6EC01 key definitions

Term

Definition

Normative statement

It is a statement that contains a value

judgement and cannot be tested; i.e. what
ought to be.

Positive statement

It is a statement that is testable; i.e. what is,

was or will be.

PPF

A production possibility frontier is a graphical

representation of the maximum output an
economy can produce given a finite combination
of resources. Movement along the frontier
implies an opportunity cost in terms of the
output of one good foregone to gain the output
of another.

Quantity of
Good Y

Quantity of Good X

Opportunity cost

The value of the next best alternative foregone.

Division of labour

The breaking of a production process into

separate, sequential tasks leading to workers
specialising.

Specialisation

A system of organisation where individuals

specialise in the production of particular goods
or services and then trade the surplus to satisfy
their wants, as opposed to self-sufficiency.

Price mechanism

An economic system which allocates resources

using prices to transmit information, provide
incentives and distribute rewards.

Rationing function of the The price mechanism allocates scarce resources

to those buyers who are prepared to pay a high
price mechanism
enough price.

Signalling function of the Prices help to determine where and how

resources should be allocated e.g. if prices
price mechanism.

increase, this suggests more resources should be

allocated to the market.

Incentive function of the

price mechanism

Prices act as an incentive to both buyers and

sellers e.g. a rising price may encourage sellers
to supply more of the product and buyers to
purchase less.

Market equilibrium

A position where the market price has no

tendency to change, assuming ceteris paribus,
because demand equals supply.

Ceteris paribus

An assumption that all other factors are held

constant.

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Free-market economy

An economy which tackles the basic economic

problem, the co-existence of infinite wants and
finite resources, predominately through the price
mechanism.

Command economy

An economy which allocates its resources

predominately through the direction of a central
planning authority.

Mixed economy

An economy where both the price mechanism

and the planning authority have a significant role
in allocating resources.

Consumer surplus

The difference between the amount a consumer

is willing to pay for a product and the amount
they actually pay. (Represented by the area
below the demand curve and above the price
line)

Price

P1
Demand

Quantity

The difference between the price a firm is willing

to sell a good or service for and the actual price
they sell the good or service for. (Represented
by the area above the supply curve and below
the price line)

Producer surplus
Price

Supply

P1

Quantity

Indirect tax
STAX

Price

S
Tax per P1
unit

D
Q1

Quantity

Subsidies
Price

Subsidy
per unit

SSUBSIDY

POLD
PNEW

D
QO QN

A tax on expenditure collected by the producer

on behalf of the government.
Note: the tax shifts the supply curve up vertically
by the tax per unit. Multiply this by the number
of units, Q1, gives the total tax revenue (area
shaded).

Quantity

A payment made by the government to

producers which they will receive in addition to
the market price.
Note: the subsidy shifts the supply curve down
vertically by the subsidy per unit. Multiply this by
the number of units, QN, gives total expenditure
(area shaded).

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The distribution of the burden of an indirect tax

between buyers and sellers.

Incidence of tax
Price

STAX

PNEW

POLD

The stripped area (above the original price) is

paid for by the consumers.

D
QNEW QOLD

Quantity

The dark area (below the original price) is paid

for by the producers.

Price elasticity of
demand

Measures the responsiveness of quantity

demand to a change in price. % QD
% P

Income elasticity of
demand

Measures the responsiveness of quantity

demand to a change in income. % QD
% Y

Cross-price elasticity of
demand

Measures the responsiveness of quantity

demand of good A to a change in the price of
good B. % QD of Good A
% P of Good B

Substitutes

A pair of goods which are considered to be

alternatives to each other by consumers; i.e. a
positive cross-price elasticity of demand.

Complements

A pair of goods that are consumed together; i.e.

a negative cross-price elasticity of demand.

Normal good

A good whose demand increases when income

increases; i.e. a positive income elasticity of
demand.

Inferior good

A good whose demand falls when income

increases i.e. a negative income elasticity of
demand. This relationship may arise as
consumers buy more desirable alternatives as
their income rises.

Derived demand

The demand for a factor of production that

results from the demand for the product that it
is used to make.

Price elasticity of supply

Measures the responsiveness of supply to a

change in price. % QS
% P

Short run

The period of time over which the quantity of

some factor of production is fixed.

Long run

The period of time over which the quantity of all

factors of production can be changed.

Allocative efficiency

Occurs when resources cannot be reallocated to

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produce a different combination of goods that

will increase economic welfare; i.e. economic
welfare is maximised and the sum of consumer
and producer surplus is maximised (P=MC).

Price

S
P*
D
Q*

Quantity

Market failure

Occurs when a free market produces a

misallocation of scarce resources.

Government failure

Occurs when government intervention leads to

an even greater misallocation of resources and a
movement away from the socially optimal point
of production than if there was no intervention.

Public-choice theory

The failure of government to act in the interests

of the population because public servants pursue
their own private interests ahead of the wider
public interest; i.e. salary, public reputation,
power, etc.

Asymmetric information

Where one party in an economic relationship has

more information than another; e.g. doctors and
patients.

Moral hazard

When people take actions that increase social

costs because they are insured against private
loss: sometimes it is called hidden action due to
the agents actions being hidden from the

principal.

Buffer stock scheme

Price

A scheme that buys surplus produce in periods

of abundance and sells stock in periods of
shortage, in order to stabilise the market price.

PTARGET

D
QPOOR

Q*

QGOOD

Sell stock Buy stock

Price ceiling
Price

A maximum price set by a regulator above which

suppliers cannot sell; i.e. rent controls for lowcost housing.

PMAX
D
Q1

Q2 Quantity

Excess demand

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A minimum price set by a regulator below which

buyers cannot purchase; i.e. the national
minimum wage.

Price floor
Price

PMIN

D
Q2

Q1

Quantity

Excess supply

Public goods

Goods and services that, once produced, can be

consumed by everyone in society: they exhibit
non-rivalry and non-excludability.

Free riders

People who use public goods but dont pay for

them.

Externalities
Costs and
benefits

Deadweight
loss

MSC
External costs
MPC

The costs or benefit received by a third party to

an economic transaction outside of the market
mechanism; i.e. the spillover effects of an
economic activity.

MSB=MPB
Q*

Q1

Quantity

External costs

The costs received by a third party to an

economic transaction outside of the market
mechanism

External benefits

The benefit received by a third party to an

economic transaction outside of the market
mechanism

Pigouvian tax

A tax placed on a good with negative

externalities so that the external cost is
internalised: the polluter pays principle.
The tax is set equal to the marginal negative
externality.

MSC

Costs and
benefits

Tax
PTAX

MPC

P1
MSB=MPB
QTAX

Q1

Quantity

Tradeable permits

A market-oriented solution to regulating the

quantity of pollution, where the rights to pollute
a given amount are traded so that a predetermined level of pollution abatement is
achieved for the least cost.

Property rights

A legal right to the ownership of a resource. If

this remains undefined, the resource may be
overexploited; i.e. fishing.

Command-and-control
(CAC)

The use of law and regulation backed up by

inspection and penalties for non-compliance.

Competition policy

Government policy directed at encouraging

competition in the private sector: e.g. the
investigation of takeovers or restrictive practices.

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Trade Union

An organisation of workers with the primary

purpose of collectively bargaining for improved
pay and conditions for its members.

Geographical immobility The inability of workers to move location to

attain work due to the cost of commuting or

relocating and non-pecuniary factors.

Occupational immobility

The inability of workers to move occupation or

find work due to a shortage of the required
skills.

Cost benefit analysis

(CBA)

An investment appraisal tool used to weigh up

the social benefits of a project against the social
costs.

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