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IAI CB1 practice questions

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Question 1Economic models and the economic problem

The economic problem of scarcity arises because:

  1. resources are unlimited while wants are limited
  2. governments choose to ration goods rather than let markets allocate them
  3. production always creates more wants than it can satisfy
  4. wants are unlimited while the resources available to satisfy them are limited Correct answer.

Explanation

Scarcity is the fundamental economic problem: human wants are effectively unlimited, while the resources available to satisfy them are finite. Because resources are limited, every society must choose what, how and for whom to produce. Rationing and advertising are responses to scarcity, not its cause.

Question 2Economic models and the economic problem

A student turns down a paid internship in order to study full time. In economic analysis, the opportunity cost of studying is best described as:

  1. the value of the next best alternative that is forgone Correct answer.
  2. the benefit gained from the option actually chosen
  3. the total money spent on the chosen option
  4. the sum of all alternatives that were available

Explanation

Opportunity cost is the value of the next best alternative forgone when a decision is taken. It is not the money spent on the chosen option, which is an accounting cost, nor the sum of every alternative. Only the best alternative given up is counted.

Question 3Economic models and the economic problem

An economy is operating at a point strictly inside its production possibility frontier. This indicates that:

  1. the economy is producing beyond its productive capacity
  2. resources are being used inefficiently, for example because of unemployment Correct answer.
  3. the opportunity cost of both goods has fallen to zero
  4. the combination of goods is unattainable with current resources

Explanation

Any point on the production possibility frontier is productively efficient given current resources and technology. A point inside the frontier means some resources are idle or misallocated, so more of one good could be produced without less of the other. Points beyond the frontier are unattainable.

Question 4Economic models and the economic problem

In building an economic model, the ceteris paribus assumption means that:

  1. only variables under study vary while other influences are held constant Correct answer.
  2. the model must be tested against every possible real-world outcome
  3. economic agents are assumed to behave irrationally
  4. all variables in the model change simultaneously

Explanation

Ceteris paribus, meaning 'other things equal', isolates the effect of one variable by holding other influences constant. This allows a model to predict how a change in, say, price affects quantity demanded without confounding factors. It is a modelling device, not a claim that nothing else ever changes.

Question 5Economic models and the economic problem

Which of the following statements is a normative economic statement?

  1. Unemployment in the economy rose to 7% last year.
  2. A tariff on imports raises the domestic price of the imported good.
  3. The government ought to raise the minimum wage to reduce poverty. Correct answer.
  4. A rise in the price of a good normally reduces the quantity demanded.

Explanation

A normative statement expresses a value judgement about what ought to be and cannot be settled by evidence alone. Statements about what is, such as observed prices or unemployment rates, are positive statements that can in principle be tested. The minimum wage recommendation depends on ethical and political priorities.

Question 6Economic models and the economic problem

In the circular flow of income model, an injection is best described as:

  1. income that households save rather than spend
  2. taxes collected by government from households and firms
  3. spending entering the flow from outside the household–firm loop, such as investment Correct answer.
  4. the portion of household income that is spent on domestically produced goods and services

Explanation

In the circular flow, injections add spending to the domestic economy from outside the household–firm loop; investment, government spending and exports are the standard examples. Saving, taxes and imports are leakages that withdraw spending. The distinction matters because injections and leakages together determine the equilibrium level of national income.

Question 7Economic models and the economic problem

A firm is deciding whether to produce one more unit. Economic reasoning suggests that it should compare:

  1. the price of the good with the average cost of all units produced
  2. the marginal revenue with the marginal cost of that unit Correct answer.
  3. average revenue with average cost
  4. total revenue with total cost

Explanation

Rational economic decisions are made at the margin, comparing the additional benefit of one more unit with its additional cost. If marginal revenue exceeds marginal cost, producing the extra unit adds to profit. Totals and averages can conceal this because they describe the whole output rather than the next unit.

Question 8Economic models and the economic problem

A production possibility frontier drawn concave to the origin reflects:

  1. decreasing opportunity cost because specialisation always improves efficiency
  2. zero opportunity cost at full employment
  3. constant opportunity cost, because all resources are equally suited to producing both goods
  4. increasing opportunity cost, since resources are not equally suited to both goods Correct answer.

Explanation

A concave PPF arises when resources are not perfectly transferable between goods, so successive units of one good cost increasingly more of the other. Constant opportunity cost would give a straight-line frontier, while a convex-to-origin shape would imply decreasing cost. Increasing cost reflects diminishing returns as less suitable resources are diverted.

Question 9Economic models and the economic problem

A key feature that distinguishes an economic model from a description of reality is that a model:

  1. is judged only by how realistic its assumptions are
  2. reproduces every detail of the economy it represents
  3. cannot be used to make predictions about the real world
  4. abstracts from reality, selecting key relationships and simplifying the rest Correct answer.

Explanation

Economic models are deliberate abstractions that isolate the relationships relevant to a question and ignore incidental detail. Assumptions such as perfect information need not be literally true; models are judged mainly by whether their predictions are useful. A model that tried to reproduce every detail would be intractable.

Question 10Economic models and the economic problem

An economy can produce either 100 units of food or 50 units of clothing with its resources, and its production possibility frontier is a straight line. The opportunity cost of one unit of clothing is:

  1. 2 units of food Correct answer.
  2. 50 units of food
  3. 1 unit of food
  4. 0.5 units of food

Explanation

With a linear PPF, the opportunity cost of one good is constant and equals the slope of the frontier. Giving up all 50 units of clothing releases enough resources to produce 100 units of food, so each unit of clothing forgone is worth 100/50 = 2 units of food. The cost of one unit of food is therefore half a unit of clothing.

Question 11Economic models and the economic problem

In economics, the factor of production that earns rent as its reward is:

  1. labour
  2. capital
  3. land Correct answer.
  4. entrepreneurship

Explanation

Land is the factor of production comprising natural resources, and its reward is rent. Labour receives wages, capital receives interest, and entrepreneurship receives profit. These factor incomes are distinct in the standard classification.

Question 12Economic models and the economic problem

Which of the following statements about a positive economic statement is correct?

  1. It is always concerned with the behaviour of individual firms.
  2. It cannot be contradicted by data.
  3. It can be tested against evidence. Correct answer.
  4. It expresses a value judgement about what ought to be.

Explanation

A positive statement is an assertion about what is, and it can be tested against evidence. By contrast, a normative statement expresses a value judgement about what ought to be. Positive statements are not restricted to microeconomics and can be refuted by data.

Question 13Economic models and the economic problem

The three fundamental questions that every economy must answer are:

  1. when to produce, where to produce and why to produce
  2. what to produce, how to produce and for whom to produce Correct answer.
  3. how much to save, how much to invest and how much to tax
  4. who owns resources, who works and who consumes

Explanation

Every economy must decide what goods and services to produce, how to produce them, and how output is distributed among people. These are the three fundamental allocation questions. The other options describe policy choices or ownership arrangements rather than the core questions.

Question 14Economic models and the economic problem

A production possibility frontier for two goods shifts outward if:

  1. the price of one good rises relative to the other
  2. there is an increase in the quantity or quality of productive resources Correct answer.
  3. consumers change their preferences between the two goods
  4. the economy moves from an inefficient point to an efficient point

Explanation

An outward shift of the production possibility frontier represents economic growth, caused by more or better productive resources or improved technology. A change in preferences alters the chosen point on the frontier, not the frontier itself. Moving from inefficiency to efficiency uses existing capacity and price changes do not shift the frontier.

Question 15Economic models and the economic problem

Which item is a leakage from the circular flow of income?

  1. investment by firms
  2. export sales by domestic firms
  3. government spending on infrastructure
  4. saving by households Correct answer.

Explanation

In the circular flow of income, saving, taxation and imports are withdrawals or leakages because they remove spending from the domestic flow. Government spending, exports and investment are injections that add to the flow. Saving by households is therefore the leakage among these options.

Question 16Economic models and the economic problem

In a pure command economy, the allocation of resources is determined mainly by:

  1. the independent decisions of private firms
  2. central planning by government agencies Correct answer.
  3. consumer sovereignty expressed through demand
  4. the price mechanism operating in free markets

Explanation

In a pure command economy, the state owns most resources and central planners set output targets and prices. The price mechanism and independent private decisions are features of a market economy. Consumer sovereignty is also associated with market allocation rather than central planning.

Question 17Economic models and the economic problem

A firm has already spent £50,000 on market research for a new product. The research cannot be recovered. When deciding whether to launch the product, the firm should:

  1. include the £50,000 as a cost of the launch because it was incurred
  2. abandon the launch because the research was expensive
  3. ignore the £50,000 because it is a sunk cost Correct answer.
  4. treat the £50,000 as the opportunity cost of launching

Explanation

A sunk cost has already been incurred and cannot be recovered, so it should not affect a forward-looking decision. The firm should compare the additional costs of launching with the additional revenues expected. The original £50,000 is irrelevant to that marginal comparison.

Question 18Economic models and the economic problem

A production possibility frontier drawn as a straight line implies that:

  1. the economy cannot achieve full employment
  2. one good can be produced without sacrificing the other
  3. resources are perfectly adaptable between the two goods and opportunity cost is constant Correct answer.
  4. opportunity cost increases as more of either good is produced

Explanation

A straight-line production possibility frontier has a constant slope, meaning that each additional unit of one good costs the same amount of the other good. This implies resources are equally suited to producing either good. A concave frontier, by contrast, reflects increasing opportunity cost.

Question 19Economic models and the economic problem

The fallacy of composition is best illustrated by which statement?

  1. If one firm lowers its price, it may gain market share; if all firms lower prices, the market shares of firms may be unchanged. Correct answer.
  2. An increase in government spending raises aggregate demand in the short run.
  3. A rise in the price of a good reduces the quantity demanded, other things equal.
  4. A fall in the exchange rate makes exports cheaper in foreign currency.

Explanation

The fallacy of composition assumes that what is true for one individual or firm must be true for the whole group. If one firm cuts its price it may gain market share, but if all firms cut prices their relative shares may not change. The other statements are standard economic propositions rather than fallacies of composition.

Question 20Economic models and the economic problem

An economy that devotes more resources to producing capital goods rather than consumer goods today is most likely to:

  1. experience a movement along its current production possibility frontier toward consumer goods
  2. increase current consumption at the expense of future growth
  3. shift its production possibility frontier outward in the future Correct answer.
  4. reduce its future production capacity because capital goods are not consumed

Explanation

Capital goods are used to produce other goods and can raise an economy's productive capacity over time. Devoting more resources to capital goods means sacrificing current consumer goods but shifts the production possibility frontier outward in the future. This is the basic growth trade-off.

Question 21Economic models and the economic problem

Which of the following is a stock concept rather than a flow concept?

  1. Government expenditure
  2. National wealth Correct answer.
  3. National income
  4. Investment spending

Explanation

A stock is measured at a single point in time, whereas a flow is measured over an interval. National wealth is a balance at a date; the other entries record activity over a period.

Question 22Economic models and the economic problem

In an economic model, a variable whose value is determined within the model is called:

  1. autonomous
  2. exogenous
  3. endogenous Correct answer.
  4. nominal

Explanation

Endogenous variables are explained by the model's equations, while exogenous variables are set outside it. The terms nominal and autonomous do not describe whether a variable is internally determined.

Question 23Economic models and the economic problem

A mixed economy is best characterized by which statement?

  1. A central planning authority allocates all resources.
  2. Markets and government both allocate resources. Correct answer.
  3. Private markets alone allocate all resources.
  4. Custom and tradition alone allocate all resources.

Explanation

A mixed economy combines market allocation with government intervention. Pure command, pure market and traditional systems are the alternatives, so combining both is the defining feature.

Question 24Economic models and the economic problem

Which event would shift an economy's production possibility frontier inward?

  1. Large new deposits of raw materials are discovered within the country.
  2. The labour force expands substantially because of increased immigration.
  3. A war destroys a large part of the country's capital stock. Correct answer.
  4. A new technology raises productivity in both industries at the same time.

Explanation

The production possibility frontier shifts inward when an economy's productive capacity falls. Destruction of capital reduces the ability to produce both goods, whereas the other events increase capacity.

Question 25Economic models and the economic problem

In the circular flow of income, if planned injections exceed planned leakages at the current level of income, the equilibrium level of income will:

  1. rise Correct answer.
  2. become zero
  3. fall
  4. remain unchanged

Explanation

When injections exceed leakages, spending entering the circular flow is greater than income withdrawn from it, so output and income expand. The expansion continues until leakages rise enough to equal injections.

Question 26Economic models and the economic problem

The law of diminishing marginal returns states that, in the short run, as more units of a variable factor are added to a fixed factor:

  1. Marginal product always increases as the variable input rises.
  2. Average fixed cost eventually rises as output expands.
  3. Marginal product eventually declines. Correct answer.
  4. Total output eventually falls as the variable input increases.

Explanation

The law concerns the short-run response to adding a variable factor to a fixed factor. Beyond some point, each extra unit adds less to total output, so marginal product falls.

Question 27Economic models and the economic problem

A combination of two goods located on a production possibility frontier is:

  1. equitable for society
  2. allocatively efficient but not necessarily productively efficient
  3. productively efficient Correct answer.
  4. unattainable with current resources

Explanation

A point on the frontier uses all resources fully and efficiently, so more of one good requires less of the other. Allocative efficiency depends on whether the combination matches consumer preferences, which the frontier alone does not show.

Question 28Economic models and the economic problem

In a free-market economy, the price mechanism primarily:

  1. guarantees that incomes are distributed equally among all households
  2. conveys information and creates incentives Correct answer.
  3. sets detailed production targets for private firms
  4. eliminates the fundamental problem of scarcity in the economy

Explanation

Prices act as signals: they summarise scarcity and relative demand, and they reward producers who respond. They do not remove scarcity or guarantee equity.

Question 29Economic models and the economic problem

An economy's production possibility frontier is a straight line between 60 units of X and 30 units of Y. The opportunity cost of producing 10 units of Y is:

  1. 5 units of X
  2. 20 units of X Correct answer.
  3. 30 units of X
  4. 10 units of X

Explanation

With a straight-line frontier the trade-off is constant: 30 units of Y cost 60 units of X, so each unit of Y costs 2 units of X. Ten units of Y therefore cost 20 units of X.

Question 30Economic models and the economic problem

A model assumes that all consumers have perfect information. A critic says this is unrealistic. The standard economic defence is that:

  1. a model is judged by the usefulness of its predictions, not by the literal realism of its assumptions Correct answer.
  2. an assumption must be a fully accurate description of reality before the model can be used for prediction
  3. unrealistic assumptions make a model normative rather than positive in its conclusions
  4. models that assume perfect information cannot produce a determinate equilibrium outcome

Explanation

Economic models are tools for prediction and explanation, and assumptions are simplifying devices. A model can be useful even when its assumptions are not literally true, provided its predictions perform well.

Question 31Economic models and the economic problem

The fundamental economic problem of scarcity arises because:

  1. Some countries have fewer natural resources than others.
  2. Human wants are unlimited while the resources available to satisfy them are limited. Correct answer.
  3. Governments always choose to ration goods and services.
  4. Firms lack the information needed to produce the goods consumers want.

Explanation

Scarcity is a universal condition: wants are effectively unlimited, but land, labour, capital and enterprise are finite. It is not caused by government rationing or by a particular country's resource endowment. Because resources are limited, choices must be made about what to produce.

Question 32Economic models and the economic problem

Which of the following is a normative economic statement?

  1. An increase in the minimum wage may raise unemployment among young workers.
  2. The government should raise the minimum wage to reduce poverty. Correct answer.
  3. The minimum wage in the UK is set by the government.
  4. A higher minimum wage increases the hourly pay of covered workers.

Explanation

Normative statements express value judgements about what ought to be and cannot be tested solely by evidence. The other statements are positive claims that can in principle be checked against data. The word "should" signals the normative judgement here.

Question 33Economic models and the economic problem

In economic model building, the ceteris paribus assumption means that:

  1. All variables in the model change together.
  2. Other relevant factors are held constant while one variable changes. Correct answer.
  3. The model must include every feature of the real world.
  4. Predictions are made without any theoretical framework.

Explanation

Ceteris paribus, Latin for "other things equal", allows economists to isolate the effect of a single variable. By holding other influences constant, the model can show a clearer cause-and-effect relationship. It is a simplifying device, not a claim that nothing else ever changes.

Question 34Economic models and the economic problem

Economists deliberately use simplifying assumptions when constructing models mainly in order to:

  1. Make the model's predictions impossible to test.
  2. Remove the need for empirical evidence.
  3. Isolate the key relationships they wish to analyse. Correct answer.
  4. Ensure the model describes every detail of reality.

Explanation

Abstraction strips away secondary detail so the model can focus on the variables of interest. Good models are judged by their predictive usefulness, not by whether their assumptions are literally realistic. Simplification makes complex economic behaviour tractable.

Question 35Economic models and the economic problem

In the classification of factors of production, the reward for capital is:

  1. Wages
  2. Rent
  3. Profit
  4. Interest Correct answer.

Explanation

The four factors and their rewards are land–rent, labour–wages, capital–interest and enterprise–profit. Capital refers to produced means of production such as machinery. Interest is the return to the owners of capital for supplying it.

Question 36Economic models and the economic problem

Specialisation and division of labour tend to raise output per worker mainly because:

  1. Each worker produces the complete final good from start to finish.
  2. The total amount of capital in the economy automatically increases.
  3. Workers become more proficient at repetitive tasks and save time switching between tasks. Correct answer.
  4. Governments are required to coordinate every production decision.

Explanation

Dividing production into narrow tasks allows workers to build skill and avoid lost time moving between jobs. It also makes mechanisation easier. The result is higher productivity, though it can bring monotony and interdependence.

Question 37Economic models and the economic problem

Microeconomics is best distinguished from macroeconomics by its focus on:

  1. Only government policy decisions.
  2. Historical rather than contemporary data.
  3. The economy as a whole and aggregate variables.
  4. Individual decision-making units and specific markets. Correct answer.

Explanation

Microeconomics studies households, firms and individual markets, while macroeconomics studies economy-wide aggregates such as inflation and unemployment. The distinction is one of level of aggregation, not of policy versus non-policy.

Question 38Economic models and the economic problem

Which best describes an economic good?

  1. A good that is available in unlimited quantities at zero price.
  2. A good that has no opportunity cost because it is useful.
  3. A good that is produced only by the public sector.
  4. A good that is scarce and therefore requires a sacrifice to obtain. Correct answer.

Explanation

An economic good is scarce relative to demand, so obtaining it uses resources that could have been used elsewhere. A free good, by contrast, is non-scarce at zero price. Usefulness alone does not make a good economic.

Question 39Economic models and the economic problem

A production possibility frontier that is bowed outward from the origin indicates that:

  1. The opportunity cost of producing more of one good rises as more resources are transferred to it. Correct answer.
  2. The economy can produce unlimited quantities of both goods.
  3. Opportunity cost is constant as production switches between the two goods.
  4. Resources are perfectly interchangeable between the two goods.

Explanation

A bowed-out PPF reflects increasing opportunity cost. As production of one good expands, resources less suited to it must be used, so each extra unit costs more of the other good. A straight-line PPF would imply constant opportunity cost.

Question 40Economic models and the economic problem

When an economic model assumes that consumers maximise utility subject to a budget constraint, the model is applying:

  1. The ceteris paribus assumption only.
  2. The fallacy of composition.
  3. The concept of the rational economic agent. Correct answer.
  4. A normative judgement about fairness.

Explanation

The rational-agent assumption treats decision-makers as choosing the best outcome they can afford given their constraints. Utility maximisation subject to a budget is a standard behavioural assumption in microeconomic models. It is a positive modelling device, not a statement that people are always fair or fully informed.

Question 41Microeconomics: consumer and firm behaviour

In consumer theory, marginal utility is best defined as:

  1. total utility divided by quantity consumed
  2. total satisfaction from all units consumed
  3. extra utility from one more unit Correct answer.
  4. satisfaction from the first unit consumed

Explanation

Marginal utility measures the change in total satisfaction caused by consuming one more unit of a good, holding other consumption constant. It is an incremental concept, distinct from total utility, which sums the satisfaction from all units consumed.

Question 42Microeconomics: consumer and firm behaviour

For a budget line showing goods X and Y, with quantity of X on the horizontal axis, the slope of the line equals:

  1. income divided by Px
  2. Px divided by Py
  3. minus Py divided by Px
  4. minus Px divided by Py Correct answer.

Explanation

The budget line is Px·X + Py·Y = income, so rearranging gives Y = income/Py − (Px/Py)X. The slope is therefore −Px/Py, showing how many units of Y must be given up for one more unit of X.

Question 43Microeconomics: consumer and firm behaviour

Consumer surplus is best described as:

  1. the total amount consumers pay for a good
  2. the cost of producing the last unit sold
  3. the welfare loss caused by a price increase
  4. willingness to pay minus the price paid Correct answer.

Explanation

Consumer surplus is the area below the demand curve and above the market price up to the quantity purchased. It measures the benefit consumers receive because they pay less than their maximum willingness to pay.

Question 44Microeconomics: consumer and firm behaviour

A consumer's indifference curves for two goods are typically convex to the origin because:

  1. the consumer prefers more of both goods to less
  2. the marginal rate of substitution diminishes Correct answer.
  3. the marginal rate of substitution is constant along the curve
  4. the budget line is downward sloping

Explanation

Convexity reflects a diminishing marginal rate of substitution: as the consumer obtains more of one good, they are willing to give up less of the other good for an additional unit. This follows from diminishing marginal utility and produces the curved shape.

Question 45Microeconomics: consumer and firm behaviour

For a normal good, a fall in its price causes quantity demanded to rise because:

  1. the substitution effect increases quantity but the income effect reduces it
  2. the income effect increases quantity but the substitution effect reduces it
  3. neither the substitution nor the income effect changes quantity
  4. the substitution effect and income effect both increase quantity Correct answer.

Explanation

When the price of a normal good falls, it becomes cheaper relative to other goods, so the substitution effect raises quantity demanded. The fall also raises real income, and for a normal good the income effect reinforces the increase in quantity.

Question 46Microeconomics: consumer and firm behaviour

In the short run, the law of diminishing marginal returns implies that as more of a variable input is added to a fixed input:

  1. total output always falls as inputs rise
  2. average product is always rising
  3. marginal product eventually falls Correct answer.
  4. fixed cost rises with output

Explanation

The law of diminishing marginal returns states that, with at least one input fixed, the marginal product of the variable input eventually declines as more of it is employed. Total output can still rise, but at a decreasing rate after the inflection point.

Question 47Microeconomics: consumer and firm behaviour

The marginal cost curve crosses the average variable cost curve:

  1. only when average variable cost is rising
  2. at the minimum of average fixed cost
  3. at the minimum of average variable cost Correct answer.
  4. at the minimum of marginal cost

Explanation

Marginal cost pulls average variable cost toward itself: when MC is below AVC, AVC falls; when MC is above AVC, AVC rises. Therefore MC must cross AVC at the minimum point of the AVC curve.

Question 48Microeconomics: consumer and firm behaviour

A profit-maximizing firm that sells its output in a perfectly competitive market should produce the quantity at which:

  1. price equals average total cost
  2. marginal revenue equals average revenue
  3. total revenue is maximized
  4. marginal cost equals marginal revenue Correct answer.

Explanation

Profit is maximized where marginal revenue equals marginal cost, provided price covers average variable cost in the short run. In perfect competition marginal revenue equals price, so the rule becomes price equals marginal cost.

Question 49Microeconomics: consumer and firm behaviour

Along a linear downward-sloping demand curve, at the midpoint price elasticity of demand is unit elastic. A small increase in price at that midpoint will:

  1. reduce quantity demanded to zero
  2. decrease total revenue
  3. increase total revenue
  4. leave total revenue unchanged Correct answer.

Explanation

With unit elasticity, the percentage fall in quantity demanded equals the percentage rise in price, so total revenue is approximately unchanged. Revenue rises with a price increase only when demand is inelastic, and falls when demand is elastic.

Question 50Microeconomics: consumer and firm behaviour

In the long run, a firm minimizing the cost of producing a given output with two inputs will choose the input combination where:

  1. average cost equals marginal cost
  2. the isoquant is tangent to the highest possible isocost line
  3. the marginal products of both inputs are equal
  4. MRTS equals the input price ratio Correct answer.

Explanation

Cost minimization for a given output occurs where the isoquant is tangent to the lowest attainable isocost line. At that tangency the marginal rate of technical substitution equals the ratio of input prices, which is equivalent to equalizing the marginal product per unit cost across inputs.