Principles of Economics

1. Overview

The Economic problem is how best to allocate scarce resources. Economists study resources’ allocation, distribution, and utilisation to meet human needs.

  • Land -> (rent)
  • Labour -> (wages)
  • Capital -> (interest)
  • Entrepreneurship -> (profit)


  • What? – what goods are to be produced with scarce resources; clothes, food, armaments?
  • How? – how best can the resources available be combined to produce the goods and services we want?
  • For whom? – once made, how are the goods and services distributed to people in the economy.

Positive: what is or will be. Normative: what should be. Ceteris paribus: other things equal

Opportunity Cost is the cost of any activity is measured in terms of the best alternative forgone.

Types of economies

Command EconomyMixed EconomyMarket Economy
Difficult to decide what consumers want.
The planning process is slow.
Based on need:-equality.
It can be sluggish and inefficient.
Makes value judgements about products
In a free enterprise sector – economic decisions are taken through the workings of the market.
Government regulation of the economy through budgets etc.
Public ownership of some industries.
welfare services provided by the state
A large number of buyers’ tastes communicated.
Can be dynamic.
Based on ability to pay, can cause inequality.
Produces all products consumers want.

National income accounting

There are several well-known macroeconomic objectives: economic growth, low unemployment, inflation and balance of payments.

In the circular flow of income, there are injections and withdrawals. The Injections are investment, government expenditure and export expenditure. Whereas the withdrawals are net savings, net taxes and import expenditure. It it calculated by consumer expenditure + investments + government spending + (exports – imports).

Economic growth

  • Actual output – What the economy actually produces, normally measured in GDP
  • Potential output – What could be produced if all resources were full employed
  • Actual growth – Change in actual output
  • Potential growth – Change in potential output

When potential growth is greater than actual growth it creates unemployment. When potential growth is less than actual growth it creates inflation.

To increase the potential output there needs to be:

  • Increase in productivity
  • An increase in the stock of resources
  • Increase in land, labour or capital
  • Reallocate resources from low-growth industries to high-growth industries

2. Supply and demand and Elasticity

Factors determining price elasticity of demand

  • Availability of substitutes (more/closer) Advertising pressure (less)
  • Importance of product in consumer’s budget – cheap or v expensive (less)
  • The good is a necessity (less)
  • Where price changes are easily noted (more) e.g. foodstuffs

Shifts in the supply curve could be shifted by the size of the population, unearned income and market access.

3. Cost and revenues of the firm

Economics and diseconomies of scale: in the short run there is one fixed factor, whereas, in the long run, all factors are variable.

Internal economics of scale: Technical economies, increased specialisation. Internal diseconomies of scale: large factory floor cost, coordination and communication. External economies of scale – labour, specialised firms and transport.

4. Theory of the firm

Types of competition

  • Perfect competition: Many buyers and sellers, perfect knowledge and no barriers to entry and exit.
  • Monopoly: This is when there is one seller, and high barriers to entry.
  • Oligopoly: Don’t tend to compete on price, as would cause a price war. Tend to have high fixed costs.

5. Factor markets: Labour

Labour demand is a derived demand, demand for labour will shift if: productivity increases, demand for goods changes, or there is a change in the price of other factors.

6. Market Failure

Assumptions of Markets

  • Assume firms seek to profit maximise
  • Profits come from making things that consumers wish to buy
  • Thus, profit motive (inadvertently) drives firms to maximise well-being.
  • Firms only respond to what consumers want
  • “Firms have one social responsibility – to make a profit”

The inflationary gap occurs when there is excess expenditure in the system. I.e. there is greater demand than there is for the output to cope, meaning we would expect price levels to rise and inflation to follow. One way to get it to fall is to reduce government expenditure by the vertical difference (inflationary gap). The assumption made is that we can’t have low unemployment and low inflation.

Price discrimination

  • First degree – Sell at a price that the consumer is willing to pay. Extracts all consumer surplus.
  • Second degree – Price varies with volume unit
  • Third-degree – Repackages the product and sells at different prices