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Key concepts

Key concepts are the big ideas and understandings that we hope will remain with our students long after they have left school.

Key concepts or big ideas in economics

The following are key concepts/big ideas in economics:

Scarcity results in choices with opportunity costs

Resources are scarce when unlimited wants exceed the capability of the available resources to satisfy them, so that economic choices must be made.

Resources are used when an economic decision is made, meaning that a cost is incurred.

The “opportunity cost” is the next best alternative use of those resources.

Opportunity cost can be used to evaluate decisions. If the net benefits from a choice are greater than the next best alternative, then a sensible economic choice has been made.

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Economic growth reduces scarcity

Economic growth occurs when the real value of the goods and services produced by an economy enables more wants to be satisfied.

Accordingly, societies strive for economic growth as a way of reducing scarcity.

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Full employment reduces scarcity

Full employment occurs when all resources are fully utilised.

If resources are fully employed, then more can be produced. Societies therefore strive for full employment as a way of reducing scarcity.

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International trade reduces scarcity

Countries trading products and services they are comparatively better at producing will be able to sell them overseas for a higher price than they sell them locally. They will be able to buy other imports for a lower price than they can be produced locally. This enables more wants to be satisfied and reduces scarcity.

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Values influence economic choices

Values are the core beliefs that people hold. The different values or perspectives held by individuals and groups influence the economic choices they make.

Values affect the importance (or weighting) people give to the different factors they consider in making a choice. Groups and individuals with the same information, but different values, may make different choices.

For example, Māori may believe that their traditions and values best suit them to conserve natural resources and that they should be given the responsibility to manage the stretches of the New Zealand foreshore they own.

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Markets provide incentives and ration scarce resources

Markets are places or situations where producers and consumers exchange goods and services.

In free market economies, the prices set by the interaction of supply and demand allocates scarce resources.

Whenever resources are particularly scarce, demand exceeds supply, and prices are driven up. The effect of higher prices is to discourage demand and conserve resources.

The greater the scarcity, the higher the price, and the more the resource will be conserved. For example, as oil slowly runs out and its price rises, demand will be discouraged, leading to more oil being conserved than at lower prices.

An incentive is something that motivates a producer or consumer to follow a particular course of action or to change it.

Higher prices resulting from increased consumer demand are an incentive for producers to supply more of a good or service because they may earn more profit.

For example, as world demand for dairy products rises, New Zealand farmers are switching to dairying. Similarly, students are likelier to work hard to develop skills they recognise as required for the high paying job they aspire to.

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Perfectly competitive markets are efficient

Efficiency is an economic concept related to how well an economy allocates scarce resources to meets the needs and wants of consumers.

Efficient markets allocate scarce resources so that the price consumers are prepare to pay for a good equals the marginal cost of the resources used to produce that good.

Adam Smith (widely cited as the father of modern economics) argued that if consumers are allowed to freely choose what to buy and if producers choose freely what to sell and how to produce it, a free market will, as if led by an invisible hand, settle on products and prices that make both consumers and producers both better off.

For example, market equilibrium occurs at the price where the quantities demanded by consumers equals the quantity supplied by producers, meaning that just the right amount of resources are used, since there are neither shortages nor surpluses.

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Market failure may require government intervention

Market failure occurs when free markets fail to allocate resources efficiently.

For example, in the cigarette market, consumers’ decisions can impact negatively on other people in a variety of ways.

One such negative impact is the health problems caused by inhaling second hand smoke in domestic settings or public areas.

When the smoker pays only the price at which the producer sells the cigarettes, they are not paying for the cost of these negative impacts.

The government intervenes by applying an excise tax on tobacco products to deliver a more efficient and equitable outcome.

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The benefits of market activities may not be equitable

Equity is an economic objective relating to fairness or evenness.

A market may be efficient, but society may be concerned that the benefits from market activity are unfairly shared out.

For example, free markets inevitably distribute incomes unevenly because the income earned depends on supply and demand for labour resources, which are different in different markets.

If a government believes the gap between rich and poor is too great, it will redistribute wealth by giving benefits to the poor, for example, unemployment benefits, and taxing the rich at higher rates.

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Government intervention may involve an equity–efficiency trade-off

Government interventions to improve equity may sometimes diminish efficiency.

For example, higher marginal tax rates may discourage high-income earners from working harder or longer if they feel that more of their income goes to the government. As a result, productivity falls.

Some governments seek to help low-income families by adopting policies to stimulate economic growth. They believe that the benefits of higher growth will trickle down to the low-income families.

Other governments recognise that reducing poverty will improve economic efficiency.

For example, reducing poverty tends to reduce levels of illness, which are linked to poor housing and nutrition. Improved public health reduces demand for more hospital services and the need for more hospitals to be built.

Improved economic efficiency also gives a government the opportunity to can spend more on developing infrastructure to improve productivity.

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Interdependence results in flow-on effects

The different sectors of an economy (households, producers, financial, government, overseas) rely on each other (are interdependent).

Events impacting on one sector will flow on to affect other sectors.

For example, when overseas countries that trade with New Zealand go into recession and reduce their spending, the flow-on effect for New Zealand is fewer export receipts and lower levels of economic growth.

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Marginal analysis will maximise results

Marginal analysis compares the additional benefit of an activity with its additional cost.

An economist would recommend the use of scarce resources to satisfy wants only when the extra benefit gained from using the scarce resources exceeds the extra cost associated with using them.

For example, a student with an after-school job could use marginal analysis to optimise the number of hours worked. How much the student values their time not working (the opportunity cost) represents the marginal cost. The amount they are paid is the marginal benefit.

Although the marginal cost of the first or second hour worked may be low (the student still has plenty of times to do other things), the cost of further hours begins increase.

If the student is paid $15 an hour, but values the marginal cost of a third hour spent working at more than $15 – they really want to use it for study or to be with friends – then the most hours they should work are two.

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Economic indicators aid economic analysis

Economic indicators are usually economic statistics, such as the unemployment rate, real GDP, or the inflation rate.

These statistics are important for economists. They use indicators to estimate how well the economy is doing and to highlight trends in contemporary macro-economic issues, such as economic growth, employment, international trade, inflation, and equity.

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Inflation can distort economic indicators

Nominal indicators have not accounted for the effects of inflation.

Real indicators account for the effects of inflation.

For example, nominal national income is the dollar value of an economy’s income in a particular year. Real national income is the income with the effects of inflation removed, thereby indicating the actual purchasing power of the income.

Economists use increases in real income to identify economic growth – increasing real income shows that a country, with its resources, is now able to satisfy more wants and needs.

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Economic models aid economic analysis

Economic models are simplifications of the real world. They are developed to aid analysis and support predictions about economic behaviour and performance.

Economists have developed a variety of models to aid analysis of both macroeconomic and microeconomic issues.

A supply and demand model

Microeconomics uses a supply and demand model. This model combines producer supply and consumer demand to support analysis of the effects of choices on price and the flow-on effects of decisions on others.

More sophisticated applications allow users to make predictions about economic efficiency.

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An aggregate supply and aggregate demand (AS AD) model

The macroeconomic AS AD model aids analysis of changes in the internal and external influences affecting an economy, in particular, their impact on inflation, economic growth, and employment.

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Micro and macro-economics

Economics is traditionally divided up into two branches – microeconomics and macroeconomics. ‘Micro’ means small and ‘macro’ means big.

Micro-economics is the branch of economics that examines individual decision-making by firms and households and the way they interact in specific industries and markets. Among economists, the most commonly accepted set of ideas about how the economy works is called neoclassical economics. Key concepts outlined above, including, opportunity cost, thinking at the margin, incentives in consumer/producer decision-making, markets efficiency, and why markets fail are all based on neoclassical ideas and form the basis of micro-economic theory.

Macro-economics is the branch of economics that examines the workings and problems of the economy as a whole. It is concerned with aggregate supply (total national output of goods and services) and aggregate demand (the total spending of the whole economy ) and issues such as economic growth, inflation, unemployment, and economic fluctuations. Macroeconomic policy suggestions therefore tend to focus on the balance of aggregate demand and aggregate supply. Demand side policies seek to influence the level of spending in the economy. This in turn indirectly affects the level of production, prices, and employment. Supply side policies are designed to influence production directly.

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Last updated May 13, 2013