What is the process of developing models in economics, and why are assumptions required?

Economists develop models to try and gain insight into the function of the economy. Economists need to make assumptions when they create these models to focus on a few variables, as it would be very difficult to take into account all of the possible variables that could impact a model.

How is ceteris paribus used in building models?

Ceteris paribus is a Latin phrase and an assumption used in economics meaning 'other things being equal'. It is used in building economic models to show the effect of a change in one variable while keeping all other variables that are relevant constant.

Why is there an inability in economics to make scientific experiments?

It is difficult to conduct experiments in economics due to practical constraints and because economic systems are often extremely complex. Thus, economists normally use historical data and models to attempt to understand the economy.

What is the distinction between positive and normative economic statements?

Positive economic statements are factual, and objective and can be tested and proven. A hypothetical example of a positive statement could be 'inflation is at 2%'. Normative economic statements that normally involve a value judgement (subjective opinions about what ought to be), are subjective and can't be tested or proven. A hypothetical example of a normative statement could be 'the government should spend more on education'.

What is the role of value judgements in influencing economic decision-making and policy?

A value judgement is a subjective opinion about what ought to be. Value judgements influence economic decision-making and policy as individuals and policymakers have lots of opinions of what they believe is best for the economy.

What is the problem of scarcity (concerning unlimited wants and finite resources)?

The main economic problem is that of scarcity. This arises as a result of the wants of those in the economy being unlimited while resources in the economy are finite and limited. Hence it is necessary to decide what should be produced in an economy, how it should be produced, and for whom the goods and services in an economy should be produced.

What is the distinction between renewable and non-renewable resources?

Renewable resources are resources in an economy that can be replenished. This is as long as these renewable resources are not over-consumed. An example of a renewable resource could be trees. Whereas, non-renewable resources are resources that can't be replenished after being consumed and are finite. An example of a non-renewable resource is natural gas.

What is the importance of opportunity costs to economic agents (consumers, producers and the government)?

Opportunity cost is the value associated with the next-best alternative that is given up when a decision is made.

When consumers decide on what they want to purchase given a limited income, they must evaluate the opportunity cost of buying one good over another.

When producers choose what to produce with their resources, they must analyse the opportunity cost of producing one good or service over another.

When the government spends on the economy, the government must analyse what area requires spending. When making this decision, the government must analyse the opportunity cost of diverting spending to one area which will not be spent on another.

How can a production possibility frontier depict the maximum productive potential of an economy?

A Production Possibility Frontier (PPF) depicts the maximum possible combinations of goods and services that an economy is able to produce given that all available resources in the economy are employed efficiently. Thus, any point on the PPF curve below depicts the economy at maximum productive potential.

How can a production possibility frontier depict opportunity cost (through marginal analysis)?

At point A on the production possibility frontier, 40 consumer goods can be produced and 15 capital goods can be produced. At point B on the production possibility frontier, 20 consumer goods can be produced and 20 capital goods can be produced. A movement from point A to point B on the production possibility frontier would lead to 5 more capital goods being produced but incur an opportunity cost of 20 consumer goods (at point A, 40 consumer goods could be produced whereas now only 20 can be produced and 40-20=20). A movement from point B to point A on the production possibility frontier would lead to 20 more consumer goods being produced but would incur an opportunity cost of 5 capital goods (at point B, 20 capital goods could be produced, whereas at point A only 15 capital goods can be produced and 20-15=5). This is because, when there is a movement along the production possibility frontier from one point to another, resources are diverted from producing one good or service to another.

How can a production possibility frontier depict economic growth or decline?

Economic growth can be shown by an outward shift of the production possibility frontier as economic growth indicates that an economy's maximum potential output of goods and services has increased. It can be shown by the diagram below.

An economic decline can be shown by an inward shift of the production possibility frontier as an economic decline indicates that an economy's maximum potential output of goods and services has fallen. It can be shown by the diagram below.

How can a production possibility frontier depict the efficient or inefficient allocation of resources?

When the economy is operating at any point along the production possibility frontier, the economy is producing at its maximum potential output ensuring the efficient allocation of resources. If the economy is producing at a point inside of and beneath the production possibility frontier curve, then not all resources are being fully or efficiently employed, resulting in the inefficient allocation of resources.

Point X shows the efficient allocation of resources in an economy as point X lies on the production possibility frontier with 40 consumer goods being produced and 15 capital goods being produced. Point Y shows the inefficient allocation of resources as point Y lies underneath and inside of the production possibility frontier. At point Y, 40 consumer goods are being produced and 5 capital goods are being produced, even though if the economy were to be at its maximum potential output when producing 40 consumer goods, the economy should be producing 15 capital goods instead of merely 5 capital goods.

How can a production possibility frontier depict possible and unobtainable production?

Any point on or beneath the production possibility frontier is possible. However, any point above the production possibility frontier is unobtainable as this point is beyond the maximum potential output of the economy.

For example, on the diagram above point X and point Y are obtainable levels of production. This is because point X is a point on the production possibility frontier and point Y is a point lying inside of the production possibility frontier. Point Z is unobtainable as it lies above the production possibility frontier and beyond the maximum potential output of the economy.

What is the distinction between movements along and shifts in production possibility curves, and what are the potential causes for such changes?

A movement along a production possibility curve is where the economy moves to a different point along the production possibility curve. Movements along a production possibility frontier occur as a result of an economy reallocating resources from producing one good or service to producing another good or service.

A shift of a production possibility curve is a complete inward or outward movement of the production possibility curve. This occurs as a result of a change in the maximum potential output of the economy. Economic growth will result in an outward shift of the production possibility frontier, and an economic downturn will lead to an inward shift of the production possibility frontier.

What is the distinction between capital and consumer goods?

Capital goods are goods that serve to produce other goods and services within the economy. Whereas consumer goods are goods that are used for direct consumption to satisfy the needs and wants of consumers.

What is specialisation and division of labour (with reference to Adam Smith)?

Specialisation is where individuals, firms and economies concentrate on producing a few particular goods or services.

Division of labour is where the production process is broken down into smaller, specialised tasks. This allows workers to focus on one area of production. 

Adam Smith, a famous economist, stated that if workers in a pin factory concentrated on one particular task in the production process of pins, then the productivity levels in the pin factory would rise greatly as workers become more efficient in their role, leading to a significant increase in the number of pins produced by the pin factory. Thus, Adam Smith's example of the pin factory shows the effectiveness of the use of division of labour in the production process.

What are the advantages and disadvantages of specialisation and the division of labour in organising production?

Advantages:

1. Division of labour is likely to increase the productivity levels of workers as they are likely to become more efficient when they focus on one area of the production process.
2. Lower average costs of production for firms as their workers become more productive when there is division of labour.
3. When a firm specialises in the production of one good or service, they are likely to become significantly more efficient as they gain expertise on how to produce this good or service.

Disadvantages:

1. Tedious work for workers due to the division of labour may result in workers becoming bored, potentially leading to workers leaving their jobs.
2. A firm may become over-reliant on some workers at specific stages of the production process due to the division of labour being practised. If these workers were to go on strike or leave their roles, the whole production line may collapse.
3. When a firm specialises in the production of one good or service, the firm is less able to spread its risk over multiple goods or services as the firm is reliant on the revenue from the sale of only one good or service.

What are the advantages and disadvantages of specialising in the production of goods and services to trade?

Advantages:

1. Countries may be able to produce higher quality goods and services, due to specialisation in certain goods and services, making their goods and services more non-price competitive on the international markets.
2. Due to a large scale of production, large economies of scale can be accessed, resulting in large falls in the average cost of production for firms, likely leading to a fall in the price of goods and services, making a country's goods and services more price competitive on the international markets.
3. Countries are likely to be able to produce more goods and services as they become more specialised in the production of the goods and services that they are better at producing.

Disadvantages:

1. A country specialising in the production of one good or service may lead to a dependency risk for this country on this one good or service. If demand declines for the good or service that the country has specialised in producing, it is likely that there will be large falls in revenues for firms within this country.
2. When a country specialises in the production of a good or service, this may result in a country's resources being over-exploited to produce this good or service.
3. A country may specialise in the production of a good or service where the country may not be as good at producing the good or service as it thinks it is. As a result, the country may be outcompeted, potentially resulting in structural unemployment.

What are the functions of money (as a medium of exchange, measure of value, store of value and method of deferred payment)?

1. Medium of exchange - money is a universally accepted means of payment.
2. Unit of account - money can be used to measure the value of goods and services.
3. Store of value - money can be stored for use in the future without losing a significant amount of its value and purchasing power.
4. Method of deferred payment - money can be used in order to make a purchase in the present whilst actually paying for this purchase in the future.

What is the distinction between free market, mixed and command economies (with reference to Adam Smith, Friedrich Hayek and Karl Marx)?

Free market economies are economies where goods and services are allocated by the market forces of supply and demand. Adam Smith was the founder of free market economics and he supported free market economies, but he did highlight that there was some need for government intervention within the economy. Friedrich Hayek also believed in free market economies. Friedrich Hayek believed that there was no need for government intervention. Mixed economies are economies where market forces assist in the allocation of resources, but there is a level of government intervention which also plays a part in allocating resources. A command economy is where the government decides how resources are allocated within the economy, with the government deciding what should be produced in the economy, and how these goods and services should be produced. Karl Marx believed in command economies. He believed that capitalism would be overthrown by communism as he suggested that, in a capitalist economy, firms would pay workers extremely low wages due to the profit incentive, eventually resulting in the working class overthrowing wealthy property owners, resulting in communism.

What are the advantages and disadvantages of a free market economy and a command economy?

Advantages of a free market economy:

1. Firms are likely to become more efficient as they are incentivised by higher profits, so they will aim to reduce costs.
2. There may be greater levels of innovation as firms attempt to increase their market share through producing more innovative goods and services.
3. Large amounts of consumer choices as firms compete to try and sell lots of goods and services to consumers so that these firms can make higher profits.

Disadvantages of a free market economy:

1. Rising inequality as some individuals and firms may benefit from free market economies more than others if some individuals and firms have greater access to resources or capital.
2. Merit goods that have positive effects on society are likely to be under-provided in a free market economy.
3. Monopolies are likely to exploit their dominant market position if they are not regulated in a free market economy.

Advantages of a command economy:

1. In a command economy, there are likely to be improved levels of equality as individuals are likely to have relatively equal access to healthcare and education, and are likely to earn similar incomes.
2. Long-term economic goals may be achieved through central planning.
3. There is likely to be full employment as the government gives a job to those who require one.

Disadvantages of a command economy:

1. High levels of bureaucracy and red tape may result in resources not being allocated efficiently.
2. There are likely to be low levels of innovation as there is no profit incentive.
3. There is likely to be a limited choice of goods and services available to the consumer as the government decides what should be produced instead of the market forces of supply and demand.

What is the role of the state in a mixed economy?

The state aims to provide public goods and services and subsidise the production of merit goods which would likely be under-provided in a free market economy. Moreover, the state also plays a role in the redistribution of income and wealth in order to improve income and wealth equality and ensure that individuals in the economy have a basic income to maintain a minimum standard of living. The state also provides information to help economic agents make informed decisions.