PAPER 3
MICRO
4.1.1.1 Economic methodology
Economics is considered to be a social science because it looks at the behaviour of humans, either
as individuals or as part of organisations (such as firms and governments), and their use of scarce
resources.
The methodology that economists use to tackle economics is similar to the methodology used by
scientists in natural and other sciences (e.g. Biology). Economists will:
• Develop theories and create economic models to explain phenomena (e.g. how exchange
rates are determined).
• Use simplifying assumptions to limit the number of variables in an investigation.
• Test theories and models against relevant known facts, making use of observation,
deduction, graphs, statistics and other tools.
• Use empirical data to improve and revise their economic models.
• Use economic models to make predictions.
However, unlike in natural sciences, economists can’t conduct controlled laboratory experiments
where only one variable is changed at a time. For example, if an economist examines the impact of
price on the demand for cheese, they can’t keep consumers’ income constant — in the real world,
income won’t remain constant.
To get around the problem of the existence of multiple variables in an economy, economists use the
assumption known as ceteris paribus, which is Latin for ‘all other things remaining equal’.
Economists use ceteris paribus when they’re looking at the relationship between two factors (e.g.
price and demand). They’ll assume that only these two factors change and all other factors (e.g.
income, changes in taste) that would have an effect on any other variable being considered remain
the same. Using ceteris paribus enables economists to develop theories and models and make
predictions.
Types of economic statements:
Positive statements are objective statements that can be tested by referring to the available
evidence. For example: “A reduction in income will increase the amount of people shopping in
pound shops.” With suitable data collected over a period of time, you should be able to tell if the
above claim is true or false. Positive statements are important because they can be tested to see
whether economic ideas are correct.
Normative statements are subjective statements which contain a value judgement, they’re
opinions. For example: “The use of fossil fuels should be taxed more highly than the use of
renewable fuels” - it’s not possible to say whether the above statement is true or not — only
whether you agree or disagree with it. Normative statements are also important because value
judgements influence decision-making and government policy, e.g. a political party in government
may wish to increase taxes for the rich to redistribute income to the poor.
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• Value judgements can influence economic decision making and policy. Different economists
may make different judgements from the same statistic. For example, the rate of inflation
can give rise to different conclusions.
• People’s views concerning the best option are influenced by the positive consequences of
different decisions and by moral and political judgements.
4.1.1.5 Production possibility diagrams
The basic economic problem is how best to allocate scarce resources. A production possibility
frontier (PPF) shows the options that are available when you consider the production of just two
types of goods or services. It depict the maximum productive potential of an economy, using a
combination of two goods or services, when resources are fully and efficiently employed.
The PPF below shows the maximum number of houses (on the
horizontal axis) and vehicles (on the vertical axis) that can be
made, using the existing level of resources in an economy.
• Points A, B, C and D (and every other point on the PPF) are all achievable without using any
extra resources. However, they are only achievable when all the available resources are used
as efficiently as is actually possible.
• Notice how, as you move along the curve from A to B, you’re building more houses (about
22 500 instead of 1000) but fewer vehicles (80 000 instead of 120 000). Moving along the
curve from A to B like this corresponds to allocating more resources to the production of
houses, and fewer resources to the production of vehicles. In other words, there’s a trade-
off between ‘building more houses’ and ‘making more vehicles’ — to do more of one, you
have to do less of the other
• Point E lies outside the PPF, so it isn’t achievable using the current level of resources in the
economy. To build that many houses and vehicles at the same time, extra (or better)
resources would need to be found.
• Point F lies inside the PPF (rather than on it) — this means making this mix of goods is
productively inefficient. With the current level of resources, you could build more houses
without making fewer vehicles (or more vehicles without making fewer houses).
• All points on the PPF are productively efficient because all resources are used as efficiently
as possible to produce the maximum possible output.
• Not all points on the PPF are allocatively efficient because not all points will reflect the
production of goods that people want or need — e.g. if all resources are used to produce
vehicles, this might not match society’s need for houses.
A trade-off is when you have to choose between conflicting objectives because you can’t achieve all
your objectives at the same time. It involves compromising and aiming to achieve each of your
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objectives a bit. The trade-off described involves an opportunity cost. The opportunity cost of a
decision is the next best alternative that you give up in making that decision.
Movements along the PPF:
Moving along the PPF uses the same number and state of resources and shifts production from
fewer consumer goods to more capital goods, for instance. This incurs an opportunity cost.
Unemployment occurs when firms/economy are working within the PPF
Shifts in PPFs:
An increase in the quantity or quality of resources shifts the PPF curve outwards, so the productive
potential of the economy increases, and there is economic growth. This can be achieved with the
use of supply side policies.
Economic growth can be shown by an outward shift in the PPF. Similarly, negative economic
growth or decline can be shown by an inward shift in the PPF.
4.1.2.1 Consumer behaviour
Consumers always get marginal utility from consuming an additional unit i.e. they always get
satisfaction from consuming a unit (otherwise they wouldn’t consume it!). So, as more units are
consumed, total utility must increase as consumers get satisfaction from each extra unit. However,
they get less satisfaction from each unit as they consume more units, and this is known
as diminishing marginal utility. Diminishing marginal utility says that, as you consume more of a
good, the utility (or satisfaction) that you get from each additional unit will decrease.
Consumers get positive marginal utility from consuming an additional unit i.e., they always get
satisfaction from consuming a unit (otherwise they wouldn’t consume it!). So, as more units are
consumed, total utility must increase as consumers get satisfaction from each extra unit.
So, for the first unit consumed, the graph shows that the consumer will receive 10 units of utility
(called utils, but don’t worry about that!). That means that the first Mars bar I eat will give me a
huge 10 units of satisfaction! For the second Mars bar consumed, I will only get 8 units of
satisfaction. And by the time I get to my third Mars bar, I’m feeling pretty sick and only get 6 units of
satisfaction.
This gives a downward sloping marginal utility curve.
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Most traditional economic models assume that consumers will behave rationally. A rational
consumer will make decisions which maximise utility. Utility is just an economics word
for satisfaction or benefit.
Behavioural economics
Behavioural economics looks at psychological, emotional and social factors to explain why people
don’t always act rationally.
For example, the model of perfect competition assumes that consumers will behave rationally. So, if
one shop is selling a product for a higher price, the consumer with perfect information will behave
rationally by buying from a cheaper shop. It would be hard for the model to work without this
assumption. If a consumer makes bad decisions (like buying from the more expensive shop even
though they know it’s more expensive!) then the model won’t be reliable. Unfortunately, people do
make bad decisions and behavioural economics attempts to explain reasons for this.
Consumers are most likely to make a rational decision which maximises their utility if they have as
much information as possible about each option.
Being selfish is actually likely to lead to rational decisions as a selfish decision is more likely
to maximise your own utility. It is an altruistic decision (one that increases the utility of others)
which is more likely to lead to irrational decisions.
Bounded rationality refers to our limited mental processing - our limited brain power when it comes
to decision making.
Bounded rationality means our brains just don’t have the brain power to precisely calculate which
deal will maximise our utility and make us happiest in the future - so we might choose badly.
Bounded rationality could be caused by; incomplete information, poor calculation skills
or information overload. Having perfect information will reduce the chance of bounded
rationality rather than cause it. Although, even with perfect information, our limited mental abilities
can still mean that we make an irrational decision which doesn’t maximise utility.
