Economics Theme 1

Introduction to markets and market failure

Economics

The scientific study of the ownership, use and exchange of scarce resources.

The basic problem

Infinite wants and finite resources

Why do economists use models?

Economist use abstract models based on scientific evidence to

• explain and predict behaviour of economic actors in the exchange of goods and services

• To simplify a complex reality

• To test hypothesis by isolating variables and applying ceteris paribus

Assumptions

That behaviour is predictable and all economic actors behave perfectly rationally

Ceteris paribus - all other factors remain equal

Positive vs Normative statements

Positive statements can be proven true or false and can be supported or refuted by evidence. (e.g. the UK economy is currently in recession)

Normative statements are value judgements, they cannot be supported or refuted and are influenced through factors such as political views. (e.g. Brexit led to a healthier economy)

Scarcity

The quantity available is insufficient to meet demand

Scarce resources are economic goods

Free goods

Abundant resources that have no opportunity costs

e.g. air, sunlight, clean beaches

Susceptible to population change so they become scarce / behaviour that undermines quality

Needs vs Wants

Needs are essential to survival

Wants are desired

Opportunity cost

The value of the next best alternative foregone

What are the factors of production

Land

Labour

Capital

Enterprise

What do PPF curves show

1) Capacity of the economy

2) Opportunity cost

3) Economic growth

Movements show how resources are allocated

Shifts show capacity changing as a result in the changes in quantity / quality of the factors of production

Specialisation

The concentration on the production of a specific good / service

Benefits - Focus on areas means higher quality of goods and services because of experts , encourages investment into specialised machinery (efficiency) , surplus that increases economic welfare for all, economies of scale achieved through mass production - lower cost per unit

Drawbacks - Markets may not be large enough to allow specialisation , too much creates risk (e.g. market collapse)

Division of labour

When an individual focuses on a specific task within the production process

Adam Smith - 1 worker in a pin factory makes 20 pins by themselves whereas 10 working together makes 48,000 a day

Benefits - highly skilled staff (productivity), time saved by the movement of workers limited, makes specialist machinery cost effective through high volume produced

Drawbacks - Repetitive tasks bring motivation down and less prideful of their work, risk of skills too narrow leading to structural unemployment, higher worker turnover because of boredom so higher hiring and training costs

Productivity

The amount of output possible with a given quantity of resources

Labour productivity - output per worker

Capital productivity - output per unit of capital

Markets

Any set of convenient arrangements allowing buyers and sellers to communicate to exchange goods and services

Can be defined by geography or product

4 uses of money

1) medium of exchange

2) measure of value

3) store of value

4) method of deferred payment

The 2 approaches to allocating resources

1) The market mechanism - the quantity of goods/services provided is determined by the interaction between supply and demand. The ‘invisible hand’.

2) Planning- administrative decisions made by an authority

What are the types of economy

1) Free (market mechanism)

2) Mixed (both the market mechanism and planning)

3) Command (planning)

Free market economies

Most resources allocated by the market mechanism with little to no government intervention

No pure free market economies

e.g. USA (37% output is government spending)

Mixed economies

Some resource allocated by the market, some by the state

State intervention likely to focus on public and merit goods

Most mixed economies have government spending make up 40-60% of output

Command economies

Most to all resources allocated by the state through central planning

e.g. North Korea

Innovation in economies

There is a big incentive in a market economy for innovation but not in a command economy due to the lack of competitive pressure because value is more on meeting production demands than development.

Adam Smith

Credited with the concept of the invisible hand

Argued the selfish pursuit of profit by economic actors is beneficial for all

Advocate for free markets and laissez faire politics but recognises the need for state intervention as the market wont provide all goods and sevr

Friedrich Hayek

Believes state intervention comes at the expense of individual freedoms

Suggested that being poor in a market economy is better than being poor in a control economy because of the freedom

Karl Marx

Marx advocated for the abolition of private property and the establishment of a command economy, where the state controls the factors of production to ensure equitable distribution

Utility

The satisfaction derived from the consumption of a particular good / service

Economic theory assumes consumers make rational decisions meaning maximising utility

Marginal utility

The extra utility from consuming one more unit of a good

Why is behaviour not always rational

We value the immediate rewards over long term positives

Emotional choices

Consumers are loss averse

Influence of others

What is demand

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

Conditions of demand (factors that cause shifts)