Unit 1 - Introduction to markets and market failure
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Unit 1 - Introduction to markets and market failure
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Microeconomics Revision Notes
Theme 1: Nature of Economics
Economics is the study of how society organises scare productive resources in order to satisfy people
unlimited wants
Economic Methodology and Ceteris Paribus:
Economics is considered a social science. Economists develop models to understand behaviour.
However, it is impossible to perfectly recreate everything. Therefore, models are based on a set of
assumptions.
§ Models and theories are used to explain real world evidence
§ These models use real life data and can be used to forecast the future
§ Nearly all models rely on assumptions and simplifications
Ceteris Paribus:
§ Economists rely on the ceteris paribus assumption. This means 'everything else remains
equal'.
§ So when economists study the relationship between two factors, they'll assume that one
factor changes while the rest stay constant.
§ This is the most important assumption for economists to create functioning models.
Inability to make scientific experiments
§ Controlled laboratory tests aren’t possible, economists can’t keep variables constant
§ Economists build models based on assumption
Economic decisions don’t always make sense
§ Normative statements- people’s opinions
§ Moral views and value judgements
§ Political judgements (e.g. lowering taxes may win votes for a government)
§ Short term positive consequences of a decision, regardless of long term consequences
Economic statements:
§ Positive statements- are objective statements that can be tested by referring to evidence/
data (‘will’). They include what was or will be (value free statements)
§ Normative statements- are subjective statements which contain a value judgement. They
relate to what ‘ought’ to be, ‘should’/ ‘must’
§ Value judgement- a complete opinion, a judgement as to whether something is right or
wrong
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.
,The Economic Problem:
The basic economic problem is that there are not enough resources to satisfy humans' consumption
demands and desires. It involves working out how to allocate limited resources as effectively as
possible to satisfy people’s unlimited wants and needs
§ The problem of scarcity – where there are unlimited wants and finite resources
§ The distinction between renewable and non-renewable resources
§ The importance of opportunity costs to economic agents (consumers, producers and
government
It’s up to 3 main economic agents to decide how to allocate resources:
§ Producers- people/ firms that supply resources
§ Consumers- people/ firms who purchase the goods/ services
§ Governments- establishes rules for economies
Scarcity
§ The basic economic problem is scarcity. In economics scarcity means that there are not
enough resources to produce all the goods and services which consumers want.
§ Scarcity arises because human wants for goods and services are unlimited but the resources
required to produce them are limited.
Scarce goods and free goods.
§ Scarce goods, also called economic goods, are those which have a price i.e. something has to
be sacrificed to obtain them.
§ Free goods are those goods of which there are enough to satisfy everyone’s wants e.g. fresh
air, sea, water.
§ Free goods have no price.
§ All scarce goods have an opportunity cost whereas free goods do not.
Scarcity is not the same as shortage.
• A shortage is when the demand for a product is greater than its supply.
• Scarcity is when wants for a product are greater than its supply.
Demand means what consumers want and can afford to buy. Therefore if there is enough of a
product to meet the demand of those consumers who want and can afford to pay the price there is
no shortage. However the product will remain scarce because of all those consumers who want the
product but cannot afford to pay the price
The foundation of economic decisions are:
§ What goods/ services we produce
§ How we produce those goods/services
§ Who we produce those goods/ services for
,Factors of Production (CELL) - Consumers have needs and wants that people hope to be satisfied.
This is achieved by economic activity and the production of goods and services.
Factor Description Reward/ incentive
Capital Physical: goods which can be Interest from investment
used in the production process
Fixed: Machines; buildings
Working: finished or semi-
finished consumer goods
Enterprise Managerial ability. The Profit- an incentive to take risks
entrepreneur is someone who
takes risks, innovates, and uses
the factors of production.
Resources are drawn together
into the production process.
Land Natural resources such as oil, Rent
coal, wheat, water. It can also
be the physical space for fixed
capital.
Labour Human capital, which is the Wages
workforce of an economy
These factors of production are inputs, and they produce outputs in the form of goods and services.
This forms the economy.
Economic activity includes a wide variety of actions such as:
§ Production of goods (tangible products) and services (intangible products)
§ Consumption of goods/ services
As resources are scarce – what, how and who to produce for
Renewable and non-renewable resources:
Renewable resources can be replenished, so the stock level of the resources can be maintained over
a period of time. If the resource is consumed faster than it is renewed, the stock of the resource will
decline over time.
This is important in environmental economics, and can be managed by preventing or limiting
deforestation, or imposing fishing quotas. Renewable resources are sustainable. However, currently,
resources are being consumed faster than the planet can replace them. The Worldwide Fund for
Nature claims that two planets will be required to meet global demand by 2050 if this continues.
Non-renewable resources cannot be. Methods such as recycling and finding substitutes, such as wind
farms, can reduce the rate of decline of the resource.
,Choices and Opportunity Costs
Because of the problem of scarcity it follows that choices have to be made. Consumers must choose
what to buy out of their limited incomes. Producers must choose what to produce with their limited
resources. Governments must choose what services to provide out of their limited tax revenues.
Opportunity Cost- The next best alternative foregone for the option that is chosen
§ The cost of one item can be seen as the lost opportunity to consume something else.
Economists call this the opportunity cost.
It is a useful concept when thinking about allocating resources
Issues with opportunity cost
§ Not all factors have alternatives
§ Some alternatives are unknown
§ Agents may lack information on alternatives
§ It can be difficult to switch some factors to another use
The same resources cannot be used to produce different goods at the same time so decisions have to
be made on how to use them, this leads to the opportunity cost. The limited amount of resources
allied to the unlimited wants means that choices have to be made.
Consumers will make choices on how to use their limited income based on what gives them the
greatest level of satisfaction. Producers must choose what to do with their limited resources and their
decisions will be based on profit. The government must make decisions on where they should spend
their limited tax revenues based on what will maximise social welfare. There is no opportunity cost
for free resources.
You can have opportunity cost as a price, or as money and time
§ Sometime opportunity costs exceeds the monetary costs
§ E.g. uni- the total opportunity cost is greater than the financial cost of uni due to the
potential lost earnings
,Production possibility frontiers:
§ The PFF represents the maximum output of any combination of two types of products that an
economy can produce with its current resources and technology
It tends to be drawn as a curve because the first resources switched from capital to consumer good
production are resources that are not adding much to capital goods but will be much more
productive in the production of consumer goods, and vice versa.
It gives no indication of which combination of goods is best and so countries have a choice of what
to produce: economics is concerned with explaining why they chose this point.
Trade-offs: the sacrifice of the production of one good when making a decision to make more of
another good. This is often illustrated by a movement along a production possibility curve
§ People face a trade-off when they make a choices
§ If you choose to buy a video game, you cannot spend that income on movies
§ The opportunity cost would be what you could’ve spent that money on
a) The use of production possibility frontiers to depict:
§ The maximum productive potential of an economy
§ Opportunity cost (through marginal analysis)
§ Economic growth or decline
§ Efficient or inefficient allocation of resources
§ Possible and unobtainable production
b) The distinction between movements along shifts in production possibility curves, considering
the possible causes for such changes
c) The distinction between capital and consumer goods
, PPF and economic growth
§ The PPF shifts outward if there’s economic growth
§ This is because the productive capacity of the economy has increased
§ e.g. this could be caused from improvements in technology
But this improvement isn’t necessary equal across all products
§ e.g. an improvement in the technology to produce better cars isn’t necessarily going to affect
the ability to produce butter
PPF and productive efficiency:
On the line= efficient use of current
resources
Inside the line= inefficient use of current
resources
Outside the line= impossible given current
resources
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