IB Economics FINAL EXAM REVIEW

Final Examination 2008

Economics Notes – Review for Mocks and Final Exam Section 1 – Introduction to Economics What is economics? Economics is a branch of knowledge concerned with the production, consumption and tranfser of wealth. Economics is considered to be a social science, a scientific study of human society and social relationships. Economics is about studying how people use their limited resources to satisfy unlimited wants. Economics is divided into microeconomics (Section 2) and macroeconomics (Section 3). Microeconomics: The study of economic behaviour of households and firms, and how the price of goods and services are determined. Macroeconomics: The study of the economy as a whole and economywide issues such as unemployment, inflation and growth. Before moving into more details about the various different fields, one have to be familiar with the terminology used: Economic growth: The increase in an economy’s real level of output (all the goods and services produced) over a period of time.

Development: A process to improve the lives of all people in a country. This involves not only raising living standards through the provision of more and better quality goods and services, but the promotion of selfesteem, dignity and respect. Sustainable development: Using resources in a way that allows future generations to meet their own needs. In terms of natural resources this means to use the resources in such a fashion that the Earth can replenish them.

Factors of Production To produce goods and services requires resources, these economic resources are scares relative to the infinite needs and wants of people and businesses operating in the economy. It is important to use these resources efficienty in order to maximise the output. There are four distinct types of resources • • • •

Land Labour Capital Entrepreneurship

Land Land is the natural resources available for production. Some nations are endowed with natural resources and exploit these by specialising in the extraction and production of these resources, e.g. Oil in the Middle East. Only one major resource is for the most part free; air. The rest are scarce because there are not enough natural resources in the world to satisfy the demands of consumers and producers. Air is classified as a free good since consumption by one person does not reduce the air available for others. Labour Labour is human input to the production, i.e. the work force. Two important points need to be remembered about labour as a resource: 1. A housewife, a keen gardener and a DIY entusiast all produce goods and services, but they do not get paid for them. They are all producing a non-marketed output and the output of these people is not included in the Gross Domestic Product (GDP).

2. Not all labour is of the same quality. Some workers are more productive than others because of the education, training and experience they may have received. Human capital refers to the quality of labour resources, which can be improved through investments in education, training and health. Capital To an economist, capital has several meanings — including the finance raised to operate a business. Normally the term capital means investment in goods that can produce other goods in the future. Capital refers to the machines, roads, factories, tools, etc. which human beings have produced in order to produce other goods and services. A modern industrialized economy possesses a large amount of capital, and it is continually increasing. Increases in the capital stock of a nation are called investment. Investment is important if the economy is to achieve economic growth in the long run. Capital accumulation or capital formation is the process of adding to the net physical capital stock of an economy in an attempt to achieve a greater total output, i.e. to produce more. The rate of accumulation of an economy’s physical stock is an important determinant of the rate of growth of an economy. There are two distinctions between rates of capital accumulation: Capital widening: Capital stock rising at a rate which keeps pace with labour force growth so the proportion of capital to labour remains unchanged. Capital deepening: Capital stock grows faster than labour force so that proportionally more capital to labour is used to produce national output. Capital consumption: A reduction in a country’s capital stock incurred in producing a years’s GDP. This is a result of depreciation of roads, machines, vehicles, etc. over time these become worn out or obsolete. In order to maintain or increase next year’s GDP a proportion of new investment must be devoted to replacing worn out capital stock. Entrepreneurship Entreprenours are people who organize other productive resources to make goods and services. Some economists regard entreprenours as a specialist form of labour input. Others believe that they deserve recognition as a separate factor of production in their own right. The success and/or failure of a business often depends critically on the quality of entrepreneurship.

Section 2 – Microeconomics Markets Demand Demand is defined as the quantity of a good or service consumers are able and willing to buy at a given price in a given time period. The law of demand states that there is an inverse relationship between the price and demand of a good. As prices fall there is an expansion of demand, demand shifts out, and if the prices rise there is a contraction of demand. There is only a demand when consumers are able and willing to pay for a good, this is referred to as effective demand. Demand can also be said to be latent if consumers are willing to pay for a good, but not able to. Consumers will tend to act rationally when considering a product. They will chose the good or service that gives the most in return for their money.

Supply Supply is the quantity of a good or service that a producer is able and willing to supply onto the market at a given price in a given period of time. Normally, when demand rises supply will shift outwards in order to meet the demand and thus there is an extension of supply. The law of supply states this, saying that higher quantity will be supplied at higher prices, all other factors stays the same. There is a positive relationship between the market price and the quanity supplied. This is due to three main factors, one of them being that it becomes more profitable for businesses to increase their output when the price of a good increases. The second factor is that higher prices send signals to firms that there is a potential to increase production. With increased production comes

increased production costs and thus a higher price is needed to cover the extra costs associated with the increased production. The third factor is that when prices goes up it becomes more profitable for other firms to enter the market, which in turn leads to an increase in supply. This is why there is a higher quantity supploed at a higher price level.

Elasticities Elasticity is the measure of responsiveness in one varable when another changes. For example, if the price of cigarettes falls how much will the quantity demanded change? We use this analogy because elasticities streches and changes in length. As the price of a good changes, the quantity demanded changes, but by how much? There are four key elasticities to examine: 1. Price elasticity of demand 2. Income elasticity of supply 3. Cross elasticity of