Economics revision chapter 1 12

Chapter 1 – The basic economic problem

Summary

Nearly all resources are scarce;

Human wants are infinite

Scarce resources and infinite wants give rise to the basic economic problem –

resources have to be allocated between competing uses.

Allocation involves choice and each choice has an opportunity cost.

The production possibility frontier (PPF) shows the maximum potential output of an

economy.

Production at a point inside the PPF indicates an inefficient use of resources-

Growth in the economy will shift the PPF outwards.

Key definitions

Scarce resources - Resources which are limited in supply so that choices have to be made

about their use.

Basic economic problem – Resources have to be allocated between competing uses because

wants are infinite whilst resources are scarce.

Choice – Economic choices involve the alternative uses of scarce resources.

Economic goods – Goods which are scarce because their use has an opportunity cost.

Opportunity cost – the benefits forgone of the next best alternative.

Production Possibility Frontier – (A.K.A the production possibility curve or the production

possibility boundary or the transformation curve) a curve that shows the maximum potential

level of one good given a level of output for all other goods in the economy.

Notes

The production possibility frontier illustrates the principle of opportunity cost

The curve shown in the diagram is

the production possibility frontier. In

point B there is 120 units of guns

produced while 50 units of butter are

produced. At point A there are 100

units of butter and 30 units of guns.

Point C would only be possible if

there is an injection of resources into

the economy, for example the

number of workers may increase. It

can also become point C if the quality

of resources at an economy is

increased, for example there is an

investment in technology which

makes the manufacturing of goods

more efficient. Point D occurs when there is an inefficient use of resources in an

economy. The Production possibility frontier is the maximum an

economy can produce and therefore it would only decrease if

something tragic would happen, for example a war. It would

decrease the labour in that economy.

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Chapter 2 – The function of an economy

Summary

An economy is a social organization through which decisions about, how and for whom

to produce are made.

The factors of production – land, labour, capital and entrepreneurship – are combined

together to create goods and services for consumption.

Specialisation and the division of labour give rise to large gains in productivity.

The economy is divided into three sectors, primary, secondary and tertiary.

Markets exist for buyers and sellers to exchange goods and services using barter or

money.

The main actors in the economy, consumers, firms and government, have different

objectives. Consumes, for instance, wish to maximise their welfare whilst firms might

wish to maximise profit.

Key definitions

Capital productivity – Output per unit of capital employed.

Division of labour – specialisation by workers.

Factors of production – CELL Capital Entrepreneurship land and labour. These factors make

production possible.

Fixed capital – economic resources such as factories and hospitals which are used to transform

working capital into goods and services.

Human capital – the value of the productive potential of an individual or group of workers. It is

made up of the skills, talents, education and training of an individual or group and represents

the value of future earnings and production.

Labour productivity – output per worker.

Market – any convenient set of arrangements by which buyers and sellers communicate to

exchange goods and services.

Non-renewable resources – resources, such as coal or oil, which once exploited be replaced.

Non -sustainable resources – resource which is being economically exploited cannot be

replaced.

Primary Sector – extractive and agricultural industries.

Productivity – output per unit of input employed.

Profits – the reward to the owners of a business. It is the difference between a firm’s revenues

and its costs.

Renewable resources – resources such as fish stocks or forests, which can be exploited over

and over again because they have the potential to renew themselves.

Secondary sector – production of manufactured goods.

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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The objective of economic actors

There are four main types of economic actors in a market economy – consumers, workers,

firms and governments. It is important to understand what are the economic objectives of

each of these sets of actors.

Consumers – In economics, consumers are assumed to want to maximise their own economic

welfare, sometimes referred to utility or satisfaction. They are faced with the problem scarcity.

They do not have enough income to be able to purchase all the goods or services that they

would like. So they have to allocate their resources to achieve their objective. To do this, they

consider the utility to be gained from consuming an extra unit of a product with its opportunity

cost.

Workers – Workers are assumed in economics to want to maximise their own welfare at work.

Evidence suggests that the most important factor in determining welfare is the level of pay. So

workers are assumed to want to maximise their earning in a job.

Firms – The objectives of firms are often mixed. However, in the UK and the USA, the usual

assumption is that firms are in business to maximise their profits. This is because firms are

owned by private individuals who want to maximise their return on ownership. This is usually

achieved if the firm is making the highest level of profit possible. In Japan and continental

Capital – the manufactured

stock of tools, machines,

factories, offices, roads and

other resources which is

used in the production of

goods and services. There

are two types of capital:

working capital, stocks of

raw materials, semi

manufactured goods and

finished goods which are

waiting to be sold; fixed

capital is the stock of

factories, offices, plant and

machinery. Fixed capital is

fixed in the sense that it

will not be transformed

into a final product.

Entrepreneurship –

Entrepreneurs are

individuals who: organize

production: organize all

factors to production in the

production of goods and

services.

Factors of

Production

Land- All natural

resources that

process of

production requires

to be complete.

Labour – The

workforce of an

economy,

everybody from a

house person to a

doctor. The value of

a worker is called his

or her human

capital.

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Europe, there is much more of a tradition that the owners of firms are just one of the

stakeholders in a business. Workers, consumers and the local community should also have

some say in how a business is run. Making profit would then only be one objective amongst

many for firms.

Governments – Governments have traditionally been assumed to want to maximise the

welfare of the citizens of their country or locality. They act in the best interest of all. This can

be very difficult because it is often not immediately obvious what are the costs and benefits of

a decision. Nor is there often a consensus about what value to put on the gains and losses of

different groups. So governments may have a variety of motives when making decisions. In an

ideal world, governments should act impartially to maximise the welfare of society. In practice

they may fall short of this.

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Chapter 3 –The function of an economy

Summary

Economic data are collected not only to verify or refute economic models but to

provide a basis for economic decision making.

Data may be expressed at nominal (current) prices or at real (or constant) prices. Data

expressed in real terms take into account the effects of inflation.

Indices are used to simplify statistics and to express averages.

Data can be presented in a variety of forms such as tables and graphs.

All data should be interpreted with care given that data can be selected and presented

in a wide variety of ways.

Key definitions

Base period – the period, such as a year or a month, with which all other values in a series are

compared.

Index number – an indicator showing the relative value of one number to another from a base

of 100. It is often used to present an average of a number of statistics.

Nominal values – values unadjusted for the effects of inflation.

Real values – values adjusted for inflation.

Notes

In economics, by far the most important measure used is the value of an item measured in

monetary terms, such as pounds sterling, US dollars or Euros. One problem in using money as

a measure is that inflation erodes the purchasing power of money.

Values unadjusted for inflation are called Nominal values. These values are expressed at

current prices (i.e. at the level of prices existing during the time period being measured).

If data are adjusted for inflation, then they are said to be at real values or at constant prices.

To do this in practice involves taking one period of time as the Base period.

Nominal value Inflation between year

1 and 2

Value at year 1 prices

Value at year 2 prices

Example 1 100£ in year 1 10% 100£ 110£

Example 2 500£ in year 1 50% 500£ 750£

Example 3 200£ in year 2 20% 166.66£ 200£

Example 4 400£ in year 2 5% 380.95£ 400£

In example 1 there was an increase of 10% in prices from the base year, and thus prices rose

from 100£ to 110£. In example 2, there was a 50% rise in prices from year 1 and thus prices at

year 2 were 750£. In example 3, there was a 20% increase on 166.66£ and therefore at year 2

prices were 200£. In example 4 there was a 5% increase on 380.95£ and became 400£.

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It is often more important in economics to compare values than to know absolute values. The

Retail Price Index (the measure of the cost of living) is calculated by working out what it would

cost to buy a typical cross-section or “basket” of goods. Comparing say 458.92 in one month

with 475.13£ the next is not easy.

So, many series are converted into Index Number form. One time period is chosen as the base

period and the rest of the statistics in the series are compared to the value in that base period.

The value in the base period is usually 100. The only reason the figure 100 is chosen is because

it’s easy to work with mathematically.

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Chapter 4 – Positive and Normative economics

Summary

Positive economics deals with statements of “fact which can either be refuted or

supported. Normative economics deals with value judgements, often in the context of

policy recommendation.

Economics is generally classified as a social science.

It uses the scientific method as a basis of its investigation.

Economics is the study of how groups of individuals make decisions about the

allocation of scarce resources.

Economists build models and theories to explain economic interactions.

Models and theories are simplifications of reality.

Models can be distinguished according to whether they are static or dynamic,

equilibrium or disequilibrium or partial or general.

Key definitions

Ceteris paribus – the assumption that all other variables within the model remain constant

whilst one change is being considered.

Equilibrium – the point where what is expected or planned is equal to what is realised or

actually happens.

Law – a theory or model which has been verified by empirical evidence.

Normative economics – the study and presentation of policy prescriptions involving value

judgements about the way in which scarce resources are allocated.

Normative statement – a statement which cannot be supported or refuted because it is a value

judgement.

Partial and general models – a partial model is one with few variables whilst a general model

has many.

Positive economics – the scientific or objective study of allocation of resources.

Positive statement – a statement which can be supported or refuted by evidence.

Static and dynamic models – a static model is one where time is not a variable. In a dynamic

model, time is a variable explicit in the model.

The scientific method – a method which subjects theories or hypotheses to falsification by

empirical evidence.

Theory or model – a hypothesis which is capable of refutation by empirical evidence.

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Notes

Economics is concerned with two types of investigation.

Positive economics – is the scientific or objective study of the subject. It is concerned with

finding out how economies and markets actually work- Positive statements are statements

about economic which can be proven to be true or false. They can be supported or refuted by

evidence. For example, “ The UK economy has high unemployment” is a positive statement.

Normative economics – is concerned with value judgements. It deals with the study of and

presentation of policy prescriptions about economics. Normative statements are statements

which cannot be supported or refuted. Ultimately, they are opinions about how economies

and markets should work. For example, The government should increase the unemployment

subsidies” and “ Manufacturing companies should invest more” are normative statements.

Theories and Models

The terms “theory and model” are often used interchangeably. There is no exact distinction to

be made between the two. However, an economic theory is generally expressed in looser

terms than a model. For instance “consumption is dependent upon income” is a economic

theory. “Ct = 567 + 0.852Yt” where 567 is a constant, Ct is current consumption and Yt current

income would be a economic model. Theories can often be expressed in words. But economic

models, because they require greater precision in their specification, are often expressed

mathematical terms.

Types of model

Equilibrium and disequilibrium models – In economics, equilibrium can be described as a point

when expectations are being realised and where no plans are being frustrated. Equilibrium

models are models where is it predicted that the market or economy will return to an

equilibrium point. Disequilibrium models are more complex and tend to be expressed using

complex mathematical language.

Static and Dynamic models- A dynamic models i one which contains time as one of its

variables. A static model is one which contains no time element within the model. Dynamic

models tend to be complex. They are more suited for computer modelling.

General and partial models – A general model is one which contains a larger number of

variables. A partial model is one which contains relatively few variables. A partial model will be

one in which most variables are assumed to be in the category of ceteris paribus.

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Chapter 5 – The Demand Curve

Summary

Demand for a good is the quantity of goods or services that will be bought over a

period of time at any given price.

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.

A change in price is show by a movement along the demand curve.

A change in any other variable affecting demand, such as income, is shown by a shift in

the demand curve.

The market demand curve can be derived by horizontally summing all the individual

demand curves in the market.

Key definitions

Consumer surplus – the difference between how much buyers are prepared to pay for a

good and what they actually pay.

Demand curve – the line on a price-quantity diagram which shows the level of effective

demand at any given price.

Demand or effective demand – the quantity purchased of a good at any given price, given

that other determinants of demand remain unchanged.

Individual demand curve – the demand curve for an individual consumer, firm or other

economic unit.

Market demand curve – the sum of all individual demand curves.

Shift in the demand curve – a movement of the whole demand curve to the right or left of

the original caused by a change in any variable affecting demand except price.

Notes

Demand is the quantity of goods and services that will be bought at any give price over a

period of time. If everything else were to remain the same (ceteris paribus) what would

happen demanded of a product as its price changed?

Prices rises Demand falls

Prices fall Demand rises

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Price is a factor a affects demand, there are a another few important factors:

1. Price of substitution goods- If price of potatoes rise the amount of pasta, bread and rice bought will increase.

2. Changes in population- An increase in population will likely cause an increase in the demand for goods.

3. Changes in Fashion; 4. Changes in legislation; 5. Advertising; 6. Weather; 7. Income;

For income, it affects it two different ways. If there is a rise in income, there will be a rise in

demand for normal goods. However, if income rises there will be a fall in demand for inferior

goods.

The difference between the value to buyers and what they actually pay is called the consumer

surplus. If there are a few goods available to buy, as with diamonds, the consumers are

prepared to pay a high price for them. If goods are plentiful, then consumers are only prepared

to pay a low price.

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Chapter 6 – The supply curve

Summary

A rise in price leads to a rise in quantity supplied, shown by a movement along the

supply curve.

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.

The market supply curve in a perfectly competitive market is the sum of each firm’s

individual supply curve.

Key Definitions

Individual supply curve – The supply curve of an individual producer.

Market supply curve – the supply curve of all producers within the market. In a perfectly

competitive market it can be calculated by summing the supply curves of individual

producers.

Producer surplus – the difference between the market price which firms receive and the

price at which they are prepared to supply.

Supply – the quantity of goods that suppliers are willing to sell at any given price over a

period of time.

Notes

In economics supply is defined as the quantity of goods that sellers are prepared to sell at

any given price over a period of time. Supply is the opposite of Demand as price rises and

supply falls and vice versa. A fall In price will lead to a fall in quantity supplied, shown by a

movement along the supply curve.

Prices rises Supply rises

Prices fall Supply falls

The supply curve is drawn on the assumption that the general costs of production in the

economy remain constant. If other things change, then the supply curve will change. If

costs rise, firms will attempt to pass on these increases in the form higher prices. Thus, the

supply curve will shift upwards and to the left.

Changes in the prices of some goods can affect the supply of a particular good.

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Other factors that affect suppy are:

1. The goal of sellers – If there is a change in profit levels, there will be a change in

supply.

2. Goverment Legislation – Anti- pollution controls which can raise the costs of

production is an example how governments can affect supply.

3. Expectation of future events – if firms expect future prices to be much higher, they

may restrict supplies and stockpile goods.

4. Weather – in agricultural markets, the weather plays a crucial role in determining

supply.

5. Producer cartels – in some markets, producing firms or producing countries band

together, usually to restrict supply.

For instance, if the price of beef increases substantially there will be an increase in the

quantity of beef supplied. More cows will be reared and slaughtered. As a result there will be

an increase in the supply of hides for leather. At the same price, the quantity of leather

supplied to the market will increase. Thus, an increase in the price of beef will lead to an

increase in the supply in leather.

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Chapter 7 – Price Determination

Summary

The equilibrium or market clearing price is set where demand equals supply.

Changes in demand and supply will lead to a new equilibrium prices being set.

A change in demand will lead to a shift in the demand curve, a movement along

the supply curve and a new equilibrium price.

Markets do not necessarily tend towards the equilibrium price.

The equlibrium price is not necessarily the price which will lead to the greatest

economic efficiency or the greatest equity.

Key notes

Equilibrium price – the price at which there Is no tendency to change because planned

purchases are equal to planned sales.

Excess demand – where demand is greater than supply.

Excess supply – where supply is greater than demand.

Free market forces – forces in free markets which act to reduce prices when there is

excess supply and raise prices when there is excess demand.

Market clearing price – the price at which there is neither excess demand nor excess

supply but where everything offered for sale is purchased

Equilibrium

Equilibrium is a term relating to a 'state of rest', a situation where there is no tendency to change. In economics, equilibrium is an important concept. Equilibrium analysis enables us to look at what factors might bring about change and what the possible consequences of those changes might be. Remember, that models are used in economics to help us to analyze and understand how things in reality might work. Equilibrium analysis is one aspect of that process in that we can look at cause and effect and assess the possible impact of such changes.

For the purposes of this resource we are going to look at market equilibrium. Market equilibrium occurs where the amount consumers wish to purchase at a particular price is the same as the amount producers are willing to offer for sale at that price. It is the point at which there is no incentive for producers or consumers to change their behavior. Graphically, the equilibrium price and output are found where the demand curve intersects (crosses) the supply curve.

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Assume the demand is Qd = 150 - 5P and that supply is given by Qs = 90 + 10P. What we now have is a task that involves understanding how to do simultaneous equations. In equilibrium we know that Qs = Qd. Remember that Qs = 90 + 10P and that Qd = 150 - 5P. Given that we know that an equation means that whatever is on the left hand side must be the same as that on the right hand side we can re-write our simultaneous equation as follows:

90 + 10P = 150 - 5P

We can now go about collecting all the like terms onto each side ( by doing the same to both sides) and solving the equation to find P. Explanation 1 shows the long route and Explanation 2 the route you might normally see in a textbook.

Explanation 1

(90 - 90) + (10P + 5P) = (150 - 90) - (5P + 5P) We have added 5P to both sides and taken away 90 from both sides. This gives us: 15P = 60 Now divide both sides by 15 to get P on its own. 15P / 15 = 60 / 15 The 15P term will now cancel down. How many times does 15 go into 15P? Once. 60 / 15 = 4 P = 4

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Chapter 8 – Interrelationships between markets

Summary

Some goods are complemens, in joint demand.

Other goods are substitues for each other, in competitive demand.

Derived demand occurs when one good is demanded because it is needed for the

production of other goods or services.

Composited demand and joint supply are two other ways in which market are linked.

Key notes

Competitive demand – when two or more goods are substitutes for each other.

Complement – a good which is purchased with other goods to satisfy a want.

Composite demand – when a good is demanded for two or more distinct uses.

Derived demand – when the demand for one good is the result of or derived from the demand

for another good.

Joint demand – when two or more complements are bought together.

Joint supply- when two or more goods are produced together, so that a change in supply of

one good will necessarily change the supply of other goods with which it is in joint supply.

Substitute – a good which can be replaced by another to satisfy a want.

Notes

Derived demand – Many goods are demanded only because they are needed for the

production of other goods. For example steel in car manufacturing.

Composite demand – A good is said to be in composite demand for two or more distinct uses.

For instance, milk may be used for yoghurt, for cheese making, for butter and drinking.

Joint supply – A good in joint supply with another good when one good is supplied for two

different purposes. For instance, cows are supplied for both beef and leather. An oil well , may

give both oil and gas.

A substitue good is a good which can be replaced by another. They are said to be in

competitive demand : for example Coca-cola and Pepsi.

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Chapter 9 – Price elasticity of demand

Summary

Elasticity is a measure of the extent to which quantity responds to a change in a

variable which affects it, such as price and income;

Price elascity of demand measure the proportionate response of quantity demanded

to proportionate change in price.

Price elasticity of demand varies from zero, infinitely inelastic, to infintely elastic.

The value of price elasticity of demand is mainly determined by the availability of

substitutes and by time.

Key notes

Elastic demand – where the price elasticity of demand is greater than 1. The

responsiveness of demand is proportionally greater than the change in price. Demand is

infinetly elastic if price elasticity of demand is ifinity.

Inelastic demand – where the price elasticity of demand is less than 1. The responsiveness

of demand is proportionally less than the change in price. Demand is infinitely inelastic if

price elasticity of demand is zero.

Price elasticity of demand or own elasticity of demand – the proportionate response of

changes in quantity demand to a proportionate change in price, measured by the formula:

Unitary elasticity – when the change in demand is the same as the change in price,

elasticity is 1.

Notes

The determinants of price elasticity of demand:

The exact value of price elasticity of demand for a good is determined by a wide variety of

factors. Economists, however argue that two factors in particular can be singled out _ the

availability of substitutes and time.

The availability of substitutes: The better the substitutes for a product, the higher the

price elasticity of demand will tend to be. For instance, salt has few good substitutes.

When the price of slat increases, the demand for salt will change little and therefore the

price elasticity of salt is low. On the other hand, spaghetti has many good substitutes, from

other types of pasta, to rice, potatoes, bread, and other foods. A rise in the price of

spaghetti, all other food prices remain constant, is likely to have a significant effect on the

demand for spaghetti. Hence the elasticity of demand for spaghetti is likely to be higher

than that for salt.

Width of market definition The more widely the product is defined, the fewer substitutes

it is likely to have. Spaghetti has many substitutes, but food in general has none. Therefore

Percentage change in quantity demanded / Percentage change in price.

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the elasticity of demand for spaghetti is likely to be higher than that for food. Similarly the

elasticity of demand for boiled sweets is likely to be higher than confectionery in general.

A 5% increase in the price of boiled sweets, all other prices remaining constant, is likely to

lead to a much larger fall in demand for boiled sweets than a 5% increase in the price of all

confectionery.

Time The longer period of time, the more price elastic is the demand for a product. For

instance, 1973/74 when the prices of oil quadrupled the demand for oil was initially little

affected. In the short term the price of oil was price inelastic. This is hardly surprising.

People still needed to travel to work in cars and heat their houses whilst industry still

needed to operate. Oil had few good substitutes. Motorists couldn’t put gas into their

petrol tanks whilst businesses could not change oil-fired systems to run on gas, electricity

or coal. However, in the longer term motorists were able to, and did, buy cars which were

more fuel efficient. Oil-fire central heating systems were replace by gas and electric

systems. Businesses converted or did not replace oil fired equipment. The demand for oil

fell from what it would otherwise have been. Taking the ten year period to 1985, and given

the changes in other variables which affected demand for oil, estimates suggest that the

demand for oil was slightly elastic. It is argued that in the short term, buyers are often

locked into spending patterns through habit, lack of information or because of durable

goods that have already been purchases. In the longer term, they have the time and

opportunity to change those patterns.

Luxuries and necessities It is sometimes argued that necessities have lower price elasticity

than luxuries. Necessities by definition have to be bought whatever their price in order to

stay alive. So an increase in the price of necessities will barely reduce the quantity

demanded. Luxuries on the other hand are by definition goods which are not essential to

existence.

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Chapter 10 – Elasticities

Summary

Income elasticity of demand measures the proportionate response of quantity

demanded to a proportionate change in income.

Cross elasticity of demand measures the proportionate response of quantity

demand of one good to a proportionate change in price of another good.

Price elasticity of supply measures the proportionate response of quantity

supplied to a proportionate change in price.

The value of elasticity of supply measures the proportionate response of quantity

supplied to a proportionate change in price.

The value of elasticity of supply is determined by the availability of substitutes and

by time factors.

The price elasticity of demand for a good will determine by whether a change in

the price of a good results in a change in expenditure on the good.

Key notes

Cross price elasticity of demand – a measure of the responsiveness of quantity demanded

of one good to a change in price of another good. It is measured by dividing the

percentage change in quantity demanded of one good by the percentage change in price

of other good.

Income elasticity of demand – a measure of the responsiveness of quantity demanded to a

change in income. It is measured by dividing the percentage change in quantity demanded

by the percentage in income.

Price elasticity of supply – a measure of the responsiveness of quantity supplied to a

change in price. It is measured by dividing the percentage change in quantity supplie by

the percentage change in price.

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