• Progressive tax = takes a higher percentage of income as income rises.
• National minimum wage = the lowest wage rate an employer may legally pay.
• State benefits give help quickly; education and healthcare work in the long term.
• A minimum wage set above the market wage may reduce the demand for labour and cause unemployment.
• Growth reduces poverty only if the poor share in the extra income and jobs.

Population

• Birth rate = live births per 1,000 of the population per year (births ÷ population × 1,000).
• Death rate = deaths per 1,000 of the population per year.
• Natural increase = birth rate − death rate.
• Net migration = immigration − emigration.
• Population change = births − deaths + net migration.
• Optimum population = the population size at which output per head is highest.
• Below the optimum a country is under-populated; above it, over-populated.

Differences in economic development between countries

• Productivity = output per worker (or per hour worked).
• Low-income countries tend to have: a large primary sector, low saving and investment, fast population growth, low productivity.
• High-income countries tend to have: a large tertiary sector, high saving and investment, slow population growth, high productivity.
• Saving provides the funds for investment in capital goods, and investment raises productivity.
• Better education and healthcare raise the quality of labour, so output per worker rises.
• Fast population growth can mean output per head falls, even if total output rises.
• Natural resources help only if the income is invested and shared; a country can be rich in resources and still poor.

International trade and globalisation

Specialisation and free trade

• Specialisation by country = a country concentrates on the products it is best at producing.
• Basis: produce what you can make at a lower cost, or with a better use of resources, than other countries.
• Free trade = international trade with no restrictions (no tariffs, quotas or other barriers).
• Gains: higher world output, lower prices, more choice, economies of scale, more competition and efficiency.
• Risks: over-dependence on a few products, falls in world price or demand, structural unemployment, exhausted resources.
• From free trade, consumers and efficient exporters gain; protected domestic firms and their workers may lose.

Globalisation and trade restrictions

• Globalisation = the growing integration of economies through trade, investment and movement of people and firms.
• MNC = a company that produces in more than one country.
• Tariff = a tax on imports. Price after tariff = price before × (1 + tariff rate).
• Import quota = a limit on the quantity of a good that can be imported.
• Embargo = a ban on trade in a product or with a country. Subsidy = a payment to domestic producers that lowers their costs.
• Dumping = selling a product abroad below its cost of production.
• Reasons for protection: infant and declining industries, strategic industries, dumping, current account deficit, tax revenue, demerit goods, the environment.

Foreign exchange rates

• Foreign exchange rate = the price of one currency in terms of another.
• Floating exchange rate = a rate determined by market demand and supply, with no government target.
• More demand for a currency (exports, higher interest rates, inward investment) → it appreciates.
• More supply of a currency (imports, investment abroad, profits sent abroad) → it depreciates.
• Depreciation: exports cheaper in foreign currency, imports dearer in home currency.
• Appreciation: exports dearer in foreign currency, imports cheaper in home currency.
• Price in dollars = price in rupees ÷ rupees per dollar.

Current account of the balance of payments

• Current account balance = trade in goods + trade in services + primary income + secondary income.
• Balance of trade in goods = exports of goods − imports of goods (the same method for services).
• Primary income = profit, interest and dividends from investments, plus wages earned abroad.
• Secondary income = transfers with nothing given in return, e.g. workers' remittances and foreign aid.
• Deficit = payments abroad are greater than receipts; surplus = receipts are greater.
• A deficit means more of the currency is supplied than demanded, so a floating exchange rate depreciates.
• Policies to reduce a deficit: tariffs and quotas, lower government spending or higher taxes to cut spending on imports, depreciation, supply-side policy.