Theme 1 - Nature of Economics and How Markets Work Flashcards
1
Q
What does ceteris paribus mean?
A
‘all other things remaining equal’
2
Q
What is a positive statement?
A
An objective statement that can be tested or rejected by referring to the available evidence
3
Q
What is a normative statement?
A
Statements that express an opinion about what ought to be
4
Q
What is the basic economic problem?
A
The world’s resources are scarce, but human wants are infinite
5
Q
What is a production possibility frontier?
A
A boundary which shows the combinations of 2 or more goods and services that can be produced whilst using all available factor resources efficiently - a shift outwards shows economic growth
6
Q
What is a renewable resource?
A
A resource of economic value that can be replenished or replaced on a level equal to consumption
7
Q
What is a non-renewable resource?
A
A resource of economic value that cannot be readily replaced by natural means on a level equal to consumption
8
Q
What is opportunity cost?
A
The cost of one thing in terms of the next best thing given up
9
Q
What do consumers base their decisions on?
A
What will bring them the highest level of satisfaction
10
Q
What do producers base their decisions on?
A
Whatever will bring them the most profit
11
Q
What choices must a government make?
A
Where to spend limited tax revenue based on what will maximise social welfare
12
Q
What are consumer goods?
A
Goods that are demanded and bought by households and individuals
13
Q
What are capital goods?
A
Goods that are produced in order to aid the production of consumer goods in the future
14
Q
What is specialisation?
A
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
15
Q
What is division of labour?
A
When labour becomes specialised in a particular part of the production process
16
Q
What did Adam Smith do?
A
- 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.
17
Q
Advantages of specialisation and the division of labour in organising production
A
- 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
18
Q
Disadvantages of specialisation and the division of labour in organising production
A
- 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
19
Q
Advantages of specialising in the production of goods and services to trade
A
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
20
Q
Disadvantages of specialising in the production of goods and services to trade
A
- 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
21
Q
What are the functions of money?
A
- Medium of exchange
- Measure of value
- Store of value
- Method for deferred payment
22
Q
Why does money function as a medium of exchange?
A
It can be used to buy and sell goods and services and is acceptable everywhere
23
Q
Why does money function as a measure of value?
A
It can compare the value of 2 goods, and is able to put a value on labour
24
Q
Why does money function as a store of value?
A
It is able to keep its value and can be kept for a long time
25
Why does money function as method for deferred payment?
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
26
What are the underlying assumptions of rational economic decision making?
- 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
27
What is demand?
The ability and willingness to buy a particular good at a given price in a given time period
28
What are the conditions of demand?
- Population
- Income
- Related goods
- Advertising
- Tastes
- Expectations
- Seasons
- Government legislation
29
Why is population a condition of demand?
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
30
Why is income a condition of demand?
If income increases, demand increases because a person can afford to buy more of the product
31
Why are related goods a condition of demand?
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
32
Why is advertising a condition of demand?
If a firm carries out a successful advertising campaign, demand is likely to increase
33
Why are tastes a condition of demand?
If something becomes more fashionable, we expect demand to increase
34
Why are expectations a condition of demand?
If people expect a shortage of something, or that price will rise in the future, then demand for that product will increase
35
Why are seasons a condition of demand?
Some products will have demand that is affected by the weather e.g. ice creams and umbrellas
36
Why is government legislation a condition of demand?
If the government make something a necessity, the demand for that good will increase, e.g. car seats
37
What does the law of diminishing marginal utility state?
The satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumer, ceteris paribus
38
Why does the law of diminishing marginal utility explain why the demand curve sloped downwards?
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
39
What is supply?
The ability and willingness to provide a good or service at a particular price at a given moment in time
40
What are the conditions of supply?
- Costs of production
- Price of other goods
- Weather
- Technology
- Goals of the supplies
- Government legislation
- Taxes and subsidies
- Producer cartels
41
Why are costs of production a condition of supply?
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
42
Why are the prices of other goods a condition of supply?
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
43
Why is weather a condition of supply?
Especially in agriculture, supply is dependent on weather
44
Why is technology a condition of supply?
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
45
Why are the goals of the supplier a condition of supply?
If a supplier is motivated by helping society and providing a service, they may increase supply, even when that doesn't provide extra profit
46
Why is government legislation a condition of supply?
High levels of regulation may increase costs, and so decrease supply
47
Why are taxes and subsidies a condition of supply?
A tax decreases supply and a subsidy increases supply by affecting the costs of production
48
Why are producer cartels a condition of supply?
Some firms or countries come together in order to decrease supply and therefore increase the price of their product, increasing their revenue
49
What is consumer surplus?
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)
50
What is producer surplus?
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)
51
What are the functions of the price mechanism?
Signalling
Rationing
Incentive
52
What is price elasticity of demand?
A measure of the responsiveness of demand to a change in the price of a product
53
How do you calculate PED?
% change in quantity demanded / % change in price
54
What do PED coefficients tell you?
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
55
What are the determinants of PED?
- 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
56
What is the significance of PED?
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
57
What are the effects of different PED values on profit?
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
58
What is income elasticity of demand (YED)?
A measure of the responsiveness of the quantity demanded to a change in income
59
How do you calculate YED?
% change in quantity demanded / % change in real consumer incomes
60
What do the values of YED mean?
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
01 relatively elastic
61
What is cross elasticity of demand (XED)?
XED measures responsiveness of demand for a product to a change in the price of other related products
62
What do XED coefficients mean?
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
63
How do you calculate XED?
% change in demand for X / % change in price of Y
64
What is the significance of YED?
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
65
What is the significance of XED?
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
66
What is price elasticity of supply (PES)?
The relationship between a change in quantity supplied and a change in price
67
How do you calculate PES?
% change in quantity supplied / % change in price
68
What do the PES coefficients mean?
PES>1 then it is elastic
PES<1 then it is inelastic
69
What are the determinants of PES?
- 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
70
What is the effect of an indirect tax on the supply curve?
It increases costs of production, so supply shifts left
71
What is the effect of a subsidy on the supply curve?
It reduces costs of production, so supply shifts right
72
What is an indirect tax?
A tax imposed on producers by the government
73
What is a subsidy?
Subsidies are payments to producers from the government which reduce producers' costs of production and encourage them to expand their output
74
What part of a supply and demand diagram shows the incidence of tax on the consumer?
The area between the old price equilibrium and the new price equilibrium
75
How does the incidence of tax on consumers and producers vary with elasticity?
inelastic = more incidence on consumer
elastic = more incidence on producer
76
What area of a supply and demand diagram shows the gain from a subsidy on the consumer?
The area between the original equilibrium and the new equilibrium
77
How does the gain from a subsidy for consumers and producers vary with elasticity?
Inelastic demand: consumers gain more
Elastic demand: producers gain more
78
What is a specific tax?
A tax charged as a fixed amount per unit of a good.
It is illustrated by a parallel shift in supply
79
What is an ad valorem tax?
A tax charged as a percentage of the price of a good.
It is illustrated by a pivotal shift in supply
80
What is the 'invisible hand' of the market?
How the price mechanism is able to set prices
81
What is the signalling function of the price mechanism?
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
82
What is the rationing function of the price mechanism?
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
83
What is the incentive function of the price mechanism?
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.
84
What is a free market economy?
- 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
85
Adam Smith
- 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
86
Friedrich Hayek
- 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
87
What is a mixed economy?
- 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
88
John Mayard Keynes
- 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
89
What is the role of the government in a mixed economy?
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.
90
What are the advantages of a free market economy?
● 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
91
What are the disadvantages of a free market economy?
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.
92
What is a command economy?
- 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
93
Karl Marx
- 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
94
Advantages of a command economy?
● 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.
95
Disadvantages of a command economy?
● 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.
96
Developing economic models
- Models are developed to explain how the economy works, and are developed by putting forward a model, gathering evidence, then accepting, changing or disregarding the model
- Theories can be expressed in words, models are expressed in mathematical terms because they require greater precision
- The purpose of theories and models is to explain why something is the way that it is. They are simplified to make them more useful
- There are too many variables within an economic model that can change, so some assumptions must be made
97
Scientific experiments in economics
- As economics is a social science, it is difficult to set up experiments to test hypothesis'
- Data has to be gathered in the normal world, so variables are always changing, so it is difficult to decide whether or not evidence fits with a hypothesis, so economists tend to some up with very different interpretations of data
- Some argue economics is not a science as it studies human behaviour, which cannot be reduced to scientific law, but groups of individuals are more predictable than individuals themselves, and much of economics deals with groups of individuals. The laws cannot be definite as we don't know what each individual will do
98
The role of value judgements in economics
- Economists tend to use positive statements to back up normative statements
- Value judgements can influence economic decision making and policy. Different economists may make different judgements from the same statistics
99
What causes movement along the demand and supply curve?
Changes in price
100
What causes consumers to behave irrationally?
Other peoples influence
Habitual behaviour
Consumer weakness at computation
101
How does other people's influence cause consumers to behave irrationally?
Rationality assumes people act individually to maximise their own benefits, but sometimes individuals are influenced by social norms, known as bias. Consumers become unwilling to change their bias, even if it would benefit them, if it goes against social norms. 'Herding behaviour' occurs when the individual follows the actions of a large group
102
How does influence of habitual behaviour cause consumers to behave irrationally?
Most people have habits, and these habits reduce the amount of time it takes to do something, because consumers dont have to think consciously about their decisions. Habits create a barrier to decision making since they limit or prevent consumers considering an alternative. It includes addictions, and so this influences people's decisions
103
How does weakness at computation cause consumers to behave irrationally?
Many consumers aren't willing or able to make comparisons between prices and so they will buy more expensive goods than needed, for example many customers buy multipack goods because they assume they are cheaper, but this is not always the case. Consumers are sometimes poor at self-control so do things they know they shouldn't. Consumers will also make decisions without knowing about the long term effects, so make irrational decisions.
104
