Principles of Economics 1.1 - Introduction to Economics Flashcards
Explain the history about the formation of the definition of Economics
Alfred Marshall’s definition is that it’s ‘the study of mankind in the ordinary business of life’. However, this is vague and not particularly informative
* Alfred Marshall came up with Economics. It traces its origins to the late 19th century. Before then there was only “political economy”
* 3 key questions pertaining to “the economy”
1. What goods should be produced and what services should be provided?
2. How are the goods and services produced?
3. Who should enjoy these goods and services?
Economics is the science that looks to answer these questions
* Underlying those questions is the following issue: resources are limited and we have to make decisions about how to use them. Answering the questions would be easy if resources were so plentiful that society could produce everything its citizens could ever want, but sadly that’s not the case
* We are limited in terms of land, labour and capital – “factors of production”
* A fourth factor, entrepreneurship, is also important
* 2 important concepts: scarcity and choice
The prevailing definition is something akin to the definition provided
by Lionel Robbins: “Economics is the science which studies human
behaviour as a relationship between ends and scarce means
which have alternative uses.”
- Embedded in this are the notions of scarcity and choice
* This Lionel Robbins definition is from his book, where he sought to find a proper definition for Economics
* Economics started out getting taught in Cambridge University and then LSE took the mantel for the king of teaching Economics. There was this whole thing where Lionel Robbins went against another Economist who carried on Alfred Marshall’s work
- Otherwise stated, economics is about how goods and services are
produced, consumed and distributed amongst people in an
economy, given the constraints we face.
This definition
can, however, mask the complexity and extent of the reach of economics. We might characterize households as having unlimited wants, but not everyone in society is materialistic, which the idea of unlimited
wants might imply. Some people are more content with the simple things in life and their choices are based
on what they see as being important. These choices are no less valid but reflect the complexity of the subject. Some people choose to maintain their standard of living through crime. A decision to resort to crime
has reasons and consequences, and these may be of as much interest to an economist as the reasons why
firms choose to advertise their products or why central banks make decisions on monetary policy
Explain the concept of Scarcity
Scarcity is an important concept in economics:
* People don’t have unlimited money to spend.
* Firms (i.e. companies that make stuff) don’t have unlimited resources.
* How do we allocate scarce resources between competing
choices? Well, people have to make trade-offs. This can be in behaviour or resources
* In order to decide, we have to consider the alternatives that are available to us and choose the best available. This means we buy something (or do something) if we like it more than the next best available option.
* Economic agents do a cost-benefit analysis – they look at the costs & benefits of 2 choices and pick the option that has more benefit and less cost
* This leads us to another important concept: opportunity cost.
Explain what a ‘cost-benefit analysis’ is
A technique economic agents use when deciding between 2 choices. They look at the costs & benefits of 2 choices and pick the option that has more benefit and less cost
What are the 3 factors of production? Name one more important economic factor
- Land, labour and capital
- Entrepreneurship
Explain what opportunity cost is
- The opportunity cost of doing something is captured by whatever
you miss out on by doing it. - Of relevance is the next best alternative option.
*For example: - You chose to come to university and study a degree.
- Suppose your second choice would have been to get a job.
- The opportunity cost of going to university is captured by the wages from
full-time work that you have sacrificed in order to be here.* - Opportunity Cost is subjective – the value of what you lose by picking another option can vary depending on who you are as a person. For example, if you don’t care much for travelling around the world, the opportunity cost of exploring the world because ur in uni isn’t that high
What are ‘marginal changes’?
Marginal changes describe incremental changes (for
example to costs and benefits). It’s essentially the gain or loss received from doing 1 unit of an action
What’s ‘marginal benefit’?
The change in benefit
What’s the name for ‘the change in benefit’?
Marginal Benefit
What’s ‘marginal cost’?
The change in cost
What’s the name for ‘the change in cost’?
Marginal Cost
Explain what ‘thinking at the margin’ is
In short, if the marginal benefit of doing something is greater than the
marginal cost, then I would prefer to do that thing
Explain how rationality affects marginal analysis
Marginal analysis is based on the idea that economic agents (i.e.
individuals or firms) seek to maximise or minimise outcomes when
making decisions (and that this is rational).
* Individuals may be assumed to want to maximise their satisfaction.
Firms may be assumed to maximise their profits (or sometimes
minimise their costs).
* If we are talking in terms of how much of something to buy or do,
thinking at the margin means that decision makers will choose a level
such that marginal benefit = marginal cost. Why so?:
- If MB > MC, you would like to buy (or do) more.
- If MB < MC, you would like to buy (or do) less.
- If MB = MC, you are content that you have maximised your choice.
- i.e. If a decision results in greater marginal benefits than marginal costs, it is worth making that decision and
continuing up to the point where the marginal cost of the decision is equal to the marginal benefit
Explain the idea behind rational people responding to incentives
Since rational people make rational decisions by weighing up costs
and benefits, their decisions may change in response to changes in those costs and benefits. This creates opportunities for policymakers to create incentives and
disincentives to alter behaviour. For example, adding a price to plastic bags in supermarkets aims to discourage their
purchase (and use) and encourage people to reuse existing bags
How do economic agents react to the price of a good rising?
- People will generally buy less of it because the cost has gone up.
- Companies will allocate more resources to the production of the
good because the benefit from selling it has risen
Explain the basic idea of trade in Economics
- Trade between people is fundamental in Economics. Imagine it’s 300 years ago and you live in a village, the notion that people in the village go to the bakery to buy bread IS trade. In a barter economy, say you had all the cows so all the milk, you’d exchange milk for bread with the baker.
- In economic activities, there is scope for specialisation. People
can focus on what they are best at, & there can be exchange or redistribution to improve the situation for everyone. - This is linked to opportunity cost (from earlier) and the notion of
“division of labour” (i.e. focusing on certain tasks).
** For example, consider the clothes you are currently wearing: Why didn’t you make them yourself? Why did you buy them? Look at the labels – why weren’t these garments made in the UK?*
What’s an ‘economic system’?
The economic system is the way resources are organised and allocated to address the needs of an economy’s citizens
What’s the name for ‘the way resources are organised and allocated to address the needs of an economy’s citizens’?
The Economic System
What are the features of a capitalist economic system?
Features:
* Private ownership of factors of production.
* Goods & services are exchanged through a price mechanism.
* Firms are predominantly driven by profits
In the context of a capitalist market system, why are markets good?
They are a good way to allocate resources via
decentralised decision-making
What’s a ‘pure market economy’?
A market where there is no government intervention and economic agents are left to their own devices (aligned with Adam Smith’s “invisible hand”)
What’s the name for ‘a market where there is no government intervention and economic agents are left to their own devices’?
A pure market economy
Explain the basis of a ‘pure market economy’ on Adam Smith’s idea
The pure market economy is based off of the ideas introduced by Scottish economist Adam Smith and his ‘invisible hand’. This is it: If each individual person is ‘rational’ and is left totally to their own devices, we will arrive at an outcome where the prices of everything is efficient. There’s nobody guiding their decisions but we still arrive at this equilibrium system where, for example, the price of a pint of milk is what it is and the price of a uni degree is what it is
Explain the main alternative to a pure market economy
A planned economic system,
wherein economic activity is determined by “central planners” like the government which tells everyone their role in society
Give examples of direct interventions in markets on a microeconomic scale (2)
specific taxes, quotas and price ceilings
When do governments most often intervene with a market?
- When there’s a market failure
- If too few companies decide to operate on a certain industry
What’s market failure?
Market failure is where scarce resources are not allocated to their most efficient use by free markets
What’s the name for when ‘scarce resources are not allocated to their
most efficient use by free markets’?
Market Failure
Explain the history of the introduction of ‘Micro’ and ‘Macro’ Economics
In the time of Alfred Marshall, there was no distinction along these lines - only “economics”. In the 1930s Ragnar Frisch invented the terms “microeconomics”
and “macroeconomics” (as well as “econometrics”)
What is Ragnar Friesch famous for as an Economist?
In the 1930s, Ragnar Frisch invented the terms “microeconomics” and “macroeconomics” (as well as “econometrics”). Also, Ragnar Frisch shared the first ever Nobel Prize in Economics during the 60s and was
one of the main driving forces behind the “Keynesian revolution”.
What does ‘Microeconomics’ study?
The behaviour of individuals and firms at a disaggregated level – it looks at specific markets
What’s the name for ‘the study of the behaviour of individuals and firms at a disaggregated level – it looks at specific markets’
Microeconomics
What does ‘Macroeconomics’ study?
The aggregate behaviour of the economy
(e.g. issues like unemployment, inflation, economic growth)
What’s the name for ‘the aggregate behaviour of the economy (e.g. issues like unemployment, inflation, economic growth)’?
Macroeconomics
What are the names for the 2 approaches that Economists debate they ought to take in economic thought?
positive approach or a
normative approach
What’s the ‘positive approach’ when it comes to economic thought?
Claims they attempt to describe how the world is
Which of the 2 approaches to economic thought makes claims that attempt to describe how the world is?
Positive approach
What’s the ‘normative approach’ when it comes to economic thought?
Claims they attempt to prescribe how the world should be
Which of the 2 approaches to economic thought makes caims that attempt to prescribe how the world should be?
Normative approach
Which of the 2 approaches to Economic thought did Lionel Robbins support?
Positive
What’s ‘Falsifiability’?
The possibility of a theory being rejected as a result of new
data or observations
What’s the name for ‘the possibility of a theory being rejected as a result of new
data or observations’?
Falsifiability
What’s ‘Cause and effect’?
Establishing whether one factor causes another (as
opposed to correlation)
What’s the name for ‘establishing whether one factor causes another (as
opposed to correlation)’?
Cause & Effect
Why do economists use models?
Because they’re interested in falsifiability and cause & effect
Describe the history behind the normative approach to economic thought vs the positive approach
A lot of normative economists were very left-wing, they wanted to influence how the world SHOULD behave - How can we redistribute things to make it more equitable, how can we take from the rich and give more to the poor. Lionel Robbins was a scientist so much preferred to advocate to not try to tell people how the world SHOULD be and instead just analyse why it is what it is NOW – the positive approach
What important thing must we note down about models?
- Models are more about understanding than
forecasting. (Predicting the future is notoriously difficult!) - Our understanding of how the economy works is imperfect - it is impossible to foresee all factors that might affect future economic trends.
- As a result, economic models often have to make many assumptions. Assumptions take us away from reality, but make it possible to isolate
how a change in one variable might impact some other.
What aspects must we be conscious of every time there’s a model?
- The model’s assumptions and limitations.
- Its endogenous and exogenous variables
What are ‘endogenous variables’?
Endogenous variables are those that a model seeks to explain
What’s the name for ‘variables that a model seeks to explain’
Endogenous variables
What are ‘exogenous variables’?
Exogenous variables are those that are determined outside of a
model and so cannot be explained by it… however, these factors can have an impact on the endogenous variables of the model.
What’s the name for ‘variables that are determined outside of a model and so cannot be explained by it… however, these factors can
have an impact on the endogenous variables of the model’?
Exogenous variables
What are the 2 key components of a model?
Diagrams and Functions
What are the 2 types of economic functions?
general and specific
functional forms
What do ‘general’ functions do?
They describe, generally, what affects what.
** An example could be ‘A=F(B,C)’ which tells us that “A is a function of B
and C”.
* This tells us the general relationship between A, B, C, but not the
exact detail of it.
* Note that the same function might simply be represented as ‘A(B,C)’ – for
all intents and purposes this is the same as A=F(B,C). Economists
sometimes use subtly different notation*
Which economic function describes, generally, what affects what?
General function
What do ‘specific’ functions do?
They describe the explicit relationship between
variables in a model.
Examples of specific functions could be:
* A = 20B + 30C
* A = B^0.5C^0.5
* This second example is a ‘Cobb-Douglas’ function – something that is
commonly used in economics
* These functions tell us the exact way that B and C influence A.
* The first example is probably easy for you to understand
Which economic function describes the explicit relationship between
variables in a model?
Specific functions
What’s the difference between a ‘Cobb-Douglas’ function and another specific function with 2 multipliers, each with a power?
‘Cobb-Douglas’ function has a power of 0.5 for both multipliers
What are ‘households’?
Individuals that purchase goods and services for final consumption and provide the inputs into production – land, labour and capital
What’s the name for ‘Individuals that purchase goods and services for final consumption and provide the inputs into production – land, labour and capital’?
Households
What are ‘firms’?
The organizations which buy factors of production and use them to produce goods and services
What’s the name for ‘The organizations which buy factors of production and use them to produce goods and services’?
Firms
What’s ‘economic activity’?
The amount of interaction between households and firms – the amount of buying and selling which
takes place
What’s the name for ‘The amount of interaction between households and firms – the amount of buying and selling which
takes place’?
The level of ‘economic activity’
What’s the ‘economy’?
Households and firms engaging in production and exchange in a particular
geographic region
What’s the name for ‘Households and firms engaging in production and exchange in a particular
geographic region’?
The Economy
Define ‘land’ as a resource of economies
All the natural resources of the earth. This includes mineral deposits such as iron ore, coal, gold and copper; oil and gas; fish in the sea; and all the food and raw materials produced from the land
Define ‘labour’ as a resource of economies
The human effort, both mental and physical, that goes into production. A worker in a factory producing precision tools, an investment banker, an unpaid carer, a road sweeper, a teacher – these are all forms of labour
What’s the name for ‘The human effort, both mental and physical, that goes into production’?
Labour
Define ‘capital’ as a resource of economies
The equipment and structures used to produce goods and services. Capital goods include machinery in factories, buildings, tractors, computers, cooking ovens – anything where the good is not
used for its own sake but for the contribution it makes to production
What’s the name for ‘The equipment and structures used to produce goods and services’?
Capital
What’s ‘efficiency’ in Economics?
In economics, efficiency deals with ways in which society gets the most it can from its scarce resources
What’s the name for the term that deals with ways in which society gets the most it can from its scarce resources
Efficiency
What’s ‘equity’?
The property of distributing economic prosperity fairly among the members of society
What’s the name for ‘the property of distributing economic prosperity fairly among the members of society’?
Equity
Who introduced the origins of the equity and efficiency trade-off and when?
Arthur Okun in the 1970s
Why is acknowledging and understanding the consequences of trade-offs important?
Because people are likely to make more informed decisions if they understand the options they have available
Give the equation for opportunity cost
Opportunity cost of good y = Sacrifice of good x divided by Gain in good y
What’s ‘rational’?
The assumption that decision-makers can make consistent choices between alternatives
Describe the history of the introduction of the assumption of rational behaviour
The assumption of rational behaviour provides a framework around which decisions can be analyzed
and has been a basic tenet of economics since the 1870s, with thinkers such as William Stanley Jevons
and Carl Menger building on work by David Ricardo and Jeremy Bentham, which became part of the
so-called marginalist school
Explain whether trade can make everyone better off
The United States and China are competitors with Europe in the world economy because US and Chinese
firms produce many of the same goods as European firms. It might be thought that if China increases its
share of world trade at the expense of Europe this might be bad news for people in Europe. This might
not be the case. In some circumstances trade between economies can
make all better off. Households, firms and countries have different resource endowments; individuals
have talents and skills that allow them to produce some things more efficiently than others; some firms & countries
have experience and expertise in the production of goods and services. Trade allows individuals, firms and countries to specialize in the activities they do best. With the income they receive
from specializing they can trade with others who are also specializing and can improve their standard of
living as a result. However, while trade can provide benefits and winners, there are also likely to be costs and losers. The
economic development of some countries in the last 50 years has meant that many people have access to
cheap, good quality goods and services as a result of the export of these goods and services. For workers
and employers in these industries in developed economies, the competition from developing countries
might mean that they find themselves without work or must close their businesses. In some situations, it
is difficult for these people to find alternative work, and whole communities can be greatly affected by the
changes being experienced. They may not agree that ‘trade can benefit everyone’
What’s a ‘capitalist economic system’?
A system which relies on the private ownership of factors of production to produce goods
and services which are exchanged through a price mechanism and where production is operated primarily for profit
Why do governments intervene when there are too few firms operating in a market?
Because then the price of goods in that industry can get too high, so governments may want to intervene if this occurs as the good may be very important to society
