Key terms and economists

Scarcity arises when available resources cannot satisfy all the uses people value. Economic choices allocate those limited resources. Opportunity cost is the value of the best feasible alternative forgone, rather than the sum of everything rejected. A good can involve scarce resources even when its user pays no price. Identify the decision, the resources committed and the alternatives that are genuinely feasible. Compare benefits on a consistent basis. If alternatives are mutually exclusive, retain the most valuable rejected one. For a production change, divide output sacrificed by additional output gained when a cost per unit is requested.

An economic model simplifies selected relationships to explain or predict behaviour. A positive claim describes something that can in principle be checked against evidence; it need not be true. A normative claim expresses a judgement about what ought to happen or which outcome is desirable. State the assumptions and the conditions for a prediction. Ceteris paribus means holding other relevant influences unchanged when studying one relationship. Compare predictions with relevant observations, investigate discrepancies and revise where appropriate. An association alone does not identify a cause when other influences differ.

A production possibility frontier (PPF) shows the maximum feasible combinations of two outputs using given resources and technology. Points on it use productive capacity fully. Interior points are feasible but involve incomplete use of capacity; points beyond it cannot be produced under those conditions. Read the units on both axes. For a movement along a fixed frontier, divide output sacrificed by extra output gained to find average opportunity cost per unit. A bowed frontier can reflect resources with different suitability and increasing opportunity cost. A straight frontier has a constant output trade-off.

Specialisation concentrates activity on a narrower range of tasks or outputs. Division of labour separates a production process into tasks performed by different workers. Productivity is output per unit of input, rather than total output alone. Practice, suitable equipment and less switching can raise output per labour hour. Compare like outputs and count all relevant labour time, including coordination. A slow stage can limit an entire production line. Narrow skills and reliance on other producers can also create adjustment costs when demand or trading conditions change.

Market allocation uses decentralised choices coordinated through prices. Central planning uses direct instructions about production and resources. A mixed economy combines market activity with government provision or intervention. It does not require an equal public/private split. Distinguish ownership from the allocation mechanism. Public enterprises can charge prices, and private enterprises can face binding instructions or regulations. Assess resource constraints, incentives, information and the objective being pursued. A financial balance alone is not a complete measure of social benefits and costs.

Demand describes quantities buyers are willing and able to purchase at different prices over a stated period. Quantity demanded is one point on that schedule. Market demand adds buyers’ quantities at the same price; it does not average them. A change in the product’s own price causes a movement along its demand curve, holding other conditions constant. A price fall creates an extension (sometimes called an expansion); a price rise creates a contraction. A change in income, tastes, buyer numbers or a related product’s price can shift the whole curve. More demand means a rightward shift at each given price. Normal goods have higher demand when income rises; inferior goods have lower demand. A dearer substitute raises demand, while a dearer complement reduces it.

Supply describes quantities producers are willing and able to offer at different selling prices over a stated period. Quantity supplied is one point on this schedule. Market supply adds firms’ quantities at the same price. It differs from stocks accumulated over time or technical production capacity. With other supply conditions fixed, a higher own price causes an extension along an upward-sloping supply curve; a lower own price causes a contraction. Changes in input costs, productivity, taxes, subsidies, weather or the number of firms can shift supply. Lower unit costs usually shift it right: more can be offered at each price. Higher unit costs shift it left. For products competing for the same resources, a more profitable alternative can reduce supply of the original product.

Market-clearing equilibrium occurs where quantity demanded equals quantity supplied. A shortage is excess demand at a quoted price; a surplus is excess supply. These gaps compare planned purchases and offers in the same period. Neither gap is the total quantity traded. Set the demand and supply equations equal to find equilibrium price, then substitute into either equation for equilibrium quantity. With downward-sloping demand, upward-sloping supply and flexible prices, a shortage encourages buyers to bid price up. Quantity demanded contracts and quantity supplied extends until the gap closes. A surplus encourages sellers to cut price, reversing these movements. Neither adjustment requires a shift of the curves when their non-price conditions stay unchanged.

Markets are linked through consumption and production. Substitutes can replace one another, so a higher price for one tends to increase demand for the other. Complements are used together, so a higher price for one tends to reduce demand for the other. These are shifts at each given own price. Derived demand is demand for productive inputs arising from demand for the output they help produce. More planned output tends to raise input demand if production methods stay unchanged. Producers may also switch shared resources towards a more profitable alternative, reducing supply of another product. Separate consumer substitution from producer resource allocation: they can move demand and supply in opposite directions.

Price elasticity of demand (PED) measures the percentage response of quantity demanded to a percentage price change, other demand conditions unchanged. Demand normally has a negative signed PED. Use its magnitude to classify responsiveness: below one is inelastic, above one is elastic, and one is unit elastic. When initial-value bases are specified, divide each change by its own initial value before forming the ratio.

Total revenue is price multiplied by quantity sold. For a sufficiently small move, an inelastic demand response makes revenue move with price; an elastic response makes revenue move against price. For a finite change with both endpoints known, calculate both revenues directly.

Price elasticity of demand (PED) measures the percentage quantity demanded response to a percentage change in the product’s own price. Its magnitude describes responsiveness. Determinants explain why the magnitude differs between products, buyers and adjustment periods; they do not give an exact coefficient without further information. Consider close substitutes, budget share, necessity, brand loyalty and time to adjust. More close substitutes and a larger budget share tend to increase responsiveness. Essential use and stronger loyalty can reduce it. Over longer periods buyers can change habits and equipment. Demand for a narrowly defined brand is often more elastic than demand for its whole category because other brands are close substitutes. These influences can work in opposite directions.

Income elasticity of demand (YED) measures the percentage response of quantity demanded to a percentage change in income, with other demand conditions fixed. Keep its sign. A positive coefficient identifies a normal good; a negative coefficient identifies an inferior good over the range considered. Divide each change by its own original value when original-value bases are specified. Then divide the percentage quantity change by the percentage income change. A normal necessity has YED strictly between zero and one. A normal luxury has YED above one. Exactly one means unit income elasticity; exactly zero means no income response.

Cross elasticity of demand (XED) measures the percentage response of quantity demanded of one good to a percentage change in another good’s price, holding other demand conditions fixed. Define the direction explicitly: quantity of A responding to the price of B is different from quantity of B responding to A’s price. Divide the percentage quantity change of the responding good by the percentage price change of the other good. Use each original value as its percentage base when specified. A positive coefficient indicates substitutes; a negative coefficient indicates complements. Zero indicates no response over the price change considered.

Price elasticity of supply (PES) measures the percentage response of quantity supplied to a percentage change in the product’s own price, holding other supply conditions fixed. On an upward-sloping supply curve it is positive. A coefficient above one is elastic; between zero and one is inelastic; one is unit elastic. Use each original value as its percentage base when specified. Divide the percentage quantity supplied change by the percentage price change. Zero responsiveness means perfectly inelastic supply, drawn vertically. A horizontal supply curve represents perfectly elastic supply, rather than unit elasticity.

Market prices help coordinate buyers and sellers. Rationing allocates a limited quantity among people willing and able to pay. Signalling conveys information about changes in demand or supply. Incentives change the rewards from consumption, production and alternative uses of resources. These functions can operate together. Start with the source of a change, then identify excess demand or excess supply at the old price. In a competitive market with flexible prices, a shortage puts upward pressure on price; unsold stocks put downward pressure on it. Trace movements along the unchanged curve separately from shifts. A higher selling price strengthens the incentive to supply when relevant costs are unchanged.

Consumer surplus is maximum willingness to pay minus actual payment, summed over purchases. Producer surplus is payment received above the minimum required to supply the units sold. Sales revenue includes the minimum payments needed to supply the units sold; producer surplus measures the excess above those supply requirements. For straight curves, use the triangle area: one half multiplied by the quantity base and the relevant price height. Consumer surplus lies below demand and above price. Producer surplus lies above supply and below price. Keep the unit basis: pounds per unit multiplied by units per day gives pounds per day.

Market failure means an inefficient allocation of scarce resources. A feasible change could improve total social welfare, taking relevant private and third-party effects into account. It does not mean that a business failed, that a price fell or that some participants received smaller shares than others. Compare the total social benefits and opportunity costs of feasible alternatives over the same period. Net social benefit is social benefit minus social cost. Include external damage as a cost and external gains as benefits, without counting the same effect twice. Private decisions can diverge from this comparison when prices omit effects on others, information is incomplete or payment cannot be collected for a useful service.

A pure public good is non-rival and non-excludable. Non-rivalry means an additional user does not reduce what others can consume. Non-excludability means preventing non-payers from benefiting is impractical. Public ownership and a zero user price do not define either property. A free rider benefits without helping to finance provision. When exclusion is difficult, voluntary payments may be too small to cover costs even when total benefits justify provision. Add separate beneficiaries’ valuations for the same service to assess total benefit; distinguish those valuations from cash pledged. Compulsory taxation can help raise funding, but the project still uses resources and requires a benefits-and-costs assessment.

Imperfect information means decision-makers lack relevant knowledge. Asymmetric information means one party has more relevant knowledge than another. Both sides can face the same uncertainty, so incomplete information need not be asymmetric. Different incomes or preferences do not establish either condition. Compare decisions based on perceived benefits and costs with decisions based on accurate information. Underestimating benefits can discourage useful purchases; underestimating costs can encourage purchases that informed buyers would reject. Hidden defects or charges can create a gap between what a buyer expects and what the transaction delivers. Independent tests, clear disclosure and credible reputations can reduce gaps, although information provision can also use resources.

A merit good is considered socially desirable and liable to be underconsumed in a free market, for example because buyers underestimate private benefits. A demerit good is considered liable to be overconsumed, for example because buyers underestimate private harms. These labels include judgements about desirable consumption. Identify the information gap and who receives the benefit or bears the harm. A private effect falls on the consumer; an external effect falls on someone outside the transaction. Correcting underestimated benefits can shift demand right. Correcting underestimated harms can shift demand left. Neither label determines whether consumption is rival or whether non-payers can be excluded: those properties define public goods.

Income is a flow received over a period, such as monthly earnings. Wealth is a stock of assets at a point in time; net wealth subtracts outstanding liabilities. Equal current incomes do not establish equal accumulated resources, debts or liquid funds available for an upfront purchase. Market demand reflects willingness and ability to pay. People can value the same service but have different access because their budgets differ. Compare income over the same period, account for relevant commitments and distinguish money amounts from purchasing power. A larger total income does not establish that each household gained or that inequality fell. Distributional fairness involves judgements as well as measurement.

Factor immobility makes it difficult to move resources between uses or locations. Occupational labour immobility concerns skills or qualifications needed for different work. Geographical labour immobility concerns reaching jobs elsewhere. Workers can remain underused in one industry while other industries need skills they do not yet possess. Compare workers’ skills and locations with employers’ requirements. National totals of vacancies and unemployment can conceal mismatches. Higher wage offers may encourage adjustment, but training, housing, transport and moving costs can delay it. Retraining addresses skills; relocation or transport support addresses access to places. Where both barriers exist, removing one may leave the other binding.

An external cost is uncompensated harm imposed on someone outside a market transaction. It can arise from production, such as factory smoke, or consumption, such as noise affecting neighbours. Total social cost adds private resource costs and external costs. Payments the producer already bears are private costs. In an unregulated competitive market, buyers and sellers consider their own costs and benefits. When third-party harm is omitted and there are no offsetting failures, market output can exceed the socially efficient quantity. Overproduction compares market output with the output that maximises net social benefit; it does not mean that goods remain unsold.

An external benefit is a gain to someone outside a transaction who does not pay for it. It can arise in consumption, such as unpaid community gains from someone’s study, or production, such as knowledge spilling from one firm’s research to others. Social benefit adds private and external benefits. Private decisions can omit unpaid third-party gains. In a competitive market with no offsetting failures, this can make output lower than the quantity that maximises net social benefit. Underproduction can exist even when ordinary private demand and supply balance; it is different from a market shortage.

A negative production externality is an uncompensated cost imposed on third parties by production.

A negative production externality is an uncompensated cost imposed on third parties by production. Marginal social cost (MSC) adds marginal external cost to marginal private cost (MPC). Here MPC means cost, not the marginal propensity to consume. With no consumption externality, marginal private benefit (MPB) and marginal social benefit (MSB) coincide. Competitive private decisions equate MPB with MPC. Efficiency instead equates MSB with MSC. Positive external cost puts MSC above MPC, making unregulated output excessive in the standard diagram. Welfare loss concerns the net social cost of excess units, rather than all pollution damage.

A positive consumption externality is an unpaid benefit received by third parties from someone’s consumption. Marginal social benefit (MSB) adds marginal external benefit to marginal private benefit (MPB). With no production externality, marginal social cost (MSC) equals marginal private cost (MPC). Here MPC means production cost. In the competitive model, private market output equates MPB with MPC. Efficient output instead equates MSB with MSC. The positive benefit gap makes market output too low. The welfare-loss triangle measures net social gain forgone on missing units, not gains already enjoyed or the total spillover on existing consumption.

A negative consumption externality is uncompensated harm caused to third parties by consumption. Marginal social benefit (MSB) equals marginal private benefit (MPB) minus marginal external cost. With no production externality, marginal social cost (MSC) equals marginal private cost (MPC). Here MPC refers to production cost. Private competitive output equates MPB with MPC. Efficient output equates MSB with MSC. Social benefit lies below private benefit, so unregulated consumption is excessive. Count consumption harm once: also adding it to the cost curve would double count the same effect.

A positive production externality is an unpaid gain to third parties arising from production. In the standard net-cost representation, marginal social cost (MSC) equals marginal private cost (MPC) minus marginal external benefit. Here MPC means production cost. With no consumption externality, marginal private benefit (MPB) equals marginal social benefit (MSB). Competitive private decisions equate MPB with MPC. Efficiency equates MSB with the lower MSC curve. Private output is too low because producers do not capture the full social return. The triangle between MSB and MSC over missing units is a potential social gain forgone, rather than a gain already realised.

An indirect tax is charged through spending or transactions. A specific tax is a monetary amount per unit; an ad valorem tax is a percentage of a stated price base. Distinguish the consumer price from the producer price net of tax. In a competitive model a specific tax creates a wedge: consumer price minus producer price equals the tax. Multiply the per-unit charge by the new taxable quantity for government revenue. The side with less price-responsive behaviour tends to bear more of a small tax. The party that remits the payment need not bear its whole economic burden.

A per-unit producer subsidy is a government payment for each eligible unit supplied. The producer receives the consumer payment plus the subsidy. It differs from a fixed grant unrelated to output, which does not add a payment for each extra unit. Draw competitive supply in consumer-price terms lower by the per-unit payment. Solve using the difference between the producer receipt and consumer price. Direct government expenditure equals the payment per unit multiplied by the new eligible quantity. Incidence depends on relative price responsiveness rather than the identity of the legal recipient.

A maximum price is a legal ceiling; it binds below the otherwise clearing price. A minimum price is a legal floor; it binds above that price. Compare each rule with the competitive equilibrium before predicting a shortage or excess supply. With demand sloping down and supply sloping up, a binding ceiling raises quantity demanded and lowers quantity supplied. Legal trades are supply-limited if all offered units sell. A binding floor lowers quantity demanded by private buyers and raises quantity supplied. State whether government buys the excess before calculating sales or public expenditure.

Regulation imposes enforceable requirements, such as an emissions limit. Tradable permits authorise a stated amount of a covered activity; their total can cap emissions. Information provision changes what people know without necessarily restricting their choices. Public funding and public production are separate decisions. Match the tool to its mechanism. A permit cap requires monitoring and enforcement. Trading can shift abatement towards lower-cost firms without changing the permit total. Information helps people reassess private choices but does not automatically charge them for harm to others. Publicly financed services still use resources with alternative uses.

Government failure occurs when intervention leads to a worse allocation than a relevant feasible alternative. Sources include imperfect information, administrative and compliance costs, delays, capture by interest groups and unintended responses to changed incentives. Public spending or redistribution alone is not proof of failure. Specify the objective and compare complete benefits and resource costs on the same basis. Include the counterfactual: what would have happened without the policy? Separate gross activity from additional activity, and check whether displaced activity offsets gains. Consider feasible improvements as well as abolition.

A rational-choice model describes a consumer choosing the feasible option that best satisfies their preferences. Relevant benefits and costs can include money, time, convenience and other valued attributes. Different preferences or constraints can produce different rational choices. State the consumer’s objective and include the effects relevant to it. For the lowest monetary payment, add compulsory fees and subtract applicable discounts. For a broader preference comparison, include other attributes consistently. Habits can repeat earlier choices without a fresh calculation. Social influences can shape preferences, while limited time and processing ability can constrain detailed comparisons. Observing a purchase alone need not reveal the decision process.

Utility means satisfaction from consumption. Total utility is satisfaction from the quantity consumed in the stated period. Marginal utility is the change in total utility caused by one additional unit. These hypothetical utility units are not automatically money values or comparable measures between different people. For a discrete schedule, subtract the previous total from the new total to obtain marginal utility. Conversely, add marginal increments to reconstruct total utility. Diminishing marginal utility means successive increments become smaller. If they stay positive, total utility still rises, but more slowly. A zero increment leaves total utility unchanged; a negative increment reduces it. Keep the consumption period and relevant circumstances fixed.

Behavioural analysis studies influences that can differ from complete, deliberate calculation. Bounded rationality concerns limits on information and processing; bounded self-control concerns following a considered plan despite immediate temptation. Anchoring uses an initial reference value, while availability gives weight to easily recalled examples. Rules of thumb, or heuristics, simplify decisions. Social norms are expectations about what others do or approve of. Choice architecture is the setting in which decisions are made. Defaults, presentation and social cues can influence choices. A nudge keeps options readily available without substantially changing economic incentives. A restriction removes an option; mandated active choice requires a selection. Neither should be confused with a preset that applies through inaction.

Adam Smith connected specialisation and exchange with greater productive capacity. Exchange allows people pursuing their own interests to obtain the products of others’ specialised work.

Karl Marx analysed capitalism through the relationship between owners of the means of production and wage workers who sell their labour power. Equal worker ownership of all assets and comprehensive state production describe different arrangements.

Friedrich Hayek argued that knowledge relevant to economic decisions is dispersed among people. Price signals can help coordinate their separate decisions without collecting that knowledge into a comprehensive central plan.