MICROECONOMICS – THEME 1 NOTES
Table of Contents
1.1 The Nature of Economics.........................................................................................................................2
1.1.1 Economics as a Social Science............................................................................................................................2
1.1.2 Positive and Normative Economic Statements...................................................................................................2
1.1.3 The Economic Problem......................................................................................................................................3
1.1.4 Production Possibility Frontiers.........................................................................................................................5
1.1.5 Specialisation and the Division of Labour...........................................................................................................8
1.1.6 Free Market Economies, Mixed Economy and Command Economy.................................................................10
1.2 How Markets Work................................................................................................................................14
1.2.1 Rational Decision Making.................................................................................................................................14
1.2.2 Demand...........................................................................................................................................................14
1.2.3 Price, Income and Cross Elasticities of Demand................................................................................................15
1.2.4 Supply..............................................................................................................................................................19
1.2.5 Elasticity of Supply...........................................................................................................................................21
1.2.6 Price Determination.........................................................................................................................................22
1.2.7 Price Mechanism..............................................................................................................................................23
1.2.8 Consumer and Producer Surplus......................................................................................................................24
1.2.9 Indirect Taxes and Subsidies............................................................................................................................25
1.2.10 Alternative Views and Consumer Behaviour..................................................................................................26
1.3 Market Failure.......................................................................................................................................29
1.3.2 Externalities.....................................................................................................................................................29
1.3.3 Public Goods....................................................................................................................................................31
1.3.4 Information Gaps.............................................................................................................................................32
1.4 Government Intervention.......................................................................................................................34
1.4.1 Government Intervention in Markets..............................................................................................................34
1.4.2 Government Failure.........................................................................................................................................37
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,1.1 The Nature of Economics
1.1.1 Economics as a Social Science
- Economics is classified as a social science and is the study of how people make decisions about the
allocation of scarce resources
- Economists build models and theories, the ceteris paribus assumption is used to build these models
- Positive economic statements deal with facts and what can be proven true or false. Normative statements
are a valued judgement.
The Scientific Method
- Many sciences cover a wide variety of knowledge and what links the sciences is the scientific method,
which has three processes.
1. The scientist will put forward an idea called a hypothesis which can be proven true or false
2. Then they will collect evidence which proves or disproves their hypothesis
3. The scientist then decides whether to accept, change or refute the hypothesis. If it becomes accepted,
then it will be called a law
Economics – The Science
- In natural sciences it is much easier to carry out the scientific method to prove a theory or hypothesis. This
is because experiments can be done in laboratories where:
- Variables can be controlled
- Observations can be made with a high level of certainty
- In social sciences it’s very difficult to conduct experiments to test hypotheses as you cannot control the
variables. This is because experiments are done in the everyday world where everything is constantly
changing over any amount of time.
- Economists often come to difficult conclusions as interpretations may vary
- Can be argued that economics is not a science because it studies human behaviour which can’t be
contained by scientific laws
- It is very hard to understand and predict human behaviour which is why economists use terms such as ‘it
is likely that’ or ‘this may happen’ as they do not have enough data to make a firm prediction.
Theories and Models
- There is no clear distinction between a theory and model but:
- Theories are written in looser terms, usually in words
- Models require greater precision in their statements so are usually expressed in mathematical terms
The Purpose of Modelling
- We use models to understand why things are the way that they are
- They are also used to help us decide how to act
Simplification
- A criticism often made about economic models and theories is that they are ‘unrealistic’ which to an
extent is true
- Theories and models must be simplified so that they are useful.
- This could mean that some factors have been kept in the theory/model, some unused or some altered to
emphasise a particular point
Assumptions and Ceteris Paribus
- Sciences make assumptions when building models or theories
- They do this as the scientist can then simplify the problem to make it more manageable to solve
- This is done by using the ceteris paribus assumption which means ‘all other things equal’ in Latin
1.1.2 Positive and Normative Economic Statements
- A positive statement is a statement which is objective and made without any obvious value judgements or
emotions. They can be tested to be proven or disproven and they are often expressed in the form of a
hypothesis that can be analysed and evaluated. Statements about the future can be positive if they can be
proven or disproven in the future.
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, - For example, “Raising taxes will lead to an increase in tax revenue” is a positive statement as it can be
tested to see whether it is true or false. Another example is “Warm weather will lead to an increase in
ice cream sales”.
- A normative statement is one which is subjective and based on opinion, so cannot be proven or disproven.
It often includes words such as ought, maybe, unwise, should etc. or says that one action is better than
another.
- One example of a normative statement is “The free market is the best way to allocate resources” as it
is suggesting one method of resource allocation is better than another, which cannot be tested. “The
government should increase taxes” is also a normative statement, since it presents an opinion.
The Role Of Value Judgements:
- Economists tend to use positive statements to back up normative statements. For example, ‘The
government should increase the interest rate’ is a normative statement which can be a backed up by ‘The
rate of inflation is at 5%’, a positive statement.
- Value judgements can influence economic decision making and policy. Different economists may make
different judgements from the same statistic, for example rising inflation could mean different things
1.1.3 The Economic Problem
- Economists assume that human wants are unlimited
- When faced with a choice between consuming more or consuming less, people will typically choose to
consume more
- This is because consuming goods and services generates pleasure. Economists refer to this pleasure as
utility
- To maximise our utility, we aim to maximise out consumption
- However the supply of goods and services is limited. This is because to produce goods and services,
resources are needed. And the supply of resources is limited
- Economists refer to the resources needed to produce goods and services as factors of production
Scarcity
- Worlds resources are finite, there are limited amounts of land, water, food etc. economists say that these
resources are scarce
- Scarcity: resources are limited in supply so that choices have to be made about their allocation and use
- Means that firms, individuals and governments can only obtain a limited amount of resourced at any
one time
- A household must live on a limited budget as it cannot have everything that it wants
- Resources which are scarce are called economic goods
- Not all resources are scarce e.g. air. These are called free or environmental goods
- Previously food, water and shelter have been free, however with the recent increase in the population of
the planet and production of goods have increased, free goods have decreased
Infinite Wants
- Peoples needs are limited (which must be satisfied if they want to survive), however their wants are
unlimited
- Even though needs are finite, no one would choose to live off basic necessities only if they could have a
higher standard of living
- Human wants are unlimited no matter who the person is
The Basic Economic Problem
- Resources are scarce but wants are infinite
- The basic economic problem forces economic agents to make basic choices – allocating resources
between competing uses
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, -every choice involves a range of alternatives e.g. should the government spend money on nuclear
weapons or education
- choices are made based on what benefits will be gained from each alternative
- this means that other alternatives will have to be given up
- the benefit lost from the next most valuable alternative is what is called the opportunity cost of the
choice
- for consumers, opportunity cost is what was given up when spending money on an item
- for producers the opportunity cost of buying a machine is three or four years of wages for a worker
- for government the opportunity cost of building a fighter plane may be building a new school
- Free goods have no opportunity cost as no resources need to be sacrificed
What is an Economy?
- An economy is a system which attempts to solve the basic economic problem
- Many different levels and types of economy
- Household economy, local economy, national economy and international economy
- Free market economies attempt to solve the problem with minimum government intervention, and the
state make decisions about allocations of resources
- All of these types of economies face the same problem
Three parts to the Economic Problem:
- What is to be produced:
- An economy chooses the mix of goods to be produced
- So which proportion of money should be spent on which goods and services
- How is production to be carried out:
- Where should the goods be made and what from
- For whom is production to take place
- What proportion of output should go to workers? How much should pensioners get etc.
Economic Resources
- Factors of production are the four types of resources available for the production process:
- Land: itself and the natural resources it provides
- Labour: workforce of an economy – not all workers are the same as each have a unique set of skills
- Capital: the stock of manufactured resources used in the production of goods and services
- Working capital is stocks of raw materials, semi-manufactured and finished goods which are
waiting to be sold. Products circulate through the production process until they are sold to a
consumer
- Fixed capital is the stock of factories, offices, plant and machinery. Will not be transformed into a
final product to be bought by a consumer. Used to transfer working capital into finished products
- Entrepreneurs: individuals who seek out profitable opportunities for production and take risks in
attempting to exploit them
Non – Renewable Resources: Renewable Resources
- Coal, oil, gold and copper (land resources) - Fish stocks, wind, solar
- Will be used once and never replaced - Can be used and replaced
Sustainable Resources Non – Sustainable Resources
- Provide intergenerational equity - Diminishing over time due to economic
- Can be exploited economically and not exploitation
diminish or run out - Oil is an example as it cannot be replaced
- A resource is only sustainable if it survives
over time
The Rewards to Factors of Production
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