1.1 Nature of Economics

Ceteris paribus

The assumption that whilst the effects of one variable are being considered, all other relevant variables are held constant

"All things held equal"

Economists vs scientists

Scientists can use experiments to prove/disprove theories, whereby all external variables are controlled

Economists cannot conduct experiments to prove/disprove theories, given that economic experiments are too large to test in a lab setting; moreover, economic variables are unpredictable and hard to control

Models

A representation of something real, often in a simplified or a small scale manner

Reliance on models

Economists use models to study economic behaviour and economic systems

Validating theories

Economists use calculations to validate theories, but they must also make assumptions when using simplified models, as economic systems are so complex, thus they are allowed to make predictions

Positive statements

A statement that can be supported or refuted by evidence

Value judgements

A statement based on your opinion or beliefs, rather than facts

Normative statements

A statement that cannot be supported or refuted by evidence, as it is a value judgement

The role of value judgements in economic decisions

When making economic decisions, economics agents may need to make value judgments because it is difficult to prove the outcome of an economic decision from facts only

The basic economic problem

There is an unlimited set of wants and needs, but there is a limited amount of resources

Renewable resources

Renewable resources can be replenished, hence the opportunity cost is lower

Non-renewable resources

Non-renewable resources cannot be replenished, thus it would eventually run-out

Opportunity cost

The value of the next best forgone alternative when making a choice

Factors of production

Land - natural physical resources (farmland), reward = rent

Labour - human input into production (workers), reward = wages

Capital - man-made inputs used in the production process (machinery), reward = interest

Enterprise - an individual who supplies a good or service (self-employed), reward = profit

Production possibility frontiers

Demonstrates the maximum possible output of two goods/services in any combination, assuming a fixed amount of starting resources

PPF as an economic model

The PPF is a model of production and the behaviour of PRODUCERS

It is also effectively a model of scarcity, hence it also demonstrates opportunity cost and choice

PPF's to depict maximum productivity

Points on the CURVED diagram indicate an economy operating at maximum productivity

Macroeconomic PPF

PPF's to depict opportunity cost

Opportunity cost increases as the line approaches the intercepts

Microeconomic diagram

PPF's to depict economic growth/decline

A leftward shift in the PPF curve indicates a decline in the economy

A rightward shift in the PPF curve indicates a growth in the economy

Macroeconomic curved diagram

PPF's to depict inefficient allocation of resources

Points inside the PPF curve indicate an inefficient allocation of resources

PPF's to depict impossible production

Points outside the PPF curve indicate impossible production

Linear microeconomic diagrams

Linear microeconomic diagrams are drawn when both products on the axis require unspecialised resources

(e.g. tables and chairs both require wood)

Curved microeconomic diagrams

Curved microeconomic diagrams are drawn when both products on the axis require specialised resources

(e.g. planes and chairs both require different resources)

Macroeconomic PPF curve

A macroeconomic PPF curve is a diagram of all goods

The x and y axes are labelled as consumer and capital goods

Anywhere on the curve indicates the economy has reached maximum productive potential

Movement in a PPF curve

A movement in the PPF curve causes both the x and y values to change

In a curved diagram, a relatively large decrease in the value of y causes a small increase in the x value, and vice versa

Causes of a movement in a PPF curve

A firm decides to alter the distribution of resources to one of the two products

Shift in a PPF curve

A shift in the PPF curve can cause the x value to change without a change in the y value, and vice versa

Hence, there is no opportunity cost as the x value can stay the same whilst the y value changes

Causes of a shift in a PPF curve

More initial resources; if there is more input into production, the maximum possible output increases

More productive means to combine resources (better machinery or technology); if resources can be used in a more productive/efficient manner, the maximum output with a given input increases

A pivot in a PPF curve

A pivot represents productivity improvements in one output of a good, which does not affect the other

Capital goods

Goods used by producers to consume other goods, e.g. machinery/tools

Consumer goods

Good used by consumers for satisfaction

Specialisation

When an individual, firm or economy concentrates on producing a certain good or service

Division of labour

The process where the production of a good is broken down into many separate tasks, each performed by different workers

Advantages of specialisation

More efficient in producing a good or service

They benefit from economies of scale, increased output = lower average costs

Disadvantages of specialisation

Overreliance on a certain good

(e.g. Cuba specialises in producing sugar, and if the sugar price decreases so will the Cuban economy)

Advantages of division of labour for firms

Higher productivity = higher output

Workers only need to be trained for their certain area of expertise, saving time and money

Disadvantages of division of labour for firms

Only works for large-scale production

High staff turnover costs as they get bored

Hard to find a replacement for a specialised worker

Advantages of division of labour for workers

Higher wages

Workers can become an expert in a field of work

Workers can make use of their skills or qualifications

Disadvantages of division of labour for workers

Workers get bored, potentially leading to inefficiency

Money

Money is seen as an intermediary good given that it is not a factor of production or a consumer good

Functions of money - medium of exchange

Medium of exchange; money is a resource solely used for exchange, this function encourages more trade/exchange because it avoids the double coincidence of wants (used in a barter economy)

Functions of money - store of value

Store of value (assuming no inflation); for those who sell perishable or depreciating products (farmers), money allows them to sell their output and retain the value of it for future spending

Functions of money - unit of account (measure of value)

Unit of account; by providing a universal measure of the value/worth of all goods and services, it makes price listing much easier, comparing prices is more efficient and less time consuming, as values do not need to be converted like in a barter economy, quicker/easier trade/exchange = more trade/exchange

Functions of money - standard of deferred payment

Standard of deferred payment; because money stores its value, it is also acceptable as a means of delayed payment, allowing economic agents to move their purchasing power from the future to the present

(e.g. when taking out a loan, we sacrifice the ability to consume in the future for the ability to consume in the present)

How money enables greater specialisation

Without money (in a barter economy), it would be very risky for producers who don't produce necessities to specialise as necessity producers (farmers) might not want to trade for your products

Therefore, money solves the double coincidence of wants, it removes the risk from specialisation

(e.g. if Mr Dyas wanted to offer a farmer his economics tuition for food, the trade may not happen as the farmer may not want economics tuition)

Economic structures

The system under which resources are allocated in an economy or market

Free market economy

An economic system where resources are allocated through the market mechanism

Properties of a free market economy

What to produce is decided by what consumers demand to maximise utility, and what producers can efficiently produce

How to produce is decided by producers based on what maximises

Who gets the production is decided by which consumers are willing and able to pay

Command economy

An economic system where a government or central authority allocates resources in society

Properties of a command economy

What to produce is decided by the government

How to produce is decided by the government

Who gets the production is decided by the government

Advantages of a free market economy or disadvantages of a command economy

Consumer preferences are met and satisfied, as producers are incentivised to allocate resources to the goods/services consumers want the most; if demand for products rises, free markets automatically extend supply (so more resources are allocated); this does not happen effectively in a command economy, as the government cannot easily understand or anticipate changes in consumer preferences

The quality of products in free market economies tends to be higher, as private producers will risk going out of business if their product quality is low or harmful to consumers; however, in command economies, the government does not have the risk of going bankrupt, and therefore the quality may be low (e.g. exploding TVs in Soviet Russia)

Advantages of a command economy or disadvantages of a free market economy

Consumers may be irrational, and therefore, satisfying their preferences may not actually be ideal; consumers may fail to maximise their benefits, because of factors like social influence, habitual behaviour and weakness at computation; command economies can solve this weakness through government intervention to help consumers make rational decisions or ban/limit consumption of certain products

Free markets encourage inequality, as only those willing and able to pay have access to the most desirable resources (e.g. houses, private schools), and workers are paid according to the demand for their skill; therefore, more skilled/wealthier individuals can generate even greater income/wealth over time (e.g. sending children to private schools or having opportunities to start a business); this can lead to the inequality of opportunity and misallocation of labour, as due to nepotism, networks and unequal access to jobs, less skilled workers may end up in high skilled jobs

Conclusion on free market economies and command economies

Mixed economies are always preferable as it is the ‘best of both worlds’; the government can control some of the largest drawbacks of free market economies (e.g. inequality, under consumption of merit goods, whilst still providing the preferable economic incentives that markets create

Karl Marx

Associated with command economies/communism; ‘from each according to his ability, to each according to his need”

Adam Smith

Associated with mixed economies, leaning towards free market economies; he advocated for government intervention when markets were not working well (e.g. in a monopoly)

Friedrich van Hayek

Associated with pure free market economy ideology and almost no government intervention in the economy