Economics. Synopsis. 1. Economic Concepts, Issues and Tools. 2. An Overview of Economics. Sections. Learning Summary. Sections

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1 Synopsis Economics 1. Economic Concepts, Issues and Tools 1.1 Introduction 1.2 Scarcity and Choice 1.3 Preferences, Resources and Economic Efficiency 1.4 Marginal Analysis and Opportunity Cost 1.5 Different Economics Systems 1.6 Production Possibilities Curve This module has taught you that it is the dual existence of insatiable wants and limited resources that produces for all societies the fundamental fact of scarcity, and consequently the need for choice. Resources used to satisfy one want are no longer available to satisfy others. The decisions to be faced by all societies are the what, how and for whom decisions. A useful tool for analysing problems involving maximisation is marginal analysis a technique that pervades all aspects of economics so that it is important that you master the concept at this stage. You are now aware that not all societies solve the what, how and for whom problems in the same way and you know the differences among them. One useful tool for analysing output decisions facing an economy at a point in time and also over time is the production possibilities curve. You are now reasonably familiar with this tool you will meet it again. 2. An Overview of Economics 2.1 Introduction 2.2 Strengths and Weaknesses of the Capitalist System 2.3 Macroeconomics an Overview

2 3. Demand 3.1 Introduction 3.2 The Theory of Consumer Choice 3.3 Individual (Household) Demand 3.4 Market Demand 3.5 The Theory of Consumer Behaviour and the Real World The keystone of the market mechanism is the determination of prices. To understand this mechanism requires you to appreciate the interaction between demand and supply. This module has introduced you to the first of these and you have learned to distinguish between movements along a demand curve and shifts in a demand curve, and the relevant factors involved in both. The importance of the concept of elasticity is reflected in its relationship to total expenditure, a concept vital to both firms and governments in setting prices and taxes. You now understand the meaning of equilibrium conditions for maximising consumers utility and how expenditure on goods and services changes as prices, incomes and other related factors change. Such an understanding is a necessary condition for grasping the meaning of economic efficiency in a market economy (Module 6). 4. Supply 4.1 Introduction 4.2 Productivity 4.3 Costs 4.4 Firm Supply in the Short Run 4.5 Market Supply 4.6 Real-World Applications You should by now understand thoroughly the relationship between productivity of factor inputs and cost of goods produced and that underlying every cost curve is a productivity curve. You can derive average and marginal productivity curves from total production functions, and marginal and average cost curves from total cost functions. You are able to use marginal analysis to find profit-maximising outputs at different prices and profitmaximising input combinations for different levels of output. You can now explain the difference between the short and long run, understand the significance of fixed costs versus variable costs, know the meaning of equilibrium for the

3 firm in both the short and long run, and derive market supply curves. You can distinguish between returns to factor input and returns to scale. 5. The Market 5.1 Introduction 5.2 Market Supply and Demand 5.3 The Operation of Markets 5.4 Changes in Market Equilibrium 5.5 Intervention in the Market 5.6 Dynamic Adjustments in the Market You are now in a position to understand how the forces of demand and supply in competitive markets determine equilibrium prices and equilibrium quantities of goods bought and sold. You can explain how equilibrium prices and quantities respond to changes in demand and supply. (You will meet the concept of equilibrium again and again as you make progress through the course.) You are also able to explain how price ceilings and price floors can lead to black markets and surpluses respectively in controlled markets. You understand the impact of sales taxes on both prices and quantities. You can explain why some markets adjust only after a time lag and why such adjustments can cause the price of the goods in question to fluctuate in a cyclical fashion. 6. Economic Efficiency 6.1 Introduction 6.2 The Marginal Equivalency Conditions 6.3 Resource Allocation and Profit-Maximising Behaviour in the Short Run 6.4 Resource Allocation and Profit-Maximising Behaviour in the Long Run 6.5 The Wonderful World of Adam Smith versus the Real World The meaning of economic efficiency is captured in the marginal equivalency conditions. In understanding these conditions you have become familiar with the utility-maximising behaviour of consumers and the profit-maximising behaviour of firms and you have seen how market prices are the common factor in establishing the marginal equivalency conditions. You can distinguish between profit-maximising behaviour of firms in both the short run and the long run and are able to show the implications for resource allocation. You also

4 realise the differences between the real world and the world of economic models and the fact that, while market forces tend to produce an efficient allocation of resources, there is no guarantee that economic efficiency will ever be attained. You are aware of the real-world factors that prevent the achievement of economic efficiency and how such factors affect society s well-being in the long run. 7. Organisation of Industries 7.1 Introduction 7.2 Perfect Competition 7.3 Monopoly 7.4 Imperfect Competition 7.5 Oligopoly 7.6 Regulation and Economic Efficiency The assumption of perfect competition is relaxed and different forms of the real-world organisation of industries are introduced. You understand the differences among perfect competition, monopolistic or imperfect competition, oligopoly and monopoly, and recognise what types of goods and services are produced by the different types of firms and why. You are able to explain why only in perfectly competitive markets do prices equal marginal costs, and you can explain the implications for economic efficiency. Finally, you are able to understand the issues involved in regulating monopolies and oligopolies to achieve both economic efficiency and the benefits of economies of scale. 8. Public Goods and Externalities 8.1 Introduction 8.2 Private Goods and Public Goods 8.3 Externalities: Positive and Negative 8.4 Externalities, Collective Action and Economic Efficiency 8.5 The Problems of Collective Decision Making You can distinguish between private goods and public goods and explain the free rider problem. You understand why the price mechanism fails to provide the optimum amount of public goods and why collective action is necessary. You also understand why the decision on what public goods and how much of each public good to produce is a separate issue from who should pay for them.

5 You realise why, in the presence of externalities, private and societal benefits, and private and societal costs, diverge and why, therefore, economic efficiency does not prevail. You are able to explain how the establishment of property rights, as well as the use of taxes and subsidies in the presence of externalities, can bring about a more efficient allocation of resources. Finally, you have been exposed to the difficulties inherent in reaching a social consensus through the voting mechanism the single failure of the democratic system? 9. Income Distribution 9.1 Introduction 9.2 Marginal Productivity 9.3 Economic Rent 9.4 Monopsony 9.5 Trade Unions 9.6 Income Distribution, Collective Action and Economic Equity You now understand how factor prices are determined by the forces of demand and supply, and how the demand for factors is determined by the value of the marginal product of these factors. You are able to explain the meaning of economic rent. You understand the meaning of monopsony power and trade union power in factor markets, and how the presence of either in a factor market affects returns to the factors of production and quantities hired. Finally, you can demonstrate how market forces determine income distribution in society and the advantages and disadvantages of the tools available to alter the market-determined distribution. 10. International Sector 10.1 Introduction 10.2 The Theory of Absolute Advantage 10.3 The Theory of Comparative Advantage 10.4 The Terms of Trade and Voluntary Exchange 10.5 Tariffs and Quotas 10.6 Arguments for Trade Restrictions 10.7 Exchange Rates 10.8 The Balance of Payments 10.9 The Operation of the International Sector (Simplified Model)

6 You are now able to distinguish between the theory of absolute advantage and the theory of comparative advantage, and understand why all countries can gain from international trade. You understand why trade restrictions lower the volume of exports and imports, and consequently the world s consumption possibilities but may benefit a few protected workers at the expense of many. You can explain how international trade is financed, what constitutes the balance of payments, what determines the amount of international lending and borrowing, and what determines exchange rates. 11. Macroeconomics Overview 11.1 Introduction 11.2 Potential and Actual Output 11.3 The Demand for Gross National Product 11.4 Policy Tools 12. Potential Output 12.1 Introduction 12.2 Potential Output in the Long Run 12.3 Measuring Potential Output 12.4 The Relation Between the Unemployment Rate (U), Potential Output (Q) and Actual Output (Y) 12.5 Output and Inflation You can now distinguish potential output from actual output and are thoroughly familiar with the representation of both of these concepts on the production possibilities frontier. You understand the factors that cause potential output to grow over time, i.e. growth in the quantity and quality of the labour force, and growth in the quality and quantity of the capital stock, recognising the important role of technological change. You also understand the concepts of gross investment, net investment and depreciation, and their impact on the capital stock and, simultaneously, the causes and characteristics of different types of unemployment in the labour force. While later modules will analyse the causes of unemployment and inflation in detail, you currently understand why, when actual output is less than potential output, unemployment must result. You also have a basic grasp of the mechanisms that cause prices of goods and services and factor inputs to rise and fall, and why some prices are sticky downwards,

7 leading to the inflationary bias that exists in market economies. Understanding what inflation is, requires a grasp of price indexes, from which various measures of inflation are derived. You are familiar with Okun s Law, the relationship between changes in the unemployment rate and changes in the output gap. You recognise the Phillips Curve and understand how changes in aggregate demand influence both the unemployment and inflation rates in the short run. You are also aware that a shifting Phillips Curve over time can have inflation rates and unemployment rates moving in the same direction, whereas a movement along a Phillips Curve shows higher inflation rates associated with lower unemployment rates. The curvature of the Phillips Curve suggests the short-run inflation unemployment trade-off is not constant but varies depending upon where an economy actually is on the curve. Finally, you understand that the existence of the Phillips Curve can pose a dilemma for policy makers desiring low rates of both inflation and unemployment. 13. The Circular Flow of Income 13.1 Introduction 13.2 The Structure of the Economy: A Two-Sector Model 13.3 The Equilibrium Level of National Income 13.4 The Savings Investment Schedule 13.5 The Concept of Equilibrium You now understand, given the assumptions of the simple model devised, that output and employment move together in a fixed relationship. There are two vital lessons to be learned from this module. The first is that economic activity is like a coin it has two faces; it can be recognised and measured by looking at the output side or the income side it doesn t really matter which, for you get an identical measure of economic activity. If Robinson Crusoe and Man Friday shake down 20 coconuts, the output of their island economy is 20 coconuts; their income is also 20 coconuts. The second important lesson is that while income recipients earn sufficient income to purchase the output they produce, they may not elect to spend that income on the currently produced output of goods and services. This decision determines whether output in the next time period increases, remains constant or decreases. You now understand the difference between intermediate goods and services, and final goods and services; only final goods and services are considered in the GNP accounts. You can also recognise that GNP can also be calculated by summing the value added of all firms in the production process. If households plan to spend less on goods and services than firms anticipate, household planned savings will exceed firms planned investments and there will be a leakage from the circular flow of income, causing total output to contract. Conversely, if planned savings are

8 less than planned investment, with people buying more goods and services than firms anticipated, output will expand provided always that sufficient unemployed resources exist. 14. A Simple Model of Income Determination 14.1 Introduction 14.2 The Development of Macroeconomic Models 14.3 The Consumption Function 14.4 The Solution to the Simple Model 14.5 The Multiplier You are strongly advised to accept the reasoning, however apparently divorced from reality, of economists. Such reasoning attempts to isolate the important variables in the macroeconomic world and estimate how changes in certain factors affect incomes, output and employment. You now understand the similarities and differences between economic models and hard science models. These differences in the real world are small. While the physical sciences have laboratories, economics has as its laboratory the real world. The constantly changing nature of the world poses problems for the economics researcher. Exogenous shocks and the imperfect specification of models provide challenges for physical scientists and economists alike. You have a firm grasp of the short-run and long-run consumption functions and understand how the multiplier is derived from the slope of the consumption function. You are able to solve the simple model and understand the meaning of equilibrium. You understand how autonomous changes in aggregate demand lead to induced changes in demand, and how these changes affect output and employment. You are also aware of the factors that limit the full multiplier effect. 15. Expanded Model of Income Determination 15.1 Introduction 15.2 The Investment Function 15.3 The Government Sector 15.4 In-Built Stabilisers 15.5 The International Sector 15.6 Business Savings

9 You are now able to distinguish between the simple model of income determination and the expanded, more realistic, model. The concepts understood include the marginal efficiency of investment, the cost of financing investment, expected rates of return on investment over time, uncertainty and risk, and the accelerator principle. You understand the importance of the government sector as it affects the circular flow of income and how the government, by altering various taxes, transfers and expenditures, can affect output and unemployment. You are familiar with in-built stabilisers and their impact on the economy and know how to calculate the government budget. You can analyse the impact of imports, exports and business savings on the circular flow of income, and are thoroughly familiar with the income expenditure equality. 16. Fiscal Policy 16.1 Introduction 16.2 Deflationary and Inflationary Gaps 16.3 Real and Money GNP: Index Numbers 16.4 Fiscal Policy This module summarises the contents of Modules It is important at this stage that you can distinguish between potential and actual output, and understand that when they are not equal to each other, an inflationary or deflationary gap emerges. You can explain the implications of both types of gap and understand what the government can do to bring about equality. You are able to distinguish between real and money GNP, and know the difference between current and constant prices. You understand the policy implications of the naive monetarist view versus the naive Keynesian view. 17. Money, the Central Bank and Monetary Policy 17.1 Introduction 17.2 The Function of Money 17.3 A Brief History of Banking 17.4 The Fractional Reserve System, Credit Creation and the Credit Multiplier 17.5 The Central Bank and Monetary Policy

10 You now know what money is, what characteristics it must possess and what its three main functions are in the economy. You understand how the banking system operates and how it developed from the gold days to the modern fractional reserve system. You understand the system of credit and a bank s balance sheet. You are now aware of the function of the central bank in controlling commercial banks to support the monetary policy of an economy. You also understand how monetary policy can affect the level of aggregate demand, and consequently, national income. 18. The Quantity Theory and the Keynesian Theory of Money 18.1 Introduction 18.2 The Quantity Theory of Money 18.3 The Keynesian Theory You can now understand the central role that money plays in the Quantity Theory and the Keynesian theory, and the resulting possible impact on aggregate demand. You are also able to explain the role of interest rates in affecting investment expenditure and aggregate demand, and why monetary policy may be ineffectual under specific assumptions. 19. Integration of the Real and Monetary Sectors of the Economy 19.1 Introduction 19.2 Equilibrium Interest Rates and National Income Levels The Monetary Sector 19.3 Equilibrium Interest Rates and National Income Levels The Real Goods Sector 19.4 The Expanded Model: Shifting the Curves This module pulls together much of the analysis of earlier modules. You are now in a position to understand how equilibrium is determined in the monetary sector and how each level of national income is associated with a unique interest rate. You can trace this connection through the separable demand functions for money and money supply. In a similar vein, you should understand the connection between different levels of income and interest rates in the real goods market and are able to trace the interconnection through the savings function and marginal efficiency of investment function. By combining the monetary and real goods sectors, you can see how an interaction between the two produces a level of income and a rate of interest that together achieve equilibrium in both sectors simultaneously.

11 The macroeconomic model is then expanded and you can analyse how the policy tools at the disposal of governments cause the IS and LM curves to shift, producing new equilibrium outputs. You have also become aware that the relative efficiency of fiscal and monetary policies is critically affected by the existing state of the economy, that is, by the existing positions of the IS and LM curves. 20. Inflation and Unemployment 20.1 Introduction 20.2 Causes and Effects of Inflation 20.3 Anti-Inflationary Policies 20.4 The Modern Quantity Theory versus Keynes: Policy Implications 20.5 National Goals: Policy Implications You now understand that the IS/LM analysis produces equilibrium only in the real goods and money sectors; that is, it tells us what the level of national output and what the interest rate will be. Knowing the levels of actual and potential output tells us what the unemployment rate will be. What remains to be determined is the inflation rate. The two schools of thought, the Keynesians and the monetarists, have different explanations of what determines the inflation rate; you have been made aware of these differences. For the monetarists, inflation is a monetary phenomenon alone; for the Keynesians, many factors can affect the price level. The importance of the different schools of thought arises when policy issues are discussed, since the appropriate policy to deal with inflation will depend on the type of inflation. You are also aware that low inflation and low unemployment rates are not the only two desirable macroeconomics goals, but increasing the number of goals increases the complexities of policy making. Again, the differences between the monetarists and the Keynesians emerge. You understand why the monetarists believe that there are equilibrating forces at work in the economy and why the Keynesians believe there is no inherent tendency for an economy to return to full employment with price stability. 21. Economics and the World Today 21.1 Introduction 21.2 Developing Countries 21.3 The Changing Global Economy 21.4 The Pessimists versus the Optimists 21.5 Globalisation 21.6 The Environmentalists

ECONOMIC ENVIRONMENT LEVEL 1 PAPER 3 STUDY TEXT

ECONOMIC ENVIRONMENT LEVEL 1 PAPER 3 STUDY TEXT www.naarocom.com Page 1 OVERALL AIM To enable the learner develop knowledge and understanding of the economic environment in which businesses operate LEARNING