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  • Created on: 16-12-19 19:15

Economics as a social science

Economics is concerned with the ways by which societies organise scarce productive resources in order to satisfy people's wants.

Economists often use models to develop theories of behaviour.

Ceteris paribus- all things being equal; the assumption that while the effects of a change in one variable are being investigated, all other variables are kept constant.

Positive economic statements- objective statements based on evidence or facts which can, therefore, be proved or disproved.

Normative economic- statements are subjectives statements based on value judgments and cannot be proved or disproved.

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The economic problem

Basic economic problem- resources have to be allocated between competing uses because wants are infinite, but resources are scarce.

Scarcity-resources are finite whereas wants are infinite.

Factors of production-resources and include land, capital (any man-made aid to production)), labour and enterprise.

Renewable resources- resources, such as fish stocks or forests, that can be exploited over and over again, because they have the potential to renew themselves.

Non-renewable resources- resources, such as coal or oil, which once exploited cannot be replaced.

Opportunity cost- the next best alternative that is forgone when a choice is made.

Opportunity cost is a real cost measured in terms of something that is foregone.

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Economic goods and free goods

Economic goods- goods that are scarce because, their use has an opportunity cost.

Free goods- goods that are unlimited in supply, and therefore have no opportunity cost.

Production possibility frontier- illustrates the maximum potential output of an economy when all resources are fully employed.

In some PPFs it is assumed that the economy can produce either consumer goods or capital goods.

Consumer goods- goods and services that are used by people to satisfy their needs and wants.

Capital goods- goods that are used in the production of other goods, such as factories, offices, roads, machines and equipemnt.

All points on the PPF indicate the maximum productive potential of an economyy and that resources are being used efficiently.

If the economy was operating inside it's PPF- unemployed resources are not being allocated efficiently.

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Possible and unobtainable production- PPF

Any point inside, or on the PPF, represent combinations of the two products which are obtainable.

Any points to the right of the PPF would be currently unobtainable until economic growth.

Marginal analysis- the impact of additions or subtractions from the current situation.

A marginal increase in the output of capital good means that some consumer goods must be sacrificed (the opportunity cost).

Economic growth- an increase in the productive capacity of the economy indicating an increase in real output.

Economic decline- a decrease in the productive capacity of the economy indicating a decrease in real output.

Economic decline would shift the PPF inwards and might have occured as a result of resources being reallocated from the production of capital goods to the production of consumer goods.

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Shifts in the PPF

Factors causing an outward shift in the PPF:

  • Discovery of new natural resources
  • Development of new methods of production- increase productivity.
  • Advances in technology
  • Improvements in education and training
  • Increase in the size of the workforce e.g. immigration, increase in retirement age, better childcare-more women workings.

Factors causing an inward shift in the PPF:

  • Natural disasters
  • Depletion of natural resources
  • Factors causing a reduction in the workforce size E.g. emigration, increase in the number of years in compulsory education
  • Deep recession- loss of productive capacity.

PPF represents the possible outputs of two goods which could potentially be produced.

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Specialisation and the division of labour

Division of labour- specialisation by workers, who perform different tasks at different stages of production to make a good or service, in co-operation with other workers.

Adam Smith set out the view that economic growth could be achieved by increasing the division of labour, saving time and enabling workers to become experts in the task given to increase productivity.

Specialisation- a system of organisation where economic units, such as households or nations are not self-sufficient but concentrate on producing certain goods and services and trading the surplus with others.

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Advantages and disadvantages division of labour

Advantages of division of labour:

  • Each worker specialises in tasks for which they are best suited- trained in one task.
  • Less time is wasted- no moving from task to task.
  • Enables production line methods to be employed- increased use of machinery- increase productivity- reduce average costs.

Disadvantages of division of labour:

  • Monotony and boredom- decreased productivity.
  • Loss of skills
  • Strike by one group of workers could bring entire production facility to a standstill.

Specialisation to trade makes a country become over-dependent on imported goods and services yet increases output, generates greater choice and lowers prices.

Limits division of labour:

  • Market size: small market- difficult to specialise.
  • Type of producer- unique not suitable 
  • Transport costs- high than not possible.
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Functions of money

Money- anything that is used as a means of exchange for goods and services.

Functions of money:

  • Medium of exchange
  • Store of value
  • measure of value
  • Means of deferred payments. (buy goods and pay for them on credit).
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Free market economy

Free market economy- an economic system that resolves the basic economic problems mainly through the market mechanism.

Characteristics free market economy:

  • Private ownership of resources
  • Market forces E.g. Supply and demand determine price.
  • Producers aim to maximise profits
  • Consumers aim to maximise satisfaction
  • Resources are allocated by the price mechanism.

Adam Smith suggested that when individuals follow their own self-interest, they indirectly promote the good of society.

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Command or centrally planned economy

Command economy- economic system where government, through a planning process, allocate resources in society.

Characteristics command economy:

  • Public (state) ownership of resources.
  • Price determination by state
  • Producers aim to meet production targets set by the state
  • Resources are allocated by the state
  • There is greater inequality of income and wealth than in a free market economy.

Karl Marx thought that capatalism was inherently unstable because workers are exploited by bourgeoisie (the owners of the factors of production).

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Mixed economy

Mixed economy- an economy where both the free market mechanism and the government planning process allocate significant proportions of total resources.

Role of state in a mixed economy:

  • Defence and internel security
  • Provision of public goods
  • Provision of essential public services E.g. health and education
  • Redistribution of income from the rich to the poor.
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Advantages and disadvantages free market economy

Advantages of free market economies:

  • Consumer sovereignty- spending decisions determine what is produced.
  • Flexibility
  • No officials
  • Competition- promotes efficient allocation of resources.
  • Increased choice
  • Economic and political freedom

Disadvantages of free market economies:

  • Inequality
  • Trade cycles- suffer from instability in the form of booms and slumps.
  • Imperfect information- no rational choices.
  • Monopolies- exploit consumers by charging prices higher than free market equilibrium.
  • Externalities
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Advantages and disadvantages of command economies

Advantages command economies:

  • Greater equality
  • Macroeconomic stability
  • External benefits and external costs
  • No exploitation
  • Full employment

Disadvantages command economies:

  • Inefficiency
  • Lack of incentives to take risks
  • Restrictions on freedom of choice
  • Shortages and surpluses
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Rational decision-making

Neoclassical analysis makes two assumptions:

  • Consumers act rationally to mximise utility
  • Firms act rationally to maximise profits

Utility- the level of satisfaction a consumer receives from the consumption of a product or service.

Demand- how much is demanded at each price over a certain period of time. The quantity purchased of a good at any given price, given that other factors of demand remain unchanged.

Factors causing a shift in the demand curve:

  • Real incomes- incomes have increased
  • Size or age distribution of the population
  • Tastes, fashions or preferences.
  • Prices of substitutes or complements
  • The amount of advertising or promotion
  • Interest rates
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Concept of diminishing marginal utility

Total utility- amount of satisfaction a person derives from the total amount of a product consumed.

Marginal utility- the change in total utility from consuming an extra unit of a product.

The law of diminishing marginal utility- as consumption of a product is increased, the consumer's utility increases but at a decreasing or diminishing rate.

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Price elasticity of demand (PED)

Price elasticity of demand- a measure of the responsiveness of quantity demanded for a product to a change in its price.

PED= (Percentage change in quantity demanded/ percentage change in price) * 100

If the percentage change in quantity demanded is larger than the percentage change then demand is price elastic.

When demand is unit elastic, the value of PED will equal to -1 and the demand curve will be a rectangular hyperbola.

When demand is perfectly price inelastic, the value of PED will be 0 and the demand curve will be vertical.

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Factors influencing price elasticity of demand

Factors influencing price elasticity of demand:

  • Availability of substitutes
  • Proportion of income spent on a producer
  • Nature of the product
  • Durability of the product
  • Lenght of time under consideration
  • Breadth of defenition of a product.

Total revenue- the value of goods sold by a firm and calculated by multiplying price times quantity sold.

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Cross elasticity of demand (XED) and YED

Cross elasticity of demand- a measure of the responsiveness of quantity demanded for one product (Y) to a change in the price of another product (X).

XED= Percentage change in quantity demanded of product Y/ percentage change in price of product X.

Positive sign- substitutes

Negative sign- Complements

Income elasticity of demand (YED)- a measure of the responsiveness of quantity demanded for a product to a change in real income.

YED= percentage change in quantity demanded/ percentage change in real income.

Positive sign- normal good

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Supply- the quantity of goods that suppliers are willing to sell at any given price over a period of time.

Factors causing a shift in the supply curve:

  • Costs of production
  • Productivity of workforce
  • Indirect taxes
  • Subsidies
  • Technology
  • Discoveries of new reserves of a raw material.

Price changes cause a movement along an existing supply curve.

Price elasticity of supply (PES)- a measure of the responsiveness of quantity supplied for a product to a change in its price.

PES= percentage change in quantity supplied/ percentage change in price.

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Factors influencing price elasticity of supply

Factors influencing the price elasticity of supply:

  • TIme
  • Stocks
  • Spare capacity
  • Availability and cost of switching resources from one use to another.
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Equilibrium price

Equilibrium (price and quantity)- when the quantity supplied is equal to the quantity demanded of a particular product.

Changes in the equilibrium price:

  • Change in the conditions of demand
  • Change in the conditions of supply.

Price mechanism in a free market economy:

  • rationing device
  • Incentive- profit act as incentive
  • Signalling device- to producers to increase or decrease supply
  • To determine changes in wants- reflected in a change in price.
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Consumer and producer surplus

Consumer surplus- the difference between how much consumers are willing to pay and what they actually pay for a product.

Producer surplus- the difference between the cost of supply and the price received by the producer for the product.

Factors affecting producer surplus:

  • Gradient of supply curve
  • Changes in the conditions of supply

Indirect taxes- taxes on expenditure

  • Ad valorem taxes- a percentage of the price of the product.
  • Specific taxes- a set amount per unit of the product.

Incidence of tax- relates to how the burden of a tax is distributed between different groups.

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Subsidy- a grant from the government which has the effect of reducing costs of production.

Behavioural economics- a method of economic analysis that applies psychological insights into human behaviour to explain economic decision-making.

Reasons why consumers may not behave rationally:

  • Influence of other people's behaviour
  • Importance of habitual behaviour
  • Inertia- consumers make no effort to change due to information overload, complexity of information and too much choice available.
  • Consumer weakness at computation- attention to recent events.
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Market failure

Market failure- occurs when the forces of supply and demand (market forces) do not result in the efficient allocation of resources.

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Externalities- affect parties that are not directly involved in a transaction and may be either costs or benefits. (effects on stakeholders).

Private costs- direct cost to producers and consumers for producing and consuming a product.

External costs- costs in excess of private costs that affect third parties who are not part of the transaction.

External costs of production:

  • Air pollution
  • Noise pollution
  • Pollution

External costs of consumption:

  • Passive smoking
  • Overeating by individuals- costs for National Health Service.
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Social costs

Social costs- the sum of private costs and external costs.

Social costs= private costs + external costs

External costs= social costs - private costs

Private benefits- direct benefits to producers and consumers for producing and consuming a product.

External benefits- benefits in excess of private benefits which affect third parties who are not part of the transaction.

Social benefits-sum of private benefits and external benefits.

Social benefits= private benefits + external benefits

External benefits= social benefits - private benefits

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Public goods

Public goods- goods that are non-rivalrous (amount available does not fall after one person's consumption) and non- excludable (cannot prevent anyone from consuming them.

Free rider problem- the problem that once a product is provided, it is impossible to prevent people from using it and, therefore, impossible to charge for it.

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Symmetric and asymmetric information

Symmetric information- where both parties in a transaction have the same information.

Asymmetric information- where one party in a transaction has more or superior information compared to another.

Examples of markets with asymmetric information:

  • Housing markets
  • Life insurance
  • Second-hand car sales
  • Financial services
  • High-tech products.
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Maximum price

Maximum price- a price, usually set by the government, which makes it illegal for firms to charge more than a certain price for a given quantity of a product.

Advantages maximum price:

  • enable consumers on low incomes to afford product
  • Helps prevent an increase in inflation.

Disadvantages maximum price:

  • Danger that shortages mean customers are unable to find supplies of product.
  • Producer may exist market
  • Significant cost to taxpayer if government subsidies producers.
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Minimum price

Minimum guaranteed price (MGP)- a price, usually set by the government, which is guaranteed to producers.

Advantages minimum price:

  •  Producers know the price they receive for product.
  • Greater certainty- producers can plan investment and output.

Disadvantages minimum price:

  • Surpluses each year if set too high.
  • Schemes involve cost of storage- borne by taxpayers.
  • Encourage over-production- inefficient allocation of resources.
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Tradable pollution permits- rights to sell and buy actual or potential pollution in artificially created markets.

Property rights- exclusive authority to determine how a resource is used. Property rights are ownership rights.

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Government failure

Government failure- government intervention results in a net welfare loss.

Causes of government failure:

  • Distortion of price signals
  • Unintended consequences
  • Excessive administrative costs
  • Information gaps

Government failure might be observed in:

  • Indirect taxes
  • Agricultural stabilisation schemes
  • Housing policies
  • Environmental policies
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