Central Problem of Economics

Question 1

What is a positive statement?

Answer 1

A statement of fact, may be right or wrong but its accuracy can be verified by appealing to facts.

Question 2

What is a normative statement?

Answer 2

A statement of value or opinion, about what ought to be or what ought not to be, good or bad, desirable or undesirable. It cannot be proved or disproved by appealing to facts and is subjective.

Question 3

What is the basic problem of economics?

Answer 3

Scarcity, which arises from limited resources and unlimited wants.

Question 4

What are the 4 resources/factors of production?

Answer 4

Capital, Entrepreneurship, Labour, Land.

Question 5

What is capital?

Answer 5

It refers to physical capital, and are man-made resources such as machines, factories, transport etc.

Question 6

What is entrepreneurship?

Answer 6

Performing the functions of organising and managing the other factors of production, innovating new products and ways of production and taking the risks of being in business, taking overall responsibility for the decision-making process in a firm so that other factors of production could be combined to provide a good or service.

Question 7

What is land?

Answer 7

All the natural resources available, which could be renewable or non-renewable in nature.

Question 8

What is labour?

Answer 8

Also known as human capital, refers to people, including their skills and abilities, consisting of those who are able and willing to work, employed and unemployed.

Question 9

Scarcity implies that…

Answer 9

Choices have to be made by producers, consumers and governments.

Question 10

What is opportunity cost?

Answer 10

The (expected) benefits from the next best alternative that is forgone when making a decision.
Opportunity costs may include both explicit costs and implicit costs of making a decision. Explicit costs are costs that require a direct money payment while implicit costs are costs that do not require a direct money payment. Instead, implicit costs are the value of anything other than the direct payment that is sacrificed (e.g. time) when a decision is made.

Question 11

What are the characteristics of opportunity costs?

Answer 11

They are subjective, their values are difficult to calculate, and they vary with circumstances.

Question 12

Why is opportunity cost subjective?

Answer 12

Only individuals 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 forgone benefits equally.

Question 13

Why is the value of opportunity cost difficult to calculate?

Answer 13

We seldom know the actual value of the forgone benefits because the next best alternative is “the road not taken”. it is always difficult to rank these preferences by assigning an exact value to each one of them.

Question 14

Why does opportunity cost vary with circumstances?

Answer 14

Circumstances affect the valuation of the forgone benefits arising from not choosing the available alternative at the point of making the decision, as well as the choice made itself.

Question 15

What is the assumption for all economic agents?

Answer 15

They are rational and aim to maximise their own benefits.

Question 16

What is marginal benefit?

Answer 16

The additional benefit derived from undertaking an additional unit of an activity.

Question 17

What is marginal cost?

Answer 17

The additional (opportunity) cost incurred when undertaking an additional unit of an activity.

Question 18

What is the marginalist principle?

Answer 18

At any given unit of an activity, if the marginal benefit exceeds the marginal cost, it is rational for the economic agent to undertake the activity (or do more of it) because the agent would gain more benefit than cost through this action. If the marginal cost exceeds the marginal benefit, however, it is rational to not undertake it (or do less of it) because the agent would otherwise incur more cost than benefit.

Question 19

Who are the economic agents?

Answer 19

Consumers, producers and governments.

Question 20

What is the ABCDE decision-making approach?

Answer 20

Aim: Maximise net benefits based on problem, options and constraint faced by the economic agent.
Benefits: Both monetary and non-monetary, consider information and perspectives.
Cost: Both implicit and explicit, consider perspectives, information available and constraint arising from scarcity.
Decision-making: Use Marginalist Principle (Undertake more of the activity if MB > MC, stop when MB = MC, undertake less of the activity if MB < MC).
Evaluate: Decide whether to change decision, consider different scenarios.

Question 21

ABCD’s of consumers:

Answer 21

Aim: Maximise utility
Benefits: Marginal benefit, aka marginal utility, additional satisfaction gained from consuming one extra unit of the good within a given period of time.
Costs and constraints: Marginal costs, limited income
Decision-making: Consume quantities of a good up to the point where MU ≥ price

Question 22

What is the Law of Diminishing Marginal Utility?

Answer 22

As the quantity of a good consumed increases, the marginal utility falls. Up to a point, the more of a good consumed, the greater the total utility derived by the consumer. However, as the consumer becomes more satisfied, each additional unit of the good consumed will probably give less additional utility than previous units.

Question 23

ABCD’s of producers;

Answer 23

Aim: Maximise profits.
Benefits: Marginal benefit, aka marginal revenue, additional revenue that a producer receives from selling the additional unit of the good.
Costs and constraints: Marginal cost, limited factors of production.
Decision-making: Produce quantities of a good up to the point where MR ≥ MC.

Question 24

What is the Law of Diminishing Marginal Returns?

Answer 24

When increasing amounts of a variable factor of production 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 as the firm’s output rises beyond a certain threshold, its marginal cost of production would start to increase as factors of production become more inefficient.

Question 25

ABCD’s of governments:

Answer 25

Aim: Maximise social welfare.
Benefits: Marginal social benefit.
Costs and constraints: Marginal social cost, limited government budget (largely determined by tax revenue).
Decision-making: Make decisions by weighing MSB and MSC.

Question 26

What are the three key economic questions that need to be explained whenever you encounter questions on how scarce resources are allocated in an economy?

Answer 26

1. What and how much to produce?
   - Due to limited resources, choices need to be made as to what goods to be produced and in what quantities.
2. How to produce?
   - Many goods can be produced by a variety of method with different composition of resources. Choices need to be made on the composition of resources used and the technology that is to be adopted.
3. For whom to produce?
   - The total output needs to be distributed among members of the society.

Question 27

What are the 3 main economic systems?

Answer 27

1. Free market economy
   - Markets decide and allocate resources through the price mechanism based on forces of market demand and supply, with a limited role for the government.
2. Planned economy
   - Usually associated with a socialist or communist system, scarce resources are owned by the government. The state allocates resources, sets production targets and growth rates and distributes (or rations) the goods and services to people according to its own view of people’s wants and needs. Market prices play little or no part in informing resource allocation decisions.
3. Mixed economy
   - Some resources are owned by the public sector (government) while others are owned by the private sector (firms and households). The public sector typically supplies public and merit goods and intervenes in markets to correct perceived market failure, mix changes over time, differs in extent of state vs. market control.

Question 28

What is the PPC model?

Answer 28

The Production Possibility Curve (PPC) model is a useful tool to use when explaining the concepts of scarcity, choices and opportunity cost. A PPC 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.

Question 29

How does the PPC illustrate scarcity?

Answer 29

Scarcity is illustrated by the country being able to produce only at one of the points on or within the PPC at a given point in time as well as by the country not being able to attain points outside the boundaries of the PPC. (Trade can help a country consume beyond the PPC)

Question 30

How does the PPC illustrate that choices have to be made?

Answer 30

Countries can only produce one point on the PPC.

Question 31

How does the PPC illustrate opportunity cost?

Answer 31

The negative gradient of the PPC illustrates the presence of opportunity cost, as a country chooses to produce at a different point on the PPC, the country while being able to increase production in one kind of good, will have to forgo production at the other kind.

Question 32

Why is the PPC concave to the origin?

Answer 32

As more consumer goods are produced, the opportunity cost of expanding output of consumer goods measured in terms of forgone units of capital goods increases. This is because resources in an economy are not perfectly suited to the production of both goods (as a country chooses to produce more of one good, they have to use resources less and less suitable for producing that good). 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 the greater amount of alternative good that has to be forgone.

Question 33

What does economic efficiency comprise of?

Answer 33

Allocative efficiency and productive efficiency.

Question 34

What is productive efficiency?

Answer 34

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 PPC. All points inside the PPC are productively inefficient and occur when the country faces unemployment or underemployment.

Question 35

What is allocative efficiency?

Answer 35

The situation where society produces and consumes a combination of goods and services that maximises its social welfare. It is achieved when the goods and services that are wanted by the economy are produced in the right quantities. Only one point on the PPC is allocative efficient.

Question 36

What does movement from a point within to a point on the PPC represent?

Answer 36

Actual economic growth ie increase in national output, caused by increase in productive efficiency.

Question 37

What does an outward shift in the PPC represent?

Answer 37

Potential economic growth, which is an increase in the economy’s ability to produce goods and services. When productive capacity increases, the maximum quantities and combinations of both capital and consumer goods produced by the country would increase thus causing an outward shift of the PPC.

Question 38

What are the factors that affect a country’s productive capacity and shift in PPC?

Answer 38

1. Change in the country’s quantity of resources
   - e.g. increase in capital goods, government’s efforts to build infrastructure, war, natural disaster.
2. Change in the country’s quality of resources
   - Refers to the efficiency or productivity of the factors of production.
3. Change in technology
   - Technological improvement represents new and better methods of producing goods. Technology can increase the productivity of resources such that for a given amount of resources, more output can be produced. It can enhance production of both goods equally (parallel shift) or just one type of good (skewed shift).

Question 39

What affects the extent of economic growth?

Answer 39

The available stock of capital goods (a factor of production) plays a significant role in determining the extent of economic growth that an economy enjoys in the future. However, the production of capital goods involves postponing current consumption as resources used for the production of capital goods in the current time period cannot be used to produce consumer goods, which are for current consumption.
Hence, an economy must decide on the trade-offs between producing goods for current consumption and producing goods for future production and consumption. The opportunity cost of producing for current consumption is forgoing future production and consumption.