economics theme 1

what is the basic economic problem?

The basic economic problem is that there are infinite wants and finite resources. Resources are scarce in relation to wants. Choices need to be made about how to allocate resources among competing uses: What to produce? How to produce? For whom to produce?

what are the resources/ factors of production?

land- natural physical resources

labour- human input

capital- man-made machinery

enterprise/ entrepreneurship- the ability and willingness to organise, coordinate and take risks in the production process

rewards to the factors of production

land- rent

Labour- wages

capital- interest

enterprise- profit

what is macroeconomics?

considers the economy as a whole

what is microeconomics?

branch of economics that studies the behaviour of individuals and firms in the market

aims of rational agents

consumers- total utility

workers- wages and benefits

producers- profit

government- social welfare

what is opportunity cost?

is the value of the next best alternative forgone when a choice is made

what is a positive statement?

describes the world as it is, without making any value judgments. they are based on objective facts, they can be proven or disproven.

what is a normative statement?

express an opinion about what ought to be. they are subjective statements.

what is a productions possibility frontier (PPF)?

shows the maximum possible combinations of 2 goods or services an economy can achieve when all resources are fully and efficiently employed.

why are PPF diagrams curved?

PPF’s are usually curved because of the law of diminishing return

what is the diminishing law of return?

the extra output of consumer good diminishes as more factor resources are allocated to it.

what causes an outward shift in the PPF?

an increase in the quantity of the factors of production- discovery and extraction of new natural resources.

an increase in the quality of the factors of production- increase in labour productivity due to better management

an advance in technology- a new innovation in resource use

what causes an inward shift in the PPF?

a decrease in the quantity of the factors of production- war or conflict or natural disasters

a decrease in the quality of the factors of production- capital scrapping or labour hysteresis in a prolonged recession

what is a non parallel shift?

an advancement in one particular sector

what does a straight PPF indicate?

indicates resources are equally efficient at producing both goods shown on the PPF axis

what is factor mobility?

occurs when factors of productions can easily be changed from 1 good to another

what is geographical mobility?

resources can move easily between regions/areas/countries

what is occupation mobility?

resources can move easily between different types of work

what is geographical immobility of labour?

labour may not be fully mobile because regional house prices, family and social ties, children in school ETC

what is occupational immobility of labour?

can occur because of insufficient education and training, a lack of transferable skills, inability to afford training ETC

mobility of land

land is not geographically mobile, but can be occupationally mobile

mobility of capital

can be both occupationally and geographically mobile, e.g. hand tools or viechles, but heavy industry capital, e.g. a blast furnace may not be as mobile

specialisation of labour

the concentrations of individuals, firms or nations on producing a limited range of goods or services

division of labour

a form of specialisation where the tasks needed to produce an item are divided among workers.

advantages of specialisation and division of labour

increased productivity- greater output from same resources, allows workers to become more skilled and experienced in specific tasks, leading to higher efficiency , develop specialist machinery

lower costs- reduced training time and waste

economies of scale- mass production possible including assembly lines, larger quantities of identical goods can be produced more efficiently

disadvantages of specialisation and division of labour

higher staff turn over- workers may find tasks repetitive, monotonous and unrewarding, leading to job dissatisfaction

dependancy- over reliance on one work/task/factory makes units vulnerable to staff illness or economic shock

lack of variety- mass produced goods can reduce consumer choice

what is money?

anything generally accepted in payment of a debt; removes the need to barter, avoiding the double coincidence of needs

characteristics of money

acceptable, portable, durable, divisible, uncounterfitable and scarce

what are the 4 functions of money?

medium of exchange–money facilitates transactions between buyer and seller; specialisation and the division of labour requires a means of exchanging goods and services; money promotes this.

Unit of account - a nominal unit of measure used to value/cost/price products, assets, debts, incomes and spending

Store of Value – an asset that holds value over time

Standard for deferred payment – the accepted way in each market to settle debt

what is an economic system?

a network of individuals, organisations and institutions used by a society to resolve the basic problem of what, how much, how and for whom to produce.

what are the characteristics of a free market economy (also known as laissez-faire, market or capitalist economy)?

Private ownership of resources

Owners of resources and producers are free to buy/sell

Economic agents are motivated by self-interest

Consumers have sovereignty – they determine what is produced by being willing and able to buy goods and services

income depends on the market value of an individual's work

Resources are allocated by the price mechanism (market mechanism)

what are the advantages of a free market economy?

Resources can be bought and sold

Consumer sovereignty

Freedom of choice

Profit-motive and self-interest incentivises

Incentive to worker harder for higher wages; productivity rises

Firms face competitive forces driving down prices

Incentive to innovate and invest in new ideas (dynamic efficiency)

what is Adams smith’s invisible hand?

if economic agents act in their own best interests, the forces of demand and supply in the market can promote an efficient allocation of scarce resources for society

price mechanisms in action

If consumers exercise their sovereignty and are willing and able to buy more of a good, the market demand curve shifts right

Suppliers are incentivised to extend supply to meet the demand and can increase price to reduce the excess demand

This causes the market price and quantity to increase

The market has allocated more scarce resources to the production of this good – the quantity has increased.

disadvantages of a free market economy

Income/wealth inequality, and poverty

Market failure can reduce social welfare

Lack of provision of public goods

Over-provision of goods with negative externalities

Under-provision of goods with positive externalities

Information gaps may cause market failure

Unemployment/worker exploitation/low pay for some​

Environmental depletion/degradation

Resources may be wasted on advertising and marketing

Firms may develop monopoly power and push up prices

Macroeconomic instability

Friedrich Hayek

He had a strong belief in the individual in an economy rather than government. In the 1930s Keynes supported active government intervention to stimulate growth, whereas Hayek did not. Hayek favoured market economies – he thought a small group of individuals in government would never have enough information to meet people's needs.

characteristics of a command economy

Government owns and allocates resources deciding what, how and for whom to produce

Government sets productions targets and growth rates according to its view of people's wants

Goods are allocated through rationing

Workers are given job by the government

Market prices do not inform resource allocation

Queuing is used to ration scarce goods

advantages of a command economy

Resources are allocated by the government to maximise social welfare

Relatively even distribution of income/wealth

Workers are given jobs by the state; there is no unemployment

Adequate provision of public goods

Government should take externalities into account in decision-making

Environmental protection possible

Government can invest in economy's infrastructure easily

Policies to manage the macroeconomy

Welfare safety net

National interest considered rather than individual profits

Karl Marx

In his Communist Manifesto, Marx defined a command economy as 'common ownership of the means of production’ . Marx argued free markets are chaotic and there is often surplus labour; labour specialisation and population growth push wages down – workers are exploited (not paid the value they add to production). He argued that capitalism would eventually push workers towards revolution against the capital owners. Communism is not the same as Socialism, but both favour more government intervention in the economy.

disadvantages of a command economy

Danger of government failure

Difficult for the government to set and correct output planning targets and fix prices appropriately

Government may not have enough information to make good decisions eg malinvestment by state

Very bureaucratic – lots of red tape which reduces efficiency

Underemployment

Lack of choice for consumers

Lack of incentives to be innovative and entrepreneurial

Lack of incentives to work hard, causing lower productivity

Corruption is likely to develop

Shadow market activity can flourish

what is a mixed economy

There is a mix of private and public (government) sectors Resources are allocated by the price mechanism, when it works efficiently, but the government intervenes to correct market failures Aims to achieve the best aspects for both free market and command economies while avoiding their disadvantages.

what are traditional economies?

characterised by family groups, low productivity, little specialisation, barter trade and no surplus production for investment

what are transition economies?

are in the process of moving from a command economy to a mixed/free market economy. Markets are liberalised, state assets are privatised, state subsidies are removed. This can cause some short-term problems such as inflation and unemployment

what is effective demand?

demand supported by intention and ability to buy

what is latent demand?

willingness to buy but not yet ability to buy

what is joint/complimentary demand?

demand for one good is closely linked to the demand for another, ie two or more goods that go well together

what is competitive demand?

two or more goods that are close substitutes for each other

what is derived demand?

when demand for one product drives the demand for another (eg demand for factors of production driven by demand for final goods)

what is composite demand?

good is demanded for more than one use

what is individual demand?

a consumer's demand for a good/service

what is market demand?

all consumers' demands in the market summed together

what is the law of demand?

as price falls, the quantity demanded increases and vice versa. Demand slopes downwards to the right

what is an extension in demand?

a movement along the demand curve (lower P, higher Qd)

what is a contraction in demand?

a movement along the demand curve (higher P, lower Qd)

what does ceteris paribus mean?

all other influencing factors are held constant The demand curve is drawn “ceteris paribus”. Other factors affecting demand, such as income and tastes, are held constant to show how demand varies with price.

factors effecting a shift in demand

Change in tastes/preferences

Change in incomes

Change in the price of related goods (complements or substitutes)

Change in size/structure of the population

Changes in interest rates

Changes in the law

Changes in expectations

what is the substitution effect?

consumers substitute in favour of the good that become relatively cheaper; if price of good X falls, consumers buy more of good X

what is the real income effect?

if the price of good X falls, the consumer buying good X will gain purchasing power; this extra 'income' available for spending can be used to buy more X

what is total utility?

the total satisfaction the consumer gets from purchasing units of a good. Rational consumers aim to maximise their total utility.

what is marginal utility?

the change in total utility from consuming an extra unit of a product.

what is the law of diminishing marginal utility?

as a consumer buys and consumes more units of a good, the extra satisfaction gained diminishes. This means at higher quantities, consumers are less willing to pay a higher price, helping to explain the downward sloping demand curve.

what is joint supply?

two or more goods that derive from a single production process; a change in the supply of one good leads to a change in the supply of a by-product

what is individual supply?

a producer's supply of a good/service

what is market supply?

all producers' supplies to the market summed together

what is the law of supply?

as price falls, the quantity supplied decreases and vice versa. Supply slopes upwards to the right

what is an extension in supply?

a movement along the supply curve (higher P, higher Qs)

what is a contraction in supply?

a movement along the supply curve (lower P, lower Qs)

why does the supply curve slope upwards?

Higher market prices motivated firms to supply more as they expect more

profit Producing more increases the marginal cost of production so firms need higher prices to cover these costs (assumes Law of Diminishing Returns)

factors effecting shifts in supply

Change in the costs of production (raw materials, wages, energy....)

Change in production technology

Change in weather/climate

Events such as strikes, pandemic

Changes in indirect taxes

Changes in producer subsidies

Changes in the price of substitutes in production

Changes in the number of firms supplying to the market

what is the equilibrium?

a state of rest

At equilibrium E1, there is one unique price P1, where the plans of producers match the plans of consumers

The quantity demanded equals the quantity supplied at P1

This is sometimes called the market-clearing price.

what is a substitute?

if supply of a good shifts left, this increases the market price, so the demand for a substitute will shift to the right

what is price elasticity of demand (PED)?

the responsiveness of quantity demanded of a good to a change in its price

what is the formula for PED?

% change in quantity demanded/% change in price

why is PED always negative?

quantity demand is inversely related to price

what is inelastic demand?

quantity demanded is not responsive to price changes; the % change in Qd is < the % change in P; value is between 0 and -1

what is elastic demand?

quantity demanded is very responsive to price changes; the % change in Qd is more than the % change in P; value is between -1 and -∞

what is unit or unitary demand?

PED = -1; the % change in Qd is the same as the % change in P

when is PED perfectly elastic?

PED=-infinity

when is PED perfectly inelastic?

PED=0

PED along a straight line

PED is NOT the gradient or slope of the demand curve

PED = -1 at the mid-point of the demand curve

PED is elastic at high prices

PED is inelastic at low prices

PED varies all the way along the demand curve

when PED is elastic and P rises what happens to total revenue (TR)?

TR falls

when PED is elastic and P falls what happens to total revenue (TR)?

TR rises

when PED is inelastic and P rises what happens to total revenue (TR)?

TR rises

when PED is inelastic and P falls what happens to total revenue (TR)?

TR falls

when PED is unitary and P rises/falls what happens to total revenue (TR)?

TR does not change

factors influencing PED

Availability of close substitutes

Cost of switching suppliers

Breadth of product definition

Degree of necessity

Time frame when making choice

Brand loyalty

%of income spent on product

Habitual demand

uses of PED

Determination of pricing policy/impact on revenue

Indication of competition faced (number/closeness of substitutes)

Price setting in price discrimination

Government decision on which goods to tax indirectly

what is price elasticity of supply (PES)?

the responsiveness of quantity supplied of a good to a change in its price

what is the formula for PES?

% change in quantity supplied/% change in price

what is elastic supply?

quantity supplied is very responsive to price changes; the % change in Qs is more than the % change in P; value lies between +1 and +∞

what is inelastic supply?

quantity supplied is not responsive to price changes; the % change in Qs is less than the % change in P; value lies between 0 and +1.

what is unit or unitary supply?

PES = +1; the % change in Qs is the same as the % change in P

what is perfectly elastic supply?

PES=+infinity

what is perfectly inelastic supply?

PES=0

factors influencing PES

Time period

Bottlenecks in supply

Breakdowns in supply chains

Spare capacity

Stock levels

Availability of producer substitutes

Ease of entry into the market

what is income elasticity of demand (YED)?

the responsiveness of demand for a good to a change in income

what is the formula for YED?

YED = % change in demand % change in income

what does it mean when YED is positive?

it is a normal good (when incomes rise, the Qd increases)

what does it mean when YED is negative?

it is an inferior goods (when income rises, the Qd decreases)