GCE O Level Study Material

O level study material
Exclusively for Cambridge students
JAHFARALI K P
ECONOMICS FOR CAMBRIDGE O LEVEL
jafaralira@gmail.com
Contents
INTRODUCTION TO ECONOMICS
THE BASIC ECONOMIC PROBLEM
ALLOCATION OF RESOURCES
THE INDIVIDUAL AS A PRODUCER, CONSUMER, AND BORROWER
THE PRIVATE FIRM AS PRODUCER AND EMPLOYER
ROLE OF GOVERNMENT IN AN ECONOMY [GOVERNMENT AS A PRODUCER,
CONSUMER, AND BORROWER]
DEVELOPED AND DEVELOPING ECONOMIES
INTERNATIONAL ASPECTS
Topics
Grade-8
Scarcity
Factors of production
Opportunity cost
Economic systems
Specialization, Exchange and money
Banks
Stock Exchange
Business organization
Cost and Revenue
Market structure
Principle of profit maximization
Grade-9
How a market functions
Demand
Supply
Elasticity
Equilibrium
Demand for factors of production
Wage differentials
Trade union
Size of firms and integration
Income spending, saving and borrowing
Market failure
Role of government in an economy
Macro economic problems
Aims of government
Unemployment
Inflation
Grade - 10
Growth and development
Inequality and poverty
Population
Conflicts between aims of government
International trade
Exchange rate
Structure of balance of payment
Chapter 1
Introduction to the subject

What is economics?
It is a science (social science) that deals with unlimited human wants and
their satisfaction in relation to scarce resources.
Facts: Human wants are unlimited
Resources are limited (scarce)
What is scarcity?
It is a situation where there is not enough (resources) to satisfy everyones
wants.
Or
Resources are not enough to satisfy all our wants.
Fact: It is a problem to the society.
What is economic problem?
Because of human wants exceeds resources, we are not able to satisfy all
our wants. So we have to decide:
What to produce?
How to produce? And
For whom to produce?
This is known as economic problem (Allocation problem).
What do the above three questions mean?
What to produce means what kind of product (goods and services) and
how much quantity should be produced.
How to produce means what kind of method of production (technology)

should be used for production (whether capital intensive or labour intensive
technology).
For whom to produce means to which section of the people it should be
produced and distributed.
Points to remember
Technology means method of production.
Capital intensive technology: it is a method of production in which
more capital (machines) and less labour are used.
This method is also known as labour saving or capital deepening
technology.
To produce goods and service we should use some resources.
Labour intensive technology: it is a method of production in which
more labour and less capital are used.
This method is also known as capital saving or labour deepening
What are economic resources?
technology.
The things that are used to produce other goods and services are called
economic resources or factors of production.
They are natural resources, human resources and man-made resources.
Free goods: the goods that are freely available in nature and need not pay
for them to get.
Economic goods: those good for we have to pay to get.
Durable goods: Those goods which have long life. They can be used for
many times.
Non- durable goods: those goods that can be used very short period or
only once.
Chapter 2
FACTORS OF PRODUCTION
The economic resources of land, labour, capital and enterpricse are called
factors of production.
I.
Land as a factor of production

Land: gift of nature available for production of goods and
services.
Land is a natural resource. Any natural resource that is used in
production is a part of land.
It includes air, water, soil, sea, oceans, rivers, rain forests, etc.
It is a gift of nature.
Land is geographically immobile.
Land is occupationally mobile.
The reward for land is rent.
Occupationally mobile: capable of changing use.
Eg: Same land can be used for cultivation, construction of a
building etc.
Geographically immobile: Cannot move from one place to
another.
II.
Labour as factor of production

Labour: All the human efforts in the production of goods and
services.
It includes both mental and physical efforts.
Labour is a human resource.
Labour is mobile - both occupationally and geographically.
The reward for labour is wage.
Geographical mobility of labour: the movement of labour from one

place to another.
Eg: One teacher came to Maldives to teach in a school.
Occupational mobility of labour: the movement of labour from one
job to another.
Eg: one doctor came to teach biology in a school.
How the wage is determined for a labour?
The reward for a labour is influenced by many factors. The important
factors are the demand and supply of labour.
If the supply of labour increases (if the number of labours increases)
wage tends to fall and vice versa.
III.
Capital as a factor of production

Man-made resources which is used for the production of goods and
services is called Capital
All the tools, machines, equipments, vehicles, buildings etc are examples of
capital.
Working capital: The capital that varies according to the production. We
have to use more capital to increase output, such capital include in working
capital.
Eg: Raw materials, Fuel etc.
Fixed capital: Some capital goods do not change according to the
production. They are fixed at any level of output. These capital goods are
called fixed capital.
Eg: machines, Building etc.
The reward for capital is interest.
7
IV.
Entrepreneur as a factor of production.

Entrepreneur is a person who takes the risk and responsibilities of the
production.
Functions of an Entrepreneur
1. Planning the production.
2. Organize other factors of production.[organizer]
3. Rewarding other factors.
4. Takes the risk and responsibilities of the production.
5. Innovation.
Profit is the reward for entrepreneur for taking risk.
Innovation: Bringing new ideas to the business to make more profit or
make the production more efficient.
Investment
Investment means the production of new capital goods in the economy or in
business.
It is the expenditure made on the creation of new capital asset. Such as Machines,
Tools, factories, Roads, bridges etc.
Gross investment
The total value of investment made during a financial year.
Net investment
Net investment = Gross investment Depreciation
Points to remember
Factor
Land
Labour
Capital
entrepreneur
Reward
Rent
Wage
Interest
profit
Chapter 3
ECONOMIC SYSTEMS
How an economy solves its basic economic problem determines its economic
system [type of economy].
That means how an economy answers the basic questions of what, how and
for whom to produce determines its economic system.
If these questions are solved by automatic price mechanism or by private
individuals freely (without any government control), then, it follows a market
economy.
If these questions are solved by the state (Government) alone, then it
follows a command economy.
If these questions are solved by both private individuals and government,
then, it follows a mixed economy.
Economic
systems
Chart 1
Market
economy
Command
economy
Mixed
economy
Traditional
economy
MARKET ECONOMY
[Laissez faire Economy or Free market economy or Capitalist economy]
It is an economic system in which people have considerable freedom to buy
what they want, to sell what they produce and to do what job they wish to
do.
Features
1. Freedom of choice; people have complete freedom to:
a) buy what they want,
b) sell what they produce and
c) do what job they wish to do
2. Private ownership: Resources are owned and controlled by private
individuals.
3. Profit motive: The aim of production is only making profit.
4. Laissez faire policy: people have freedom to do their own business
without any government interventions.
5. Price mechanism: the prices are determined by the automatic
mechanism of market forces of demand and supply.
6. Competition: firms compete each other in the market.
7. Commodity production: Whatever produced is to sell in the market.
Price mechanism
In a market economy the prices are determined by the market forces of
demand and supply.
If the demand is more, price goes up and if demand is less, price comes
down.
If the supply is more, price comes down and if supply is less price goes up.
These changes take place automatically in a market economy. This
automatic adjustment is called price mechanism or market mechanism.
10
Price mechanism
Advantages of market economy

1. People have freedom of choice.
2. There is a variety of goods for consumers.
3. Competition brings the prices down. Consumers get goods at a
cheaper price.
4. Consumers sovereignty. Here consumers are considered as the
uncrowned king in the market.
5. No government control.
6. Firms will be more efficient.
Disadvantages of market economy
1.
2.
3.
4.
Chances of wasteful competition.

Peoples welfare is not considered.
Private ownership may lead to inequality.
There are the chances for the production of demerit goods. [Profit
motive].
5. Profit motive may lead to the production of less quality products.
6. It may leads to monopoly
7. Social costs are not considered.
11
COMMAND ECONOMY
[Planned economy or socialist economy]
A command economy is an economy in which all the resources are owned
and controlled by the state (government).
Features of a command economy
1. Public ownership: In a command economy everything is under
government ownership.
2. Welfare motive: the aim of production is the welfare of the people not
making profit.
3. No individual freedom: unlike market economy there is any freedom of
choice for people in a command economy.
4. Government fixes the prices for goods and services.
Advantages of a command economy
1.
2.
3.
4.
5.
6.
Welfare motive
Equal distribution of income and wealth
Planning helps to avoid wastage of resources
No competition
Quality products and services
Reasonable price
Disadvantages of command economy

1.
2.
3.
4.
5.
Chances for corruption

Firms may not be efficient
Consumer has no choice
Less freedom for people
No competition, so price may not comes down.
12
MIXED ECONOMY
It is an economic system in which there exists both private sector and public
sector together.
It is a blend of both market economy and command economy.
Economic
system
Market
economy
command
economy
Mixed
economy
Features
1.
2.
3.
4.
5.
6.
Co-existence of both public sector and private sector.

Government control over private sector.
Freedom of choice and planning.
Both welfare of the people and profit motive
Firms are efficient because there is competition.
Less inequality
Advantages
Why a mixed economy is better than a market system and a
command economic system?
There are many answers for the question above.
The market economy is strictly criticized for the existence of private
ownership and thereby greater inequality among people. On the other hand
a command economy is criticized for lack of freedom for the people.
But a mixed economy solves these two problems in an economy by blending
the advantages of both market and command economic systems and it tries
to avoid the drawbacks of both market and command economic systems.
13
In a mixed economy we have:

1. Freedom of choice
2. Government control and thereby equal distribution of income and
wealth.
3. Planning
4. Efficient firms
5. Less corruption etc.
In short, a mixed economy solves the problems faced by a market economy
and a command economy.
Why do we need a public sector? (Why there should be a
government?)
We need a public sector because private sector provides goods and services
only if its production is profitable. They never consider the needs of the
society. But in public sector,
1.
2.
3.
4.
5.
6.
It
It
It
It
It
It
provides merit goods like education and health.

produces for the welfare of the people.
protects the country from the external attacks.
considers social cost and social benefit.
maintains law and order within the country.
prevents the use of demerit goods like drugs and alcohols.
Merit goods: Those goods which government thinks that everybody ought
to have.
Examples: health facilities, education
Demerit goods: those goods that government thinks that nobody should
get it. Examples: drugs, alcohols
Social cost: The total cost of the production to the producer and to the
society as well.
Social cost = private cost + external cost
External cost is also called negative externalities.
Social benefit: The total benefit of the production to the producer and the
society as well.
Social benefit = private benefit + external benefit
14
Market Failure
When markets do not provide us with the best outcome in terms of efficiency
and fairness, then we say that there exists market failure. This brief chapter
introduces us to some of the main causes of market failure; we will explore
them in more detail in succeeding chapters.
What is market failure?
Market failure occurs whenever freely-functioning markets operating without

government intervention, fail to deliver an efficient allocation of
resources and the result is a loss of economic and social welfare. Market
failure exists when the competitive outcome of markets is not satisfactory
from the point of view of society. This is usually because the benefits that
the free-market confers on individuals or businesses carrying out an activity
diverge from the benefits to society as a whole.
One useful distinction is between complete market failure when the market
simply does not exist to supply products at all (i.e. we see missing
markets), and partial market failure, when the market does actually
function but it produces the wrong quantity of a good or service at the
wrong price.
15
Markets can fail for lots of reasons and the main causes of market failure are
summarized below:
1. Negative externalities (e.g. the effects of environmental pollution)
causing the social cost of production to exceed the private cost
2. Positive externalities (e.g. the provision of education and health
care) causing the social benefit of consumption to exceed the private
benefit
3. Imperfect information means merit goods are under-produced while
demerit goods are over-produced or over-consumed
4. The private sector in a free-markets cannot profitably supply to
consumers pure public goods and quasi-public goods that are needed
to meet peoples needs and wants
5. Market dominance by monopolies can lead to under-production and
higher prices than would exist under conditions of competition
6. Factor immobility causes unemployment hence productive inefficiency
7. Equity (fairness) issues. Markets can generate an unacceptable
distribution of income and consequent social exclusion which the
government may choose to change
Market failure and economic efficiency
When markets function well we experience an efficient and fair (equitable)
allocation of resources.
Market failure results in:
Productive inefficiency: Businesses are not maximising output from given
factor inputs. This is a problem because the lost output from inefficient
production could have been used to satisfy more wants and needs. Costs are
higher and productivity is lower than it might have been.
Allocative inefficiency: Resources are misallocated and the economy is
producing goods and services that are not wanted or not valued by
consumers. This is a problem because resources might be put to a better
use making products that we value more highly. Allocative efficiency is the
most relevant concept that you can use at AS level to analyse and evaluate
market failure.
Privatization: Transferring public ownership to private ownership.
Nationalization: Transferring private ownership to public ownership.
16
Chapter 4
HOW A MARKET FUNCTIONS

While we discuss about a market we should know about demand, supply and price.
In a market system (market economy) the prices are determined by market forces
of demand and supply. This is called price mechanism or market mechanism. How
this mechanism works. Before answering this question we should know about
Demand and supply.
DEMAND
Demand for a good or service means the amount of that good or service that
people are willing to buy at a given period of time at particular price.
In other words demand for good (or service) is the amount of that good (or service)
bought (demanded) by the consumers at a given time and at a given price.
The relationship between demand and price.
There is an inverse relationship between price and quantity demanded, if other
things are remaining unchanged.
Demand schedule
It a table showing the relationship between price and quantity demanded of a
commodity.
In other words, a demand schedule is the tabular presentation of the inverse
relationship between demand and price.
Demand curve is the graphical presentation of the inverse relationship between
quantity demanded and price.
It is curve showing the relationship between price and quantity demanded.
An imaginary demand schedule and demand curve is shown below.
Demand Schedule
Price
1
Quantity
Demanded
25
20
15
10
17
Demand curve
Determinants of demand [Factors affecting demand]

1. Price: there is an inverse relationship between quantity demanded and the
price, if other things remain unchanged.
2. Income of the consumer: Demand increases as income increases and falls
as income falls.
3. Taste, fashion and preferences of the consumer: if these are in favor of
the consumer demand increases and vice versa.
4. Price of related goods; price of substitutes and price of
complementary goods: If the price of substitutes increases demand for the
goods increases and vice versa. If the price of complementary goods
increases demand falls and vice versa.
5. Advertisement: if the producer spend more for advertisement and it is
effective demand increases.
6. Size and structure of population: when population increases the demand
for goods and services also increases. If the number of younger population is
more, there will be more demand. If there are older people, then demand will
be less.
7. Climate and seasons: some products are demanded more only in some
particular seasons. For example umbrella and rain coat are demanded in
rainy season and ice cream is demanded more in a hot climate.
8. Expectation of a change in price in future: if there is an expectation
about a fall in price in future demand falls and if there is a increase in price in
future the demand also rise.
The relationship between demand and different determinants of demand
Determinants
Demand
Relationship
Price
Demand
Inverse
Income
Demand
Direct
Taste and preference
Demand
Direct
Advertisement
Demand
Direct
Population
Demand
Direct
Price of substitutes
Demand
Direct
Price of complementary goods
Demand
Inverse
Expectation of changes in price in future
demand
Direct
18
CHANGES IN QUANTITY DEMANDED AND SHIFT IN DEMAND

Demand changes due to the changes in any one of the factors that affect
demand (determinants of demand). These factors are price and non-price factors.
Changes in Quantity Demanded
If the changes in demand is due to a changes in price is known as changes in
quantity demand. It can be extension of demand and contraction of demand.
Extension of demand (Expansion of demand)
Extension of demand means rise in quantity demanded due to a fall in price.
Contraction of demand
Contraction of demand means a fall in quantity demanded due to a rise in
price.
These changes can be shown in a single demand curve. These changes are
movements along demand curve.
When price decreased from P to P1 demand increased from Q to Q1. It

shows extension of demand.
The downward movement along demand curve from X to Y.
When price increased from P to P2 demand falls from Q to Q2. It shows
contraction of demand.
The upward movement along demand curve from X to z.
19
Shifts in demand
If the changes in demand is due to a change in non-price factors is known as
shift in demand. It can be increase in demand and decrease in demand.
Increase in demand means a rise in demand due to a change in any one
of the factor that affect demand other than price. It is a forward shift in
demand curve.
Decrease in demand means a fall in demand due to any one of the factor
that affect demand other than price. It is a backward shift in demand curve.
These changes can be shown in the following figure.
The shift from D to D1 if increase in demand. Here Price is not changing,

but demand increases demand increases
The shift from d to D2 is decrease in demand. Here price has no change,
but demand decreases at each price.
20
SUPPLY
Supply refers to the amount of a good or service firms or producers are
willing to produce and sell at a given price at given time period.
The relationship between supply and price.
The quantity of a product supplied per period of time will fall as the price
falls and will rise as the price rises, the other things remaining the same.
There is a direct relationship between price and supply.
Supply schedule
Supply curve
Price Quantity
Supplied
1
2
3
4
5
4
8
12
16
20
Determinants of supply
1. Price of the commodity: There is a direct relationship between price and
supply. (it is already explained above)
2. Cost of production: As cost of production increases, supply fall.
3. Legislation (govt. laws, tax etc): Government laws and policies will affect
supply. As tax increases supply falls and vice versa. Subsidies to firms also
will increase the supply.
4. Expectations: Expectation of an increase in the price in future tends to
decrease the supply and a fear about a fall in price in future increases the
supply. More over expectation about the tax changes also will affect supply in
the same manner.
5. Price of other goods: Producers or suppliers always think to get more
profit. So when the price of other goods increases, the producer thinks to
stop his production or reduce the production and to shift his production to
the production of those goods whose prices are increased.
6. Weather and climate: A favorable or a good weather condition gives a
good harvest. So supply increases. A bad or unfavorable weather will spoil
the crops and a fall in supply.
For example a good summer may bring a good harvest and a natural
calamity such as heavy rain, drought, flood, storm etc spoils the agriculture
and supply falls.
7. Technical progress: An improvement in technology increases the supply.
21
Expansion and contraction of supply

Expansion of supply: A rise in supply due to a rise in price is called expansion of
supply. In the figure given below when price increased from 3 to 4, supply expands
from12 to 16.
Contraction of supply: A fall in price causes a fall in supply. It called contraction
of supply. In the figure, supply falls from 12 to 8, when price falls from 4 to 2.
Increase and decrease in supply

Increase in supply means a rise in supply due to the changes in any one of
the factor that affect supply except price. It is a forward shift in supply
curve.
Decrease in supply means a fall in supply due to the changes in any one of
the factor that affect supply except price. It is a backward shift in supply
curve.
S
S
1
S
1
1
S
Increase
1
1
P
Decrease
1
2
Q2
22
Q1
Q
EQUILIBRIUM
Equilibrium means a state of stability or balance. We are able to stand, walk,
Qq
run etc. because our body is in balanced state (equilibrium), otherwise we
Q2
fall down.
A market is in equilibrium when the demand and supply are equal. In
equilibrium state a market (or economy) move smoothly without any
fluctuations.
There will not be any excess demand (shortage of supply) or excess supply
(deficient demand) and any price rise and fall in price.
So, equilibrium means a situation where zero excess demand and zero
excess supply.
Equilibrium
Equilibrium price is the price where demand and supply are equal. In the
diagram it is 3.
Equilibrium quantity is the quantity where demand and supply are equal.
In the diagram it is 3units.
Disequilibrium
A market is in disequilibrium when the demand and supply are not equal. In
this state there will be excess demand (shortage of supply) or excess supply
(deficient demand) and price rise and fall in price.
23
Excess demand (shortage of supply)

It is situation where demand is more than supply. (DD > SS)
Excess supply (Deficient demand)
It is a situation where supply more than demand. (SS > DD)
CHANGES IN EQUILIBRIUM
The equilibrium point will change as demand or supply or both changes. So
any factor that affects demand or supply makes a change in equilibrium
price and equilibrium quantity.
1. When demand increases due to any one of the factors, the demand
cure shift right and new equilibrium will be achieved. The new price will be
higher than the previous price. The reasons to increase in demand may be
the following factors.
1. An increase in income of the consumer (people).
2. More credit facilities.
3. A change in the taste of the consumer in favor of goods in
consideration.
4. An increase in the population.
5. An increase in the price of substitutes
6. A fall in the price of complementary goods
7. A successful advertisement etc.
These entire situations the changes in equilibrium will be as shown below.
In the diagram E is the initial equilibrium where DD and SS intersect each

other. After an increase in demand (forward shift in demand curve) new
equilibrium is E1 where D1D1 and SS meet each other. As a result price
increases to P1 and supply expands to Q1.
24
2. When demand decreases due to any one of the factors, the demand
cure shifts left and new equilibrium will be achieved. The new price will be
lower than the previous price. The reasons for a decrease in demand may be
the following factors.
1. A decrease in income of the consumer (people).
2. Less (Reduce) credit facilities.
3. A change in the taste of the consumer against the goods in
consideration.
4. A decrease in the population.
5. A decrease in the price of substitutes
6. A raise in the price of complementary goods
These entire situations the changes in equilibrium will be as shown below.
25
3. When supply increases due to any one of the factors (that affect
supply), the supply cure shifts right and new equilibrium will be achieved.
The new price will be lower than the previous price and there will be an
expansion in demand. The reasons for an increase in supply may be the
following factors.
1. A fall in cost of production
2. A favorable climate (good harvest)
3. Technical progress
4. A change in the price of other goods etc.
26
4. When supply decreases due to any one of the factors (that affect
supply), the supply cure shifts to left and new equilibrium will be achieved.
The new price will be higher than the previous price and there will be a
contraction in demand. The reasons for a decrease in supply may be the
following factors.
1. A rise in cost of production
2. A unfavorable climate (flood, heavy rain, earth quake, storm,
drought etc)
3. A change in the price of other goods etc.
27
ELASTICITY OF DEMAND
Elasticity of demand refers the responsiveness of quantity demanded to the
changes in any one of the factors that affect demand.
It can be:
Price elasticity
Income elasticity
Cross elasticity
Advertisement elasticity
Price elasticity of demand
Price elasticity of demand refers the responsiveness of quantity demanded to
the changes in price of the commodity.
OR,
PED =
Where P is original Price and QD is original quantity demanded.

means changes.
Types of price elasticity of demand.
1.
2.
3.
4.
5.
Unitary elastic demand

Elastic demand (more than unitary elastic demand)
Inelastic demand (Less than unitary elastic demand)
Perfectly elastic demand (infinite elasticity of demand)
Perfectly inelastic demand (Zero elasticity of demand)
28
1. Unitary elastic demand

If there is equal and proportionate change in price and quantity demanded
then elasticity is said to be unitary elastic. A change in price makes same
and proportional change in demand. Here PED = 1.
Eg: if price falls 5 to 3 (40%) and as a result quantity demanded increases
100 to 140 (40%), then elasticity will be:
2. Elastic demand
If there is a large change in quantity demanded as a result of a small change
in price it is called elastic demand. A small change in price makes a large
change in demand. Here, PED>1
Eg: if price falls 5% and as a result quantity demanded increases 20%, then
elasticity will be:
29
3. Inelastic demand
If there is a small change in quantity demanded as a result of a large change
in price it is called inelastic demand. A big change in price makes a small
change in demand. Here, PED<1
Eg: if price increases from 4 to 8 (100%) and as a result quantity demanded
falls from 20 to 15 (25%), then elasticity will be:
4. Perfectly elastic demand

A slight change in price leads to infinite change in quantity demanded.
PED =
30
5. Perfectly inelastic demand

A change in price has no effect on the quantity demanded. Whatever may be
the price same quantity is demanded.
PED = 0
DEMAND CURVES OF FIVE TYPES OF PRICE ELASTICITY
Expenditure and elasticity

If with fall in price, total expenditure of the commodity increases Ed >1
(elastic)
If with fall in price, total expenditure of the commodity remains same Ed =1
(unit)
If with fall in price, total expenditure of the commodity decreases Ed <1
(inelastic)
31
Uses of price elasticity

1. It helps the producer to make decisions regarding price.
If the product has elastic demand the producer can reduce the price
and increase his sales revenue.
If the product has inelastic demand the producer can increase his
revenue by increasing the price.
Eg: A producer sells his product at $10 and his sales are 1000 units.
So his total revenue is 10 x 1000 =$10000.
If he increases the price to $12 (20%), demand falls to 600 (40% fall)
units.
Here elasticity is 40/20 = 2. (Elastic)
Here his revenue is 12 x 600 = 7200. (Revenue fall)
It is a bad decision; if he reduces the price demand would have
increased.
If he reduces the price to $8 (20%) the demand increases to 1400
(40%) units.
Now elasticity is 40/20 =2.
Then the revenue is 8 x 1400=11200.(revenue increases; It is a good
decision)
2. It helps the government to make decisions regarding taxation.

Government can impose a high tax on those goods having inelastic
demand and a less tax on elastic products.
Factors affecting elasticity of demand
1. Nature of goods;
Necessaries are often inelastic and luxuries are elastic.
Habit forming goods are inelastic.
2. Number of substitutes available; more substitutes are available
then the product will be more elastic and less substitutes less elastic.
3. The proportion of income spent on the product; if the proportion
of income used to pay for the product is more, then the demand will
be elastic and vice versa.
32
Chapter 5
PRODUCTION
Production is the process of converting raw-materials (inputs) into finished
goods (output).
Inputs are factors of production, ie, land, labour, capital etc.
Production can be expressed as:
Output (Q) = function of input.
ie, Output = f(Land, Labour, capital and entrepreneur)
Q = f(L, L, C & O)
Production means
Input
process
Output
Productivity
It refers the ability or efficiency of factors to produce goods and services.
The main divisions of production (sectors of production)

1. Primary sector [primary production]
2. Secondary sector [industrial sector]
3. Tertiary sector [service sector]
Quaternary sector: It consist of those services, which are concerned
with the collection, processing, and transmission of information with
research, development and financial management
33
I. Primary sector production

It is the first stage of production. They produce raw materials.
It consists of agriculture, farming, fishing, mining, quarrying etc.
These are production closely related to nature and also called extractive
industries because they extract natural resources.
Primary sector supplies raw materials to secondary sector.
II. Secondary sector production
This is the second stage of production.
These are the processing and manufacturing industries.
They change raw materials into finished goods or semi finished goods.
It includes manufacturing, processing, building, construction etc.
III. Tertiary sector
This sector provides all types of services.
It includes trade, banking, administration, communication, transportation
etc.
34
Cost of production
It refers the expenditure incurred in the production.
It is the total payment to the factors of production.
It includes the rent given to land, wage given to the labour, interest given to
the capital, price paid to the raw materials, electricity charges, taxes, profit
given to the entrepreneur etc.
Factors of production can be two types; Variable factors and fixed factors
Variable factors
These are the factors whose supply can be changed quickly and easily.
These factors change according to the production in short run.
Examples: labour, raw materials etc.
Fixed factors
These are the factors whose supply cannot be changed easily and quickly.
These factors do not change according to the production in short run.
Examples: factory building, machinery
Shot run: This is the period of time over which at least one of the
factors of production is fixed in supply.
Long run: This is a period of time over which all factors of production
(both fixed and variable) can be changed easily.
35
Fixed cost [Indirect cost or Overhead cost]

The cost for the fixed factors is called fixed cost. This cost does not change
as output changes.
Eg: rent, insurance, interest on a loan etc.
This cost is paid even when output is zero.
FC = TC VC
Variable cost [Direct cost or Prime cost]
These are the cost of variable factors. This cost changes as output changes.
Eg: wages, cost of raw materials, fuel and power.
VC = TC FC
Total cost
It is the sum total of fixed cost and variable cost
TC = FC + VC
When output is zero total cost is equals to fixed cost because variable cost is
zero.
When output is zero, TC = FC + 0
ie,
TC = FC.
Diagrammatic presentation of TC, VC and FC

TC
VC
FC
36
Average cost (AC)

Cost per unit is called average cost. It is obtained by dividing total cost by
number of output produced.
Where, Q =
Average cost falls as output increases in the first stage of production, but
after a limit AC starts to increase. So AC curve is a U shaped curve as shown
bellow.
Cost
AC
Output
Average Fixed Cost (AFC)
It is the fixed cost per unit. It is obtained by dividing FC by number of output
produced.
AFC falls as output increases. So AFC curve slopes downward.
37
Average variable cost

It is the variable cost per unit. It is obtained by dividing VC by number of
output produced.
Marginal cost
It is the cost for an additional unit of output produced.
It is obtained by dividing the changes (increase or decrease) in total cost by
changes in total output.
Where, Q =
= changes
Diagrammatic presentation of MC, AVC and AFC
MC
Cost
AVC
AFC
Output
38
REVENUE
The income from the sales of goods and services is called revenue.
It is calculated by multiplying total output sold by the unit price.
Total revenue
Total revenue = Total output sold x Price
Average revenue
It is the per unit revenue. It is always equal to the price, ie, price = AR
Marginal revenue
It is the revenue from the sales of an additional unit.
Breakeven point
Breakeven point is a point where total cost equals to total revenue. In
breakeven point there is no profit no loss.
A firm makes profit where TR > TC (TC < TR) and it makes lose where
TR < TC (TC > TR).
When TR = TC, there is no loss no profit. This situation is called BEP.
This is shown in the following figure.
39
In the diagram point E is the breakeven point. At Point E TR and TC intersect

each other. Before E there is loss and after E there is profit. At point E there
is neither profit nor loss.
40
Chapter 6
MARKET STRUCTURES
Perfect completion and monopoly
Market refers to all the places in which buyers and seller are in contact with
each other for the purchase and sale of the commodity. Markets are
classified into:
Perfect competition:
It refers to a market situation in which large number of buyers and sellers
sells homogeneous product at a single uniform price.
Features:
a) Large number of buyers and sellers.
b) Homogeneous product
c) free entryand exit of firms.
Under perfect competition, the firm is a price taker because it has to accept
the price determined by the demand and supply of goods in the market. It
cannot change price by individual action.
The seller may sell any amount of output at the given price as a result the
demand curve facing a firm is perfectly elastic. Moreover AR and MR are
equal and parallel to x-axis.
Profit maximization in short run:
The conditions are
a) MC = MR.
b) MC cuts MR from below.
c) PAVC
In short run firm may get abnormal profit, losses or Normal profit depends
on the price. The firm never produces output below shut down point.
Profit maximization in Long run:
The conditions are
a) MC = MR.
c) PAC
In long run the firm earns only normal profit. For instance, if the firm is
making abnormal profit in the short run new firms enter into the industry,
causing an outward shift in the market supply cure. Thereby reducing price
to long run average cost curve.
41
MONOPOLY
A Firm is a Monopoly if it is the sole seller of its products without close
substitutes.
Features
1. One Seller
2. No entry and exit
3. No Close Substitute
4. Full Control over supply
5. Price discrimination
6. Demand Curve is downward sloping.
Profit maximization in short run:
The conditions are
a) MC = MR.
c) PAVC
In short run firm gets abnormal profit. In Equilibrium price is greater than
marginal Cost
Profit maximization in Long run:
The conditions are
a) MC = MR.
c) PAC
In long run also the firm earns abnormal profit.
42
Chapter 7
LABOUR MARKET
CHOICE OF OCCUPATION
The factors that affect the choice of occupation of an individual can be
classifies as wage factors and non wage factors.
Wage factors: It includes the factors in the form of money payments.
1. Rate of pay: people always choose a job having a high rate of pay(high
salary)
2. Bonus: Bonus is an extra payment for better or efficient performance.
People usually prefer a job having bonus payment.
3. Gratuity, provident fund and pension: another important attraction of
a job is gratuity, PF and pension.
4. Other cash allowances: Medical allowances, Travelling allowances,
hose rent allowances, risk allowances are given in some job. People
prefer jobs which offer such allowances.
Non-wage factors: it includes the attractions of a job other than wage or
money.
1. Chances of promotion: Some people look for a job having the chances
to be promoted.
2. Job security: People always search for a secure job.
3. Nature of job; easy or risky: Usually normal people prefer easy job but
adventurous people like risky jobs.
4. Job satisfaction: If the work gives a happy environment then people
choose that job.
5. Working condition: people always prefer a pleasant working condition
and so such work as well.
6. Working hours: Usually people choose a job with less working hours.
7. Chances of entertainment.
8. The distance from home to work site.
43
WAGE DIFFERENTIALS
Workers get different wages in the same job (wage differentials within
occupation) and in different jobs as well (wage differentials between
occupation).
Wage differentials within occupation
What are the factors responsible for wage differences within an occupation?
Why do people get different wages (salary) in the same occupation (job)?
The factors responsible for wage differences within an occupation are:
1.
2.
3.
4.
5.
6.
7.
Seniority and experience

Over time payment
payment scheme (Piece rate or hour based)
Bonus
Regional differences
Sexual discrimination
Racial discrimination etc.
Wage differentials between occupations

The factors responsible for wage differences between occupations are:
1. Skill: Skilled labour gets more than unskilled.
2. Talent: talented persons like football players, actors get high
payments.
3. Educational qualifications: educated and qualified get more than
uneducated workers.
4. Training: Trained gets more than untrained.
5. Nature of job (risky or easy): Risky jobs are always paid more.
6. Membership in trade union: Trade union members always get more
than a worker without membership in any trade union.
44
Trade union
Trade union is an association of workers for the purpose of improving the
pay and working conditions of their members.
Functions of a trade union
The major roles of a trade union are:
1. Represents the worker in wage negotiation(collective bargaining): to
improve the wages of the workers (members)
2. Provides better working condition for the workers
3. Protects the members from unfair dismissal.
4. Gives right to compensation for injury at work.
5. Gives right to redundancy pay and many other benefits.( If the
workers are without job in the firm because there is not enough work)
Different situations in which a trade union can claim for higher
wages for its members.
a trade union can claim for higher wages for its members in the following
situations.
1.
2.
3.
4.
When there is an increase in the cost of living.

When there is an increase in profits.
When there is an increase in productivity.
When there is an increase of wages of worker in other similar
companies.
5. When the wage is a small part of the total cost.
Collective bargaining
It is a negotiation (talk or discussion) between trade union leaders and
management of the companies regarding the wages or working condition of
workers. It is method of settling wage disputes.
45
Chapter 8
GROWTH OF FIRMS AND INTEGRATION

How does a firm grow?
A firm can grow in two ways:
I.
II.
Internal growth
External growth
Internal growth is by increasing output, increasing the number of existing

plants and production units.
External growth can be by merger or integration.
Integration means two firms are joining together with a purpose of
growth.
Types of integration
Integration can be in the following three types
1. Two firms producing same products join together- Horizontal
integration.
2. Two firms producing different stages of same product join togetherVertical integration.
This can be two ways
i)
Vertical integration backward.
One firm merges to another firm which is the source of
supply [raw materials or components of its products].
For example:
ii)
a. A tea factory buys tea plantation.

b. A tyre company buys rubber estate.
Vertical integration forward.
One firm merges to its retail outlets.
For example: A petroleum refinery buys a chain of petrol
stations.
3. Two firms producing two different products join togetherconglomerate integration.

46
ECONOMIES OF SCALE
Why should a firm grow? [Advantages of growth]
A firm grows because it has some advantages out of its growth. These
advantages are called Economies of scale.
Economies of scale: The advantages resulting from the growth of a firm or
industry in the form reducing average cost.
Growth is possible in long run. So we consider LRAC (Long Run Average Cost)
Internal Economies of scale: Lower LRAC resulting from a firm growing in
size.
External Economies of scale: Lower LRAC resulting from an industry
growing in size.
For example:
In the table up to 5 units of output AC (LRAC) falls. It shows economies of

scale. After that (6 units onwards) AC starts to increase. It indicates that
when a firm becomes too large, it results some disadvantages. These
disadvantages are called Diseconomies of scale.
47
Types of Internal Economies of Scale

Buying economies of scale: (marketing economies of scale)
Bulk purchases get discount and get better treatment than small firms.
It can place large orders and get preferential treatment about quality
and delivery.
The packing cost can be reduced
It can employ specialists like sales manager, marketing manager etc.
Advertisement cost can be reduced.
Technical economies of scale
The larger the firm large and modern sophisticated machines can be
used.
The capital equipments can be efficiently utilized.
It can maintain research and development departments.
Financial economies of scale.
The larger firm, the lesser the risk in lending a loan to them.
The larger the firm, the more the number of lenders.
Risk bearing economies of scale.
Larger firms usually produce a variety of products, so its success

depends not on a single product.
They can depend both on home market and overseas market.
What is meant by take-over?

When a company buys another company with that the complete ownership
will be transferred is a takeover.
But in case of integration ownership will not be transferred but they join
together with some agreement for growing the firm.
48
MACRO ECONOMIC PROBLEMS

The problems faced by the entire economy are called macro
economic problems.
Or, the problems that affect the economy as a whole is called macro
economic problems.
Unemployment, Inflation, Inequality, BOP deficit and less of
economic growth are considered major macro economic problems.
The main aim of government is to solve (to deal) these problems.
For this, government takes some actions. These actions are called
economic policies.
UNEMPLOYMENT
INFLATION
INEQUALITY
BOP DEFICIT And
LESS OF ECONOMIC GROWTH
49
Chapter 9
MACRO ECONOMIC PROBLEMS I

UNEMPLOYMENT
The number of people who are actively looking for a work but they are
currently without a job.
The number of the people without jobs even they are willing to work at
current wage rate and able to do the work.
Unemployment rate: the number of unemployed expressed as a percentage
of the labour force.
TYPES OF UNEMPLOYMENT
1. Frictional unemployment ( search unemployment)
It is the unemployment that occurs as a result of lack of information in
the labour market. It often takes time, when workers shift their jobs,
to find a new job and in the mean time they are unemployed.
2. Seasonal unemployment
It is the Unemployment that occurs as a result of seasonal changes.
3. Cyclical or general unemployment
It is the unemployment that occurs as a result of lack of effective
demand in the economy.
4. Structural unemployment
It is unemployment that occurs as a result of structural changes in the
economy.
5. Technical unemployment
It is the unemployment that occurs as a result of technological
improvement, inventions and findings.
50
What are the causes of unemployment?

1. A fall in aggregate demand:
If there is lack of effective demand in the economy, it may cause
unsold commodities and thereby cut on production, finally leads
to cyclical (general) unemployment.
2. A change in the structure of the economy:
If there is a change in the structure of the economy, it may
cause to close down some industries. It leads to structural
unemployment.
3. Technological advance:
If there is a technological advance, it may cause the replacement
of labour intensive technology by capital intensive technology. It
will leads to technical unemployment.
4. Changes in the seasons and climate:
Some laborers are employed only in some particular seasons.
They are unemployed in off seasons. It is called seasonal
unemployment.
5. Length of training and education:
If the length and duration of the training courses and education
is more, the time to work will be less. It causes frictional
unemployment.
6. Over population:
Due to overpopulation countries are unable to give job to all
working population. It causes disguised unemployment.
7. Imperfection in the labour market:
Lack of information about the job opportunities is another major
reason for unemployment. It is also one of the causes of
frictional unemployment.
51
The cost of unemployment (consequences of unemployment)

1. Loss of output of goods and services
Waste of economic resources
Less output
Less GDP
Less economic growth
Low standard of living
Poverty
Inequality etc
2. Fiscal cost to government
Less income from taxes
More unproductive expenditure
3. Social cost
Social and economic deprivation
Rising crimes
Worsening social dislocation
Worsening health
Less life expectancy
Loss of social prestige
How can the unemployment problem be solved?
Government can reduce unemployment by the following policies.
1. An expansionary fiscal policy: Government should spent more on
Education and health
More investment on infrastructure
Industrialization
Vocational training programs
Subsidies to the domestic producers
2. An expansionary monetary policy
Giving more loans and advances to productive projects
Reduce the bank rate to induce investment
3. Introduce more liberal policies to attract foreign investors and MNCs.
4. Practice the policies to protect the infant and small scale industries.
Unemployment in between jobs is called frictional unemployment.
Unemployment due to lack of aggregate demand is called cyclical unemployment.
Government can reduce unemployment and increase employment by an expansionary
fiscal policy and an expansionary monetary policy of central bank.
52
Chapter 10
MACROECONOMIC PROBLEMS II
INFLATION
Inflation refers to a general and sustained rise in the level of prices of goods
and services.
It is a situation where too much money chasing too few goods.
How to measure inflation
Inflation is measured by calculating Retail price Index (consumer price
index).
Measuring inflation the following steps are followed.

1. To take the average price of goods and services a collection of goods
and services are taken.
2. One year is selected as base year and the price index for this year is
assumed as 100.
3. Selected households are asked to record the price of goods and
services they buy in every two weeks.
4. The authority also collects the price list of those goods under
consideration.
5. More weight is given to those goods for which more income spent.
6. Then the RPI is calculated for each product by using the above
equation.
An example is shown below.
Year 1
Commodity
Weight
Price
Index
Weighted index
A
1
0.10p
100
100
B
2
1.00
100
200
C
3
5.00
100
300
6
600
Year 2
Commodity
Weight
Price
Index
Weighted index
A
1
0.12P
0.12/0.10x100=120
1x120=120
B
2
1.50
1.50/1.00x100=150
2x150=300
C
3
4.50
4.50/5.00x100=90
3x90=270
6
690
Average index for Year 1 is 6006=100
Average index for year 2 is 6906=115
The difference is 15, means the average price has increased 15%.
So inflation is 15%.
53
CAUSES OF INFLATION
The main reasons for inflation are;
1.
2.
3.
4.
Increase in aggregate demand

Increase in the cost of production
Increase in money supply
Imported inflation
Any policy of government or any action in the economy that increases

demand or increases cost of production or increases money supply will result
in inflation.
1. Increase in aggregate demand: When the demand increases than
the supply there will be an increase in the price. It causes demandpull inflation.
2. Increase in the cost of production: When the cost increases the
prices also increase. It causes cost push inflation.
3. Increase in money supply: When there is an increase in money
supply, the purchasing power of the people will increase and as a
result there will be a hike in aggregate demand and a rise in price, and
inflation is the result.
4. Imported inflation
Effects of inflation (consequences of inflation)
1.
2.
3.
4.
5.
6.
7.
It reduces the real income (purchasing power) of the people.

Fixed income group suffers more.
Lenders lose and borrowers gain.
It reduces demand
Business groups gain
More gap between rich and poor.
Export will reduce and import will increase, thus BOP deficit.
Demand-pull inflation: Inflation caused by an increase in aggregate

demand.
Cost-push inflation: Inflation caused by an increase in the cost of
production.
Money supply: The total quantity of money in circulation in the
economy and the deposits with banks and other financial institutions.
54
How can inflation be solved?

Inflation can be reduced or price stability can be achieved by a
contractionary fiscal and contractionary monetary policy. It can be in the
form of;
1. Reducing the demand by imposing more taxes on income of the people
and reducing public spending.(to control demand pull inflation)
2. Give more subsidies to producers and reduce taxes on them in order to
increase supply. (to control cost push inflation)
3. Reducing the money supply by central bank.
4. Increase interest rate to reduce borrowing.
5. Control of hire purchase facilities.
If the inflation is cost push, government should control the price and the
producers can be given subsidies.
Real income: it means the purchasing power. How much goods and
services can be purchased by an income.
As price increases real income falls.

Hyper inflation: it means a high rate of inflation, usually more than %.
Creeping inflation: it means a very low rate of inflation, usually less
than 2%.
55
Chapter 11
ECONOMIC GROWTH
Economic growth means growth of GDP.
If the total goods and services produced in an economy increase, we can
say the economy is growing.
How is economic growth possible?
Economic growth can be achieved through the following ways.
1. Use of more capital: The production of new capital goods
(investment) is the key to economic growth. An investment makes
more employment opportunities, more output, more income more
better living standard.
2. Use of more efficient labour: Training and education for people will
improve the quality of human resource, productivity and an increase in
output.
3. More efficient use of land: Use of land is more important for agro
based economies. Investment in irrigation, drainage and fertilizers can
improve the agricultural output.
4. Mobility of economic resources from declining sector to better
performing industries.
5. Increase in the technical knowledge: The improvement in science
and technology is one of the major causes of economic growth.
6. Discovery of new natural resources.
Benefits of economic growth

As economy grows there will be
1. An improvement in the living standard.
Better food
Better clothing
Better shelter
Better medical facilities etc.
2. More income to government and better social services.
As income increases people can pay more taxes and government
can spend more on health and education and other social
services.
3. National prestige.
Economic growth indicates the success of a government and the
people of the country. It increases the prestige of the nation.
4. More equal distribution of income and wealth.
56
Cost of economic growth

1. External cost (Negative externalities)
Environmental pollution by factories and large industries.
Congestion and overcrowding of urbanization.
2. Opportunity cost
Production of more capital goods reduce the output of consumer
goods
Any development project destroys some part of agricultural land
or forest or a river etc.
3. The faster growth may leads to the exhaustion of non renewable
resources.
Different phases of economic growth (Trade cycle or Business cycle)
Economic growth does not happen along a smooth and straight path.
There are ups and downs in the growth path of an economy. These ups
and downs are called economic fluctuations (trade cycle).
A trade cycle has four phases. They are boom, recession, depression
(slump) and recovery.
Boom means a sudden increase in the economic growth and it is the
upper most stage of growth.
Recession is a path to slump. It is a downward trend of an economy.
Depression means a sudden fall in the growth and it is the bottom level
of economic growth.
Recovery is the path to boom from a depression.
These are shown below.
57
DEVELOPED COUNTRIES AND DEVELOPING COUNTRIES

Based on the facilities available and standard of living the countries in the
world are classified in to developed, developing and less developed(under
developed) countries.
Compared to developed countries both developing and under developed
countries have almost same features.
Developed countries are called first world. And developing and less
developed countries are called third world.
Features of developed countries

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
High per capita GDP

High standard of living
High capital investment
High level of education
High life expectancy
Low birth rate and low death rate
Very low infant mortality rare
Less population
High productivity of primary, secondary and tertiary sectors
More people work in tertiary sector.
High level of technology
Political and social stability
Features of developing/less developed countries

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
Rapidly growing population(over population)

Less per capita GDP
Poor natural resources and poor climate
Over dependence on agriculture (primary sector)
Unequal trade (importing manufactured and exporting raw materials)
Extreme poverty
High birth rate
High death rate
Less life expectancy
High infant mortality rate
Lack of infrastructure
Less medical facilities
Low level of standard of living
Foreign debt problem
Lack of capital and technology
Political and social instability
58
How can a county develop? / What policies can a government

implement in order to achieve economic growth and development?
The policies to achieve economic development are:
1. To increase investment
2. Improve productivity (training and education)
3. Invention of new technology (conduct research, starting universities)
4. Improve health and education
5. Family planning to control population growth
6. Discovery of new natural resources (conduct research, starting
universities, colleges and other educational institution)
7. Improvement of infrastructure.
Why is the standard of living in developed country always better
than that of developing countries?
In a developed country they have always a high standard of living compared
to a developing country because;
In a developed country they
have:
1. High per capita GDP
2. Less population
3. High level of education
4. Better health facilities
5. Better infrastructure
6. High level of capital investment
7. High technology
59
In a developing country they

have:
Low per capita GDP
Over population
Less education
Poor health facilities
Poor infrastructure
Lack of capital
Poor technology
Chapter 12
ROLE OF GOVERNMENT IN AN ECONOMY

[Taxes and Public Expenditure]
Government has a major role to play in an economy. Government has some
aims to achieve in an economy. To achieve that aims government
implements some policies. Thats why the aims of government are called
policy aims. These are also called macroeconomic aims.
They are mainly
1.
2.
3.
4.
5.
To
To
To
To
To
achieve a high economic growth.

increase employment [to reduce unemployment]
achieve price stability [to reduce inflation rate]
achieve a BOP surplus [to reduce BOP deficit]
achieve equality [to reduce inequality]
For the achievement of these aims government make some changes in its
public expenditure and taxation. This is known as fiscal policy.
Public expenditure
It means Government spending or public spending for public sector works
such as salary for government employees, expenditure for public
enterprises, expenditure for public works like construction of roads, building
schools, hospitals, expenses for defence etc.
Meaning of Government Budget:
A Government budget is a statement showing item wise estimates of
receipts and expenditure under various heads during a fiscal year.
Types of Government Budget:
1. Surplus Budget:
Excess of estimated revenue of the year over the anticipated expenditure is
known as surplus budget.
2. Deficit Budget:
Deficit Budget is a situation where in estimated Government expenditure
exceeds the anticipated revenue.
3. Balanced Budget:
Balanced Budget is a situation where in estimated Government expenditure
equals the anticipated revenue.
60
Sources of Revenue of the Government

Revenue of a Government can be generated from following sources.
1. Tax Revenue
Tax revenue refers to receipts from all kinds of taxes. A tax is a legally
compulsory payment imposed by the government on income and profit of
persons and companies without reference to any benefit. The central
government collects revenue in the form of various taxes such as income
tax, corporate tax, custom duty, excise duty etc.
2. Non-tax Revenue
These are income, which the government gets by way of sale of goods and
services rendered by different government departments. It comprises the
following items. Interest, profits and dividends, fees and fines, special
assessment, external grant in aid.
Public Expenditure
Public expenditure refers to the expenditure of the public authorities either
in protecting the citizens or promoting their economic and social welfare.
Why public spending. [Reasons for public spending]
Why do we need a public sector?
We need a government and it should spend money in the economy for the
following reasons.
1. To provide public goods like defence, police, street lights etc.
2. To provide merit goods such as health service, education etc.
3. To reduce inequalities and help vulnerable people (those who are
suffering from poverty, handicapped, old people, homeless people,
unemployed, widows etc.
4. To invest on economic infrastructure and improve the physical and
social infrastructure.
5. To support agriculture and industries by providing grants and
subsidies.
6. To control the economy through fiscal policies.
61
GOVERNMENTS REVENUE [pubic revenue taxation]

Government receives its revenue to finance its expenditure from different
sources. They are mainly:
(The different ways of financing public expenditure)
Taxes
Revenue from government owned firms
Rent from publicly owned land, buildings, some other capital goods
Different kinds of fees
Borrowing from public
Privatization
TAXATION (Types of taxes, aims of taxation, and systems of taxation)

A tax is a compulsory payment to the government from the people.
Direct taxes
Direct taxes are taken directly from the tax payer (the person who pays the
tax) on his income or wealth.
In direct taxes the impact and incidents are on the tax payer.
Income tax, corporation tax, capital gain tax, wealth tax etc are examples
for direct tax.
Indirect taxes
Indirect taxes are taxes collected indirectly on income of the people when
they spend it on goods and services. It is included in the price of the goods
and services.
In indirect tax impact will be on producer (tax payer) and incidence will be
on the customer.
Sales tax, ad valorem tax, tariffs, excise duties, VAT etc are examples of
indirect taxes.
EXAMPLES FOR DIRECT TAX

Income tax: the taxes on income of people.
Corporation tax: taxes on the total profit of a firm.
Capital gain tax: taxes on the profit earned from the sales of an asset.
Wealth tax: taxes on wealth and property.
Inheritance tax: taxes on the inherited property by the death of
father.
62
TAX SYSTEMS
A tax system means how a county impose the taxes on its people. Different
countries are following different methods of taxation. The main the systems
of taxation are progressive taxes, proportional taxes and regressive taxes.
Progressive tax
In this system tax rate (% of tax imposed) increases as income increases.
That means a high rate taxes on rich and a less on poor.
Proportional tax
In this system a same rate of tax are imposed on all levels of income.
Whatever may be the income, same percentage of tax should be given.
Regressive tax
In this system tax rate decreases as income level increases. That means a
high rate of tax on poor (less income group) and fewer rates on rich (high
income group).
These three systems can better be understood from the following table
Persons
A
B
C
D
Income
10000
20000
30000
40000
Progressive
Tax
Amount
rate
of tax
10%
1000
15%
3000
20%
6000
30%
12000
Proportional
Tax
Amount of
rate
tax
10%
1000
10%
2000
10%
3000
10%
4000
Regressive
Tax
Amount of
rate
tax
10%
1000
8%
1600
7%
2100
6%
2400
Aims of taxation
The aims of taxation or the reason for why government imposes taxes are varied.
They are mainly:
1. To raise an income for government (to raise public revenue).
2. To discourage consumption and thereby reduce import and achieve a BOP
surplus.
3. To reduce the gap between rich and poor (to maintain equality in the
economy)
4. To reduce inflation.
5. To discourage the consumption of harmful goods like cigarettes, alcohol etc.
6. To reduce pollution. Special taxes on uses of petroleum products and some
other chemicals.
63
Effects of taxation
When a tax is imposed it reflects on different aspects in the economy. The
main effects of taxation are:
1. Effects on income: when tax imposed on the income of the consumer
it will reduce the amount of disposable income. They can by less.
And if it is an indirect tax imposed on the goods and services the real
income of the consumer falls.
2. Effects on aggregate demand (consumption): Tax on income
reduces the disposable income of the people and thus aggregate
demand falls. On the other hand a reduction in tax will increase the
aggregate demand.
3. Effects on employment: An increase in taxes reduce aggregate
demand and so a fall in employment also.
4. Effects on price level: An increase in tax can reduce the general
price level and so inflation can be reduced and a cut in tax rate may
lead to inflation. But an increase in the indirect taxes may lead to a
further cost push inflation.
5. Effect on income distribution: the taxes on income of the people
will reduce the gap between rich and poor. A redistribution of income
is possible by taxation.
6. Effects on economic growth: A high tax may discourage the
demand, employment and finally a fall in the production and a fall in
the GDP.
64
How does a government control an economy?

A government affects an economy by its fiscal policy.
It will increase or decrease public spending and taxes according to the
different economic situations. How government implements its fiscal policy in
different situations is explained below.
1. In An inflationary situation
[How does a government reduce inflation / How to achieve price
stability?]
In an inflationary situation government implement a
contractionary fiscal policy.
It means taxes will be increased and public spending will be
decreased.
It will reduce the volume of income with people.
It reduces aggregate demand in the economy.
As a result price level comes down.
Inflation rate will be controlled
2. In a situation of high level of unemployment
[How does a government reduce unemployment in an economy / How
to increase employment?]
In a situation of high level of unemployment government
implement an expansionary fiscal policy.
It means taxes will be reduced and public expenditure will be
increased.
It will increase the output and employment.
It will increase the volume of income with people.
Spending and investment will increase.
Demand and output will increase.
More employment opportunities were created.
3. In a situation of balance of payment deficit
[How does a government achieve BOP surplus]
In a situation of balance of payment deficit government
implement a contractionary fiscal policy.
It means taxes will be increased and public spending will be
decreased.
It will reduce the output and employment
People get less income
Demand for imports falls and trade balance become favorable
(surplus).
65
4. In a situation of inequality
[How does a government achieve the aim of equality / how to reduce
inequality?]
In a situation of high inequality government tries to redistribute
income by imposing more taxes on high income group and this
tax revenue used to spend for the benefit of the low income
group.
This will reduce the gap between rich and poor to an extent.
5. In a situation of low rate of economic growth
[How can the aim of high economic growth be achieved?]
66
In a situation of low rate of economic growth government

implement an expansionary fiscal policy.
It means taxes will be reduced and public expenditure will be
increased.
It will increase investments.
It will increase the output and employment.
It will increase the volume of income and GDP.
POLICY CONFLICTS
The various aims of government are difficult to achieve all at once. In some
cases the policies to achieve some aims might conflict. Some policy conflicts
are discussed below.
1. Policy Conflict between unemployment and BOP surplus.
During an unemployment situation government try to boost aggregate
demand might help to raise output and employment but it may
increase the demand for imported goods also. Thus import increases
and leads to an unfavorable trade balance. So these two aims cannot
be achieve by a policy at the same time.
2. Policy Conflict between inflation and unemployment
A cut in public spending and a raise in tax (a contractionary fiscal
policy) will help to reduce inflation but this policy may result in lower
output and more unemployment. On the other hand an expansionary
fiscal policy to reduce inflation may result in inflation.
3. Policy Conflict between economic growth and inflation
An expansionary fiscal policy will help to increase aggregate demand
employment, and as result increase in output. It leads to economic
growth but it may leads to raise the prices also and finally results
inflation.
4. Policy Conflict between equality and economic growth
Government may try to impose a high tax on high income group and
sped it for poor section to maintain equality (to reduce inequality) but
it discourage the rich business group to invest more. On the other
hand if government tries to encourage the business group by a liberal
policy, it will lead to greater inequality.
67
Conflict between unemployment and BOP surplus

One side
An expansionary fiscal policy
Leads to
Leads to
Increase in output and
employment
Leads to
Increase the demand for
imported goods also
Leads to
Import increases and BOP
become unfavorable
Other side
A contractionary fiscal policy
Reduce aggregate demand

including demand for
imported goods also
Leads to
A reduction in import and BOP
surplus
Leads to
A decrease in the output and
employment
Leads to
unemployment
Conflict between inflation and unemployment

One side
An expansionary fiscal
policy
Other side
A contractionary fiscal
policy
Leads to
Leads to
Decrease in aggregate
demand
Leads to
a decrease in the price level
and reduce inflation
Leads to
employment
and reduce unemployment
Leads to
An increase in price level
Leads to
inflation
68
Leads to
less output and less
employment
Leads to
unemployment
Conflict between economic growth and inflation

One side
policy
Other side
An contractionary fiscal
policy
Leads to
Leads to
Decrease the demand for
goods and services
Leads to
Decrease in output
Leads to
Lower economic growth
Leads
Leads
to
Increase in output
to
Economic growth
Leads to
Increase in the price level
Leads to
Decrease the price level
Leads to
Inflation
Leads to
Less inflation
Conflict between unemployment and equality

One side
policy (less tax)
Other side
An high tax on rich people
Leads to
Leads
Leads
Leads to
employment
Leads to
Reduce unemployment
to
High tax on rich
Discourage investment
to
Less output
Leads to
More unemployment
Leads to
Inequality (rich can be richer

and richer)
Leads to
More equal distribution
(reduce inequality)
69
Chapter: 13
POPULATION
Population - Definitions
There are a number of terms which are important to understand in studying
population.
The crude birth rate is the number of births per 1000 people in a year.
The crude death rate is the number of deaths per 1000 people in a year.
The natural increase is the number of extra people (birth rate minus the death
rate). This is usually given as a percentage.
The infant mortality rate is the annual number of deaths of infants (before age 1)
less than one year old per 1,000 live births.
Standard of Living and Population Density
A person's standard of living tells you how well off they are. We can measure their
standard of living by looking at
Their average income (GDP per head)

The average number of calories eaten per person (Quality of food)
The number of people per doctor (health facility)
The percentage of people who are able to read and write
The average life expectancy
The infant mortality rate
These factors are known as standard of living indicators.

Countries that have a high standard of living are mainly found in the northern part
of the world, and are called developed countries. Canada, France and Japan are
examples of developed countries. This part of the world is also known as the
"North".
Countries that have a low standard of living are mainly found in the southern part
of the world and are called developing countries. Bolivia, Chad and Afghanistan
are examples of developing countries. This part of the world is also known as the
"South".
70
Differences between Developed and Developing Countries

1. Birth Rates
Developing countries have high birth rates because
Many parents will have a lot of children in the expectation that some
will die because of the high infant mortality rate
Large families can help in looking after the farm
The children will be able to look after their parents if they become old
or sick; there may not be a old age pension scheme
There may be a shortage of family planning facilities and advice
Developed countries have low birth rates because
It is expensive to look after large families

More women prefer to concentrate on their careers
Increasing sexual equality has meant women have more control over
their own fertility
There is a ready availability of contraception and family planning
advice
2. Death Rates
Developing countries have high death rates because, in many cases, there
are
Dirty, unreliable water supplies

Poor housing conditions
Poor access to medical sevices
Endemic disease in some countries
Diets that are short in calories and/or protein
Developed countries have low death rates because, in many cases, there
are
Good housing conditions
Safe water supplies
More than enough food to eat
Advanced medical services which are easy to access
Some developed countries have a high death rate as they have an ageing
population with many older people.
71
3. Infant Mortality: It is the annual number of deaths of infants (before

age 1) less than one year old per 1,000 live births.
The infant mortality rates are higher in developing countries. The
reasons for these higher rates are that developing countries often have
A shortage of medical services

A greater number of children born to mothers
Poor nutrition of mothers and babies
Less knowledge of health matters and Dirty water supplies
The chances of surviving to your fifth birthday depend on where you
are born in the world.
Model of Population Change

If you look at how the population structure of countries like the U.K. change
it is possible to identify four stages
1. High birth rate and high death rate, low natural increase - the
population grows slowly
2. High birth rate and decreasing death rate, large natural increase rapid growth in population
3. Both birth and death rates are falling, still large natural increase population still growing, but at a slower rate
4. Low birth and death rate, low natural increase, slow population growth
Reasons for Population Change
Stage 1
High death rate - poor medical knowledge, diet, water supply and sanitation
High birth rate - children used on farms, no reliable contraception
Stage 2
Decreasing death rate - medical knowledge and diet improves
High birth rate - still children used on farms, no reliable contraception
Stage 3
Decreasing death rate - more medical advances, clean water, greatly
decreased infant mortality
Decreasing birth rate - children needed less on farms, people have smaller
families when infant mortality decreases
Stage 4
Low death rate - advanced medical services, good living conditions, increased
health education
Low birth rate - children cost money, contraception widely available, women
gain higher status and control
72
Changing Population Growth

How to control populations growing too quickly?
The steps that have been taken to reduce the problems caused by a rapidly
growing population include
Education about family planning, with the increased availability of a

range of contraceptive methods
Extra taxes for parents who have large families
Extra benefits for the parents that have only one or two children
Raising the age of marriage
Increasing the industry and wealth in a country - this allows it to
"afford" the increased population
When a country develops - that is has a higher quality of life, higher

standard of living and increased wealth - the birth rate goes down. This is
the greatest influence in reducing problems caused by rapid population
growth.
How to increase populations growing too slowly?
Governments have been concerned when the population of their country is
only growing slowly. Indeed some countries, e.g. Hungary and Germany
have recently had population decline. The governments have responded by
Giving mothers longer paid maternity leave; giving paternity leave to

fathers
Generous child benefit payments
Raising the age of retirement - this increases the workforce and
reduces the amount that has to be spent on pensions
Population Dependency Ratio
The dependency ratio tells us how many young people (under 16) and
older people (over 64) depend on people of working age (16 to 64).
The dependency ratio is worked out with this formula
That means, Dependency Ratio = Dependent population Work force
73
A worked example should make this clearer. Pakistan, which is a

developing country, has 41% of its population less than 15, and 4%
over 65. This makes 55% (100 - (41+4)) between the ages of 15 and
64.
New Zealand, a developed country, has 23% of its population less than
15, and 12% over 65. This makes 65% between 15 and 64.
Countries that have a high dependency ratio have more people who are not
of working age, and fewer who are working and paying taxes. The higher the
number, the more people that needs looking after.
Why do people migrate?
Migration is the movement of people from one place to another. It can be
over a short or long distance, be short term or permanent, voluntary or
forced.
The problems of an area that encourage people to leave are known as push
factors. Examples include
Natural disasters
Lack of employment
Low pay, and poor standard of living
Poor housing
Lack of educational opportunities
Shortage of medical facilities and services
War and/or persecution
74
The attractions of a area that migrants move to are called pull factors.
They include
Better employment opportunities

Better education chances, including higher education
Better medical care
Higher wages, and improved standard of living
The bright lights, that is entertainments like pubs and clubs
Some advantages of migration are:

The area people migrate from has less overcrowding
The gaining area gets workers
Migrants may sent back some money to their families
Some disadvantages of migration are:
The area people migrate from loses some of its most go ahead, active
people
The gaining area has to find housing and provide services for the
migrants
The reality for the migrant does not match up with the expectation many migrants have to live in slum housing, and work in low status,
low paid jobs
As many people leave the countryside to live in the cities, they have grown
particularly quickly. This process is known as urbanisation. The graph
shows the trend in Mexico, and it is typical of a developed country
75
Population Structure
When we discuss the population structure of a country we have to see their
regional distribution, occupational distribution, sex distribution and age
distribution.
Regional distribution: it means where do they live, whether in rural
(villages) area or urban area (cities).
In a developed country more people live in cities and very less people live in
rural areas.
Occupational distribution: it means where do they work, whether in rural
(villages) area or urban area (cities) or in primary sector or secondary sector
or tertiary sector.
In a developed country more people work in secondary and tertiary sector in
cities and very less people work in primary and agricultural sector in rural
villages.
Sex distribution and age distribution
The age and sex distribution of population is the main aspect of population
structure of a contry. The common method to show the structure is by a
population pyramid. This diagram is made up by putting two bar graphs
(one for male, one for female) side by side. From this you can read off what
percentage of a population is of a certain gender and age range. In the
example below 4% of the population is females aged between 25 and 29.
Population Structure - Developing Countries
76
This population pyramid is wide at the base, which means there are a large
proportion of young people in the country. It tapers very quickly as you go
up into the older age groups, and is narrow at the top. This shows that a
very small proportion of people are elderly.
This shape of pyramid is typical of a developing country, such as Kenya or
Vietnam.
Population Structure - Developed Countries
This shape is typical of a developed country. It is narrow at the base, wider

in the middle, and stays quite wide until the very top, as there is a sizable
percentage of older people. Note that there are more old women than men.
Italy and Japan have population structures that are of this shape.
77
Countries with Rapid Population Growth (developing

countries)
When a country's population grows quickly it has the following effects
The large number of young people have to have services e.g. schools
provided for them
There are fewer older people, so less money needs to be spent on
them
There is a relativly small proportion of adults of working age; these
people provide the wealth for the services
There is pressure on the countryside with the extra population to feed;
this can result in overgrazing, over cropping and soil erosion
People move to the cities to find work; developing countries with
rapidly growing populations have the fastest growing cities in the
world
Shanty towns grow up on the edge of cities; these are self-constructed
buildings of poor quality which can lack vital services such as water,
electricity and sanitation
Some people apply to migrate to developed countries in order to
improve their standard of living
78
Countries with Slow Population Growth (developed countries)
When a country's population grows slowly it has the following effects
It has an ageing population, so large amounts of money is spent in

providing services, e.g. healthcare, for older people
As there is fewer young people less money needs to be spent on
this age group
There could be a shortage of workers in the future, with so few
young people
Migrants move into the country, often to work in the low paid, low
status jobs that would otherwise be difficult to find workers for
Population structure of a country

sex distribution and age distribution
regional distribution
occupational distribution
79
Chapter 14
INTERNATIONAL TRADE
Balance of payment and Exchange rate
Trade means buying and selling goods and services.
International trade means buying and selling goods and services between
countries.
It includes import and export.
Import means buying goods and services from other countries.
Export means selling goods and services to other countries.
The reasons for why countries trade with each other.
1. Some countries produce goods and services that other countries cannot
produce.
2. Some countries produce certain goods and services at a lower cost.
3. Differences in the availability of resources.
4. Differences in the cost of production.
Balance of Payments (BOP)
The difference between import and export is called balance of payment. It
includes both visible and invisible items. It is a financial statement of
international trade of a country. All inflows and outflows of money into and
out of an economy are shown in BOP account.
Structure of BOP
It has three accounts.
1. Current account
Visible trade in export and imports
Invisible trade in services
Income debits and credits as wage, rent, profit, interest
etc.fro and to the country.
Taxes and subsidies.
80
2. Capital account
Inflow and out flow of money into and out of economy to
pay for fixed assets (capital)
3. Financial account
Inflow and out flow of money into and out of economy as
foreign investments, company shares and loans.
Balance of trade
It is an account of only visible import and visible export. it is the difference
between visible import and visible export.
BOP surplus: BOP will have a surplus if export is more than import.
BOP deficit: BOP will have a deficit if import is more than export.
FREE TRADE
Trade without any restrictions such as tariffs, quota, exchange control etc is
called free trade.
Arguments for free trade (Advantages of international trade)
4.
5.
6.
7.
8.
It increases specialization.
It helps the maximum utilization of resources.
It makes the home industries more competitive and efficient.
More choice of goods and services to the consumers.
It improve the friendly relationship between countries
Arguments Against free trade

1.
2.
3.
4.
5.
BOP problem.
Unreliable imports.
Infant and small scale industries will be deteriorated.
It may lead to unemployment.
It leads to the monopoly of MNCs.
Protectionism (trade restrictions)

The restrictions on international trade such as tariffs, quota, exchange
control etc are called trade restrictions or protection.
81
Methods of trade restrictions

Some of the ways in which trade is restricted are follows.
1. Tariffs: A tariff is tax on imports. When tax is imposed on imported
goods their price increase and as a result the demand for import
reduces.
2. Quotas: Quota is upper limit on how much goods can be imported. If
a quota is fixed for import more than that a country cannot import.
3. Exchange control: To import goods or services from any country the
importer should get the foreign currency (foreign exchange) from the
foreign exchange markets (Banks). So in order to restrict trade
government can control the supply of foreign currencies with the help
of central bank.
4. Subsidies to the home producers to compete with the foreign goods.
Arguments for Protectionism
The reasons for why government sometimes chooses a policy of
protectionism are:
1.
2.
3.
4.
5.
Supplies of imports are sometimes unreliable.

A high level of imports can cause a BOP problem.
To protect infant and small scale industries.
Cheep import can cause unemployment.
It will increase the demand for home produced (import competing)
goods.
Arguments against Protectionism

1.
2.
3.
4.
It reduces specialization.
It reduces the consumers choice.
Home industries become lazy and inefficient.
It gives way for retaliation.
82
EXCHANGE RATE
The price of one currency in terms of another currency is called exchange
rate.
For example 1= $1.5
Floating exchange rate
It is an exchange rate system in which the rate is determined by the market
forces of demand and supply for the currency. If the demand for currency
increases exchange rate increases (appreciate) and if the demand falls
exchange rate also falls (depreciate).
Depreciation
When the value of one currency falls against another currency in floating
exchange rate regime is called depreciation. (In the figure from 4 to 3)
Appreciation
When the value of one currency increases against another currency in
floating exchange rate regime is called depreciation. (In the figure from 2 to 3)
83
Factors affecting exchange rate

1. Speculation: exchange rate is influenced by speculation as the demand
for the currency increases with speculation. The trade in financial assets
or currency expecting future gains is called speculation.
2. Interest Rates: a high interest rate in a foreign country attracts
investors to that country, thereby increasing the demand for the currency
of that country.
3. Income: as income increases consumption increases-domestic and
foreign- leading to higher imports. This increases demand for foreign
exchange.
9. Inflation: Inflation will affect export and import demands and as a result
BOP also. It may lead to a deprecation of domestic currency.
10. Changes in balance of trade in goods and services.
FIXED EXCHANGE RATE SYSTEM
Under fixed exchange rate system the exchange rate between two countries
is fixed.
Pegged Exchange Rate System
In pegged exchange rate system the exchange rate is maintained by
monetary authority of a country and the rate of exchange is a policy matter.
In short it may be changed under a policy change of the monetary authority.
In other words devaluation or revaluation of the domestic currency is
possible. It is also a fixed exchange rate system with the provision of
devaluation.
Devaluation and Revaluation
Under a pegged exchange rate system an increase in the exchange rate is
called devaluation. In this case, the value of the domestic currency
decreases.
Revaluation means a decrease in the exchange rate and a rise in the value
of domestic currency.
Managed Floating exchange rate system
Managed floating is a system that allows adjustments in exchange rate
according to a set of rules and regulations which are officially declared in the
foreign exchange market. It is a mixture of flexible exchange rate system
and fixed exchange rate system.
84
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ECONOMICS FOR CAMBRIDGE O LEVEL

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Introduction to the subject

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How to produce means what kind of method of production (technology)

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Land as a factor of production

Labour as factor of production

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Geographical mobility of labour: the movement of labour from one

Capital as a factor of production

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Entrepreneur as a factor of production.

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Advantages of market economy

Chances of wasteful competition.

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Disadvantages of command economy

Chances for corruption

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Co-existence of both public sector and private sector.

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In a mixed economy we have:

provides merit goods like education and health.

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Market failure occurs whenever freely-functioning markets operating without

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HOW A MARKET FUNCTIONS

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Determinants of demand [Factors affecting demand]

Taste and preference

Price of complementary goods

Expectation of changes in price in future

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CHANGES IN QUANTITY DEMANDED AND SHIFT IN DEMAND

When price decreased from P to P1 demand increased from Q to Q1. It

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The shift from D to D1 if increase in demand. Here Price is not changing,

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