Economics Unit 1.1

1.1.1 Scarcity

Human wants are unlimited but the resources available to satisfy them are finite, so not all wants can be met. This is the fundamental economic problem.

1.1.1 Why is scarcity a relationship, not a quantity?

A resource is scarce because less of it exists than people want at a zero price — not because there is a small amount of it.

1.1.1 The chain that scarcity sets off

Scarcity → choice → opportunity cost. Resources are limited, so we must choose; choosing one thing means giving up another.

1.1.2 Why must every economic agent make choices?

Because resources are scarce. Individuals face limited income and time, firms limited revenue, premises and labour, and governments limited tax revenue.

1.1.2 Example of choice at each of the three levels

Individual: an hour revising Economics is an hour not revising Physics. Firm: a bakery using its ovens for bread cannot use them for cakes. Government: money spent on a hospital is a road not built.

1.1.3 Opportunity cost

Opportunity cost is the benefit forgone of the next best alternative when a choice is made.

1.1.3 What does 'next best' mean in opportunity cost?

One alternative only — the single highest-valued option you did not choose, not every option added together.

1.1.3 Is opportunity cost the money spent or the benefit given up?

The benefit given up, not the money spent. The opportunity cost of a free university place is the wage you could have earned instead.

1.1.3 Does opportunity cost apply only to money?

No. It applies to any scarce resource, including time.

1.1.3 What is the opportunity cost of a free good?

Zero, because obtaining it uses no scarce resources.

1.1.3 How do you calculate opportunity cost from a table of outputs?

It is a ratio of goods: divide the quantity given up by the quantity gained.

1.1.4 The three basic questions of resource allocation

What to produce; how to produce; for whom to produce. Every economy must answer them because resources are scarce.

1.1.4 'What to produce?' means

Which goods and services, and in what quantities. Resources given to consumer goods cannot also go to capital goods or defence.

1.1.4 'How to produce?' means

With which combination of factors of production — labour-intensive or capital-intensive methods, and which techniques.

1.1.4 'For whom to produce?' means

How output is shared out. In a market economy this is settled by ability to pay, so by the distribution of income and wealth.

1.1.4 What do the answers to the three questions determine?

The economy's economic system — the way it is organised to answer what, how and for whom to produce.

1.2.1 Why is economics a social science?

It is scientific in its method, because it forms hypotheses and tests them against evidence; it is social in its subject matter, because its subject is human behaviour.

1.2.1 The four steps of the economic method

Observe (what is happening?); hypothesise (what might be causing it?); model (simplify the key relationship); test (compare with the evidence).

1.2.1 Model

A model is a simplified representation of reality, built on assumptions — for example that consumers act rationally to maximise satisfaction and that firms act to maximise profit.

1.2.1 Why is simplification both the strength and the weakness of a model?

Simplification is what makes a model usable, but it means the model leaves out influences that operate in reality.

1.2.1 Two limits that separate economics from a natural science

Controlled experiments are rarely possible — an economist cannot hold an economy still and change one variable; and correlation is not causation — two variables moving together does not prove one causes the other.

1.2.2 Positive statement

A positive statement is an objective statement that can be tested against evidence and shown to be true or false.

1.2.2 Normative statement

A normative statement is a subjective statement based on a value judgement, which cannot be proved true or false by evidence.

1.2.2 Can a positive statement be false?

Yes. 'Unemployment in Egypt is 40%' is testable and wrong. Testability is the criterion, not truth.

1.2.2 Do numbers make a statement positive?

No. 'Income tax should be raised to 45%' contains a figure and is still normative. A forecast such as 'unemployment will reach 10% next year' contains no value judgement, so it is positive.

1.2.2 Signal words for a normative statement

should; ought; unfair; too high; best — anything expressing what ought to be rather than what is.

1.2.2 Positive vs normative: one example of each

Positive: 'A rise in the price of petrol reduces quantity demanded.' Normative: 'The government should reduce the price of petrol.'

1.2.3 Ceteris paribus

Ceteris paribus means 'all other things being equal' — the assumption that all other influences are held constant while the effect of one variable on another is examined.

1.2.3 Why is ceteris paribus used?

In reality many variables change at once, so the effect of any single one cannot be isolated. Holding the others constant identifies one cause-and-effect relationship at a time.

1.2.3 Where have you already used ceteris paribus?

It is the reason a demand curve can be drawn: quantity demanded falls as price rises, holding income, tastes and the prices of other goods constant.

1.2.3 Limitation of ceteris paribus

It is an assumption, not a description of reality. A fall in a good's price may not raise quantity demanded if incomes fall or a cheaper substitute appears at the same time.

1.2.4 How are the three time periods defined?

By which factors of production can be varied — never by calendar length.

1.2.4 Short run

The period in which at least one factor of production is fixed (usually capital or land). Output can be raised only by using more of the variable factor within the same fixed capacity.

1.2.4 Long run

The period in which all factors of production are variable but technology is unchanged. The scale of production can change, so a larger factory can be built and all inputs rise together.

1.2.4 Very long run

The period in which all factors are variable and technology and other background conditions can change, so new production methods, products and industries become possible.

1.2.4 Does each time period have a fixed length?

No. There is no fixed timescale. The long run for a street-food seller may be a few weeks; for an electricity generator building a power station it may be a decade.

1.3.1 Factors of production

The resources used to produce goods and services: land, labour, capital and enterprise. Each earns a different reward.

1.3.1 Land

All natural resources used in production — the surface itself and what is on or under it. Examples: farmland, oil, forests, fish stocks. Reward: rent.

1.3.1 Labour

The human effort, physical and mental, used in production. Examples: workers, managers, engineers. Reward: wages.

1.3.1 Capital

Any man-made resource used to produce goods and services. Examples: machinery, factories, tools, roads. Reward: interest.

1.3.1 Enterprise

The factor that organises the other three and bears the risk of production. Supplied by the entrepreneur. Reward: profit.

1.3.3 The four rewards to the factors of production

Land earns rent; labour earns wages; capital earns interest; enterprise earns profit.

1.3.1 Is money a factor of production?

No. Capital means capital goods — physical, man-made resources used in production. Money is the means of buying factors, not a factor itself.

1.3.2 Physical capital

Man-made, tangible productive assets, created by investment by firms and governments. It belongs to the firm and can be bought and sold. Example: a textile factory's looms.

1.3.2 Human capital

The skills, knowledge and experience embodied in the workforce, created by education, training and work experience. It belongs to the worker and cannot be separated from the person.

1.3.2 How does each type of capital raise output?

Physical capital raises output per worker by giving workers more to work with. Human capital raises labour productivity by making the worker more effective.

1.3.2 How do physical and human capital each shift the PPC?

Both shift it outwards, but physical capital increases the quantity of the capital factor, while human capital increases the quality of the labour factor.

1.3.4 Specialisation

Specialisation is the concentration by a worker, firm, region or country on a narrow range of tasks or products.

1.3.4 Division of labour

The division of labour is the breaking up of a production process into separate tasks, each carried out by a different worker.

1.3.4 Difference between specialisation and the division of labour

The division of labour is specialisation applied within a production process. Specialisation is the broader idea.

1.3.4 The four levels at which specialisation operates

The individual worker; the firm; the region; the country — the last being the basis of international trade.

1.3.4 Advantages of the division of labour

Workers repeat one task, become more skilled and waste no time switching, so labour productivity rises; higher output per worker cuts average cost per unit; simple repeated tasks make specialised machinery worthwhile; workers can be matched to the task they are relatively best at; larger output allows firms to serve national and international markets.

1.3.4 Disadvantages of the division of labour

Repetition causes boredom and demotivation; absenteeism and labour turnover rise, raising recruitment and training costs; narrow training means skills do not transfer, causing occupational immobility; the process becomes interdependent, so one absence or breakdown can halt the line; standardised mass production reduces variety.

1.3.4 Occupational immobility

Workers trained in one narrow task cannot transfer their skills to another occupation if they lose that job.

1.3.5 The two functions of the entrepreneur

Organisation — deciding what to produce and in what quantity, then acquiring and combining the other three factors. Risk-bearing — committing their own or borrowed funds before knowing whether the output will sell.

1.3.5 Why is profit the reward for enterprise?

Profit is a residual: it exists only if the risk pays off. Rent, wages and interest are contractual and are paid whether or not the firm succeeds.

1.3.5 How are the entrepreneur's two functions separated in large companies?

The risk is borne by shareholders while the organising is done by salaried managers.

1.3.5 What happens without the enterprise factor?

The other three factors remain unused resources — nothing combines them so that production can take place.

1.4 Economic system

An economic system is the way an economy is organised to answer the three basic questions — what to produce, how to produce and for whom to produce.

1.4 How are economic systems classified?

By who makes the decisions, and by what mechanism resources are allocated.

1.4.1 Market (free market) economy — decision-making

Individuals and firms decide independently (decentralised); factors are privately owned; the motive is self-interest — consumers maximise satisfaction and firms maximise profit; the coordinating mechanism is the price mechanism.

1.4.1 Planned (command) economy — decision-making

The state decides through a central planning authority (centralised); the state owns the factors; objectives are social or strategic and set by the plan; coordination is by output targets, quotas and fixed prices.

1.4.1 Mixed economy — decision-making

Both a private sector and a public sector decide; factors are owned by both; self-interest operates privately and social objectives publicly; the price mechanism operates but is modified by government intervention.

1.4.2 The three functions of price in a market economy

Signalling, incentive and rationing.

1.4.2 Price as a signal

A rise in consumer demand raises the price, which tells producers that consumers want more of the good.

1.4.2 Price as an incentive

The higher price raises the profit available in that industry, so producers move resources into it — and out of industries where price and profit have fallen.

1.4.2 Price as a rationing device

The higher price reduces quantity demanded, rationing the limited supply to those consumers willing and able to pay.

1.4.2 How does a market economy answer the three questions?

What: by consumer spending (consumer sovereignty). How: by firms minimising costs in pursuit of profit. For whom: by ability to pay.

1.4.2 Consumer sovereignty

Consumers determine what is produced through their spending; firms that produce what consumers do not want make losses.

1.4.2 How does a planned economy allocate resources?

By administrative decision rather than by price: the planning authority sets output targets for each industry and directs factors of production to them, and prices and wages are fixed by the state.

1.4.2 Why can prices in a planned economy not signal, incentivise or ration?

Because they are set administratively rather than determined by demand and supply, so they carry no information about relative scarcity.

1.4.2 What happens when a planned economy fixes a price below the market-clearing level?

Demand exceeds supply, and the resulting shortage is rationed by queuing, waiting lists or coupons instead of by price.

1.4.2 Four ways a government intervenes in a mixed economy

Direct provision of public goods, which the free market would not supply at all; subsidy or provision of merit goods, which the free market under-consumes; taxation or regulation of demerit goods, which the free market over-consumes; redistribution of income through taxation and welfare payments.

1.4.2 Strengths of a market economy

Consumer sovereignty — firms produce what consumers want or make losses; the profit motive is a continuous incentive to cut costs and innovate; prices adjust automatically and quickly, at no administrative cost.

1.4.2 Weaknesses of a market economy

Public goods are not provided at all, merit goods are under-consumed and demerit goods over-consumed; 'for whom' is answered purely by ability to pay; firms may grow into monopolies and restrict output to raise price.

1.4.2 Strengths of a planned economy

Public and merit goods can be provided directly, so are not under-supplied; output can be distributed far more equally; resources can be directed to a national priority quickly; no private monopoly exploiting consumers.

1.4.2 Weaknesses of a planned economy

Planners lack the information prices convey, so shortages and surpluses persist; there is no profit incentive, so little pressure on costs, quality or innovation; consumer choice is limited to what the plan produces.

1.4.2 Why is essentially every real economy mixed?

Because all economies use both the price mechanism and government intervention. They differ only in the degree of government involvement, so the three systems form a spectrum rather than three separate boxes.

1.4.2 Government failure

Intervention is not costless: it may itself be inefficient or politically motivated, producing an outcome worse than the one the market would have given.

1.5.1 Production possibility curve (PPC)

A PPC shows the maximum combinations of two goods that an economy can produce when all of its resources are fully and efficiently employed, given the existing state of technology.

1.5.1 The four assumptions behind a PPC

Only two goods are produced; the quantity and quality of the factors of production are fixed; the state of technology is given; on the curve all resources are fully and efficiently employed.

1.5.1 Which three concepts does a PPC show at once?

Scarcity — points beyond the curve are unattainable. Choice — every point on the curve is a different combination, and society must pick one. Opportunity cost — moving along the curve, more of one good can only be had by giving up some of the other.

1.5.1 What does a point ON the curve mean?

All resources are fully and efficiently employed. The point is attainable and productively efficient.

1.5.1 What does a point INSIDE the curve mean?

Resources are unemployed or being used inefficiently, so output of both goods could be increased at no opportunity cost.

1.5.1 What does a point BEYOND the curve mean?

It is unattainable with existing resources and technology.

1.5.2 Why is a PPC drawn as a straight line?

Because the factors of production are perfectly substitutable between the two goods, so each extra unit of one always costs the same quantity of the other. This is constant opportunity cost.

1.5.2 Why is a PPC normally drawn concave to the origin?

Because the factors are not equally suited to the two uses. As output of one good expands, resources progressively less well suited to it must be transferred, so each extra unit costs more of the other good than the last. This is increasing opportunity cost.

1.5.2 What does the shape of a PPC tell you?

A straight line means constant opportunity cost; a curve concave to the origin means increasing opportunity cost. Opportunity cost determines the shape of the curve, not whether there is a curve — scarcity does that.

1.5.3 Causes of an OUTWARD shift of the PPC

An increase in the quantity or quality of the factors of production, or an improvement in technology: net investment in capital, discovery of new natural resources, a growing labour force, education and training raising human capital.

1.5.3 Causes of an INWARD shift of the PPC

A fall in the quantity or quality of factors: war or natural disaster destroying capital, depletion of a natural resource, net emigration of workers, capital depreciating faster than it is replaced.

1.5.3 What is a pivot of the PPC?

A change affecting the production of one good only — for example a rise in agricultural productivity. The intercept on the other axis is unchanged, so the curve rotates instead of shifting bodily.

1.5.3 An outward shift of the PPC is called what?

Economic growth — a rise in the economy's productive potential.

1.5.3 Why does a shift of the PPC not involve an opportunity cost?

Because with additional or better resources more of both goods can be produced, whereas moving along the curve always requires one good to be given up.

1.5.3 How does today's choice along the curve determine tomorrow's curve?

An economy devoting more resources to capital goods gives up consumer goods today — that is the opportunity cost — but builds the capital stock that shifts its PPC further outwards in future. An economy producing mainly consumer goods enjoys higher living standards now and grows more slowly.

1.5.4 Significance of a position within the PPC

Resources are unemployed or being used inefficiently, so output of BOTH goods can be increased at no opportunity cost simply by bringing idle resources into use. That is never true of a point on the curve.

1.5.4 Moving from inside the curve onto it vs shifting the curve outwards

Moving onto the curve: nothing about the economy's resources changed — idle ones are now employed; it is using up spare capacity, a recovery, at no opportunity cost. Shifting outwards: the quantity or quality of resources or technology changed; it is economic growth, and it requires investment, which costs consumption today.

1.5.4 Why is a position inside the curve not normally permanent?

In a market economy unemployed resources push their own price down. As wages and rents fall it becomes profitable for firms to employ them again, and the economy moves back towards the curve.

1.5.4 When can a position inside the curve persist?

If wages are inflexible downwards, if unemployed workers are occupationally or geographically immobile, or if the shortfall in demand is severe.

1.6 What decides how a good is classified?

Its own characteristics — whether its provision uses scarce resources, whether it is rival and excludable, and whether consumers have full information about it. Neither who supplies it nor what it costs to buy affects the classification.

1.6.1 Free good

A free good is a good that is not scarce: it can be obtained without using any scarce resources, so it has no opportunity cost. Examples: air, sunlight.