Introduction to Economics

Videos on this page: Watch: Opportunity Cost and Scarcity · Watch: Supply and Demand

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What is Economics?

Economics is the study of how individuals, firms, and governments make decisions about allocating scarce resources to satisfy unlimited wants. The central challenge in all of economics flows from one inescapable fact: resources are finite, wants are not.

Scarcity and Choice

Scarcity means that there is never enough of every resource to satisfy all desired uses. Because of scarcity, every economic actor must choose. Every choice involves a trade-off: selecting one option means giving up another.

The concept that ties scarcity and choice together is opportunity cost — the value of the next best alternative forgone when a decision is made.

Factors of Production

Economists group all productive resources into four categories:

Factor	Definition	Return earned
Land	All natural resources (soil, minerals, water, climate)	Rent
Labour	Physical and mental effort of workers	Wages
Capital	Man-made resources used in production (machinery, buildings, tools)	Interest
Entrepreneurship	The organisational talent and risk-taking that combines the other factors	Profit

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Economic Systems

Because resources are scarce and choices must be made, every society must answer three fundamental questions:

1. What to produce?
2. How to produce it?
3. For whom is it produced?

Different economic systems answer these questions in different ways.

Free Market Economy

In a free market, prices are determined by the interaction of buyers and sellers through the price mechanism. Firms decide what to produce based on the profit motive; consumers signal their preferences through willingness to pay.

Advantages of the free market:

• Efficiency — resources flow toward uses where they generate the most value
• Consumer sovereignty — production responds to consumer preferences
• Innovation — competition and the profit motive incentivise firms to innovate
• Wide variety of goods and services

Disadvantages of the free market:

• Market failures — public goods are underprovided; negative externalities (pollution) are overproduced
• Inequality — income and wealth can become highly concentrated
• Monopoly power — dominant firms may exploit consumers
• Cyclical unemployment — no automatic mechanism prevents recessions

Command Economy

In a command (planned) economy, a central government authority decides what, how, and for whom to produce. All major firms are state-owned.

Advantages of the command economy:

• Can direct resources to social priorities (healthcare, education, defence)
• Can reduce inequality through redistribution
• Eliminates private monopoly exploitation

Disadvantages of the command economy:

• Information problem — no price system to signal scarcity, leading to shortages and surpluses
• Lack of incentives — workers and managers have little reason to innovate or improve productivity
• Bureaucracy and inefficiency
• Historical record of low living standards

Mixed Economy

Almost every real-world economy is a mixed economy — a combination of free-market and government intervention. The government provides public goods, regulates markets, and redistributes income through taxes and transfers, while private firms and consumers drive most economic activity.

Watch: Opportunity Cost and Scarcity

ACDCEcon (Jacob Clifford) · 7 min · Explains scarcity, opportunity cost, and the fundamental economic problem using clear, exam-ready language — the foundation for every IB Economics Paper 1 essay.

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The Production Possibilities Curve

The Production Possibilities Curve (PPC) — sometimes called the Production Possibilities Frontier (PPF) — is a diagram showing all possible combinations of two goods that an economy can produce when all resources are fully and efficiently employed.

Drawing the PPC

Axes: Each axis represents the quantity of one good. Label them clearly (e.g., “Consumer goods” on the vertical axis, “Capital goods” on the horizontal axis).

Shape: The standard PPC is concave to the origin (bowed outward). This shape reflects the law of increasing opportunity cost: as more of one good is produced, increasingly large amounts of the other must be sacrificed, because resources are not perfectly adaptable between uses.

Key points on the diagram:

• A point on the curve (e.g., point A) = productively efficient — all resources are fully employed
• A point inside the curve (e.g., point B) = inefficient — some resources are unemployed or misallocated (e.g., during a recession)
• A point outside the curve (e.g., point C) = currently unattainable with existing resources and technology

Consumer
goods
  |
  |  *A (on curve — efficient)
  |       *B (inside — inefficient)
  |
  |_________________ Capital goods
         *C is outside the curve — unattainable

Opportunity Cost on the PPC

Moving along the PPC illustrates opportunity cost directly. If the economy moves from point A (producing 80 consumer goods and 20 capital goods) to point D (producing 60 consumer goods and 40 capital goods), the opportunity cost of producing 20 more units of capital goods is 20 units of consumer goods.

Shifts in the PPC

A shift outward of the entire PPC represents economic growth — the economy can now produce more of both goods. Causes include:

• Discovery of new resources (e.g., new oil reserves)
• Improvement in technology
• Increase in the quantity of labour (population growth, immigration)
• Investment in physical capital
• Improvements in education and training (human capital)

A shift inward represents a decrease in productive capacity: natural disaster, war, emigration of skilled workers, depletion of resources.

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Demand

The Law of Demand

The law of demand states that, all other things being equal (ceteris paribus), when the price of a good rises, the quantity demanded falls; when the price falls, the quantity demanded rises.

This inverse relationship between price and quantity demanded is explained by two effects:

• Substitution effect: When a good becomes more expensive relative to substitutes, consumers switch to the cheaper alternatives.
• Income effect: When a good becomes more expensive, consumers’ real purchasing power falls, so they buy less.

The Demand Curve

The demand curve slopes downward from left to right. Plot price (P) on the vertical axis and quantity demanded (Qd) on the horizontal axis.

A movement along the demand curve occurs only when the price of the good itself changes. All other factors cause a shift of the demand curve.

Determinants of Demand (Shifts)

Use the mnemonic PIRATE to remember what shifts the demand curve:

Substitutes: Goods that can be used in place of each other (e.g., butter and margarine). If the price of butter rises, demand for margarine increases (demand curve shifts right).

Complements: Goods consumed together (e.g., cars and petrol). If the price of cars rises, demand for petrol decreases (demand curve shifts left).

Normal goods: When income rises, demand increases (positive income elasticity).

Inferior goods: When income rises, demand falls (negative income elasticity) — e.g., instant noodles, bus travel.

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Supply

The Law of Supply

The law of supply states that, ceteris paribus, when the price of a good rises, the quantity supplied increases; when the price falls, the quantity supplied decreases.

This direct (positive) relationship exists because higher prices make production more profitable, attracting more suppliers and encouraging existing suppliers to expand output.

The Supply Curve

The supply curve slopes upward from left to right. Price (P) is on the vertical axis; quantity supplied (Qs) is on the horizontal axis.

A movement along the supply curve occurs only when the price of the good changes. Everything else shifts the curve.

Determinants of Supply (Shifts)

Determinant	Effect on supply if it increases
Cost of inputs (wages, raw materials)	Decreases supply (curve shifts left)
Technology improvements	Increases supply (curve shifts right)
Number of sellers	Increases supply (curve shifts right)
Government subsidies	Increases supply (curve shifts right)
Indirect taxes (e.g., excise tax)	Decreases supply (curve shifts left)
Price of other goods the firm could produce	Decreases supply of this good if prices of alternatives rise
Expectations of future prices	May decrease current supply (firms hold back stock)

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Market Equilibrium

Equilibrium Price and Quantity

The equilibrium is the price at which the quantity demanded equals the quantity supplied. Graphically, it is the point where the demand and supply curves intersect.

• Equilibrium price (P):* the price at which the market clears — no shortage, no surplus
• Equilibrium quantity (Q):* the quantity bought and sold at the equilibrium price

Excess Supply and Excess Demand

Excess supply (surplus): When price is above equilibrium, Qs > Qd. Unsold inventory accumulates. Sellers reduce prices to clear stock. The market moves back toward equilibrium.

Excess demand (shortage): When price is below equilibrium, Qd > Qs. Consumers compete for the limited good. Prices are bid upward. The market moves back toward equilibrium.

How Markets Self-Correct: The Price Mechanism

The price mechanism (also called the invisible hand, following Adam Smith) automatically adjusts prices to eliminate shortages and surpluses, coordinating the decisions of millions of buyers and sellers without central direction.

Watch: Supply and Demand

ACDCEcon (Jacob Clifford) · 9 min · Walks through supply and demand curves, equilibrium, and what causes shifts — the most-tested diagram in IB Economics. Covers the exact material needed for Paper 1 Section A diagrams.

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Elasticity

Elasticity measures the responsiveness of one variable to a change in another. The four elasticities examined in IB Economics are PED, PES, YED, and XED.

Price Elasticity of Demand (PED)

Definition: PED measures the responsiveness of quantity demanded to a change in the price of the good itself.

$PED = \frac{\%\Delta Q_d}{\%\Delta P}$

Because demand curves slope downward, PED is always negative (price and quantity move in opposite directions). IB convention is to state PED as an absolute value or to acknowledge the negative sign explicitly.

Interpretation of values:

| Value of |PED| | Interpretation | |---|---| | Greater than 1 | Elastic demand — quantity changes more than proportionally to price | | Equal to 1 | Unit elastic | | Less than 1 | Inelastic demand — quantity changes less than proportionally | | Equal to 0 | Perfectly inelastic | | Infinity | Perfectly elastic |

Determinants of PED:

• Availability of substitutes: More substitutes = more elastic (consumers can switch easily)
• Proportion of income: Goods taking a large share of income tend to be more elastic
• Necessity vs. luxury: Necessities (insulin, bread) are inelastic; luxuries (holidays, jewellery) are elastic
• Time period: Demand becomes more elastic over time as consumers find alternatives
• Brand loyalty: Strong brand loyalty reduces elasticity

PED and Total Revenue (TR):

• Elastic demand (|PED| > 1): Price increase → TR decreases; price decrease → TR increases
• Inelastic demand (|PED| < 1): Price increase → TR increases; price decrease → TR decreases
• Unit elastic (|PED| = 1): Price changes have no effect on TR

Price Elasticity of Supply (PES)

Definition: PES measures the responsiveness of quantity supplied to a change in the price of the good.

$PES = \frac{\%\Delta Q_s}{\%\Delta P}$

PES is always positive (supply curves slope upward). Elastic supply (PES > 1) means producers can respond quickly to price changes. Inelastic supply (PES < 1) means they cannot.

Determinants of PES:

• Time period: Supply is more elastic in the long run (firms can build new capacity)
• Ability to store inventory: If goods can be stored (e.g., canned food), PES is more elastic
• Spare capacity: Firms with idle machines and workers can increase output quickly
• Ease of factor substitution: Can inputs be easily switched to produce this good?
• Agricultural goods generally have inelastic supply in the short run (growing season constraints)

Income Elasticity of Demand (YED)

Definition: YED measures the responsiveness of demand to a change in consumer income.

$YED = \frac{\%\Delta Q_d}{\%\Delta Y}$

where Y = income.

Sign of YED	Type of good
Positive (YED > 0)	Normal good — demand rises as income rises
Negative (YED < 0)	Inferior good — demand falls as income rises
YED > 1	Luxury good (income elastic normal good)
0 < YED < 1	Necessity (income inelastic normal good)

Significance: YED is important for firms forecasting how demand will change during economic booms and recessions, and for governments understanding how tax revenues will respond to economic growth.

Cross Elasticity of Demand (XED)

Definition: XED measures the responsiveness of demand for good A to a change in the price of good B.

$XED = \frac{\%\Delta Q_{dA}}{\%\Delta P_B}$

Sign of XED	Relationship between goods
Positive (XED > 0)	Substitutes (e.g., Coke and Pepsi)
Negative (XED < 0)	Complements (e.g., printers and ink cartridges)
Zero	Unrelated goods

Significance: XED helps firms assess competitive threats and plan pricing strategies.

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Government Intervention

Governments intervene in markets to correct market failures, redistribute income, and achieve social objectives. The main tools are price controls, indirect taxes, and subsidies.

Price Floors (Minimum Prices)

A price floor is a legally imposed minimum price, set above the equilibrium price. The most common example is the minimum wage in the labour market.

Effect:

• At the floor price, quantity supplied exceeds quantity demanded → excess supply (a surplus).
• In the labour market: workers want to work more hours than firms want to hire → unemployment.

Welfare analysis:

• Consumer surplus (CS) decreases — buyers pay a higher price.
• Producer surplus (PS) may increase (higher price) or decrease (lower quantity sold), depending on elasticities.
• Deadweight loss (DWL) arises — transactions that would have been mutually beneficial at equilibrium no longer take place.

Diagram requirements: Show D and S curves, original equilibrium, the floor price P_floor above equilibrium P*, the resulting quantity demanded Q_d and quantity supplied Q_s (with Q_s > Q_d), label the surplus (Q_s - Q_d), and the DWL triangle.

Price Ceilings (Maximum Prices)

A price ceiling is a legally imposed maximum price, set below the equilibrium price. The classic example is rent control.

Effect:

• At the ceiling price, quantity demanded exceeds quantity supplied → excess demand (a shortage).
• Housing shortages, queuing, black markets, and deteriorating quality can result.

Diagram requirements: Show D and S, original equilibrium, the ceiling P_ceiling below P*, resulting Q_d > Q_s, label the shortage, and the DWL triangle.

Indirect Taxes

An indirect tax (also called a specific tax or excise tax) is a per-unit tax placed on producers. It effectively increases the cost of production, shifting the supply curve to the left (upward by the amount of the tax).

Effect:

• Price paid by consumers rises (by less than the full tax if demand is elastic).
• Price received by producers falls.
• Quantity traded decreases.
• Tax incidence is shared between consumers and producers — the relative burden depends on the price elasticities of demand and supply.

Tax incidence rule:

• More inelastic demand → consumers bear more of the tax burden.
• More elastic demand → producers bear more of the tax burden.

Diagram requirements: Show the original S1 and new S2 (shifted left by the tax amount), new higher price P_consumer, lower price P_producer, the tax rectangle (shaded between P_consumer and P_producer), and the DWL triangle.

Subsidies

A subsidy is a payment by the government to producers, effectively reducing their costs. It shifts the supply curve to the right (downward by the subsidy amount).

Effect:

• Price paid by consumers falls.
• Price received by producers rises (they receive the market price plus the subsidy).
• Quantity traded increases.
• The government incurs a fiscal cost equal to the subsidy per unit multiplied by the quantity produced.

Rationale for subsidies:

• Encourage production of goods with positive externalities (e.g., education, public transport, vaccines)
• Support domestic industries (e.g., agriculture)
• Keep essential goods affordable for low-income consumers

Diagram requirements: Show S1 shifting right to S2, new lower price P_consumer, higher price P_producer (= P_consumer + subsidy), quantity increasing from Q1 to Q2, and the subsidy rectangle (= subsidy per unit x Q2).

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IB Paper 1 Essay Structure

IB Economics Paper 1 essays are marked out of 25 (part a: 10 marks; part b: 15 marks). Both sections require diagrams and two-sided analysis.

For “Explain” questions (part a):

1. Define key terms.
2. Draw a clearly labelled diagram.
3. Explain the mechanism (the sequence of cause and effect, using the diagram).
4. Give a real-world example.

For “Evaluate” questions (part b):

1. Define key terms and state your argument.
2. Draw a diagram supporting your main argument.
3. Develop the argument with theory and evidence.
4. Present a counter-argument with a second diagram if appropriate.
5. Conclude — make a balanced, supported judgement. Use phrases like “the extent to which… depends on…” and reference elasticity, time period, or context.

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Practice Questions

Short-answer (Paper 2 style):

1. Define scarcity and explain, using an example, why it necessitates choice. (4 marks)

2. Using a diagram, explain what happens to the market for electric vehicles if the government introduces a subsidy for EV manufacturers. (4 marks)

3. Calculate the PED for a good whose price falls from 20 dollars to 16 dollars and whose quantity demanded rises from 500 to 600 units. State whether demand is elastic or inelastic and explain one implication for total revenue. (4 marks)

Essay questions (Paper 1 style):

4. (a) Explain, using a diagram, how a price ceiling below the equilibrium price affects a market. (10 marks) (b) Evaluate the use of a price ceiling as a method of making housing affordable for low-income consumers. (15 marks)

5. (a) Explain the factors that determine the price elasticity of supply for agricultural products. (10 marks) (b) Evaluate the view that the price mechanism efficiently allocates resources in free markets. (15 marks)

Answer guidance — Question 3

$\%\Delta P = \frac{16-20}{20} \times 100 = -20\%$

$\%\Delta Q_d = \frac{600-500}{500} \times 100 = +20\%$

$PED = \frac{+20\%}{-20\%} = -1 \text{ (unit elastic)}$

With unit elastic demand, the TR test predicts revenue will barely change when price changes. Here TR falls from 10,000 dollars to 9,600 dollars (a 400 dollar drop) — a small movement that is consistent with unit elasticity. This happens because the simple percentage-change formula is an approximation: using the original values as the base, the percentage changes do not perfectly cancel. For IB exam purposes, a minor TR movement when |PED| ≈ 1 is within expected range and does not indicate a calculation error.

TR test and unit elasticity: The TR test states that when PED = −1, total revenue barely changes when price changes. In IB exam calculations, use whichever formula the question specifies and state your assumption clearly.

The implication is that a firm facing unit elastic demand gains no meaningful revenue advantage from changing price — any gain from a price increase is approximately offset by the proportional fall in quantity demanded.