Topic 1 - Introduction To Markets Flashcards
What do economists develop to understand behaviour?
Models
What are economic models based on ?
a set of assumptions
What does ceteris paribus mean ?
This means ‘everything else remains equal’.
So when economists study the relationship between two factors, they’ll assume that one factor changes while the rest stay constant.
This is the most important assumption for economists to create functioning models.
Why do economists make models ?
Inability to make scientific experiments
Controlled laboratory tests aren’t possible. In real life, economists can’t keep variables constant.
Therefore, economists build models based on a set of assumptions
How can you ‘think like an economist’ ?
Economic methodology is similar to that of other social sciences:
Models and theories are used to explain real world evidence.
These models use real life data and can be used to make forecasts about the future.
Statistical analytics can be used to test hypothesise against evidence.
Nearly all models rely on assumptions and simplifications.
What are the similarities between economics and other social sciences ?
The models use real life data
The theories are used to prove empirical evidence
The models rely on assumptions
What is the difference between posited and normative statements ?
Positive statements describe the world as it is (can be proved)
normative statements describe how the world should be (opinions that contain value judgments)
What’s an example of a positive statement ?
the proposal of the new high speed rail HS2. If the exact benefits exceed the exact costs, you could say the project is worth doing. This is positive analysis. However, you may not always know costs & benefits perfectly.
What’s a normative statement ?
imagine an economist argued for higher unemployment benefits during a recession, because a rich country should take care of its citizens. This is normative analysis
What are value judgments?
Value judgments are often found in normative statements. They are judgements about society that cannot be quantified and tested.
E.g the homelessness problem in Oxford needs to be addressed and funds should be redistributed to do this. This judgement is within a normative statement.
Value judgements affect economic decision-making, so normative statements are important.
What’s the economic problem ?
The basic economic problem is that there are not enough resources to satisfy humans’ consumption demands and desires
(It’s a problem of scarcity, there’s unlimited wants but not enough (finite) resources)
OR
There are not enough resources on earth to satisfy humans’ unlimited wants and needs.
The basic economic problem involves working out how to allocate limited resources as effectively as possible to satisfy people’s unlimited wants and needs.
What are needs ?
Needs - things people can’t live without (e.g. water).
What are wants ?
Wants - things people can live without but desire (e.g. smartphones).
How do we allocate our scare resources ?
There are scarce resources in society. Because of this, choices have to be made on how to use these resources. This brings us to the foundation of economic decisions
What is the foundation of economic decisions ?
What goods/services we produce?
How we produce those goods/services?
Who we produce those goods/services for?
What is opportunity cost ?
defined as the ‘next best alternative foregone’
What are the issues with opportunity cost ?
Not all factors have alternatives.
Some alternatives are unknown.
Agents may lack information on alternatives.
It can be difficult to switch some factors to another use.
What’s meant by opportunity cost as a price ?
You can sometimes refer to the opportunity cost as a price.
If you buy a new bike for £300, then £300 measures the amount of consumption you have given up.
How can opportunity cost be used ?
Opportunity cost is a useful concept when thinking about allocating resources.
E.g. consumers use it to decide how to spend their earnings
What’s an example of a trade off ?
Tradeoffs
People face a tradeoff when they make choices.
If you choose to buy a video game, you cannot spend that income on movies.
The opportunity cost is the ‘next best alternative foregone’ - what you would use the money from the video game to buy instead.
What’s opportunity cost as time and money ?
In some cases, opportunity cost exceeds the monetary cost.
For example, attending university.
As well as the financial cost of tuition, you are giving up time that could be spent earning money at a paying job.
So the total opportunity cost is greater than the financial cost of university because of the lost potential earnings.
What are the three main economic agents ?
Producers - people/firms that produce goods or supply services.
Consumers - people/firms who purchase the goods/services.
Governments - establishes rules for economies.
What’s it up to the the three economic agents to decide ?
on how to allocate resources
Producers - people/firms that produce goods or supply services.
Consumers - people/firms who purchase the goods/services.
Governments - establishes rules for economies.
How do economic agents make their decision making (how do the decisions link to one another) ?
Economic agents make decisions based on their various incentives.
E.g. for firms this might be profit maximisation.
Producers must decide what products to make and the selling price of products.
Consumers decide what products to purchase and how much they want to spend on products.
Governments decide how much they should get involved in the production and consumption process.
What is economic activity ?
Production of goods (tangible products) and services (intangible products).
Consumption of goods/services.
Because resources are scarce, we must ask three questions about economic activity.
What, how, and who to produce for?
What’s are the two types of resources ?
Renewable and non renewable
What are the features of non renewable resources?
There is a finite supply of these resources.
This means that as they are increasingly used up, their cost will get higher.
What are examples of non renewable resources ?
Gas
Coal
Oil
What is the feature of renewable resources?
the resource comes in unlimited supplies
Deemed as better for environment
Why can a renewable resource have an issue with its supply ?
It this depends on the ‘rate of extraction’.
If the rate we consume the resource is quicker than the natural rate of production, the resource will become depleted and will have a finite supply.
What are examples of renewable resources?
Oxygen (O2)
Wind energy
Solar energy
What is division of labour ?
Division of labour involves dividing the workforce and allocating specific individuals to specific tasks
What’s the benefit of division of labour ?
It allows labour to specialise in a tasks - workers will become more efficient over time cutting out on waste and therefore costs
What’s a real life example of division of labour ?
E.g restaurant operations like Nando’s divide up their labour force.
There will be a business manager to oversee the process, as well as designated cooks to make the food and sometimes waiters to serve it.
If each person does one job a lot, they are usually better at that one job than if they did four different jobs with a quarter of their time
Who in the late 1700s proved through an example that division of labour could boost productivity in his book The Wealth of Nations ?
Adam Smith
He used the example of a pin factory he visited. He said 10 workers produced 48,000 pins through specialisation. But if each individual carried out every step of production themselves, they’d only make 10-20 each. So the firm avoids employing 2,400-4,800 people through division of labour.
How does specialisation through division of labour allow firms to take advantage of economies of scale ?
So as production increases, average unit cost decreases.
E.g if a BMW factory made 1,000 cars each year, each car would be quite expensive.
If they make 50,000 each year, then it can set up an assembly line and cost per unit will decrease.
What are the advantages of specialisation ?
Specialisation can lead to economies of scale.
This lowers the long run average cost for the firm.
Specialisation reduces the cost of training workers because they only have to be trained for their particular job.
Specialisation can increase labour productivity. Workers do tasks they’re good at and so should produce better quality and/or a higher quantity of products.
What are the disadvantages of specialisation ?
Specialised firms are often not flexible.
Workers may struggle to adapt and do a new role quickly if the environment changes. This is because they are only trained in their specialised skill.
Workers may become bored. This could reduce productivity if they start to do their work more slowly.
Countries may be less self-sufficient and struggle when trade suffers
What problem did money solve ?
problems created by the barter system
What are the 4 main functions of money ?
Deferred payment - Money is a standard of deferred payment
Unit of account - Money is a comparable unit of account
Store of value - Money is a store of value
Medium of exchange - Money is a medium of exchange between the buyer and the seller
What’s the issues of a PPF ?
Only a finite amount of goods & services can be produced with a fixed amount of resources
What does PPF show ?
The PPF shows economy at its maximum productive potential
How many good are in a PPF ?
Society can choose any two goods on or inside the PPF.
How is opportunity cost shown on a PPF ?
The opportunity cost is the slope of the PPF
Why is the PPF curved ?
The PPF is curved because of the law of diminishing returns
As you increase units of one resource and keep other factors constant in a PPF, what happens to the marginal benefit from the extra units ?
the marginal benefit from the extra units will eventually start to decline
How is economic growth shown on a PPF ?
The PPF shifts outward if there is economic growth.
This is because the productive capacity of the economy has increased.
E.g. this could be caused from improvements in technology.
But this improvement isn’t necessarily equal across all products.
E.g. an improvement in the technology to produce cars isn’t necessarily going to affect the ability to produce butter.
Why does a trade off occur on the PPF ?
The trade-offs occur when producing on the PPF.
To produce more of one good, you must produce less of another.
For example, if an economy is producing at point A and wants to increase the number of Good X they produce, they must give up producing some of good Y.
The PPF shows the economy working at its maximum potential.
If there are any points underneath the PPF, this means not all economic resources are being deployed.
If point A is outside the PPF what’s does this mean ?
If point B is on the PPF what does this mean ?
If point C is inside the PPF what does this mean ?
Point A is a point outside the PPF. It is not currently possible to produce at this point.
Point B is a point on the PPF. At this point, all available factors of production are being fully used. All points along the PPF like point B are productively efficient.
Point C is inside the PPF. At this point, there are factors of production being underemployed.
What does PPF stand for ?
Production Possibility Curve
Are all points on the PPF productively efficient or allocative efficient.
Every point on the Production Possibility Frontier (PPF) is productively efficient.
Not every point is allocatively efficient.
What is efficiency?
Efficiency refers to a lack of waste
What is static efficiency ?
Static efficiency refers to the efficiency at a point in time.
How does productive efficiency occur ?
With all available inputs and technology, it is impossible to produce more of one good without decreasing the quantity of another good being produced.
So, every point on the PPF is productively efficient.
How does allocative efficiency occur ?
This occurs when a specific combination of goods is efficient for society.
As this is a specific combination of goods, it refers to a point on the PPF, not the entire curve.
So, not every point on the PPF is allocatively efficient
When the total level of resources change what happens to the PPF ?
When the total level of resources changes, the PPF shifts.
What happens to the PPF when there’s increasing resources?
- PPF shifts outwards as output increases (economic growth).
What happens to the PPF when there decreasing resources ?
PPF shifts inwards as output decreases (negative economic growth).
What’s one reason that the PPF shifts outwards even when there is fixed resources?
Improvements in technology
When resources are fixed but output increases (e.g. through improving labour or technology), the PPF shifts outwards.
So an outward shift reflects economic growth.
Explain opportunity costs using a PPF with consumer goods vs capital goods ?
Capital vs consumer goods
Goods can be split into two groups:
Capital goods.
Consumer goods.
There is an opportunity cost in producing these goods. For example, if we increase the output of capital goods, we cannot produce as many consumer goods.
But if a country invests in increasing capital goods, the economy’s productive capacity can increase and the PPF curve can shift outwards.
What are the two types of market systems (economies) ?
A free market and a command economy
How does the free market economy work ?
This type of market allocates scarce resources based on the price mechanism.
What are the benefits of a free market economy ?
It is efficient - only the highest value products are in demand. So firms are incentivised to produce as efficiently as they can.
It rewards entrepreneurship.
Consumers have greater choice of products because of the increased levels of innovation.
What are the negatives of a free market economy?
Inequitable - what is fair in the free market may not necessarily be fair in reality.
Missing markets - goods we need in society may not be produced if they cannot generate a profit.
Monopolies may arise.
How does the command economy work ?
Government is in charge of resource allocation. North Korea has a command economy.
What are the benefits of a command economy ?
This can correct the inequalities that exist in the free market.
There could also be a possible reduction in unemployment.
They can break up monopolies.
Negatives of the command economy ?
Less efficient - the government is not a profit maximising entity. So the incentive for entrepreneurship and efficiency pushing activities is reduced.
Asymmetric information - the government may not actually know what is best because of asymmetric information.
Choice restriction.
What’s the mixed economy ?
Where the government meets the free market
The government forms the public sector.
Firms form the private sector.
Together, they are responsible for the allocation of scarce resources.
What did Adam smith believe when it came to free market economies and command economies ?
Smith was an advocate of the free market and the power of the ‘invisible hand’.
He thought consumers and producers were both driven by self-interest.
He believed that the interaction of profit maximising firms and consumers would lead to a mutually beneficial allocation of resources.
He believed that there should be no monopolies and low barriers to entry.
What did Karl Marx believe when it came to free market economies and command economies ?
Marx argued that the free market creates inequality and a situation where the working class are exploited.
He said this would lead to a revolution where means of production would be seized.
Marx’s theories gave rise to communism, even though they said little about how command economies could actually work. Communism started to lose popularity when communist states began collapsing towards the end of the 20th century.
What did Friedrich Hayek believe when it came to free market and command economies ?
Hayek was skeptical of command economies. He argued that asymmetry of information stopped them from making good decisions about resource allocation.
He believed that firms and consumers know best, and they should use the price mechanism to interact effectively.
He thought the price mechanism was a means of communication between producers and consumers.
What are the rational agents ?
(people, governments or companies/producers)
who use utility theory to guide their decision-making
How do agents make decisions?
A rational agent wants to maximise their utility.
To do this, they will try to maximise their total utility.
A rational consumer will want to consume something up until the point where marginal utility and price are equal
How is the rational agent (producers) meant to gain their utility ?
Through maximising profits
What are the reasons that the rational agent (producers) want to profit maximise ?
Survival.
To reinvest profits.
To offer managers and staff members better rewards.
Maximising revenue.
Maximising market share (and gaining monopoly power).
Ethical objectives (e.g. supporting the local economy).
What does the rational agent (government) do to get their utility ?
Governments should act in ways that best serve the population and, trying to maximise overall welfare.
Achieving economic growth.
Reducing inflation.
Reducing or eliminating unemployment.
Achieving a balance between payments in and payments out (equilibrium).
How do the rational agent (consumers) maximise utility?
Consumers are said to act rationally and maximise utility within the limits of their income.
Different consumers will have different interpretations of utility. One consumer might prioritise financial security (e.g. in saving for a property). Another consumer might want flashy clothes.
Consumers may also want to maximise their work-life balance (i.e. maximising their income while enjoying as much free time as they can). Consumers act as workers when they do this.
What illustrates the relationship between quantity demanded and price ?
A demand curve
What’s the relationship between price and quantity demanded ?
Price is what the buyer pays for a specific good or service.
Quantity demanded is the total number of units purchased at that price.
The demand curve is downward sloping and shows the relationship between price and quantity.
This means that the higher the price is, the lower demand is.
The law of demand shows the inverse relationship between price and quantity, assuming all other variables are constant.
What is “willingness to pay” ?
desire to pay based on tastes and preferences
What is “ability to pay” ?
Ability to pay - factors in a person’s income, and whether they can afford the good or service or not
What are substitute goods ?
an increase in the price of one good will increase the quantity demanded of the other.
E.g Persil and Ariel washing pods
What are complement goods ?
an increase in the price of one good will cause a decrease in the quantity demanded of the other.
E.g flights to Spain and suncream.
What are the two theories that explain the relationship between price and quantity ?
Income and substitution effects
What’s the income effect ?
when prices fall, consumers can afford a greater quantity of goods and services (assuming income is fixed). So demand for these goods and services increases.
What’s the substitution effect ?
when the price of one good falls, consumers will buy more of the cheaper good or service and less of the more costly good or service. So demand for the cheaper good will increase; demand for the costlier good decreases.
