Important Economic Concepts

Question 1

Catch-up and social capability

Answer 1

Explains why poorer countries take a long time to catch-up with the income levels of richer countries
Social capability: skill level of labour force and nature of the government
e.g. if government cannot guarantee the rule of law, entrepreneurs won’t invest due to no guarantee of investment benefits
undemocratic systems also have the social capability to increase total factor productivity and grow richer (e.g. China)

Question 2

Comparative advantage

Answer 2

A country has a greater cost advantage in producing B and importing A than it does trying to produce A and B simultaneously, so it specialises in producing and exporting B and obtaining more A through imports

Question 3

Contagion

Answer 3

Collapse of a major bank/banks that affects other banks that are considered healthy and will likely lead to the collapse of those banks because all banks have large funds with other banks
Solution: government protects the banking system usually by increasing money supply and in some circumstances nationalise or partyly nationalise the banks
e.g. Lehman Brothers collapse (2008), US government let them go bankrupt but compensated other banks/institutions who were owed money by Lehman Brothers.

Question 4

Price elastic

Answer 4

Shows how much more of a commodity will be purchased if the price falls and how much less will be purchased if the price rises
price increases -> total revenue (price x quantity) falls
e.g. 10% fall in price -> 10% rise in purhcases = price elastic
sale of textiles in a relatively poor country

Question 5

Price inelastic

Answer 5

price increases -> total revenue rises
e.g. 10% fall in price -> <10% rise in purchases = price inelastic
demand for food in a relatively rich country

Question 6

Income elastic

Answer 6

10% rise in income -> >10% rise in sales = demand for good is income elastic
e.g. demand for healthcare in rich countries

Question 7

Endogenous factor

Answer 7

Factor that is internal to a system/model and often determined by other aspects of a system/model

Question 8

Exogenous factor

Answer 8

Factor that is external and originates from outside a system/model

Question 9

Entrepreneur

Answer 9

People who take risks of obtaining and using capital to make a profit by seeing a market, raising finance and organising production
Governments often engage in entrepreneurial behaviour
=/ investors, though may use inventions

Question 10

External economies

Answer 10

Affects cost and efficiency and is the reason why industries tend to cluster together and why cities grow
Economy needs to do more than import technology to catch-up
e.g. ‘thick’ labour market where many people have similar skills, and existence of decent transport links

Question 11

Internal economies

Answer 11

Affects the plant directly

Question 12

Factor endowment

Answer 12

Factors of production that a given place possesses at any point in time
e.g. land, labour capital, coal and oil

Question 13

Gains from trade

Answer 13

Where two countries have comparative advantages in the production of something
e.g. gains from export of frozen beef from Argentina to the UK (early 20th century)
Argentine meat farmers and those involved in the trade (like railway companies) GAINED
British consumers GAINED because price of meat fell
Other Argentine farmers LOST because land became more expensive
American meat farmers LOST due to loss of the UK market
British meat farmers LOST

Question 14

Gross domestic product (GDP)

Answer 14

Measures output made within country
Includes exports but not money made from overseas investments (profits from overseas factories)

Question 15

Gross national product (GNP)

Answer 15

Measures total output/size of an economy
Includes all output of goods (manufactures), resources (oil), services (transport and universities) and all exports
Also includes all money returned to country from overseas investments

Question 16

Hedge funds

Answer 16

Rationale: to lead the market
e.g. during depression: hedge funds sell local currency to force devaluation then change money back again at a profit
Thailand devaluation (1997)

Question 17

Human capital

Answer 17

The skills (extent of literacy, formal schooling, and learning on the job) embodied in the labour force
e.g. majority of skilled workers in Britain before the First World War learned at work rather than formal training

Question 18

Increasing returns to scale

Answer 18

The cost of a product is related to the scale of production
Increasing returns: double the scale and use double the inputs = more than double output = unit costs fall
Occurs because cost of technology can be spread over a greater amount of ouput
Easier to achieve scale economies in manufacturing if market is large enough
Remember economies in production aren’t the only economies, can be economies in marketing like purchasing raw materials AKA internal economies bc it only affects the plant

Question 19

Liquidity trap

Answer 19

Situation in a depression where very few people are willing to risk putting their money into an investment = economy stagnates
Normal times: premium for investment that compensates so people don’t put excessive funds into cash, usually involving (additional) government expenditure (often paid out in borrowing)
Liquidity preference: people likely to hold cash/government bonds because interest rate on investment is low relative to the risk involved in investment
If liquidity preference is high: government expenditure =/ increase in income level, individuals will save their money rather than spend it

Question 20

Negative external economies

Answer 20

e.g. pollution coming from industry = raises costs for a firm = workers are less healthy and less productive (problem in USSR & eastern Europe in 1960s and 1970s)

Question 21

Non-tariff barriers

Answer 21

More protective than tariffs, a barrier to trade in services and frequently used when tariff barriers are low/non-existent
e.g. state railway may have unusual technical standards to which its electric trains must conform in order to stop foreign makers of railway locomotives competing with local firms
e.g. refusal to recognise foreign qualifications to reserve jobs for locally trained people. Protect local colleges & teachers against foreign competition and preserve jobs for locals

Question 22

Opportunity cost

Answer 22

Cost of the next best alternative
e.g. if you dont employ group of workers at $1000/month and instead lend the money to someone else and receive interest of $10/month, opportunity cost of employing group of workers = $1010. $1010 is the opportunity forgone by employing the group of workers, so won’t employ them unless they make you > $1010/month

Question 23

Principal-agent problems

Answer 23

Conflict of priority and interest when an agent (person/entity) does something on behalf of the principal (person/entity)
e.g. Dutch trade ensuring captain of ship heading to the Indies goes there by using his relatives who can be disinherited if things go wrong

Question 24

Quantitative easing

Answer 24

During a depression quantitative easing: way of increasing money supply by countries with an independent central bank where the government sells additional tranche of government stock to the independent central bank, giving the government usable currency. The central bank doesn’t market the government stock
May not work if money is saved -> doesn’t increase money supply like when liquidity preference is very high

Question 25

Rational expectations

Answer 25

People can anticipate what government policy will be in the future, making it difficult for government policy to be effective
e.g. inflation -> gov wants to control -> increases interest rates -> but if population anticipates that government will do that -> at present moment they will spend as much as possible and borrow at old interest rate before the rate goes up -> inflation increases -> may have to rise interest rate for the second time, subject to rational expectations and may damage the economy

Question 26

Tariff barriers

Answer 26

A way to protect a country from imports by imposing a charge (fixed payment per unit or proportional tariff/ad valorem tariff where tariff varies according to price of import) on goods entering the country

Question 27

How tariffs affect countries trading

Answer 27

Prevents countries from following their comparative advantage in trade because it changes the price of goods when they are traded
Import tariff may discourage a country to specialise in good B and export B while importing good A

Question 28

Terms of trade

Answer 28

Shows the prices a country obtains for exports compared with the prices for imports.
If import is rising compared to exports = terms of trade are moving AGAINST the country
Whether/not country is worst off depends on volume of exports and imports

Question 29

The prisoner’s dilemma

Answer 29

Explains why it’s difficult to make agreements because one party is unable to predict what the other will do
e.g. two farms alongside a river, both farmers lose if river floods unless $1000 is spent on flood control -> best way: both farmers pay $500, but both know if other farmer pays $1000, they reap the benefit without paying -> both farmers wait for the other to pay $1000 -> river floods and costs each farmer >$500
Necessary for governments to force cooperation in the best interests of parties

Question 30

Total factor productivity (TFP)

Answer 30

Way of measuring efficiency. Calculates amount of each input (labour, capital, other resources) used and price of inputs to the producer. Shows how well/efficiently producer (and ultimately whole economy) is using the factors at its disposal
Residual: rough unmeasured part of changes in technology that increases the output which is unaccounted for by more labour/capital/resources. May include the effect on output if quality of inputs increases
e.g. effect of better education on the quality of workers
Modern economies: TFP growth = more important > increase in resources, labour or capital

Question 30

The production function

Answer 30

Way of measuring inputs (capital and labour) that go into making goods (outputs)
e.g. US farmers used more machinery and less labour than European farmers (late 19th century)
=/ tell us which combination was more efficient because cost of machinery and labour were different in Europe and USA

Question 31

Transactions costs

Answer 31

One way to look at the process of economic development through continuous reduction in the cost of making deals (including payments)
e.g. cost of raising government revenue = initially very high, costed a lot of money (paying for tax-gatherers) to raise a little
now, taxgatherers cost relatively little money but taxes raise a lot -> gov expenditure can be used for beneficial purchases rather than paying for tax-gathering
Recent years: information technology reduced transaction costs to very low levels and there are now large parts of the service sector whose purpose is to reduce transaction costs (like lawyers who make and enforce contracts)