Chapter 1 Flashcards
What is economics?
Economics is the study of the management of scarce resources to satisfy unlimited human wants.
In other words, economics is the study of the use of scarce resources to satisfy unlimited human wants.
What are the five factors of production?
- Capital (plant, equipment, inventory, residential cost)
- Land (natural resources, natural capital)
- Labour (human resources, human capital)
- Technology (change in the productive process)
- Entrepreneurship (innovation, invention)
How are produced goods divided?
Goods (tangible - e.g., car) and services (intangible - e.g., haircut)
Define production.
Transforming inputs into outputs.
Define consumption.
The using up of production to satisfy human wants.
What is scarcity? [5]
- Scarce - limited, bounded, inadequate (Qd > Qs at P=0)
- Factors of production are limited
- Desires are unlimited (i.e., relative to our desires, existing resources are scarce)
- Economics manages these scarce factors to satisfy unlimited human desires
- Politics decides among the unlimited desires or ends (i.e., scarcity implies the need for choice)
What is the scarcity principle?
Stuff is scarce!
What is the choice principle?
People make decisions as tradeoffs.
What is the difference between a free good and a scarce good?
scarce good = limited supply
free good = unlimited supply (e.g., ideas - entrepreneurship input)
What does scarcity imply?
The need for choice - made by evaluating costs.
Every choice has an associated cost - opportunity cost.
What is opportunity cost?
The value of the next best alternative that is forgone when one alternative is chosen. (value/benefit)
In other words, the value of what you give up to have the the item to the value of what you would have had: a ratio.
What are the four elements of opportunity cost?
- value: subjective; benefit
- next-best: what you would have chosen
- forgone: what you give up
- alternative: choice
What is the opportunity cost principle?
The cost of something is what you give up to get it.
Opportunity cost includes costs affected by the choice including sunk cost.
True or false?
False.
Opportunity cost includes only those costs affected by the choice.
Exclude sunk cost (= cost incurred in the past, cannot be recovered, thus irrelevant; no resale or salvage value)
What is sunk cost?
Cost incurred in the past, cannot be recovered, thus irrelevant; no resale or salvage value.
“No sense crying over spilt milk.”
What is a PPC? (a.k.a. PPB)
Production possibility curve (a.k.a. boundary): shows all possible combinations of production, if all inputs are fully and efficiently employed.
What does a PPC/PPB illustrate? [4]
A production possibilities boundary/curve illustrates:
-
scarcity: right of line
- PPC is maximum output of given inputs
- ‘possible’ boundary
- point on line - inputs fully and efficiently employed
- point inside the line - inputs underused or inefficiently used
-
choice: negative slope
- cannot produce more of both
- Production efficiency - cannot produce more of one without less of the other
- “Trade-off”
-
opportunity cost: value of slope
- opportunity cost of producing one more unit rises as more is produced
- Producer chooses the lowest cost input first
- Producer chooses the most efficient input first
- Opportunity cost is a ratio
- MRT = marginal rate of transformation = slope of PPC
-
efficiency: shift of PPC
- same inputs, greater outputs - PPC shifts right - more efficient
What is MRT?
Marginal rate of transformation = slope of PPC
Why is the PPC concave to the origin?
- High comparative advantage inputs used first
- assume the most efficient factors are used first and the most inefficient resources are switched out first
- Law of increasing marginal opportunity cost = the opportunity cost of X increases as the production of X inccreases. Thus, to increase the production of X, one must give up ever increasing amounts of Y.
What is the increasing opportunity cost principle?
Rational producers use the lowest opportunity cost input first.
What is the law of increasing marginal opportunity cost?
The opportunity cost of X increases as the production of X increases.
In order to increase production of X, one must give up ever increasing amounts of Y.
(i.e., the PPC is concave to the origin)
What is the effect of increased productivity?
Increased productivity = increased efficiency = output/input
Increased productivity shifts PPC outward.
How do we decide where to be on the PPC?
Society equates SMC = SMB
(social costs/benefits - will return to this concept later in the course)
What are the four key economic problems for any economy?
Microeconomics:
- Production - What will be produced and by whom? (i.e., allocation of resources)
- Consumption - What will be consumed and by whom? (i.e., distribution of income)
Macroeconomics
- Idle capacity - output gaps (Why are resources idle? Why is the economy below PPC?)
- Increase capacity - I.R. growth (How to increase productive capacity? How to shift PPC outward?)
Describe the first key economic problem.
- What is produced and how?
- Resource allocation determines the quantities of various goods that are produced.
- What determines which goods are produced and which ones are not?
- Is there some combination of goods that is ‘better’ than others?
Describe the second key economic problem.
- What is consumed and by whom?
- What determines the distribution of a nation’s total output among its people?
- Who gets a lot and who gets a little, and why?
- Should governments care about this distribution of consumption and if so, what tools do they have to alter it?
- Will the economy consume exactly the same goods that it produces?
Describe the third key economic problem.
- Why are resources somtimes idle?
- An economy is operating inside its production possibilities boundary if some resources are idle.
- Why are some resources idle?
- Should governments worry about idle resources?
- Is there some reason to believe that occasional idleness is necessary for a well-functioning economy?
Describe the fourth key economic problem.
- Is productive capacity growing?
* Growth in productive capacity is shown by an outward shift of the PPB
What is microeconomics?
The study of the causes and consequences of the allocation of resources as it is affected by the workings of the price system.
Questions relating to what is produced and how, and what is consumed and by whom, all fall within the realm of microeconomics.
What is macroeconomics?
The study of the determination of economic aggregates such as total output, employment, and growth.
Questions relating to the idleness of resources and the growth of the economy’s productive capacity fall within the realm of macroeconomics.
Describe the nature of market economies. [4]
- Self-organizing
- The market provides not from benevolence, but according to their self-interests (i.e., measures of their advantages, not our own necessities)
- Efficiency (i.e., use of the least possible amount of resources)
- Individuals respond to incentives and pursue self-interest
- Sellers want to sell more when prices are high, buyers want to buy more when prices are low.
What are three types of decision makers operating in any economy?
- Consumers
- Producers
- Government
Describe the circular flow of income and expenditure. [4]
- Factor services flow from individuals through factor markets to firms, who use them to produce goods and services.
- The goods and services flow from firms through goods markets to households.
- Money payments flow from firms to individuals through factor markets.
- When households use this income to buy goods and services, the money flows from households to firms through goods markets.
Describe production and trade. [3]
- Specialization (i.e., allocation of different jobs to different people) and division of labour (i.e., breaking up production processes into sequences of specialized tasks)
- Money facilitates trade. Trade facilitates specialization.
- Globilization (i.e., increased importance of international trade)
What are two major causes of globilization?
- The rapid reduction in transportation costs
- The revolution in information technology
Advancements in transportation and communication.
How does money eliminate the barter system?
By separating the transactions involved in the exchange of products.
Why is the allocation of different jobs to different people (i.e., specialization) better than self-sufficiency? [2]
- Individual abilities differ (i.e., comparative advantages/disadvantages)
- Focusing on a single ability leads to improvements (i.e., learning by doing)
What are the three pure types of economic systems?
- Traditional
- Command
- Free-market
In practice, every economy is a mixed economy, combining elements of all three systems.
What did Karl Marx (1818-1883) argue in opposition of free-market economies?
He argued that free-market economies cannot be relied upon to generate ‘just’ distribution of output.
He argued the benefits of a centralled-planned system. (i.e., socialist/communist systems).
Do socialist/communist systems raise living standards?
No. As a result most governments replaces their systems of central planning with much freer markets.
Describe the government’s role in the modern mixed economy.
Markets often work well, but sometimes government policy can improve the outcomes of society as a whole.
Key government-provided institutions in market economies are private property and freedom of contract.
Governments intervene to correct market failures, provide public goods, and offset the effects of externalities.
What does it mean for a market to be self-organizing?
‘spontaneous economic order’
The economy based on ‘free market’ is self-organizing.
Adam Smith’s invisible hand (Wealth of Nations, 1776) organizes millions of independent decisions, for the common good.
What is the basis of social order?
Self-interest, not benevolence.
“If you look out for yourself the result is the common good. The collective as a whole is better off.” Prof G lecture quote.
What is the coordination principle?
Free markets automatically coordinate.
What is the efficiency principle?
Efficiency is better than inefficiency.
What does it mean for a market to be efficient?
Sellers produce what buyers want (allocative efficiency) at the least cost (productive efficiency).
- Free markets are relatively efficient.
- Free markets coordinate the buyers and the sellers thru the price.
- Free markets may fail or be unfair.
What is the incentives principle?
Rational decision makers respond to incentives.
What is the rational self-interest principle?
- Behavioural assumption
- Rational decision makers take actions that
- Decrease their individual costs and increase their benefits.
What is the price mechanism?
Buyers and sellers negotiate the exchange of commodities in markets.
What are the ‘rules of the game’ that govern markets? [4]
- Rule of Law
- Property rights; freedom of contract; limited liability
- Institutions (e.g., the court system)
- Instincts, habits, customs, conventions
‘Preconditions’
How do decision makers make decisions? [4]
- Incentives principle
- Rational self-interest principle
- Maximization principle
- Marginal principle
What is the maximization principle?
The rational decision maker takes actions to maximize something.
- Individuals consumer maximize happiness in the form of utility.
- Individual producer maximize happiness in the form of profits.
- Government maximizes happiness in the form of power.
Individuals prefer happiness over unhappiness.
What is the cost-benefit principle?
Take action when extra benefits exceed extra costs.
What is the marginal principle?
The rational decision maker takes an action when the marginal benefit exceeds the marginal cost.
- Marginal = additional = extra
What are the four thespians in the economic tragedy (wow these notes)
- Households
- Firms
- Government
- The rest of the world
What is a household (consumer), and what are assumptions about households in macroeconomics?
- = live under one roof and make joint financial decisions
- Assumptions about households:
- act in consistent union as one unit
- maximize satisfaction
- exchange inputs for income
- spend income on goods and services.
What is a firm (producer) and what are assumptions made about them in macroeconomics?
- = employs factors (inputs) to produce Goods & Services.
- Assumptions about firms:
- act in consistent fashion as a unit
- maximize profits
- exchanges outputs for income
- spend income on factors of production
What is the Government and what are assumptions made about it in macroeconomics?
- = any body under control of federal, provincial, or municipal government
- Assumptions:
- do not act consistently
- may not maximize anything, except votes
What is the rest of the world in macroeconomics, and what is an assumption made about it?
- = export and import markets
- Assumptions made about the rest of the world
- act like rational consumers and producers
Draw a circular flow diagram.
What are the four ‘economies’ included?
- Spendthrift economy
- Frugal economy
- Governed (closed) economy
- Open economy
What is a market?
Area over which buyers and sellers negotiate the exchange of a commodity.
What is the specialization of labour?
One product produced by one specialized worker (e.g., family lawyers specialize in family law)
What is the division of labour?
One product divided into individual tasks, each done by a different worker.
What is the specialization principle?
Specialization of labour requires trade and markets.
What does money facilitate?
Specialization and trade.
What is the comparative advantage principle?
‘Trade may lead to gains from trade - win-win’
Natural and acquired factor endowments (advantages) allow individuals to do what they are best at doing. Everyone wins when individuals specialize in doing that in which they have a ‘comparative advantage’.
What is the intervention principle?
Sometimes Government can improve on market outcomes.
What is the result of globalization?
Globalization of demand (markets) and supply (transnational corporations) results in increased international trade and world per capita GDP.
Describe a traditional economic system.
- allocation and distribution is based on custom
- effective in an unchanging environment
- e.g., fuedal system - traditional prices offered to all
Describe a command economic system.
- allocation and distribution - central planning authority
- requires forecasting - very difficult
- e.g., Soviet Union, North Korea
Describe a free market economic system.
- allocation and distribution - private households & firms
- free-enterprise economy
- decisions are decentralized
- price system acts to coordinate buyers and sellers
Describe a mixed economic system.
- allocation and distribution - by private and public sectors
- e.g., on a spectrum: North Korea, Canada, Hong Kong
Describe the failure of central planning. [4]
- Misplaced incentives
- Failure of coordination
- Failure of quality control
- Environmental degradation
Compare Adam Smith’s argument to Karl Marx’s.
Adam smith stressed efficiency and allocation of resources.
Karl Marx stressed equity and distribution of income.
What could market economies have difficulties with?
- Monopolies
- Externalities (e.g., pollution)
- Public goods (e.g., national defence)
- Fairness
Do not confuse efficient allocation with equitable distribution (dealing with social justice).
Also don’t confuse free economies with democratic politics.
What are the four principles economists base their thoughts on?
- Property Rights and Freedom to Contract; these allow for creation and retention of incentives
- People react to incentives
- People are self-interested in maximization of something
- Marginal thinking (i.e., trading takes place on the margin)
What are the three general categories of any economy’s resources?
Land
Labour
Capital
Economists refer to these resources as factors of production.
Scarcity is indicated by […].
Choice is illustrated by […].
Opportunity cost is illustrated by […].
- Scarcity is indicated by the unattainable combinations outside the boundary.
- Choice is illustrated by the need to choose among the alternative attainable points along the boundary.
- Opportunity cost is illustrated by the negative slope of the production possibility boundary (PPB/PPC)
Explain the difference between scarcity and poverty.
Scarcity means an excess of wants over the resources available to satisfy those wants while poverty is involved with the level of resources below some threshold of sufficiency.
