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Basic Economic Ideas

AS Econs #1

Sue Ann Lim

on 19 March 2013

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Transcript of Basic Economic Ideas

Basic Economic Ideas Money basic economic problem
caused by scarce resources in relation to unlimited human wants
wants are satisfied through consumption of G & S
resources are FOPs which are used to satisfy wants
3 basic decisions to solve problem of allocation: what to produce, how to produce and for whom to produce Economic Systems Factors of production 1. Land all natural resources (renewable & non-renewable)
reward: rent 2. Labour physical & mental work of people
reward: wages 3. Capital man-made goods used to aid production of G & S
reward: interest 4. Enterprise organises the other 3 FOPs & takes the risk of profit or loss
reward: profit AS Econs #1 society cannot produce everything
needs to choose what to G & S to produce and how much to produce
more of one good may mean less of another 2. How to produce Scarcity 3 basic decisions 1. What to produce need to consider how much of each FOP to use in producing G & S
how to maximise use of available resources while considering side effects (moral objections; environmental damage)
usually method w/ least cost is used deciding if everyone will have a more/less equal share of G & S or some will have more than others
deciding how NY is to be distributed among the people positive statements are facts; can be proven true or false
normative statements are opinions; can't be proven right or wrong; uses 'ought to', 'fair/unfair', 'deserve' Opportunity Cost sacrifice of alternatives
definition: the next best alternative forgone when making an economic decision Economic good has opportunity cost
scarce & has economic value Free good has no opportunity cost
not scarce and has no monetary value
e.g. fresh air, sunlight 3. For whom to produce Positive vs Normative Production Possibility Curve also known as production possibility frontier or product transformation curve
illustrates the principal of opportunity cost as it is downward sloping
shows various possible combinations of 2 goods a country can produce if all resources are fully utilised given that technology is constant and resources are fixed
shows max production potential of an economy
any point on the PPC shows the economy's potential output; an economy can't produce outside it's PPC At pt A, all resources are used in the production of consumption gds
At pt B, resources are used to produce 1 unit of capital gds & 9 units of consumption gds
At pt C, resources are used to produce 2 units of capital gds & 6 units of consumption gds
At pt D, all resources are used in the production of capital gds
If the economy chooses to produce more capital gds, it has to sacrifice the production of some consumption gds
Based on the PPC on the left, the opportunity cost of 1 unit capital gds is 3 units of consumption gds
At pt E, there is unemployment of resources (land // labour)
At pt G, it is unattainable because there is not enough resources
Movement from pt C to pt E is known as economic recession
Movement from pt E to pt C is known as economic recovery
Movement from pt B to pt C means no change in current SOL but will cause an increase in future SOL because production of > capital goods will produce > G & S Shapes of PPC bows outwards = increasing OC
linear straight line = constant OC
bows inwards = decreasing OC not all FOPs are equally suitable to produce different G & S
different FOPs have different properties
certain FOPs are more suited for one purpose than another
as an economy concentrates more on production of one good, it has to start using less suitable resources Reasons for increasing OC // diminishing returns: Economic Growth causes PPC to shift right (pt G is now achievable)
due to increase in quantity and/or quality of resources or an improvement in technology Improvement in quantity & quality of FOPs: Land = discovery of new resources or land reclamation
Labour = increase of labour force via immigration
Capital = more efficient machinery, more factories are built
Entrepreneurship = increase in working population
Increase in quality: Technology, education & training Technological progress: increases efficiency of FOPs, thus reducing average costs in the long run
invention, innovation and R & D results in new & better products, better & cheaper methods of production, and less wastage Negative Growth PPC shifts to the left
fall in output of NY
caused by wars, man-made & natural disasters, diseases, or depletion of natural resources 3 types of ES: free market economy, planned economy & mixed economy Free market economy aka 'free enterprise system', 'laissez faire system' or 'capitalist system' Characteristic #1: Private ownership of FOPs almost all FOPs are owned by individuals & firms
govt ownership is limited to public buildings & other facilities provided by the govt such as national defense, law & order, and roads Characteristic #2: Allocation of resources done via price mechanism
individuals aim to obtain max satisfaction from G & S bought
firms have profit motive
prices of G & S, prices of FOPs, & profit motive of producers signal what, how and for whom to produce WHAT TO PRODUCE:
consumers indicate what to produce by spending money on gds they want
price consumers are willing to pay signals to producers that its the good they want
prices respond to shortages & surpluses
ceteris paribus, consumers will buy at the cheapest price
profit motive & prices of FOPs signal to producers how to produce
combination of FOPs which has the lowest cost will be chosen
either labour-intensive or capital-intensive methods are chosen
amount of money consumers spend on G & S depends on their Y
those w/ high Y are able to buy more, & vice versa
those owning FOPs that are highly demanded get higher Y Characteristic #3: Role of Govt minimal & limited
provides legal framework, issues money, protects the environment, provides public goods & intervenes when price mechanism malfuntions a completely free market economy is an ideal which does not exist Advantage #1: Efficient allocation of resources free market economy responds to changing dd & ss conditions quickly & effectively
when there is a surplus, P falls, which signals fall in profits to firms causing producers to cut back production to eliminate initial surplus
when there is a shortage, P rises & producers' profit motive causes them to increase production to meet the shortage
no wastage of resources as there is no over // under production of G & S
market functions automatically; no need for costly & complex bureaucracy to coordinate economic activities Advantage #2: Consumer Sovereignty exists when consumers dictate to producers what G & S they want
production of G & S is determined by P which reflect consumers' wishes
when consumers want more of a good, dd rises, causing P to increase, & profit motive of producers will cause them to produce more; vice versa Advantage #3: Good quality at low P assumed that many firms are competing to sell G & S to consumers
competition forces firms to use cheapest COP so that G & S can be sold at the lowest P possible
competition also forces firms to increase innovation to sell consumers quality goods Disadvantage #1: Unequal distribution of Y P determines what G & S to produce, which means scarce resources are diverted to the production of G & S for ppl w/ more Y
those w/ more Y are able to indicate their dd; thus, they get more G & S
those w/ less Y are less able to indicate their dd
rich gets richer, poor gets poorer; Y of the nation will be invested more in the rich than the poor Disadvantage #2: Market failure (a) missing market
(i) underprovision of merit gds (socially desirable gds for society, e.g. essential services such as educational & health)
these gds tend to be costly to produce
if provided by private sector, can only be afforded by ppl w/ higher Y & not by the poor
(ii) overprovision of demerit gds (socially undesirable gds, e.g. cigarettes & alcohol)
profit motive of producers cause them to produce gds when dd is indicated
these gds are demanded but are detrimental to society's health
(iii) non-provision of public gds (e.g. defense, judiciary)
these gds can only be consumed on a collective basis
no producers would want to produce these gds is no dd is indicated
non-exclusive to payers & non-payers
(b) negative externalities
a cost that affects someone not directly involved in the production // consumption of a good & is incurred w/out compensation
not factored into firms' cost to reflect true cost to society
e.g. production of G & S may cause pollution & ecological destruction, which is not taken into account
(c) imperfect knowledge
in reality, completion in market often breaks down because efforts by firms to restrict competition are successful
a few giant firms such as monopolies & oligopolies may dominate the market
firms exploit consumers by reducing output & charging high P, persuading customers by extensive advertising, thus undermining consumer sovereignty Disadvantage #3: Moral issue by rewarding self-interested behaviour, selfishness, materialism & acquisition of power is encouraged
capitalism has taught society to overconsume
pursuit of wealth in order to buy more G & S has resulted in many broken homes, suicides, etc. Capitalism: an economic & political system in which a country's trade & industry are controlled by private owners for profit, rather than by the state Planned/Command Economy Characteristic #1: Public ownership of FOPs all FOPs are state-owned except for labour
no private properties; all industries are nationalised Characteristic #2: Centralised decision making decisions are made by central planning boards & organisations to enterprises that are state owned
allocation of resources are done by planning mechanism WHAT TO PRODUCE
planners decide whether to produce more capital // consumer gds
decisions are made after considering the collective preferences of consumers & manufacturing enterprises
planners use input-output analysis to make decisions as this method charts the flow of resources in an economy
planners decide what combo of FOPs are used
long-term plans are used to plan EG of a country
Y distribution tends to be more equal as the general community gets more or less the same goods except for the elites
some decisions are decentralised; some choices are left to the individuals
workers receive wages & they are free to choose within limits how to spend their money Characteristic #3: Externalities production decisions are made based on social costs & benefits, i.e. externalities are taken into account associated w/ the Communist/Marxist regime
theoretically, unemployment doesn't exist
exists as an ideal only Characteristic #4: Distribution of Y govt provides basic gds which sets max P for essential gds; thus, P of G & S are within ppl's spending power
firms are state-owend to maximise welfare of society, not profit
Y is said to be equally distributed as ppl more or less enjoy the same amount of G & S Characteristic #5: Inefficient allocation of resources planners don't have perfect knowledge on what & how to produce G & S
wrong amount of G & S are produced at a higher cost
insufficient gds cause shortages which give rise to black markets
there is also abuse of power by ppl in position
special shops are set up for the privileged
surplus may also occur
lack of competition & no profit motive results in no incentive to cut cost or to produce quality gds Characteristic #6: Choice consumers have little // no say in what gds to produce
lack of competition results in poor & non-innovative products
production targets are set in terms of volume only (workers are not penalised for poor quality products) Mixed Economy Characteristic #1: Ownership of FOPs partly by private sector, partly by govt Characteristic #2: Competition & allocation of resources in the private sector: allocation by price mechanism
in the govt sector: allocation by planning mechanism
govt owns key industries, e.g. postal service, healthy service, electricity & water supply Characteristic #3: Govt's role regulates economic activities of private sector
sets min & max P
controls monopolies; prevents 1 company from owning everything
provides merit gds either directly or subcontracted to private firms
controls production of demerit goods Transition Economies an economy that is changing from central planning to free market
usually face severe short term difficulties
e.g. former Soviet Union & its satellite states (Poland, Hungary & Bulgaria) Problem #1: Price liberalisation P of G & S are allowed to be determined by market forces rather than fixed by the govt
when P controls are removed, newly privatised firms charge P that reflect true COP
P skyrocketed (hyperinflation) Problem #2: Restructuring & privatisation enterprises are reformed so that they are capable of producing gds that can be sold in free markets
ownerships of firms are transferred into private hands
many countries lack the capital & financial institutions to lend private firms to buy over SOE Problem #3: Reform of financial sector central bank is needed to control money supply
banks are needed to channel funds to former SOEs
a market needs to be created for govt to borrow funds through selling bonds to finance its expenditure Problem #4: 4 macro problems massive unemployment
SOEs employ more ppl than needed
to be more efficient, newly privatised firms cut back labour costs
reduction in the size of the govt also caused many employees to lose their jobs
-ve EG (GDP fell)
unfavourable balance of payment (BOP) Other problems social disorientation
difficulty in adapting to new conditions Specialisation a system of organisation where individuals // nations are not self-sufficient but concentrate on producing certain G & S and trade the surplus w/ others
divided into specialisation by individuals, firms & nations 1. Specialisation by individuals aka division of labour
production is broken down into a number of simple/specialised tasks
increase in efficiency
increase in productivity
increase in wages
boredom // monotony
difficult to switch jobs // immobile
ppl become too dependent on each other 2. Specialisation by firms a firm only produces one range of products
increase in efficientcy // productivity
increase in production // output
decrease in COP
firm benefits from growing bigger
risk of "putting all eggs in one basket
if dd for the good declines, may suffer from loss 3. Specialisation by nations the nation is not a subsistence economy
does not produce all the G & S it consumes
produces some products & sells its surplus to other countries
products that are not produced have to be imported
increase in efficience, output & GDP
increase in living standards
necessitates international trade; more G & S enjoyed
dependent on others
if dd for the good decreases, there is increase in unemployment & decrease in GDP Function #1: Medium of exchange w/ barter, there must be a coincidence of wants; which is costly & difficult
money is any medium generally acceptable as a means of payment for G & S
avoids the need of double coincidence of wants
encourages trade as it facilitates payment easily; increase in trade -> increase in EG Function #2: Unit of account used to establish values of all G & S
allows ppl to readily compare the relative wort of various G & S
avoids need to measure value of G & S against other G & S
simplifies trading process; promotes trade Function #3: Store of value money tends to hold its value over time
easily storable & kept away; convenient method to hold wealth
when ppl keep money, they are saving
savings supply a source of funds for banks to give loans to firms & individuals; allow businesses // investments to grow; promotes EG Function #4: Standard of deferred payment buying on credit means paying for the good later
using barter is risky as at a later date the gds returned may have lost its value
using money, lenders & creditors have more confidence as they are assured that at the end of the credit period, they will receive money
allows businesses to be done on credit Desirable features of $$: ACCEPTABLE TO ALL
as a means of payment
must have value intrinsically // made legal tender by govt.
convenient, easy to use, light
must be storable & durable w/out its physical properties deteriorating
able to split into diff denominations to facilitate exchange of G & S
LIMITED IN SUPPLY (necessary to be a medium of exchange)
if too abundant, will cause a fall in value
forgeries cause $$ to lose its value & become unacceptable in exchange LIQUIDITY: ease in which assets can be converted to a means of payment
cash is most liquid,houses & properties are not very liquid Inflation & the functions of $$ MEDIUM OF EXCHANGE
almost impossible to destroy this function
for $$ to lose this function, inflation must be extremely high
at its worst, inflation causes ppl to abandon currency of the nation & adopt other currencies UNIT OF ACCOUNT
inflation makes it difficult to compare values of G & S
if P of a good rise due to inflation, it's diff to ascertain how much was due to increase in quality & inflation STORE OF VALUE
inflation discourages savings as it causes the value of savings to diminish
if value of inflation is higher than savings rate, real value of savings will fall
ppl may save in assets that give better returns, causing savings to fall
reduction in source of funds; increase in interest rate in banks; discourage firms from borrowing; reduce investments; limits EG STANDARD FOR DEFERRED PAYMENT
inflation causes value of $$ returned at end of credit period to fall
firms become reluctant to give credit; may insist on cash transactions; discourages trade
special clauses are written into loan contracts to take inflation into account
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