Theme 1 - Nature of Economics and How Markets Work

Question 1

What does ceteris paribus mean?

Answer 1

‘all other things remaining equal’

Question 2

What is a positive statement?

Answer 2

An objective statement that can be tested or rejected by referring to the available evidence

Question 3

What is a normative statement?

Answer 3

Statements that express an opinion about what ought to be

Question 4

What is the basic economic problem?

Answer 4

The world’s resources are scarce, but human wants are infinite

Question 5

What is a production possibility frontier?

Answer 5

A boundary which shows the combinations of 2 or more goods and services that can be produced whilst using all available factor resources efficiently

Question 6

What is a renewable resource?

Answer 6

A resource of economic value that can be replenished or replaced on a level equal to consumption

Question 7

What is a non-renewable resource?

Answer 7

A resource of economic value that cannot be readily replaced by natural means on a level equal to consumption

Question 8

What is opportunity cost?

Answer 8

The cost of one thing in terms of the next best thing given up

Question 9

What do consumers base their decisions on?

Answer 9

What will bring them the highest level of satisfaction

Question 10

What do producers base their decisions on?

Answer 10

Whatever will bring them the most profit

Question 11

What choices must a government make?

Answer 11

Where to spend limited tax revenue based on what will maximise social welfare

Question 12

What are consumer goods?

Answer 12

Goods that are demanded and bought by households and individuals

Question 13

What are capital goods?

Answer 13

Goods that are produced in order to aid the production of consumer goods in the future

Question 14

What is specialisation?

Answer 14

The production of a limited range of goods by a company/individual/country which means that trade is essential as it is the only way they are all able to access what they need

Question 15

What is division of labour?

Answer 15

When labour becomes specialised in a particular part of the production process

Question 16

What did Adam Smith do?

Answer 16

• Adam Smith stated the concept of specialisation and the division of labour and showed how it can ​increase labour productivity ​(output per worker), allowing firms to increase efficiency and lower their costs of production.
• He visited a factory and observed that the pin making process had been split into ​18 different operations​. As a result, the company were able to produce 5,000 pins per person employed. If the work had been carried out by workers making the whole pin from start to finish, it would have been less a few dozen.

Question 17

Advantages of specialisation and the division of labour in organising production

Answer 17

• Enables labour productivity to be increased
• Leads to a higher quality of goods and services
• More cost effective to develop specialist tools
• No time wasted moving between jobs
• Saves training costs

Question 18

Disadvantages of specialisation and the division of labour in organising production

Answer 18

• Poor quality of work as workers become bored
• Reduction of craftsmanship and a much more standardised product because of mechanisation
• If one process in production is delayed, every other task is delayed until the problem is solved
• Workforce could suffer from structural unemployment

Question 19

Advantages of specialising in the production of goods and services to trade

Answer 19

Theory of competitive advantage states that countries should specialise in producing those goods where they have a lower opportunity cost, and so they are relatively best at producing. This will help them boost their economy. On the whole, there is greater output globally

Question 20

Disadvantages of specialising in the production of goods and services to trade

Answer 20

• Countries may become overdependent on one particular export, and if this fails their economy may collapse
• Other countries specialise in non-renewable resources, and these could run out, which will result in a high loss of income for that country
• There will be high interdependence, and this will cause problems if trade is prevented
• There may be increased competition to cut costs and therefore wages will fall

Question 21

What are the functions of money?

Answer 21

• Medium of exchange
• Measure of value
• Store of value
• Method for deferred payment

Question 22

Why does money function as a medium of exchange?

Answer 22

It can be used to buy and sell goods and services and is acceptable everywhere

Question 23

Why does money function as a measure of value?

Answer 23

It can compare the value of 2 goods, and is able to put a value on labour

Question 24

Why does money function as a store of value?

Answer 24

It is able to keep its value and can be kept for a long time

Question 25

Why does money function as method for deferred payment?

Answer 25

It can allow for debts to be created. People can therefore pay for things without having money in the present and can pay for it later. This relies on money storing its value

Question 26

What are the underlying assumptions of rational economic decision making?

Answer 26

• Consumers aim to maximise utility: utility is the satisfaction gained from consuming a product
• Firms aim to maximise profit: economic theory assumes that firms are run for their owners and shareholders and so aim to maximise profit in order to keep the shareholders happy
• Governments aim to maximise social welfare: governments are voted in by the public and work for the public, so should aim to maximise their satisfaction by taking decisions which increase social welfare

Question 27

What is demand?

Answer 27

The ability and willingness to buy a particular good at a given price in a given time period

Question 28

What are the conditions of demand?

Answer 28

• Population
• Income
• Related goods
• Advertising
• Tastes
• Expectations
• Seasons
• Government legislation

Question 29

Why is population a condition of demand?

Answer 29

If populations rises, we would expect demand for all products to increase, and so demand curve will shift to the right - the more people there are, the more people who will want a good

Question 30

Why is income a condition of demand?

Answer 30

If income increases, demand increases because a person can afford to buy more of the product

Question 31

Why are related goods a condition of demand?

Answer 31

If goods are complements or substitutes of each other, then a change in price of another good can cause a shift in the demand curve

Question 32

Why is advertising a condition of demand?

Answer 32

If a firm carries out a successful advertising campaign, demand is likely to increase

Question 33

Why are tastes a condition of demand?

Answer 33

If something becomes more fashionable, we expect demand to increase

Question 34

Why are expectations a condition of demand?

Answer 34

If people expect a shortage of something, or that price will rise in the future, then demand for that product will increase

Question 35

Why are seasons a condition of demand?

Answer 35

Some products will have demand that is affected by the weather e.g. ice creams and umbrellas

Question 36

Why is government legislation a condition of demand?

Answer 36

If the government make something a necessity, the demand for that good will increase, e.g. car seats

Question 37

What does the law of diminishing marginal utility state?

Answer 37

The satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumer, ceteris paribus

Question 38

Why does the law of diminishing marginal utility explain why the demand curve sloped downwards?

Answer 38

If more of a good is consumed, there is less satisfaction derived from the good. This means that consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction - this means the demand curve will be more elastic at the top than at the bottom

Question 39

What is supply?

Answer 39

The ability and willingness to provide a good or service at a particular price at a given moment in time

Question 40

What are the conditions of supply?

Answer 40

• Costs of production
• Price of other goods
• Weather
• Technology
• Goals of the supplies
• Government legislation
• Taxes and subsidies
• Producer cartels

Question 41

Why are costs of production a condition of supply?

Answer 41

If a business has an increase in their costs, but their selling price stays the same, they will make less money on what they sell. They will put up their prices in order to avoid making a loss, and so less is supplied at each price, meaning the supply curve will shift to the left

Question 42

Why are the prices of other goods a condition of supply?

Answer 42

Joint supply is where the production of one good automatically causes the production of another good. Competitive supple is where the production of one good prevents the supply of another

Question 43

Why is weather a condition of supply?

Answer 43

Especially in agriculture, supply is dependent on weather

Question 44

Why is technology a condition of supply?

Answer 44

If new technology is introduced, it will lead to a fall in production costs as there is a higher productive efficiency. This will encourage firms to lower prices or produce more goods for the same price and so the curve will shift to the right

Question 45

Why are the goals of the supplier a condition of supply?

Answer 45

If a supplier is motivated by helping society and providing a service, they may increase supply, even when that doesn’t provide extra profit

Question 46

Why is government legislation a condition of supply?

Answer 46

High levels of regulation may increase costs, and so decrease supply

Question 47

Why are taxes and subsidies a condition of supply?

Answer 47

A tax decreases supply and a subsidy increases supply by affecting the costs of production

Question 48

Why are producer cartels a condition of supply?

Answer 48

Some firms or countries come together in order to decrease supply and therefore increase the price of their product, increasing their revenue

Question 49

What is consumer surplus?

Answer 49

The extra amount a consumer is willing to pay for a good or service
(it is the area below the demand curve and above the price point)

Question 50

What is producer surplus?

Answer 50

The difference between the amount the producer was willing to sell at and the price they actually sell at (it is the area above the supply curve and below the price point)

Question 51

What are the functions of the price mechanism?

Answer 51

Signalling
Rationing
Incentive

Question 52

What is price elasticity of demand?

Answer 52

A measure of the responsiveness of demand to a change in the price of a product

Question 53

How do you calculate PED?

Answer 53

% change in quantity demanded / % change in price

Question 54

What do PED coefficients tell you?

Answer 54

PED > 1, it is elastic
PED < 1, it is inelastic
PED = 1, it is unitary price elastic
PED = 0, it is perfectly inelastic
PED = infinity, it is perfectly elastic

Question 55

What are the determinants of PED?

Answer 55

• Number of close substitutes for a good / uniqueness of a product
• If the good is perceived as a luxury or a necessity
• Percentage of a consumer’s income allocated to spending on the good
• Whether it is subject to habitual consumption
• Peak and off peak demand

Question 56

What is the significance of PED?

Answer 56

Along with PES, it determines the effects of the imposition of taxes and subsidies, and can allow firms to predict what will happen when they change the price

Question 57

What are the effects of different PED values on profit?

Answer 57

Elastic demand curve: If price rises, total revenue falls, if price falls, total revenue increases
Inelastic curve: If price rises, total revenue rises, if price falls, total revenue falls
Unitary elastic: no change in revenue as price changes

Question 58

What is income elasticity of demand (YED)?

Answer 58

A measure of the responsiveness of the quantity demanded to a change in income

Question 59

How do you calculate YED?

Answer 59

% change in quantity demanded / % change in real consumer incomes

Question 60

What do the values of YED mean?

Answer 60

Normal goods have a positive YED - as incomes rise, demand rises
Inferior goods have a negative YED - as incomes rise, fewer are bought
The higher the coefficient, the more luxury the item
0<YED<1 it is relatively inelastic
YED>1 relatively elastic

Question 61

What is cross elasticity of demand (XED)?

Answer 61

XED measures responsiveness of demand for a product to a change in the price of other related products

Question 62

What do XED coefficients mean?

Answer 62

Substitutes have a positive coefficient
- high coefficient = close substitute (flatter curve)
- low coefficient = weak substitute (steeper curve)
Complementary goods have negative coefficient
- strong complement = high coefficient = flatter curve
- weak complement = low coefficient = steeper curve

Question 63

How do you calculate XED?

Answer 63

% change in demand for X / % change in price of Y

Question 64

What is the significance of YED?

Answer 64

Important for businesses to know how their sales will be affected by changes in income
It may impact the types of goods that a firm produces

Question 65

What is the significance of XED?

Answer 65

Firms need to be aware of competition and those producing complementary goods. They need to know how price changes by other firms will impact them so they can take appropriate action

Question 66

What is price elasticity of supply (PES)?

Answer 66

The relationship between a change in quantity supplied and a change in price

Question 67

How do you calculate PES?

Answer 67

% change in quantity supplied / % change in price

Question 68

What do the PES coefficients mean?

Answer 68

PES>1 then it is elastic
PES<1 then it is inelastic

Question 69

What are the determinants of PES?

Answer 69

• spare capacity: if there is no spare capacity, producers cant produce more to supply and supply will be inelastic
• ease of factor substitution: if FoPs can be put to alt. uses, PES will be more elastic
• levels of stock: if stock levels are low, firms cant react to boosts in demand, and PES will be inelastic
• time period: PES over a week is different than over a year

Question 70

What is the effect of an indirect tax on the supply curve?

Answer 70

It increases costs of production, so supply shifts left

Question 71

What is the effect of a subsidy on the supply curve?

Answer 71

It reduces costs of production, so supply shifts right

Question 72

What is an indirect tax?

Answer 72

A tax imposed on producers by the government

Question 73

What is a subsidy?

Answer 73

Subsidies are payments to producers from the government which reduce producers’ costs of production and encourage them to expand their output

Question 74

What part of a supply and demand diagram shows the incidence of tax on the consumer?

Answer 74

The area between the old price equilibrium and the new price equilibrium

Question 75

How does the incidence of tax on consumers and producers vary with elasticity?

Answer 75

inelastic = more incidence on consumer
elastic = more incidence on producer

Question 76

What area of a supply and demand diagram shows the gain from a subsidy on the consumer?

Answer 76

The area between the original equilibrium and the new equilibrium

Question 77

How does the gain from a subsidy for consumers and producers vary with elasticity?

Answer 77

Inelastic demand: consumers gain more
Elastic demand: producers gain more

Question 78

What is a specific tax?

Answer 78

A tax charged as a fixed amount per unit of a good.
It is illustrated by a parallel shift in supply

Question 79

What is an ad valorem tax?

Answer 79

A tax charged as a percentage of the price of a good.
It is illustrated by a pivotal shift in supply

Question 80

What is the ‘invisible hand’ of the market?

Answer 80

How the price mechanism is able to set prices

Question 81

What is the signalling function of the price mechanism?

Answer 81

The price mechanism acts as a signal for where resources should be used. When prices rise, producers move resources into the manufacture of that product. The change in price indicates to suppliers and consumers that market conditions have changed so they should change the quantity bought and sold - when price equilibrium moves, output moves with it

Question 82

What is the rationing function of the price mechanism?

Answer 82

When price increases, some people will no longer be able to afford the product and others may no longer have the desire to buy the good. The limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly

Question 83

What is the incentive function of the price mechanism?

Answer 83

Price mechanism acts as an incentive for people to work hard. Buyers realise that the more money they have, the more they are able to buy. Suppliers realise that if they make more goods, they will make more money. Low prices act as an incentive for consumers to buy more of a good, and high prices act as an incentive for producers to supply more of a good. The price mechanism encourages people to act a certain way.

Question 84

What is a free market economy?

Answer 84

• Markets allocate resources through the price mechanism
• Increased demand raises price, and encourages businesses to use more resources in the production of that good or service
• Quantity consumed by people depends on their income, and their income depends on the market value of their labour
• There is a limited role for the government
• In a pure free market system the government limits itself to protecting property rights of people and businesses using the legal system and protecting the value of money

Question 85

Adam Smith

Answer 85

• Free market thinker
• Wrote ‘An Inquiry Into the Nature and Causes of the Wealth of Nations’ 1776
• Each individual strives to become wealthy ‘intending only his own gain’. but he must exchange what he owns or produces with others who sufficiently value what he has to offer
• Assumed consumers chose for the lowest price and producers chose for the highest profit
• Asserted that by making excess or insufficient demand known through market prices, consumers signalled entrepreneur’s’ use of resources to the most profitable industry
• Founded classical economics; a laissez-faire attitude by government toward the free market will allow the ‘invisible hand’ to guide everyone in their economic endeavours, create the greatest good for the greatest number, and generate economic growth

Question 86

Friedrich Hayek

Answer 86

• Free market thinker
• Wrote ‘The Road to Serfdom’
• Warned that the dead hand of the bureaucrat could threaten a free society almost as much as the iron boot of Stalin
• His explanation for economic crisis says it is all down to gov. meddling, to policy makers not giving markets the benefit of the doubt
• Worst kind of meddling came in the gov.’s determination to control the price of money
• Distracted monetary and fiscal policy

Question 87

What is a mixed economy?

Answer 87

• Some resources owned by the public sector
• Public sector typically supplies public and merit goods and intervenes in markets to correct perceived market failure
• Nearly all economies are mixed; mix changes over time as industries get nationalised and privatised

Question 88

John Mayard Keynes

Answer 88

• Supporter of the mixed economy
• Wrote ‘The General Theory of Employment, Interest and Money’
• What works for one family in economic crisis won’t work for the whole economy
• The more people cut back on spending to increase savings, the more the people they pay are forced to cut back their spending, resulting in a downward spiral known as the Paradox of Thrift
• When companies dont invest and consumers dont spend, the gov. must intervene in the free market and break the dangerous cycle by stepping up its own spending or cutting tax

Question 89

What is the role of the government in a mixed economy?

Answer 89

Creating a framework of rules: They prevent the abuse of monopolies. They can protect customers as they pass a large amount of consumer protection laws to protect the consumers from poor quality products or services. They protect property rights, ensuring whatever a person owns cannot be taken away by someone else. Also, they ensure safety standards, protecting employers and employees.
● Supplements and modifies the price system: They produce public and merit goods, such as emergency services and transport, and limit the production of demerit goods like child pornography. Government action ensures the consideration of externalities.
● Redistributes income​: They move income from one group of people to another, from the rich to the poor. They use tax, such as income tax, to take money away from one group then give the money to the poor. This is in the form of benefits for those who are out of work or on low incomes, and in the provision of services for all, such as education and the NHS, allowing the poor to access these services when they might not have been able to afford to.
● Stabilises the economy: The government will attempt to manage the level of demand in the economy to prevent extremes of too much or too little demand. They do this through fiscal and monetary policy.

Question 90

What are the advantages of a free market economy?

Answer 90

● The system is ​automatic ​due to the invisible hand; resources are moved out of production of a good when people stop wanting it or costs are too high. - price reflects demand
● Consumers have freedom of choice, called ​consumer sovereignty​.
● There is ​high motivation as people know working hard could lead to high potential
rewards, creating conditions where initiative and enterprise flourish.
● There is ​political freedom​.
● Because firms are in competition, they will produce goods at the lowest cost they
can, ensuring ​productive efficiency​.
● In general, freer market economies tend to have ​higher growth​.
- Innovation

Question 91

What are the disadvantages of a free market economy?

Answer 91

There tends to be high levels of ​inequality, ​since the rich own more factors of production and so can grow richer​.
● There may be a ​lack of merit goods (goods considered as intrinsically good) and little control of ​demerit goods​ (intrinsically bad).
● Resources could be wasted on ​unproductive expenses such as advertising, switching the factors of production and providing competitive services.
● If competition disappears then there may be ​monopolies​, who charge high prices and offer low quality of service.
● There is the problem of ​externalities​.

Question 92

What is a command economy?

Answer 92

• Associated with a socialist or communist system
• Scarce resources owned by the government
• State allocates resources, and sets production targets and growth rates according to its own view of people’s wants
• Market prices play little or no part in informing resource allocation decisions and queuing rations scarce resources

Question 93

Karl Marx

Answer 93

• Command economy thinker
• Wrote ‘Das Kapital’
• Capitalisits profits come from exploiting labour - when production is set up, it is the labour that creates the value
• situation of management exploiting labour underlies the class struggle he saw at the heart of capitalism
• Predicted the struggle would destroy free market capitalism and it would be replaced with command market communism
• Felt free market capitalism was divisive and split the population into the workers and the owners

Question 94

Advantages of a command economy?

Answer 94

● The state provides a ​minimum standard of living​, ensuring no one is extremely poor as there is less inequality.
● There is ​less wastage of resources as there is no need for competitive services nor advertising, which is very expensive.
● Long term planning ​means that the industry doesn’t have to keep changing and shifting resources. This is important as some industries may take a number of years to get established and would fail if planning was short term.
● Standardised products​ means that they are produced cost effectively.
● As the government, who are generally motivated by the ​wellbeing of the country, rather than the companies, who are motivated by profit, decide resource allocation, objectives other than profit can be followed: merit goods are encouraged and
increased whilst demerit goods aren’t produced.

Question 95

Disadvantages of a command economy?

Answer 95

● It is impossible for the state to make so many decisions correctly, which could lead to over or under supply and a ​waste of resources​.
● Decision making will be slow as it has to go through various stages and there could be an increase in ​bribery and corruption​ (an increase in bureaucracy).
● As everyone receives the same wage, there is ​less motivation and efficiency because people know that working harder will not increase their standard of living.
● Consumers ​lose their freedom ​and it is often led by dictators.