(1.1) Nature of Economics

• Economists

  Develop models to explain how the economy works, for example theories of supply and demand or the circular flow of income
• The purpose of theories and modelling is to explain why something is as it is
• Theories and models are simplified to make them more useful
• Assumptions

  Must be made when developing economic models and theories due to the many variables that can change
• Ceteris paribus

  All other things remaining equal
• Economics is a social science, unlike natural sciences it is difficult to set up experiments to test hypotheses
• Economists tend to come up with very different conclusions for a particular set of data
• Economics is considered a science by some, but the laws cannot be definite because we cannot know exactly what each individual will do
• Positive statement

  Objective statement made without value judgements or emotions, can be tested and proven or disproven
• Positive statements

  • Raising taxes will lead to an increase in tax revenue
  • Warm weather will lead to an increase in ice cream sales
• Normative statement

  Subjective statement based on opinion, cannot be proven or disproven, often includes words like 'ought', 'should', etc.
• Normative statements

  • The free market is the best way to allocate resources
  • The government should increase taxes
• Economists tend to use positive statements to back up normative statements
• Value judgements can influence economic decision making and policy
• Scarcity

  The basic problem of economics, where people have finite needs but infinite wants, and resources are finite and limited
• Scarcity is a relative concept, as resources are scarce in relation to the demands placed upon them
• Examples of scarcity

  • Water in India and China
  • Food shortages around the world
• Ways economies try to solve the basic economic problem

  • What to produce
  • How to produce it
  • For whom production should take place
• Renewable resource

  Resource of economic value that can be replenished or replaced on a level equal to consumption
• Renewable resources

  • Oxygen
  • Solar power
  • Fish
• Non-renewable resource


  Resource of economic value that cannot be readily replaced by natural means on a level equal to consumption
• Non-renewable resources

  • Fossil fuels such as coal, oil and gas
• Opportunity cost


  The cost of one thing in terms of the next best option which has been given up
• Opportunity cost example


  • If you have £1 and can buy a chocolate bar or a bag of crisps, the opportunity cost of buying the chocolate bar is the bag of crisps you could not buy
• There is no opportunity cost for free resources
• Production possibility frontier (PPF)


  Shows the maximum possible combinations of capital and consumer goods that the economy can produce with its current resources and technology
• The PPF is typically drawn as a curve because the first resources switched from capital to consumer good production are not adding much to capital goods but will be much more productive in the production of consumer goods, and vice versa
• The PPF gives no indication of which combination of goods is best, economics is concerned with explaining why a country chose a particular production point
• Opportunity cost on the PPF

  Moving from point A to point B, the opportunity cost of producing an extra 15 consumer goods is 30 capital goods
• Producing 60 capital goods

  Means the economy can only produce 60 consumer goods, losing 20 consumer goods compared to producing 0 capital goods
• Opportunity cost calculation on the PPF

  The opportunity cost of producing 1 consumer good is 3 capital goods, and the opportunity cost of producing 1 capital good is 1/3 of a consumer good
• Purple arrows on the PPF


  Show economic growth, as the economy can produce more of both goods
• Orange arrows on the PPF

  Show economic decline, as the economy can produce less of both goods
• Economic efficiency is achieved when resources are used for their best use, which occurs at all points on the PPF
• Point A on the PPF is possible and efficient production, point B is possible but inefficient, and point C is unobtainable production beyond the PPF
• Factors that could cause a fall in production

  • Natural disasters
  • Natural resources running out
  • Decrease in the quantity/quality of labour due to war, migration or a fall in spending on education
• Economic efficiency

  Achieved when resources are used for their best use. At all points on the PPF, resources are allocated efficiently.
• Possible and efficient production

  Producing at any point on the PPF curve
• Inefficient production


  Producing within the PPF curve, not maximising output
• Unobtainable production


  Producing beyond the PPF curve, due to lack of resources/technology