Chapter 1

Question 1

What is economics concerned with?

Answer 1

The production and consumption of goods and services.

Question 2

Define scarcity

Answer 2

Human wants are basically unlimited, but the means of fulfilling human wants are limited. Thus, scarcity is the excess of human wants over what can actually be produced.

Question 3

Define the 3 factors of production.

Answer 3

1. Labour (human resources)
2. Land and raw materials (natural resources)
3. Capital (manufactured resources). Capital consists of all the inputs that have themselves been produced in the first place (e.g., computers, machines, etc.).

Question 4

Define macroeconomics

Answer 4

Macroeconomics is concerned with the economy as a whole. It focuses on economic aggregates (grand totals; e.g., the overall level of prices, output and employment in the economy). It studies the determination of national output and its growth (or not) over time.

Question 5

Define aggregate demand

Answer 5

The total amount of spending in the economy

Question 6

Define aggregate supply

Answer 6

The total national output of goods and services

Question 7

What happens if aggregate demand is too high relative to aggregate supply?

Answer 7

1. Inflation – this is the general rise of prices throughout the economy. If demand has increased substantially, firms will increase their prices to make more profit. If firms in general put up their prices, inflation will result.
2. Balance of trade – deficits are the excess of imports over exports. If demand rises, people are likely to buy more imports. Also if inflation is high people will buy more foreign goods but people abroad will buy less of our exports.

Question 8

What happens if aggregate demand is too low relative to aggregate supply?

Answer 8

1. Recession – decline in the output of an economy (negative growth) for two or more consecutive quarters. Associated with low levels of consumer spending, shops will have excess stock which leads them to buy less from manufacturers, which results in less production.
2. Unemployment – if firms are producing less they will employ less people.

Question 9

Define demand-side policy

Answer 9

Government macroeconomic policy which seeks to influence the level of spending in the economy

Question 10

Define supply side policy

Answer 10

Government macroeconomic policy which seeks to influence the level of production directly

Question 11

What are the 3 main choices associated with microeconomics?

Answer 11

1. What things are going to be produced and in what quantities?
2. How are things going to be produced?
3. For whom are things going to be produced?

Question 12

Define opportunity cost

Answer 12

The sacrifice of alternatives in the production or consumption of a good.

Question 13

Define rational choices

Answer 13

Weighing up the (marginal) costs and (marginal) benefits of any activity

Question 14

Define marginal cost/benefit

Answer 14

The additional cost/benefit of doing a little bit more (e.g., 1 unit more) of an activity

Question 15

Define economic model

Answer 15

Representation of a r/s between 2 or more variables. These are a simplification of reality in order to show how things are related.

Question 16

Define the “other things being equal” assumption

Answer 16

To use economic models we assume that the other things that might affect the outcome do not change. Otherwise, we would have to adjust the model.

Question 17

Define the production possibility curve.

Answer 17

A graph with a curve showing the possible combinations of two goods that a country can produce within a specified time period with all its resources fully and efficiently employed. Production cannot take place beyond the curve as there are not enough resources to do this.

Question 18

What are the 2 simplifying assumptions of the production possibility curve?

Answer 18

1. There are just two goods that can be produced (only 2 axes)
2. Need to measure them in the same unit (e.g., tonnes)

Question 19

How does the production possibility curve illustrate the microeconomic issue of choice and opportunity cost?

Answer 19

If a country chooses to make more clothing, it sacrifices the production of some food. The sacrifice of food is the opportunity cost of the extra clothing. The fact that producing more of one good involves producing less of the other is illustrated by the downward sloping nature of the curve.

Question 20

How does the production possibility curve illustrate the microeconomic issue of increasing opportunity costs?

Answer 20

Different factors of production have different properties. Thus, as the nation focuses more on producing one good it has to start using resources that are less and less suitable – resources that would have been better suited to producing other goods.

Question 21

Discuss the production possibility curve in the context of macroeconomics.

Answer 21

In macroeconomics, the focus is not on the combination of goods produced, but whether the total amount produced is as much as it could be. There is no guarantee that resources are used efficiently. Thus, the nation could be producing at a point inside the curve. This means the economy is producing less of both goods than it could possibly produce, either because some resources are not being used or not being used efficiently.
It is unlikely that an economy could sustain full-capacity output in the long-term due to inflationary pressure and resources becoming scarce. However, the production possibilities of a nation are likely to increase over time. E.g., investing in new machinery/capital, technological advancements, etc. This growth in potential output is illustrated by an outward shift in the curve.

Question 22

Describe the “demand and supply” relationship between firms and households.

Answer 22

Households are the consumers, firms are the producers.
Firstly, in a money economy, firms exchange goods and services for money. This interaction between buyers and sellers is known as a “market”.
Secondly, firms and households come together for factors of production. Firms demand the use of factors of production owned by households – labour, land and capital. Households supply this and in return firms pay households money.
Thus, there is a circular flow. Households earn income from firms and firms earn income from households. There is also a circular flow of goods and services, but in the opposite direction. Households supply factor services to firms, and firms use them to supply goods and services to households.

Question 23

Define the command/centrally planned economy.

Answer 23

Usually socialist or communist. Land and capital are collectively owned. The state plans the allocation of resources at 3 levels:
1. Plans the allocation of resources between current consumption and investment for the future – depends on the importance it attaches to growth vs current consumption.
2. It plans the output of all industries, including the techniques that will be used, labour, resources, etc. The state would likely use input-output analysis (e.g., matching inputs and outputs of each industry so that planned demand is equal to planned supply).
3. Plans the distribution of output between consumers. Might distribute goods according to the judgement of peoples needs, or may give more to those who produce more (incentive to work harder). It may distribute goods and services directly or may distribute income and allow individuals to decide how to spend it. Even with income these governments will control the prices (high to discourage consumption and vice versa).

Question 24

What are six consequences of a command/centrally planned economy?

Answer 24

1. If the economy is large and complex, it will be more complex to plan for. Will be more costly to administer and collect data for.
2. Will likely involve the inefficient use of resources as prices are set by the state. i.e., how can you make a rational decision between oil and coal if their prices do not reflect their scarcity?
3. Hard to encourage workers to be more productive without a reduction in quality. Then, a large number of people would need to be employed to monitor quality.
4. Loss of individual liberty
5. The government could enforce plans even if they were unpopular
6. If consumers can spend money as they wish there will be a problem if the consumer wishes for change (e.g., shortages or surpluses).

Question 25

Define the free market economy.

Answer 25

Associated with a pure capitalist system, land and capital are privately owned. Economic decisions are made by households and firms, which are assumed to act in their own self-interest. The following assumptions are made:
1. Firms want to maximise profits
2. Consumers want the best value for money
3. Workers want to maximise wages relative to the human cost of working in a particular job

Question 26

Define the price mechanism.

Answer 26

If consumers want more of a good, demand will exceed supply. This shortage will encourage sellers to raise the price. Less people will buy it. At the same time, it will have encouraged sellers to make more because of increased profit. The price will continue rising until the shortage has been eliminated.
If consumers want less of a good, supply will exceed demand. This surplus will encourage sellers to lower the price. This will discourage producers from producing more as it is less profitable. It will encourage consumers to buy more. The price will continue falling until the surplus has been eliminated.

Question 27

Define the equilibrium price.

Answer 27

The price where the quantity demanded equals the quantity supplied: there is no shortage or surplus.

Question 28

How does the price mechanism respond to changes in consumer demand or producer supply?

Answer 28

Changes in supply act as signals and incentives.
Rise in demand = rise in price. Fall in demand = fall in price.
Rise in supply = fall in price. Fall in supply = rise in price.

Question 29

What is the interdependence of markets?

Answer 29

Based on the price mechanism goods markets affect factor markets (elaborate). It can also affect different goods markets (i.e., if prices rise and there are alternatives, this will drive up the cost of alternative goods as well and encourage more supply).

Question 30

Define perfect competition.

Answer 30

A highly competitive market, with many firms competing against each other. They are too numerous to have control over prices, so they are price takers.

Question 31

Define mixed economy.

Answer 31

Markets are the primary way that resources are being allocated, but there is still some government intervention. The degree and type of government intervention vary from country to country.

Question 32

Define the four roles that governments play in a mixed economy.

Answer 32

1. Allocative role: affects the allocation of resources in consumption or production. E.g., levy taxes, compulsory primary and secondary education.
2. Distributive role: affects the distribution of resources. E.g., income tax system, welfare, provision of services such as libraries and parks.
3. Regulatory role: regulates economic activity through legally enforceable rules or actions. E.g., the correct labelling of products or prohibiting collusion between powerful firms.
4. Macroeconomic role: interventions to stabilise the economy in the short term or promote longer-term economic growth.