Economic methodology and the economic problem

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  • Created by: ekenny5
  • Created on: 27-10-20 12:14

economic methodology

  • economics as a social science - study the choices people make uder conditions of scarcity and uncertainty, not a natural sciemce as they are not exact results, never sure how people act under different circumstances, consumers not always rational 
  • traditional economic theory is that consumers maximise own satisfaction and businesses maximise profits 
  • behavioural economics studies the social aspects of decisions 
  • positive statement -  objective statements that can be tested, ammended or rejected referring to evidence 
  • normative statement - carry value judgement about what ought to be (which objective is most important/bigger impact
  • politicians and governments make decisions using normative statements (what they think based on the positive statements)
  • microeconomics is the study of how individual firms, industries and consumers/households behave together 
  • what consumers decide to buy, how businesses determine what is produced and how it's supplied 
  • analysing the effect of government regulations, subsidies, taxes ect on consumer habits and supply/demand 
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The nature and purpose of economic activity

  • the production of goods and services to satisfy needs and wants 
  • needs are things that are neccessary for an organism to live a healthy life, eg water
  • wants are to feel a desire for something, to wish for
  • aiming for economic welfare - evaluating well being, usually measure in income/GDP - ^income, ^welfare (though this isnt always the case as there is a large inequality of wealth, and a large income gap
  • key economic decisions are:
  • what to produce
  • how to produce 
  • who is to benefit from the goods and services produced 
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Economic systems

An economic system is a network of organisations used to resolve the probelm of what, how much and for whom to produce 

the types of ecocomy are:

  • free market
  • mixed 
  • command 
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Free Market Economy

  • markets allocate resources 
  • driven by profit motive 
  • limited role for state
  • private sector dominates 
  • the invisible hand - businesses compete for consumers using better quality and/or lower prices. any unwanted products won't be purchased and will drop out of the market 
  • lassaiz faire approach from the governments 
  • Hong Kong ranks as 90.2% economically free, the highest in the world, with extremely low tax rates and minimal business regulations 
  • Singapore is second at 89.4% economically free
  • New Zealand, Switzerland and Australia make up the rest of the top 5 most economically free markets 
  • Adam Smith in the 1700s wrote the wealth of nations, where he displayed his belief in free markets, saying people act in their own self interest (businesses maximise profit and consumers maximise own satisfaction), so the invisible hand would sort out the supply/demand within an economy
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Mixed Economy

  • mix of state and private ownership 
  • government intervention in markets 
  • the mix will vary between countires, governments make limits and regulations for private producers eg sugar tax 
  • governments involved with improving welfare, eg healthcare, benefits, education, minimum wage. for example in the UK, USA and Canada 
  • Fredrich Hayek believed that free market economies allow for more efficient resource allocation, but that government intervention is necessary 
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Command Economy

  • most resources are state owned 
  • planning allocates resources 
  • little role for market prices 
  • restricted freedom for citizens 
  • businesses/governments have no competition so could have higher prices 
  • Karl Marx believed in command economies, saying that free market economies led to the exploitation of workers, as profit is the main aim of businesses. This economy fits in with Marx' theory of commmunism 
  • the least free (most command-like) economies are Zimbabwe, Equatorial Guinea, Bolivia, Timor-Leste and Algeria 
  • famously used by formally USSR and Cuba 
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Free Market Competition

  • efficeint allocation of scare resources - go where the market return is the highest
  • competitive prices for consumers 
  • more innovation as businesses need competitive advantage 
  • profit motive stimulates capital investment 
  • competition with international trade helps reduce domestic monopoly power and increases choice  
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The Role of the State

  • in mixed economies 
  • state owned industries wholly or part-state owned indsutries eg RBS, Network Rail 
  • welfare state - welfare benefits, universal, eg state pension, means tested eg housing benefits 
  • government spending on public services - education and health, capital spending on infrastructure 
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Economic Resources

economic resources = factors of production

  • the inputs available to supply goods and services in an economy 
  • Land - natural resources available for production, this could include the sea for oil
  • Labour - the human input into the process of production 
  • Capital - goods used in the supply of other goods eg machinery and tech
  • Enterprise - entrepreneurs organising factors of production and taking risks, to generate profit

Factor Rewards - how incomes flow in and out of each of the main factors of production 

  • Land - rental income to land owners 
  • Labour - wages and salaries from employers 
  • Capital - interest from savings and dividends from shares, ^productivity with machinery
  • Enterprise - profit  
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The Economic Problem

ulimited wants with limited supply 

the rationing of scarce resources is done by 

  • market price - increased price decreases demand eg house prices ^ as only limited supply, so less people can now afford house prices 
  • consumer income - free prescriptions if unemployed
  • assessment of need 
  • household postcode
  • education level 
  • age 
  • gender 
  • nationality 
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Types of Goods

capial goods are goods that are used to make consumer goods and services eg machinery, hardware, buildings

consumer goods and services are goods/services that satisfy needs and wants directly 

consumer durables provide a steady flow of satisfaction utility over time eg washing machine 

consumer non-durables are used up in the act of consumption eg a cup of coffee

consumer services eg hair cut 

non-renewable resources - finite supply, for some there are no mechanisms for replenishing them, the rate of extraction depends on current market price (^price as lower supply). though as a switch to renewable resources price decreases of finite resources 

renewable resources - replaceable over time providing that the rate of extraction of the resource is less than the natural rate at which the resource renews itself 

free goods - do not use any factor inputs when supplied. zero opportunity cost eg air 

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Opportunity Cost

measures the cost of a choice in terms of the next best alternative forgone or sacrificed  -- a good way to evaluate a decision  - look at what could have been 

eg work vs leisure choices 

government spending proiroties

investment today vs consumption tomorrow 

use of scarce farming land, what to grow/produce 

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Production Possibility Diagrams

  • PPF show alternative combinations of two goods or services attainable when all resources are fully and efficiently employed
  • normally draw a PPF as concave to the origin, when we move along the PPF, as resources are allocated towards good Y, the extra output gets smaller 
  • law of diminishing marginal returns, occurs because not all factor inputs are equally suited to producing items leading to lower productivity
  • if the equlibrium point lies on the curve, it is operating at full current potential, productivley effiecient 
  • if below the curve, not all tghe factor inputs are being used efficiently eg unemployment
  • if above the curve, this productive potential is not yet attainable 
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Economic Growth

economic growth causes the PPF to shift outwards, this could be due to improvement in the factor inpus, eg more advanced technology 

economic shrink causes the PPF to shift inwards, eg natural disasters or the brain drain, meaning the overall production potential has decreased - this is permanent, unlike strikes or unemployment which are the inputs not being used efficiently

  • when operating inside the curve, get closer to the curve by increasing outputs of goods and services
  • trade between countries allows nations to consume beyond their own productive potentials
  • producing more of both goods with the same resources represents an improvement of welfare and gain allocative efficiency  
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PPF Opportunity Cost

to produce 100 more cotton, we must produce 40 less wheat (opportuinty cost of wheat)

Diminishing return 

if 100 more cotton loses 40 wheat, but then to make another 80 cotton, we lose another 80 wheat, there is a higher opportunity cost further down the curve. this is diminishing return 

it is still productivley efficient as it's operating on the curve, but the opportuity cost is still greater 

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Linear PPF

A straight line PPF is an indication of perfect factor substitutability of resources 

The marginal opportunity cost of switching resources between consumer and capital goods is constant 

The exact same resources/labour are needed for both outputs. They are substitutable 

Outward shift in a linear PPF is increasing a countries potential output due to changes in production technology or more factor inputs. More can be made at each level 

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Causes of Outward Shifts

  • higher productivity/efficiency of factor inputs > increases output per unit of input used in production 
  • better management of factor inputs eg decrease waste or increase quality 
  • increased stock supply of capital and laboour supply eg inward migration/ capital investment 
  • innovation and invention of new products and resources > improved production process helps increase efficiency 
  • discovery/ extration of natural resources (land) > comercially viable laand inputs drives extraction - eg Dubai oil being discovered in the 1980s and was extracted, GDP went from around $40bn USD in 1980 to around $340bn in 2015
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Causes of Inward Shifts

  • natural disasters/ destruction of resources > no longer as many resources so production potential decreases 
  • civil or international wars > liked to destruction of factor inputs eg land and labour
  • outward labour migration  > shrinking labour force (brain drain)
  • persistant depression > decline of productivity, net investment negative 
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Resource Depreciation and Depletion

Depreciation is the loss in value of assets over time (not including natural resources)

  • machinery
  • skill atrophy (waste)
  • buildings 
  • basic infrastructure 

Depletion is the loss in value of natural resources over time 

  • human capital flight 
  • capital scrapping 
  • natural disasters 
  • deforestation 
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Economic Recovery and Growth

Recovery means getting closer to the curve. During recovery aggregate demand will be rising. this leads to an increase in real national output, and a decrease in amount of spare capacity. Factor inputs are more efficient, eg increased employment 

Growth means increased supply of both goods (increased productive capacity). Supply side policies (labour policies and apprenticeships) can shift out the PPF 

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