Central Problem of Economics Flashcards
Explain and apply the concept of scarcity and rational decision making by economics agents by defining marginal benefit and marginal cost.
Key Point:
Economic decision making involves the use of the marginalist principle where individuals will only undertake an activity when MB ≥ MC.
In making decisions or choices, we assume that all economic agents are rational and use the marginalist approach of weighing the marginal costs and marginal
benefits of an activity to maximise their net benefit.
Marginal benefit refers to the additional benefit derived from undertaking an additional unit of an activity.
Marginal cost refers to the additional cost derived from undertaking an additional unit of an activity.
If the marginal benefit exceeds the marginal cost, it is rational to do the activity (or to do more of it). If the marginal cost exceeds the marginal benefit, it is rational not to do it (or to do less of it). Thus, rational decision-making dictates that an individual should only undertake an activity if the marginal benefit from taking the action is at least as great as the marginal
cost.
State and give examples of the 4 factors of productions
CELL
1) Capital - refers to physical capital. This refers to man-made resources and include factories, machines, transportation and other equipment. (Physical vs. Financial Capital: Economists are only concerned with physical capital and NOT financial capital. Financial capital refers to financial assets such as bonds, stocks or bank deposits.)
2) Entrepreneurship - one who performs the functions of organising and managing the factors of production, innovating new products and ways of production and taking the risks of being in business. In other words, the entrepreneur takes overall responsibility for the decision-making process in the firm so that other factors of production could be combined to provide a good or service.
3) Land - refers to all the natural resources available, which could be renewable or non-renewable in nature.
Renewable resources (e.g. wind & water) renew themselves at a fast enough rate for sustainable economic extraction. Non-renewable resources (e.g. fossil fuels & mineral ores) do not renew themselves at a fast enough rate to allow for sustainable economic extraction.
4) Labour - refers to human capital, refers to people, including their skills and abilities. The quantity of labour available for an economy consists of those who are able and willing to work. This includes the employed and unemployed.
Explain how the idea of opportunity cost come about as a result of scarcity
Due to the fundamental economic problem of scarcity which implies that every individual faces constraints when making a choice because of the limited resources, choices have to be made. This is because resources devoted to one area cannot be available to meet another. Hence, there is an opportunity cost of any choice being made by an individual as it always entails the sacrifice of the next best alternative (i.e forgoing benefits/utility).
Explain what is a Production Possibility Curve (PPC)
The Production Possibility Curve (PPC) model is a useful tool to use when explaining the concepts of scarcity, choices and opportunity cost. It shows all the
maximum attainable combinations of two goods that a country can produce within a specified time period with all its resources fully and efficiently employed, at a given state of technology.
State the assumptions of a concave PPC.
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Explain why is the PPC concave to the origin.
This is because resources in an economy are not perfectly suited to the production of both goods. As the country concentrates on the production of one good (e.g. consumer good), it has to start using resources that are less and less suitable i.e.resources that would have been better at producing other goods. To produce an additional unit of one good means having to move increasingly greater amounts of resources from the production of the alternative good, hence a greater amount of alternative good that has to be forgone. There is an increasing opportunity cost of production.
(Since a concave PPC illustrates increasing opportunity cost, a straight-line PPC would arise when constant opportunity cost exists and all factors of production are perfectly suited to produce both goods. This is highly unlikely in the real world.)
Explain the concepts of scarcity, choice and opportunity cost, using the PPC.
Given the quantity and quality of resources available and the state of technology in a country, attainable combinations of the two goods include points on the PPC curve. Scarcity is illustrated by the country being able to produce only one of the points on or within the PPC at a given point in time as well as by the unattainable points outside the boundaries of the curve. Without trade, consumption is constrained by the availability of resources in an economy. However, international trade may allow countries to consume outside the PPC.
Countries may choose to produce along various points of the PPC. For example, if Country X chooses to devote all of its resources to produce capital goods (Point A) or consumer goods (Point E). It cannot produce at Points A and E at the same time.
Reallocating scarce resources from producing one good to another involves opportunity cost. As Country X increases its production/output of consumer goods,
fewer resources are available for the production of capital goods. As such, the negative gradient of the PPC illustrates the concept of opportunity cost.
Identify and able to explain which points in the PPC represent productive efficiency and allocative efficiency
The economy achieves productive efficiency when all the available resources are fully and efficiently employed. It is achieved when society produces at any point on the production possibility curve (PPC).
On the other hand, all points inside the PPC are productive inefficient. They are attainable but inefficient combinations. Resources have not been fully and efficiently employed and the economy is experiencing unemployment or underemployment. More goods can be produced by increasing the employment of the
idle resources or use them more efficiently.
Allocative efficiency is the situation in which society produces and consumes a combination of goods and services that maximises its welfare. It is achieved when the goods and services that are wanted by the economy are produced in the right quantities. Though Points A, B, C, D and E are productively efficient, only 1 point on the PPC is allocative efficient (and thus maximises society’s welfare).
Can a country produce within PPC? Can a country produce on PPC? Can a country produce outside PPC?
Can produce outside by trading
Can produce on and within but by producing within, its resources have not been fully and efficiently employed and the economy is experiencing unemployment or underemployment.
Explain the causes of movements and shifts in the PPC
MOVEMENT FROM A POINT WITHIN TO A POINT ON THE PPC: Actual economic growth refers to an increase in real national output (quantity of goods and services produced by an economy). This may lead to greater and more efficient use of existing resources.
Potential economic growth refers to an increase in an economy’s ability to produce goods and services (otherwise known as productive capacity). As productive capacity increases, the maximum quantities and combinations of both capital and consumer goods produced increase thus causing an outward shift of the PPC. Shifts in the PPC may be either in a parallel or non-parallel manner, depending on whether the change affects the production of both goods or only one good.
Explain how a rational economic agents - consumers, firms and governments would make decision using the marginalist approach and marginalist principle
Faced with a limited income, consumers make decisions on the combination of goods and services to consume which maximises utility (or satisfaction).
The marginal private benefit of consuming an additional unit of a good is known as the marginal utility (the additional satisfaction gained from consuming one extra unit). Up to a point, the more of a commodity consumed, the greater will be total utility. However, as one becomes more satisfied, each extra unit consumed will probably give less additional utility than the previous units. As the quantity consumed increases, marginal utility falls. This is also known as the Law of diminishing marginal utility (LDMU).
The marginal private cost of consuming an additional unit of a good is the price paid for the additional unit. Thus, a rational consumer will thus consume up to the point where marginal utility/marginal benefit is equal to price and his utility (total) is maximised.
Faced with limited resources (or factors of production), firms have to decide what goods and services to produce in order to maximise their profits, where profits = total revenue – total cost. Firms also have to decide on how to produce these goods and services (i.e. the method of production). The marginal benefit of producing an additional unit of a good is the additional revenue that a producer receives from selling an additional unit of the good. This is otherwise known as marginal revenue. The marginal cost of producing an additional unit of a good is the marginal cost of production. As output rises beyond a certain threshold, marginal cost rises as factors of production become more inefficient. This is known as the Law of diminishing marginal returns (LDMR), which states that when increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit. Thus, a rational producer will produce up to the point where marginal revenue equals to marginal cost and profit is maximised.
Faced with government budget constraints (largely determined by tax revenue), governments will have to prioritise their spending to maximise social welfare (so as to maximise the number of votes) and achieve both microeconomic and macroeconomic objectives.
- Microeconomic objectives include efficiency and equity.
- Macroeconomic objectives include sustained economic growth, price stability, full employment and a healthy balance of payments.
The marginal benefit of a government’s decision is marginal social benefit while the marginal cost of a government’s decision is marginal social cost.
Distinguish between positive and normative statements.
A positive statement is a statement of fact. It may be right or wrong, but its accuracy can be tested by appealing to the facts. Positive economics could be defined as a branch of economics that describes and explains economic phenomena, focusing on facts and cause-and-effect behavioural relationships and includes the development and testing of economic theories.
A normative statement is a statement of value: a statement about what ought or ought not to be, about whether something is good or bad, desirable or undesirable. They cannot be proved or disproved by a simple appeal to the facts. Normative economics could be defined as the branch of economics that expresses values judgements about economic fairness.
Evaluate the concept of opportunity cost.
Opportunity cost is subjective: Opportunity cost differs between individuals and between societies. Only the individual making the choice can identify the most attractive alternative based on their individual preferences and needs, and quantify the value of the forgone benefits accordingly. As such, no two individuals are likely to value the foregone benefits equally.
Calculation of the value of opportunity cost is difficult.
When choosing one option over another, we seldom know the actual value of the forgone benefits because the next best alternative because it is always difficult to rank our preferences by assigning an exact value to each one of them. Moreover, acquiring accurate information about alternatives is often costly and time
consuming. Too many choices lead to indecisiveness and some choices turn out to be poor.
Opportunity cost may vary with circumstances.
The opportunity cost of undertaking a certain activity will vary with circumstances since it depends on the valuation of the forgone benefits arising from not choosing the available alternatives. For instance, the valuation placed on essential goods by lower-income individuals is likely to be greater since the marginal utility derived from the consumption of an additional unit of an essential good is likely to be higher for a lower-income individual than a higher income individual due to the law of diminishing marginal utility. Hence, the marginal opportunity cost of spending an additional dollar on healthcare is significantly higher for lower-income individuals based on the circumstances.
Describe the three types of economic systems.
Free market economy: Where markets allocate resources through the price mechanism. An increase in demand raises price and encourages businesses to use more resources into the production of that good or service. The quantity of products consumed by people depends on their income and income itself depends on the market value of an individual’s work. In a free-market economy, there is a limited role for the government and limits itself to protecting property rights of people and businesses using the legal system and protecting the value of money or the value of a currency.
In a planned or command-economy system associated with a socialist or communist system, scarce resources are owned by the government. The state allocates resources and sets production targets and growth rates according to its own view of people’s wants. Market price play little or no part in informing resource allocation decisions and queuing rations scarce goods.
In a mixed economy, some resources are owned by the public sector (government) and some are owned by the private sector. The public (or state) sector typically supplies public and merit goods and intervenes in markets to correct perceived market failure. Nearly all economies in the
world are mixed although that mix changes over time for example as some industries are privatised (sold to the private sector) or nationalised (taken back into state ownership).
