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ECONOMICS
Stephen Ison and Stuart Wall
fourth edition

ECONOMICS
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ECONOMICS
Fourth Edition
Stephen Ison
Loughborough University
Stuart Wall
Anglia Ruskin University

Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world
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Fourth edition published 2007
© Pearson Education Limited 2007
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have been asserted by them in accordance with the Copyright, Designs and Patents
Act 1988.
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any affiliation with or endorsement of this book by such owners.
ISBN-13: 978-0-273-68107-6

ISBN-10: 0-273-68107-9
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
Ison, Stephen.
Economics / Stephen Ison, Stuart Wall. — 4th ed.
p. cm.
Includes bibliographical references and index.
ISBN-13: 978-0-273-68107-6
ISBN-10: 0-273-68107-9
1. Economics—Textbooks. I. Wall, Stuart, 1946– II. Title.
HB171.5.I84 2006
330— dc22
2006047252
10987654321
10 09 08 07 06
Typeset in 10/12pt Minion by 35
Printed and bound in Great Britain by Ashford Colour Press, Hampshire
The publisher’s policy is to use paper manufactured from sustainable forests.

Contents
Preface xvii
Acknowledgements xix
Publisher Acknowledgements xx
Chapter 1 The nature of economics 1
Learning objectives 1
1 Introduction 1
2 Defining economics 2
2.1 The ways in which an economist thinks 2
2.2 The use of tables and diagrams 2

2.3 The economic problem 4
2.4 Opportunity cost 5
2.5 The production possibility frontier (PPF) 5
2.6 The PPF and opportunity cost 7
3 Economic systems 9
4 The market economy 10
4.1 Advantages of the market economy 11
4.2 Disadvantages of the market economy 11
5 The planned economy 13
5.1 Advantages of the planned economy 13
5.2 Disadvantages of the planned economy 13
6 The mixed economy 15
7 Positive and normative economics 15
8 Micro- and macreconomics 16
Key points 16
Further reading 17
Web references 17
Progress and review questions 17
Part One MICROECONOMICS
Chapter 2 Demand, supply and market equilibrium 23
Learning objectives 23
1 Introduction 23
2 The market 23
3 Demand 24
3.1 What is demand? 24
3.2 Factors influencing demand 24
3.3 ‘Movements along’ and ‘shifts in’ the demand curve 29
3.4 The derivation of market demand 30

vi CONTENTS

4 Supply 32
4.1 What is supply? 32
4.2 Factors influencing supply 32
4.3 The derivation of market supply 35
4.4 ‘Movements along’ and ‘shifts in’ the supply curve 36
5 Market equilibrium 36
5.1 The equilibrium market price 36
5.2 Changes in the equilibrium market price 37
Key points 39
Further reading 39
Web references 40
Progress and review questions 40
Chapter 3 Elasticity 45
Learning objectives 45
1 Introduction 45
2 Price elasticity of demand (PED) 45
2.1 What is price elasticity of demand? 45
2.2 Price elasticity of demand and total revenue 49
2.3 Factors determining price elasticity of demand 50
3 Income elasticity of demand (YED) 52
3.1 What is income elasticity of demand? 52
3.2 Types of income elasticity of demand 53
4 Cross elasticity of demand (CED) 55
4.1 What is cross elasticity of demand? 55
5 Price elasticity of supply (PES) 57
5.1 What is price elasticity of supply? 57
5.2 Factors determining price elasticity of supply 58
6 The importance of the elasticity concept 60
7 Applications of demand and supply 60
Key points 63

Further reading 64
Web references 64
Progress and review questions 65
Chapter 4 Consumer theory 69
Learning objectives 69
1 Introduction 69
2 Marginal utility theory 69
2.1 What is marginal utility theory? 69
2.2 Total utility 70
2.3 Marginal utility 70
2.4 The law of diminishing marginal utility 70
2.5 The consumer equilibrium 72
2.6 Derivation of the demand curve 74
3 Indifference curve analysis 74
3.1 What is indifference curve analysis? 74
3.2 Indifference curves 75
3.3 The budget line 78

CONTENTS vii
4 The consumer equilibrium under indifference curve analysis 80
4.1 A change in income 81
4.2 A change in price 81
5 The substitution and income effect 82
6 Inferior product or good 84
7 Giffen good 85
8 Derivation of the demand curve 85
Key points 86
Further reading 87
Web references 87
Progress and review questions 88

Chapter 5 Production and costs 94
Learning objectives 94
1 Introduction 94
2 Types of business enterprise 95
2.1 Sole trader 95
2.2 Partnership 95
2.3 Joint stock company 95
2.4 Public sector companies 96
3 The growth of firms 96
3.1 Why do firms wish to grow? 96
3.2 Internal growth 98
3.3 External growth 98
4 The factors of production 100
4.1 What are the factors of production? 100
4.2 Land 100
4.3 Labour 100
4.4 Capital 100
5 Production 100
5.1 Production function 100
5.2 Production in the short run: law of diminishing returns 101
5.3 The average and marginal concept 102
5.4 Production in the long run 103
6 Isoquants 104
7 Isocost 106
8 The least-cost process of production 108
9 The expansion path 108
10 Costs 109
10.1 What are costs? 109
10.2 Short-run and long-run costs 110
10.3 Total, average and marginal cost 111

10.4 Long-run average cost (LRAC) and economies of scale 113
10.5 Sources of economies of scale 114
10.6 Economies of scope 116
10.7 Diseconomies of scale 116
Key points 117
Further reading 118
Web references 118
Progress and review questions 118

viii CONTENTS
Chapter 6 Theory of the firm: perfect competition
and monopoly
123
Learning objectives 123
1 Introduction 123
2 Revenue, costs and profit 124
2.1 Revenue 124
2.2 Profit maximisation 127
3 Perfect competition 128
3.1 What is perfect competition? 128
3.2 Short-run equilibrium in perfect competition 129
3.3 Long-run equilibrium in perfect competition 131
3.4 Allocative and productive efficiency 132
3.5 Contestable market theory 133
4 Monopoly 134
4.1 What is monopoly? 134
4.2 Barriers to entry 135
4.3 Advantages of a monopoly 136
4.4 Disadvantages of a monopoly 137
5 Price discrimination 138

5.1 Consumer surplus 138
5.2 First degree price discrimination 139
5.3 Second degree price discrimination 140
5.4 Third degree price discrimination 140
Key points 142
Further reading 142
Web references 142
Progress and review questions 143
Chapter 7 Theory of the firm: monopolistic
competition and oligopoly
147
Learning objectives 147
1 Introduction 147
2 Monopolistic competition 147
2.1 What is monopolistic competition? 147
2.2 Short-run equilibrium in monopolistic competition 148
2.3 Long-run equilibrium in monopolistic competition 149
3 Oligopoly: non-collusive 150
3.1 What is oligopoly? 150
3.2 The kinked demand curve and price rigidity 150
3.3 Other pricing strategies 152
3.4 Non-price competition 152
4 Oligopoly: collusion 153
4.1 Methods of collusion 154
4.2 Cartels 154
4.3 Price-leadership models 155
5 Game theory 157
5.1 Zero sum games 157
5.2 Non-zero sum games 159

CONTENTS ix
6 Contestable markets 160
Key points 161
Further reading 162
Web references 162
Progress and review questions 162
Chapter 8 Wages, rent and profit 166
Learning objectives 166
1 Introduction 166
2 Marginal productivity theory of wages 166
2.1 Perfectly competitive product and labour market 167
2.2 The firm’s demand curve for labour 168
3 The supply of labour 169
4 The labour market equilibrium 170
4.1 Labour demand and imperfect product markets 172
5 A monopsony market for labour 173
6 Trade unions and the market for labour 175
6.1 Impacts of trade unions 175
6.2 The bargaining strength of trade unions 176
7 Economic rent and transfer earnings 178
7.1 Economic rent 178
7.2 Transfer earnings 178
7.3 Economic rent versus transfer earnings 178
8 Profit 180
8.1 What is profit? 180
8.2 Profit as a cost of production 181
8.3 The function of profit 181
8.4 Determination of profit 181
Key points 182
Further reading 182

Web references 182
Progress and review questions 183
Chapter 9 Regulation, deregulation and competition 187
Learning objectives 187
1 Introduction 187
2 Regulation 187
2.1 Types of regulation 187
2.2 Reasons for deregulation 188
2.3 Deregulation and public interest theory 189
3 Privatisation 190
3.1 The case for privatisation 190
3.2 The case against privatisation 192
3.3 ‘Natural monopoly’ argument 193
4 Regulation of privatised companies 194
4.1 Objectives of regulators 194
5 UK competition policy 194
5.1 The key institutions in UK merger policy 194

x CONTENTS
5.2 Restrictive practices legislation 196
5.3 Cartels in the UK 197
6 EU competition policy 197
7 EU restrictive practices and EU legislation 199
Key points 200
Further reading 201
Web references 201
Progress and review questions 201
Chapter 10 The environment 205
Learning objectives 205
1 Introduction 205

2 The economy and the environment 205
3 A model of pollution 207
4 Policy options 208
4.1 Bargaining and negotiation 208
4.2 Bargaining, game theory and the free-rider problem 209
4.3 Environmental taxes 210
4.4 Tradable permits 211
4.5 Environmental standards 215
5 Transport and the environment 216
5.1 The economic background 217
5.2 Possible policy options 218
Key points 222
Further reading 223
Web references 223
Progress and review questions 223
Part Two MACROECONOMICS
Chapter 11 National income and its determination 229
Learning objectives 229
1 Introduction 229
2 The circular flow of income 230
2.1 Circular flow of income: simplified 230
2.2 Circular flow of income: withdrawals and injections 231
3 National income: definitions and measurement 233
3.1 National income definitions 233
3.2 National income measurement 234
3.3 National income accounts 238
4 Using national income statistics 239
4.1 Comparing national living standards over time 239
4.2 Comparing living standards of different nations 241
5 National income determination 242

5.1 Equilibrium in the circular flow: W/J approach 242
5.2 Equilibrium in the circular flow: 45° diagram approach 246
5.3 Equivalence of the two approaches 251
6 Changes in national income 252

CONTENTS xi
6.1 Changes in injections (J) 252
6.2 Changes in withdrawals (W) 253
7 National income and employment multipliers 254
7.1 National income multiplier 254
7.2 Employment multiplier 257
Key points 257
Further reading 258
Web references 258
Economic models and simulation 258
Progress and review questions 259
Chapter 12 Public expenditure, taxation and
fiscal policy
267
Learning objectives 267
1 Introduction 267
2 Rationale for a public sector 268
3 Government expenditure 270
3.1 What is government expenditure? 270
3.2 Growth of public expenditure 270
3.3 Total managed expenditure (TME) 271
3.4 Fiscal ‘rules’ 271
3.5 Explanation of the growth in public expenditure 271
4 Planning, monitoring and control 273
4.1 Public Expenditure Survey (PES) 273

4.2 Control total (CT) 274
5 Reasons for the control of public expenditure 274
5.1 More freedom and choice 274
5.2 To control the money supply 275
5.3 Crowding out 275
5.4 Incentives to work, save and take risks 275
6 Taxation 276
6.1 Direct and indirect taxes 277
6.2 Specific and percentage taxes 278
6.3 Progressive and regressive taxes 278
7 Individual taxes 279
7.1 Income tax in the UK 279
7.2 Other direct taxes in the UK 280
7.3 Indirect taxes in the UK 280
7.4 Other taxes in the UK 281
8 Taxes and economic incentives 281
8.1 Taxes and incentives to work 281
8.2 Comparative tax rates 283
9 Direct versus indirect taxes 284
9.1 Macroeconomic management 284
9.2 Economic incentives 285
9.3 Economic welfare 285
9.4 Administrative costs 285
10 Poverty and unemployment ‘traps’ 286
10.1 Poverty trap 286
10.2 Unemployment trap 287
10.3 The black economy 288

xii CONTENTS
11 Fiscal policy 289

11.1 The Budget 289
11.2 Budget terminology 289
12 Fiscal policy and stabilisation 290
12.1 Business cycle 290
12.2 Built-in stabilisation 291
12.3 Discretionary fiscal stabilisation 291
13 Fiscal policy and globalisation 293
Key points 293
Further reading 294
Web references 294
Progress and review questions 296
Chapter 13 Money, financial institutions and
monetary policy
300
Learning objectives 300
1 Introduction 300
2 The functions of money 300
2.1 A medium of exchange 301
2.2 A unit of account 301
2.3 A store of value 301
2.4 A standard of deferred payment 301
3 Money supply 302
3.1 What is money? 302
3.2 Near money 302
3.3 Measuring the money supply 303
3.4 Credit creation 304
4 Financial institutions 306
4.1 The role of the financial system 306
4.2 The role of financial intermediaries 307
5 UK financial intermediaries 309

5.1 The UK banking financial intermediaries 310
5.2 UK non-bank financial intermediaries 311
5.3 The Bank of England 313
6 Money supply and the Bank of England 314
6.1 Supply of money 314
7 Money demand and interest rates 316
7.1 What is interest? 316
7.2 Theories of interest rate determination 316
8 Monetary policy 321
8.1 Controlling the money supply 321
8.2 Rate of interest 322
9 Monetary policy and financial globalisation 322
Key points 323
Further reading 324
Web references 324
Progress and review questions 325

CONTENTS xiii
Chapter 14 Exchange rates and the balance
of payments
329
Learning objectives 329
1 Introduction 329
2 Exchange rate 330
2.1 Determination of exchange rates 331
2.2 Types of exchange rate 332
3 The terms of trade 334
4 The Marshall–Lerner elasticity condition 335
5 The J-curve 337
5.1 Diffusion path for price changes following a currency depreciation 337

5.2 Time lag in adjustment of consumer behaviour to price changes 339
6 Expenditure switching v expenditure reducing policy instruments 339
7 Exchange rate policy and financial globalisation 340
8 Exchange rate systems 341
8.1 Fixed exchange rates (gold standard) 341
8.2 Adjustable peg system (IMF) 342
8.3 The floating exchange rate system 343
9 Single currency (euro) 343
9.1 Advantages of single currency 344
9.2 Disadvantages of single currency 345
9.3 Developments in the eurozone 346
9.4 The ‘Growth and Stability Pact’ 346
10 Balance of payments 347
10.1 Current account 347
10.2 Capital account 348
10.3 Financial account 348
10.4 Balancing item 348
11 Oil prices and the global economy 348
Key points 350
Further reading 351
Web references 351
Progress and review questions 352
Chapter 15 Unemployment and inflation 358
Learning objectives 358
1 Introduction 358
2 Aggregate demand and aggregate supply analysis 358
2.1 Aggregate demand schedule 359
2.2 Aggregate supply schedule 360
2.3 AD/AS and equilibrium national output 362
3 Unemployment and its characteristics 363

3.1 Definition of unemployment 363
3.2 Measuring unemployment 363
3.3 The costs of unemployment 364
3.4 The characteristics of unemployment 364
4 The causes and remedies of unemployment 366
4.1 Frictional unemployment 366

xiv CONTENTS
4.2 Structural unemployment 367
4.3 Demand deficient unemployment 367
4.4 Real wage unemployment 368
4.5 Regional unemployment 370
4.6 Technological unemployment 371
4.7 Natural rate of unemployment (NRU) 372
4.8 Unemployment and supply-side policies 373
5 Inflation 373
5.1 The Retail Price Index (RPI) 374
5.2 RPIX 375
5.3 RPIY 375
5.4 Consumer Price Index (CPI) 376
6 The effects of inflation 376
6.1 Perfectly anticipated inflation 376
6.2 Unanticipated inflation 376
7 Economic theory and inflation 379
7.1 The quantity theory of money 379
7.2 The Phillips curve and inflation 379
7.3 The expectations-augmented Phillips curve 381
8 Aggregate demand, aggregate supply and inflation 382
8.1 Demand-pull inflation 382
8.2 Cost-push inflation 383

9 Counter-inflationary policies 385
9.1 Fiscal policy 385
9.2 Monetary policy 385
9.3 Prices and incomes policy 385
9.4 Supply-side policies 385
Key points 386
Further reading 387
Web references 387
Progress and review questions 388
Chapter 16 International trade, international
institutions and globalisation
392
Learning objectives 392
1 Introduction 392
2 The gains from trade 393
2.1 Why trade internationally? 393
2.2 Absolute advantage 393
2.3 Comparative advantage 394
2.4 Comparative advantage and opportunity cost 395
2.5 Limitations of the theory of comparative advantage 396
2.6 National competitive advantage 397
3 The terms of trade 399
4 Free trade and economic welfare 399
5 Protectionism 400
5.1 Tariffs 400
5.2 Quotas 402
5.3 Exchange controls 402

CONTENTS xv
5.4 Subsidies 402

5.5 Administrative barriers 402
5.6 Voluntary export restraints 402
5.7 Arguments for protection 402
5.8 Arguments against protection 403
6 International framework for trade 404
6.1 General Agreement on Tariffs and Trade (GATT) 404
6.2 World Trade Organisation (WTO) 405
7 Regional trading arrangements (RTAs) 407
7.1 Types of regional trading agreements 407
8 Globalisation 408
8.1 Characteristics of globalisation 409
8.2 Indicators of globalisation 411
8.3 Globalisation and the value chain 414
8.4 Relative unit labour costs (RULCs) 414
Key points 416
Further reading 416
Web references 416
Progress and review questions 417
Chapter 17 Economic integration and
the European Union
422
Learning objectives 422
1 Introduction 422
2 Customs unions: trade creation and trade diversion 423
3 Origins of the EU 425
3.1 Single European Act (SEA) 426
3.2 Maastricht Treaty 426
4 EU laws and regulations 426
4.1 European Commission (EC) 428
4.2 European Parliament (EP) 428

4.3 European Court of Justice (ECJ) 429
4.4 Council of Ministers 429
4.5 European Council 429
5 Characteristics of the EU 431
5.1 Country-specific data on the original EU 15 431
5.2 EU enlargement 431
6 EU Common Agricultural Policy (CAP) 431
7 Common Fisheries Policy 434
8 EU industrial policy 436
9 EU Social Chapter 438
9.1 Main directives of the Social Chapter 439
9.2 Economic analysis of the Social Chapter 440
9.3 Failures of the competitive labour-market process 443
10 EU competition policy 443
10.1 Cross-border mergers policy 444
10.2 New EU cross-border merger regulations 445
10.3 Restrictive practices and EU legislation 445
10.4 EU competition policy and economic efficiency 447

xvi CONTENTS
Key points 448
Further reading 449
Web references 449
Progress and review questions 450
Chapter 18 Growth, sustainable development and
the less developed countries
454
Learning objectives 454
1 Introduction 454
2 Theories of economic growth 455

2.1 Classical growth theory 455
2.2 Neo-classical growth theory 456
2.3 Modern growth theories 459
3 Sustainable development 459
3.1 Characteristics of sustainable development 459
3.2 Key conditions for sustainable development 461
3.3 Measuring sustainable development 463
3.4 Technical change and sustainability 465
4 GNP data, developed and developing countries 466
4.1 Human Development Index (HDI) classification 467
5 Major features of LDCs 469
6 International Development Targets 473
7 Urbanisation and developing economies 474
7.1 Impacts of urbanisation 474
7.2 Reasons for urbanisation 476
8 Aid, trade and development 476
8.1 Foreign aid and development 476
8.2 Trade and development 478
9 Debt and development 479
9.1 Reasons for LDC borrowing 479
9.2 Resolving the debt problem 480
10 The role of the IMF and World Bank 480
10.1 IMF ‘stabilisation programmes’ 480
10.2 World Bank ‘structural adjustment lending’ 481
10.3 Stabilisation 481
10.4 Structural adjustment 482
10.5 Criticisms of IMF action 482
Key points 483
Further reading 483
Web references 483

Progress and review questions 484
Answers to selected Mini Case Studies and Progress and
Review Questions 488
Index 528

This fourth edition of Economics is somewhat of a departure from the previous editions
in that it involves Stuart Wall as a co-author who has vast experience in terms of writing,
editing and publishing in the area of economics and business management. His involve-
ment in the revision of this book has substantially enhanced the final product.
As with the previous editions of this book, a key objective has been to introduce stu-
dents to the main concepts, theories and applications of economics in a clear and concise
manner. The fourth edition has been thoroughly updated with the addition of many new
features. The new features include the following:
● Learning objectives at the beginning of each chapter, which carefully identify what the
reader should learn from the particular chapter.
● Pause for thought boxes, to be found at strategic points throughout each chapter, to
stimulate thinking about issues under discussion. Responses to these can be found on
the website to accompany this book.
● Examples so that the reader can relate the concepts introduced to real world situations.
● Mini Case Studies and, on occasions, longer Case Studies based on up-to-date informa-
tion and events, with questions asked and responses available at the back of the book,
or on the student website, as indicated. As with the boxed Examples, the idea is to
emphasise the relevance of economics to the real world.
● Key points at the end of each chapter, which serve as a check to help the reader focus on
the main elements of the chapter.
● Progress and review questions at the end of each chapter, with answers and responses at
the end of the book, or on the student website, as indicated, so that the reader can
check on progress made.
● Key terms are to be found in the margins of each chapter, with the various economic
terms defined the first time they appear in the text.

The eighteen chapters are divided into two parts, microeconomic related chapters (2–10)
and macroeconomic related chapters (11–18), though it is readily acknowledged that this
distinction is sometimes rather arbitrary. The book is aimed primarily at those students
who are new to economics, taking the subject as part of a first year degree or degree
equivalent programme or on professional courses. The book may also be useful to the
more serious students engaged on A level economics and business studies courses.
There are certain topic areas which progress the subject beyond the level expected of
the non-specialist or introductory economist. These topics are identified in the few chap-
ters in which they occur and can be omitted without interfering with the flow of the book.
Whilst these topics are more advanced than is usually required, if you feel that you can
cope with them they are worth reading and will enhance your overall understanding of
the subject.
Preface

xviii PREFACE
Finally, every effort has been made to make the book as user-friendly as possible for
students who are new to economics. This is quite a responsibility but I sincerely hope that
you find the book both useful and interesting.
Stephen Ison
Nottingham
April 2006
Supporting resources
Visit www.pearsoned.co.uk/ison to find valuable online resources
Companion Website for students and instructors
● Answers to mini case studies throughout the chapters of the book
● Responses to the pause for thought boxes throughout the chapters of the book
● Answers to end of chapter progress and review questions
● Suggested outlines to essay questions
For instructors
● PowerPoint slides that can be downloaded and used for presentations

For more information please contact your local Pearson Education sales
representative or visit www.pearsoned.co.uk/ison

Our combined thanks go to Eleanor for many long hours in helping us put the
manuscript together. We would also like to thank our respective families for enduring
long periods of our working in front of the computer screen. For Stephen, this especially
involves Susanna, James, Naomi and Lydia, and for Stuart, Eleanor, Lizzy and Jonathan.
Our sincere thanks go to Alan Griffiths for much helpful support and content involv-
ing many chapters. Particular thanks also go to Carsten Zimmermann for contributing
Chapter 17 on Economic integration and the European Union.
We would also like to thank Rachel Byrne and Paula Harris for much helpful advice
and encouragement. Other thanks go to students undertaking economics as part of
undergraduate courses in Air Transport Management and Transport and Business
Management at Loughborough University who have used the book and made useful sug-
gestions which have been incorporated in this new edition.
Finally, our thanks go to the four anonymous reviewers who made a number of
insightful comments in terms of an early draft of the book. We found their contribution
to be most useful and it certainly enhanced the final version. Of course, any errors and
omissions are entirely our responsibility.
Stephen Ison and Stuart Wall
Acknowledgements

We are grateful to the following for permission to reproduce copyright material:
Financial Times for Mini Case Study 9.1; HMSO for an extract from The Government’s
White Paper on the Future of Air Transport (Cm 6046) published December 2003;
Pearson Education for extracts adapted from Economics for Business and Management
2005 by Griffiths and Wall.
In some cases we have been unable to trace the owners of copyright material and we would
appreciate any information that would enable us to do so.
Publisher Acknowledgements

The nature of economics
CHAPTER
1
Learning
objectives
By the end of this chapter you should be able to:
● Define what is meant by ‘economics’.
● Outline the ways in which an economist thinks.
● Understand the importance of graphs, diagrams and charts to the economist.
● Understand the nature of the economic problem.
● Outline what is meant by the production possibility frontier and show how useful
it is when analysing opportunity cost.
● Discuss the economic merits and weaknesses of the market economy.
● Outline the differences between a market economy and a planned economy.
● Define what is meant by ‘public goods’.
● Distinguish between positive and normative economics.
● Distinguish between microeconomics and macroeconomics.
1 INTRODUCTION
What determines the demand for a good or service? What happens to the demand for a
good if its price rises or falls? Why do firms supply goods? How can firms charge different
prices for the same good or service to different groups of customers? What causes unem-
ployment? What determines the wage level? What is the role of money in the economy?
What causes inflation? Is there a need for government intervention in the economy?
These are the types of questions economists are interested in and around which theories
have been developed in order to aid our understanding.
This chapter seeks to introduce a number of the basic concepts which you will find useful
as you progress through the book. The chapter introduces the way in which economists
think and the use they make of economic models. In addition, economists make extensive
use of graphs, diagrams, charts and tables, which are to be found throughout this book,

and are therefore introduced in this chapter. The economic problem of scarcity and
choice, which is central to economics, will also be covered in this chapter, together with
an explanation of the free market, which is the main mechanism by which resources are
allocated throughout the world. The use of a free market is an attempt by nations and the
global economy to address this central economic problem of scarcity and choice.

2 ECONOMICS
2
DEFINING ECONOMICS
There is no one definition of economics, although a useful starting point is the well estab-
lished definition provided by Lord Robbins as long ago as 1932. He defined economics as
‘the science which studies human behaviour as a relationship between ends and scarce means
which have alternative uses’. At first reading this may appear a difficult definition to
understand; however, if it is studied in more detail it can be seen to offer a useful insight.
We can dissect the definition as follows:
(a) Economics is a ‘social science’ in that it uses scientific methods to study human
behaviour.
(b) Human needs are unlimited whereas resources are in limited supply, hence the prob-
lem of scarcity.
(c) The resources can be put to alternative uses in order to meet certain ends, such as the
building of a power station or a new hospital. Since resources are scarce, choices have to be
made as to how resources are utilised.
2.1 The ways in which an economist thinks
Economics has its own ‘language’ which makes extensive use of selected words and which
you will encounter throughout this book, such as production possibility frontier, demand,
supply, elasticity, consumer surplus, the multiplier, comparative advantage and so on.
Economic models form an important part of the economists’ thinking. They represent
a simplification of the real world and often incorporate assumptions, making it easier
to understand how the world operates. For example, when international trade is studied
the economist may assume that there are only two countries, each of which produces

only two products. This is in fact the assumption that is made when studying the benefits
from trade in Chapter 16, and using such a ‘two-by-two’ model allows us to focus
our thoughts. However, the principles or ideas that apply in the ‘two-by-two’ model can
usually be generalised to many countries and many products, though mathematics may
be required to capture this more general relationship. Simple economic models will be
used all the way through this book and they often utilise diagrams in order to aid in our
understanding.
2.2 The use of tables and diagrams
Raw data refers to numbers and facts in their original form and which have not, as yet,
been treated in any way. One of the simplest ways to give meaning to raw data is to con-
struct a table in which some order or shape is given to the raw data. Such tables can often
be expressed in visual form as a diagram. Diagrams are used extensively in economics and
you will encounter them throughout this book. In order to think like an economist it is
important to understand and be able to interpret diagrams. For example, data giving the
demand for chocolate bars is presented in Table 1.1 and this can be represented in the
form of a diagram as in Figure 1.1.
Diagrams have a vertical and horizontal axis each representing a different variable. The
price of chocolate bars is measured on the vertical axis and the quantity demanded is
measured on the horizontal axis. Remember to express the unit for each variable, pence

CHAPTER 1 · THE NATURE OF ECONOMICS 3
for price and million bars for quantity. The quantity demanded also makes use of a time
period, here ‘per week’.
The dotted lines shown in the diagram are important, indicating specific parts of the
diagram you wish to emphasise. For example, point A indicates two pieces of informa-
tion, namely that at a price of 30 pence, 6 million chocolate bars will be demanded per
week. Point B represents a different price and quantity situation, namely that at a price of
20 pence, 8 million bars will be demanded per week.
It is worth noting that the relationship between price and quantity shown in Figure 1.1
is a negative or inverse relationship. This means that the two variables move in the

opposite direction, with a reduction in price leading to a rise in the quantity demanded,
and vice versa. If the relationship had been positive, then the two variables would have
moved in the same direction and the line would have sloped upwards from left to right.
Table 1.1 A demand schedule for chocolate bars
Price Quantity demanded
(pence per bar) (million bars per week)
012
10 10
20 8
30 6
40 4
50 2
60 0
Figure 1.1 The demand for chocolate bars with the price for chocolate bars
on the vertical axis and the quantity demanded (million bars demanded
per week) on the horizontal axis.

4 ECONOMICS
By simplifying the situation and dealing with only two variables, economists are
making use of the ‘other things equal’ (ceteris paribus in Latin) assumption. In practice,
economists are aware that many variables may influence, say, the demand for a particular
chocolate bar besides its price – for example the price of rival chocolate bars, the income
of the consumer, the amount of advertising, and so on. However, when economists draw
the demand curve for a chocolate bar, as in Figure 1.1, they are assuming that all these
other variables are unchanged as the price of this chocolate bar rises or falls. Whilst this is
an oversimplification of reality, it does allow economists to concentrate on important
relationships between two variables.
2.3 The economic problem
Economics studies the allocation, distribution and utilisation of resources to meet human
needs. A central element in the economic problem, then, is the allocation of scarce

resources among alternative uses. Resources (human, physical and financial) are limited in
supply while human needs and desires are infinite. These needs are usually called ‘wants’.
Some of the wants are necessities such as basic food, clothing and housing but there are
also desires for other items such as CD players, DVD players or even a night at the opera.
Probably at the level of the individual and certainly for humankind as a whole, human
wants are unlimited. If you think about your own situation, some of the goods and services
you require you will be able to obtain with the scarce resources, i.e. income, available to
you. There are likely, however, to be other items you would like to have but are unable to
obtain because of limited resources. The same economic problem faces all individuals,
organisations and societies – unlimited wants, limited resources.
The resources an economy has at its disposal are used to satisfy the unlimited wants.
These are often termed by economists inputs or factors of production. They are the means
of producing the goods and services society requires to meet human needs and can norm-
ally be divided into three main categories:
a) Land, the natural resource
b) Labour, the human resource
c) Capital, the physical resource.
The factors of production will be dealt with in more detail in Chapter 5: Section 4.
Since the resources are limited in supply (i.e. scarce) and there is the existence
of unlimited wants, choices have to be made – choices involving the allocation of scarce
resources among alternative uses to achieve given ends. Economics is also concerned
with the distribution of resources between different groups in society. So, in addition to
the problem of what gets produced (allocation), there is the problem of who gets what
!
Pause for thought 1
Can you find the equation for the straight line in Figure 1.1? Why do economists make
use of diagrams?
The information presented in Table 1.1 and Figure 1.1 could have been presented
mathematically, given by the equation of a straight line. This is beyond the scope of this
book but you may like to consider what the equation for the demand curve would be

given the above information.
Economic problem
Relates to the
allocation of scarce
resources among
alternative uses.
Choices have to be
made as to how the
scarce resources are
allocated among the
different ends,
resulting in
‘opportunity costs’.
Factors of
production
The inputs used
by an economy in
the production of
goods and services.
They comprise land,
labour, capital and
entrepreneurial
ability (in some
definitions).