Nature of economics Flashcards
What do economists need to do
Make key assumptions
Define ceteris paribus
The assumption that other factors remain equal or constant so that nothing else changes
What is a key assumption that economists need to make
Assuming that events occur with ceteris paribus
Why is the assumption that other factors remain equal need
Economists cannot test models in scientifically controlled laboratory conditions
What is the impact of economists unable to conduct scientific experiments
Economists need to use real-life scenarios to devise models as an alternative in order to form assumptions
Define economics
The allocation of scarce resources to provide for unlimited human wants
Define positive statements(will/is)
Value-free statements based on facts which can be tested as true or false
Define normative statements
Statements concerned with value judgements with a non-scientific approach
Role of value judgements in influencing economic decision making
Personal preferences and subjective assessment can underpin decisions made by consumers and producers
Example of value judgements influencing consumers
A highly cautious consumer may prefer to save their income in a pension fund rather than increase spending on goods
Example of value judgements influencing firms
A producer prone to taking high risks may prefer to spend cash reserves on developing new goods rather than saving reserves
Role of value judgements in influencing government policy
A government may prefer to cut income tax rather than increase expenditure on healthcare/provision if they have a preference for free market forces
What is the basic economic problem based on
Scarcity
Define scarcity
the idea that because there are finite resources compared to infinite wants, choices must be made about how to use those resources
Why does scarcity arise
When there are insufficient resources to provide for everyone’s wants
Why does scarcity occur in all economies
Resources are finite compared to human material wants
Where is scarcity obvious in
Countries that face famine or drought where insufficient food or water is available to meet all needs
Why can scarcity exist in wealthy countries
Not all human material wants can be satisfied
Why does scarcity mean for us
We have to make choices over the use of our limited resources to provide for our material wants
What decisions must be made due to scarcity
Crucial decisions must be made over what, how and for whom to produce
Who faces these decisions
Consumers, producers and the government
What happens once a decision has been made about what to use a resource for
An opportunity cost arises
Define opportunity cost(OC)
The value of the next best alternative forgone
Who faces opportunity cost
Consumers, producers and the government
Importance of OC to consumers
May have to decide between spending a meal at a restaurant or on a new T-shirt if their budget cannot buy both at the same time
Importance of OC to firms
Managers of firms may have to decide between investing in a new machine or to invest in a training programme for employees
Importance of OC to governments
May have to decide between using extra tax revenue for a new hospital or on a large school
Define factors of production
Finite inputs used in the production of goods and services that are classified into land, labour, capital and enterprise
Define renewable resource
A resource whose stock level can be replenished naturally over a period of time
Examples of renewable resources
Solar energy, wind power, tidal power
Evaluation of renewable resources
They may decline over time if they are consumed at a faster rate than the environment can replenish them
Why do renewable resources require careful management
To avoid deforestation and soil erosion
Define non-renewable resource
A resource whose stock level decreases over time as it is consumed
Examples of non-renewable resources
Fossil fuels such as coal, oil and gas
Commodities such as steel, copper
How can we reduce the rate of decline of non-renewable resources
Through recycling and the development of substitutes
How does the price mechanism affect the rate of consumption of non-renewable resources
Reduces the rate of consumption of non-renewable resources via higher prices
What do production possibility frontiers (PPF) show
- The maximum potential level of output for two goods and services
- that an economy can achieve
- when all resources are fully and efficiently employed
- given the level of technology available
Define utility
The state of being useful, profitable, or beneficial
Define consumer goods
Goods that directly provide satisfaction or utility to consumers and are wanted for the satisfaction it gives
Define capital goods
Goods used to produce more consumer goods or services such as machinery and indirectly provide satisfaction to consumers
PPF of an economy with capital and consumer goods
(Real card 1)
Where is the economy initially at
point Z
What is the cost of increasing the production of capital goods by 20 units and move to point W
There is an opportunity cost of 30 units of consumer goods
What does the movement from Z to W do
Increase economic growth as capital goods are crucial for increasing production
How can economic growth be shown by on the PPF
An outward shift of the PPF
What will the loss of 30 units of consumer goods mean
Current living standards will fall in order to enable future living standards to rise at a faster rate
What does it mean if the economy is located at any point ON its PPF
There is an efficient allocation of resources as none are being wasted
What does it mean if the economy is located at any point WITHIN its PPF
There is an inefficient allocation of resources as not all are being used
How can we increase production of both consumer and capital goods at point U
By utilising unemployed resources without sacrificing any other goods in return, allowing no opportunity cost
Where is a typical PPF bowed to
The origin
What does a typical PPF show
As more of one good is produced, an increasing amount of the other is forgone so the opportunity cost rises
Why does the OC rise
Not all resources are as efficient as other resources in the production of both goods, so diminishing returns set in
What is the law of diminishing returns
A point at which the level of profits or benefits gained is less than the amount of money or energy invested.
Example of PPF in action
- We can assume that farmland can be used for growing wheat of livestock production
- East Anglia has highly fertile and light soils with suitable rainfall for growing wheat
- Their output per acre is very high
- As we move towards the southwest, soil becomes too heavy
- Rainfall becomes too high for growing wheat
Why would livestock farming be more productive per acre
- If farmland in the southwest were converted to wheat production, yields would be very low
- Yields would only be achieved at a cost of forgoing livestock output
Diagram of increase in the PPF
(Real card 2)
What does the outward shift in the PPF show
That a country’s production potential may increase over time and this represents economic growth
What may be the causes of economic growth shown by the PPF
- An increase in the quantity or quality of resources
- The expansion of further and higher education
- Expansion in government training schemes
- An increase in investment
- The development of new technology
What does the inward shift of the PPF towards the origin indicate
A decrease in the potential output of an economy which represents a reduction in economic growth
What may a decrease in potential output be cased by
•A natural disaster where resources are destroyed
Define specialisation
- When an individual, firm, region or country
* Concentrates on the production of a limited range of goods and services
Advantages of specialisation
PUGS
- Productivity rises
- UK specialises in production of medicinal drugs and tourism
- Goods and services can be traded for other goods and services by other countries
- So higher levels of global output and higher living standards
Disadvantages of specialisation
MALT
- Many developing countries face an unfavourable rate of exchange
- A country that specialises in production of export of minerals may face problems of resource depletion
- Large increase in structural unemployment when demand for a good/service falls
- This means they have to sell commodities at a low price compared to the goods they purchase overseas
Define division of labour
The specialisation of workers on specific tasks in the production process
Process of division of labour
- Individuals focus on the production of a particular good/service
- Production is broken down into a series of tasks
- Each task is conducted by different workers
Adam Smith division of labour example
- If pin production were broken down into 18 different specialist tasks
- Where each task was carried out by a different worker
- The output of pins would increase by 2000%
- In comparison to a situation where each worker completed all the tasks involved
Main advantages of division of labour
COLE
- Cost per unit of output reduced
- Output per worker per hour rises-higher productivity:
- Living standards rises
- Efficiency of resources increases
What are the reasons for increased productivity
- Workers becoming highly skilled in a task due to repetition
- No time is wasted in moving from one job to another
- Capital equipment used continuously in production
- Less time required to train workers for specific tasks
- More choice of jobs for workers
- Workers can specialise in the tasks they are most suited to
Disadvantages of division of labour
•Structural unemployment can be caused
(self-service scanning machines instead of cashiers)
•High turnover of staff leads to increased recruitment costs
•Interdependence in production-if one group of workers were on strike, production could be halted across the whole industry
•Repetition creates monotony and boredom
•Easier to replace skilled workers with machines if production broken down into different tasks
Define money
Anything that is generally acceptable in the payment of a good or service, or of a debt
What forms do money come in
Largely cash and bank deposits
What do advances in technology mean for money
We are moving towards a cashless society where most payments occur through debiting and crediting bank accounts
What has the development of money enabled
It has enabled specialisation and trade to grow, leading to sophisticated economies of today
Why is it crucial that people have confidence in the money used
Otherwise it will lose its general acceptability for making transactions, and so will cease to be money
Example of why confidence in money is important
In Zimbabwe the government printed off too much money leading to hyperinflation and a worthless currency
What are the four functions of money
- Medium of exchange
- Measure of value
- Store of value
- Method of deferred payment
What does money as a medium of exchange enable
- Enables buying and selling of products which makes exchange easier
- Money eliminates the need for barter
What does money as a measure of value enable
- Enables a value to be placed on products
- So they can be bought and sold with ease
- Money creates a unit of measure that enables comparisions between relative values of products
What does money as a store of value enable
- It is a convenient way of storing wealth so that it can be spent at a later date
- Money will tend to hold its value in the short term if inflation remains low
What does money as a method of deferred payment enable
- It enables borrowing and lending
* This means someone can borrow money to buy a product rather than waiting until enough funds have been saving
What is the rate of interest
The price set for borrowing and lending
Why does an economy organise its resources in different ways
To produce goods and services
What are the three markets included in an economic system
- Free market
- Mixed economy
- Command economy
Percentage of resources allocated by the price mechanism for a free market economy
- 100%
- All resources are allocated by the price mechanism
- No government intervention
Percentage of resources allocated by the price mechanism for a mixed economy
- 50%
- Some resources are allocated by the price mechanism
- Some resources are allocated by the government
Percentage of resources allocated by the price mechanism for a command economy
- 0%
- All resources are allocated by the government
- No price mechanism
In reality what do the vast majority of economies comprise of
A mixture of the private sector (private enterprise) and the public sector(state enterprise), making them mixed economies
Resource allocation by economies to the UK
- 60% are allocated by the private sector
* 40% are allocated by the public sector
What does the government provide in UK society
Major provider of: •Education •Healthcare •Defence •Law and order
Public sector size in other European economies
Greater than private sector size
Public sector size in North America economies
Lower than private sector size
Define free market economy
- Where all resources are privately owned and allocated via the price mechanism
- There is minimal government intervention
What is the free market economy associated with
Writings of Adam Smith and Friedrich Hayek
Why are there no pure free market economies in the world today
In every economy, the government directly controls some resources and output
Evaluation of the lack of free market economies
- The proportion of government intervention tends to be significantly less in some developing countries
- Compared to the developed world
- Best example of a developed country with a small government sector is Japan
Advantages of a free market economy
1.Economic efficiency and lower prices:
1.Economic efficiency and lower prices:
•Competition means firms try keep production costs low
•In order to sell goods and services at competitive prices(productive efficiency)
•Competition means firms try to produce goods and services that consumers demand(allocative efficiency)
•This means the price mechanism will equate consumer demand with producer supply
Advantages of a free market economy
2.Quality of products
2.Quality of products
•Competition means firms continuously try to improve quality of their products
•This allows firms to gain an advantage over rivals
•There is considerable consumer power and authority in the market
Advantages of a free market economy
3.Greater choice
3.Greater choice
•Consumers can often choose to buy from a wide selection of goods and services
•Workers often have a wide choice of employment opportunities
Advantages of a free market economy
4.Financial incentives
4.Financial incentives
•Entrepreneurs have an incentive to invest and take risks in order to earn profit
•Labour has an incentive to work hard to gain more earnings
Disadvantages of a free market economy
2.Unequal distribution of income
2.Unequal distribution of income
•The distribution of income and wealth is very unequal
•The lack of welfare support may lead to people living in absolute poverty
Disadvantages of a free market economy
3.Ignored external costs and benefits
3.Ignored external costs and benefits
•External costs and benefits from production/consumption are sometimes ignored
•For example, the price mechanism ignores the external costs of pollution and external benefits of education
Disadvantages of a free market economy
4.Persistent information gaps
4.Persistent information gaps
•People may consume excessive amounts of demerit goods whilst being unaware of their dangers
•E.g drugs, tobacco and alcohol
•There is a lack of regulations and taxation to protect consumers
Disadvantages of a free market economy
5.Insufficient quantity of goods
5.Insufficient quantity of goods
•An insufficient quantity of public goods and merit goods is provided in a market economy
•Public goods include defence and street lighting
•Merit goods include healthcare and education
•These goods may be underprovided by the free market
Disadvantages of a free market economy
6.Erratic swings in the business cycle
6.Erratic swings in the business cycle
•Erratic swings in the trade cycle may cause high inflation during an economic boom
•They may also cause high unemployment during an economic slump
Define command economy
- Where there is public ownership of resources and these are allocated by the government
- Therefore there is no role for the price mechanism
Who makes the decisions on what, how and for whom to produce
The government
What did Karl Marx believe
Production should be directed on the basis of human need rather than profit
When can command economies work effectively
During times of national crisis:
•E.g the UK was run like a command economy during WW2
Evaluation of effectiveness of command economies
- However personal freedom and living standards can be jeopardised
- For example North Korea
Advantage of a command economy:
1.maximised output
- Cooperation between firms leads to high levels of output
* Maximisation of output replaces the maximisation of profits as the key aim of firms in general
Advantage of a command economy:
2.reduction in inequality
•There is a reduction in inequality compared to free market economies as the government controls wages of all workers
Advantage of a command economy:
3.Limited external costs
- Governments may limit external costs from production and consumption
- E.g they can limit pollution emissions from firms and place taxes on demerit goods such as alcohol
Advantage of a command economy:
4.Funding of public goods + increased external benefits
- The government can fund the provision of public goods such as defence and law and order
- Governments can also increase the provision of goods which yield high external benefits to society
- E.g education and healthcare
Advantage of a command economy:
5.Less unemployment and inflation
- The government has more control of the economy
* Therefore there are smaller swings in the business cycle, leading to less unemployment and inflation
Disadvantage of a command economy:
1.Inefficient allocation of resources
- Price mechanism unable to operate
- So markets may suffer from excess demand and excess supply/shortages and surpluses
- This leads to an inefficient allocation of resources
Disadvantage of a command economy:
2.Low productivity
- Lack of competition between firms
- This leads to inefficiency
- Therefore productivity is low
Disadvantage of a command economy:
3.Poor quality products
- Lack of competition between firms
- May be more emphasis on maximising output rather than profit
- This leads to poor-quality products
Disadvantage of a command economy:
4.Narrow choice of goods, services and labour
- Less choice of goods and services for consumers to choose
* Labour may be directed into specific jobs with no choice depending on their location
Disadvantage of a command economy:
5.Lack of financial incentives
- Main focus for managers is to maximise output
- So managers have no profit incentive to take risks
- Wages are fixed by government so labour has little incentive to work hard
Disadvantage of a command economy:
6.Under-performance of command economies
- Economic growth and living standards tend to grow at a slower rate than in market-based economies
- This was a major cause of the collapse of the Soviet Union during the early 1990s
- This indicates under-performance of command economies
Who makes the decisions on what, how and for who to produce for a mixed economy
The private sector and the government
Define mixed economy
Where some resources are owned and allocated by the private sector and some by the public sector
What is the reasoning for a mixed economy
To gain the advantages of the market economy whilst avoiding its disadvantages through government intervention
Who is associated with mixed economies
John Maynard Keynes
Why does government intervention occur
To correct market failure and help markets work more effectively:
•E.g the under-provision of merit goods such as education and healthcare
•E.g the non-provision of public goods such as defence
