Introduction to - Weebly



Introduction to

Microeconomics

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o Positive and Normative Economics

o The Basic Economic Problem

o Opportunity Cost

o Production Possibility Frontiers

o Specialisation and Division of Labour

o Free Market & Mixed Economies

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Microeconomics vs. Macroeconomics

There are two main strands of economics – microeconomics and macroeconomics. During Year 12 the first module examines ‘micro’, whilst the second module is studying ‘macro’

Put simply, microeconomics is the study of individual markets, e.g. labour markets, whereas macroeconomics is the study of the entire economy as a whole e.g. studying the UK and EU economies.

Positive vs. Normative Economics

|Positive Statement |Statements that can be tested or rejected by referring to the available evidence and |

| |involve objective explanation. |

|Normative Statement |Statements that express a value judgement about what ought to be. They are subjective |

| |statements rather than objective statements |

For example, the top two statements are positive statements whereas the final two are normative statements.

• A rise in consumer incomes will lead to a rise in the demand for new cars.

• A reduction in income tax will improve the incentives of the unemployed to search for work.

• The level of duty on petrol is too unfair and unfairly penalizes motorists.

• The London congestion charge for drivers of petrol-guzzling cars should increase to £25 - three times the current charge.

EXAM TIP:

• In exam questions you need to explain why particular statements are normative or positive

Governments use value judgements to help make policy decisions

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Governments have to make multiple decisions about the direction of economic policy. With such a wide range of decisions to make it is not possible for all these to be tested, if it is even possible to do so. Therefore policymakers have to use value judgements when constructing their policy decisions.

The political party in place could therefore make different policy decisions based on their own opinions and ideologies. In general Conservative governments have been more in favour of free markets and less Government intervention, whereas traditional (Old) Labour governments have a preference for state intervention and helping provide social protection for all.

For example different economists may have different value judgements about the following:

• How much should we tax the rich and the poor?

• Who should receive benefits from the Government?

• Should we join the Euro?

• How large should the London Congestion Charge be?

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Introduction

Although there are different types of economics (micro, macro, positive, normative) they are all trying to solve one thing. Governments, producers, consumers and all other members of economies suffer from: the fundamental economic problem.

Economic Resources

The world has a limited number of resources (or factors of production). These can be classified as:

• Land: not just physical land, includes resources underground and in the sea/air

• Labour: is an economy’s workforce and the skills/training they have

• Capital: is the manufactured stock of tools, machines etc used in the production of goods and services

• Enterprise: is skill entrepreneurs have, specifically in organising other factors of production and taking risks by setting up business enterprises.

Resources can also be classified as renewable and non-renewable:

• Non-Renewable Resources: are resources that will never be replaced once they are used e.g. coal, oil, copper

• Renewable Resources: are resources which can be used and replaced

e.g. solar power (the Sun), wind power (wind)

However, sustainable resources are a particular type of renewable resource. Sustainable resources are ones which are used up at the same rate as they are renewed i.e. if they are managed well they are renewable but if managed badly they are non-renewable.

For example, a forest is a renewable resource but it is only sustainable if due to good management it survives over time despite commercial logging etc. Clearly if the forest is cleared and a factory built on the land the forest ceases to be a sustainable resource at all.

Needs, Wants & Scarcity

People’s needs are also finite (shelter, water etc.)

However, people have an unlimited number of wants (CDs, healthcare, houses, swimming pools etc.) and given there is only limited resources we cannot fulfil all these wants.

There are literally not enough resources in the economy to make all the goods and services we desire; this problem is called scarcity.

Choices and Opportunity Cost

|Opportunity Cost |The value of the next best alternative foregone |

Due to scarcity in the economy we all have to make choices:

• Governments only have certain tax revenue to spend on the economy

e.g. spend on healthcare or defence?

• Firms only have a certain amount of finance with which to invest

e.g. buy a new factory to expand production or researching new products?

• Consumers only have a certain amount of income with which to spend/save.

e.g. spend on TV or save for a holiday?

Whenever choices are made there is always a cost of the alternative we gave up, this is called opportunity cost. More specifically the opportunity is the value of the second best alternative that cannot now be chosen.

Most goods are scarce and have an opportunity cost, these goods are called economic goods. Scarce resources are limited in supply and therefore choice need to be made about their use. However, some have no opportunity cost and these are called free goods; such as the air we breathe (unless we pollute is significantly).

The Allocation of Resources

Economics is the study of how resources should be allocated – what choices should be made. More specifically any economy has to answer three questions:

1. WHAT goods & services should be produced and in what quantity?

2. HOW is the production of these going to be organised?

3. FOR WHOM are the goods and services produced for?

We will later study how market and planned economies answer these questions in very different ways.

Opportunity Cost Example

Orange Wednesdays: a waste of resources?

Do you think that Orange’s spending on cinema advertising is worthwhile for the company?

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For several years Orange has prominently used cinema advertising to promote its Orange Wednesday’s two-for-one cinema ticket promotion. Some commentators suggest that advertising is wasteful and has limited impact on consumers.

• What is the opportunity cost of Orange spending on cinema advertising?

• What are the benefits and/or drawbacks of their cinema policy

• Would they be advised to use their money in another way?

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1. What are PPFs?

|Production Possibility Frontier |A PPF shows all the maximum combination of goods and services that can be produced in a |

| |given period with available resources being used efficiently |

This definition is very important and fairly detailed but all elements are important in order to get a mark for a definition in the exam. It states that it shows the maximum combination of goods and services, it is not just the maximum of one good. It is in a given period of time where some factors of production will be fixed (i.e. the short-term). Finally it is with all resources used efficiently i.e. resources are working at their highest potential in order to achieve the maximum combination of goods and services.

2. The Production Possibility Frontier showing Efficiency / Inefficiency

Mark on this PPF (showing the trade-off between consumption and investment), the following points:

A: an efficient allocation but producing only consumption goods

B: an efficient allocation but producing only capital goods

C: a different efficient allocation

D: an inefficient allocation with unemployed resources

E: an unfeasible allocation

F: an allocation that will benefit living standards in the long-run

3. The Production Possibility Frontier and Opportunity Cost

• When an allocation is inside the PPF there is no opportunity cost involved as there are unemployed resources which were previously not in use.

• However, when an economy is operating efficiently on the frontier there are opportunity costs involved.

An example:

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The Shape of the PPF and Opportunity Cost

• If the PPF is a straight line then the opportunity cost will be the same along the length of the line.

• However, if the PPF is not a straight line and is bowed then the opportunity cost will vary. The nearer to the extremes the higher the opportunity cost.

• We will consider reasons for this later in the handout (law of increasing costs)

4. Shifts in the Production Possibility Frontier & Economic Growth

• If the PPF shifts outwards then this shows an increase in the productive potential of the economy or economic growth

• Economic growth means that the economy has grown in size in terms of what it can produce i.e. its productive potential has increased.

• Economic growth occurs if there is an increase in the quantity or quality of an economy’s factors of production (land, labour, capital and enterprise)

• PPFs can also shift inwards if there is a reduction in the quantity or quality of factors of production e.g. natural disasters.

Illustrate economic growth using a PPF and give three reasons why this may have occurred:

|Cause of Growth |Impact on Factors of Production |Any downsides? |

|1. Education | | |

| | | |

| | | |

|2. Healthcare | | |

| | | |

| | | |

|3. Investment (capital goods)| | |

| | | |

|4. Competition | | |

|(e.g. privatisation, free | | |

|trade) | | |

|5. Population increases | | |

| | | |

5. Movement along the PPF

• As we have just seen the PPF can shift outwards illustrating economic growth and can also shift inwards when resources in an economy are depleted e.g. through natural disasters.

• However, in order to move along the PPF there is no need for a change in the amount of resources (or factors of production).

• Instead, there is just a need for a reallocation of resource, with resources put to different resources. Governments or policymakers may reallocate resources to try and increase the welfare of citizens by meeting their needs more precisely.

• Remember, there will be an opportunity cost associated with any movement along the PPF.

6. The Shape of the PPFs & the Law of Increasing Costs

The law of increasing costs states that:

“The opportunity cost of additional units of a good generally increases as society attempts to produce more of that good.”

a) Why is this so?

This is because some resources are better suited for the production of some things than others. Many economic resources are not easily adaptable to other uses, nor are workers skills perfectly transferable. Therefore as you approach the extremes of the PPF the opportunity cost increases (you lose more of the other good).

Think of a society with only rugby players and snooker players trying to win as many points as possible. As more and more rugby players take up snooker they will hopefully score some points at snooker but they are now unable to do what they do best and score a lot more points at rugby. It will take a lot of rugby players giving up rugby to gain more snooker points (the opportunity cost increases).

b) How does this concept explain the shape of the PPF?

The PPF is bowed; it is concave to the origin. Its shape represents the law of increasing costs graphically. Generally, the more specialised resources are, the more bowed society’s PPF will be. Alternatively, if all resources are equally suited to all forms of production, then the PPF would be a straight-line curve.

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Introduction

Everyday peope specialise in what they do best, Wayne Rooney plays for Manchester United whilst David Cameron runs the country. This seems a sensible idea and indeed is beneficial for the economy as resources (in this case labour) are being used effectively.

Point to Ponder

What if the roles were reversed?! Why would this be inefficient for the economy and the future success of England and Manchester United?

|Specialisation |The process by which individuals, firms and economies concentrate on producing those |

| |goods and services in which they have an advantage |

|Division of Labour |The process whereby the production process is broken down into a sequence of stages with |

| |workers assigned to particular stages |

Specialisation has been used to increase the efficiency of the production process; this is called division of labour. This idea was described by the grandfather of economics, Adam Smith when he described the benefits of division of labour at a pin factory.

“The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour...This great increase of the quantity of work which, in consequence of the division of labour, the same number of people are capable of performing, is owing to three different circumstances; first, to the increase of dexterity in every particular workman; secondly, to the saving of the time which is commonly lost in passing from one species of work to another; and lastly, to the invention of a great number of machines which facilitate and abridge labour, and enable one man to do the work of many.” (From the Wealth of Nations by Adam Smith)

Example: Adam Smith’s Pin Factory

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.

I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

Extract from Adam Smith, the Wealth of Nations

This is an extract from Adam Smith and his famous pin factory example. In your own words explain Adam Smith’s method for increasing the production of pins.

Example: Henry Ford’s Model T

Watch the video clip about Ford’s Model T & answer the following questions



1. What happened to the price/cost of a car before and after Ford introduced his new working methods?

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2. How did Ford operate his factories and organise his workers?

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3. To what extent do you think that Ford’s ideas are still used in modern car production?

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Division of Labour: Advantages & Disadvantages

+ Higher productivity & lower cost per unit of output: the main advantage of division of labour is that workers should be more productive. Therefore cost per unit will also fall as either less labour is needed to produce the same output (saving costs on wages) or more is made with the existing labour force (labour costs are spread over more units of output). Overall, this should aid economic growth and living standards.

Higher productivity can be achieved by using division of labour because:

• Under division of labour there are more jobs available and therefore workers can specialise in the task which they do best. This should allow tasks to be done quicker.

• A person spending more time on a specific task should become more skilled over time and therefore better at their job (e.g. quicker).

• There is less time wasted moving from one job to another as each person will just remain doing their specialised part of the production process

• Capital machinery can be used continuously in production (e.g. a production line) which will also aid the speed of the production process.

• Time is saved in training workers which will mean more time working (higher productivity) and less costs (helping to further reduce cost per unit).

- Monotony of work: as workers specialise in a limited range of tasks their work may become more monotonous and boring. Possible consequences of this are:

• Lower quality work or workers becoming less productive (leading to higher cost per unit)

• Increased staff turnover for the firm (i.e. more people leaving the business) and therefore increased recruitment and selection costs for the business to replace these workers.

- Chance of structural unemployment: breaking down tasks into different parts could mean that workers are more likely to be replaced by machines. This could lead to workers becoming unemployed in one sector of the economy (e.g. ship building) and therefore structurally unemployed.

- Greater interdependence & higher risk: if tasks are split up into separate parts then each one will rely on another. Therefore, should one part of the production process breakdown, then the whole production process will come to a halt. This could damage a firm’s reputation as products may be delayed, which could impact on their productivity.

Specialisation

These advantages and disadvantages could apply to other forms of specialisation, not just division of labour. For example, the UK specialising in financial services would hopefully allow higher productivity from specialising in one area and hopefully higher economic growth & living standards. However, they would face problems if demand for financial services fell and there is a chance of unemployment if this occurred.

The same arguments hold true for firms specialising in one product area rather than diversifying their product range.

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Introduction

As we have seen when we studied the fundamental economic problem (summarised below) there is a need for choices about the allocation of resources. We are now going to study the way different types of economies make these decisions.

Definitions of types of economies

|Free Market Economy |Where scarce resources are allocated entirely by the price mechanism (i.e. consumers & |

| |producers or demand & supply)” |

|Mixed Economy |Where scarce resources are allocated partly by the price mechanism (i.e. consumers & |

| |producers or demand & supply) and partly by the Government |

|Planned (or Command) Economy |Where scarce resources are allocated entirely by the Government |

Advantages and Disadvantages of Market & Command Economies

There is a spectrum of economy types ranging from fully planned to totally free market economies. In reality most economies are somewhere in the middle of the spectrum (e.g. UK) as an extreme market or planned economies have serious problems. Mixed economies are hopefully “the best of both worlds”.

|Advantages of Free Markets |Disadvantages of Free Markets |

| | |

|+ Competition & Efficiency: in free markets firms compete for profits |- Inequality: as there is no Government there will be no state |

|(& survival) and therefore should strive to increase efficiency. |provision of benefits or public services. Therefore those on low |

| |incomes, the underprivileged & the disabled will struggle to survive |

| |and could remain in poverty. |

| | |

|+ Consumer Choice: also in order to survive and make profits businesses|- Market failure: there are other market failures that occur when free |

|must match their production to what consumers want to buy. There should|markets don’t allocated resources efficiently: |

|also be more firms competing, offering different goods & services which| |

|will aid consumer choice. |e.g. dominant firms may charge high prices |

| |e.g. some goods may be under-provided, such as healthcare & education |

|+ Incentives & Economic Growth: in a free market there is no (or low) |e.g. some goods may be over-provided, such as cigarettes, alcohol & CO2|

|income or corporation tax. This gives workers a greater incentive to | |

|work and businesses more incentive to make profits. These incentives | |

|should help fuel higher economic growth. | |

The Need for Mixed Economies

So, free markets give incentives for workers and firms to make money. These incentives therefore lead to economic efficiency (nearer the PPF) and then consumers have free choice over how to spend their money. However, will some people starve? Will there be inequality?

Planned economies often try to guarantee a minimum standard of living for all their citizens and provide all public services. However, can anyone plan on this scale effectively? Will the powerful become corrupt? Will there be large scale inefficiently? Will the system collapse in time?

Therefore one reason why mixed economies are needed is to provide Government intervention to solve the market failure (when the price mechanism fails to allocate resources efficiently) experienced in a free market system and provide better equality. Similarly, another reason is that a mixed economy allows the use of free markets which could make a planned economy more efficient.

In essence a mixed economy is trying to gain the best of both worlds i.e. free market discipline coupled with the drive for equality of a planned economy. In reality, all economies are mixed but they will be nearer to one extreme than the other depending on the value judgements made by the leaders of that country.

SUPPORTED CHOICE QUESTIONS

Exam Technique Reminder

• In your Unit1 exam the first eight questions are Supported Choice. This means you need to not only select the correct answer from a choice of four but you must also provide some explanation for why you have chosen your answer.

• You get 1 mark for the correct letter and up to 3 marks for your explanation

• To get the explanation marks you can do the following:

a) Provide key definitions (maximum 2 definitions)

b) Explain why your answer is correct using your economic understanding

c) Draw a relevant economic diagram or annotate a diagram

d) Showing mathematical calculations

• However, on different supported choice questions they require different explanations. Some will lend themselves to different explanations e.g. when a diagram is provided you are likely to get marks for annotation and calculation questions get marks for workings.

• There are often several different ways of getting your marks for explanation. The more questions you do the better your exam technique will get at explaining your supported choice answers and finding the possible answers from the mark scheme.

Eliminating Answers

• You may also eliminate an incorrect answer if you can give an economic reason why one is not correct and you are not repeating yourself from your explanation. Adding definitions or can help gain an elimination mark.

• You can eliminate up to 3 different answers for one mark each assuming each elimination is saying something different and an economic reason is given. It is often best not to eliminate all answers unless you have no idea how to explain the correct answer.

1.

Statement 1 If the government raises the tax on beer, this will lead to a fall in profits of the brewers.

Statement 2 The government is right to introduce a ban on smoking in public places.

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2.

Statement 1 The best way to provide UK healthcare is through the NHS

Statement 2 Healthcare spending should not be cut as much as other Government departments

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3. A firm is planning to spend £5 million on a range of new retail outlets. The opportunity cost of this decision to the firm is best represented by:

A. The cost of advertising planned by the firm’s rivals after the retail outlet opens

B. The cost of purchasing the new retail outlets

C. The forecast increase in profit from purchasing the new retail outlets

D. A new product development project they were considering

4.

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The diagram above shows a production possibility frontier for an economy. Which of the following is true?

A. The economy is operating inefficiently at both point X and Y

B. A movement from point X to point Y would decrease living standards in the short-term but increase them in the long-term

C. There is an opportunity cost when moving from point Z to point X

D. Point Z is not a feasible allocation of resources

5.

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Which of the following is true?

A. The opportunity cost of moving from 5 to 6 tractors is less than moving from 6 to 7 tractors

B. The opportunity cost of moving from producing 0 tractors to 3 tractors is 15 motor cars

C. The production possibility frontier will be a straight line

D. Producing 12 motor cars and 4 tractors is not economically efficient

6. An economy has seen their PPF shift inward from XX to YY.

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Which of the following is most likely to have caused this shift?

A. An increase in education spending

B. Discovery of untapped raw materials

C. Investment in capital goods

D. Global warming causing more extreme weather

7. The most likely benefit of a bakery switching from making individual, hand-made loaves to using division of labour on an assembly line is increased:

A. Productivity

B. Staff turnover

C. Dependence on raw material suppliers

D. Cost per unit

8. One reason for the UK being a mixed economy rather than a free-market economy is:

A. To reduce Government bureaucracy and inefficiency

B. To reduce income inequality

C. To increase the incentive to work

D. To increase market failure

DATA RESPONSE QUESTIONS

1. Higher Education

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Extract 2

Before 1997, Government spending on the service was just 6.8% of gross domestic product, well below the level of countries such as France and Germany. The number of hospital beds had been falling for years and 1.2 million people were waiting for operations. Doctors and nurses complained of being overworked and underpaid. Eight years on and significant improvements have been made according to a report by the Kings Fund, an independent research body. Since 1997, government expenditure on the NHS has increased in real terms by 70% and it is set for further increases up until 2008. This is an attempt to keep up with increasing demand and cost pressures on the health care budget.

Source: adapted from ‘Inside the NHS’ by Lois Rogers, Sunday Times, March 2005 and The Economist, 8 January 2005

a) Explain the opportunity cost of increasing government expenditure on the NHS by 70% in real terms since 1997 (4)

b) Examine the likely impact on the production possibility frontier for the economy of ‘increased Government investment in higher education’. Illustrate your answer with a diagram (10)

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What is Economics?

Positive Economics

Normative Economics

Cannot be tested or verified

Involve facts, can be tested

Require a value judgement

No need for a value judgement

The Government should spend more on universities

Education spending increased by 10% last year

p

1

The Economic Problem

p

1

Production Possibility Frontiers

C

I

19

23

p

1

Specialisation & Division of Labour

?

p

1

Types of Economies

Unlimited Wants, Limited Resources

Choices need to be made.

(Allocation of resources)

Who allocates resources?

Scarcity

Planned

Economy

Mixed Economy

Free Market

Economy

Mixed Economy

Free Market

Economy

Planned

Economy

(1)

(1)

(1)

.Z

.Y

(1)

(1)

(1)

(1)

(1)

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