National Year 12 Economics

Chapters: 10

1. 4.1.1 Economic methodology and the economic problem

4.1.1.1 Economic methodology · 4.1.1.2 Purpose of economic activity · 4.1.1.3 Economic resources · 4.1.1.4 Scarcity, choice and allocation · 4.1.1.5 Production possibility diagrams

Economic Methodology: How Economists Think – Economics is a social science. It studies how people, firms and governments choose when resources are scarce. Economists use a scientific method: make a guess (hypothesis), collect data, test it, and build a theory. But people are not lab chemicals, so economists cannot run perfect experiments. They use models and the idea of ceteris paribus (all other things equal). Statements are of two kinds. Positive statements say what is, and data can test them. Normative statements say what should be, and they carry a value judgement. Real decisions need both.
Factors of Production: Land, Labour, Capital and Enterprise – Factors of production are the resources used to make goods and services. There are four: land (natural resources, rewarded with rent), labour (human effort, rewarded with wages), capital (man-made tools and machines, rewarded with interest) and enterprise (organising the others and taking risk, rewarded with profit). Because wants are unlimited but these resources are scarce, every society must choose what to produce, how and for whom. The purpose of economic activity is to satisfy as many wants as possible.
Introduction to Microeconomics and the Production Possibility Frontier – Microeconomics studies single units like one buyer or one firm; macroeconomics studies the whole economy. Resources are scarce and have other uses, so every economy must decide what, how and for whom to produce. The production possibility frontier (PPF) shows the best mixes of two goods an economy can make with all its resources used fully. Moving along it has an opportunity cost, which usually rises, so the PPF is concave.

2. 4.1.3 Price determination in a competitive market

4.1.3.1 Demand · 4.1.3.2 Elasticities of demand · 4.1.3.3 Supply · 4.1.3.4 Price elasticity of supply · 4.1.3.5 Equilibrium prices · 4.1.3.6 Interrelated markets

Demand and Price Elasticity of Demand – Demand is the quantity of a good buyers are willing and able to buy at each price in a period. Market demand adds up all buyers' demand at each price. Demand depends on own price, income, prices of related goods, tastes, expectations and number of buyers. A change in own price moves us along the curve; a change in any other factor shifts it. Price elasticity of demand (Ed) = % change in quantity ÷ % change in price; it can also be judged from total expenditure.
Producer's Equilibrium and Supply – A producer is in equilibrium when profit is the highest and there is no reason to change output. By the MR–MC approach two conditions must hold: MR = MC, and MC must be rising (MC cuts MR from below). Supply is the quantity firms are willing and able to sell at each price. Market supply adds all firms' supply. Supply depends on own price, input prices, technology, taxes, prices of other goods, number of firms and expectations. Own price moves us along the curve; other factors shift it. Es = % change in quantity supplied ÷ % change in price.
Perfect Competition and Price Determination – In perfect competition, very many firms sell the same product to very many buyers, so each firm is a price taker. The market price is set where market demand equals market supply (Qd = Qs). If demand rises, price and quantity both rise; if supply rises, price falls and quantity rises.
Related Markets: Substitutes, Complements and Other Links – Markets are linked, so a change in one market moves demand or supply in others. Substitutes (competitive demand) are goods used instead of each other: if the price of one rises, demand for the other rises. Complements (joint demand) are goods used together: if the price of one rises, demand for the other falls. Derived demand is demand for something because it helps make another good (bricks for houses, workers for output). Composite demand is one good wanted for several uses, so more of one use leaves less for others. Joint supply means making one good also makes another (meat and leather). These links cause knock-on effects that spread from market to market.

3. 4.1.4 Production, costs and revenue

4.1.4.1 Production and productivity · 4.1.4.2 Specialisation and exchange · 4.1.4.4 Costs of production · 4.1.4.5 Economies of scale

Productivity: Getting More Output from Each Input – Production is the total amount made. Productivity is output per unit of input, for example boxes per worker per hour. Labour productivity = output ÷ workers (or worker-hours). It rises with training, better machines and technology, motivation, better methods and specialisation. Higher productivity lowers cost per unit, can raise wages and profits, and helps a country grow. Businesses also watch capacity utilisation (actual ÷ maximum output × 100) and choose between labour-intensive and capital-intensive methods.
Division of Labour and Specialisation – Specialisation means a person, firm, region or country concentrates on making one thing (or a few things). Division of labour is specialisation inside a workplace: a big job is split into small tasks and each worker does one task. Workers get skilled and fast, no time is lost switching tasks and special machines can be used, so output per worker rises and the cost per item falls. The costs: boring repetitive work, the whole line stops if one worker is missing, narrow skills and dependence on others. Because a specialist makes more of one thing than they need and none of the other things they need, specialisation forces exchange, and money makes exchange easy by removing the need for a double coincidence of wants.
Cost and Revenue: TC, AC, MC and TR, AR, MR – Cost is what a firm spends on inputs. Total cost (TC) = total fixed cost (TFC) + total variable cost (TVC). Dividing by output gives AFC, AVC and AC; marginal cost (MC) is the extra cost of one more unit. AFC keeps falling; AVC, AC and MC are U-shaped, and MC cuts AVC and AC at their minimum. Revenue is money from sales: TR = P × q, AR = TR/q = price, MR = extra TR from one more unit. With a fixed price AR = MR; with a falling price MR lies below AR and TR is highest where MR = 0.
Economies of Scale: Why Bigger Can Be Cheaper – Average cost = total cost ÷ output. Economies of scale are the falls in long-run average cost that come from growing bigger. Internal economies happen inside one firm: purchasing, technical, financial, marketing, managerial and risk-bearing. External economies come from the whole industry growing in one area: skilled labour, suppliers, infrastructure, shared research. If a firm grows too big, diseconomies of scale (poor communication, coordination and motivation) push average cost up. The long-run average cost (LRAC) curve is often U-shaped or L-shaped; the minimum efficient scale (MES) is the lowest output where average cost is at its minimum.

4. 4.1.5 Competitive and concentrated markets

4.1.5.1 Market structures · 4.1.5.2 Objectives of firms · 4.1.5.3 Competitive markets · 4.1.5.6 Monopoly and monopoly power · 4.1.5.8 The competitive market process

Market Structures: From Perfect Competition to Monopoly – A market structure describes how many firms sell, how alike their products are, and how easy it is to enter. Perfect competition: many firms, identical goods, free entry, price takers, normal profit in the long run. Monopolistic competition: many firms, differentiated goods, easy entry, some price power. Oligopoly: a few interdependent firms, high barriers, strategic behaviour (game theory, collusion, price leadership). Monopoly: one firm, no close substitutes, high barriers, price maker with possible supernormal profit and price discrimination. Contestable markets show that the threat of entry also limits power.
Perfect Competition and Price Determination – In perfect competition, very many firms sell the same product to very many buyers, so each firm is a price taker. The market price is set where market demand equals market supply (Qd = Qs). If demand rises, price and quantity both rise; if supply rises, price falls and quantity rises.

5. 4.1.8 Market mechanism, market failure and government intervention

4.1.8.1 How markets allocate resources · 4.1.8.2 Market failure types · 4.1.8.3 Public goods · 4.1.8.4 Externalities · 4.1.8.5 Merit and demerit goods · 4.1.8.6 Market imperfections and inequality · 4.1.8.9 Government intervention in markets · 4.1.8.10 Government failure

Market Failure – A market fails when buying and selling on its own does not give the best result for society. Resources are used in the wrong amounts: too much of some goods (pollution, cigarettes), too little of others (street lights, vaccines, education). Main causes: externalities, public goods, merit and demerit goods, imperfect information, market power and unfair inequality. Governments try to fix it with taxes, subsidies, rules, direct provision and information, but government action can also fail.
Public Goods and the Free-Rider Problem – Most goods are private: if I use one, you cannot (rival), and the seller can stop anyone who does not pay (excludable). A pure public good is the opposite. It is non-rival (one more user takes nothing away) and non-excludable (people who do not pay cannot be stopped). Street lights, flood defences and lighthouses are examples. Because people can enjoy it free, many wait for others to pay. This is the free-rider problem. A private firm cannot earn enough, so the market provides too little or none. This is a market failure, so governments usually provide public goods and pay for them with taxes.
Merit and Demerit Goods – A merit good, like education or a vaccine, is better for you than you think, and it also helps other people. Left to the free market, people buy too little of it. A demerit good, like cigarettes or alcohol, is worse for you than you think, and it often harms others too. People buy too much of it. The main reason is information failure: people do not have, or do not use, full information about long-term benefits and harms. Governments correct this with subsidies, free provision and information for merit goods, and with taxes, rules, bans and warnings for demerit goods.
Price Ceiling and Price Floor – A price ceiling is a legal maximum price set below equilibrium; it causes a shortage (excess demand), queues, rationing and black markets. A price floor is a legal minimum price set above equilibrium; it causes a surplus (excess supply) that the government often buys and stores, as with Minimum Support Price. A ceiling above, or a floor below, equilibrium has no effect.
Government Intervention in Markets – Markets often work well, but they can fail: harmful goods are over-used, useful ones under-used, public goods are not provided, firms gain monopoly power, and incomes become very unequal. Governments step in with indirect taxes (which raise price and cut quantity), subsidies (which lower price and raise quantity), maximum and minimum prices, regulation, state provision of public goods and services, public ownership or privatisation, competition policy, and redistribution through taxes and benefits. They also use fiscal and monetary policy to smooth the economic cycle. Intervention can itself go wrong – this is government failure.

6. 4.2.1 Measurement of macroeconomic performance

4.2.1.1 Government policy objectives · 4.2.1.2 Macroeconomic indicators · 4.2.1.3 Index numbers

Macroeconomic Objectives and Policy Conflicts – Governments want four main things for the whole economy: steady growth of real GDP, low unemployment, stable prices (low inflation, often about 2%) and a sustainable balance of trade. Many also aim for a fairer spread of income and a protected environment. These goals often clash: a policy that helps one can hurt another, so governments must choose trade-offs.
Macroeconomic Indicators: GDP, Inflation and Unemployment – Governments judge how well an economy is doing with a few key numbers called macroeconomic indicators. The main ones are real GDP growth (is output rising?), inflation (are prices rising, and how fast?), unemployment (are people who want work able to find it?) and the current account balance (is the country paying its way with the rest of the world?). Each has a clear formula and each has limits.
Index Numbers: Simple Aggregative Method, WPI, CPI, IIP, Uses and Inflation – An index number is a number that shows how much something (like prices or output) has changed compared with a base year, whose index is 100. The simple aggregative price index is ΣP1 ÷ ΣP0 × 100. Weighted indices give more importance to items bought more. India's key indices are the Consumer Price Index (CPI) for retail prices, the Wholesale Price Index (WPI) for wholesale prices and the Index of Industrial Production (IIP) for factory output. The inflation rate is the percentage rise in a price index over a year.

7. 4.2.2 How the macroeconomy works

4.2.2.1 Circular flow of income · 4.2.2.2 AD/AS analysis

Circular Flow of Income and the Three Methods of Measuring National Income – In a two-sector economy households give factor services to firms and get factor payments (rent, wages, interest, profit); they spend this income on the firms' goods. Money moves in a circle opposite to the real flow of goods and services. Because the same money passes three points, national income can be measured three ways: value added by producers (product method), incomes paid to factors (income method) and spending on final goods (expenditure method). All three give the same total.
Aggregate Demand, Propensities to Consume and Save, and the Investment Multiplier – Aggregate demand (AD) is total planned spending on final goods: C + I + G + (X − M); in a two-sector model AD = C + I. Consumption depends on income: C = c̄ + bY, where b = MPC. APC = C/Y, MPC = ΔC/ΔY, APS = S/Y, MPS = ΔS/ΔY; APC + APS = 1 and MPC + MPS = 1. Short-run equilibrium output is where AD = AS (planned spending = output), or saving = planned investment. A rise in investment raises income by a multiple: k = ΔY/ΔI = 1/(1 − MPC) = 1/MPS.

8. 4.2.3 Economic performance

4.2.3.1 Growth and the economic cycle · 4.2.3.2 Unemployment · 4.2.3.3 Inflation and deflation · 4.2.3.4 Policy conflicts · 4.2.6.3 Balance of payments: current account

Economic Growth: How a Country Makes More Each Year – Economic growth is a rise in a country's real GDP: the value of all final goods and services it makes in a year, after removing the effect of price rises. The growth rate is the percentage change in real GDP. GDP per head tells us the average output per person. Growth goes up and down around a trend in the economic cycle, creating output gaps. Growth comes from more and better resources (workers, skills, machines, technology) and brings higher incomes and jobs, but can also cause pollution, inequality and inflation.
Unemployment: Meaning, Rate, Types, Costs and Cures – A person is unemployed when they have no job, are able to work, and are actively looking for work. The labour force is everyone who is employed plus everyone who is unemployed. The unemployment rate is the unemployed divided by the labour force, times 100. Economists sort unemployment by its cause: frictional (moving between jobs), structural (skills or places no longer match the jobs), cyclical (a slump in total demand) and seasonal (work only in some months). Unemployment costs the person income, costs the country lost output and tax, and can harm health and society. Governments fight it with spending and interest-rate policy for cyclical unemployment and with training, information and mobility for the other types. Some unemployment always remains; the lowest sustainable level is called the natural rate.
Inflation: Why Prices Keep Rising – Inflation is a general, continuing rise in the price level, which lowers the purchasing power of money. It is measured with a price index such as the CPI: inflation rate = (new index − old index) ÷ old index × 100. Causes: demand-pull (demand grows faster than output), cost-push (costs rise) and expectations. Effects hit savers, fixed incomes and competitiveness. Deflation is a falling price level. Central banks aim for low, stable inflation, often about 2%, using interest rates; governments also use fiscal and supply-side policies.
Macroeconomic Objectives and Policy Conflicts – Governments want four main things for the whole economy: steady growth of real GDP, low unemployment, stable prices (low inflation, often about 2%) and a sustainable balance of trade. Many also aim for a fairer spread of income and a protected environment. These goals often clash: a policy that helps one can hurt another, so governments must choose trade-offs.
Balance of Payments – The balance of payments (BoP) is a yearly record of all money dealings between residents of a country and the rest of the world. The current account records goods, services, transfers and income; the capital account records investment, loans and deposits. Autonomous items are done for their own sake; accommodating items (reserve changes) settle the gap. A BoP surplus raises reserves; a deficit lowers them.

9. 4.2.4 Monetary policy

4.2.4.3 Monetary policy

Monetary Policy – Monetary policy is the use of interest rates and the money supply by a central bank to keep prices stable and support growth and jobs. Raising the policy rate makes borrowing dearer, cuts spending and aggregate demand, and lowers inflation (contractionary). Cutting it does the opposite (expansionary). Other tools include open market operations, quantitative easing, reserve requirements and forward guidance. Most central banks follow an inflation target and are independent of the government. Monetary policy works with time lags and is weaker when rates are already near zero.

10. 4.2.5 Fiscal policy and supply-side policies

4.2.5.1 Fiscal policy · 4.2.5.2 Supply-side policies

Government Budget and the Economy – A government budget is a yearly plan of expected receipts and planned expenditure. Receipts are revenue (taxes, non-tax income) or capital (borrowing, loan recovery, disinvestment). Spending is revenue (builds no asset) or capital (builds an asset or cuts debt). A budget can be balanced, surplus or deficit, and the deficit is measured as revenue, fiscal and primary deficit.
Supply-Side Policies – Supply-side policies try to raise how much an economy CAN produce (its productive capacity), not just how much people want to buy. They aim to make workers more skilled, markets work better and firms invest more. Market-based policies give people and firms more reason to work and compete: cutting income and profit taxes, removing unneeded rules (deregulation), selling state firms (privatisation) and reforming trade unions. Interventionist policies use government spending: education and training, roads and ports, broadband and research. If they work, the long-run aggregate supply (LRAS) curve shifts right: output and jobs can grow without pushing up prices, and exports become more competitive. But they are slow, can be costly, and some may increase inequality.