AS Economics Introductory Microeconomics Sixth Form pre-reading
The economic problem Economics is a social science which studies how humans behave when faced by the economic problem of scarcity. Economic problem/scarcity = human wants for goods and services are unlimited, but resources for producing goods and services to satisfy the wants are limited. There are two aspects to human wants Needs = the minimum goods and services required for human survival (limited) Wants = desire for goods and services = needs + non essential items/luxuries (unlimited) Resources at any moment in time are limited because of the restrictions of the Earth. Renewable resources = resources that can be replaced (eg vegetation and people). Non-renewable resources = resources that can only be used once and will ultimately run out (eg fossil fuels, mineral ores). Some of these resources can be recycled. Free good = a good that is not scarce, so is available in sufficient quantity to satisfy all human wants it carries no price because it is not scare (eg air). Economic good = a good that is scarce so there is not enough to satisfy all wants for the good it carries a price that reflects its relative scarcity (eg milk).
The nature and purpose of economic activity The central purpose of economic activity is the production of goods and services to satisfy human needs and wants, thus providing economic welfare. Production = any process that takes resources and uses them to make goods and services. Production can be undertaken by firms for profit eg Fords produce cars individuals for themselves eg cooking lunch government for society eg the armed forces Consumption = any process by which goods and services are used to satisfy human needs and wants ie giving economic welfare. Consumption can take different forms eating a meal watching a film in the cinema taking a walk in the countryside Economic resources Factor of production = one of the limited resources that exist to produce goods and services to satisfy our unlimited wants. The factors of production include Land = any natural resource, except humans, used in production eg minerals, fossil fuels, livestock, crops, rivers. Labour = the human input to production by muscle or brain, skilled or unskilled. Capital = man-made items which help in the production of other goods and services eg tools, machines, factories, etc. Enterprise = the entrepreneur is the decision maker and risk taker in a business. He/she is responsible for putting the money up to start the business and organising the other factors of production within it. Most big businesses today are run by companies in which the entrepreneur s jobs are split between the shareholders, who take the risk, and the managing directors, who make the decisions.
There are three key points to remember about capital capital goods increase the productivity of the land and labour so that more output can be produced from the same amount of land and labour. This allows more wants to be satisfied, making us richer. to get capital goods, resources must be diverted away from producing goods and services for consumption. Consumption is the opportunity cost of capital. each time a capital good is used, depreciation occurs so that the good will eventually need to be replaced. Productivity = the amount of output produced in a firm by a given amount of factor input. Depreciation = the fall in value of a capital good as a result of its use in production over time. The different types of capital are Fixed capital = items like tools and machines that can be used in production many times over. With each use these goods depreciate a little. Working capital = these are stocks of raw materials that are carried by businesses. They represent capital because like a tool or machine, the stocks increase productivity/efficiency of the producer. Stocks can only be used once in production. Social overhead capital = infrastructure like roads is available for all producers and society to use in assisting the production of goods.
The production process Factor Land Labour Capital Enterprise inputs Production process with a set technology Product outputs goods services consumer goods capital goods durable goods non-durable goods Goods = physical items that can be packaged and carried. Consumer goods = goods that satisfy a consumer s want when they are used. Consumer durable goods = goods that satisfy a want over and over again eg cars, computers, furniture, clothes. Consumer non-durable goods = goods that satisfy a want once eg cakes, sweets, drinks. Capital goods = goods that are used to assist in the production of other goods eg tools and machines. Services = tasks that are performed to satisfy a consumer s want. They are not physical items that can be packaged and carried eg haircut, holiday, school lesson.
Choice and opportunity cost As a result of the economic problem of scarcity, people cannot have everything they want from their limited resources, so they are forced to make choices about how to use their resources. Each choice that people make involving scarce resources has an opportunity cost. Opportunity cost = the next best alternative use for some resources that is sacrificed by choice. Free goods have no opportunity cost. Examples of opportunity cost Choosing to save the rainforest has an opportunity cost of less farm land. Choosing to install cashpoint machines has an opportunity cost of jobs for bank cashiers. Choosing to give one patient a heart transplant has an opportunity cost of six hip replacements. Choosing to buy a new coat has an opportunity cost of a pair of shoes. Economic decision making There are three main resource allocation decisions/choices arising from the economic problem of scarcity. What to produce? The consumption decision How to produce? The production decision For whom to produce? The distribution decision Rational behaviour = people behave in a logical or reasoned way when making economic choices, seeking the best possible outcome from the choice. The different economic agents have different objectives that determine their choices/behaviours. Rational consumer behaviour = maximising the utility/satisfaction obtained from spending the consumer s limited resources (money). Rational producer behaviour = maximising the profit obtained from supplying a product. Rational government behaviour = maximising social welfare/welfare of the whole community.
Cost-benefit analysis (CBA) = a process for making economic decisions/choices that compares the costs (disadvantages) and benefits (advantages) of the alternative uses for the resources so that they can be allocated to the use with the maximum net benefit (benefits - costs) for the decision maker. Different categories of cost and benefit to consider. Private cost = any cost of the decision to the decision maker Private benefit = any benefit of the decision to the decision maker. External cost = any cost of the decision to people other than the decision maker (negative externality). External benefit = any benefit of the decision to people other than the decision maker (positive externality). Social cost = the total cost of the decision to the whole of society = private cost + external cost. Social benefit = the total benefit of the decision to the whole of society = private benefit + external benefit. Example of CBA: some of the costs and benefits of choosing to drive to school by car. Private Costs Petrol Depreciation of car External Costs Road congestion Pollution Private Benefits Convenience Can listen to radio External Benefits More space on public transport Greater profit for petrol company The individual will only consider the private cost and benefits when making his/her choices. This can result in resources being allocated in ways that are not necessarily in society s best interest because any externalities are not taken into consideration (conflict of individual welfare v social welfare). The process of CBA Decide the objective for the decision what is to be maximised? Identify all the costs and benefits of the different alternatives. Forecast future costs and benefits where appropriate.
Place present monetary values on all costs and benefits. Make choice between the alternatives. Problems with CBA include Identification of external costs and benefits Placing monetary values on costs and benefits, especially externalities like pollution, loss of human life, etc. Forecasting future costs and benefits. Discounting future costs and benefits to obtain their present values. The need to have a margin for error to allow for uncertainties of CBA. Economic systems as a means of allocating scarce resources An economy or economic system is a decision-making system designed to tackle the three key choices or decisions that stem from the economic problem of scarcity. These decisions are What to produce? How to produce? For whom to produce? The consumption decision The production decision The distribution decision There are three types of economic system designed to cope with these problems. A command or planned economy A free market economy A mixed economy The basic aim of any economic system is to allocate the scarce resources available, thus answering the three key questions above, while minimising any waste of resources. Possible sources of waste include producing goods that people do not want producing goods that people want inefficiently producing goods that people want efficiently, but failing to get them to the people that want them
A Planned Economy (Command economy) In a panned economy, the consumption, production and distribution decisions are made by a group of planners appointed by the government/state. The system has the following features Main economic agents Government (planners) Consumers Factor ownership Motivation Workers All factors of production are owned by the state Planners make decisions to maximise social welfare The consumption, production and distribution decisions are made by planners who collect information on what resources the economy has, and what its consumers want. Strengths of a planned economy All industries are state owned monopolies so there is less chance of consumer exploitation. Planners can ensure that public goods such as national defense are available. Planners can ensure that people have sufficient levels of merit goods, such as health care. Planners can take externalities into consideration when making their decisions. Planners can ensure that there is a job for all so unemployment is not a problem. Planners can distribute goods equally or fairly if they wish, so there is less chance of income inequality. Weaknesses of a planned economy Resources used in planning are not available to produce goods and services to satisfy wants. Planners may get the plan wrong causing gluts and shortages of goods.
Once in operation it is difficult to adjust the plan to cope with changing economic conditions. There is limited choice and variety of goods for consumers. There is little incentive to work hard or to take risks because the state owns all resources and planners decide on the distribution of goods. The economy is likely to grow more slowly and technology may lag behind others. Planners may be corrupt in their decision making.
A Free Market Economy (Capitalist, laissez-faire economy) In a free market economy, the consumption, production and distribution decisions are solved by the operation of market forces and the price mechanism. The system has the following features Main economic agents Consumers Producers Factor ownership Motivation Owners of factors of production All factors of production are privately owned Individuals make decisions to maximise individual welfare The consumption decision is made in the markets for goods and services. People spend their money on the goods they want most, thus registering votes. Popular goods attract more votes, sell quickly and rise in price. Unpopular goods attract few votes, remain unsold and fall in price. Producers respond to these price changes in order to make profits. They expand the output of popular goods and cut back output of unpopular goods, thus allocating resources in a way consistent with what consumers want. Producers in competition with each other make the production decision. They will produce goods as efficiently as possible to keep their costs to a minimum. This allows them to keep prices low to compete with other firms, and to make maximum profits on the goods they sell. The distribution decision is made in the markets for factors of production. People own various factors and they sell the services of these factors to producers. The price that they receive for the factors will be their income, which in turn determines how many goods and services they can afford to buy, and hence their share of the economy s output. Strengths of a free market economy Competition in markets promotes an efficient use of resources. Competition produces a greater variety of goods and hence more choice for consumers. Risk taking and initiative are encouraged by the profit motive, and these are likely to promote economic growth. The price mechanism adjusts quite quickly to changing economic conditions so that resources are not wasted producing unwanted goods or being unemployed.
Weaknesses of a free market economy Competition may break down, causing market failure, such as monopolies, which charge higher prices for fewer goods. Markets may not operate efficiently causing some resources to be unemployed. Public goods, like streetlights, will not be provided in markets because free riders can enjoy the benefits of the goods without paying, so nobody will pay and firms cannot make profits. Merit goods, like education and health services, can be provided at a price in markets, but some people may choose not to buy them, so they will be under consumed to the detriment of society the workforce will deteriorate in quality. Decisions are made solely on private costs and benefits, thus ignoring external costs, like pollution, and external benefits. As a result, resources may not be allocated in a way that is not in society s best interests. An unequal distribution of income occurs because some people own factors of production, which are scarcer than others and are paid more. These richer people can divert resources into making luxuries at the expense of necessities for the poor.
A Mixed Economy A mixed economy contains elements of both a market economy and a planned economy. The key decisions of what? how? and for whom to produce? are partly answered by market forces and partly by government planners. Main economic agents Consumers Producers Owners of factors of production Factor ownership Motivation Government Mixture of private and public ownership Private sector individuals make decisions to maximise individual welfare Public sector planners make decisions to maximise social welfare The functions of the government in the UK economy include The provision of goods that would not be provided by private companies (such as national defense) The redistribution of income from rich to poor. The control of externalities and consumption of demerit goods. The protection of individuals against powerful market influences like monopolies. The management of the economy to the macroeconomic policy objectives The aim of a mixed economy is to get the best of both systems without too many of the disadvantages. All countries have mixed economies, but the strength of the mixture varies. In the UK, about 60% is determined by market forces and 40% by planners. To what extent are incentives needed to promote economic growth?
For any economy to move beyond a basic subsistence level, it needs to produce a surplus above that which is needed to sustain life. Crucial to the ability to produce a surplus is the idea of Specialisation. Specialisation Specialisation = organising scarce resources so that people are not self sufficient, but concentrate on producing certain goods and services. This helps to maximise output from these limited resources, helping to resolve the economic problem more effectively. Division of labour = specialisation by workers in production. It can take two forms by product = workers specialise in producing a whole good or service by process = workers specialise in one aspect of the production of a good or service Benefits of specialisation/division of labour include increased labour productivity better quality and more consistent quality goods talent and ability are utilised more effectively time is saved changing tasks, training workers, etc the best capital goods can be used because they are in constant use practice makes perfect for workers Costs of specialisation/division of labour include worker boredom and monotony of work over specialisation makes it difficult for workers to find new jobs when unemployed technological unemployment machines replace workers in simple tasks interdependence if one specialist link in the production chain breaks, the whole chain stops Measures can be taken to overcome these costs job rotation, worker retraining, etc. Specialisation operates on several levels individual workers firms towns regions countries A consequence of specialisation is that people produce surplus products, which need to be exchanged. This exchange takes place in markets. Your Unit 1 AS Level paper is entitled Markets and Market Failure, so how markets operate is crucial to your understanding of the subject. This will be covered in detail in your classes.