Economics Magic Notes! Explain These Essential Theories Economics SL Topic 1.2

Table of Contents

• Define and explain the difference between normative and positive economics.
• Explain the concept of ‘utility’ 
• Explain the contributions of John Keynes during the 20th century.
• Explain Say’s law of markets.
• What to consider when you collect data from experiment, compare it with info previously gathered and analyse your results. 
• Explain briefly what behavioural economics is about and how it relates to the prevailing new classical assumptions of consumer decision making. 
• Understand the foundations of modern economic theory.
• Explain the meaning of the assumption ‘ceteris paribus’.
• Explain the approach of a circular economy and its implications for sustainability. 
• Explain the economic idea during the 18th century.
• Describe the most important contributions of Adam Smith: explain how does the invisible hand work?
• What questions to consider when you test hypothesis to prove or disprove it by designing an experiment/procedure to caollect necessary data to analyse?
• What to consider when you do background research to asses what you know and what is useful to your investigation? 
• Understand the dynamics of the Keynesian–new classical debate during the 20th century.
• Explain the scientific methodology used in economics to confirm and elaborate on its theories.
• Explain the view of the economy as a linear process.
• Explain what a model is and the use of them in economics.
• Explain the concept of marginal utility. 
• Describe the most important contributions of Adam Smith: explain the laissez-faire concept.
• Explain Karl Marx’s critique of classical economics.
• Explain the concept of margin.
• Explain the economic idea before 18th century.

Make sure you know how to explain these essential theories!

Define and explain the difference between normative and positive economics.

• D of positive: Economics statements based on facts or evidence, free from subjectivity. They can be tested scientifically and proved or disproved.
• D of normative: Economic statements based on norms, and thus based on subjective evaluation. They cannot be proved or disproved scientifically.
• Both used by economist.
• PE refers to pure economic theory to discover patterns based on empirical facts while NE relates to how we value judgement in economic context.
• PE studies how economy works, not making policy recommendations like NE. (no should be)
• Ex of PE: If the government increases spending, unemployment will fall’ or ‘Brazil’s inflation rate in 2016 was 9 per cent
• Ex of NE: Health care should be provided free to everyone.
• Application of PE knowledge to achieve goals determined by NE is political economics.

Explain the concept of ‘utility’ 

• Classical economics value a good by cost of labour and inputs to produce it.
• Neoclassical economics value good by the value consumers place on good based on utility from consumption.
• Utility is measure of satisfaction or usefulness a consumer receives when they consume a product.

Explain the contributions of John Keynes during the 20th century.

• After WW1, USA become rich from sales of defense equipment to Europe.
• 1920s become Roaring Twenties when mass consumption of cars and increase in stock market trading occured.
• By 1929, huge boom in asset prices, causing market crash on Wall Street on 29 Oct 1929, leading to the Great Depression.
• John Keynes published ‘The General Theory of Employment, Interest and Money’ which describes new approach to economics.
• Argues GOVT need to use monetary and fiscal policy to help economy through work business cycle periods.
• GOVT should run budget deficit during low economic activity, spend more than earned from taxes to ease unemployment. These are known as demand-side policy, core of Keynesian theory.

Explain Say’s law of markets.

• States that: production of goods creates its own demand (supply creates demand).
• Buyer’s ability to buy goods and services based on buyer’s successful past production for the market and so generate income.
• When firms sells goods or services, creates wages for workers and income for businesspeople.
• Both now have income to spend to purchase goods and services.
• So production increase wealth, leading to demand for other goods.
• However, it contradicts mercantilist view that money is source of wealth. For Say, money is mean to exchange goods, not an end in itself.
• This implies production is key to economic growth of country, so GOVT should encourage production instead of consumption.
• Supports no GOVT intervention to free market and adopt laissez-faire economics.

What to consider when you collect data from experiment, compare it with info previously gathered and analyse your results. 

• look at charts/graphs of results
• compare data with other sets of data and info
• see if evidence collected supports hypothesis

Explain briefly what behavioural economics is about and how it relates to the prevailing new classical assumptions of consumer decision making. 

• D: A branch in economic theory that incorporates the study of psychology into the analysis of the decision-making behind an economic outcome, such as the factors leading up to a consumer buying one product instead of another.

• How it relates to the prevailing new classical assumptions of consumer decision making:
• New classical approach assume people decide what to consume and pay based on utility gained in relation to it cost.
• Assume consumers make rational decisions for own benefit, self interest, satisfaction maximisation.
• Not always true in real world as not such thing as perfect info for each personal rational decision, no time anyways.
• This idea is challanged by BE.

Understand the foundations of modern economic theory.

• Adam Smith is father of modern economics.
• In 1776, one of his most important books ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ was written at start of Great Britain’s industrial revolution (from farming based to industrialised system). In it he explain that GOVT shouldn’t interfere with market coordinated economic decisions.
• Advocates free market and that most efficient outcome results from people following their own best interest without GOVT intervention in economy.
• Believes in existence of invisible hand and laissez-faire, define them, being his two most important contributions to the foundations of modern economics.

Explain the meaning of the assumption ‘ceteris paribus’.

• D: The Latin expression for ‘everything else being equal’. It means that all other variables, except the one that you are studying, are assumed to be fixed or unchanged.
• Many variables change at same time in real world.
• When economists need to know effect of one variable on another, need to isolate its effect, assuming no change in other variables, thus using ceteris paribus.
• Need to acknowledge ceteris paribus when analysing economic situation if not, conclusions and effects arrived might be untrue in real-world situation.

Explain the approach of a circular economy and its implications for sustainability. 

• Solution and replacement to linear economy.
• Products designed to last longer, made with renewable materials and packaging.
• Materials are reused, restored or recycled from old to new products.
• Focus of minimising waste and environmental damage from extraction of raw materials to production process to consumption.
• Potential gain for firms from recycling, reuse or restoration is saving cost and complying to environmental regulations.

Explain the economic idea during the 18th century.

• Mercantilism changed to capitalism.
• Capitalism: An economic system based on the private ownership of the means of production and their operation for profit. Characteristics central to capitalism include private property, capital accumulation, wage labour, voluntary exchange, a price system and competitive markets.
• Beginning of industrial revolution, middle class become more resentful of aristocracy for inequality, causing revolution like in 1776 America or 1789 in France.
• Adam Smith’s influence and contribution to modern economic theory occurred during this time.

Describe the most important contributions of Adam Smith: explain how does the invisible hand work?

• D: A term first brought up by the Scottish philosopher Adam Smith in the 18th century, in reference to the tendency of free markets to regulate themselves by means of competition in the pursuit of self-interest.
• Every economic agent makes decisions based on self interest resulting in best outcome for all.
• Producers sell products to people that want to buy, signalled by prices of g/s, hoping to make profit.
• If effective, people consume more and satisfy needs and wants, thus producer develop business with purpose of earning money.
• At same time, consumers only buy preferred g/s that fulfil needs and wants.
• Competition make firms produce better goods at lower prices, resulting in efficient allocation of scarce resources based on consumer preferances.
• Idea goes together with laissez-faire concept.

What questions to consider when you test hypothesis to prove or disprove it by designing an experiment/procedure to caollect necessary data to analyse?

• Can prediction be tested?
• What is the best way to test it?
• What tools and methods to use?

What to consider when you do background research to asses what you know and what is useful to your investigation? 

• see if other have asked the question before
• research similar questions
• gather info useful for your analysis
• observe pattern arise from that information

Understand the dynamics of the Keynesian–new classical debate during the 20th century.

• Keynesian theory dominated early 1970s.
• Late 1970s, 80s and 90s, revival of free market view influenced by Friedrich Hayek and Milton Friedman from the University of Chicago.
• KT under pressure in 70s as when OPEC decreases oil prices four fold from USD 3 to 12 in response to US involvement in Yom Kippur War.
• Causes periods of high inflation and unemployment.
• KT centered around DS management but this period’s problems centered around SS.
• KT lost influence when in 80s Friedrich Hayek influences mainstream politics, Margaret Thatcher and Ronald Reagan won the election in UK and US respectively.
• At this time, Nobel prize-winning economist Milton Friedman, a graduate from the Chicago School of Economics (where Hayek had taught), published many studies informing MT and RR’s policy, advocate money supply stability to prevent inflation, and use of SS policies to improve competitiveness of affect economies.
• Neo-liberal and new classical economic policy of 1980s continued for 2 decades with higher privatisation and deregulation causing global recession of 2008 due to lower market stability.
• Responded with KT fiscal and monetary policy, bringing GOVT back to this debate.

Explain the scientific methodology used in economics to confirm and elaborate on its theories.

• Scientific methodology consist of: collecting data, observing emerging patterns. formulating a hypothesis, testing it against another set of data.
• Done to study reality and formulate general theory.
• Steps: 6
  • Ask a question arise from world observations:
• Do background research to asses what you know and what is useful to your investigation.
• State a hypothesis to verify or determine extent to which it is true, using observed data and theory to make prediction.
• Test hypothesis to prove or disprove it by designing an experiment/procedure to caollect necessary data to analyse. 
• Collect data from experiment, compare it with info previously gathered and analyse your results.
• Make conclusion that support/rejects hypothesis. If supported, test again and results should be the same to formulate general theory/model.

Explain the view of the economy as a linear process.

• Mainstream economics is a linear process with the problem of sustainability – the interrelation between the society trying to provide for society’s needs and its effect on the world’s environment and natural resources.
• Circular economy is aware of interdependence between economy, society and environment.
• EG is based on continual use of SR to produce g/s.
• Once used, disposed and incinerated or added to landfill sites.
• More pollution generated as raw material extracted and produced into products, overexploitation of NR, threatening to sustainability.

Explain what a model is and the use of them in economics.

• D: A simplified representation of reality with the intention of analysing, describing or predicting the relationships and behaviours of specific variables in a real-world situation.
• Used to simplify reality to see what outcome would be if only one of the market/economic variables change.

Explain the concept of marginal utility. 

• Two ways to measure utility: total utility and marginal utility.
• Total utility is total satisfaction gained by consuming a certain amount of a good or service, maximised when marginal utility = 0.
• Marginal utility is benefit gained from consuming one additional unit of a product or service. (current total utility – previous total utility – the difference)
• Utility increases as amount of goods consumed increases but only to certain point.
• Then, consuming additional units adds less satisfaction each time, marginal utility starts falling.
• Known as law of diminishing marginal utility: The principle that as additional units of a good or services are consumed, the marginal utility will decline.
• www.youtube.com/watch?v=cEdDOzoa8wM

Describe the most important contributions of Adam Smith: explain the laissez-faire concept.

D: A term that comes from the French phrase ‘laissez faire et laissez passer’ (it means approximately ‘leave alone’). It makes reference to the economic concept of government not interfering in the working of the free market.

Explain Karl Marx’s critique of classical economics.

• Sees capitalism as oppressive to majority of population.
• Argued workers would eventually revolt and so capitalism would not last long as it will be replaces by socialist economic system.
• Inspires many 20th century communist regimes when railroads and mass production spreads all over the world.
• Capitalism is doomed as it did not best serve worker interest, so economies go through depression period and revolutionary upheavals that GOVT must interfere, causing communist system or command economy.

Explain the concept of margin.

• Introduced by Jevons, Menger and Walras, neoclassical economists of 1870s.
• Means: consumer decide whether to consume next unit of good depending on how much utility (satisfaction) that extra unit get them (value depend on marginal utility).
• Ex: producer decide whether to produce next unit of a good depending on the extra cost to produce that good.
• Alfred Marshall presented first model of demand and supply, illustrating how prices prices are determined in a market.
• Together with margin theory, economics become more mathematical and scientific and not all philosophical or political.
• Heavy reliance to mathematical models, equations, diagrams allow economics to be seen as a science.

Explain the economic idea before 18th century.

• Feudalism – economic system that governed most of Europe during Dark Ages to end of 18th century.
• D of feudalism: The dominant social system in medieval Europe, in which the nobility held lands from the Crown in exchange for military service, and vassals were in turn tenants of the nobles, while the peasants were obliged to live on their lord’s land and give him homage, labour, and a share of the produce, in exchange for military protection.
• Majority of EA was agriculture so landowners become much more wealthy than peasants.
• Towards end of Middle Ages, market become central event and merchants become more rich and politically powerful than lords, thus needed to obtain trading permits/privelleges from kings making them even more powerful. Thus, feudalism switched to mercantilism.
• D of mercantilism: The economic system predominant in Europe during the 1500s, based on the idea that a nation’s wealth and power were best served by increasing exports, in an effort to collect precious metals like gold and silver. Mercantilism replaced the feudal economic system in Western Europe.

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