NATURE OF ECONOMICS
If economists are to cope with the complexities of the real world, they must simplify reality in someway, and thus, work with models.
These simplified versions of reality make analysis more manageable and often begin as assumptions. Ceteris paribus is a Latin
phrase meaning ‘other things being equal’ - meaning being able to focus on one variable while holding others constant.
The basic economic problem: people have unlimited wants, but there are finite resources. Thus, economists must attempt to
reconcile this problem of scarce resources and infinite desires.
Economic activity is the production and distribution of goods and services. The purpose of economic activity is the production of
goods and services to satisfy wants and needs, and thereby improve economic welfare. Consumers seek to maximise utility, firms
seek to maximise profits, governments seek to maximise social welfare, by correcting market failures.
An economy consists of the economic system of a country or other area, the labour, capital and land resources, and the
economic agents that socially participate in the production, distribution, exchange and consumption of goods and services in that
area.
Normative economics: subjective attempt to describe what ought to be, involving a value judgement.
Positive economics: deals with objective or scientific explanations of the economy, and can be tested against evidence.
FACTORS OF PRODUCTION
Factors of production are input resources required to produce output goods and services (output resources) for individuals to satisfy
desires.
1) Land - natural resources available for production.
2) Labour - human input into the production process.
3) Capital - investment in goods that are used to make other goods in the future. Fixed capital includes machinery and factories.
4) Enterprise - an individual who seeks to supply products to a market for a rate of return (i.e profit). Entrepreneurs will usually
invest their own financial capital in a business and take in the risks associated with business investment.
Factor payments:
- Land = rent.
- Labour = wages.
- Capital = interest.
- Enterprise = profit.
Factor immobility: when FOPs are not mobile and the free market cannot allocate them to their most efficient use (market failure)
- Land: resources in earth’s crust may be inaccessible due to poor infrastructure or legislation and planning permission may
restrict use of some land.
- Labour: occupational and geographical immobility.
- Capital: traditionally governments tried to control flows of international finance however, the development of global capital
markets and improved telecommunications have vastly improved flows of capital.
- Enterprise: enterprise should be the most mobile of all factors, as entrepreneurs should move in pursuit of profit, however
human factors may also influence decisions such as conscience (when it comes to saking workers) and family ties.
PRODUCTION POSSIBILITY FRONTIER
A PPF is the maximum combinations of output that can be produced with a given set of resources.
The PPF is concave as a result of the trade-off between goods and services as an economy specialises production in one
industry. FOPs in an economy are better suited to one industry rather than another, and thus when the output of ‘wheat’
approaches its maximum, the extra land, capital and labour used will be takes from the ‘butter ‘industry, and will now be less efficient
and relatively unproductive, so output would decrease.
Productivity is output per unit input. Labour productivity measures output per worker, therefore an increase in labour productivity
means a given labour force can produce a greater level of output in a given time.
, N -
0.6 : diferente between a
varntriéí Current Wet
and their productiva of output
capa city
Increase in quality or quantity in any FOPs (potential growth) Levels of production
.
G Wheat
| |
pull Wheat
• ""
/
" " att" "
^ .
•
A
. .
.
.
→ •
unemployment
of resources
nitter
O
-
-
Butter
O S
An opportunity costs is the benefits of the next best alternative forgones as a result of a particular choice. E.g. due to scarcity
of resources in the economy, production of any good or service means there will be less production of something else.
Opportunity cost - PPF analysis
Wheat Wheat
the opportunity nrtgrowwng
}
is B,
Banning
Production from We to her
-
production forgonl
butter .
•
Wz
- - - - - -
tw
|
. - - - -
! -
¡
1 1
1 1
÷
Brus B , Butter
Specialisation: when societies engage in trade, a means of exchange, and thus do not have to produce all the goods and
services they need. Instead they ‘specialise’ in producing the good or service they are most efficient at producing, and thus
increasing total output, thus standard of living increases.
Division of labour: the delegation of specific tasks to individuals, in which they will develop a set of skills that allows them to
increase their productivity, thus increasing total output and standard of living.
Capital vs consumer goods:
- At any point in time, an economy has to choose between allocating FOPs to the production of consumer or capital goods.
- If more capital goods are produced, in the short term consumer goods production will decline.
- But in the long run, supply of consumer goods can increase, as the PPF shifts out due to greater quantity of capital in the
economy.
MARKET TYPES
Free market economies
- Market forces allocate resources based on supply and demand and the price mechanism. Adam Smith argued the idea of an
‘invisible hand’ which guides firms to produce the goods and services that consumers wish to consume. Smith also pointed
out in order for the free market to work properly there could not be monopolies and there would have to be low barriers to
entry. Friedrich Hayek argued governments are faced with imperfect information and that markets should rely on price signals
and incentives.
PUSITIVES NEGATIVA
- Efficiency: any product can be bought and sold, only - Inequalities: can lead to huge differences in income
those of the best value will be in demand. So firms have which can be called unfair, e.g. if someone is unable to
the incentive to be efficient. work they would receive no income.
- Entrepreneurship: rewards for good ideas can mean - Non-profitable goods may not be made: e.g. drugs to
money, this encourages risk-taking and innovation. treat rare medical conditions may never sell enough for
- Choice: incentives for innovation can lead to increased a firm to make profit, so would not be made.
choice for consumers and consumers are not restricted - Monopolies: successful businesses can become the
to buying what the government recommends. only supplier of a product and this market dominance
can be abused.
Command economies
- Governments plan and direct how resources should be allocated. Karl Marx argued that in a capitalist society in which there is
private ownership of productive resources, owners of capital would exploit their position at the expense of labour, eventually
resulting in revolution. Although this did not transpire in the way Marx expected, there was a move in some countries away
from private ownership and state control of resource allocation through central planning.
, - Maximise welfare: governments can redistribute income - Imperfect information: as argued by Hayek.
and prevent inequality, additionally they can ensure the - Restricted choice: consumers have limited choice and
production of goods and services that are beneficial to firms are told what to produce.
society. - Lack of risk-taking and efficiency: government-owned
- Low unemployment: government can provide everyone firms have no incentive to increase efficiency, take risks
with a job and salary. or innovate, because they do not need to make profit.
- Prevent monopolies - Micromanagement is costly
Mixed economies
- Market failure exists when free markets fails to distribute goods and services efficiently and fairly. Governments may intervene
to correct this market failure by altering the allocation of resources, it is called a mixed economy. Is is often argued that state
intervention should be market friendly, helping markets work rather than replacing market forces.
MARKETS
MONEY has multiple functions which are essential for prices to fulfil their role of allocating resources in a society:
- Medium of exchange
- Measure of value
- Method of deferred payment
DEMAND
Demand = the quantity of a good or services that consumers are willing to purchase at any given price.
The demand curve shows this relationship. The demand curve is downwards sloping because as more is demanded price falls. One
reason for this is the concept of diminishing marginal utility:
- When a consumer buys more units, the marginal utility (change in total utility or satisfaction derived from consuming one extra
unit) of the g/s declines, therefore they are less willing to buy the g/s, and will only do so if the price was less.
Non-price factors that will shift the demand curve, as more or less is demanded at any given price:
- changes in tastes and preferences
- price of substitutes
- price of complementary goods
- income
- population
Change in price will cause expansion or contraction along demand curve.
PRICE ELASTICITY OF DEMAND
PED measures the responsiveness of quantity demanded to a change in price.
% change in quantity demanded new−original
PED = % change in price % change = new x 100
Factors that affect PED:
- availability of substitutes
- necessity or luxury good
- proportion of income
- time period
(for the sake of interpretation, we ignore the ‘-’)
0 = perfectly inelastic 0 to -1 = inelastic -1 = unitary elasticity -1 to -∞ = elastic -∞ = perfectly elastic
demand does not demand changes less demand changes demand changes more demand falls to 0 in
change in response to than proportionally to proportionally to change than proportionally to response to change in
change in price change to price to price change in price price
If economists are to cope with the complexities of the real world, they must simplify reality in someway, and thus, work with models.
These simplified versions of reality make analysis more manageable and often begin as assumptions. Ceteris paribus is a Latin
phrase meaning ‘other things being equal’ - meaning being able to focus on one variable while holding others constant.
The basic economic problem: people have unlimited wants, but there are finite resources. Thus, economists must attempt to
reconcile this problem of scarce resources and infinite desires.
Economic activity is the production and distribution of goods and services. The purpose of economic activity is the production of
goods and services to satisfy wants and needs, and thereby improve economic welfare. Consumers seek to maximise utility, firms
seek to maximise profits, governments seek to maximise social welfare, by correcting market failures.
An economy consists of the economic system of a country or other area, the labour, capital and land resources, and the
economic agents that socially participate in the production, distribution, exchange and consumption of goods and services in that
area.
Normative economics: subjective attempt to describe what ought to be, involving a value judgement.
Positive economics: deals with objective or scientific explanations of the economy, and can be tested against evidence.
FACTORS OF PRODUCTION
Factors of production are input resources required to produce output goods and services (output resources) for individuals to satisfy
desires.
1) Land - natural resources available for production.
2) Labour - human input into the production process.
3) Capital - investment in goods that are used to make other goods in the future. Fixed capital includes machinery and factories.
4) Enterprise - an individual who seeks to supply products to a market for a rate of return (i.e profit). Entrepreneurs will usually
invest their own financial capital in a business and take in the risks associated with business investment.
Factor payments:
- Land = rent.
- Labour = wages.
- Capital = interest.
- Enterprise = profit.
Factor immobility: when FOPs are not mobile and the free market cannot allocate them to their most efficient use (market failure)
- Land: resources in earth’s crust may be inaccessible due to poor infrastructure or legislation and planning permission may
restrict use of some land.
- Labour: occupational and geographical immobility.
- Capital: traditionally governments tried to control flows of international finance however, the development of global capital
markets and improved telecommunications have vastly improved flows of capital.
- Enterprise: enterprise should be the most mobile of all factors, as entrepreneurs should move in pursuit of profit, however
human factors may also influence decisions such as conscience (when it comes to saking workers) and family ties.
PRODUCTION POSSIBILITY FRONTIER
A PPF is the maximum combinations of output that can be produced with a given set of resources.
The PPF is concave as a result of the trade-off between goods and services as an economy specialises production in one
industry. FOPs in an economy are better suited to one industry rather than another, and thus when the output of ‘wheat’
approaches its maximum, the extra land, capital and labour used will be takes from the ‘butter ‘industry, and will now be less efficient
and relatively unproductive, so output would decrease.
Productivity is output per unit input. Labour productivity measures output per worker, therefore an increase in labour productivity
means a given labour force can produce a greater level of output in a given time.
, N -
0.6 : diferente between a
varntriéí Current Wet
and their productiva of output
capa city
Increase in quality or quantity in any FOPs (potential growth) Levels of production
.
G Wheat
| |
pull Wheat
• ""
/
" " att" "
^ .
•
A
. .
.
.
→ •
unemployment
of resources
nitter
O
-
-
Butter
O S
An opportunity costs is the benefits of the next best alternative forgones as a result of a particular choice. E.g. due to scarcity
of resources in the economy, production of any good or service means there will be less production of something else.
Opportunity cost - PPF analysis
Wheat Wheat
the opportunity nrtgrowwng
}
is B,
Banning
Production from We to her
-
production forgonl
butter .
•
Wz
- - - - - -
tw
|
. - - - -
! -
¡
1 1
1 1
÷
Brus B , Butter
Specialisation: when societies engage in trade, a means of exchange, and thus do not have to produce all the goods and
services they need. Instead they ‘specialise’ in producing the good or service they are most efficient at producing, and thus
increasing total output, thus standard of living increases.
Division of labour: the delegation of specific tasks to individuals, in which they will develop a set of skills that allows them to
increase their productivity, thus increasing total output and standard of living.
Capital vs consumer goods:
- At any point in time, an economy has to choose between allocating FOPs to the production of consumer or capital goods.
- If more capital goods are produced, in the short term consumer goods production will decline.
- But in the long run, supply of consumer goods can increase, as the PPF shifts out due to greater quantity of capital in the
economy.
MARKET TYPES
Free market economies
- Market forces allocate resources based on supply and demand and the price mechanism. Adam Smith argued the idea of an
‘invisible hand’ which guides firms to produce the goods and services that consumers wish to consume. Smith also pointed
out in order for the free market to work properly there could not be monopolies and there would have to be low barriers to
entry. Friedrich Hayek argued governments are faced with imperfect information and that markets should rely on price signals
and incentives.
PUSITIVES NEGATIVA
- Efficiency: any product can be bought and sold, only - Inequalities: can lead to huge differences in income
those of the best value will be in demand. So firms have which can be called unfair, e.g. if someone is unable to
the incentive to be efficient. work they would receive no income.
- Entrepreneurship: rewards for good ideas can mean - Non-profitable goods may not be made: e.g. drugs to
money, this encourages risk-taking and innovation. treat rare medical conditions may never sell enough for
- Choice: incentives for innovation can lead to increased a firm to make profit, so would not be made.
choice for consumers and consumers are not restricted - Monopolies: successful businesses can become the
to buying what the government recommends. only supplier of a product and this market dominance
can be abused.
Command economies
- Governments plan and direct how resources should be allocated. Karl Marx argued that in a capitalist society in which there is
private ownership of productive resources, owners of capital would exploit their position at the expense of labour, eventually
resulting in revolution. Although this did not transpire in the way Marx expected, there was a move in some countries away
from private ownership and state control of resource allocation through central planning.
, - Maximise welfare: governments can redistribute income - Imperfect information: as argued by Hayek.
and prevent inequality, additionally they can ensure the - Restricted choice: consumers have limited choice and
production of goods and services that are beneficial to firms are told what to produce.
society. - Lack of risk-taking and efficiency: government-owned
- Low unemployment: government can provide everyone firms have no incentive to increase efficiency, take risks
with a job and salary. or innovate, because they do not need to make profit.
- Prevent monopolies - Micromanagement is costly
Mixed economies
- Market failure exists when free markets fails to distribute goods and services efficiently and fairly. Governments may intervene
to correct this market failure by altering the allocation of resources, it is called a mixed economy. Is is often argued that state
intervention should be market friendly, helping markets work rather than replacing market forces.
MARKETS
MONEY has multiple functions which are essential for prices to fulfil their role of allocating resources in a society:
- Medium of exchange
- Measure of value
- Method of deferred payment
DEMAND
Demand = the quantity of a good or services that consumers are willing to purchase at any given price.
The demand curve shows this relationship. The demand curve is downwards sloping because as more is demanded price falls. One
reason for this is the concept of diminishing marginal utility:
- When a consumer buys more units, the marginal utility (change in total utility or satisfaction derived from consuming one extra
unit) of the g/s declines, therefore they are less willing to buy the g/s, and will only do so if the price was less.
Non-price factors that will shift the demand curve, as more or less is demanded at any given price:
- changes in tastes and preferences
- price of substitutes
- price of complementary goods
- income
- population
Change in price will cause expansion or contraction along demand curve.
PRICE ELASTICITY OF DEMAND
PED measures the responsiveness of quantity demanded to a change in price.
% change in quantity demanded new−original
PED = % change in price % change = new x 100
Factors that affect PED:
- availability of substitutes
- necessity or luxury good
- proportion of income
- time period
(for the sake of interpretation, we ignore the ‘-’)
0 = perfectly inelastic 0 to -1 = inelastic -1 = unitary elasticity -1 to -∞ = elastic -∞ = perfectly elastic
demand does not demand changes less demand changes demand changes more demand falls to 0 in
change in response to than proportionally to proportionally to change than proportionally to response to change in
change in price change to price to price change in price price
