Basic Concepts and Techniques
1. Nearly all resources are scarce.
2. Human wants are infinite.
3. Scarce resources and infinite wants give rise to the basic economic problem- resources have to be allocated between competing uses.
4. Allocation involves choice and each choice has an opportunity cost.
5. The Production Possibility Frontier (PPF) shows the maximum potential output of an economy.
6. Production at a point inside the PPF indicates an inefficient use of resources.
7. Growth in an economy will shift the PPF outwards.
The Function of an Economy
1. An economy is a social organisation through which decisions about what, how and for whom to produce are made.
2. The factors of production- land, labour, capital and entrepreneurship- are combined together to create goods and services for consumption.
3. Specialisation and the division of labour give rise to large gains in productivity.
4. The economy is divided into three sectors, primary, secondary and tertiary.
5. Markets exist for buyers and sellers to exchange goods and services using barter or money.
6. The main actors in the economy, consumers, firms and government have different objectives. Consumers, for instance, wish to maximise their welfare whilst firms might wish to maximise profit.
1. Economic data are collected not only to verify or refute economic models but to provide a basis for economic decision making.
2. Data may be expressed at nominal (or current) prices or at real (or constant) prices.
Data expressed in real terms take into account the effects of inflation.
3. Indices are used to simplify statistics and to express averages.
4. Data can be presented in a variety of forms such as tables or graphs.
5. All data should be interpreted with care given that data can be selected and presented in a wide variety of ways.
Positive and Normative Economics
1. Positive economics deals with statements of ‘fact’ which can be either refuted or supported. Normative economics deal with value judgements, often in the context of policy recommendations.
2. Economics is generally classified as a social science.
3. It uses the scientific method as the basis of its investigation.
4. Economics is the study of how groups of individuals make decisions about the allocation of scarce resources.
5. Economists build models and theories to explain economic interactions.
6. Models and theories are simplifications of reality.
7. Models can be distinguished according to whether they are static or dynamic, equilibrium or disequilibrium, or partial or general.
Free Market and Mixed Economies
1. The function of any economic system is to resolve the basic economic problem.
2. In a free market economy, resources are allocated through the spending decisions of millions of different consumers and producers.
3. Resource allocation occurs through the market mechanism. The market determines what is to be produced, how it is to be produced and for whom it is to be production is to take place.
4. Government must exist to supply public goods, maintain a sound currency, provide a legal framework within which markets can operate, and prevent the creation of monopolies in markets.
5. Free markets necessarily involve inequalities in society because incentives are needed to make markets work.
6. Free markets provide choice and there are incentives to innovate and for economies to grow.
7. In a mixed economy, a significant amount of resources are allocated both by government through the planning mechanism, and by the private sector through the market mechanism.
8. The degree of mixing is a controversial issue. Some economists believe that too much government spending reduces incentives and lowers economic growth, whilst others argue that governments must prevent large inequalities arising in society and that high taxation does not necessarily lead to low growth.
The Demand Curve
1. Demand for a good is the quantity of goods or services that will be bought over a period of time at any given price.
2. Demand for a good will rise or fall if there are changes in factors such as incomes, the price of other goods, tastes and the size of the population.
3. A change in price is shown by a movement along the demand curve.
4. A change in any other variable affecting demand, such as income, is shown by a shift in the demand curve.
5. The market demand curve can be derived by horizontally summing all the individual demand curves in the market.
The Supply Curve
1. A rise in price leads to a rise in quantity supplied, shown by a movement along the supply curve.
2. A change in supply can be caused by factors such as a change in costs of production, technology and the price of other goods. This results in a shift in the supply curve.
3. The market supply curve in a competitive market is the sum of each firm’s individual supply curves.
1. The equilibrium or market clearing price is set where demand equals supply.
2. Changes in demand and supply will lead to new equilibrium prices being set.
3. A change in demand will lead to a shift in the demand curve, a movement along the supply curve and a new equilibrium price.
4. A change in supply will lead to a shift in the supply curve, a movement along the demand curve and a new equilibrium price.
5. Markets do not necessarily tend towards the equilibrium price.
6. The equilibrium price is not necessarily the price which will lead to the greatest economic efficiency or the greatest equity.
Interrelationships Between Markets
1. Some goods are complements, in joint demand.
2. Other goods are substitutes for each other, in competitive demand.
3. Derived demand occurs when one good is demanded because it is needed for the production of other goods or services.
4. Composite demand and joint supply are two ways in which the markets are linked.
Price Elasticity of Demand
1. Elasticity is a measure of the extent to which quantity responds to a change in a variable which affects it, such as price or income.
2. Price elasticity of demand measures the proportionate response of quantity demanded to a proportionate change in price.
3. Price elasticity of demand varies from zero, or infinitely inelastic to infinitely elastic
4. The value of price elasticity of demand is mainly determined by the availability of substitutes and by time.
1. Income elasticity of demand measures the proportionate response of quantity demanded to a proportionate change in income.
2. Cross elasticity of demand measures the proportionate response of quantity demanded of one good to a proportionate change in price of another good.
3. Price elasticity of supply measures the proportionate response of quantity supplied to a proportionate change in price.
4. The value of elasticity of supply is determined by the availability of substitutes and by time factors.
5. The price elasticity of demand for a good will determine whether a change in the price of a good results in a change in expenditure on the good.
Normal, Inferior and Giffen Goods
1. An increase in income will lead to an increase in demand for normal goods but a fall in demand for inferior goods.
2. Normal goods have a positive income elasticity whilst inferior goods have a negative elasticity.
3. A Giffen good is one where a rise in price leads to a rise in quantity demanded. This occurs because positive substitution effect of the price change is outweighed by the negative income effect.
4. Upward sloping demand curves may occur if the good is a Giffen good, if it has a snob or speculative appeal or if consumers judge quality by the price of a product.
Indirect Taxes and Subsidies
1. Indirect taxes can be either ad valorem taxes or specific taxes.
2. The imposition of an indirect tax is likely to lead to a rise in the unit price of a good which is less than the unit value of the tax.
3. The incidence of indirect taxation is likely to fall on both consumer and producer.
4. The incidence of tax will fall wholly on the consumer if demand is perfectly inelastic or supply is perfectly elastic.
5. The incidence of tax will fall wholly on the producer if demand is perfectly elastic or supply is perfectly inelastic.
The Labour Market
1. The labour market is a factor market where the price of labour is the age rate and the quantity is the level of employment.
2. Labour is a derived demand.
3. One of the determinants of the demand for and supply of labour is the wage rate paid.
4. Other determinants of the demand for labour include the price of other factors of production and demand for the good being made.
5. Other determinants of the supply of labour include population migration, income tax and benefits, trade unions and government regulations such as the national minimum wage.
6. Economic theory suggests that trade unions, high levels of the minimum wage and high marginal rates of income will reduce employment levels, but economists disagree about how much impact these will have on employment.
Markets and Resource Allocation
1. The market is a mechanism for the allocation of resources.
2. In a free market, consumers, producers and owners of the factors of production interact, each seeking to maximise their returns.
3. Prices have three main functions in allocating resources. These are the rationing, signalling and incentive functions.
4. If firms cannot make enough profit from the production of a good, the resources they use will be reallocated to more profitable uses.
Economic Efficiency and Market Failure
1. Static efficiency refers to efficiency at a point in time. Dynamic efficiency concerns how resources are allocated over time so as to promote technical progress and economic growth.
2. Productive efficiency exists when production is achieved at lowest cost.
3. Allocative efficiency is concerned with whether resources are used to produce the goods and services that consumers wish to buy.
4. All points on and economy’s production possibility frontier are both productively and allocatively efficient.
5. Free markets tend to lead to efficiency.
6. Market failure occurs when markets do not function efficiently. Sources of market failure include lack of competition in a market, externalities, missing markets, information failure, factor immobility and inequality.
1. Externalities are created when social costs and benefits differ from private costs and benefits.
2. The greater the externality, the greater the likelihood of market failure.
3. Market failure occurs when marginal social cost and marginal social benefit are not equal at the actual level of output. There will be a welfare loss at this level of output shown by the ‘welfare triangle’ on a marginal social and private cost and benefit diagram.
4. Governments can use regulation, the extension of property rights, taxation and permits to reduce the market failure caused by externalities.
Public and Merit Goods
1. There will inevitably be market failure in a pure free market economy because it will fail to provide public goods.
2. Public goods must be provided by the state because of the free rider problem.
3. Merit goods are goods which are underprovided by the market mechanism, for instance because there are significant positive externalities in consumption.
4. Governments can intervene to ensure provision of public and merit goods through direct provision, subsidies or regulation.
1. Two types of immobility of labour are geographical immobility and occupational immobility.
2. Structural unemployment arises because of the immobility of labour.
3. Governments use a variety of policies to tackle the problems associated with immobility including education and training, relocation subsidies and regional policy.
Imperfect Market Information
1. Market Failure may be caused by asymmetric information in a market.
2. Principal- agent problems, adverse selection and moral hazard all occur because of asymmetric information in markets such as healthcare, pensions, education and tobacco and alcohol.
1. The price of a good may be too high, too low or fluctuate too greatly to bring about an inefficient allocation of resources.
2. Governments may impose maximum or minimum prices to regulate a market.
3. Maximum prices can create shortages and black markets.
4. Minimum prices can lead to excess supply and tend to be maintained only at the expense of the taxpayer.
5. Prices of commodities and agricultural products tend to fluctuate more widely than the prices of manufactured goods and services.
6. Buffer stock schemes attempt to even out fluctuations in price by buying produce when prices are low and selling when prices are high.
1. Government failure can be caused by inadequate information, conflicting objectives, administrative costs and creation of market distortions.
2. Public choice theory suggests that governments may not always act to maximise the welfare of society because politicians may act to maximise their own welfare.