Chapter 1 - The Fundamentals of Economics

3.

Define each of the following terms carefully and give examples:

PPF:

or production-possibility frontier shows the maximum amounts of production thatcan be obtained by an economy, given its technical knowledge and quantity of inputsavailable. The PPF represents the menu of goods and services available to society.

e.g. if the two outputs are guns and butter, then for a given technical knowledge andquantity of inputs:

The line shows the total amount of guns and/or butter a society can make given itstechnical knowledge and quantity of inputs available. It can make 5 million pounds ofbutter, and no guns. Or it can make 15 thousand guns, and no butter. Or it can makevarying amounts of each as described by the line, where the society is operating on itsPPF. It makes explicit the opportunity costs of making more butter, or more guns, whenwe move along the PPF. For example, we can see that increasing gun production fromzero to five thousand means reducing our butter production by one million pounds.It cannot work outside the PPF. Itmay work inside its PPF, where it isleaving inputs idle,or not producing outputs efficiently.

Scarcity:

A situation in which goods and services are limited relative to desires. Scarcityis the distinguishing characteristic of an economic good.That an economic good isscarce

means not that it is rare but only that it is not freely available for the taking. To obtainsuch a good, one must either produce it or offerother economic goods in exchange.e.g cars are scarce. There are not enough cars in theworld for everyone to have as manyas they desire. We cannot get them for free.

Productive efficiency:

occurs when an economy cannot produce more of onegood without producing less of anothergood; this implies that the economy isonits production-possibility frontier.e.g. if weare operating on the production-possibility frontier, we cannot producemore butter without first withdrawing resources frommaking guns and divertingthem to making butter.

Inputs:

are commodities and services that are used to produce goods andservices. They are sometimes called

factors ofproduction

: which can beclassifiedinto three broad categories

land, labour and capital.

Land

are those natural resources given by nature toaid our productive processes

such as land to build on, materials to build with andair to breathe.

Labour

is human time spentin production.

Capital

resources are durable goods that are used to aid production to produceyet further goods, suchas machines, roads, computers, cars and buildings.e.g. flour, eggs, a hotoven, the skills of a chef arethe inputs used to make pizza.

Outputs:

are the goods andservices produced when existing technology has beenused to combine inputs. They can be consumed or used forfurther production.e.g. a pizza is the output from combining our inputs in theprevious example.

Chapter 2 - Markets and Government in a Modern Economy

2.

When a good is limited, some means must be found to ration the scarce commodity.Some examples of rationing devices are auctions, ration coupons, and first-come, first-served systems. What are the strengths and weaknesses of each? Explain carefully in

what sense a market mechanism rations scarce goods and services.

Auctions:

are similar toa market mechanism, in that the dollar votes of people determinethe price at which goods aresold. If an item is desired bymany people, then each bidderwill have to increase their bidding price to outbid their rivals. The good is eventually soldto the highest bidder, that person who shows they value the good most by paying thehighest price. The goods should be allocated efficiently to those who most want them.The disadvantage is similar to the market mechanism in that those will high incomes willbe able to outbid those with low incomes, which might seeminequitable.

Ration coupons:

may have the advantage that they could bedistributed more equitablythan market incomes.Their disadvantage is that, unlike market mechanisms, they take no

account of peoples

dollar votes. They will be allocated by some non-market mechanism, and so may notmatch supply and demand, and so allocate the goods or service efficiently. For instance,

the coupons may not be sufficiently scarce to reflect the goods

scarcity, so consumersmay not usethe good efficiently and producers will not begiven the signal and incentiveto produce more.

First-come, first-served:

has the advantage of simplicity.Its disadvantage is that goods may not go to those whovalue it most.

The market mechanism rations scarce goods and services as follows. Ifa good is scar

ce,that is if the demand is higher than the supply of the good, then its price will be high. Ifthe price is high, then consumers will buy less of the good, and substitute cheaper (lessscarce) goods for it. Those who most value the good(represented by those willing to paythe high price) will buy it.

Chapter 3 - Basic Elements of Supply and Demand

1.

a. Define carefully what is meant by a demand schedule or curve. State the law ofdownward-sloping demand. Illustrate the law of downward-sloping demand with two cases from your own experience.

The law of downward-sloping demandis: When the price of a commodity is raised (another things are held constant), buyers tend to buy less of the commodity. Similarly, when the price is lowered, other things being constant, quantity demanded increases. Two examples from my personal experience: When a store drastically reduces prices offood (such as pastries or chocolate) just before its

best before

date, I will buy more ofthese than I normally would.Another example was when the

Financial Times

offered a cheap years subscript

ion online, I decided to buyit, whereas I would not have subscribed at full price

b. Define the concept of a supply schedule or curve. Show that an increase in supply means a rightward and downward shift of the supply curve. Contrast this with the rightward and upward shiftof the demand curve implied by an increase in demand.

The Supply schedule shows the relationship between the market price of a commodity and the quantity of that commodity that producers are willing to produce and sell, other things held constant.

For example, the supply schedule for a boxof cornflakes could look like this

If there is an increase in supply, then the quantity supplied ateach price will increase. Anew schedule, with quantity supplied increased by 5million boxes per year at each price, is

At the time the market equilibrium

quantity demanded equals the quantity supplied. Thereisno tendency for prices to rise or fall at the equilibrium. Looking at the above table, wesee that at $3 a box, 12 million boxes ofcornflakes are supplied and 12 million boxes aredemanded. Al

l supply and demand orders are filled, the books are cleared of orders,

and demanders and suppliers aresatisfied.The same thing can be seen by looking at the supply and demand curves. Where thedemand curveDDand supply curveSSintersect

at pointE- the quantity demandedequals the quantity supplied. AtE, we can see the equilibrium price is $3 (see where ahorizontal line fromEintersects the vertical axis) and the equilibrium quantity is 12million boxes per year (see where a vertical line fromEintersects the horizontal axis).Now, imagine the market price starts out too high at $5. This can be seen towards thetop of the curves diagram. Here we see that the quantity supplied (18 million boxes) isgreater than the quantity demanded (9 million boxes). There is a surplus of cornflakes.Cornflakes will pile up onthe supermarket shelves. In order tosell these, the supermarketwill start cutting prices. As prices decrease, the quantity demanded will increase (we willmove along the demand curveDDas shown by the arrows) but thequantity supplied willbe reduced (wewill move along the supply curveSSas shown by the arrows). Eventuallythe price will reduce tothe equilibrium price atE.Now, imagine the market price starts out too low, at $2. This can be seen towards thebottom of the curves diagram. Here we see that the quantity demanded (15 millionboxes) is greater than the quantity supplied (7 million boxes). There is a shortage ofcornflakes. Long queues will form at the supermarket for cornflakes. Buyers will bid uptheir prices in order to get the scarce cornflakes. As prices increase, the quantitydemanded will decrease (we will move along the demand curveDDas shown by thearrows) but the quantity supplied will increase (we will move along the supply curveSSas shown by the arrows). Eventually the price willincrease to the equilibrium price atE.

4.

Explain why each of the following is

false

:a.

A freeze in Brazils coffee

-growing region will lower the price of coffee.

A freeze in Brazils

coffee-growing region will reduce the supply of coffee. The supplycurve will shift to the left, as less coffee is supplied at each price. Assuming that thedemand for coffee remains thesame, the equilibrium price will be higher, notlower, thanbefore, as shown below.

(N.B. Price on the vertical axis is denoted byP. Quantity on the horizontal axis is denotedbyQ. Demand curves are denotedDD. Supply curves are denoted bySS.Erepresents theintersection of the two curves, which gives the equilibrium price and quantity. An

apostrophe, , is suffixed to the

D,S, orEto indicate a shifted curve or equilibrium. The

bold red arrows

indicate the change in price and quantity due toa shifted curve)

v

v