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Introduction to Economics

a) ‘The production possibilities frontier is the boundary between those combinations of goods and services that can be produced and those that cannot’ (McTaggart, Findlay & Parkin, 2007). The PPF compares two products and a model economy is used where everything remains the same (ceteris paribus), i.e. production cost, demand, and supply, etc remain the same. Here is an example of a PPF using two goods, milk and steak. On the x-axis there is the amount of milk that can be produced in liters and on the y-axis, there is the amount of steak which can be produced in kilograms. Each position on the PPF is efficient. It uses all the resources available. Any point within the area of the PPF is obtainable, but resources are being wasted. For example, if there are 10 cows that can either be used for producing milk or steak, and we milk one and slaughter the other, the other eight are out on the field eating grass not producing anything, i.e. we could be either milking or slaughtering them. Any point outside of the PPF is unobtainable, as there are not enough resources available.

The marginal cost is the cost of producing one more unit of it. The gradient of the PPF shows the marginal cost. As more steak is produced, the marginal cost of producing milk increases. That is the more cows that we slaughter, the less milk we are able to produce. The marginal benefit is the benefit received from consuming one more unit of it. Marginal benefit is measured by the most that someone is willing to pay for another unit. As all points on the PPF are efficient, which one point on the PPF is more important than any other? It is the point where the resources are allocated efficiently, that is, we are not trading off another good that we value higher than the other. This point is found when the marginal cost is equal to the marginal benefit. As we can see, the point of intersection of the marginal benefit and marginal cost shows us the most efficient amount to produce, in this case, 5 units of steak and 20 units of milk.

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(b) ‘There are two major influences which affect economic growth. They are technological change and capital accumulation. Technological change is the development of new goods and of better ways of producing goods and services. Capital accumulation is the growth of capital resources, which includes human capital. Economic growth is not free. The notion is in order to have more tomorrow we will have less today. By allocating resources to developing technologies to improve our standard of living in the next 10 years, we are unable to use those resources for other things that we could be using today. The opportunity cost of economic growth is forgone current consumption’ (McTaggart, Findlay & Parkin, 2007).

Example: A mobile phone company may instead of dedicating the whole factory to producing mobile phones, rather allocate half of its resources (i.e. time, money, and manpower) into developing the next generation of mobile phone technology (both mobile phones and ways of producing them). The cost of economic growth here is that instead of producing the maximum amount of phones, revenue is sacrificed in order to create better phones increase the quality of life. Phone technology shows us the limits between producing mobile phones and developing mobile phone technology. As a year goes by, phone technology 2 is invented and it shows that we can now produce more mobile phones with less of an opportunity cost than technology 1. Even though the standard of living increases and economic growth through technological change takes place, opportunity costs and tradeoffs do not disappear.

Question 2 (a) ‘The term demand refers to the entire relationship between the price of the good and the quantity demanded of the good. The demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same (ceteris paribus)’ (McTaggart, Findlay & Parkin, 2007). Here is a graph showing the demand curve. The law of demand states: With all variables remaining the same, the lower the price, the higher the demand, the higher the price, the lower the demand. This is reflected in the demand curve below. ‘There are 6 main things that affect the amount of demand.

  • The prices of related goods – can I satisfy the same need or want with something cheaper or of better quality for the same price?
  • Income – can I afford this now?
  • Expected future income – will my income rise or fall, can I afford this later or do I need to buy it now?
  • Expected future prices – will this be cheaper in the future, or do I need to buy now to make a savings?
  • Population – how many people are in demand for this product/service?
  • Preferences – how many people are interested in this product/service?’ (McTaggart, Findlay & Parkin, 2007)
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A change in the price of related goods means the change in substitutes and the change in complementary goods. (b) ‘Total revenue refers to the price of the good or service sold multiplied by the amount sold. The price elasticity of demand is a unit-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same. Elastic demand: If the percentage change in the quantity demanded exceeds the percentage change in the price then the price elasticity of demand is greater than one and the good is said to have an elastic demand. Inelastic demand: If the percentage change in the quantity demanded is less than the percentage change in price then the price elasticity of demand is between zero and one and the good is said to have an inelastic demand.

Unit elastic demand: If the percentage change in the quantity demanded equals the percentage change in price then the price elasticity equals one and the good is said to have a unit elastic demand. If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total revenue increases. Therefore, if a price cut increases total revenue, demand is elastic. If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent, and total revenue decreases. Therefore, if a price cut decreases total revenue, demand is inelastic. If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and so total revenue does not change. Therefore if a price cut leaves total revenue unchanged, demand is unit elastic.’ (McTaggart, Findlay & Parkin, 2007).

Question 3. (a) As shown previously, the marginal benefit curve shows the willingness of the market to consume just one more unit of a good or service. The curve can also be known as the demand curve. The marginal cost curve shows the cost of producing just one more unit of a good or service. The curve can also be known as the supply curve. With all other influences on the market remaining the same(ceteris paribus) we can find the consumer and producer surplus by using the marginal benefit and marginal cost curves. The area where all lines intersect is the point of efficiency and the market price for this good or service. The area above the market price but below the marginal benefit is the consumer surplus. We can see that the first unit purchased was for $6, but the market was willing to pay $10. In other words, the first unit bought was sold for $4 less than what the market was willing to pay for it, and a bargain or saving was made.

This continues until we reach the point of efficiency where marginal benefit and marginal cost intersect and there is no consumer surplus, i.e. no bargain. The area below the market price buy above the marginal cost is the producer surplus. We can see that the first unit sold was $6, but the cost for producing it was $2. In other words, the first unit produced was sold for $4 more than the production cost of that unit. This continues until we reach the point of efficiency where marginal benefit and marginal cost intersect and there is no producer surplus, i.e. no profit. ‘A deadweight loss occurs when there is inefficiency. Either there is too much or too little and the total surplus (consumer and producer) is decreased’ (McTaggart, Findlay & Parkin, 2007).

(b) The housing market works like a normal market. There is a demand for rental properties and there is a supply of rental properties, i.e. there are families wanting to pay rent for a house and there is a landlord willing to let his property to them. The rent price is reflective of the market condition, i.e. how much demand and supply in the market will determine the rent. Governments may try to regulate the housing market by imposing a price ceiling. Price ceilings make it illegal to charge any amount higher than the amount imposed. In the housing market, a price ceiling is referred to as a rent ceiling. Rent ceilings may have 2 effects on the housing market. If the rent ceiling is priced at the equilibrium point or higher it will have no effect on the market. If it is priced lower than the equilibrium point it creates conflict in the market as it starts to regulate the actual quantities in demand and supply.

The landlord may however still try and let their properties illegally for the rent that the market is willing to pay or charge the renter miscellaneous charges, i.e. new locks or keys but at extremely high prices to make up for the loss from the rent ceiling. Once there is a scarcity of houses, people will need to spend more time finding a place to rent as there isn’t an abundance of rental properties. Buying newspapers, fuel, and spending time looking for places is called the search activity. ‘The opportunity cost of a good is equal not only to its price but also to the value of the search time spent finding the good’ (McTaggart, Findlay & Parkin, 2007). For example, the local council of Glenelg, South Australia imposes a rent ceiling so that rent prices are lower and more people are attracted to the area. The current market is willing to pay $600 per month in rent. The council imposes a rent ceiling of $400 per month.

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As the diagram shows, with the price ceiling in place, only 3000 houses are available at the $400 per month, yet there are 7000 houses in demand. The price ceiling has created a shortage of houses. Also, with the supply of houses at 3000, the market is willing to pay $800 per month (double that of the price ceiling). The price ceiling has decreased the amount of houses in supply, consumer surplus, and producer surplus has in turn also shrunk and a deadweight loss has occurred. The deadweight loss, shown in the small triangle (sectioned off by the demand, supply, and deadweight loss lines), shows the inefficiency of the price ceiling.

Question 4. (a) ‘A household’s budget line describes the limits to its consumption choices’ (McTaggart, Findlay & Parkin, 2007). When looking at a budget equation we are assuming that all factors influencing the market or household are remaining the same (ceteris paribus). For example, Max’s income is $150, and buys two goods: DVDs and chips. A DVD costs $50 and a bag of chips costs $1. The area below the budget line is affordable and anywhere above the line is unaffordable. ‘Real income is the income expressed as a number of goods a person can afford to buy’ (McTaggart, Findlay & Parkin, 2007). In Max’s case, his real income expressed in chips would be $150 (his income) divided by $1 (the price of chips), which is equal to 150 packets of chips. The real income is shown on the graph at the points where the budget line intersects the x and y-axis (x-axis for DVDs and y-axis for chips).

‘The relative price is the price of one good divided by the price of another good. An indifference curve is a line that shows combinations of goods among which a consumer is indifferent (McTaggart, Findlay & Parkin, 2007). The points below the indifference curve are not preferred, the points on the curve are indifferent and the points above the curve are preferred. ‘The marginal rate of substitution is the rate at which a person will give up one good for the other (in this case, chips for DVDs), yet still remain on the indifference curve. The gradient of the slope measures the marginal rate of substitution (McTaggart, Findlay & Parkin, 2007). The two curves show Max’s preference map. The points on the highest line are preferred over any point on the line below.

‘To get the most value for his budget, Max consumes at the best affordable point. That is a point that is on her budget line, is on his indifference curve (the highest of all of them), and has a marginal rate of substitution between DVDs and chips equal to the relative price of DVDs and chips. The substitution effect is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new one. The income effect is the effect of a change in income on consumption’ (McTaggart, Findlay & Parkin, 2007). We can show these two effects using the preference map and budget line. For a normal good, if it becomes cheaper the more we are going to buy of it. These two effects will help us understand how. When Max’s income increases his budget line will move to the right parallel to his old budget line, thus intersecting the highest indifference curve. When the price of the good changes, he can afford more of one of them and his budget line moves rightward (but not parallel) and again his budget line will intersect at a different point on the indifference curve. From this, we can predict consumer buying patterns.

(b) There are 24 hours in a day, and therefore 164 hours a week. We allocate these hours into work, rest, and play. We earn money for our work or labor. The time that we allocate for leisure can be seen as a time that we have not allocated for work, i.e. that there are a trade-off and an opportunity loss. If Max is paid $5 an hour, the opportunity loss is $5 for every hour allocated for leisure. As Max’s wage increases, so do his opportunity loss, i.e. he is more willing to work as he is losing more for every hour that he isn’t working. This doesn’t mean that the more we are paid the more we will work indefinitely. That would mean that if we were paid a certain amount we would work the full 164 hours a week. When would one stop? Would we stop working 40 hours a week if we were paid 1 million dollars an hour?

Would we work the full 40 hour week at 1 million dollars an hour or just the first hour and then stop? Would we work the full week as opportunity cost has risen significantly? But as we have earned this high wage, we need time to spend it. So as our wage increases so do our demand for leisure. This puzzling change in supply for labor doesn’t occur at the one million dollar mark but rather much closer to what we are earning right now. As Max’s pay increases from $5 to $7.50, he increases his workload from 25 hours to 40 hours a week. And as his pay increases from $7.50 to $10 he decreases from 40 hours to 30 hours. The pay rise from $5 to $7.50 makes him think that he should spend his time working instead of having fun as the money is worth more to him. But as his pay rises from $7.50 to $10 he cuts his hours of labor down until he is earning the same amount per week, but now can spend that saved time on leisure.

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Question 5. (a) ‘A firm is an institution that hires productive resources and organizes those resources to produce and sell goods and services’ (McTaggart, Findlay & Parkin, 2007). In the short run, the firm’s plant (buildings, technology, and capital) is fixed. The firm’s goal is to maximize its profit. It looks at its relationship between the labor employed and the output. It looks at the total product (the total output), the marginal output (the change in output with extra labor), and the average product (the total product divided by the quantity of labor employed). ‘The law of diminishing marginal returns occur when the marginal product of a worker is less than the marginal product of the previous worker’ (McTaggart, Findlay & Parkin, 2007). As we can see as labor increases the amount of product output flattens, i.e. diminishes. At which point are we producing the most for labor employed? If we look at the relationship between the average product and the marginal product we can find this point. It occurs when the marginal product and average product are equal. As we can see, the average product first increases, and then decreases.

(b) ‘The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied’ (McTaggart, Findlay & Parkin, 2007).

Question 6. (a) ‘Perfect competition is an industry in which:

  • Many firms sell identical products to many buyers
  • There are no restrictions on entry into the industry
  • Existing firms have no advantage over new ones
  • Sellers and buyers are well informed about prices’ (McTaggart, Findlay & Parkin, 2007).

Economic profit is calculated by taking the total average cost of producing a good from the price of the good and finally multiplied by the quantity sold. If the total average cost is equal to the price of the good, the firm will break even and a normal profit is reached (zero economic profit). If the total average cost of production is less than the price then an economic profit is reached. If the total average cost of production is greater than the price then an economic loss is reached.

(b) ‘A monopoly is a firm that produces a good or service for which no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or service (McTaggart, Findlay & Parkin, 2007). When the number of firms is fixed and each firm has given plant size, we can study the market price (i.e. how much is in demand and how much is in supply). In perfect competition, the market would decide on the price of a good, whereas in a monopoly, a firm can be in a single price monopoly or discriminate on price. An example of price discrimination is a hotel. The hotel tries to sell every room night for the highest price possible, which may mean that they sell one room for $100 and the room next to it for $120. A single price monopoly can not do this, as the consumer will only buy at the lowest price, if the firm tried to discriminate on price, consumers would start to only buy from the low-price consumers.

‘In regards to output, a firm in a monopoly is affected by some types of technological and cost constraints as a competitive firm’ (McTaggart, Findlay & Parkin, 2007). ‘All firms maximize profit by producing the output at which marginal revenue equals marginal cost. For a competitive firm, price equals marginal revenue, so the price also equals marginal cost. For a monopoly, price exceeds marginal revenue, so the price also exceeds marginal cost’ (McTaggart, Findlay & Parkin, 2007). ‘Compared to a perfectly competitive industry, a single-price monopoly restricts its output and charges a higher price’ (McTaggart, Findlay & Parkin, 2007). A firm in a perfectly competitive industry runs efficiently as the price and amount produced are determined by the market. However, as a monopoly is an industry, it determines its own prices (the point where profit is maximized). ‘This creates a deadweight loss, because:

  • Consumers pay more (decrease in consumer surplus).
  • Consumers get less of the good (decrease in consumer surplus).
  • Lose of original producer surplus because of the smaller monopoly output’ (McTaggart, Findlay & Parkin, 2007).

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