AS Level Economics formulas and key terms

Basic economic ideas and resource allocation

Scarcity, choice and opportunity cost

• Scarcity: limited resources compared with unlimited wants.
• Opportunity cost: the next best alternative forgone when a choice is made.
• Choices are made at all levels: individuals, firms and governments.
• What to produce: which goods and services, and how much of each.
• How to produce: which mix of labour, capital and other resources to use.
• For whom to produce: who receives the output, which depends on the distribution of income.
• If the resources used would otherwise be unemployed, the opportunity cost of using them is very low.

Economic methodology

• Positive statement: a statement of fact or prediction that can be tested with evidence. It may turn out to be false.
• Normative statement: a statement based on a value judgement. Look for words such as should, ought, fair, too high, better.
• Ceteris paribus: all other things being equal (other factors are held constant).
• Short run: at least one factor of production is fixed.
• Long run: all factors of production can be varied, but technology is taken as given.
• Very long run: technology and all other influences on production can change as well.

Factors of production

• Land earns rent; labour earns wages; capital earns interest; enterprise earns profit.
• Physical capital: man-made goods used to produce other goods, such as tools, machines and buildings.
• Human capital: the skills, knowledge and experience of the workforce. Training and education increase it.
• Profit is an uncertain reward for bearing risks that cannot be insured. It is not agreed in advance.
• Advantages of division of labour: workers gain skill through repetition, less time is lost changing tasks, and specialised machinery can be used.
• Disadvantages: boredom, over-dependence between workers, and risk of unemployment if a narrow skill is no longer needed.
• Division of labour is limited by the size of the market.

Resource allocation in different economic systems

• Market economy: resources are allocated by the price mechanism; private ownership; the profit motive.
• Planned (command) economy: resources are allocated by the state; state ownership; output targets.
• Mixed economy: both the market (private sector) and the government (public sector) allocate resources.
• Consumer sovereignty: consumers' spending decisions determine what firms produce.
• Market problems: public goods not provided, merit goods under-consumed, demerit goods over-consumed, unequal incomes.
• Planning problems: shortages and surpluses, little incentive to cut costs or innovate, limited consumer choice.
• When price controls are removed, prices rise towards market levels and queues shorten.

Production possibility curves

• Opportunity cost of one extra unit of X = units of Y given up ÷ units of X gained.
• On the curve: full and efficient use of resources. Inside: unemployment or inefficiency. Outside: unattainable now.
• Straight line: constant opportunity cost. Bowed outwards: increasing opportunity cost.
• Outward shift: more or better resources (labour, capital, natural resources) or better technology.
• Inward shift: loss of resources, for example emigration of workers, war or natural disaster.
• Better technology for only one good: the curve pivots outwards along that good's axis; the other intercept stays the same.
• Making more capital goods now means fewer consumer goods now, but a faster outward shift in future.

Classification of goods and services

• Free good: no opportunity cost; supply is enough to meet all wants at zero price.
• Economic (private) good: scarce, so it has an opportunity cost.
• Rival: one person's use reduces the amount available to others. Excludable: people who do not pay can be prevented from using it.
• Public good: non-rival and non-excludable, for example national defence, street lighting, flood defences.
• Free rider: someone who benefits from a good without paying for it.
• Merit good: under-consumed in a free market because of imperfect information, for example education, health care.
• Demerit good: over-consumed in a free market because of imperfect information, for example cigarettes, alcohol.

The price system and the microeconomy

Demand and supply curves

• Effective demand: willingness to buy backed by the ability to pay.
• Market demand (or supply) = sum of the individual quantities demanded (or supplied) at each price.
• Demand shifts with: income, prices of substitutes and complements, tastes and advertising, population, expected future prices.
• Normal good: demand rises when income rises. Inferior good: demand falls when income rises.
• Supply shifts with: costs of production, technology, indirect taxes and subsidies, weather, number of firms, prices of other goods the firm could make.
• A specific tax or a rise in unit costs shifts supply upwards (to the left) by that amount; a subsidy or lower costs shift it downwards (to the right).
• Change in own price: movement along the curve (extension or contraction), never a shift.

Price elasticity, income elasticity and cross elasticity of demand

• PED = % change in quantity demanded ÷ % change in price. It is normally negative.
• YED = % change in quantity demanded ÷ % change in income. Positive: normal good (above 1 luxury, between 0 and 1 necessity). Negative: inferior good.
• XED = % change in quantity demanded of X ÷ % change in price of Y. Positive: substitutes. Negative: complements. Zero: unrelated.
• PED size (ignore the sign): 0 perfectly inelastic (vertical curve); 0 to 1 inelastic; 1 unitary; above 1 elastic; infinity perfectly elastic (horizontal curve).
• Straight-line demand curve: elastic above the midpoint, unitary at the midpoint, inelastic below it.
• Elastic demand: price and total revenue move in opposite directions. Inelastic: they move in the same direction. Unitary: revenue does not change.
• Demand is more price elastic with more close substitutes, a larger share of income, a longer time period, and when the good is a luxury rather than a necessity or habit.

Price elasticity of supply

• PES = % change in quantity supplied ÷ % change in price. It is positive.
• PES = 0: perfectly inelastic (vertical supply curve). PES = infinity: perfectly elastic (horizontal supply curve).
• 0 to 1: inelastic. 1: unitary. Above 1: elastic.
• Straight-line supply through the origin: PES = 1 at every point, whatever the slope.
• Straight-line supply that starts from the price axis: PES above 1. Starting from the quantity axis: PES below 1.
• More elastic with: spare capacity, large stocks, goods that can be stored, short production time, mobile factors, longer time period.
• Farm products and perishable goods have inelastic short-run supply, so their prices change a lot when demand changes.

The interaction of demand and supply

• Equilibrium: quantity demanded = quantity supplied. Disequilibrium: excess demand (shortage) or excess supply (surplus).
• Demand rises: price and quantity both rise. Demand falls: both fall.
• Supply rises: price falls and quantity rises. Supply falls: price rises and quantity falls.
• Both rise: quantity rises, price uncertain. Demand rises and supply falls: price rises, quantity uncertain.
• Joint demand (complements): used together, such as cars and petrol. Alternative demand (substitutes): one replaces the other.
• Derived demand: a factor or input is wanted for what it helps to produce. Joint supply: making one good also produces another, such as beef and leather.
• Rationing: a higher price limits a good to those most willing and able to pay. Signalling: price changes show producers what consumers want. Incentivising: higher prices and profits encourage firms to supply more.

Consumer and producer surplus

• Consumer surplus = what consumers are willing to pay − what they actually pay
• Producer surplus = price received − lowest price producers would accept
• With straight-line curves each surplus is a triangle: area = ½ × base (quantity) × height (price gap)
• Supply increases (demand unchanged): price falls, quantity rises, consumer surplus rises
• Demand increases (supply slopes upwards): price and quantity rise, producer surplus rises
• A specific tax reduces both consumer surplus and producer surplus
• The side of the market that is more price inelastic bears more of the change: inelastic demand means consumers lose most from a tax

Government microeconomy intervention

Reasons for government intervention in markets

• Public good: non-excludable (non-payers cannot be kept out) and non-rival (one person's use does not reduce the amount left for others)
• Free rider: someone who benefits from a good without paying for it
• Public goods are not provided by the market, so the government provides them and pays from taxation
• Merit good: better for people than they realise, so under-consumed in a free market
• Demerit good: more harmful than people realise, so over-consumed in a free market
• Maximum price: set to keep a good affordable for consumers
• Minimum price: set to protect producers' incomes, or to cut consumption of a demerit good

Methods and effects of government intervention in markets

• Tax paid by consumers per unit = rise in market price; tax paid by producers per unit = tax − rise in price
• Tax revenue = tax per unit × quantity sold after the tax
• Total cost of a subsidy = subsidy per unit × quantity sold after the subsidy
• The more price inelastic demand is (compared with supply), the more of a tax falls on consumers and the more of a subsidy they gain
• Maximum price below equilibrium: quantity demanded exceeds quantity supplied (shortage)
• Minimum price above equilibrium: quantity supplied exceeds quantity demanded (surplus)
• Buffer stock: buy when price falls to the floor, sell from stock when price rises to the ceiling

Addressing income and wealth inequality

• Income is a flow (per week, month or year); wealth is a stock (at a point in time)
• Gini coefficient = area between the line of equality and the Lorenz curve ÷ total area under the line of equality
• Gini coefficient of 0 = perfect equality; 1 = perfect inequality; a rise means more inequality
• Progressive tax: takes a larger percentage of income as income rises
• Transfer payment: money paid by the government with no good or service given in return, e.g. pensions, unemployment benefit
• Inheritance and capital taxes reduce inequality of wealth; income tax reduces inequality of income
• Wealth is usually distributed more unequally than income, because it builds up over time and is passed on

The Macroeconomy

National income statistics

• GDP = total value of output produced within a country in a year
• GNI = GDP + net primary income from abroad
• NNI = GNI − depreciation (capital consumption)
• Basic prices = market prices − indirect taxes + subsidies
• Net = gross − depreciation
• Count only value added at each stage (or only final goods) to avoid double counting
• Transfer payments are left out because no output is produced in return

Introduction to the circular flow of income

• Injections = investment + government spending + exports (I + G + X)
• Leakages = saving + taxation + imports (S + T + M)
• Equilibrium: I + G + X = S + T + M (the totals must be equal, not each pair)
• Closed economy with a government: equilibrium when I + G = S + T
• Injections > leakages: national income rises until leakages have risen to match
• Leakages > injections: national income falls until leakages have fallen to match
• Spending on domestic output = income − taxes − saving − imports

Aggregate Demand and Aggregate Supply analysis

• AD = C + I + G + (X − M): consumption, investment, government spending, net exports
• AD shifts right when C, I, G or (X − M) rises, e.g. lower interest rates, lower income tax, higher confidence
• SRAS shifts left when costs of production rise, e.g. higher wages, dearer raw materials or oil
• LRAS shifts right when the quantity or quality of factors of production rises, e.g. better technology, education, more capital
• AD shifts right: real output and the price level rise (on vertical LRAS only the price level rises)
• SRAS shifts left: real output falls and the price level rises
• SRAS shifts right: real output rises and the price level falls

Economic growth

• Growth rate = change in real GDP ÷ original real GDP × 100
• Real GDP = nominal GDP ÷ price index × 100
• Approximate real growth = nominal GDP growth − inflation rate
• Approximate growth in real GDP per head = real GDP growth − population growth
• Actual growth: more output is produced (AD or SRAS shifts right)
• Potential growth: productive capacity rises (LRAS shifts right) through investment, technology, education, a larger labour force
• If actual growth stays above the growth of capacity, spare capacity runs out and inflation rises

Unemployment

• Unemployment rate = number unemployed ÷ labour force × 100
• Labour force = employed + unemployed (not the whole population)
• Frictional: people moving between jobs, short term
• Structural: an industry declines and workers' skills or location do not fit the jobs available
• Cyclical (demand-deficient): AD falls in a recession, so unemployment rises in most industries
• Seasonal: demand for labour falls at certain times of year; technological: machines replace workers
• Claimant count misses the unemployed who cannot or do not claim; the survey is a sample, so it is costly and may have sampling errors

Price stability

• Inflation rate = change in CPI ÷ earlier CPI × 100
• Weighted price index = sum of (weight × price index) ÷ sum of weights
• Real value = money (nominal) value ÷ price index × 100
• Approximate real change = % change in money value − inflation rate (same for the real rate of interest)
• Demand-pull: AD shifts right, price level and real output rise
• Cost-push: SRAS shifts left, price level rises and real output falls
• Inflation harms people on fixed incomes, savers and lenders, and makes exports less competitive; borrowers gain

Government macroeconomic intervention

Government macroeconomic policy objectives

• Price stability = a low, stable rate of inflation (for example a 2% target), not zero price change.
• Low unemployment = a small percentage of the labour force is without work and looking for it.
• Economic growth = an increase in real GDP over time (measured as the % change in real GDP).
• Falling prices (deflation) are not the aim: people delay spending and the real value of debt rises.
• Demand too high and inflation above target: use contractionary fiscal or monetary policy.
• Demand too low and unemployment high: use expansionary fiscal or monetary policy.
• Growth without extra inflation near full capacity: use supply-side policy to raise productive capacity.

Fiscal policy

• Budget deficit: government spending > tax revenue. Budget surplus: tax revenue > government spending.
• National debt = total stock of government borrowing; a deficit adds to it each year and interest must be paid on it.
• Direct tax: on income or wealth (income tax, corporation tax). Indirect tax: on spending (VAT, sales tax, excise duty).
• Progressive: average rate rises as income rises. Proportional: average rate stays the same. Regressive: average rate falls as income rises.
• Average rate of tax (art) = total tax paid ÷ total income × 100. Marginal rate of tax (mrt) = change in tax paid ÷ change in income × 100.
• Capital spending: on assets that last, such as roads and schools. Current spending: day-to-day, such as wages and medicines.
• Expansionary: higher spending or lower taxes, AD shifts right. Contractionary: lower spending or higher taxes, AD shifts left.

Monetary policy

• Monetary policy = use of interest rates, money supply and credit regulations to influence AD.
• Tools: interest rates; money supply (for example the central bank buying or selling government bonds); credit regulations (limits on bank lending, minimum deposits for loans).
• Expansionary: lower interest rates, more money, easier credit. AD shifts right.
• Contractionary: higher interest rates, less money, tighter credit. AD shifts left.
• Higher interest rates reduce consumption and investment, and also attract foreign savings so the currency rises and net exports fall.
• AD shifts right on the upward-sloping part of AS: real output, employment and the price level all rise.
• AD shifts right on the vertical part of AS: only the price level rises.

Supply-side policy

• Supply-side policy = measures to raise productive capacity, shown by a rightward shift of LRAS.
• Objectives: increase productivity and productive capacity.
• Labour productivity = output ÷ number of workers (or output per worker hour).
• Tools: training and education, infrastructure, support for technology (research grants, tax relief on research), lower marginal tax rates to improve incentives.
• LRAS shifts right with AD unchanged on the upward-sloping section: real output rises and the price level falls.
• On the horizontal section of the Keynesian AS curve, a rightward shift of LRAS changes neither output nor the price level.
• Effects come with a long time lag and many measures cost the government money.

International economic issues

The reasons for international trade

• Absolute advantage: can produce more of a good with the same resources (or the same output with fewer resources).
• Comparative advantage: can produce a good at a lower opportunity cost than another country.
• Opportunity cost of 1 unit of good X = output of good Y given up ÷ output of X gained.
• Trade benefits both countries when the exchange rate between the goods lies between their two opportunity costs.
• Terms of trade index = index of export prices ÷ index of import prices × 100.
• A rise in the index is called an improvement; a fall is a deterioration (worsening).
• Limitations: transport costs, rising opportunity costs, trade barriers, immobile factors, risk of over-dependence on one product.

Protectionism

• Tariff: a tax on imports. Price rises, domestic output rises, consumption falls, imports fall, government gains revenue.
• Import quota: a limit on the quantity (or value) of a good that may be imported. No tax revenue for the government.
• Export subsidy: a government payment to exporters that lowers their costs so they can sell abroad at lower prices.
• Embargo: a complete ban on trade in certain goods or with a certain country.
• Red tape: slow customs checks, heavy paperwork or strict standards that make importing costly.
• Tariff revenue = tariff per unit × quantity imported after the tariff.
• For: infant industries, anti-dumping, protecting jobs, strategic industries, improving the current account. Against: higher prices, less choice, inefficiency, retaliation, higher costs for firms that use imported inputs.

Current account of the balance of payments

• Trade in goods: exports and imports of physical products (cars, oil, wheat).
• Trade in services: tourism, transport, banking, insurance, education.
• Primary income: income from factors of production across borders (wages, interest, profits, dividends).
• Secondary income: transfers with nothing received in return (workers' remittances, foreign aid, payments to international organisations).
• Balance of trade in goods = exports of goods − imports of goods (the same method for services).
• Balance of trade in goods and services = goods balance + services balance.
• Current account balance (CAB) = goods balance + services balance + net primary income + net secondary income.

Exchange rates

• Exchange rate = the price of one currency in terms of another currency.
• Floating rate: determined by demand for and supply of the currency.
• Demand for a currency comes from exports, inward investment, foreign tourists and savings attracted by high interest rates.
• Supply of a currency comes from imports, investment abroad and residents travelling abroad.
• Appreciation: one unit of the currency buys more foreign currency. Depreciation: it buys less.
• Depreciation: exports cheaper, imports dearer; AD shifts right if demand is price elastic; SRAS shifts left; the price level tends to rise.
• Appreciation: exports dearer, imports cheaper; AD shifts left; SRAS shifts right; the price level tends to fall.

Policies to correct imbalances in the current account of the balance of payments

• Stability of the current account = avoiding large, persistent deficits or surpluses.
• Contractionary fiscal policy (higher taxes, lower spending): incomes fall, spending on imports falls, deficit narrows.
• Contractionary monetary policy (higher interest rates): spending on imports falls, but the currency may appreciate and make exports less competitive.
• Protectionist policy (tariffs, quotas): switches spending from imports to home goods; risk of retaliation and higher prices.
• Supply-side policy: lower costs and better quality raise exports and replace imports in the long run.
• To reduce a surplus, use the opposite: expansionary fiscal or monetary policy or lower trade barriers.