Edexcel Economics Theme 1

Economics

The study of the allocation of scarce resources.

Economic Goods

Resources that are scarce.

Short Run

A time period where at least one factor of production is fixed.

Long Run

A time period where all factors of production are variable.

Productivity

The output per unit of input.

The Economic Problem

Resources are scarce but wants are infinite.

Scarcity

The world's resources are limited, there are only limited amounts of land, water, oil, food, etc..
Therefore, resources are scarce.

Free Goods

Goods that are unlimited in supply and therefore have no opportunity cost.

Economic Agents

Consumer, Business and Governments.
Agents involved in Economic transactions.

Production Possibility Frontier

The maximum potential output of a combination of goods an economy can achieve when all its resources are fully and efficiently employed, given the level of technology.

Opportunity Cost

The next best alternative foregone.

Economic Growth

Increase an economy's productive potential.

Capital Goods

Goods intended for use in production, rather than by consumers.

Consumer Goods

Goods designed for use by final consumers.

Renewable Resources

A resource whose stock level can be replenished naturally over a period of time.

Non-renewable Resources

A resource whose stock level decreases over time as it is consumed.

Ceteris Paribus

'All other things (factors) remaining the same'
The assumption that all other variables within a model remain constant whilst the change is being considered.

Positive Statement

A statement based on facts which can be tested as true or false and are value-free.

Normative Statement

A statement based on value judgements which cannot be tested as true or false.

Adam Smith

The Father of Economics;
- The Invisible Hand (workings of the Price Mechanism)
- Specialisation
- Division of Labour

Division of Labour

Specialisation of workers on specific tasks in the production process.

Specialisation

The process of breaking down the production process into steps and then each worker is assigned a step. This would then increase labour productivity (Output per Worker).

Barter

An exchange of goods/services for other goods/services.
- Does not involve money.
- Double coincidence of wants.

Money

Anything which is acceptable to a wide number of people and organisations as payment for goods and services.

Free Market Economy

Where all resources are privately owned and allocated via the price mechanism. There is minimal government intervention.

Command Economy

Where there is public ownership of resources and these are allocated by the government.

Mixed Economy

Where some resources are owned and allocated by the private sector and some by the public sector.

Market

A channel where goods and services are exchanged.

Utility

The capacity of a good or service to satisfy some human want.

Rational Decision Making

Where consumers allocate their expenditure on goods and services to maximize utility, and producers allocate their resources to maximize profits.

Demand

The quantity of goods or services that will be bought at any given price over a period of time.

Demand Curve

Shows the quantity of a good or service that would be bought over a range of different price levels in a given period of time.
Slopes downward - Price and Quantity have an inverse (negative) relationship.

Marginal Utility

The additional satisfaction that a consumer gains for consuming one additional unit of a product.

Diminishing Marginal Utility

As successive units of a good are consumed, the utility gained from each extra unit will fall.

% Change

y2 - y1 / y1 × 100

Price Elasticity of Demand (PED)

The responsiveness of demand to changes in price.
The value is always negative.
% ∆QD / % ∆P × 100

Unitary Price Elasticity (Ped)

Ped = 1

Perfectly Price Inelastic (Ped)

Ped = 0

Price Inelastic (Ped)

Ped is < 1

Perfectly Price Elastic (Ped)

Ped = ∞

Price Elastic (Ped)

Ped is > 1

Total Revenue

Price × Quantity

Income Elasticity of Demand (YED)

The responsiveness of demand to changes in income.
%∆QD / %∆Y × 100
Negative - Inferior Good (Y increases, QD decreases)
Positive - Normal Good (Y increases, QD increases).

Negative Income Elasticity of Demand

Inferior Good (As income increases, QD decreases)

Positive Income Elasticity of Demand

Normal Good (As income increases, QD increases)

Cross Price Elasticity of Demand (XED)

The responsiveness of demand for one good to changes in the price of a related good. (Either substitutes or complements).

% ∆ inQD of Good A/ % ∆ in Price of Good B × 100
Negative Value - Complements (The 2 goods are in Joint Demand; as the Price of Good A increases the Demand of Good B decreases).
Positive Value - Substitutes (The 2 goods are in Competitive Demand; as the Price of Good A increases, the Demand of Good B increases.)

Negative Cross Price Elasticity of Demand

Complements (As the Price of one good increases, the Demand for the second good decreases)
The 2 goods are in Joint Demand.

Positive Cross Price Elasticity of Demand

Substitutes (As the Price of one good increases, the Demand for the second good increases)
The 2 goods are in Competitive Demand.

Supply

The quantity of a good or service that firms are willing to sell at a given price over a given period of time.

Supply Curve

Shows the quantity of a good or service that firms are willing to sell to a market over a range of different price levels in a given period of time.
An upward sloping curve - Price and Supply have a direct relationship.

Price Elasticity of Supply

The responsiveness of supply to changes in price.
Pes = %∆QS / %∆P

Equilibrium Price

The price at which the Quantity Demanded and Quantity Supplied are equal, ceteris paribis. "Market Clearing Price"

Excess Supply

Where the QS exceeds the QD for a good at the current market price.
QS > QD

Excess Demand

When the QD exceeds the QS for a good at the current market price.
QD > QS

Adam Smith's Invisible Hand

A hidden hand of the market operating in a competitive market through the pursuit of self-interest allocated resources in society's best interest.

Price Mechanism

The use of market forces to allocate resources in order to solve the economic problem of what, how, and for whom to produce.
The interaction of demand and supply to determine the market clearing price.

Consumer Surplus

The difference between how much buyers are prepared to pay for a good and what they actually pay.
It is represented by the area under the demand curve above the ruling market price.

Producer Surplus

The difference between the market price which firms receive and the price at which they are prepared to supply.
It is represented by the area below the ruling market price and above the supply curve.

Tax Incidence when Demand is Inelastic

Consumer Tax Burden > Producer's Tax Burden

Tax Incidence when Demand is elastic

Consumer Tax Burden < Producer's Tax Burden

Tax Incidence when Supply is Inelastic

Consumer Tax Burden < Producer's Tax Burden

Tax Incidence when Supply is elastic

Consumer Tax Burden > Producer's Tax Burden

Direct Taxes

Tax paid on incomes or profits.
Example; Income Tax and Corporation Tax.

Indirect Taxes

A tax levied on the purchase of goods and services. It includes both specific and Ad Valorem taxes.
Its shown by an inward shift of the supply curve.

Specific Tax

The amount of tax levied does not change with the value of the goods but with the amount or volume of goods purchased (Excise Duties)
- Parallel to the 1st Supply Curve

Ad Valorem Tax

Tax levied increases in proportion to the value of the tax base. (VAT)
- Steeper Gradient relative to the original Supply Curve.

Incidence of Tax

The distribution of the tax paid between consumers and producers.

Consumer Tax

Below the new EQ and above the original EQ.

Producer Tax

Below the original EQ and above the original supply curve.

Subsidy

A government grant to firms, which reduces production costs and encourages an increase in output.
Its shown as an outward shift of the Supply Curve.

Market Failure

A misallocation of resources caused by the Market Mechanism.

Reasons for Market Failure

- Missing Markets ( Merit Goods and Public Goods)
- Lack of Competition in the market.
- Externalities
- Imperfect Market Information
- Factor Immobility
- Inequality

Demerit Goods

A good which is over provided by the Market Mechanism and tends to yield more costs to individuals than they realize.
Examples; Tobacco, Drugs, Alcohol, etc..

Externalities

The costs or benefits that are external to an exchange. They are 3rd party effects ignored by the Market Mechanism.

Consumption Externality

An external cost or benefit arising from a consumption activity.

Production Externality

An external effect of production, which neither harms nor benefits the person or firm controlling the production.

External Costs

Negative 3rd Party effects that are excluded from the Market Mechanism.

Private Costs

Cost internal to a market transaction, which are therefore taken into account by the Market Mechanism.

Social Costs

External Costs + Private Costs.

External Benefits

Positive 3rd Party effects that are excluded from the Market Mechanism.

Private Benefits

Benefits internal to a market transaction, which are therefore taken into account by the Market Mechanism.

Social Benefits

External Benefits + Private Benefits.

Market Equilibrium Level

Marginal Private Costs (MPC) = Marginal Private Benefits (MPB)

Social Optimum Level

Marginal Social Costs (MSC) = Marginal Social Benefits (MSB)
This is where society should be.

Welfare Loss

The excess of social costs over social benefits for a given output.
A situation where MSB is ≠ to MSC and society does not achieve maximum utility.

Welfare Gain

The excess of social benefits over social costs.

Negative Production Externality

Positive Consumption Externality

Internalising the Externality

Eliminating the externality by bringing it back into the framework of the Market Mechanism.
= Creating a market for the Externality.
Examples; Tradable Pollution Permits, Extending Property Rights, Taxes, Regulation, etc..

Public Goods

Those goods that have non-rivalry and non-excludability by their consumption.
Non Rivalry; Consumption of goods by one person does not reduce the amount available for consumption by another.
Non-Excludable; Once provided, no person can be excluded from benefiting.
Examples; Defense, Police Service, Street Lighting, Judiciary and Prison Service.

Private Goods

Those goods that have rivalry and excludability in their consumption.

Free Rider Problem

If left to the free market, public goods would not be adequately provided for.
The market fails because firms cannot withhold the goods and services from people who refuse to pay.

Information Gaps

Where consumers, producers or the government have insufficient knowledge to make rational economic decisions.

Symmetric Information

Where consumers and producers have access to the same information about a good or service in a market.

Asymmetric Information

Where consumers and producers have unequal access to information about a good or service in the market.

Maximum Price

A ceiling price set by the government on a good or service, above which it cannot rise. It may be enforced through government legislation.

Minimum Price

A floor price set by the government on a good or service, below which it cannot fall. It may be enforced through government legislation.

Guaranteed Minimum Price

Where the surplus output created is purchased by a government agency at the minimum price. The main aim of such a scheme is to protect producer incomes.

Tradable Pollution Permits

Pollution permits that can be bought and sold in a market. They are an attempt to solve the problem pf pollution by creating a market for it.

Extending Property Rights

Water companies are given the right to charge companies which dump waste into the rivers or the sea.
A way of internalising the externality.