Economics Unit 1

Explain the basic economic problem

Wants are unlimited. Resources are finite so therefore not all wants can be met. This creates scarcity.

What makes a resource scarce

Less of it exists that what people want at a zero price

State the chain following scarcity

Scarcity → Opportunity Cost → Choice

Explain what is meant by choice

Since resources are scarce economic agents must allocate these resources and choose where to allocate them

State what are the 3 economic agents

1. Individuals

2. Firms

3. Government

State what is scarce for individuals / households

Income and time

State what is scarce for firms

Revenue, premises, labor

State what is scarce for governments

Tax revenue

For these economic agents if a resource is scarce what does this mean?

That the agent has to choose where to allocate their scarce resources

State what is meant by opportunity cost

The benefit of the next best alternative forgone when choosing something else

Does opportunity cost apply to all resources?

No free goods have no opportunity cost

Why exactly do free goods have no opportunity cost?

As obtaining them uses no scarce resources so no choice is made since no resources are allocated to obtaining them

What must every economy do?

Answer the 3 fundamental questions of resource allocation

State what are the 3 fundamental questions of resource allocation (Include a brief explanation)

1. What to produce (Given the scarce amount of resources it needs to be decided what goods and services are to be produced and at what quantities)

2. How to produce (What combination of the factors of production should be used to produce said goods and services)

3. For whom to produce (How is the output of goods and services shared out in an economy? What decides who get what goods and services)

The way an economy answers the 3 fundamental questions of resource allocation determines what?

The economic system of the economy

At its core what does economics study

Economics studies how the economic agents allocate scarce resources

What are the 4 steps of the research method for economics

1. Observe (What is happening)

2. Hypothesis (What might be causing this)

3. Model (Simplify the key relationship)

4. Test (Compare the model with evidence)

State what is meant by a model

A model is a simplified representation of reality that is built on assumptions

What make a model usable but is also its limitation and explain why

Simplification make the model usable but also limits the accuracy of the model

Why are controlled experiments not possible in economics like in other subjects like physics?

As an economist cannot hold an entire economy just to test a theory

What is another issue with trying to prove an economic theory

Correlation does not mean causation, if to variables increase at the same time it does not mean because one affected the other, a third variable could be driving both

State what is meant by positive statement

An objective statement that can be tested against evidence and shown to be true or false

State what is meant by a normative statement

A subjective statement based on a value judgement which cannot be proved to be true or false by evidence

SUMMARY WHAT IS THE DIFFERENCE BETWEEN A NORMATIVE AND POSITIVE STATEMENT

Positive - Objective - Can be shown to be T OR F with evidence

Normative - Subjective - Cannot be shown to be T OR F with evidence

If you are confused look at this table to be able to tell the difference between positive and normative

What are the signal words for a normative statement

Should be, ought to be, unfair, best, too high

What are signal words for positive statements

Measurable quantities + relationships

Does including numbers make a statement positive?

No for example the statement : “Income tax should be raised to 45%” This statement is subjective and cannot be proven using evidence so it normative

State what does Ceteris Paribus mean

“all other things be equal”

Explain ceteris paribus

That we must assume that all other factors are equal when examining how one variable affects another

Why is ceteris paribus used

In reality many variable change at once, so the effect of any single one cannot be isolated

Holding all other variables constant allows a cause-effect relationship to be identified

Why is using ceteris paribus not accurate

Since in reality multiple other variables change rather than one a prediction cannot be observed

State what is meant by a time period

Time periods: Defined by which factors of production can be varied (change)

In the short run which factors of production can change

In the short run at least one factor of production is fixed (does not change), while the variable factors can change

In the short run which factors of production are usually fixed and which are usually varied

Fixed: Capital and Land

Varies: Labor

In the long run which factors of production can change

All factors of production are variable EXCEPT Technology which remains unchanged

In the Very Long Run which factors of production can change

All factors of production are variable as well as technology and other background conditions can change

NOT that each “long run and short run” don’t have a fixed time scale as it depends on the industry and how quickly each factor of production can be varied

OK

State what is meant by a factor of production

The scarce resources used in the production of goods and services

State the definition of each factor of production

1. Land: All natural resources used in producing a good or service

2. Labor: The human input/effort (mental or physical) required to produce a good or service

3. Capital: Any man-made resource used in producing a good or service

4. Enterprise: The factor that organizes the other 3 factors of production and bears the risk of production

State the reward for each factor of production

• Land: Rent

• Labor: (Wages → Unskilled Physical labor) + (Salaries → Skilled mental labor) Blue collar vs White collar

• Capital: Interest

• Enterprise: Profit

When referring to capital as in one of the factors of production we are referring to capital goods NOT money

Oks

Why is money not a factor of production

Money is not used in the production of goods and services rather a means of acquiring resources

State what are the two types of capital

Human Capital and Physical Capital

State what is meant by physical assets

Man-made productive assets

State what is meant by human capital

The skills, knowledge and expertise embodied in the workforce

How is physical capital created

Investments by firms and governments

How is human capital created

Through education, training and work experience

What is the effect of physical capital

Raises output per worker by giving workers more tools to work with

What is the effect of human capital

Raises labor productivity by making workers more effective

SUMMARY THE EFFECTS OF HUMAN AND PHYSICAL LABOR

Physical - Raises Output per worker
Human - Raises Labor productivity

EXPLANATION: Physical capital improves how much each worker outputs as they have better tools, however the worker themselves have the same skills and effectiveness, while human capital increase labor productivity as each worker can produce more and be more efficient with the same tools so in conclusion

One improves the tools and the other improves the workers (People using the tools)

What does an increase in Human or Physical capital do to the PPC

It shifts it outwards

Explain how individually an increase in Human Capital and Physical Capital cause an outwards shift of the PPC

Physical Capital - Increases the quantity of capital in an economy
Human Capital - Increase the quality of labor in an economy

Since either an increase in the quantity and quality of the factors of production cause a shift they do to

State what is meant by specialization

The concentration by a worker, firm, region, or country on a narrow range of tasks or products

State what is meant by division of labor

Dividing the production process into simpler tasks where each task is carried out by a worker

How does division of labor relate to specialization

Division of labor is specialization applied within a production process → Division of labor leads to specialization

State 5 advantages to specialization and division of labor

1. Since workers only do one task they become more skilled at it so labor productivity rises

2. Since workers are more skilled and efficient each worker can produce more with the same input so Higher output per worker → lower average cost per unit

3. Splitting the production process into simpler tasks allows specialized machinery to be used which can increase efficiency and thus overall output

4. Workers can be matched to the task they are the best at

5. Higher output allows firm to supply/serve international markets

State 5 disadvantages to division of labor and specialization

1. Repetition of doing the same task causes boredom and demotivates workers which can reduce productivity and lower the quality of output

2. Bored workers are more likely to leave and be absent thus raising absenteeism and labor turnover which increases recruitment and training costs

3. Workers have less occupational mobility

4. The production process becomes dependent on each worker so if one is absent they can’t be easily replaced and so production is affected

5. Division of labor and specialization works well with standardized mass produced products so this reduces variety and consumer preferences are less well met

Describe the enterprise factor of production

They take the risk of organizing and combining the other 3 factors of production

Outline the 2 functions of an entrepenuer

1. Organization: Entrepreneurs decide what to produce and in what quantities then acquires, organize and combines the other 3 factors of production to do so

2. Risk-Bearing: Commits their own or borrowed funds without knowing whether the output will sell. Returns are not a guaranteed and may be negative

State what is meant by an economic system

The way an economy is organized to answer the 3 fundamental questions of resource allocation.

What to produce, for whom to produce, how to produce

What 2 ways are economic systems classified - IMPORTANT

1. Who makes the decisions

2. By what mechanisms resources are allocated

State what are the 3 economic systems

1. Market (Free market)

2. Planned (Command)

3. Mixed

In a market system who decides how resources are allocated

Households and firms independently

DECENTRALIZED

In a planned economy who decides how resources are allocated

The government through a central planning authority

CENTRALIZED

In a mixed economy who decides how resources are allocated

Both the private and public sector

In a market economic system who owns the factors of production

Private individuals and firms

In a planned economic system who owns the factors of production

The state/government

In a mixed economic system who owns the factors of production

Both the public sector: government, and the private sector: Individuals and private firms

In a market economic system what mechanism allocates resources

The price mechanism

Price Mechanism: The interaction of the forces of demand and supply

How are resources allocated in a planned economic systems

By the government

How are resources allocated in a mixed economic system

By the price mechanism also however modified with government intervention

State what is meant by the price mechanism

The allocation of resources by the interaction of the forces of demand and supply

In the price mechanism what is the role of price

1. Signaling, the greater the price it signals to producers that consumers want more of that good

2. Incentive, price creates an incentive for producers to produce more of that good and allocate resources to it

3. Rationing, A greater price limits the number of people who are able to obtain that good by only allowing consumers who are willing and able to pay to acquire it

In a market economic system how are the 3 basic questions of resource allocation answered

In a planned economy how are resources allocated

Primarily by administrative decision rather than by price

How are resources allocated in a mixed economic system

Most resources are allocated by the price mechanism in the private sector but the government intervenes where the market alone produces an unsatisfactory outcome

State 4 examples of “unsatisfactory outcomes” that governments have to correct and intervene in a mixed economic system

1. Direct provision of public goods: Private firms have no incentive to produce public goods since they are non-excludable so thus they must be provided by the government otherwise they will not be provided.
   
   

2. Provision of merit goods: In a free market system merit goods are under consumed and under supplied the government must intervene and increase their consumption and supply
   
   

3. Regulation of demerit goods: To prevent overconsumption of demerit goods governments must regulate their consumption and production using regulation laws AND Taxation
   
   

4. Unfair distribution of income: through taxes and welfare benefits (which only the government can enforce) the government can increase income equality

So in essence each economic systems differ in degree of government intervention

TRUE

State 3 advantages of a market economic system

1. Consumer sovereignty - Firms produce what consumers want

2. The motive of profit incentivizes higher quality production and more variety

3. Competition leads to lower prices and increased quality, as well as increased efficiency

State 3 disadvantages to market economic systems

1. Public goods are not provided at all since there is no profit incentive. Merit goods are under-consumed and under-produced while demerit goods are overproduced and overconsumed

2. Who gets resources is purely decided by their ability to pay so often times poorer people do not have access to basic needs

3. Fast moving economy results in market failure, recession, and monopolies

State 4 advantages to a planned economy

1. Public and merit goods are not undersupplied since they are supplied by the government

2. Output can be distributed far more equally since it is a centralized authoritative system

3. Resources can be directed to national priority quicklu

4. No waste from competition

5. Consumers are not exploited

State 3 disadvantages to planned economic systems

1. Less variety and output is decided by government so output necessarily won’t be what consumers want

2. No profit incentive or competition decreases worker motivation, quality and innovation

3. Government may lack information prices convey which may result in shortages and surpluses persisting

State one disadvantage to a mixed economic system

Government intervention may be inefficient or politically motivated

State what is meant by government failure

When a government is intervention is ineffective and not efficient and is rather politically motivated rather than focused on bettering the economy

State what is meant by a PPC

A PPC shows the maximum combination of two goods an economy can produce when all of its resources are being employed efficiently given its current state of technology

What 4 assumptions does a PPC rest on?

1. Only 2 goods are being produced

2. the quantity and quality of the factors of production are fixed

3. The state of technology given

4. on the curve all resources are fully and efficiently employed towards producing only those two goods

What 3 things does a PPC show and how?

Good to know don’t need to memorize

U know this already 100% but just to remind you

oks

What does a straight line linear PPC graph show?

The factors of production are perfectly suitable for producing both goods. Each extra unit of one always costs the same quantity of the other so an example of this is producing one chocolate cake is not producing one chocolate cookie

What does a concave (Curved) PPC show?

The factors of production are not equally suited to produce each good. As output of one good expands resources that are less suited to it are progressively transferred, so each extra unit costs more of the other good than the last.

1.5.2 Why is a PPC concave? (example) Resources are not equally suited to both goods, so each extra unit of one good costs more of the other. Example: an economy producing wheat and steel gives up 10, then 20, then 30, then 40 wheat for each extra 10 steel. The first resources moved are poor at wheat and good at steel, but the last are the best farmers and farmland, which are poor at steel. A straight-line PPC (constant opportunity cost) happens only when factors are perfectly substitutable, e.g. identical workers making hoodies and T-shirts at a fixed 1 hoodie : 2 T-shirts.

What are the 2 things that cause a shift in the PPC?

1. A change in the quality of the factors of production

2. A change in the quantity of the factors of production

What causes an outwards shift in the PPC

1. An increase in the quality of the factors of production

2. An increase in the quantity of the factors of production

What does an outwards shift in the PPC show?

Economic Growth - As the productive potential of the economy has increased

What causes a PPC to shift inwards

1. A decrease in the quality of the factors of production

2. A decrease in the quantity of the factors of production

What are the primary causes of an inward shift of the PPC

1. War

2. Natural Disaster

3. Depletion of resources

4. Destruction of capital

Describe what is meant by a pivot shift of the PPC

A change affecting the ability of an economy to produce one good only