Society, choices and money

Question 1

What can production functions tell us?

Answer 1

Production functions show how inputs (e.g. labour, study) translate into outputs

(e. g. goods and services, grades), holding other factors constant (e.g. production
environment) .

1. Product per unit of input
2. Marginal product: Change in output per unit change in input (evaluated at a given
   point, holding other inputs constant)
3. Average product: Average output per unit of input

Question 2

What is an indifference curve?

Answer 2

An indifference curve shows a combination of two goods that give a consumer equal satisfaction and utility thereby making the consumer indifferent. Along the curve, the consumer has an equal preference for the combinations of goods shown—i.e. is indifferent about any combination of goods on the curve.

Indifference curves slope downward due to trade-offs: If you are indifferent between two combinations, the combination that has more of one good must have less of the other good.

Higher indifference curves correspond to higher utility levels: As we move up and to the right in the diagram, further away from the origin, we move to combinations with more of both goods.

Indifference curves are usually smooth: Small changes in the amounts of goods don’t cause big jumps in utility.

Question 3

What is an opportunity cost?

Answer 3

Opportunity costs represent the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another. Because opportunity costs are unseen by definition, they can be easily overlooked.

In economics, opportunity costs are relevant whenever we study individuals choosing between alternative and mutually exclusive courses of action. When we consider the cost of taking action A we include the fact that if we do A, we cannot do B. So ‘not doing B’ becomes part of the cost of doing A. This is called an opportunity cost because doing A means forgoing the opportunity to do B.

Question 4

What is an economic rent?

Answer 4

Economic rent is a payment or other benefit received above and beyond what the individual would have received in his or her next best alternative (or reservation option).

Economic cost = monetary costs (e.g. transport) + subjective costs (e.g. effort of work)•
If the benefit from an action exceeds the economic costs, you receive an economic rent from choosing it.

Question 5

What is the MRT?

Answer 5

Marginal rate of transformation (MRT) The quantity of some good that must be sacrificed to acquire one additional unit of another good. The marginal rate of transformation (MRT) is the
slope of the feasible frontier, and represents the tradeoffs that an individual faces moving along the curve (opportunity costs). The number of percentage points the students would gain by giving up another hour of free time.

Question 6

What is the MRS?

Answer 6

The marginal rate of substitution (MRS) The trade-off that a person is willing to make between two goods. The marginal rate of substitution is the slope of the indifference curve, and represents the tradeoffs that an individual faces. The number of percentage points the students is willing to trade off for an hour of free time.

Question 7

What is the feasible frontier?

Answer 7

The feasible frontier shows the maximum output that can be achieved with a given
amount of input. The curve made of points that defines the maximum feasible quantity of one good for a given quantity of the other: the highest grade a student can achieve given the amount of free time he takes.

Question 8

What is the utility maximizing choice?

Answer 8

The utility-maximizing choice is where the amount of one good the individual is willing to trade off for the other good (MRS) equals the actual tradeoff between the two goods (MRT)

MRS = MRT

Choice of free time/consumption depends on relative preferences and willingness to substitute one good for another

Question 9

How does technology influence the production function?

Answer 9

Example of tradeoff between grain produced and free time.

Technological progress makes it feasible to both consume more and have more free time.
Technological change shifts the production function upwards, and expands the feasible frontier.

Question 10

What is money?

Answer 10

A medium of exchange used to purchase goods or services: bank notes,
bank deposits, cheques, …

Money allows purchasing power to be transferred among people, given that
everyone trusts that others will accept your money as payment.

Question 11

What is depreciation?

Answer 11

Reduction in the value of a stock of wealth over time.

Question 12

What is Net Income?

Answer 12

The maximum amount that one could consume without running down wealth.
Net income = gross income – depreciation

Question 13

What are earnings?

Answer 13

Wages, salaries, and other income from labour.

Question 14

What are savings?

Answer 14

Income that is not consumed.

Question 15

What is an investment?

Answer 15

Expenditure on newly produced capital goods.

Question 16

What is the difference between wealth and income?

Answer 16

Wealth = Stock of things owned or value of that stock (buildings, land, machinery, capital goods –
debts owed + debts owed to you)
Income = Flow of money one receives from market earnings, investments, government.

Question 17

What is the difference between saving and dis-saving?

Answer 17

Saving means spending less than income on current consumption. One reason for doing this is so as to be able to spend more than one’s income in
the future.

Dis-saving means spending more on consumption than one’s current income, thus needing to borrow money from others.

Borrowing and lending allow us to rearrange our capacity to buy goods and services across time. Savinh is effected by lending, dis-saving by borrowing.

Question 18

What is a bond?

Answer 18

A bond is a promise to pay a sum of money greater that the current value at a
given time in the future. In simple terms, lending means buying bonds, borrowing means selling bonds.

Question 19

Policy interest rate and bank lending rate?

Answer 19

Policy interest rate = The interest rate on base money set by the central bank.

Bank lending rate = The average interest rate charged by commercial banks to firms and households.

Question 20

Explain compounding and discounting.

Answer 20

The processes of compounding and discounting are fundamental to lending and
borrowing and to the operation of all financial markets.

Compounding: is the ability of an asset to generate earnings, which are then reinvested or remain invested with the goal of generating their own earnings. In other words, compounding refers to generating earnings from previous earnings. When the interest is re-lent, money lent at interest compounds, i.e. grows exponentially. Compounding is one manifestation of exponential growth.

Discounting: is the process of converting a value received in a future time period to an equivalent value received immediately. For example, a dollar received 50 years from now may be valued less than a dollar received today—discounting measures this relative value. The rate at which future values are discounted to the present is usually considered roughly equal to the opportunity cost of capital.

Question 21

What is the SDR?

Answer 21

Social Discount Rate (SDR) is the discount rate used in computing the value of funds spent on social projects, in Cost-Benefit Analysis. Social discount rates (SDRs) are used to put a present value on costs and benefits that will occur at a later date. In the context of climate change policymaking, they are considered very important for working out how much today’s society should invest in trying to limit the impacts of climate change in the future.

Question 22

What are two ways of selecting discount rates?

Answer 22

– a ‘descriptive’ approach based on the opportunity cost of drawing funds from
the private sector; and
– a ‘prescriptive’ approach that derives from ethical views about inter-generational equity.

Question 23

Discounting climate change

Answer 23

To the extent that future generations are likely to be richer than those in the present, a
positive discount rate should be applied reflecting the diminishing marginal utility of
consumption, but…

there is a high probability that the world will suffer significantly in the future due to global change: giving future generations less weight than the current generation, through the
expression of time preference and r is ‘ethically indefensible’

Ramsey’s social discount rate is calculated as:
r = d + n ˑ g

with:
d = time preference (or impatience, the rate of discrimination through time)
n = elasticity of marginal utility of consumption (the higher the standard of living of
future generations the less should be saved for them and thus the higher is n)
g = growth rate