Theme 1

• Economic as a social science:

  • Economists develop models to explain how the economy works, such as theories of supply and demand or the circular flow of income
  • The terms "theory" and "model" can be used interchangeably
  • Assumptions must be made in economic models due to the many variables that can change
  • Ceteris paribus means 'all other things remaining equal'
• Positive and normative economic statements:

  • Positive statements are objective and can be tested
  • Normative statements are subjective and cannot be proven or disproven
  • Economists use positive statements to back up normative statements
• The economic problem:

  • The basic problem of economics is scarcity
  • Scarcity is a relative concept as resources are scarce in relation to the demands placed upon them
  • Economies solve the economic problem by determining what to produce, how to produce it, and for whom production should take place
• Production possibility frontiers:

  • Shows the maximum possible combinations of capital and consumer goods that the economy can produce
  • Any point on the curve represents the maximum productive potential of the economy
  • Economic efficiency is achieved when resources are used for their best use
• Specialisation and the division of labour:

  • Specialisation is the production of a limited range of goods
  • The division of labour increases labour productivity and efficiency
  • Adam Smith introduced the concept of specialisation and the division of labour
• Advantages of specialisation and division of labour:

  • Higher quality of goods and services, since workers are more skilled at their jobs
  • More cost-effective to develop specialist tools, improving speed or quality
  • Time is not wasted moving between jobs and getting out tools
  • Workers only need to be trained to do one specific task, saving time and money
• Disadvantages of specialisation and division of labour:

  • Work can become boring, leading to poor quality of work and people leaving the business
  • Reduction of craftsmanship and a more standardised product due to mechanisation
  • Production delays in one process can halt all other tasks
  • Workforce may suffer from structural unemployment
• Advantages of trade for countries specializing in the production of goods and services:

  • Theory of comparative advantage states countries should specialize in producing goods where they have a lower opportunity cost
  • Greater output globally
• Disadvantages of trade for countries specializing in the production of goods and services:

  • Over-dependence on one particular export can lead to economic collapse
  • Risk of resources running out, causing a loss of income and resources
  • High interdependence leading to problems if trade is prevented
  • Increased competition may not necessarily lead to falling wages
• Functions of money:

  • Medium of exchange: used to buy and sell goods and services
  • Measure of value: compares the value of goods and services
  • Store of value: keeps its value and can be kept for a long time
  • Method for deferred payment: allows for debts to be created
• Free market economy:

  • Individuals are free to make their own choices and own factors of production without government interference
  • Resources allocated through the price mechanism
  • No completely free markets exist today due to government intervention
  • Advantages include automatic resource allocation, consumer sovereignty, high motivation, political freedom, productive efficiency, and higher growth
  • Disadvantages include high levels of inequality, lack of merit goods, potential wastage of resources, monopolies, and externalities
• Command economy:

  • All factors of production, except labor, are owned by the state
  • Resource allocation carried out by the government, not the price mechanism
  • Advantages include minimum standard of living, less wastage of resources, long-term planning, standardised products, and focus on objectives other than profit
  • Disadvantages include potential over or under supply, slow decision-making, lack of motivation and efficiency, loss of consumer freedom, and often led by dictators
• Mixed economy:

  • A compromise economy where both free market mechanism and government planning allocate resources
  • Government's role includes creating a framework of rules, producing public and merit goods, redistributing income, and stabilizing the economy
• Underlying assumptions of rational economic decision making:

  • Consumers aim to maximise utility, which is the satisfaction gained from consuming a product
  • Firms aim to maximise profit to keep shareholders happy
  • Governments aim to maximise social welfare by taking decisions that increase public satisfaction
• Behavioral economists question the assumption that economic agents always have the information necessary to act rationally and make calculated decisions
• Demand is the ability and willingness to buy a particular good at a given price and moment in time
• Movements and shifts of the demand curve:

  • A movement along the demand curve is caused by a change in the price of the good
  • A shift of the demand curve is caused by a change in any factors affecting demand, known as the conditions of demand
• Factors affecting demand curve shifts:

  • Population increase leads to increased demand
  • Income increase generally leads to increased demand
  • Related goods like complements or substitutes can cause shifts in demand curve
  • Advertising can increase demand
  • Taste/fashion trends can affect demand
  • Expectations of future events can impact demand
  • Seasons and weather can influence demand
  • Government legislation can affect demand
• Diminishing marginal utility:

  • Demand curve slopes downward due to the law of diminishing marginal utility
  • Total utility represents overall satisfaction from consuming a good
  • Marginal utility represents the change in satisfaction from consuming the next unit of a good
  • Law of Diminishing Marginal Utility states that satisfaction decreases as more of a good is consumed
• Significance of PED:

  • Determines effects of indirect taxes and subsidies
  • More elastic demand leads to lower tax burden on consumers
  • Inelastic demand means tax burden is mainly on consumers but can lead to higher tax revenue for the government
• PED and revenue:

  • For elastic demand curve, price decrease increases revenue and vice versa
  • For inelastic demand curve, price decrease decreases revenue and vice versa
  • For unitary elastic curve, revenue changes with price changes
• For an inelastic demand curve:

  • A decrease in price leads to a decrease in revenue
  • An increase in price leads to an increase in revenue
• For a unitary elastic curve, a change in price does not affect total revenue
• Supply is the ability and willingness to provide a good or service at a particular price at a given moment in time
• Movements and shifts of the supply curve:

  • A movement along the supply curve is caused by a change in the price of the good
  • A shift of the supply curve is caused by a change in factors affecting supply, the conditions of supply
• Price determination:

  • Equilibrium point is where supply equals demand
  • Excess demand occurs when price is set below equilibrium
  • Excess supply occurs when price is set above equilibrium
• Price mechanism in a free market economy allocates resources based on the interactions of demand and supply
• The price mechanism has three main functions:

  • Rationing function: When prices increase, some people may no longer afford to buy the product, and resources are allocated to those who can afford and value them most highly
  • Signalling function: Prices rising indicate producers to move resources into manufacturing that product
  • Incentive function: Acts as an incentive for people to work hard and for buyers to buy more products and suppliers to produce more goods
• Price mechanism in different markets:

  • Local markets: During the coronavirus pandemic, disruptions in supply chains led to fewer goods on supermarket shelves, causing food prices to rise to ration off excess demand
  • National markets: Discrepancies in house prices across the UK are due to factors like London being a financial center, leading to high house prices through the rationing function and offering an incentive for firms to produce more houses
• Consumer and producer surplus:

  • Consumer surplus is the difference between the price consumers are willing to pay and the price they actually pay
  • Producer surplus is the difference between the price suppliers are willing to sell at and the price they actually sell at
  • Consumer and producer surpluses show the economic gain from buying and selling goods
• Shifts of demand and supply:

  • Decrease in demand leads to a fall in consumer and producer surplus, while an increase in demand increases both surpluses
  • Decrease in supply leads to a fall in consumer and producer surplus, while an increase in supply increases both surpluses
• Indirect taxes:

  • Indirect tax is a tax on expenditure where the person charged the tax is not the one paying it to the government
  • Two types: Ad valorem tax (percentage of the cost of the good) and Specific tax (added amount to the price)
  • Impacts of a tax include shifts in supply, rise in price, fall in output, and tax burdens on consumers, producers, and government
• Subsidies:

  • A subsidy is a grant given by the government to encourage production/consumption of a good or service
  • Increases supply, lowers price, and benefits both consumers and producers
  • Government spending on subsidies is equal to the size of the subsidy times the new output
• Alternative views of consumer behaviour:

  • Influences of other people can lead to bias and herding behavior
  • Influence of habitual behavior reduces decision-making time and includes addictions
  • Consumer weakness at computation can lead to buying more expensive goods, poor self-control, and making irrational decisions
• Types of market failure:

  • Externalities: Cost or benefit a third party receives from an economic transaction outside of the market mechanism
  • Over or under-production of goods due to spillover effects of production or consumption
  • Examples: Cars and cigarettes have negative externalities, while education and healthcare have positive externalities
  • Under-provision of public goods: Non-rivalry and non-excludable goods underprovided by the private sector due to free-rider problem
  • Example: Streetlights
• • Information gaps: Imperfect information leads to irrational decisions and misallocation of resources
  • Examples: Consumers not knowing the quality of second-hand products like cars, complexity of pension schemes
• External, private, and social costs and benefits:

  • Private costs/benefits: Costs/benefits to the individual participating in economic activity
  • Social costs/benefits: Costs/benefits to society as a whole
  • External costs/benefits: Costs/benefits to a third party not involved in economic activity
  • Merit goods: Goods with external benefits, tend to be underprovided by the free market
  • Demerit goods: Goods with external costs, tend to be over-provided by the free market
• Negative production externalities:

  • Social costs greater than private costs
  • Market equilibrium at Q1P1, social optimum at Q2P2
  • Examples: Noise pollution from airplanes, industrial waste
• Positive consumption externalities:

  • Social benefits greater than social costs
  • Market equilibrium at Q1P1, social optimum at Q2P2
  • Examples: Healthcare, education
• Government intervention to address external costs and benefits:

  • Indirect taxes and subsidies
  • Tradable pollution permits
  • Provision of the good
  • Provision of information
  • Regulation