OxfordAQA International AS and A-level Economics: The economic problem and method (9640)

This guide covers section 3.1.1 (the economic problem and methodology) of the OxfordAQA International AS and A-level Economics (9640) specification, first teaching September 2020. Section 3.1 is International AS content, and 3.3 and 3.4 are the extra International A2 content. All five subsections of 3.1.1 are covered below. Every figure is invented, and every country, firm and market is fictional.

Related pages: course hub, printable checklist, revision notes, practice questions, the operation of markets and the free diagnostics.

Outcomes at a glance

Reference	Skill
3.1.1.1	Explain the purpose of economic activity and the three key decisions; link welfare to distribution
3.1.1.2	Classify resources as land, labour, capital and enterprise; renewable and non-renewable; the environment as scarce
3.1.1.3	Scarcity, choice, opportunity cost; free market, mixed and centrally planned allocation
3.1.1.4	Use production possibility diagrams; productive versus allocative efficiency
3.1.1.5	Economics as a social science; positive and normative statements; value judgements

3.1.1.1 The nature and purpose of economic activity

Economic activity exists to produce the goods and services people need and want. Needs are what people require to live; wants have no obvious limit.

Every economy must answer three questions:

• What to produce: how many houses, how many phones, how much healthcare.
• How to produce: which mix of workers, machines and natural resources.
• Who benefits: how the output is shared out.

Worked example: how to produce. A workshop makes 100 units a day. Method A uses 8 workers and 1 machine. Method B uses 3 workers and 3 machines. A machine costs 60 a day.

• At a wage of 40: A costs 8 × 40 + 60 = 380, so 3.80 a unit. B costs 3 × 40 + 3 × 60 = 300, so 3.00 a unit. B is cheaper.
• At a wage of 20: A costs 220 and B costs 240. A is cheaper.
• The methods cost the same when 8w + 60 = 3w + 180, so 5w = 120 and w = 24.

The cost-minimising method depends on relative resource prices. Rising wages push firms towards capital-intensive methods.

Who benefits matters as much as how much. Economic welfare depends on distribution as well as total output. Country Green has five people who each receive 120, so total output is 600 and the mean is 120. Country Orange also produces 600, but its five people receive 400, 50, 50, 50 and 50. The mean is still 120, but the median is 50 and the richest person takes 400/600 = 66.7% of output. Equal averages hide very different living standards. Whether Orange’s distribution is acceptable is a value judgement (see 3.1.1.5).

3.1.1.2 Economic resources

Resources fall into four factors of production.

Factor	Meaning	Example
Land	All natural resources: soil, minerals, water, forests, fish stocks	A coal seam
Labour	The physical and mental effort of workers	A nurse’s working hours
Capital	Man-made goods used to make other goods	A delivery van
Enterprise	Organising the other factors and bearing risk	An owner who borrows to start a firm

Capital means physical capital, not money. A loan is finance; the van it buys is capital.

Renewable resources can regenerate within a human timescale (fish, timber, solar energy) provided they are not used faster than they regrow. Non-renewable resources (coal, oil, metal ores) have no meaningful regrowth. A woodland that grows 300 tonnes of timber a year and loses 450 tonnes to felling falls by 150 tonnes a year. A renewable resource used unsustainably behaves like a non-renewable one.

The environment is a scarce resource. Production draws on it as an input and returns waste to it, so production and consumption can damage it. Economic activity depends on the natural environment.

3.1.1.3 Scarcity, choice and the allocation of resources

Scarcity is the fundamental economic problem. It arises because resources are limited while wants are unlimited.

Scarcity forces choice. Every choice has an opportunity cost: the benefit of the best option you did not choose. Only that one option counts. Do not add up the others.

Worked example: opportunity cost in a workshop. A carpenter has 40 hours a week. A chair takes 4 hours and sells for 30. A table takes 10 hours and sells for 90.

• Maximum output is 40 ÷ 4 = 10 chairs or 40 ÷ 10 = 4 tables.
• One table costs 10 ÷ 4 = 2.5 chairs. Measured in money, 2.5 × 30 = 75 of chair sales is forgone.
• Per hour, chairs earn 30 ÷ 4 = 7.50 and tables earn 90 ÷ 10 = 9. Tables are the better use of time.

Worked example: the next best alternative. A bakery owner has 50,000. Options are: a new oven (extra profit 6,000 a year), a deposit paying 4% (50,000 × 0.04 = 2,000) or extra staff (4,500). The oven is chosen. The opportunity cost is 4,500 (the next best), not 6,500 (the sum of the other two).

Allocating resources

Societies use three broad systems.

System	How resources are allocated	Advantages	Disadvantages
Free market	Prices and profit signal where resources should go	Responds quickly to wants; competition rewards efficiency; little government cost	Ignores people without income; under-provides public goods; ignores spillover costs; may allow monopoly
Centrally planned	The state decides what, how and for whom	Can pursue social aims directly; can limit inequality; can direct resources to large projects	Information is hard to collect; weak incentives; shortages and surpluses; little consumer choice
Mixed	Markets for most goods, with government providing, taxing, subsidising and regulating	Combines market incentives with correction of failures	Government can fail too; the right balance is contested

The price mechanism as a chain. Demand for a good rises, so its price rises. Higher prices raise profit per unit, so firms expand and bid for more land, labour and capital. Resources move from lower-valued uses to higher-valued ones without anyone planning it. Governments affect the same allocation through taxes, subsidies, regulation and direct provision.

Evaluation. No real economy is purely market or purely planned. The useful question is the degree and form of intervention. A market allocates well only if prices reflect full costs and benefits, which they often do not.

3.1.1.4 Production possibility diagrams

A production possibility diagram (PPD, or production possibility frontier) plots the largest combinations of two goods that an economy can make when every resource is in full, efficient use and technology is fixed. The axes are the quantities of the two goods.

Worked example. Country A produces capital goods (K) and consumer goods (C).

Point	K	C	Extra C lost per extra unit of K
a	0	100
b	10	96	4 ÷ 10 = 0.4
c	20	88	8 ÷ 10 = 0.8
d	30	72	16 ÷ 10 = 1.6
e	40	40	32 ÷ 10 = 3.2

Reading the diagram:

• Points on the boundary use all resources efficiently. Each point is a different split of resources between the two goods, so moving along the curve shows a trade-off: more K means less C.
• Opportunity cost is the slope. Here it rises from 0.4 to 3.2 consumer goods per unit of K. The curve bows outwards because some resources are better at making one good than the other. The first units of K use the resources best suited to it, and later units pull in resources better suited to consumer goods. With perfectly adaptable resources the curve would be a straight line with constant opportunity cost.
• Points inside the curve show unemployment of resources or inefficient use. Take (K = 20, C = 60). The boundary at K = 20 is 88, so 60 is 60 ÷ 88 = 68.2% of what is possible, and 28 units of consumer goods are being wasted. Moving to (K = 30, C = 72) gives 12 more C and 10 more K at no opportunity cost.
• Points outside the curve are unattainable now. (K = 30, C = 90) cannot be reached because the boundary at K = 30 is 72.
• Economic growth is an outward shift of the whole boundary. If every output rises by 20%, the C intercept becomes 120 and point e moves to (K = 48, C = 48). The causes are more or better resources, or better technology.
• Trade-off over time. A country at point e gives up consumption today and will probably grow faster than one at point b.
• Shifts and movements. A movement along the curve is a change in the mix chosen. A shift is a change in capacity. A natural disaster that destroys capital shifts the curve inwards.

Productive and allocative efficiency. Every point on the boundary is productively efficient: no more of one good can be made without making less of the other. But not every point is allocatively efficient, which means producing the mix of goods that best matches society’s preferences. The diagram alone cannot tell you which point that is.

Worked example. Suppose society values an extra unit of K at 2.5 units of C. Moving from K = 20 to 30 costs 1.6 C per K, so it is worth doing (2.5 is greater than 1.6). Moving from 30 to 40 costs 3.2 C per K, so it is not worth doing (2.5 is less than 3.2). The allocatively efficient point is (K = 30, C = 72). Points a to e are all productively efficient, but only d is allocatively efficient here.

3.1.1.5 Economic methodology

Economics is a social science: it explains human behaviour using theory and evidence. It resembles natural science in building models, forming hypotheses and testing them against data. It differs because:

• people respond to being studied and change their behaviour;
• controlled experiments are rarely possible, so economists rely on observed data;
• many things change at once, making cause hard to isolate;
• values and politics shape the questions asked and the answers accepted.

Models and ceteris paribus. A model is a simplification that leaves out detail to isolate the main relationships. Ceteris paribus means all other things being equal. It lets you ask what one variable does while others are held constant.

Example. A rise in the price of bread of 10% would cut quantity demanded by about 6%, other things equal. If incomes rise at the same time and add about 7% to demand, the observed change is about +1%. The demand relationship has not failed; another factor moved. Models are judged by how well they explain and predict, not by realism in every detail.

Positive and normative statements. A positive statement is about what is, was or will be, and can be tested against evidence (it may still be false). A normative statement is a judgement about what ought to be, and cannot be settled by evidence alone.

Statement about fictional Country B	Type
A 10% tax on a drink cut its sales by 4%.	Positive (testable; true or false)
Unemployment is higher than it should be.	Normative (“should”)
Higher taxes will reduce saving.	Positive (a prediction that can be checked)
It is fair to tax the rich more.	Normative (“fair”)

Words such as should, fair or best usually signal normative statements. Split mixed statements into their positive and normative parts.

Value judgements and policy. Two people can agree on every fact and still disagree on policy. Choosing a tax or a spending plan involves positive consequences (who gains, who loses, by how much) and moral and political judgements (how to weigh efficiency against equality, or the present against the future). Economists add most by separating the two: show the evidence, then state the value judgement a conclusion depends on.

Common errors

• Defining opportunity cost as “the cost in money” or listing every alternative rather than naming the next best one.
• Saying points inside the boundary are “impossible”. They are possible but inefficient.
• Saying a point on the boundary is automatically allocatively efficient.
• Treating a positive statement as true by definition.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), section 3.1.1 (the economic problem and methodology), published by OxfordAQA. First teaching September 2020, first AS exams May/June 2021, first A-level exams May/June 2022.