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Bachelor of Commerce: Economics 1
Revision Questions and Answers
Economics One Ch 01 Revision Questions Exercise
1.1 Differentiate between Micro and Macro economics.
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In economics we distinguish between microeconomics and macroeconomics.
Microeconomics deals with the study of how consumers and firms behave and make decisions, and
how they interact in particular markets.
Macroeconomics studies the aggregate economy, which includes aspects of unemployment,
inflation, economic growth, and government policies. It is important to see the relationship between
microeconomics and macroeconomics. For instance, any policy decision taken by the government
that impact on the domestic macro economy will in effect influence how consumers and firms behave,
and the decisions they are likely to adopt. Conversely, any spending decisions that may arise from
consumers and firms in specific markets will inadvertently influence economic activity.
1.2 In economics resources are determined by the principle of scarcity, using a relevant example
explain scarcity.
( Refer to module guide, summarise in own words)
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1.3 Discuss using relevant examples the fundamental economic challenge.
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The Fundamental Economic Challenge
Choices and Trade-offs
The economic way of thinking places scarcity and its implication, choice, at centre stage. Because we
face scarcity, we must make choices. And when we make a choice we select from the available
alternatives.
You can think about every choice as a trade-off—giving up one thing to get something else. ―Books
versus butter‖ is a simple trade-off.
―Books‖ and ―butter‖ can stand for any two goods.
Whatever choice you make, you could have chosen something else instead.
In making choices, we have to make decisions about the best possible choices in terms of allocating
resources efficiently and effectively. This includes incurring opportunity costs. Thus for every decision
we take, we incur opportunity costs. The highest-valued alternative that we give up to get something
is the opportunity cost of the activity chosen.
The concept of opportunity costs refers to the best option forgone. It is simply, giving up something to
gain something else. For example, as a business manager you are constantly faced with the problem
of choosing among alternative methods of production, pricing of products, and maximising profits and
minimising losses. Other decisions may relate to aspects of budgeting, human resources, and a range
of other firm activities. Understanding economics and employing economic tools can help you solve
many business problems.
Thinking about a choice as a trade-off emphasizes cost as an opportunity forgone.
Choosing at the Margin
People make choices at the margin, which means that they evaluate the consequences of making
incremental changes in the use of their resources.
The benefit from pursuing an incremental increase in an activity is its marginal benefit.
The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.
By evaluating marginal benefits and marginal costs and choosing only those actions that bring greater
benefit than cost, we use our scarce resource in the way that makes us as well off as possible.
Human Nature, Incentives and Institutions
Economists take human nature as given and view people as acting in their self-interest.
Self-interested actions are not necessarily selfish actions.
But if human nature is given and people pursue self-interest, how can the social interest be served?
1.4 What are some of the assumptions made in economics and why are these assumptions important
to economic theory?
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Ceteris Paribus
This is a Latin term that means ―other things being equal‖ or ―if all other relevant things remain the
same‖ (Parkin et al 2005:15). Economic models enable us to determine the influence of one factor at
a time in the ‗imaginary world of the model.
( Suggested approach to one assumption, refer to module guide, textbooks for others)
1.5 Production possibility frontier:
1.5.1 Explain the concept of a PPF?
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The quantities of goods and services that we can produce are limited by both our available resources
and by technology. If we want to increase our production of one good, we must decrease our
production of something else – we face trade-offs. The production possibilities frontier (PPF) is the
boundary between those combinations of goods and services that can be produced and those that
cannot, that is, it is the limit to what we can produce (Parkin, Powell, and Mathews 2005:32).
To illustrate the PPF, we focus on two goods and hold the quantities of all other goods constant.
That is, we look at a model economy in which everything remains the same (ceteris paribus) except
the two goods we‘re considering. Figure 1.1 shows the PPF for CDs and pizza, which stand for any
pair of goods and services.
Points on the frontier, such as points A, B, C, D, E and F and points inside the frontier, such as Z, are
attainable. Points outside the frontier are unattainable.
Figure 1.1
Source: Parkin, Powell and Mathews (2005)
The PPF makes the concept of opportunity cost precise. If we move along the PPF from C to D, the
opportunity cost of the increase in pizza is the decrease in CDs. Note that the opportunity cost of a
CD is the inverse of the opportunity cost of a pizza.
One pizza costs 3 CDs.
One CD costs 1/3 of a pizza.
All the points along the PPF are efficient. To determine which of the alternative efficient quantities to
produce, we compare costs and benefits.
1.5.2 Using a relevant example explain the PPF and Marginal cost?
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The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity cost of producing one more unit of it.
Figure 1.2 illustrates the marginal cost of pizza.
As we move along the PPF in part (a), the opportunity cost and the marginal cost of pizza increases.
Source: Parkin, Powell and Mathews (2005)
In figure 1.3 the blocks illustrate the increasing opportunity cost of pizza.
The black dots and the line labeled MC shows the marginal cost of pizza.
Preferences and Marginal Benefit
Preferences are a description of a person‘s likes and dislikes. Economists use marginal benefit and
the marginal benefit curve to describe them.
The marginal benefit of a good is the benefit received from consuming one more unit of it.
We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a
good or service.
It is a general principle that the more we have of any good or service, the smaller is its marginal
benefit and the less we are willing to pay for an additional unit of it.
We call this general principle the principle of decreasing marginal benefit.
Figure 1.4 illustrates the marginal benefit curve which shows the relationship between the marginal
benefit of a good and the quantity of that good consumed.
The marginal benefit curve slopes downward to reflect the principle of decreasing marginal benefit.
At point A, with pizza production at 0.5 million, people are willing to pay 5 CDs per pizza. At point E,
with pizza production at 4.5 million, people are willing to pay 1 CD per pizza.
Efficient Use of Resources
When we cannot produce more of any one good without giving up some other good, we have
achieved production efficiency, and we are producing at a point on the PPF.
When we cannot produce more of any one good without giving up some other good that we value
more highly, we have achieved allocative efficiency, and we are producing at the point on the PPF
that we prefer above all other points. The following figure illustrates allocative
The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal
cost.This point is determined by the quantity at which the marginal benefit curve intersects the
marginal cost curve which is shown in figure 1.6 below.
If we produce less than 2.5 million pizza, marginal benefit exceeds marginal cost. We get more value
from our resources by producing more pizza. Looking at figure 1.7, on the PPF at point A, we are
producing too many CDs, and we are better off moving along the PPF to produce more pizza.
From Figure 1.5, if we produce more than 2.5 million pizzas, marginal cost exceeds marginal benefit.
We get more value from our resources by producing less pizza. On the PPF at point C, we are
producing too much pizza, and we are better off moving along the PPF to produce less pizza.