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Chapter 1 – Practice Exam Answers 1. Scarcity is about the mismatch of resources and demand. Demand is often in excess of supply of resources, thus society has to decide, as a whole, how best to allocate these scare resources. This is done by asking and then trying to answer the following three questions: what is to be produced? how is it to be produced? And for whom is it to be produced? Students may also want to consider the different ways in which the economy’s attempt to address these three different questions, namely a mixed economy, a planned economy and free market economy. Once this is done, students should then note that since resources are limited the only effective way to decide what to do is to consider the opportunity cost, which is the foregone alternative. From a number of alternatives, you simply choose the one that is the best for you at that moment in time. 2. This question requires the student to define and explain a planned economy, a mixed economy and a free market economy. Example of all should be provided, which shows understanding, i.e. Cuba, USA and UK respectively. Though students should note that all economies are effectively mixed. It is the degree of ‘mix’ that differs! Students should then proceed to consider the advantages and disadvantages of each. The key here is to understand that a planned economy, irrespective of degree, provides the necessary social, legal and financial framework, where as the free market economy provides the incentives, the pursuit of profit, etc. thus when working to together, i.e. in a mixed economy, the whole economy moves forward as best it can! 3. Positive economics deals with scientific explanation of how the economy operates, where as normative economics deals with what ought to happen based on personal judgement values. Economics is aided substantially by the understanding of positive and normative economics as both support each other and thus provide the necessary and acceptable rigour of economic analysis. 4. Macroeconomics is the study of the whole economy, where as microeconomics is the study of the individuals components that make up the whole economy. The link between the two is that both influences upon each other and thus are inter-related. For example if there is an observed changed at the micro level as a result of a macroeconomics change then there is a link. I.e. the current reduction in the VAT rate from 17.5% to 15% (2009) was initiated at a macroeconomic but yet has microeconomics effects. The hope and intention is that by reducing the VAT rate this should encourage expenditure at local levels, which when aggregated should result in an increase in total aggregate demand in the economy. 5. Economic data and economic modelling building aid the economist in understanding what is happening in the economy and why and then be able to predict, as best as possible, the effects of what is happening and their likely outcomes. Once this known the economist is able to devise policies which counter balance the negative effects whilst implementing those policies which provide positive outcomes to society as a whole. Model building provides the economist with the ability to predict the outcome of change, should they actually occur or be those which have been simulated. This increases the economist’s understanding of how the economy works and the model is then tested against actual and observed data! Chapter 1 - Short answer question solutions 1. Economics attempts to study how society allocates its resources by asking three very simple questions, namely, what to produce, how to produce it and for whom to produce it for. 2. Scarcity is basically where the quantity demanded at zero price would exceed the available supply, or in other words where demand is infinite and resources are finite. Opportunity cost is the forgone alternative and it helps address the problem of scarcity by allowing goods and services which are scare to be ranked in order of preference and this then helps in the decision making process. 3. Positive economics deals with scientific explanation of how the economy works, whereas normative economics is based on recommendations of a personal nature/value. 4. Microeconomics examines the individual aspect of the market, whereas the macroeconomics examines the economy as a whole. The link is that changes in either microeconomics or macroeconomics affect each other and thus are constantly influence the other whilst at the very same time being influence by the other. 5. Economists use economic models to test theories of how the economy ought to work and use economic data in the economic models to test the validity of the models. All this in the hope of being able to predict the future. If the models work, this will help policy makers, planners, governments etc., to implement policy so that desired outcomes are observed, i.e. full employment, low inflation, economic growth, etc.