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Summary Theme 1: Introduction to Markets and Market Failure
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25/10/2024, 17:14 OneNoteTheme 1: Introduction to Markets and Market
Failure
1.1 Nature of Economics
1.1.1 Economics as a Social Science
Assumptions
• Used for simplification
• Economics is a social science, human behaviour changes constantly (cannot be tested in scientific experiments)
Economic Models
• Models are constructed by economists to test hypotheses
Ceteris Paribus
• Simplifies models - isolates the relationship between two variables by assuming ceteris paribus
1.1.2 Positive and Normative Statements
Normative: a non-scientific approach to economics, it is a value judgement, and cannot be proven, based on what ‘should’ happen
Positive: a statement which can be supported/refuted by evidence, often used to back normative
1.1.3 The Economic Problem
The economic problem: there are limited resources (scarce) but unlimited wants
Opportunity cost: the next best alternative forgone
1.1.4 Production Possibility Frontiers
Outward/Inward Shift
• Reflects economic growth/decline
• Could be the result of newer more efficient technology/low consumer confidence
Along the PPF curve
• All resources are employed and used to their max efficiency
• Movements along the curve could be as a result of consumer preference changing (e.g. movement from A to B mean x units of pizza are being
forgone for y units of sugar)
Capital goods: goods used in the production of other goods (e.g. roads, machines, offices)
Consumer goods: goods and services used by people to satisfy their needs and wants
1.1.5 Specialisation and Division of Labour
Specialisation: the process by which individuals/firms/regions concentrate on producing the products they're best at producing
Division of Labour: where workers specialise in one stage of the production process
Advantages Disadvantages
• Workers become more skilled • If one area of the production line fails, all production stops
• Workers do what they're best at • Workers may find work boring/repetitive - morale falls (labour turnover may rise)
• Faster production of output • Workers cannot cover for one another
• Lower production costs (due to • Workers lack flexibility
above) • Workers may be replaced by machinery
Adam Smith used the example of pins, where one worker could make 20 pins a day, but 10 workers specialising in a number of tasks could make
48000 in a day
Functions of Money:
• Medium of exchange: enables the buying and selling of products, eliminates the need for barter
• Measure of value: a value is placed on products so buying and selling is easier, also enables relative comparisons of value between products
• Store of value: convenient way of storing wealth to be spent later. Money holds short term value as long as inflation is low
• Method of deferred payment: enables borrowing and lending
1.1.6 Free market Economies, Mixed Economy, and Command Economy
Advantages of Free Market Advantages of Command Economy
Efficiency and competition lower prices Cooperation of firms –> higher levels of output
Quality of production rises due to competition Less inequality – worker wages are controlled
Greater consumer choice, wider job range Limits external costs (e.g. severe pollution tax)
Financial incentives – entrepreneurs are willing to take risks to reap the Smaller swings in the business cycles –> less employment and inflation
profits, and workers are willing to work harder as the government has more control
Government can fund public goods
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Adam Smith: free market
• Criticised the government of his day which restricted free trade through protectionism and economic restrictions
• Invisible hand in a free market that would allocate resources to everyone’s advantages
• Recognised the necessity of the state to provide a framework – understood that employers would drive wages down, firms could combine to raise
prices, state had to provide pure public goods (e.g. roads)
Friedrich Hayek: free market
• Greater control by the state is a slippery slope to totalitarianism and loss of freedom
• Reacted to the loss of freedom in the Soviet Union under Stalin – abuse of political power to enforce decisions and Germany under Hitler but also
UK and US
Karl Marx: command economy
• Revolutionary socialist, common ownership
1.2 How Markets Work
1.2.1 Rational Decision Making
• A rational agent will always choose to perform the action with optimal expected outcome for themselves among all feasible actions
• Consumers aim to maximise utility, firms aim to maximise profits, workers aim to maximise their welfare at work (pay/job security)
and governments aim to maximise the welfare of citizens
1.2.2 Demand
Demand: the quantity of a g/s consumers are willing and able to buy at a given price at a point in time
Demand curve: shows the quantity of the goods/services which the market is willing and able to buy at any given price
Law of Demand:
• Price (P) and quantity (Q) are inversely proportional
○ Lower prices mean more can be bought with the same amount of money (income effect)
○ Lower prices mean consumers switch from buying other goods (substitution effect)
Movements along the curve are caused as a result of a change in price
Conditions of Demand
• Income: ↑Y will, ceteris paribus, ↑Q at any given price – due to more disposable income
• Consumer preferences, trends, population, season, advertisement, legislation, related goods, consumer confidence
Law of Diminishing Utility:
•
Consumers gain less additional satisfaction (utility) per unit of a good they consume therefore the amount they are willing to pay reduces
• This explains why the demand curve is downward sloping
Types of Goods:
• Normal good: demand increases as income rises (outward shift)
• Inferior good: demand decreases as income rises (inward shift)
Interrelated Markets:
• Substitutes: as price of a good rises, demand of its substitute increases – consumers will only switch when its cheap and easy to do so
• Complements: as price of a good rises, demand for its complement decreases
• Introduction of a new product: if a substitute, shift to left, if a new complement, shift to right
• Derived demand: as the demand for a good increase so will demand for goods needed to make that good
• Composite demand: if two products are made of wood and wood is at fixed supply, to make more of 1 good, less of the other must be made
1.2.3 Price, income and cross elasticities of demand
Elasticity measures sensitivity of variable (S or D) to another variable (e.g. price of goods/income)
Price Elasticity of Demand (PED)
• responsiveness of changes in quantity demanded to changes in price
• Perfectly elastic: PED = ∞ change in price –> demand falls to zero (e.g. gold)
• Relatively elastic: PED > 1 %change in demand > % change in price
• Unit elasticity: PED = 1 %change in demand = % change in price
• Relatively inelastic: PED < 1 %change in demand < %change in price
• Perfectly inelastic: PED = 0 change in price –> no effect on demand (e.g. medicine)
Determinants of PED:
• Substitutes: the more substitutes, the more price elastic – consumers can easily switch
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