Theme 1 Revision Notes: Introduction to Markets and Market Failure
1.1 Nature of Economics
Economics as a Social Science
- Economists develop models to explain how the economy works (e.g. theories of supply and
demand.) These are developed by gathering evidence for the model and adapting it.
- A theory can often be expressed in words, whereas models require greater precision and are
expressed in mathematical terms. Assumptions are made to make models useable and focus
on certain variables.
- Ceteris Paribus: All other things remain equal (allows economists to focus on the relationship
of two variables whilst others remain constant)
- Economics is a social science due to two mains reasons; there are too many everyday
variables affecting results, making it difficult to test hypothesis, and human behaviour
cannot be reduced to a law and be falsified with empirical data, making economics a social
science.
Positive and Normative Statements
- A positive statement is one that can be proven/disproven with empirical data; it is objective.
A normative statement however is opinion based; it is a value judgement, For example, ‘it is
24 degrees Celsius today’ is a positive statement, whereas ‘it is warm today’ is a normative
statement.
- Economists tend to use positive statements to back up normative statements; value
judgements can therefore influence economic decision making and policies.
The Economic Problem
- Needs and Wants – Needs refer to the minimum required for an individual to survive,
including food, water and shelter. Wants refers to the desires by individuals in the
consumption of goods and services – these are unlimited and not essential to survival.
- The basic economic problem is that human wants are unlimited whereas resources are
limited – scarcity exists. Therefore, economic agents are forced to make three key decisions:
what to produce, how to produce it and whom to produce it for.
- Opportunity cost: the cost of the next best alternative forgone
- Resources can either be renewable or non-renewable. A renewable resource is one that can
be replenished over time so that it will not run out. A non-renewable resource cannot be
replenished or replaced and will eventually run out – its amount is finite.
,Factors of Production
- Land – Natural Land that includes land on which minerals are extracted from, land on which
shops are built on and also the sea.
- Labour – Human input that refers to the skills to produce goods and services
- Capital – Human made input such as tools, machinery and technology (developed through
investment)
- Enterprise – Individuals that organise the other factors of production and take risks to make
profit.
Production Possibility Frontiers
A PPF shows the maximum potential output of two goods an economy can produce given
the resources available.
Pareto Efficiency is when we have a situation in which we cannot make on consumer or
household better off without making another one worse off.
Productive efficiency - using your resources to produce the maximum possible output (all
points on the PPF line).
Allocative Efficiency – optimal allocation of resources for society
Opportunity cost is the cost of the next best alternative forgone. Consumers make their
choices on how to use limited income based on various factors such as level of satisfaction.
Producers choose what to do with their limited resources based on profit, and governments
make choices on where to spend tax revenue to maximise social welare. All three of these
economic agents make decisions which have opportunity costs.
Law of Diminishing Marginal Returns – Falling Change in Output. After a certain level of
production is reached, adding a factor of production will result in smaller increases in
output. For example, at a manufacturing factory, after a certain capacity adding more
workers will result in less efficient production.
Capital goods are machinery used to produce consumer goods, whereas consumer goods are
the final goods that satisfy the wants and needs of an individual. Shifts outwards in PPFs are
caused by the increase in quality or quantity of:
- Capital (e.g. increased investment, research and development)
- Land (Fertile land, more land available)
- Labour(more workers due to immigration, higher skilled workers)
- Enterprise (training)
, Specialisation and the Division of Labour
Specialisation refers to individuals, firms or an economy deciding to focus on the production
of one specific good or part of a good. The division of labour refers to the process of splitting
up the production process and allocating each to a different worker.
Advantages of Specialisation:
- For the Individual: Minimal range of skills, easy to learn. By repeating a task over and over
again productivity and efficiency should increase.
- For the Firm: Output of firm should increase and training time reduced.
Disadvantages of Specialisation:
- For the Individual: Monotony of repeating a task over and over again could decrease
production, and there is a lack of flexibility.
- For the Firm: High staff turnover due to monotony of job, difficult to coordinate production
as firm expands further.
The disadvantages of specialisation can be overcome by:
- Automating simple jobs
- Incentivising workers with time off or wage bonuses
- Multi-roles, certain degree of flexibility whilst maintaining specialisation.
Adam Smith stated the concept of specialisation and the division of labour and how it can
increase output per worker. Firms can increase efficiency and lower production costs of a
factory, with the example of pin making being split into 18 different tasks, resulting in a 5000
pin per day more in production compared to if each person made an entire pin.
Functions of Money
Money has 4 key functions.
- Medium of exchange; it can be used to buy and sell goods and is acceptable everywhere
- A measure of value; money can compare the value of two goods, and also puts a value on
labour
- A store of value; money retains its value and is able to do so for a long time.
- A method for deferred payment; money allows debts to be created; people can pay for
things in the future, as money stores its value.
Types of Economies
A free market economy is an economy in which individuals are free to make their own
choices; consumers make decisions based on satisfaction and producers based on profit. In a
free market economy, there in no government intervention; there are no free market
economies in the world today, as all governments play a role in the government to some
extent.
