Download Economics - University of London International Programmes

International Foundation Programme
Foundation course:
Economics
James Abdey and Derek Gibson
FP0002
2015
This guide was prepared for the University of London International Programmes by:
J. Abdey, The London School of Economics and Political Science
D. Gibson, The London School of Economics and Political Science
This is one of a series of subject guides published by the University. We regret that due to pressure
of work the authors are unable to enter into any correspondence relating to, or arising from, the
guide. If you have any comments on this subject guide, favourable or unfavourable, please use
the online form found on the virtual learning environment.
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© University of London 2015
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ECONOMICS
i
Contents
Introduction to the course............................................................................1
Unit 1: The nature and scope of economics
Introduction to Unit 1......................................................................................................................7
Section 1.1: A brief history of economic thought..........................................................9
Section 1.2: The basic economic problem and how different
societies have attempted to solve it....................................................................................15
Section 1.3: The production possibility frontier............................................................21
Test your knowledge and understanding........................................................................30
Concluding comments................................................................................................................32
A reminder of your learning outcomes ............................................................................32
Unit 2: Competitive markets
Introduction to Unit 2...................................................................................................................33
Section 2.1: Demand and supply..........................................................................................35
Section 2.2: Equilibrium and the price mechanism...................................................44
Section 2.3: Elasticities..................................................................................................................52
Section 2.4: Consumer and producer surplus, tax and social welfare............58
Test your knowledge and understanding........................................................................65
Concluding comments................................................................................................................66
A reminder of your learning outcomes ............................................................................66
Unit 3: Market failure and government intervention
Introduction to Unit 3...................................................................................................................67
Section 3.1: Reasons for market failure..............................................................................69
Section 3.2: Externalities..............................................................................................................74
Section 3.3: Government intervention...............................................................................79
Test your knowledge and understanding........................................................................87
Concluding comments................................................................................................................88
A reminder of your learning outcomes ............................................................................88
Unit 4: Managing the economy
Introduction to Unit 4...................................................................................................................89
Section 4.1: Aggregate demand and aggregate supply.........................................92
Section 4.2: Economic growth................................................................................................99
Section 4.3: Unemployment and inflation....................................................................103
Section 4.4: Fiscal and monetary policies......................................................................109
Contents
Section 4.5: The international economy........................................................................113
Test your knowledge and understanding.....................................................................118
Concluding comments.............................................................................................................119
A reminder of your learning outcomes .........................................................................119
Unit 5: Development and sustainability
Introduction to Unit 5................................................................................................................120
Section 5.1: Measures of economic development..................................................122
Section 5.2: Why are some nations poor and others rich?.................................126
Section 5.3: Foreign aid, poverty and sustainability................................................130
Test your knowledge and understanding.....................................................................134
Concluding comments.............................................................................................................135
A reminder of your learning outcomes .........................................................................135
Unit 6: The recent financial and economic crisis
Introduction to Unit 6................................................................................................................136
Section 6.1: Causes of the crisis...........................................................................................138
Section 6.2: Consequences of the crisis and possible cures..............................145
Test your knowledge and understanding.....................................................................150
Concluding comments.............................................................................................................151
A reminder of your learning outcomes .........................................................................151
Appendix 1: Sample examination paper.............................................. 152
Appendix 2: Glossary................................................................................ 154
ii
Introduction to the course
1
Introduction to the course
Route map to the guide
2
Syllabus
2
Aims of the course
4
Learning outcomes for the course
4
Overview of learning resources
4
Examination advice
6
© University of London 2015
Introduction to the course
Route map to the guide
Congratulations on embarking on this foundation course offering you an opportunity to gain
a proper insight into economics. Economics, at its very heart, is the study of people. It seeks to
explain what drives human behaviour, decisions and reactions when faced with difficulties or
successes. Economics is a discipline which combines politics, sociology, psychology and history.
Historically, economists have been criticised for making unrealistic assumptions about human
behaviour. The main ‘sin’ is the creation of homo economicus – rational and narrowly selfinterested individuals. Of course, many people do not fit this description. Some donate blood or
bone marrow to strangers; others vote or give money to charity. But still, most economic models
take rationality for granted. Is there anything wrong with this assumption? Here is the first lesson
you will learn: models are like maps, because they are largely simplified and are often not ideal
representations of reality. Even though they are only symbolic depictions, their main role is to
highlight important relationships between various spatial elements. In the same manner, the
intention of the self-interest model is only to capture an aspect of human behaviour, albeit an
important one. The simplifications made are necessary and cannot be avoided for practical
reasons. However, as long as the conclusions we derive are applicable, and are seen to be
effective, the simplification of reality is justified.
This subject guide has 20 sections divided into six units. Units 1 and 2 focus on microeconomics
(the branch of economics that includes the behaviour of individual firms and consumers).
Units 3, 4 and 5 concentrate on macroeconomics (the branch of economics which studies
the performance of the economy as a whole). Finally, Unit 6 describes and explains the recent
financial and economic crisis.
Throughout this subject guide, you are presented with activities which will help monitor your
progress. You should attempt all of them – reading and researching widely. Remember, the more
involved you are in the course, the better you will do in your final examination. At the end of
each unit, there is a ‘Test your knowledge and understanding’ section. This is specifically aimed at
preparing you for the examination. All questions in these sections are of examination style and
level of difficulty. There is also a full Sample examination paper at the end of the subject guide.
You will be instructed to read certain sections of a textbook at the beginning of each section. The
virtual learning environment (VLE) also contains additional readings, extracts from media sources
and other resources, and, very importantly, solutions to activities and extra worked examples. You
are recommended to visit the VLE on a regular basis.
Syllabus
The course is divided into six units, each of them further divided into two to five smaller sections.
You should be aware, however, that they are not mutually exclusive, that is the sections do not
cover completely separate issues, and you will soon start to find links between them. The best
way to study is to work through the subject guide starting with Unit 1, as each subsequent unit
builds on everything else covered before.
Unit 1: The nature and scope of economics. This unit provides a broad introduction to the
study of economics and its main lines of inquiry. The focus is mainly on the basic economic
problem of choice and scarcity, and the concept of opportunity cost. You are required to use
standard production possibility frontiers to illustrate simple applications of the problem to
various real-life situations.
Unit 2: Competitive markets. This unit examines how the price mechanism allocates resources
in different markets through the demand and supply model. It introduces the concepts of
elasticities and social welfare. You should be able to use the model to illustrate changes in factors
influencing the price of commodities (for example, consumer tastes and cost of production).
2
Introduction to the course
3
Unit 3: Market failure and government intervention. This unit considers a range of reasons
why market forces may not be able to allocate resources efficiently. These include externalities,
public goods, asymmetric information, factor immobility and market power. It examines possible
government interventions and critically assesses their effectiveness. The unit is taught mainly
through specific case studies (for example, pollution and congestion charges).
Unit 4: Managing the economy. This unit provides an introduction to key measures of
economic performance and the main objectives and tools of economic policy. A basic model of
aggregate demand and aggregate supply is used to represent unemployment and inflation, as
well as the effectiveness of government interventions.
Unit 5: Development and sustainability. This unit focuses on the meaning and measures
of economic development (for example, the Human Development Index and Gross Domestic
Product per capita). You should be able to identify common and diverse features of both
developed and developing economies, as well as understand why development must be
sustainable.
Unit 6: The recent financial and economic crisis. This unit introduces you to the recent
financial and economic crisis, outlining its causes, consequences and possible cures. You are not
required to have extensive background knowledge of the crisis, although a basic understanding
of the crisis is helpful.
Week Unit
1
1: The nature and scope of
economics
2
3
4
2: Competitive markets
Section
Introduction to the course
1.1: A brief history of economic thought
1.2: The basic economic problem and how
different societies have attempted to solve it
1.3: The production possibility frontier
2.1: Demand and supply
5
2.2: Equilibrium and the price mechanism
6
2.3:Elasticities
7
2.4: Consumer and producer surplus, tax and
social welfare
3.1: Reasons for market failure
8
9
3: Market failure and government
intervention
3.3: Government intervention
10
11
3.2:Externalities
4: Managing the economy
4.1: Aggregate demand and aggregate supply
12
4.2: Economic growth
13
4.3: Unemployment and inflation
14
4.4: Fiscal and monetary policies
15
4.5: The international economy
16
5: Development and sustainability 5.1: Measures of economic development
17
5.2: Why are some nations poor and others rich?
18
5.3: Foreign aid, poverty and sustainability
19
20
6: The recent financial and
economic crisis
6.1: Causes of the crisis
6.2: Consequences of the crisis and possible cures
Introduction to the course
Aims of the course
This course aims to:
introduce you to a range of key issues and questions at the centre of the study of economics
appreciate how economics contributes to the understanding of the wider economic and
social environment
develop an understanding of current economic affairs and the role of institutions which affect
everyday life
provide tools which support you in critical evaluation of economic models and methods of
inquiry
select, interpret, analyse and evaluate appropriate data from a range of different sources
and understand the relationship between data, decisions of economic agents and policy
formation.
Learning outcomes for the course
At the end of this course, and having completed the Essential reading and activities, you should
be able to:
demonstrate familiarity with key economic concepts
use a range of simple microeconomic and macroeconomic models to predict market
behaviour and analyse current economic affairs
provide reasons for, and explain the implications of, market failure and the impact and
effectiveness of government policies
contrast and assess different approaches to the same economic problem
interpret data presented in different forms, carry out simple calculations and construct
diagrams
describe measures of economic development
explain possible causes and remedies of the recent financial and economic crisis.
Overview of learning resources
The subject guide gives you an overview of the issues discussed and will help you to understand
the main ideas – you should always refer to it first.
Essential reading
Once you have read the subject guide, you should deepen your knowledge by reading relevant
sections from the following textbooks:
Anderton, A. A Level Economics student book. (Harlow: Causeway Press, 2008) fifth edition
[ISBN 9781405892353].
Gillespie, A. AS & A Level Economics through diagrams. (Oxford: Oxford University Press, 2009)
[ISBN 9780199180899].
Further reading
The following texts, although not compulsory, can help you gain more knowledge of economics
as a whole. If you have time, you may want to read some of the following:
Davies, H. The financial crisis – Who is to blame? (Cambridge: Polity, 2010) [ISBN 9780745651644].
4
Introduction to the course
Frank, R.H. The economic naturalist: Why Economics explains almost everything. (New York: Virgin
Books, 2008) [ISBN 9780753513385]. This can be found online and the link will be posted on
the VLE.
Harford, T. The undercover economist. (London: Abacus, 2007) [ISBN 9780349119854].
Jevons, M. The fatal equilibrium. (New York: Ballantine Books Inc, 2000) [ISBN 9780345331588].
Klein, G. and Y. Bauman The cartoon introduction to Economics, Volume I: Microeconomics. (New
York: Hill and Wang, 2010) [ISBN 9780809094813].
Klein, G. and Y. Bauman The cartoon introduction to Economics, Volume II: Macroeconomics.
(New York: Hill and Wang, 2012) [ISBN 9780809033614].
Krugman, P. End this depression now! (New York: W.W. Norton & Company, 2013)
[ISBN 9780393345087].
Levitt S.D. and S.J. Dubner Freakonomics: A rogue economist explores the hidden side of everything.
(London: Penguin, 2007) first edition [ISBN 9780141019017].
Levitt S.D. and S.J. Dubner Superfreakonomics: Global cooling, patriotic prostitutes and why suicide
bombers should buy life insurance. (London: Penguin, 2010) [ISBN 9780141030708].
Sloman, J. and D. Garratt Essentials of Economics. (Harlow: Prentice Hall, 2009) fifth edition
[ISBN 9780273722519].
In addition, you could also benefit from browsing the following web links:
www.anforme.co.uk – provider of online educational resources.
www.bankofengland.co.uk – central bank of the United Kingdom.
www.bbc.co.uk/news – BBC news website.
www.bized.co.uk – provider of online educational resources.
www.economist.com – weekly newspaper with economic and socially liberal views.
www.edexcel.org.uk – education and examination board.
www.guardian.co.uk – left-of-centre newspaper
www.oecd.org – Organisation for Economic Co-operation and Development.
www.philipallan.co.uk – publisher and conference provider.
www.statisticsauthority.gov.uk – United Kingdom Statistics Authority
www.telegraph.co.uk – right-of-centre newspaper.
www.treasury.gov.uk – HM Treasury.
www.tutor2u.net – provider of online educational resources.
Accessing the Student Portal and the virtual learning environment
Any course updates, solutions to activities, video tutorials and links to online readings are posted
here. You should check it on a regular basis.
To manage all of your student administrative processes you will need to log in to the Student
Portal via: http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with your official offer, which
was emailed to the address that you gave on your application form. You have probably already
logged in to the Student Portal in order to register. As soon as you register, you will automatically
be granted access to the VLE, Online Library and your fully functional University of London email
account. If you have forgotten these login details, please click on the ‘Forgotten your password’
link on the login page.
5
Introduction to the course
In order to access your learning materials for each course, you can click on the VLE tab within the
Student Portal or login to the VLE directly via: https://ifp.elearning.london.ac.uk/
Examination advice
Important: the information and advice given in the following section are based on the
examination structure used at the time this subject guide was written. We strongly advise you to
check both the current Regulations for relevant information about the examination and the VLE
where you should be advised of any forthcoming changes. You should also carefully check the
rubric/instructions on the paper you actually sit and follow those instructions.
You may think it is too early to think about your examination, but you could not be further from
the truth! The year will pass quickly, and without even realising it you will soon be only a few
weeks away from your final test – a two-hour unseen written examination.
The examination will seek to test the following specific areas and skills:
1. subject knowledge
2. ability to respond to, and apply economic knowledge/theory, to data provided
3. ability to consider at length a particular area of economics and then to write an answer in a
coherent and structured way. Your answer must include knowledge, analysis and judgements
based upon an objective review of the evidence presented. It must clearly consider different
perspectives.
Economics cannot be learned by heart through memorisation. It must be understood and this
is a gradual process that takes both time and effort. Here are a few useful study tips to help you
prepare for the final assessment:
Be systematic – do not leave all the work until the last moment. It is impossible to squeeze
the whole course into one month before the examination. Neither is it possible to do well by
learning only selected topics. Remember that all units are interrelated.
The examination consists of questions of similar difficulty to activities in this subject guide
and it tests your knowledge of the course material, your analytical skills and your ability to
apply tools learned in the course to real-life situations. Therefore, the best way is to regularly
complete the activities. You will not learn simply by accessing the answers before you try the
questions on your own!
Graphs are essential – the best way to learn is to draw them several times.
Mind maps and revision sheets – after each unit create a mind map or a revision sheet that
highlights the most important ideas that you have learned so far. Do not rewrite the whole
book – a summary should be short and informative. Doing this will save you a lot of time
when revising for the final examination.
Glossary – definitions in economics are very important. You may want to learn some of these
by heart, but it is always more useful to try to explain the concepts using your own words. As
there are many new terms to learn, you are advised to review the glossary at the end of the
subject guide.
Last, but not least, here is a little secret about economics – it’s not all that complicated. It’s really
all about us and our behaviour. With this subject guide, you will very soon discover how exciting
and universal it is.
Good luck!
6
Unit 1: The nature and scope of economics
7
Introduction to Unit 1
Overview of the unit
8
Aims
8
Learning outcomes
8
Essential reading
8
Further reading
8
References cited
8
© University of London 2015
Introduction to Unit 1
8
Overview of the unit
This unit begins with an introduction to the history of the development of economic thought. We
do not expect you to be completely familiar with every topic, but an appreciation of the historical
background is beneficial. The second section highlights the fundamental problem which
economics seeks to answer: how can infinite wants be reconciled with finite resources? The final
section illustrates the concept of opportunity cost and the idea of the optimum use of resources.
Week Unit
1
1: The nature and scope of
economics
2
3
Section
Introduction to the course
1.1: A brief history of economic thought
1.2: The basic economic problem and how
different societies have attempted to solve it
1.3: The production possibility frontier
Aims
This unit aims to:
provide you with a general overview of the history of economic thought
introduce you to the concepts of the basic economic problem and opportunity cost
provide you with tools which support the critical evaluation of the productive capacity of a
given economy.
Learning outcomes
By the end of this unit, and having completed the Essential reading and activities, you should be
able to:
define the concepts of the basic economic problem, scarcity, efficiency, opportunity cost and
specialisation
explain what is meant by the production possibility frontier and analyse its position and shape
critically assess the advantages and disadvantages of the division of labour.
Essential reading
Anderton (2008) Units 1 and 2. Attempt all questions in these units.
Gillespie (2009) pp. 4–5.
Further reading
Frank, R.H. The economic naturalist: why economics explains almost everything. (London: Virgin
Books, 2008) Introduction.
References cited
Galbraith, J.K. The affluent society. (London: Penguin, 1999) fifth revised edition
[ISBN 9780140285192].
‘Kodak is at death’s door; Fujifilm, its old rival, is thriving. Why?’, The Economist, 14 January 2012.
Kuran, T. Islam and Mammon. (Princeton: Princeton University Press, 2005) [ISBN 97806911262996].
The Economist Pocket World in Figures. (London: Economist Books, 2012) [ISBN 9781846684739].
Note: this publication is updated annually.
Unit 1: The nature and scope of economics
9
Section 1.1: A brief history of economic
thought
Introduction
10
Ancient
10
Classical
11
Modern
12
Schools of economic thought
13
Unit 1: The nature and scope of economics • Section 1.1: A brief history of economic
thought
Introduction
You might never have studied economics before or know much about it. Yet it is all around you
physically and all about you specifically. It tries to illustrate and explain human behaviour when
faced with all sorts of challenges.
Before we start our analysis of contemporary issues, however, it is important to know about the
history of the subject. As Lionel Robbins, former head of the Department of Economics at the
London School of Economics and Political Science used to say, in order to be a respectable and
educated economist, one needs to have at least some knowledge of the history of economic
thought. To make his point even clearer, he often quoted historian Mark Pattison: ‘a man who
does not know what has been thought by those who have gone before him is sure to set
an undue value upon his own ideas’. It is no secret that the British economist John Maynard
Keynes, who is considered to be one of the most influential economists of the 20th century, and
other great minds, also shared such a view. It is virtually impossible to fully understand current
developments without understanding past affairs. And so, by way of introduction, let us offer you
a brief journey back in time. For simplicity, we have subdivided the time periods into ‘Ancient’,
‘Classical’ and ‘Modern’.
Ancient
Economic thought originated in Ancient Greece in the third century BC from the writings of
two eminent moral philosophers – Plato and Aristotle. Plato was a multitalented student of
Socrates (a Classical Greek philosopher who formalised the concepts that are today known as the
‘scientific method’, i.e. the setting and testing of hypotheses using an experiment) who founded
the first higher education institution in the Western world (the Academy in Athens). He was
also the most influential author of the period. In one of his works, Republic, Plato attempted to
describe the necessary conditions for the ideal state to exist. He was mainly concerned with the
efficient organisation of a society which requires its members to focus on the activities for which
they are most suited. In other words, Plato was the first to describe the need for, and the benefits
of, the division of labour. Although he recognised the important role of trade, his views were
rather socialist. Goods could be bought and sold, for example, but he believed that property
should be divided equally between all members of society.
Aristotle (Plato’s student) strongly disagreed with this view. According to him, private ownership
was a much better concept than the idea of common value. He argued that goods are better
cared for when property rights are clearly allocated and owners profit from their wealth. Aristotle
also widely discussed household management as well as the origins and superiority of money as
opposed to the old system of barter:
Money is a sort of medium or mean; for it measures everything and consequently
measures among other things excess or deficit, for example the number of shoes
which are equivalent to a house or a meal. As a builder then is to a cobbler, so must
so many shoes be to a house or a meal; for otherwise there would be no exchange or
association. But this will be impossible, unless the shoes and the house or meal are in
some sense equalised. Therefore, the aforementioned necessity of a single universal
standard of measurement arises. This standard is in actuality the demand for mutual
services, which holds society together.
Aristotle, 1948, p.27
Until the 18th century, this was the most concise piece of writing describing the function of
money.
10
Unit 1: The nature and scope of economics • Section 1.1: A brief history of economic
thought
Thomas Aquinas was a Catholic priest who lived in the 13th century. His main contribution to
the history of economic thought is his long discussion on the ‘just price’. According to St Thomas,
a fair price should be a common valuation and reflect the costs of production (especially those
of labour). The ideas expressed by him come close to what is now called ‘perfect competition’. St
Bernardino of Siena, and other subsequent scholars, focused on the exchange of goods and
contracts that should be made between parties. According to St Bernardino, value (and therefore
price) should be determined by the object’s:
usefulness
scarcity
desirability.
Classical
Sir William Petty, the 17th-century founder of systematic statistics (also called political
arithmetic) is also of interest. Petty travelled across the United Kingdom collecting data on
regional mortality rates, soil conditions and other economic indicators. It is thanks to him that
we know so much about standards of living at that time. His most noteworthy achievement is
his superior insight into taxes and the need for common contributions to secure funds for public
spending.
If you have time, we also recommend that you acquaint yourself with Richard Cantillon.
Cantillon was an Irish banker who believed that the existence of banks not only made money
circulate faster, but also rationalised and formalised it. He was the first to discuss the mechanism
of market prices which change with fluctuations in demand and supply for goods and services.
The discipline of systematic economics – in other words, the economics we study now –
emerged in the 18th century. Our discussion starts with classical economics and its most
prominent representative – Adam Smith.
Smith is often referred to as the ‘father of modern economics’. Born in 1723, the Scottish
philosopher is best remembered for the idea of the ‘invisible hand’ (where the interaction of
supply and demand would bring about equilibrium price and output, without the intervention
of any individual trader) mentioned in his most popular work, An Inquiry into the Nature and
Causes of the Wealth of Nations (1776). Interestingly, Smith would not have recognised the word
‘economics’; his study would have been described as ‘political economy’, reflecting the idea that
political and social factors also contribute to material welfare.
He argues that rational, self-interested homo economicus and tough competition lead to more
economic prosperity without the need for external intervention or regulation. It is, therefore,
the forces of demand and supply that guide the actions of individuals. In other words, if every
individual is allowed to follow his or her own self-interest, the interest of society as a whole is
maximised. This is sometimes referred to by using the French phrase ‘laissez-faire’, in other words,
non-intervention (a rough translation is ‘let it be’ or ‘leave it alone’). An important part of his work
is also a discussion of the division of labour which inevitably gives rise to economic growth. Apart
from his great mind, Smith is also remembered as an eccentric absent-minded professor who
never married. Although there is a general consensus that his lectures were long and boring,
his students loved him. There are many anecdotes about his unusual behaviour and, if you are
interested in learning more, we recommend reading his biography (and do not miss the account
of his last lecture before he retired). No one knows how much truth is in all of these stories as
Smith asked for his personal papers to be destroyed upon his death. Fortunately, two copies of
detailed students’ notes of Smith’s lectures survived and they provide an invaluable insight into
his teaching. There is no doubt that Adam Smith is the father of free-market economics, the
principle upon which most of modern economics is based.
11
Unit 1: The nature and scope of economics • Section 1.1: A brief history of economic
thought
Another figure worth mentioning is Thomas Malthus, the co-founder of the famous Political
Economy Club in London. He was not the first person to write about the issue of increasing
population size, but he was the one with the most original views: ‘The power of population
[to increase] is indefinitely greater than the power in the earth to produce substance for man’
(Malthus, 1798). His concern was that a time would come when there would not be enough
resources to feed all humans because population increases geometrically while food increases
arithmetically. He therefore claimed that to avoid such a scenario the population size must
be kept under strict control. Interestingly, Malthus’ theories convinced Charles Darwin of the
correctness of the fundamental law of evolution.
Malthus’ contemporary was another great economist, David Ricardo, who is best known for
his law of comparative advantage. Ricardo proved that countries are better off if they specialise
in the production of goods which they can produce with the lowest opportunity cost (the
notion of opportunity cost is discussed in Section 1.2). Countries can then trade goods across
borders – a win-win situation. Ricardo was one of the first economists to include complicated
mathematical calculations in his publications.
The development of economic thought in the 17th and 18th centuries mirrors the evolution of
trade and the expansion of European empires (sometimes referred to as mercantilism). By the
19th century, with the advent of the Industrial Revolution, we see a change of focus towards
capitalism, the role of the state and labour movements.
Modern
The end of the 19th century, and the early years of the 20th century, saw the collapse of Tsarist
Russia. This overthrow was inspired by the writings of Karl Marx and implemented by Lenin.
The revolution had been brought to a head by the disruption and losses of the First World War.
Marx argued for the ‘dictatorship of the proletariat’ (i.e. that the factors of production should
be brought under workers’ control, the profit motive should be abolished and that economic
decisions on ‘what to produce, for whom it should be produced and how it should be produced’
should be decided by a central planning state authority). Communism was established in Russia
after a bloody civil war and was exported worldwide following the Second World War.
The Chinese Communist revolution established a new regime in 1948, and Chairman Mao
Zedong applied socialist solutions to the country’s problems (the Cultural Revolution). These
‘solutions’ were applied stringently and harshly, causing widespread disruption, death and
famine. Today’s China has adopted many market-economy features (with spectacular success),
but it is still a state dominated by one political party and run by the Politburo (a committee of 25
leaders who meet frequently to guide and control policy).
In this overview of historical figures in economics, we must not forget John Maynard Keynes
whose ideas were in complete opposition to those of Adam Smith. Keynes believed that
government intervention in the form of fiscal policy (tax changes) and direct investment must be
used to control the economy. In his mind, the so-called ‘invisible hand’ advocated by Smith was
not enough to control booms and busts of economic cycles. He was mostly concerned with the
negative effects of prolonged unemployment (because he experienced the Great Depression
of the 1930s) and much less with the costs of inflation. Keynes’ views are respected and his
recommendations followed to this day.
J.K. Galbraith, a 20th-century Canadian economist, who worked for most of his life in the
USA, was a great spokesman and populariser of Keynesian principles. He was also a prolific
author and teacher. One of his most widely-read books, The Affluent Society (1958), portrays
modern economies as being influenced by big business, large labour unions and interventionist
government.
12
Unit 1: The nature and scope of economics • Section 1.1: A brief history of economic
thought
Using the same concepts and language as Keynes, but opposed to his conclusions, was
the American economist Milton Friedman. In the 1960s, he proposed an alternative
macroeconomic policy known as monetarism. Friedman believed that the government’s main
responsibility is to control the amount of money in circulation. If too much money is pumped
into the economy, it will inevitably cause inflation (discussed in Section 4.3) which could have
devastating consequences. Friedman also suggested that people base their spending decisions
not on their current income, but rather on their anticipated lifetime wealth – known as the
‘permanent income hypothesis’.
We should also mention the rise of Islamic economics in the 20th century – well documented by
Timur Kuran in Islam and Mammon (2005). The basic premise of this movement is that Western
capitalism has failed and that Islam offers the remedy. Such ideas have been heavily backed by
Saudi Arabia and other oil-rich Gulf states. Islamic economics bans the imposition of interest on
loans, seeks to redistribute wealth more fairly through Zakāt taxation, and promotes a superior
business ethic.
Albeit briefly, we have introduced a few influential figures in the history of economics and we
hope that this has given you some background that will prove helpful throughout the course.
Schools of economic thought
We conclude this introductory section with a discussion of some of the main ‘schools’ of
economic thought, to which some of the figures mentioned above are associated. A ‘school’ does
not necessarily refer to a single educational institution, but rather a set of beliefs held by a group
of like-minded economists. Indeed, in our discussion of key influential figures in economics, we
have seen that differences of opinion have been considerable. We now briefly consider some of
the major schools of economic thought.
Classical school
Adam Smith, Robert Malthus and David Ricardo, among others, are linked with the Classical
school – often held to be the first school of economic thought. The belief system of classical
economists was that markets are most effective when free of government intervention.
The laissez-faire view advocated the price mechanism to allocate resources efficiently to
foster economic development. Economic value was based on scarcity and production costs.
Self-adjustment mechanisms were assumed to always result in an economy achieving full
employment. This period of economic thought endured until circa 1870.
Neoclassical school
The neoclassical school superseded classical economics. In short it involved a change in
emphasis from the classical preoccupation with the source of wealth and its division to the ideas
which govern the optimal allocation of scarce resources to particular wants. The doctrine is
scientific in nature making use of assumptions and hypotheses to model the behaviour of firms
and consumers. Neoclassical economists assume firms and consumers are both rational with
firms seeking to maximise profit, while consumers look to maximise utility (that is, the satisfaction
they obtain when consuming goods and services). The neoclassical school is also responsible
for developing the use of ‘marginal analysis’ – the examination of the effects when an economic
variable is changed by one unit. Much of microeconomics was developed by the neoclassical
economist Alfred Marshall.
Keynesian economics
This economic doctrine is named, unsurprisingly, after John Maynard Keynes. Keynesian
economists are sceptical of the ability of free markets to achieve full employment. Rather,
Keynesians advocate state intervention through the use of macroeconomic policy, in particular
13
Unit 1: The nature and scope of economics • Section 1.1: A brief history of economic
thought
fiscal policy (discussed in Section 4.4). From the 1920s, the Keynesian and neoclassical schools
were deeply opposed to each other and such conflicts stimulated much economic debate which
continues today as governments across the world seek to remedy the adverse effects of the
recent financial and economic crisis (discussed in Unit 6).
ACTIVITY
Using material posted on the VLE and your own research, choose one of the following
19th- and 20th-century economists and prepare a 200-word summary, highlighting their
contribution to economics and describing their effect on society:
Karl Marx
Friedrich von Hayek
Paul Krugman.
ACTIVITY
Research some other schools of economic thought (for example, the Austrian school) and
prepare a 100-word summary of each.
14
Unit 1: The nature and scope of economics
15
Section 1.2: The basic economic problem
and how different societies have attempted
to solve it
Introduction
16
Scarcity of economic resources
16
Opportunity cost
17
Division of labour as an example of specialisation
18
Unit 1: The nature and scope of economics • Section 1.2: The basic economic problem
and how different societies have attempted to solve it
Introduction
In order to survive, human beings have basic needs which must be satisfied. We all need air,
water, food, clothes and shelter. But do we really need multiple cars, villas with swimming pools
and designer bags? Not really. Therefore, such kinds of goods are our wants, but not needs. As
you have perhaps realised, human wants are infinite. We always want more food, a larger house,
new clothes and faster cars. However, not all, if any, of our wants can be fully satisfied. There are
never enough resources to give everyone everything that they want to have. Therefore, we need
to make choices and decide how to allocate scarce resources between competing uses in the
best possible way. This notion is referred to as the basic economic problem.
Scarcity of economic resources
There are four main economic resources (also called factors of production). If you remember your
mathematics, the factors of the number 12 are 1, 2, 3, 4, 6 and 12 (i.e. they can be combined in a
product to give the answer 12). In a similar fashion, the following are the factors of production,
known as CELL for short:
Capital – man-made assets, such as machinery or buildings.
Entrepreneurship – the ability and originality to combine all factors of production to make
profits. Many observers now include confidence as part of entrepreneurship.
Land – all naturally occurring resources, such as soil, air, water, minerals, fauna and flora.
Labour – people who provide physical and intellectual skills (human capital).
Some resources are renewable (they can be replaced), others are not. Almost all resources,
however, are limited (at least in the short term) – there is a finite amount of water, oil, land, coal,
and so on. Economists therefore say that these resources are scarce. At any given time, there is
only a certain amount that can be obtained. In a similar manner, if you want to buy a car, you can
only purchase the one that you can afford. If the latest Ferrari is beyond your budget, you cannot
have it. If a government wants to build new hospitals, it needs resources. If there is not enough
money to fund them, no hospitals can be built. All goods that are scarce are called economic
goods. But, as you have perhaps noticed by now, not all resources are limited. Take air as an
example. There is more air than anyone could ever need. All goods that are infinite are called free
goods.
ACTIVITY
Can you think of an example when air may become an economic good? What would need
to happen?
So far, we have established that the central economic problem of scarcity arises from infinite
wants and finite resources. All societies have to deal with this issue; they differ, however, in
the approaches that they adopt. The main difference comes from the degree of economic
intervention and control over resources. We therefore distinguish between:
free-market economies
mixed economies
centrally planned economies.
In a free-market economy, resources are privately owned and therefore decentralised – decisions
about what to produce, and in which quantities, are decided by the forces of supply and demand.
Government intervention is minimal. Such minimised intervention can be observed in countries
such as Malaysia and Thailand. However, the majority of developed countries (such as France or
16
Unit 1: The nature and scope of economics • Section 1.2: The basic economic problem
and how different societies have attempted to solve it
Germany) can be classified as mixed economies, as their governments intervene to improve
efficiency, correct market failures (for example, in the education or health sectors) or provide public
goods, such as defence. In centrally-planned economies, all decisions are taken solely by the
government. The price mechanism does not affect the allocation of resources. An extreme example
of this would be Stalin’s rule of the former Soviet Union in the 1930s. In all systems, however,
production decisions do not come without a cost.
ACTIVITY
Rank the following economies from the most centrally controlled to the least centrally
controlled:
Australia
Canada
Japan
North Korea
Sweden
The UK.
ACTIVITY
How are resources allocated in a mixed economy?
ACTIVITY
Describe the main differences between free-market and centrally-planned economies.
What problems might arise when planned economies embark on a transition towards a
free-market economy? (See the VLE for some reference materials.)
Opportunity cost
Economists think about costs in a slightly different way to most people. They use the term
‘opportunity cost’ – the cost of the best alternative forgone. It is a cost associated with engaging
in a certain activity evaluated as the value of everything else you must give up in order to pursue
it.
Every day, we face the same problem – what to do with our time. An hour has only 60 minutes
and there are exactly 24 hours in a day. The average life expectancy of a British male is 78 years,
slightly more for a British female, at 82 (Pocket World in Figures, The Economist, 2012, p.234). Time
is one of the most valued of all scarce resources. Each of us needs to decide what to do with it.
You need to decide how to divide time between leisure and study. Your parents need to decide
how much time they devote to their work and how much time they spend with you. One more
hour at work means one less hour spent with family. It is often very hard to find the right balance
as it is hard to decide what is more important. Here is another example to help you understand
the concept better.
Imagine that you are spending your summer holidays in London. Your friend, a football fan,
has invited you to see Chelsea play against Arsenal in the English Premier League (EPL). He has
already bought the tickets and has got the best seats. On the same day, however, your mother
17
Unit 1: The nature and scope of economics • Section 1.2: The basic economic problem
and how different societies have attempted to solve it
comes to town and wants you to go and see the annual Latin Dance Championships with her.
For you, the opportunity cost of attending the dance event is to sacrifice the football match. And
vice versa – the opportunity cost of enjoying an afternoon at the Emirates stadium is to lose a
chance to see the best Latin dancers from all over the world.
ACTIVITY
Suppose that your father gives you a free ticket to see your favourite band perform live
tonight. You are not allowed to sell it. Your local football team, however, is also playing
tonight. You must therefore decide whether to go to the concert or watch the football
match. A football match ticket costs around £50, and you would always be willing to pay
as much as £75 to see your favourite band perform. There are no other costs involved.
What is your opportunity cost of going to see your local football team play that evening
instead?
Hint: What is the value you sacrifice by not attending the concert?
Division of labour as an example of specialisation
Specialisation occurs when a country, firm or individual focuses on the production of a limited
range of goods or services. Specialisation can occur for a number of reasons. For example, almost
30 per cent of all potatoes produced in the USA are grown in the relatively small state of Idaho
due to the particularly favourable combination of climate, soil and geography. Another reason for
specialisation is when a ‘critical mass’ of expertise, money and talent is concentrated in a single
location. For example, such a critical mass can be found in Silicon Valley, California (USA) where
there is a high concentration of high-tech firms.
One of the forms of specialisation is the division of labour which, according to Adam Smith, is
a major source of growth (see Section 1.1). Production is broken down into a series of tasks that
are conducted by individual workers – an idea famously, and successfully, implemented by Henry
Ford.
Ford was born in 1863 near Detroit, Michigan in the USA. By the time he died in 1947, he was
one of the wealthiest and most famous men of his day. Many people believe he invented the
automobile, and others think he was the first to come up with the idea of an assembly line. The
truth is he did neither. So what was his success?
Ford grew up on a farm, but he did not want to stay there forever. As a child he was fascinated
with engines and machines. At 15, he had already gained a reputation of being the best watch
repairer in his town. However, his true dream was to build fast, reliable cars as quickly and
cheaply as possible so that everyone, including the working class, could afford to own one. After
a series of failures, in 1903 Ford finally founded his own motor company. It was not until 1908,
however, that he came up with the idea of the ‘Model T’ (often referred to as the Tin Lizzie) – a car
which soon revolutionised the US automobile market. It was simple to operate, powerful, sturdy,
easy to repair and could carry the whole family. More importantly, it was much cheaper than
options offered by Ford’s competitors. In the beginning it was produced one vehicle at a time,
but soon demand for the cars greatly exceeded supply. Ford realised that a more efficient process
of production was needed. In 1913, the Ford Motor Company established what was, at the time,
the largest moving assembly line. All pieces were produced according to strict rules so that they
were virtually the same and would fit with any other. Assembly of the Model T was broken down
into smaller tasks. Each worker was trained to specialise in only a few steps in the chain. Thanks to
this division of labour, Model T production was faster, cheaper and more efficient. The assembly
time of a single car was cut down to just 93 minutes!
18
Unit 1: The nature and scope of economics • Section 1.2: The basic economic problem
and how different societies have attempted to solve it
As great as the idea of an assembly line sounds, it also had some inevitable drawbacks. Since
the tasks were mindless, repetitive and required almost no skill, workers were easily bored and
discouraged. Yet, again, it was Ford who quickly realised the need to invest in human capital.
Since most of the workers employed in the factory were immigrants, the vast majority of them
could not communicate in English. He opened a dedicated school for them, established a
hospital at the factory and doubled their wages to give incentives and boost morale. Although
many predicted bankruptcy, Ford managed to double Model T production in each of the next
three years. Henry Ford and his Tin Lizzie changed the automobile industry forever.
The next great advance in mass production techniques took place in the 1970s in Japan – ‘the
Toyota production system’. Toyota saw their workers as assets and encouraged them to come up
with new ideas and methods to improve production. Above all, the company wanted to
concentrate on quality – no car should leave an assembly line unless it was free from any fault.
The traditional friction between management (whose objective was maximum production) and
workers (who were bored and not motivated) was replaced by cooperation and mutual respect.
This system has now been exported and adopted by firms in many industries worldwide (see
Anderton, 2008, Unit 2, p.11).
ACTIVITY
Refer to the video link posted on the VLE to watch a short documentary about the Ford
Model T assembly line.
What was Ford’s best achievement?
Using the Ford example, we now sum up the advantages and disadvantages of the division of
labour.
Advantages of the division of labour:
A person who spends time focused on one task quickly becomes highly skilled.
No time is wasted in moving from one job to another.
Capital equipment (such as machinery) can be used continuously in production.
Less time is required to train workers for specific tasks, as they only need to focus on one task
at a time.
There is more choice of jobs for workers and they can specialise in tasks to which they are
best suited (in other words, if you are not good at something, you can focus on something
else).
These benefits lead to a higher output per worker and help to reduce the cost of single-unit
production. Overall, the standards of living within the population increase.
There are, however, also some drawbacks.
Disadvantages of the division of labour:
Repetition of the same, easy tasks often creates monotony and boredom.
In a large plant, where workers focus only on their own task, there might be a widespread
feeling of alienation.
Breaking down production into different tasks makes it easier to replace skilled workers with
machines, leading to structural unemployment (discussed further in Unit 4).
Specialisation creates interdependence in production – if one group of workers goes on
strike, it could halt production across the whole industry.
19
Unit 1: The nature and scope of economics • Section 1.2: The basic economic problem
and how different societies have attempted to solve it
ACTIVITY
Describe at least three innovations that you would implement to minimise the
disadvantages of the division of labour.
ACTIVITY
Choose an issue which is currently in the news where you can write a paragraph
incorporating the concepts of scarcity and opportunity cost to describe what is
happening.
ACTIVITY
Define opportunity cost and explain the importance of the term in making economic
choices.
20
Unit 1: The nature and scope of economics
21
Section 1.3: The production possibility
frontier
Introduction
22
Inefficiency – why?
24
Economic growth and the PPF
25
Shapes of PPFs
28
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
Introduction
One of the main objectives for all governments is the sustained economic growth of their
country – the long-term expansion of the productive potential of the economy. This, however,
is not easy to achieve because of the issues previously discussed (for example, scarce resources
and the need to choose between them, as well as the associated opportunity costs). The
following question naturally arises – is there any way to represent the productive potential of the
economy? The answer is yes, with a production possibility frontier (PPF).
A PPF shows all the combinations of two or more goods or services that can be produced in
an economy if all the available resources are fully and efficiently used with the best available
technology. Therefore, if an economy is fully utilising its resources, it is producing on the frontier.
Throughout this course, we will keep the analysis rather simple; from now on we will consider
only two goods. However, the model and its conclusion can easily be extended to include more
goods and services. It is possible to consider two goods as one specific good and ‘everything
else’.
Figure 1 shows a typical PPF showing the possible combinations of good A and good B
which can be produced by an economy. All points on and below the PPF are feasible points
of production, with the points on the frontier itself representing the full and efficient use of
resources.
Figure 1: A simple production possibility frontier.
Imagine that the economy can produce only food and shelter and that all raw resources (the
CELL factors of production – capital, entrepreneurship, land and labour) are needed to produce
both. If all resources are devoted to the production of food, then there are no resources available
to build shelter. This situation is represented in Figure 2 as point Q0, where Q stands for ‘quantity’.
Alternatively, if all resources are used to build shelter, then there would be no resources available
to grow food. This situation is represented by point Q1. If resources were divided between
the two – a mixture of food and shelter – then a range of combinations of the two products
is available. Consider point X. Here the economy is producing Q2 of food and Q3 of shelter.
22
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
However, point Y (Q4 of food and Q5 of shelter) is also possible. Similarly, there are more points
on the frontier representing different combinations of food and shelter which the economy
could potentially produce. The set of all points for which all resources are fully utilised is the
curve known as the PPF. Any combination of outputs represented by a point on the frontier is
said to be productively efficient – since no resources are wasted. The only way of producing more
food is by producing less shelter; to build more shelter, the production of food must be reduced.
Therefore, the PPF (or more precisely, its slope) also illustrates the concept of opportunity cost
(discussed earlier). This is calculated by finding out how many units of shelter must be sacrificed
to obtain one more unit of food. For example, in Figure 2 the opportunity cost of moving from X
to Y, and so producing Q4 rather than Q2 units of food, is giving up Q3 – Q5 units of shelter.
Figure 2: Opportunity cost of moving from point X to point Y.
So far, we have established that a PPF represents all combinations of goods that can be produced
when all resources are used efficiently. But exactly which combination should the economy
choose? How do we decide?
In a free-market economy (can you remember the features?), forces of demand and supply
ensure that the correct equilibrium is reached. (Note: the concepts of equilibrium and
disequilibrium are fully discussed in Section 2.2). Suppose that there is a sudden increase in the
need for shelter. To meet the increased demand, the economy will need to build more houses.
As a result, this sector would need more resources and the price paid for those resources would
increase. Therefore, suppliers would be willing to sell their goods to house builders rather
than to food producers because they would get more money for the same products from
house builders. As a result, resources would be shifted away from food production toward the
construction of shelter. The very same market forces that trigger an increase for one product will
also ensure that the necessary resources for production are available.
For example, by the late 1970s, Kodak (founded in 1888) products accounted for approximately
90 per cent of the US traditional film and camera market. However, the 21st century presented a
great challenge for the company. The sales of traditional photography devices started to decline
as the market for new digital photography grew rapidly. As a result, Kodak had to transfer all of its
23
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
resources to digital-oriented production; otherwise it would not have been able to keep up with
market demand (The Economist, 2012).
The situation in a centrally-planned economy, however, is different. In this case, the central
authority (i.e. the government) decides which goods are to be produced. Such decisions were
taken in the former Soviet Union in the 1930s, for example, and were carefully described in socalled ‘Five-Year Plans’. Each plan dealt with virtually all aspects of development (such as the use
of natural resources, production of consumer goods and education) with the aim of creating
an advanced industrial economy. The growth of the economy was visibly boosted under Stalin,
but at the cost of severe human suffering. Not only is it impossible for one person to be able to
determine the right amount of output, but the whole process of gathering data is costly, timeconsuming and liable to error. Most 21st-century economists agree that, unless there is a sound
reason to believe that the solution offered by the market is not the best from society’s point of
view, for example when there is monopolistic pricing and excess profit (which will be discussed
later in the course), price and quantity decisions should be left to demand and supply forces.
Inefficiency – why?
The ideal situation of productive efficiency is, unfortunately, rarely achieved. This is because
the curve is only a hypothetical concept and so can only be estimated. For example, some
resources that may be needed may not yet be known, or the cost of accessing others might be
too high. Therefore, even the best economies are very often producing inefficiently. This can be
represented graphically as a point within the PPF, such as point W in Figure 3. In this example, the
production of one or both goods can be increased without the need to sacrifice production of
the other. There is no opportunity cost involved, as there are still some spare resources that can be
used (i.e. there is slack in the economy since it is not producing at full capacity). What about point
S? Since it lies outside the PPF, even though it would be desirable, it is not feasible as there are not
enough resources and technology to be able to produce at that point.
Figure 3: Points W and S, where W is inefficient and S is not feasible.
24
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
Production at W is inefficient due to some unused resources and the possibility of increasing
output without any opportunity cost. Production at point S is not feasible due to the lack of
available resources.
Another reason for an economy not to produce at the frontier is time trade-offs. For example,
you could put money into a bank account now and go on holiday with the money next year, or,
alternatively, you could spend the money now on new clothes. In a similar manner, we can use
all of our available resources now, or, alternatively, save some of them for future generations. By
sacrificing some of our current consumption, we increase consumption for future generations.
So let us summarise what we have learned so far:
A PPF represents all the different combinations of goods (and/or services) that can be
produced within the economy if all resources are used efficiently.
Only one point on the curve can be produced – which represents the need for choice.
If all resources are fully utilised, to produce more of one good, some quantity of other goods
must be sacrificed – therefore the slope of a PPF represents the opportunity cost.
Production of all goods is not always achievable. All points outside a PPF are points the
economy would want to achieve but cannot reach due to resource scarcity.
All points within a PPF are feasible, but not desirable, as there are some spare resources that
are not fully utilised. There is no opportunity cost of expanding production from any point
within a PPF.
Some economies may choose to produce within a PPF because of time trade-offs.
Economic growth and the PPF
Once the frontier is reached, expansion is the only way to increase production. Expansion
can be achieved by either inventing new resources and/or new technologies. Such growth is
represented by an outward shift of a PPF. Possible reasons for such increases include:
increased training of employees making them more productive – fewer resources are needed
to produce the same quantity of output, so some of the workforce can be shifted to the
production of other goods
a greater increase in capital or the discovery of new resources
an increase in population – more labour means greater human capital
an improvement in technology, new discoveries, specialisation or the division of labour.
To put these factors into context, let us use the earlier example of food and shelter. Here are a
few scenarios and their corresponding graphs.
Scenario A: The entire workforce is required to attend special training before being employed
and during the training they acquire all of the skills necessary for their work. Evidence suggests
that this increases efficiency of an average worker by 30 per cent. This is depicted in Figure 4
where there is an outward shift of the original PPF as the productive capacity of the economy has
increased.
25
Shelter
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
PPF2
PPF1
Food
Figure 4: Scenario A.
Shelter
Scenario B: At a recent international summit, it was agreed that Country 1 should get its fertile
land back from Country 2. So, from Country 1’s perspective, it gains more land on which to
cultivate food and/or build shelter. Given it is fertile land, it would be better suited to producing
food rather than shelter. So, although the PPF would shift outwards, it would expand further in
the direction of food, as indicated in Figure 5.
PPF2
PPF1
Food
Figure 5: Scenario B.
Scenario C: Following the opening of the country’s frontiers and market liberalisation, the net
outflow of people aged between 20 and 45 doubled. People in this age group are likely to be
26
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
Shelter
some of the most productive in the economy. Therefore, the productive capacity would decrease
significantly due to the net emigration of this age group. Given building shelter is likely to be
more labour-intensive than food production, there would be a greater effect on shelter capacity
than on food production. So the PPF would shift inwards, as indicated in Figure 6.
PPF1
PPF2
Food
Figure 6: Scenario C.
Shelter
Scenario D: A new, faster and cheaper way of building houses has been discovered by a team
of researchers. This is effectively a new technological discovery, and hence the PPF expands
outwards. So the PPF expansion would be as shown in Figure 7.
PPF2
PPF1
Food
Figure 7: Scenario D.
27
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
Note that the shift of a PPF does not have to be parallel as a new technology can benefit some
goods more than others. Even if increased productivity affects only one of the goods, production
of all goods can increase. This is because resources saved on production of one good can be
transferred to the production of all other goods. For example, if fewer people are required to
produce food, those people could be used to build more shelter.
ACTIVITY
Using a PPF, how would you represent the impact of natural disasters (such as earthquakes
and floods) on an economy’s productive capacity?
Shapes of PPFs
Harry Potter book
The most common shape of a PPF is the one we have drawn so far – concave to the origin
(curved like a circle). This is because we assume that opportunity cost is not the same along the
curve due to diminishing marginal returns (that is, the more resources you use, the less productive
one extra unit becomes). However, this shape is not the only one that can exist. Suppose you
can read 20 pages of a history book per hour or 40 pages of a Harry Potter book per hour. If your
reading speed does not change with time, then no matter how long you read – one, two or
three hours – the opportunity cost of reading one more page of the history book is to give up
two pages of Harry Potter. The situation described here represents constant opportunity cost. The
relevant PPF therefore would be a straight line, as shown in Figure 8.
History book
Figure 8: Production possibility frontier representing constant opportunity cost
(straight line).
28
Unit 1: The nature and scope of economics • Section 1.3: The production possibility
frontier
In real life, things are often much more complicated than the examples given above.
Nevertheless, the idea of the PPF helps us to illustrate and understand general principles (see
Anderton, 2008, Unit 1, pp.3–5).
ACTIVITY
Explain what is meant by a production possibility frontier. Under which circumstances
would such a curve change position?
ACTIVITY
Draw a PPF graph in which the vertical axis shows production of public healthcare services
and the horizontal axis shows the production of private healthcare services. Currently,
the economy is producing at point A on the frontier where 70 per cent of all production is
devoted to private services and 30 per cent to public services.
Mark the following points on your diagram:
point A, as per the information above
point B, showing production after electing a new government which decides to devote
more resources to public healthcare services
point C, showing the inefficient use of resources
point D, which is currently not feasible.
ACTIVITY
Draw a PPF graph corresponding to the production of two goods and label it A. On the
same diagram, draw a new PPF which represents productive capacity if the economy
experienced a severe and prolonged civil war. Label this PPF B. Finally, draw another PPF
on the same diagram which shows discoveries of new raw materials and label it C.
29
Unit 1: The nature and scope of economics
30
Test your knowledge and understanding
SHOULD MEDICINES BE SUBSIDISED?
Since 1920, in Poland all Poles have been required to participate in a state-funded
healthcare system. Part of the funding comes from general tax revenue; the rest is
collected directly from an employee’s salary. Such contributions are compulsory and
it is impossible to opt out of the scheme. In return, people covered by the National
Health Insurance System, and their dependants, are entitled to free primary healthcare,
specialist care, hospital treatment, basic dental treatment and ambulance transportation.
In addition, those suffering from long-term illnesses (such as diabetes, heart disease and
depression) can benefit from partially-subsidised drugs. However, recent changes to the
list of state-subsidised medicines have caused much concern and consternation. Doctors
are protesting against new, stricter regulations, which impose fines on them if they make
a mistake writing out prescriptions which results in patients underpaying for drugs. This
could theoretically happen as not all people are entitled to the same level of discount.
Patients are also protesting because drugs are becoming ever more expensive. Moreover,
starting from September this year, the price of another 500 previously subsidised drugs
will also significantly increase. For example, the price of drugs commonly used to treat
Alzheimer’s disease will triple. Nurses warn that this could result in some patients being
unable to continue with their treatment. The Polish government, on the other hand,
explains that the opportunity cost of subsidising some of the drugs, especially those
produced by monopolistic pharmaceutical companies, is too high. The money saved on
subsidising old drugs can be invested in the research and development of new, more
effective and cheaper drugs.
The potential problem is that there would never be enough money for the National Health
Fund to provide the quality of healthcare and the quantity of subsidised medicines that
citizens would like. Consequently, choices, often difficult ones, have to be made.
As of 2012, Poland spends about 7.4 per cent of its GDP (that is, its total economic output)
on healthcare, which is a relatively low percentage compared to many other developed
countries.
Using your knowledge gained from Unit 1, and the article provided above, answer the following
questions.
Question 1
a. Define the term ‘economic problem’.
[2 marks]
b. Explain how the ‘economic problem’ can be addressed with reference to the
healthcare and pharmaceutical market in Poland.
[4 marks]
Question 2
a. Explain what is shown by the production possibility frontier.
[2 marks]
b. Using the production possibility frontier, show how the Polish national health system,
in conjunction with the government, needs to choose between subsidising medicines
used in the treatment of long-term diseases and investing in the research and
development of new drugs.
[4 marks]
Unit 1: The nature and scope of economics • Test your knowledge and understanding
c. On your diagram in (b), indicate point X where there is an efficient allocation
of resources. Explain why this point is efficient.
[3 marks]
d. Do you expect healthcare markets to operate efficiently? Why or why not?
[3 marks]
Question 3
a. Define ‘opportunity cost’.
[2 marks]
b. Identify and describe at least two opportunity costs of increased drug subsidies.
[4 marks]
31
Unit 1: The nature and scope of economics
32
Concluding comments
The concepts and the personalities introduced in the development of economic thought can,
and should, be further investigated as the subject is studied in greater depth. The fundamental
problem of finite resources and the question of optimisation are issues which confront every
society. Society’s reactions will be investigated later in the course.
A reminder of your learning outcomes
Having completed this unit, and the Essential reading and activities, you should be able to:
define the concepts of the basic economic problem, scarcity, efficiency, opportunity cost and
specialisation
explain what is meant by the production possibility frontier and analyse its position and
shape
critically assess the advantages and disadvantages of the division of labour.
152
Appendix 1: Sample examination paper
Important note: This Sample examination paper reflects the examination and assessment
arrangements for this course in the academic year 2014–2015. The format and structure
of the examination may have changed since the publication of this subject guide. You can
find the most recent examination papers on the VLE where all changes to the format of the
examination are posted.
Time allowed: 2 hours
Candidates should answer TEN of the following TWELVE questions: ALL FIVE from
Section A (25 marks), ALL FOUR from Section B (25 marks) and ONE (out of three) from
Section C (50 marks).
Section A
Answer the following five questions [25 marks]
1. Distinguish between ‘inflation’ and ‘hyperinflation’.
[4 marks]
2. Define the term ‘market failure’ and give three reasons why markets can fail.
[7 marks]
3. Explain how the Human Development Index is measured.
[5 marks]
4. Define income elasticity of demand. Why do you think that the income elasticity of
demand for dental implants is around 0.8?
5. Can high inflation and high unemployment coexist? If so, explain the reasons.
[4 marks]
[5 marks]
Section B
Answer the following four questions [25 marks]
Tackling the British love for fat
The British Government is concerned that UK citizens are eating too much saturated fat.
Excessive consumption of saturated fat poses a risk to people’s health, since it is associated
with cardiovascular disease, the number one cause of premature death in the UK, as well as
some cancers and diabetes. The Food Standards Agency (FSA), the Government department
responsible for protecting the public’s health in relation to food, estimates that the average
Briton consumes 20 per cent more saturated fat than the official Government recommended
amount.
The question therefore arises: Should the Government intervene to try to reduce the amount of
saturated fat consumed? The answer is not obvious. Some economists believe that consumers
themselves are those best suited for making decisions over their own consumption and
therefore no third party intervention is needed. However, others argue that increased fat
consumption is due to imperfect information and therefore leads to market failures. To correct
for that, the FSA launched an advertising campaign showing how consuming too much
saturated fat leads to clogged arteries and other long-term consequences. Another option
would be to impose a tax on products containing saturated fats. Under such a scheme, full-fat
butter products would be taxed more heavily than low-fat butter, which in turn would be taxed
more heavily than margarine products, while fat-free spreads would avoid the tax. That way the
Government hopes people will switch to healthier alternatives. Would a ‘fat tax’ really succeed
in reducing our excessive saturated fat consumption?
© University of London 2015
Appendix 1: Sample examination paper
153
Figure 1: Saturated fat consumption by various household income groups.
Adapted and reproduced with permission from O’Connell, M. ‘Tackling the British love for
fat’, Economic Review 27(2) 2009.
Using your own knowledge and the article provided, answer the following questions:
6. Using Figure 1, carefully explain the relationship between fatty food consumption and
household income.
[4 marks]
7. Should the British government intervene to limit the consumption of fatty food? Give two
reasons in support of the intervention and one against it.
[6 marks]
8. ‘Imposing high taxes on products containing saturated fats is the only way to significantly
limit the consumption of fatty foods. All other ways will not work.’ Comment on the
statement. Do you agree with it? Why or why not?
[10 marks]
9. What kind of good (normal, inferior or Giffen) are products with high content of saturated fat
mostly likely to be? Explain.
[5 marks]
Section C
Answer one of the following essay questions [50 marks]
10. Why do governments worry about inflation? You are encouraged to illustrate your answers
with the use of relevant diagrams.
11. What are the costs of unemployment? How can governments intervene to lower the
unemployment rate?
12. Explain the consequences of the recent financial and economic crisis for both developed and
developing countries.
154
Appendix 2: Glossary
A
Absolute advantage: The ability of a country to produce more output of a good or service than
another country that possesses the same resource input(s).
Absolute poverty: To be ‘poor’ means being unable to subsist (i.e. having insufficient food,
drink, shelter and clothing). In monetary terms, absolute poverty equates to living on less than $1
a day (revised by the World Bank to $1.25 a day in 2008).
Ad valorem taxes: Indirect taxes which are charged as a percentage of the price of the good,
such as value added tax (VAT).
Aggregate demand: The relationship between total output and the price level which shows
planned expenditure on final goods and services at all possible price levels. Aggregate demand
(in a closed economy) consists of consumer spending, government spending and investment.
Aggregate supply: The real value of all goods and services produced within the economy. It
tells us the amount that firms are willing to produce at all possible price levels.
Appreciation: The increase in the value of a domestic currency in terms of other currencies.
Asymmetric information: When a party involved in a transaction has more information than
the other party, and therefore well-informed decisions are not possible.
Austerity: Reducing government spending and imposing cuts and freezes on public sector jobs,
wages and pensions in the hope of reducing national debt-to-GDP ratios.
B
Balance of payments: The record of all money moving in and out of a country. For the balance
of payments to be in equilibrium, the value of imports and exports should be the same.
Balance sheet: An accounting statement of a firm’s assets and liabilities on the last day of a
trading period.
Basic economic problem: How to allocate scarce resources between competing uses in the
best possible way.
Budget (or fiscal) deficit: When a government spends more than it collects in taxes.
Budget (or fiscal) surplus: When a government spends less than it collects in taxes.
C
Capital: Man-made assets, such as machinery or buildings.
Capital account: The recording of movements of funds reflecting the net change in the
ownership of assets.
Centrally planned economies: Decisions about what to produce, and in which quantities, are
taken solely by the government.
Ceteris paribus: Latin term for ‘other things being equal’. This means that other things that
could change are, for the moment, assumed not to. The term allows us to isolate the relationship
between two economic variables controlling for all other variables.
Appendix 2: Glossary
Cheap credit: The lending of money at low interest rates.
Circular flow of income: This shows the fundamental, mutually beneficial economic
relationship between households and firms. It is a model of the flows of resources, goods and
services, as well as money, receipts and payments for them, in the economy.
Claimant count: In the UK, the number of people who are officially registered and able to work
but who currently cannot find a job and are therefore claiming unemployment benefit.
Classical school: The belief system of classical economists in which markets are most effective
when free of government intervention.
Collateralised debt obligations (CDOs): Structured asset-backed financial products.
Comparative advantage: This occurs when the marginal opportunity costs of one good in
terms of the other differ between countries.
Complements: Two goods are considered to be complements if a change in the price of one
causes an opposite shift in the demand for the other.
Consumer price index (CPI): An index of weighted prices for a representative basket of goods.
It excludes payments on housing costs (rent) and mortgage payments. It conforms to the
international harmonised index of consumer prices.
Consumer spending: The amount of goods and services (such as food and clothing) purchased
by households. It depends on income, tax to be paid, transfer payments and the marginal
propensity to consume.
Consumer surplus: The welfare gain to buyers resulting from the fact that some consumers pay
less for the good than its maximum valuation.
Consumption externality: An externality which occurs as a direct result of product
consumption.
Contagion: A situation when economic ills are propagated across borders.
Correlated variables: The linear relationship between two variables.
Credit crunch: A severe contraction in the amount of available credit.
Credit rating agencies: Companies which assign credit ratings to debt.
Creditor: A lender who is owed money.
Creeping inflation: Slowly increasing prices, such as in the UK.
Cross-price elasticity of demand (XED): The responsiveness of demand for one good to
changes in the price of another.
Current account: A summary of transactions involving ‘visible’ goods (such as raw materials and
manufactured products) and ‘invisibles’ (such as services and investment income).
Cyclical unemployment: Unemployment caused by the variable economic cycle.
D
Deadweight loss: The cost to society resulting from the loss of economic efficiency. The
deadweight loss is the total (combined) reduction in consumer and producer surpluses minus
the total tax raised.
Debt-to-GDP ratio: The ratio of outstanding national debt to GDP.
Default: When a borrower is unable to repay a loan.
Deleveraging: The selling of assets whose original purchase was financed by borrowing.
155
Appendix 2: Glossary
Demand: The relationship between price and quantity which tells us how many units of a
certain good consumers are willing to purchase at every possible price.
Demand side policies: Direct (fiscal and monetary) intervention by the government which
affects the levels of aggregate demand.
Demerit goods: Goods with underestimated or ignored harmful effects, for example, cigarettes,
drugs and alcohol. Not only do they have a negative effect on people who consume them in
excessive amounts but they can also harm others, for example, through passive smoking.
Depreciation: The decrease in the value of a domestic currency in terms of other currencies.
Determinants of demand: Factors which determine demand, such as price of the product,
price of complements (goods which are consumed together) and substitutes (replacements),
income, wealth, taste, preferences, advertising, expectations, climate, population and
demographics.
Determinants of supply: Factors which determine supply, such as price of the product,
technology, weather conditions, costs of inputs, access to raw materials, regulations, number of
firms in the industry, taxes and subsidies.
Determinants of the price elasticity of demand (PED): Factors which determine the PED,
such as availability of close substitutes, time horizon (long run versus short run), percentage of
income spent on those goods, type of goods and brand image.
Determinants of the price elasticity of supply (PES): Factors which determine the PES, such
as number of suppliers, ease of storing units, productive capacity, time horizon (long run versus
short run), length of production period and perishability of the product.
Direct taxes: Taxes (such as income tax) which are paid straight to the government by a person
or institution upon whom the tax was imposed.
Disequilibrium: A situation where the quantity demanded is different from the quantity
supplied so the market cannot clear. In the aggregate setting, the economy will be in
disequilibrium when the level of aggregate demand is not equal to the level of aggregate supply.
Disposable income: After-tax income (i.e. gross income less income tax and any other
deductions such as national insurance contributions).
Division of labour: Production is broken down into a series of tasks that are conducted by
individual workers.
E
Economic good: Any good or service which is scarce.
Economic growth: Defined in one of two ways: (i) as an increase in the real income or the gross
domestic product (GDP) of an economy (this is known as the actual economic growth), or (ii) as
an increase in the productive capacity of the economy (this is known as the potential growth).
Economies of scale: These accrue to larger firms because they have advantages over their
smaller rivals. Technical economies of scale occur when large-scale production makes the
optimum use of machine capacity. Purchasing and financial economies of scale exist because
the large firm can use its influence on suppliers and lenders. Diseconomies of scale are ultimately
experienced because of the difficulty of control over enormous corporations.
Elasticity: The responsiveness of one variable to changes in a different variable. The value of the
elasticity, in absolute terms, varies between zero and infinity. The sign of the elasticity depends on
the directions in which the two variables are moving. If both of them move in the same direction,
elasticity is positive. If they move in opposite directions, however, the sign of the elasticity is
negative. The sign only shows the direction of the movement, it does not show the actual elasticity.
156
Appendix 2: Glossary
Endogeneity: Economic variables which both affect and are affected by their relationship as
depicted in an economic model.
Entrepreneurship: The ability and originality to combine all factors of production to make
profits. Many observers now include confidence as part of entrepreneurship.
Equilibrium: When the demand for a certain good is exactly the same as the supply of that
good. There is neither excess demand nor excess supply. In the aggregate setting, the economy
will only be in equilibrium when the level of aggregate demand is equal to the level of aggregate
supply.
Equity: A bank’s buffer to cover unexpected losses which could occur. From an accounting
perspective, equity is calculated as the difference between total assets and total liabilities.
Equity ratio: The ratio of a bank’s equity to its total assets.
Euro: The official currency of the Eurozone.
Excess demand: At the given price, people are willing to buy more goods than producers are
willing to offer. In this case, the price will continue to rise until equilibrium is reached.
Excess supply: At the given price, firms are offering more goods than consumers are willing to
buy. In this case, the price will fall until the market clears again.
Exchange rate: The price of one currency expressed in terms of another currency.
Externalities: Third-party effects (delivered and received outside the market) caused by
decisions or actions made by someone else. They can either be positive or negative.
F
Fiscal policy: A government’s policy regarding taxation and government spending which can
be used to keep levels of unemployment and inflation under control.
Flow variable: A variable which is considered over a period of time, such as annual income.
Foreign aid: The voluntary assistance provided to one country by another, typically financial aid
transfers.
Foreign direct investment (FDI): Investment across borders.
Fractional reserve banking: A system of banking whereby banks keep only a fraction of their
deposits in reserve.
Free good: Any good or service which is available in (effectively) infinite quantities.
Free-market economy: Resources are privately owned with decisions about what to produce,
and in which quantities, decided by the forces of supply and demand.
Free-rider problem: A problem associated with public goods in which individuals presume
that others will pay for the public goods, so that individually they can escape paying for their
production without a reduction in production occurring.
Frictional unemployment: Unemployment which occurs when people are in-between jobs
(this type of unemployment always exists).
G
GDP per capita: GDP (see below) divided by the size of the population.
Geographical unemployment: Unemployment associated with a particular region of the
country.
Giffen goods: Goods for which demand increases as its price increases.
157
Appendix 2: Glossary
Globalisation: The increasingly integrated nature of national economies into a single
international market.
Government spending: Government expenditure using money collected from taxes on goods
and services (or borrowed) on healthcare, infrastructure (such as roads and bridges), schools and
public services (such as the police, armed forces and firefighters).
Gross domestic product (GDP): The total value of the goods and services produced by the
domestic economy within a certain period of time, usually a year.
Gross national product (GNP): GDP plus the net property income from abroad (i.e. income
earned abroad by domestic residents less the income earned by foreigners in the domestic
economy).
H
Hidden unemployment: Official unemployment statistics are not 100 per cent accurate since
people may be incorrectly included or excluded.
Human Development Index (HDI): An index of economic development consisting of the
average of three indicators: standard of living (measured by GDP per capita in PPP terms), life
expectancy at birth and adult literacy.
Human Poverty Index (HPI): Recently superseded by the Multidimensional Poverty Index, HPI
is an alternative index of economic development focusing on quantifying how well a country
is coping with reducing existing poverty. HPI consists of the percentage of infants with a life
expectancy of less than 40 years, the percentage of illiterate adults and the percentage of people
without a sufficient standard of living (no access to clean water, no access to healthcare, and
children under the age of five who are underweight).
Hyperinflation: Extremely high increases in the price level caused by a major disruption to an
economy, for example, war or depression.
I
Imperfect information: This occurs when a decision-maker has incomplete, inaccurate,
uncertain or misinterpreted information, leading him or her to potentially make an incorrect
choice.
Income elasticity of demand (YED): The responsiveness of demand to changes in income.
Indirect taxes: Taxes which are usually levied on goods and services which we consume.
Inferior goods: Goods characterised by decreased demand when income rises, and increased
demand when income falls.
Inflation: The sustained overall increase in the price level – conversely, the overall reduction in
the value of money. Inflation can either be anticipated (expected) or unanticipated (unexpected).
Interbank lending: Lending between banks (i.e. from one bank to another bank).
Interdependence: The situation where a number of countries are so closely linked by trade and
financial relationships that they depend on each other economically.
Interest rates: The cost of borrowing money.
International Labour Organization (ILO) unemployment survey: An unemployment
rate based on a quarterly survey of more than 60,000 households. Only those who state in the
survey that they have been actively seeking a job in the last four weeks are considered to be
unemployed.
158
Appendix 2: Glossary
International trade: The exchange of goods and services between countries through exports
and imports.
Investment: The spending by firms on items such as machines and buildings, which can be
used to produce goods and services in the future.
K
Keynesian economics: Keynesian economists advocate state intervention through the use of
macroeconomic policy, in particular fiscal policy.
L
Labour: People who provide physical and intellectual skills (human capital).
Land: All naturally occurring resources, such as soil, air, water, minerals, fauna and flora.
Luxury goods: Goods with upward-sloping demand curves, often bought by people to signal
their wealth and social position. These can be considered as ‘status symbols’.
M
Marginal benefit: The benefit of one extra unit produced.
Marginal cost: The cost of one extra unit produced.
Marginal propensity to consume: The proportion of (disposable) income which is spent on
consumption.
Market: A market is a place (either physical or virtual) where buyers and sellers meet in order to
exchange goods and services.
Market failure: The price mechanism fails to allocate resources efficiently.
Market power: The ability of a firm to set a price for its product above that determined in a
perfectly competitive market environment.
Maximum productive capacity: The limit on how much output can increase, beyond which
the economy cannot grow unless new technologies or new resources are found.
Merit goods: Goods which are better for people than they think. Benefits could be
underestimated, for example, due to time lags. Costs are observed immediately while positive
effects may only be visible in a few years’ time. As people find it difficult to make well-informed,
rational decisions, merit goods are usually underprovided by the free-market mechanism.
Missing market: A situation when no private company would be willing to provide a (public)
good as no profits could be made. In graphical terms, there would be no intersection of the
market demand and supply curves.
Mixed economies: Governments intervene to improve efficiency, correct market failures or
provide public goods.
Monetary policy: A tool of macroeconomic policy which involves controlling the supply
of money through open market operations, manipulating interest rates, printing money and
changes in reserve requirements.
Monetary transmission mechanism: The central bank sets the interest rate for a period of
time. This rate, in turn, will affect the rates of mortgage and bank lending. Asset prices and the
currency exchange rate can also be affected. Such changes will, therefore, influence firms and
individuals in terms of their investment decisions. This has a knock-on effect on the demand for
labour, and hence wage rates.
159
Appendix 2: Glossary
Monopoly: The market structure where there is only one supplier of a particular good in the
market.
Multiplier: The ratio of the change in the equilibrium level of national income to the change in
expenditures which brought it about. It is the total effect of the cascade of spending described
by the re-spending cycle (see below).
N
National debt: The total outstanding government debt of a country.
Negative equity: The situation when the fall in the value of a house means the house is worth
less than the outstanding mortgage secured against it.
Negative externality: An externality where one person suffers from actions taken by
somebody else. Negative externalities give rise to an inefficient allocation of resources because
external costs are not included in the free-market equilibrium. From society’s point of view,
goods are over-produced and prices charged are too low.
Neoclassical school: The belief system which assumes firms and consumers are both rational,
with firms seeking to maximise profit, while consumers look to maximise utility. The neoclassical
school is also responsible for developing the use of marginal analysis.
Normal goods: Goods for which demand increases when income increases, and falls when
income decreases.
O
Opportunity cost: The cost of the best alternative foregone. It is a cost associated with
engaging in a certain activity evaluated as the value of everything else you must give up in order
to pursue it.
Ordinary goods: Goods for which demand is downward-sloping (i.e. people buy more of a
good when its price decreases, and buy less when its price increases).
P
Positive externality: An externality where one person benefits from actions taken by
somebody else. Positive externalities give rise to an inefficient allocation of resources because
external benefits are not included in the free-market equilibrium. From society’s point of view,
goods are under-consumed.
Price adjustment: The price level within the economy changes until equilibrium is reached.
Price ceiling: A maximum price is the legally established threshold value above which the
market price cannot rise.
Price elasticity of demand (PED): The responsiveness of quantity demanded to changes in the
price of the good.
Price elasticity of supply (PES): The responsiveness of quantity supplied to the changes in the
price of a good.
Price floor: A minimum price is the legally established threshold value below which the market
price cannot fall.
Price level: The weighted average of prices of the whole spectrum of goods and services
consumed by a given country.
160
Appendix 2: Glossary
Price mechanism: The ‘invisible hand’ which responds to changes in demand and/or supply of a
certain good or service in order to maintain the balance in the market. The price mechanism has
three main functions: rationing, signalling and providing incentives.
Price taker: A price taker is a firm which must take the price of its product as given. The firm
cannot influence its price.
Private goods: Goods which are both rivalrous and excludable.
Producer surplus: The welfare gain to firms resulting from the fact that the price they receive
for their product is higher than the minimum price at which they are willing to supply the
product.
Production externality: An externality which occurs when spill over (third-party) effects result
from the physical production of a good.
Production possibility frontier (PPF): A PPF shows all the combinations of two or more
goods or services which can be produced in an economy if all the available resources are
fully and efficiently used with the best available technology. The slope of a PPF represents the
opportunity cost.
Public goods: Goods which are non-rivalrous and non-excludable, such as defence.
Purchasing power parity (PPP): PPP exchange rates aim to equalise the real purchasing power
between various currencies.
Q
Quantitative easing: A process which injects money into the economy with the objective
of boosting economic activity. A central bank creates money electronically and uses this to
purchase financial assets – usually government bonds, although other financial assets may be
purchased. This cash injection reduces the cost of borrowing and increases asset prices with the
net result of stimulating economic growth.
Quantity adjustment: The amount of goods and services produced within the economy
changes until equilibrium is reached.
Quantity demanded: The single value which tells us how many units of goods and services
consumers want to buy at a specific price.
Quantity supplied: The single value which tells us how many units of goods and services firms
want to sell at a specific price.
Quasi-public goods: Goods which exhibit mixed characteristics of both private and public
goods. They are either non-rivalrous but excludable, or non-excludable but rivalrous.
R
Real (economic) growth: An increase in the productive capacity of the economy.
Regulation: The control of economic activities by the government or some other regulatory
body.
Relative poverty: This considers poverty within a particular society, which is more suitable for
developed economies.
Re-lending cycle: The mechanism by which banks control the supply of money.
Repossession: In relation to property, the situation when a lending financial institution (typically
a bank or building society) takes possession of the property used as collateral (security) against a
loan (typically a mortgage) when the borrower defaults.
161
Appendix 2: Glossary
Re-spending cycle: The repeated use of money as it circulates through the economy. For
example, the recipients of a fiscal stimulus would then spend some of this money, a proportion
of which is subsequently spent by the next recipient, and so on. The more re-spent, as opposed
to paid as a tax or saved, the higher the final increase in total income. The total effect of this
cascade of spending is termed the multiplier (see above).
Retail price index (RPI): A statistical measure of a weighted average of prices of a specified set
of goods and services purchased by representative families.
Risk premium: In terms of interbank lending, the additional cost of borrowing above the central
bank base rate reflecting the greater risk of one bank lending to another bank.
S
Scarcity: The existence of a finite amount of resources.
School of economic thought: A set of beliefs held by a group of like-minded economists.
Seasonal unemployment: Unemployment which occurs when people are unemployed
because of the season, for example, fruit pickers.
Securitised mortgages: Financial assets formed by packaging up various mortgage loans into
financial securities.
Social benefits: Private and external benefits combined together.
Social costs: Private and external costs combined together.
Social welfare: Also known as the economic surplus, social welfare is the total (combined)
welfare of consumers, producers and government.
Specialisation: A country, firm or individual focuses on the production of a limited range of
goods or services.
Specific taxes: Indirect taxes which are charged as a fixed amount per unit sold, such as an
excise tax.
Speculative bubble: Such a bubble occurs when investors are willing to buy assets if
they believe the assets will increase in value, allowing them to sell them in the future for an
anticipated profit. Of course, bubbles cannot expand indefinitely, and therefore there would
come a point when the bubble bursts.
Stagflation: A period of simultaneous high unemployment and rising prices (i.e. a period of
both economic stagnation and inflation).
Stock variable: A variable which is fixed at a particular point in time, such as wealth.
Strato-inflation: A moderate increase in the price level, generally experienced in developing
economies such as Brazil or India.
Structural unemployment: Unemployment caused by the changes in the nature of the
economy, for example, a transition between sectors (an economy moving from agricultural to
industrial output).
Sub-prime lending/mortgages: Loans/mortgages advanced to borrowers with poor credit
histories who typically have a higher risk of default.
Subsidies: Monetary benefits provided by governments in order to increase the consumption
of merit goods and goods whose consumption generates positive externalities which benefit
other people. By subsidising the costs of production, governments help in lowering the prices of
goods.
Substitutes: Two goods are considered to be substitutes when a change in the price of one
causes a shift in demand for the other in the same direction as the price change.
162
Appendix 2: Glossary
Super-normal profits: Profits greater than that which is just sufficient to ensure that a firm will
continue to supply its existing product or service.
Supply: The relationship between price and quantity which tells us how many units of a certain
good firms are willing to sell at every possible price.
Supply side policies: Increased training, a reduction in unemployment benefits (by way of
incentives), better advertising of job vacancies, investment in new technologies and wage
negotiations with the trade unions.
Sustainability: The capability of a process to continue with minimal impact on the
environment. In general, sustainability involves meeting the needs of current generations
without compromising the ability of future generations to meet their own needs.
T
Tax: A compulsory payment charged by a government and imposed either on firms or
consumers.
Tax incidence: The amount of tax paid by each party used to describe the division of the tax
burden between consumers and producers.
Terms of trade: The ratio of export prices to import prices. It is expressed as an index because
it is based on the weighted average price of exports and the weighted average price of imports
reflecting not just one, but thousands of different export and import prices.
Trade balance: The value of exports minus imports.
Trade bloc: A free trade area established through an intergovernmental agreement.
Trade deficit: When imports exceed exports.
Trade surplus: When exports exceed imports.
Transfer payments: Monetary payments made by the government to individuals for which no
goods or services are concurrently rendered, such as unemployment benefits.
U
Unemployment: The number of people who are currently not employed but who are actively
seeking work and are able to start work immediately.
W
Wealth: The difference between the value of everything you own (i.e. assets) and the value of
everything you owe (i.e. liabilities).
Wealth effect: When asset prices rise, asset owners feel richer and therefore boost their
consumption of goods and services accordingly.
163