Learn Economics concepts from scratch
1What economics is about
People want more than there is. Time, money, land and workers are limited. This is scarcity, and it forces every person, firm and government to choose.
Every choice has a price in what you give up. The opportunity cost of a choice is the value of the best alternative you did not choose. The opportunity cost of studying full-time includes the wages you could have earned.
Economics has two halves:
- Microeconomics studies single markets, households and firms: prices, costs, competition.
- Macroeconomics studies the economy as a whole: total output (GDP), inflation, unemployment, interest rates and government policy.
Economists also separate two kinds of statement. A positive statement describes facts and can be tested: “a higher minimum wage raises labour costs”. A normative statement says what ought to be: “the government should raise the minimum wage”.
Exams use the Latin phrase ceteris paribus: “all other things equal”. You change one thing and keep everything else fixed.
Self-check You spend Saturday working a shift that pays €80 instead of going to a concert. What is the opportunity cost of working?
- Nothing, because you earned money
- The concert you gave up
- The cost of the concert ticket only
- The €80 you earned
Answer: The concert you gave up. Opportunity cost is the best alternative you gave up, here the concert. The €80 is what you gain from working, not what you give up.
2Supply, demand and equilibrium
The demand curve D shows how much buyers want at each price. It slopes down: a higher price means a lower quantity demanded. This is the law of demand.
The supply curve S shows how much sellers offer at each price. It slopes up: a higher price makes producing more attractive.
Where the curves cross is the equilibrium: the price at which the quantity buyers want equals the quantity sellers offer.
A change in the good’s own price is a movement along the curve. Anything else that changes demand or supply shifts the whole curve:
- Income. For a normal good, demand rises when income rises. For an inferior good, demand falls when income rises.
- Prices of related goods. Substitutes replace each other (tea and coffee): if coffee gets dearer, demand for tea rises. Complements are used together (cars and petrol): if petrol gets dearer, demand for cars falls.
- Supply shifts with production costs, technology, the number of sellers, taxes and subsidies.
Governments sometimes fix prices. A price ceiling (maximum price) below equilibrium, such as rent control, causes a shortage. A price floor (minimum price) above equilibrium, such as a minimum wage, causes a surplus.
Self-check A new machine lowers the cost of producing bread. Demand does not change. What happens in the bread market?
- Demand shifts right: the price and the quantity rise
- Nothing changes until the price changes
- Supply shifts left: the price rises and the quantity falls
- Supply shifts right: the price falls and the quantity rises
Answer: Supply shifts right: the price falls and the quantity rises. Lower costs let bakers offer more at every price, so the supply curve shifts right. With demand unchanged, the new equilibrium has a lower price and a higher quantity.
3Competition and market failure
Markets differ in how many sellers there are and how much power each has over the price:
- Perfect competition: many firms, identical products, free entry. No firm can set the price. In the long run economic profit is zero.
- Monopolistic competition: many firms with differentiated products (restaurants, hairdressers) and free entry.
- Oligopoly: a few large firms that depend on each other’s decisions (airlines, telecoms). A cartel is an agreement between them to fix prices or output.
- Monopoly: one seller. Barriers to entry, such as patents or huge set-up costs, keep others out.
Sometimes a free market does not give the best result for society. This is market failure. The main examples:
- A negative externality: a cost that falls on a third party, such as pollution. The market produces too much. A tax or tradeable permits can correct it.
- A positive externality: a benefit to others, such as education or vaccination. The market produces too little. Subsidies or public provision can help.
- A public good is non-rival and non-excludable, such as street lighting or national defence. People can use it without paying (free-riding), so markets under-provide it.
4The economy as a whole
Gross domestic product (GDP) is the market value of all final goods and services produced in a country in a period. With the expenditure approach:
GDP = C + I + G + (X − M)
C is household consumption, I investment by firms, G government purchases, X exports and M imports. Real GDP removes the effect of price changes; nominal GDP uses current prices.
Inflation is a sustained rise in the general price level, often measured with the consumer price index (CPI). Demand-pull inflation comes from too much spending; cost-push inflation from higher input costs, such as oil.
The unemployment rate is the number of unemployed divided by the labour force (employed + unemployed). Frictional unemployment comes from moving between jobs, structural unemployment from a mismatch of skills or location, cyclical unemployment from a recession.
Two kinds of policy steer the economy:
- Monetary policy: the central bank changes interest rates and the money supply. In the euro area this is the European Central Bank (ECB), which aims for inflation around 2%. Higher rates reduce borrowing and spending, so inflation falls.
- Fiscal policy: the government changes its spending and taxes. Spending more or taxing less raises total demand.
Self-check Inflation in the euro area is well above 2%. What is the ECB most likely to do?
- Increase government spending
- Lower its interest rates
- Raise income taxes
- Raise its interest rates
Answer: Raise its interest rates. Higher interest rates make borrowing dearer and saving more attractive, so spending and inflation fall. Taxes and government spending are fiscal policy, which is decided by governments, not the ECB.
5Reasoning through a question
These questions test reasoning more than memory. The same four steps work for most of them:
- Name the concept the question is about: a market, an externality, inflation, a policy.
- Find what changed and what stays the same (ceteris paribus).
- Decide which curve or quantity is affected, and in which direction.
- Follow the effect to the result. Then check every option against it.
Worked exampleThe price of petrol rises sharply. What happens to the demand curve for large cars?
1This is about the market for large cars, and how a related good affects demand in it.
2The price of petrol, not the price of cars. So this is not a movement along the car demand curve: the curve itself will shift.
3You need petrol to drive a car, and large cars use a lot of it. Cars and petrol are complements.
4Driving a large car becomes more expensive, so at every car price fewer people want one. The demand curve shifts to the left: D moves to D₂.
5“A movement along the curve” is wrong: the car price did not change. “Shifts right” would fit a substitute, not a complement.
Answer The demand curve for large cars shifts to the left, because cars and petrol are complements.
6Common mistakes
- Mixing up a shift of a curve with a movement along it. Only a change in the good’s own price moves you along its curve.
- Mixing up substitutes and complements. Substitutes replace each other; complements are used together.
- Confusing monetary policy (central bank, interest rates) with fiscal policy (government, spending and taxes).
- Thinking a price ceiling causes a surplus. A maximum price below equilibrium causes a shortage.
- Taking opportunity cost to be the money you spend, instead of the best alternative you give up.
Self-check The price of coffee rises. What happens to the demand curve for coffee?
- It becomes vertical
- It does not shift: there is a movement along it to a lower quantity
- It shifts to the left
- It shifts to the right
Answer: It does not shift: there is a movement along it to a lower quantity. A change in the good’s own price is a movement along its demand curve. The curve only shifts when something else changes, such as income or the price of tea.
7How exam questions look
All questions are multiple choice, with four options.
- Easy: key terms and facts. Definitions such as opportunity cost, inflation, GDP, monopoly or fiscal policy.
- Medium: applying the concepts. A short situation. Predict the effect of a shift in supply or demand, a price ceiling, an interest rate change or a tax, or do a small calculation such as an unemployment rate.
- Hard: cases and analysis. Longer cases and models, such as game theory, monopoly pricing, the multiplier or exchange rates, where several ideas are combined.
Rule out the options that are clearly wrong first. Then compare the remaining ones with the four-step reasoning above.
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