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Chapter 1 – The basic economic problem
Summary
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Nearly all resources are scarce;
Human wants are infinite
Scarce resources and infinite wants give rise to the basic economic problem –
resources have to be allocated between competing uses.
Allocation involves choice and each choice has an opportunity cost.
The production possibility frontier (PPF) shows the maximum potential output of an
economy.
Production at a point inside the PPF indicates an inefficient use of resourcesGrowth in the economy will shift the PPF outwards.
Key definitions
Scarce resources - Resources which are limited in supply so that choices have to be made
about their use.
Basic economic problem – Resources have to be allocated between competing uses because
wants are infinite whilst resources are scarce.
Choice – Economic choices involve the alternative uses of scarce resources.
Economic goods – Goods which are scarce because their use has an opportunity cost.
Opportunity cost – the benefits forgone of the next best alternative.
Production Possibility Frontier – (A.K.A the production possibility curve or the production
possibility boundary or the transformation curve) a curve that shows the maximum potential
level of one good given a level of output for all other goods in the economy.
Notes
The production possibility frontier illustrates the principle of opportunity cost
Point D occurs when there is an inefficient use of resources in an
economy. The Production possibility frontier is the maximum an
economy can produce and therefore it would only decrease if
something tragic would happen, for example a war. It would
decrease the labour in that economy.
The curve shown in the diagram is
the production possibility frontier. In
point B there is 120 units of guns
produced while 50 units of butter are
produced. At point A there are 100
units of butter and 30 units of guns.
Point C would only be possible if
there is an injection of resources into
the economy, for example the
number of workers may increase. It
can also become point C if the quality
of resources at an economy is
increased, for example there is an
investment in technology which
makes the manufacturing of goods
more efficient.
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Chapter 2 – The function of an economy
Summary
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An economy is a social organization through which decisions about, how and for whom
to produce are made.
The factors of production – land, labour, capital and entrepreneurship – are combined
together to create goods and services for consumption.
Specialisation and the division of labour give rise to large gains in productivity.
The economy is divided into three sectors, primary, secondary and tertiary.
Markets exist for buyers and sellers to exchange goods and services using barter or
money.
The main actors in the economy, consumers, firms and government, have different
objectives. Consumes, for instance, wish to maximise their welfare whilst firms might
wish to maximise profit.
Key definitions
Capital productivity – Output per unit of capital employed.
Division of labour – specialisation by workers.
Factors of production – CELL Capital Entrepreneurship land and labour. These factors make
production possible.
Fixed capital – economic resources such as factories and hospitals which are used to transform
working capital into goods and services.
Human capital – the value of the productive potential of an individual or group of workers. It is
made up of the skills, talents, education and training of an individual or group and represents
the value of future earnings and production.
Labour productivity – output per worker.
Market – any convenient set of arrangements by which buyers and sellers communicate to
exchange goods and services.
Non-renewable resources – resources, such as coal or oil, which once exploited be replaced.
Non -sustainable resources – resource which is being economically exploited cannot be
replaced.
Primary Sector – extractive and agricultural industries.
Productivity – output per unit of input employed.
Profits – the reward to the owners of a business. It is the difference between a firm’s revenues
and its costs.
Renewable resources – resources such as fish stocks or forests, which can be exploited over
and over again because they have the potential to renew themselves.
Secondary sector – production of manufactured goods.
Specialisation – a system of organisation where economic units such as households or nations
are not self-sufficient but concentrate on producing certain goods and services and trading the
surplus with others.
www.studyguide.pkFactors of
Production
Capital – the manufactured
stock of tools, machines,
factories, offices, roads and
other resources which is
used in the production of
goods and services. There
are two types of capital:
working capital, stocks of
raw materials, semi
manufactured goods and
finished goods which are
waiting to be sold; fixed
capital is the stock of
factories, offices, plant and
machinery. Fixed capital is
fixed in the sense that it
will not be transformed
into a final product.
Entrepreneurship –
Entrepreneurs are
individuals who: organize
production: organize all
factors to production in the
production of goods and
services.
Land- All natural
resources that
process of
production requires
to be complete.
Labour – The
workforce of an
economy,
everybody from a
house person to a
doctor. The value of
a worker is called his
or her human
capital.
The objective of economic actors
There are four main types of economic actors in a market economy – consumers, workers,
firms and governments. It is important to understand what are the economic objectives of
each of these sets of actors.
Consumers – In economics, consumers are assumed to want to maximise their own economic
welfare, sometimes referred to utility or satisfaction. They are faced with the problem scarcity.
They do not have enough income to be able to purchase all the goods or services that they
would like. So they have to allocate their resources to achieve their objective. To do this, they
consider the utility to be gained from consuming an extra unit of a product with its opportunity
cost.
Workers – Workers are assumed in economics to want to maximise their own welfare at work.
Evidence suggests that the most important factor in determining welfare is the level of pay. So
workers are assumed to want to maximise their earning in a job.
Firms – The objectives of firms are often mixed. However, in the UK and the USA, the usual
assumption is that firms are in business to maximise their profits. This is because firms are
owned by private individuals who want to maximise their return on ownership. This is usually
achieved if the firm is making the highest level of profit possible. In Japan and continental
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Europe, there is much more of a tradition that the owners of firms are just one of the
stakeholders in a business. Workers, consumers and the local community should also have
some say in how a business is run. Making profit would then only be one objective amongst
many for firms.
Governments – Governments have traditionally been assumed to want to maximise the
welfare of the citizens of their country or locality. They act in the best interest of all. This can
be very difficult because it is often not immediately obvious what are the costs and benefits of
a decision. Nor is there often a consensus about what value to put on the gains and losses of
different groups. So governments may have a variety of motives when making decisions. In an
ideal world, governments should act impartially to maximise the welfare of society. In practice
they may fall short of this.
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Chapter 3 –The function of an economy
Summary
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Economic data are collected not only to verify or refute economic models but to
provide a basis for economic decision making.
Data may be expressed at nominal (current) prices or at real (or constant) prices. Data
expressed in real terms take into account the effects of inflation.
Indices are used to simplify statistics and to express averages.
Data can be presented in a variety of forms such as tables and graphs.
All data should be interpreted with care given that data can be selected and presented
in a wide variety of ways.
Key definitions
Base period – the period, such as a year or a month, with which all other values in a series are
compared.
Index number – an indicator showing the relative value of one number to another from a base
of 100. It is often used to present an average of a number of statistics.
Nominal values – values unadjusted for the effects of inflation.
Real values – values adjusted for inflation.
Notes
In economics, by far the most important measure used is the value of an item measured in
monetary terms, such as pounds sterling, US dollars or Euros. One problem in using money as
a measure is that inflation erodes the purchasing power of money.
Values unadjusted for inflation are called Nominal values. These values are expressed at
current prices (i.e. at the level of prices existing during the time period being measured).
If data are adjusted for inflation, then they are said to be at real values or at constant prices.
To do this in practice involves taking one period of time as the Base period.
Inflation
between year
1 and 2
Value at year
1 prices
Value at year
2 prices
Example 1 100£ in year 1
Example 2 500£ in year 1
Example 3 200£ in year 2
10%
50%
20%
100£
500£
166.66£
110£
750£
200£
Example 4 400£ in year 2
5%
380.95£
400£
Nominal value
In example 1 there was an increase of 10% in prices from the base year, and thus prices rose
from 100£ to 110£. In example 2, there was a 50% rise in prices from year 1 and thus prices at
year 2 were 750£. In example 3, there was a 20% increase on 166.66£ and therefore at year 2
prices were 200£. In example 4 there was a 5% increase on 380.95£ and became 400£.
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It is often more important in economics to compare values than to know absolute values. The
Retail Price Index (the measure of the cost of living) is calculated by working out what it would
cost to buy a typical cross-section or “basket” of goods. Comparing say 458.92 in one month
with 475.13£ the next is not easy.
So, many series are converted into Index Number form. One time period is chosen as the base
period and the rest of the statistics in the series are compared to the value in that base period.
The value in the base period is usually 100. The only reason the figure 100 is chosen is because
it’s easy to work with mathematically.
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Chapter 4 – Positive and Normative economics
Summary
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Positive economics deals with statements of “fact which can either be refuted or
supported. Normative economics deals with value judgements, often in the context of
policy recommendation.
Economics is generally classified as a social science.
It uses the scientific method as a basis of its investigation.
Economics is the study of how groups of individuals make decisions about the
allocation of scarce resources.
Economists build models and theories to explain economic interactions.
Models and theories are simplifications of reality.
Models can be distinguished according to whether they are static or dynamic,
equilibrium or disequilibrium or partial or general.
Key definitions
Ceteris paribus – the assumption that all other variables within the model remain constant
whilst one change is being considered.
Equilibrium – the point where what is expected or planned is equal to what is realised or
actually happens.
Law – a theory or model which has been verified by empirical evidence.
Normative economics – the study and presentation of policy prescriptions involving value
judgements about the way in which scarce resources are allocated.
Normative statement – a statement which cannot be supported or refuted because it is a value
judgement.
Partial and general models – a partial model is one with few variables whilst a general model
has many.
Positive economics – the scientific or objective study of allocation of resources.
Positive statement – a statement which can be supported or refuted by evidence.
Static and dynamic models – a static model is one where time is not a variable. In a dynamic
model, time is a variable explicit in the model.
The scientific method – a method which subjects theories or hypotheses to falsification by
empirical evidence.
Theory or model – a hypothesis which is capable of refutation by empirical evidence.
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Notes
Economics is concerned with two types of investigation.
Positive economics – is the scientific or objective study of the subject. It is concerned with
finding out how economies and markets actually work- Positive statements are statements
about economic which can be proven to be true or false. They can be supported or refuted by
evidence. For example, “ The UK economy has high unemployment” is a positive statement.
Normative economics – is concerned with value judgements. It deals with the study of and
presentation of policy prescriptions about economics. Normative statements are statements
which cannot be supported or refuted. Ultimately, they are opinions about how economies
and markets should work. For example, The government should increase the unemployment
subsidies” and “ Manufacturing companies should invest more” are normative statements.
Theories and Models
The terms “theory and model” are often used interchangeably. There is no exact distinction to
be made between the two. However, an economic theory is generally expressed in looser
terms than a model. For instance “consumption is dependent upon income” is a economic
theory. “Ct = 567 + 0.852Yt” where 567 is a constant, Ct is current consumption and Yt current
income would be a economic model. Theories can often be expressed in words. But economic
models, because they require greater precision in their specification, are often expressed
mathematical terms.
Types of model
Equilibrium and disequilibrium models – In economics, equilibrium can be described as a point
when expectations are being realised and where no plans are being frustrated. Equilibrium
models are models where is it predicted that the market or economy will return to an
equilibrium point. Disequilibrium models are more complex and tend to be expressed using
complex mathematical language.
Static and Dynamic models- A dynamic models i one which contains time as one of its
variables. A static model is one which contains no time element within the model. Dynamic
models tend to be complex. They are more suited for computer modelling.
General and partial models – A general model is one which contains a larger number of
variables. A partial model is one which contains relatively few variables. A partial model will be
one in which most variables are assumed to be in the category of ceteris paribus.
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Chapter 5 – The Demand Curve
Summary
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Demand for a good is the quantity of goods or services that will be bought over a
period of time at any given price.
Demand for a good will rise or fall if there are changes in factors such as incomes, the
price of other goods, tastes, and the size of the population.
A change in price is show by a movement along the demand curve.
A change in any other variable affecting demand, such as income, is shown by a shift in
the demand curve.
The market demand curve can be derived by horizontally summing all the individual
demand curves in the market.
Key definitions
Consumer surplus – the difference between how much buyers are prepared to pay for a
good and what they actually pay.
Demand curve – the line on a price-quantity diagram which shows the level of effective
demand at any given price.
Demand or effective demand – the quantity purchased of a good at any given price, given
that other determinants of demand remain unchanged.
Individual demand curve – the demand curve for an individual consumer, firm or other
economic unit.
Market demand curve – the sum of all individual demand curves.
Shift in the demand curve – a movement of the whole demand curve to the right or left of
the original caused by a change in any variable affecting demand except price.
Notes
Demand is the quantity of goods and services that will be bought at any give price over a
period of time. If everything else were to remain the same (ceteris paribus) what would
happen demanded of a product as its price changed?
Prices rises
Demand falls
Prices fall
Demand rises
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Price is a factor a affects demand, there are a another few important factors:
1. Price of substitution goods- If price of potatoes rise the amount of pasta, bread and
rice bought will increase.
2. Changes in population- An increase in population will likely cause an increase in the
demand for goods.
3. Changes in Fashion;
4. Changes in legislation;
5. Advertising;
6. Weather;
7. Income;
For income, it affects it two different ways. If there is a rise in income, there will be a rise in
demand for normal goods. However, if income rises there will be a fall in demand for inferior
goods.
The difference between the value to buyers and what they actually pay is called the consumer
surplus. If there are a few goods available to buy, as with diamonds, the consumers are
prepared to pay a high price for them. If goods are plentiful, then consumers are only prepared
to pay a low price.
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Chapter 6 – The supply curve
Summary
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A rise in price leads to a rise in quantity supplied, shown by a movement along the
supply curve.
A change in supply can be caused by factors such as a change in costs of production,
technology and the price of other goods. This results in a shift in the supply curve.
The market supply curve in a perfectly competitive market is the sum of each firm’s
individual supply curve.
Key Definitions
Individual supply curve – The supply curve of an individual producer.
Market supply curve – the supply curve of all producers within the market. In a perfectly
competitive market it can be calculated by summing the supply curves of individual
producers.
Producer surplus – the difference between the market price which firms receive and the
price at which they are prepared to supply.
Supply – the quantity of goods that suppliers are willing to sell at any given price over a
period of time.
Notes
In economics supply is defined as the quantity of goods that sellers are prepared to sell at
any given price over a period of time. Supply is the opposite of Demand as price rises and
supply falls and vice versa. A fall In price will lead to a fall in quantity supplied, shown by a
movement along the supply curve.
Prices rises
Supply rises
Prices fall
Supply falls
The supply curve is drawn on the assumption that the general costs of production in the
economy remain constant. If other things change, then the supply curve will change. If
costs rise, firms will attempt to pass on these increases in the form higher prices. Thus, the
supply curve will shift upwards and to the left.
Changes in the prices of some goods can affect the supply of a particular good.
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For instance, if the price of beef increases substantially there will be an increase in the
quantity of beef supplied. More cows will be reared and slaughtered. As a result there will be
an increase in the supply of hides for leather. At the same price, the quantity of leather
supplied
to the
market
increase.
Other
factors
that
affectwill
suppy
are: Thus, an increase in the price of beef will lead to an
increase in the supply in leather.
1. The goal of sellers – If there is a change in profit levels, there will be a change in
supply.
2. Goverment Legislation – Anti- pollution controls which can raise the costs of
production is an example how governments can affect supply.
3. Expectation of future events – if firms expect future prices to be much higher, they
may restrict supplies and stockpile goods.
4. Weather – in agricultural markets, the weather plays a crucial role in determining
supply.
5. Producer cartels – in some markets, producing firms or producing countries band
together, usually to restrict supply.
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Chapter 7 – Price Determination
Summary
 The equilibrium or market clearing price is set where demand equals supply.
 Changes in demand and supply will lead to a new equilibrium prices being set.
 A change in demand will lead to a shift in the demand curve, a movement along
the supply curve and a new equilibrium price.
 Markets do not necessarily tend towards the equilibrium price.
 The equlibrium price is not necessarily the price which will lead to the greatest
economic efficiency or the greatest equity.
Key notes
Equilibrium price – the price at which there Is no tendency to change because planned
purchases are equal to planned sales.
Excess demand – where demand is greater than supply.
Excess supply – where supply is greater than demand.
Free market forces – forces in free markets which act to reduce prices when there is
excess supply and raise prices when there is excess demand.
Market clearing price – the price at which there is neither excess demand nor excess
supply but where everything offered for sale is purchased
Equilibrium
Equilibrium is a term relating to a 'state of rest', a situation where there is no tendency to
change. In economics, equilibrium is an important concept. Equilibrium analysis enables us to
look at what factors might bring about change and what the possible consequences of those
changes might be. Remember, that models are used in economics to help us to analyze and
understand how things in reality might work. Equilibrium analysis is one aspect of that process
in that we can look at cause and effect and assess the possible impact of such changes.
For the purposes of this resource we are going to look at market equilibrium. Market
equilibrium occurs where the amount consumers wish to purchase at a particular price is the
same as the amount producers are willing to offer for sale at that price. It is the point at which
there is no incentive for producers or consumers to change their behavior. Graphically, the
equilibrium price and output are found where the demand curve intersects (crosses) the
supply curve.
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Assume the demand is Qd = 150 - 5P and that supply is given by Qs = 90 + 10P. What we now have is a task
that involves understanding how to do simultaneous equations. In equilibrium we know that Qs = Qd.
Remember that Qs = 90 + 10P and that Qd = 150 - 5P. Given that we know that an equation means that
whatever is on the left hand side must be the same as that on the right hand side we can re-write our
simultaneous equation as follows:
90 + 10P = 150 - 5P
We can now go about collecting all the like terms onto each side (
by doing the same to both sides) and
solving the equation to find P. Explanation 1 shows the long route and Explanation 2 the route you might
normally see in a textbook.
Explanation 1
(90 - 90) + (10P + 5P) = (150 - 90) - (5P + 5P)
We have added 5P to both sides and taken away 90 from both sides. This gives us:
15P = 60
Now divide both sides by 15 to get P on its own.
15P / 15 = 60 / 15
The 15P term will now cancel down. How many times does 15 go into 15P? Once.
60 / 15 = 4
P=4
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Chapter 8 – Interrelationships between markets
Summary
 Some goods are complemens, in joint demand.
 Other goods are substitues for each other, in competitive demand.
 Derived demand occurs when one good is demanded because it is needed for the
production of other goods or services.
 Composited demand and joint supply are two other ways in which market are linked.
Key notes
Competitive demand – when two or more goods are substitutes for each other.
Complement – a good which is purchased with other goods to satisfy a want.
Composite demand – when a good is demanded for two or more distinct uses.
Derived demand – when the demand for one good is the result of or derived from the demand
for another good.
Joint demand – when two or more complements are bought together.
Joint supply- when two or more goods are produced together, so that a change in supply of
one good will necessarily change the supply of other goods with which it is in joint supply.
Substitute – a good which can be replaced by another to satisfy a want.
Notes
Derived demand – Many goods are demanded only because they are needed for the
production of other goods. For example steel in car manufacturing.
Composite demand – A good is said to be in composite demand for two or more distinct uses.
For instance, milk may be used for yoghurt, for cheese making, for butter and drinking.
Joint supply – A good in joint supply with another good when one good is supplied for two
different purposes. For instance, cows are supplied for both beef and leather. An oil well , may
give both oil and gas.
A substitue good is a good which can be replaced by another. They are said to be in
competitive demand : for example Coca-cola and Pepsi.
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Chapter 9 – Price elasticity of demand
Summary
 Elasticity is a measure of the extent to which quantity responds to a change in a
variable which affects it, such as price and income;
 Price elascity of demand measure the proportionate response of quantity demanded
to proportionate change in price.
 Price elasticity of demand varies from zero, infinitely inelastic, to infintely elastic.
 The value of price elasticity of demand is mainly determined by the availability of
substitutes and by time.
Key notes
Elastic demand – where the price elasticity of demand is greater than 1. The
responsiveness of demand is proportionally greater than the change in price. Demand is
infinetly elastic if price elasticity of demand is ifinity.
Inelastic demand – where the price elasticity of demand is less than 1. The responsiveness
of demand is proportionally less than the change in price. Demand is infinitely inelastic if
price elasticity of demand is zero.
Price elasticity of demand or own elasticity of demand – the proportionate response of
changes in quantity demand to a proportionate change in price, measured by the formula:
Percentage change in quantity demanded / Percentage change in price.
Unitary elasticity – when the change in demand is the same as the change in price,
elasticity is 1.
Notes
The determinants of price elasticity of demand:
The exact value of price elasticity of demand for a good is determined by a wide variety of
factors. Economists, however argue that two factors in particular can be singled out _ the
availability of substitutes and time.
The availability of substitutes: The better the substitutes for a product, the higher the
price elasticity of demand will tend to be. For instance, salt has few good substitutes.
When the price of slat increases, the demand for salt will change little and therefore the
price elasticity of salt is low. On the other hand, spaghetti has many good substitutes, from
other types of pasta, to rice, potatoes, bread, and other foods. A rise in the price of
spaghetti, all other food prices remain constant, is likely to have a significant effect on the
demand for spaghetti. Hence the elasticity of demand for spaghetti is likely to be higher
than that for salt.
Width of market definition The more widely the product is defined, the fewer substitutes
it is likely to have. Spaghetti has many substitutes, but food in general has none. Therefore
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the elasticity of demand for spaghetti is likely to be higher than that for food. Similarly the
elasticity of demand for boiled sweets is likely to be higher than confectionery in general.
A 5% increase in the price of boiled sweets, all other prices remaining constant, is likely to
lead to a much larger fall in demand for boiled sweets than a 5% increase in the price of all
confectionery.
Time The longer period of time, the more price elastic is the demand for a product. For
instance, 1973/74 when the prices of oil quadrupled the demand for oil was initially little
affected. In the short term the price of oil was price inelastic. This is hardly surprising.
People still needed to travel to work in cars and heat their houses whilst industry still
needed to operate. Oil had few good substitutes. Motorists couldn’t put gas into their
petrol tanks whilst businesses could not change oil-fired systems to run on gas, electricity
or coal. However, in the longer term motorists were able to, and did, buy cars which were
more fuel efficient. Oil-fire central heating systems were replace by gas and electric
systems. Businesses converted or did not replace oil fired equipment. The demand for oil
fell from what it would otherwise have been. Taking the ten year period to 1985, and given
the changes in other variables which affected demand for oil, estimates suggest that the
demand for oil was slightly elastic. It is argued that in the short term, buyers are often
locked into spending patterns through habit, lack of information or because of durable
goods that have already been purchases. In the longer term, they have the time and
opportunity to change those patterns.
Luxuries and necessities It is sometimes argued that necessities have lower price elasticity
than luxuries. Necessities by definition have to be bought whatever their price in order to
stay alive. So an increase in the price of necessities will barely reduce the quantity
demanded. Luxuries on the other hand are by definition goods which are not essential to
existence.
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Chapter 10 – Elasticities
Summary
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Income elasticity of demand measures the proportionate response of quantity
demanded to a proportionate change in income.
Cross elasticity of demand measures the proportionate response of quantity
demand of one good to a proportionate change in price of another good.
Price elasticity of supply measures the proportionate response of quantity
supplied to a proportionate change in price.
The value of elasticity of supply measures the proportionate response of quantity
supplied to a proportionate change in price.
The value of elasticity of supply is determined by the availability of substitutes and
by time factors.
The price elasticity of demand for a good will determine by whether a change in
the price of a good results in a change in expenditure on the good.
Key notes
Cross price elasticity of demand – a measure of the responsiveness of quantity demanded
of one good to a change in price of another good. It is measured by dividing the
percentage change in quantity demanded of one good by the percentage change in price
of other good.
Income elasticity of demand – a measure of the responsiveness of quantity demanded to a
change in income. It is measured by dividing the percentage change in quantity demanded
by the percentage in income.
Price elasticity of supply – a measure of the responsiveness of quantity supplied to a
change in price. It is measured by dividing the percentage change in quantity supplie by
the percentage change in price.