Economics L6

Chapter 1 – social science:

Scientific method – method of proving or disproving a theory through experimentation.
Laws – theories which gain universal acceptance.
Social science – the study of human behaviour using a scientific method and the consequences of this behaviour.
➔​ Social sciences are more difficult to prove a theory due to the variety and unpredictability of human behaviour.
➔​ Economics as a science is based largely on probabilities and use of ‘it is likely that’.
Models:
➔​ Economic theories are often expressed in words; however, models are expressed more in mathematical terms.
➔​ Models are constructed to help people understand theories and questions that they have.
Simplification and ceteris paribus:
➔​ Where some models have been simplified with some factors omitted to show the more appropriate scale.
➔​ Ceteris paribus is the Latin translation of ‘all other things being equal.’
➔​ Ceteris paribus is used to isolate a factor during an experiment as they assume all other secondary factors will remain unchanged.
Positive and normative economics:
➔​ Positive statement: A statement which can be supported or refuted by evidence.
➔​ Normative statement: A statement which cannot be supported or refuted because it is based on a value judgement.
➔​ Value judgement: A judgement that is based on an opinion or value rather than facts.
➔​ Generally normative statements can be backed up by positive statements as facts. (An opinion backed up by facts).
Chapter 2 – Economic data:
Collection and reliability of data:
●​ Economists gather data either to prove or refute a theory or hypothesis.
●​ Some information can be inaccurate, especially if predicting possible future outcomes.
●​ Surveys can also be used for collection of data but are only reliable if there is accurate sampling and measuring of the data. Some
surveys such as unemployment count are very reliable due to the wide range of sources used.
●​ Economists can also gather data for its use on case studies and reliability can depend on the scale of the study.
Real and nominal values:
●​ The most important measure used in economics is the value of an item in monetary terms.
●​ However, inflation can adjust these values as it erodes the purchasing power of money, these adjusted values are called real values.
●​ Unadjusted values are called nominal values or are said to be at ‘constant prices’.
Interpretation of data:
●​ Base period: the period, such as a year or a month, with which all other values in a series are compared. The value in a base period is
usually 100.
●​ Index number: An indicator showing the relative value of one number to another from the base of 100. It generally presents an
average of a number in statistics.
Chapter 3 – The economic problem
Scarcity:
●​ Due to limited amounts of resources, economists therefore say resources are scarce.
●​ This means that economic agents can only obtain a limited amount of resources at any given time.
●​ Resources which are scarce are called economic goods.
●​ Resources which are not scarce are called free goods. As the population of the Earth continues to increase, the number of free goods
decreases. Such as clean water, food, shelter etc . . .
Infinite wants:
●​ The needs of humans are limited, such as water and food, or psychological and emotional needs.
●​ However, the want of humans is infinite, no matter their status or wealth.
The basic economic problem:
●​ Due to scarce resources and infinite human wants, this forces economic agents to allocate their resources between uses.
●​ Economics is the study of resource allocation, which is the choice economic agents make.
●​ Opportunity cost is what is given up by the economic agent when making another choice e.g a consumer buying one product has
given up the opportunity of buying another product.
●​ Free goods have no opportunity cost e.g. someone breathing air.
What is an economy?:
●​ An economy is a system which tries to solve the basic economic problem. There are three parts to the economic problem:
●​ What is to be produced/proportion of output spent on each sector (defence, agricultural etc . . .)
●​ How production is to be organised.
●​ For whom is production to take place. (e.g. amount pensioners receive, output to workers etc . . .
Economic resources:
●​ There are four types of resources available for production process and are called the factors of production:
●​ Non-renewable resources such as coal, gold, oil and copper.
●​ Renewable resources such as water and wind
●​ Sustainable resources – a type of renewable resource that can be exploited economically and will not diminish e.g. forests.
●​ Non-sustainable resources – resources which are diminishing over time due to economic exploitation such as oil.
Examples of resources:
●​ Land
●​ Labour
●​ Capital – human made resources
●​ Enterprise
PPFs
PPFs are production possibility frontiers that show the maximum potential output of an economy.
The boundary/line shows all the different combinations we can produce if resources
are used as efficiently as possible.
➔​
➔​ Any point inside the boundary, some resources are not being
employed/ used.
➔​ Any point outside the boundary is unattainable as there is not enough
resources for that outcome.
➔​ If a point is at either end of the axis on the line, it means all of that
product is being made using the resources and none of the other.
➔​ Producing X more of goods means that there will be an opportunity
cost of
of services.
➔​ All points on the boundary are productively efficient and only one
point is
allocatively efficient (producing the things people most want), however
we cannot know from this graph where that point is.
Shifting the PPF:
➔​ The PPF will shift outwards if there is an increase in the quality or quantity of the resources in the production process.
This means an increase in productive potential and the PPF will shift outwards.
➔​ If the productive potential of an economy falls e.g. due to a natural disaster, the PPF will shift inwards.
Long Run Economic growth:
Long run economic growth is an increase in productive potential which can occur due to:
➔​ More factors of production e.g. immigration contributing to labour, more investment in production resources (capital).
➔​ Higher quality of factors of production e.g. increase in productivity.
Short Run Economic growth – Where some previously unemployed resources are now being used and the economy moves closer to
its productive potential e.g. the PPF boundary.
Why is the PPF a curve?
The PPF is curved because factors of production have different efficiencies in producing Good A and Good B. When all of Good A is
being produced and we want to increase the production of Good B, we will reallocate resources that are most efficient at producing B
and least effective at producing A.
The gain on B is large and the drop in A is small.
●​ Resources are not equally good at producing Goods A and B.
●​ If more resources are better at producing Good B, the PPF will shift outwards on the Good B axis but stay the same at
the Good A axis.
Specialisation
Division of labour allows workers to specialise in specific tasks or a narrow group of tasks.
Specialisation occurs when an individual, firm, region or country produces just one or a limited range of goods and services.
Gains:
●​ Learning by doing
●​ Save time switching between tasks.
●​ It is economically viable to provide specialist equipment (only have to buy one instead of for every person).
Disadvantages:
●​ It might become monotonous and lead to people leaving their job or productivity decreasing.
●​ Occupational immobility – might not allow your skill set to expand and employment opportunities are few and far
between.
Money
Functions of money:
1.​ Medium of exchange – Any asset widely accepted as a means of payment (it facilitates transaction).
2.​ Store of value – Any asset that holds its value over time. Allows saving and for consumption to be postponed.
3.​ Unit of account – money is a measure used to value/cost products.
4.​ Method of deferred payments – accepted way to settle a debt.
Characteristics of money:
●​ Portability
●​ Counterfeit production
●​ Divisible
●​ Scarce
●​ Traceable
●​ Safe
Types of economies:
Command economy:
●​ A command economy is one where all allocation decisions are taken centrally.
●​ This means that the government decides where resources are allocated and how many goods and services are produced
by each sector.
Market economy:
●​ A market economy is where resource allocation is determined by demand of goods and services.
●​ These prices and production are decided by individual private companies in competition with each other.
●​ This is unrestricted, compared to in a command economy.
●​ Can increase innovation and therefore economic growth of a country in the long term.
Mixed economy:
●​ A mixed economy permits economic freedom in the use of capital but also allows the government to interfere in
economic activities in order to achieve social aims.
●​ E.g. The government in the UK controls public healthcare and education.
Demand
Utility – Measure of benefit from consumption
Margin – The effect of consuming or producing one more unit of output for example and marginal cost is the cost of this.
Marginal utility – the extra utility from consuming one more unit.
●​ Assume the price of pizza is £2. A rational consumer would be prepared to buy 3 slices. If the price increases to £2.50,
this now increases the marginal utility of the 3rd slice, and the consumer would ration to 2 slices.
Law of diminishing marginal utility:
●​ Marginal utility gained from consuming an additional (marginal) unit is less than the previous one.
●​ This is the point of satiation.
●​ E.g. the more chocolate you eat, the less you enjoy eating it.
Conditions of demand:
1.​ Change in disposable income if this is a normal good.
●​ Demand will increase when income increases.
●​ For an inferior good such as public transport, demand increases as income falls.
2.​ Increase in successful advertising will increase demand.
3.​ Increase in the price of a substitute will increase demand.
4.​ Fall in the price of a compliment (things that are bought together e.g. shampoo and conditioner).
●​ This will increase demand
5.​ Increase in population will increase demand.
Rationality
Why does traditional economics assume economic agents are rational?
●​ Allows us to consider the bigger picture.
●​ Increases certainty
●​ Often people are more rational than not
●​ To deliver clearer answers
When are people more likely to be irrational than rational?
●​ Doing things that are unfamiliar
●​ Where information is lacking or overwhelming
●​ Decisions are infrequent
●​ Time is limited
●​ Where information is complex
What groups of people are more likely to be irrational than others?
●​ People living in relative poverty (close to absolute poverty but still have money).
●​ Young people e.g. children and teenagers.
Where do we use these concepts in analysis or evaluation:
●​ Assume rationality for analysis
●​ Assume irrationality for evaluation.
Econs vs Humans:
●​ Econs are rational and have well-defined preferences. They are generally also self-interested and are utility maximisers
(measure of gain from consumption).
●​ Humans are flawed, biassed in their behaviour and emotional. They are not driven purely by a need to maximise their
welfare (altruistic – consider their impact on others).
●​ Humans also have a lack of self-control and are subject to many undesirable behaviours such as overspending,
overeating or even overworking.
Availability bias:
●​ This is where people will cling onto familiarity and knowledge they have about a certain situation, even though it may
not be right.
●​ They rush into an answer due to familiarity and have not considered all possibilities.
Essay question plan:
Explain why economic agents may be irrational in some circumstances.
1.​ Traditional economics assumes economic agents are rational. This means that they can handle large amounts of
information, are utility maximisers and act in their own self-interest.
2.​ However, where information is complex and unfamiliar and decisions are taken infrequently, consumers will likely be
irrational.
3.​ An example is taking financial decisions such as choosing a pension.
4.​ Economic agents are likely to experience bounded rationality. Their rationality is bounded because they cannot handle
the required cognitive load.
5.​ In response, consumers will adopt heuristics (simple rules of thumb) to its cognitive load.
6.​ These conclude in inertia or adopting social norms.
Consumer surplus:
Consumer surplus exists because for all but the final unit, willingness to
pay>price.
●​ Is a welfare measure.
●​ Consumer surplus is higher where the red dot is and lower where
the orange dot is.
●​ Consumer surplus is the difference between the amount a consumer
is willing to pay for a product and the amount they actually pay.
Elasticity
Price elasticity of demand (PED):
➔​ Price elasticity of demand (PED) is the responsiveness of a good’s quantity
demanded to a proportionate change in its price.
➔​ Formula - % change in quantity demanded / % change in price
➔​ Price inelastic is any value less than one.
➔​ Price elastic is any value larger than one.
➔​ PED is equal to one is the unitary value - percentage change in quantity demanded is the same as the percentage change in price.
Determinants:
1.​ Number of substitutes
2.​ The width of the market
3.​ Time – elasticities will always increase with time.
4.​ Percentage of income
5.​ Necessity
Diagrams:
Perfectly price inelastic: Perfectly price elastic:
Income elasticity of demand (YED):
➔​ It is the responsiveness of quantity demanded to a proportionate change in income.
➔​ Formula - % change in quantity demanded / % change in income
Values for YED:
-​ When YED is negative, it is an inferior good (when income falls quantity demanded increases e.g. public transport).
-​ When YED is positive, it is a normal good (when income increases quantity demanded increases e.g. technology).
-​ When YED is larger than one, it is a luxury good (e.g. a holiday).
Diagrams:
Luxury and normal goods: Inferior goods:

Cross price elasticity of demand (XED):

➔​ XED measures the responsiveness of quantity demanded of one good to a change in the price of another good.
➔​ Formula - % change in quantity demanded of good A / % change in price of good B
Values for XED:
-​ When XED is positive it is a substitute
-​ When XED is negative it is a complement
-​ When XED is zero the goods are not related
Price elasticity of supply (PES):
-​ It is the responsiveness of quantity supplied to a proportionate change in price.
-​ Formula - % change in quantity supplied / % change in price
Values for PES:
-​ PES > 1 it is price elastic
-​ PES < 1 is is price inelastic
-​ PES is equal to one it is unitary
Determinants:
1)​ Amount of spare capacity e.g. resources unemployed.
2)​ Stocks of semi-finished and finished goods.
3)​ How complex is the production process.
4)​ Substitute ability of capital and labour e.g. easily change around how to produce things.
5)​ Time
Supply
Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time
period.
Market supply is the total supply brought to the market by producers at each price.
-​ Basic law of supply - as the price of the product rises so businesses expand supply to the market.
What shifts the supply curve?:
1)​ Changes in the cost of production e.g. labour costs, raw material costs.
Increase - decrease in supply
Decrease - increase in supply
-​ Exchange rate increase - increase in supply
2)​ Changes in technology influencing productivity
Increase in productivity - decrease in supply
Decrease in productivity - increase in supply
3)​ Indirect taxes
Increase - decrease in supply
Decrease - increase in supply
4)​ Subsidies
Increase - increase in supply
Decrease - decrease in supply
5)​ Red Tape - unnecessary rules and regulations
Increase - decrease in supply
Decrease - increase in supply
6)​ Agricultural products - climatic conditions
Bad weather - decrease in supply
Good weather - increase in supply
7)​ Number of firms in the market and their objectives
More firms - increase in supply
Less firms - decrease in supply
Extension and contraction:
-​ When the price of a product increases, supply extends.
-​ When the price of a product decreases, supply contracts.
Related and inter-connected markets:
Joint supply:
-​ Joint supply arises when production of one good leads to the supply of a byproduct, which can be used to produce something
else.
-​ An example would be beef and leather, which are both from cows.
Derived demand:
-​ Derived demand arises when demand for a good is not for its own sake, but as an input into the production of another.
-​ Examples include labour and transport.
-​ Demand for labour is derived from demand for the goods or services it is used to produce.
Composite demand:
-​ Composite demand is demand for a good with more than one use.
-​ For example, oil and various foodstuffs.
-​ Good in composite demand will be in competing supply.