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Introduction to Economics

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Economics

What is economics? Answering this question can be quite complex but this article will provide you with a simple answer and a short introduction to economics. We will cover the study of economics, its origin, methodology, and the problem that every economist faces.

What is Economics?

Economics attempts to describe both individuals and group economic behaviour, as well as interpersonal and intergroup economic interactions.

Economics is the study of how people make choices and decisions with scarce resources.

Most of the resources in our world are limited, be it time, money, or natural resources. Thus, individuals make constant decisions about what to buy or produce, how to produce it and for whom, and what to consume. Economics studies these behaviours.

The origins of Economics

As civilisations evolved, so did the way people provided goods and services for themselves. Some of the first economic ideas emerged in 380 BCE when Plato described his ideal state with universally accessible private property and division of labour. However, thinkers focused on economic decision-making as a philosophical and moral question for centuries.

Modern economics appeared as a distinct academic discipline only in the eighteenth century following the publication of Adam Smith’s The Wealth of Nations (1776). That is why he is considered the father of Economics.

The Industrial Revolution began in Europe and America around 1760, and that brought the transition from largely rural, agricultural societies to industrialised, urban ones. This caused a shift towards the so-called market economy. In his book, Smith argued that the market is a self-sufficient organism guided by the ‘invisible hand’. It consists of individuals focused on their self-interest, that they satisfy because they make rational decisions.

Economics as a social science

The notion that economics is a social science is a good place to start when addressing the question ‘What is economics really?’ Economics is considered a social science because it applies similar methodologies to studying economic phenomena as other social sciences do.

Social science is the field of research that explores society and the interactions between people in it.

Apart from economics, social sciences include psychology, sociology, and political science, as well as major aspects of history and geography.

Psychology is the study of the human mind and behaviour. Sociology is the study of people’s social connections in the setting of society. Economics, on the other hand, analyses the economic behaviour of both individuals and groups of people, as well as the economic interactions between them.

Economics, thus, studies two instances or types of interactions. The first instance is described by demand theory and it's about individual behaviour: how consumers act and behave when spending money on goods and services. This theory asks questions like why do people buy fewer apples as the price of apples rises?

The second instance introduces an essential economic relationship. After studying demand, we need to look at how consumers engage with corporations or producers. This is supply theory, which studies how businesses provide and sell the items that consumers purchase in the market. Supply and demand are at the heart of economics.

Market: the location where goods and services are traded.

The two kinds of economic statements

Modern economics is divided into two branches:

  • Positive economics

  • Normative economics

Positive economics

Positive economics focuses on facts and on describing cause and effect phenomena. Positive economics makes statements that can be falsifiable and avoids making judgements about the observed phenomena.

A positive economic statement is a factual statement that can be scientifically examined to verify if it is true or false.

Consider the following economic statement: ‘If the pension scheme was cancelled, a million elderly lives would be lost to diabetes’. This is a positive economic statement as it can be scientifically tested to see if it’s true.

Normative economics

Normative economics focuses on what people should do. This is especially true in the case of the government. Should the government make an effort to minimize unemployment, keep inflation under control, and create a more equitable distribution of income and wealth? Most individuals believe that all of these goals are desirable. Thus, they all fall under normative economics. Unlike positive economics, these aren’t observable and falsifiable statements that we can study with the scientific methods; they don’t necessarily happen and are ideal situations.

Normative economics is all about value judgments and specific viewpoints. Normative statements can’t be scientifically proven since individuals have differing perspectives on what is good and wrong.

Ethical or moral judgments play a large role in normative economics. Words like ought, worse, and should frequently indicate that an economic proposition is normative.

Consider this statement: ‘The pension scheme should be eliminated because it is a waste of resources’. This is a normative statement as it has a value judgment of the meaning of the term waste.

To summarise, positive statements are based on facts and can be tested to be found true or false. Normative statements cannot.

The importance of the scientific method in economics

Figure 1 below depicts the fundamentals of the scientific method in the context of the demand theory.

Demand theory studies how individual customers react to price fluctuations in the products and services they purchase.

Introduction to Economics Fundamentals of the scientific methodology StudySmarterFigure 1. The fundamentals of scientific methodology - StudySmarter Originals.

Economists follow a similar methodology as scientists do. They begin by observing a specific element of human behaviour. After the initial observation, they create a hypothesis.

A hypothesis is a proposed explanation that is the starting point for further investigation.

In the third stage, the hypothesis is used to make predictions about human behaviour. For example, an economist could have the hypothesis that when the price of a good decreases, people buy more of it. Then, they could predict that faced with a decreased price, consumers will always respond by desiring more of the commodity.

This forecast is then put to the test against data on how people act in the marketplace (the fourth step in Figure 1). If the hypothesis passes these tests, it becomes a theory.

However, if a hypothesis fails to pass the tests, one of two things can happen: it can be either rejected or altered. The second approach is more common in economics. This means that the hypothesis is adjusted and ‘watered down’.

In our example of demand theory, the theory would be that customers respond to price drops by desiring more of an item in most but not all circumstances. The demand hypothesis passes these checks to become the first law of demand.

The economic problem

The fundamental economic problem is scarcity: how to allocate resources to maximise wellbeing? This is studied at both micro and macro levels, and some issues combine both.

Every theory and notion in economics is built on a few basic economic principles. Here’s a brief rundown of the ideas that we apply to the study of the manufacture, supply, and consumption of goods and services.

Needs, wants, scarcity, and the allocation of resources

The primary goal of economic activity is to provide goods and services that meet everyone’s wants and needs.

A need is something that people must have and cannot live without.

Food is a need. Everyone needs food to survive. It’s worth emphasizing that, depending on the sort of food, food may be both a necessity and a want. Protein, vitamins, and minerals are necessities, but a bag of candy is a want.

A want is something that individuals would choose to have but isn’t necessary for living. It isn’t strictly required, but it is useful to have.

A good example of a want are books. Some may claim that books are necessary because they believe they won’t be able to function without them. They do not, however, need literature to exist.

Scarcity is the fundamental economic problem. It occurs because we as humans have endless demands that our world’s scarce resources can’t provide.

There would be no purpose to study economics if there was no scarcity. People would eat all they could possibly ingest, and they would not be forced to make swaps or decisions between products and services.

Allocating scarce resources to meet people’s needs and desires results in increased economic wellbeing. Economists use the term ‘welfare’ regarding the allocation of scarce resources, but rarely define what it means.

Welfare in the context of the allocation of goods and services refers to the overall wellbeing of society.

Economic agents and the idea of incentives

There are many different types of agents in an economy.

Economic agents are those who interact in the economy in accordance with the norms established by the monetary order and institutions.

The four main economic agents are:

  1. Corporations. Corporations strive to increase their profits for their shareholders and provide goods and services to individuals, businesses, and the government.
  2. Individuals. They serve a dual purpose. They are consumers who want goods and services, and they serve as the labour who generates those goods and services.
  3. Governments. Most of the rules governing how the rest of the economic agents should operate are set by governments. They provide products and services like highways and national security through national corporations.
  4. Central banks. A central bank is a financial organisation that has exclusive power over the creation and distribution of money and credit for a country or set of countries. The central bank is normally in charge of formulating monetary policy and regulating member banks in contemporary economies.

Governments and central banks are sometimes lumped together by economists.

The fundamental questions

The fundamental economic questions are:

  • What to produce?

  • What is the best way to produce?

  • For whom to produce?

These three questions come together to form one bigger question: What is the best way to divide scarce resources while optimising human happiness and welfare?

However, there are many challenges to allocating scarce resources efficiently. Issues like unemployment, inflation, market failure, and some economic policies implemented by the government are just a few examples.

Principles of Economics

American economist N. Gregory Mankiw (1997) developed ten principles of economics that describe the behaviour of humans and institutions in mainstream economics. Those, in turn, can be divided into the following categories.

How people make decisions

  1. People face trade-offs. This principle is connected to the fundamental economic problem. Resources are scarce. Thus, people need to make decisions about the way they will choose to allocate them. A trade-off occurs when a person chooses one thing over another.

  1. The cost of something is what you give up to get it. The second principle draws on the first one by suggesting that the price of the decisions we make stems from the value of what we are willing to give up or trade-off to get it. Using economic vocabulary, it is called opportunity cost.

  1. Rational people think at the margin. This principle actually makes two assumptions: (1) people are indeed rational decision-makers, (2) they systematically strive to maximise their outcomes. In economic terms, it means making decisions based on the size of the difference between marginal benefits and marginal costs.

  1. People respond to incentives. Building on the third principle, because people seek to maximise the difference between the marginal cost and benefit, they need to consider whether there are any incentives to make one decision over the other.

How people interact with one another

  1. Trade can make everyone better off. Trade is a mutually benefiting relationship between individuals, firms, and countries. By engaging in the exchange of goods and services, economic agents can allow themselves to pursue specialisation instead of being fully self-sufficient and providing for every need and want themselves.

  1. Markets are usually a good way to organise economic activity. Markets are where the value of a product to consumers meets the cost of the resources used to produce it.

  1. Governments can sometimes improve market outcomes. Government intervention is most useful in addressing market failure.

    A manufacturer produces drinking water in plastic bottles. Market forces determine the best price and quantity for drinking water. However, disposing of plastic bottles contaminates the environment. The government could intervene by legislating that manufacturers must bottle their drinking water using recyclable materials.

    Although this will affect the cost of production and the price and quantity of drinking water, it takes into account the benefits to the environment that the free market failed to address.

Factors that affect the economy as a whole

  1. A country’s standard of living depends on its ability to produce goods and services. Any country’s productive capacity can be used as a measure of its prosperity. One of the most common indicators is the income per capita (i.e. income per head). If the workers are well-educated, have access to technology and resources for production, they will generate marketable value and boost their own standard of living.

  1. Prices rise when the government prints too much money. When the government injects more money into the economy by printing more, it makes money more accessible. However, if money becomes more accessible, people will be willing to give up a lot less to get it than before. Hence, its value will diminish. If the value of money decreases, its purchasing power also decreases. That is the reason why we can’t simply print more money and all be wealthy. Additionally, if the government printed more money and gave it to people, they would be likely to spend it. In economic terms, that would translate into increased demand for goods and services. This increased demand would either be met with increased production or higher prices. If the increase in the price level is sustained across the whole economy, it is called inflation. And once the price level goes up, it, again, reduces the purchasing power of money.

  1. Society faces a short-run trade-off between inflation and unemployment. In the short run when prices increase, the economy is facing inflation. Yet, with higher prices, producers want to increase their production and to achieve this they must hire more workers. Hiring more workers means lower unemployment whilst there is inflation in the economy.

Introduction to Economics - Key takeaways

  • Economics is the study of how people make choices and decisions when they have limited resources.
  • The primary goal of economic activity is to provide goods and services that meet everyone's wants and needs.
  • Positive economics explains and defines a variety of economic occurrences. Its statements are falsifiable.
  • Normative economics is based on value judgements that can’t be objectively tested, accepted or disapproved.
  • The fundamental economic problem is that consumers have endless demands that our world's scarce resources can’t provide.
  • There are ten principles of economics that describe the behaviour of humans and institutions that affect the wider economy as a whole.

Introduction to Economics

Modern economics' statement is divided into two branches: 

  • Positive economics

  • Normative economics

Some of the basic economic principles are:

  • Needs
  • Wants
  • Scarcity
  • Allocation of resources

Economics is the study of how people make choices and decisions when they have limited resources.

Adam Smith is considered the father of economics.

Final Introduction to Economics Quiz

Question

What is economics?

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Answer

Economics is the study of how people make choices and decisions when they have limited resources.

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Who is the father of economics?

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Answer

Adam Smith is considered the father of economics.

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What are the two types of economics statements?

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Answer


  • Positive economics
  • Normative economics

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Which actors make up the economic agents?


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Answer

Individuals

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The primary goal of economic activity is to provide commodities and services that meet everyone's wants and needs.


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Answer

True

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Question

The government should take measures to reduce inflation. What type of statement is it? 


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Answer

Positive

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For the past five years, inflation has been above 5% every year.

What type of statement is it? 

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Answer

Positive

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What are some basic economic principles that every theory and notion in economics is built upon?

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Answer

Needs

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What does the economic problem 'scarcity' mean? 

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Scarcity is the fundamental economic problem that occurs because we as people have endless demands that our world's scarce resources cannot provide.

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What is a need in economics?

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A need is something that people must have and cannot live without.

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What is a want in economics?

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A want is something that individuals would choose to have but isn't necessary for living.

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What are three types of economic resources?

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Natural resources, human resources, capital resources.

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What are economic resources otherwise known as?

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Factors of production.

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What are the four factors of production?

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Land, labour, entrepreneurship, and capital.

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Money is an economic resource.

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False.

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What is a free market economy?

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An economy that has no or little government intervention.

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What is a planned economy?

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An economy that is centrally controlled by the government.

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What is a mixed economy?

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An economy that has both features of a free market and a planned economy.

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What is the basic economic problem?

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Resource scarcity.

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What is an opportunity cost?

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The next best alternative foregone when an economic decision is made. 

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State one pro and one con of a free-market economy.

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Example answers could be:

Pros: 

  • Consumers and competitors can drive product innovations.
  • Free movement of capital and labour.
  • Businesses have more choices in selecting a market (e.g. domestic only or international).


Cons:

  • Businesses can develop monopoly power more easily.
  • Issues relating to externalities would not be addressed to meet the social demands. 
  • Therefore, inequalities may be increased. 


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State one pro and one con of a planned economy.

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Example answers could be:

Pros:

  • Inequality would be reduced.
  • Lower unemployment rate.
  • Infrastructure and the access to necessities can be ensured.

Cons:

  • Low level of competition can lead to a loss of interest in innovation and incentive to produce.
  • Inefficiency of the allocation of resources may occur due to a lack of market information.
  • The market may not be able to respond to consumers needs and wants.

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What are the two types of economic capital?

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Physical/Fixed capital and Working capital.


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Who or what determines the prices in a free market economy?

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Supply and demand.

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Who or what determines the prices in a planned economy?

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The government.

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What can cause market failure?

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A misallocation of resources in the economy, either completely failing to provide a good or service or providing the wrong quantity. 

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Define production possibility curves.

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Production Possibility Curves (PPC) depict the maximum output combinations of two goods that are produced in the economy when all resources are employed fully and efficiently.

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What are the other names for production possibility curves?

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Production Possibility Frontier (PPF) or Transformation curve.

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What are the assumptions made while plotting a PPF?

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It is assumed that the country has a fixed quantity of resources and a constant state of technology. 

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What does a point under the production possibility curve mean?

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It means that the available resources in the economy are not fully employed.

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What does an economy have to achieve to attain production possibilities above the production possibility curve?

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The country will have to increase their resources, improve their technology and productivity.

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When does the PPC shift inward?

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When production factors such as raw materials or capital decrease, the PPC shifts inwards, indicating that the economy is producing fewer quantities.

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What happens when an economy increases its available resources and/or improves technology?'

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The PPF will shift outwards indicating an increase in production.

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How can short-run economic growth be brought about when all resources are not fully employed?

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A short-run economic growth can be brought about by using the rest of the resources and increasing aggregate demand.

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How is resource allocation among goods decided?

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Allocating more resources for a product depends on choice and demand.


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Define opportunity costs.

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 Opportunity cost is the benefit you sacrifice when choosing one option over another.

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What is productive efficiency?

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Productive efficiency is the maximisation of output from available input. 

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What is allocative efficiency?

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The best production combinations of goods and services result in allocative efficiency.

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How many principles of economics are there?

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10

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What are the three fundamental questions in economics?

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Answer

What to produce? 

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The LRAS curve of an economy represents a point on the country's PPC. 

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True

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How does economic growth affect the LRAS curve and why?

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The LRAS curve shifts to the right. This is because, when there is economic growth, it signifies more supply resulting from an increase in demand.  

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What is economic efficiency?

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Economic efficiency occurs when resources are allocated to ensure optimality.

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Which of the following is not a type of economic efficiency?

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Productive efficiency

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Dynamic efficiency is efficiency in the long run.

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True

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Static efficiency is efficiency in the short run.

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True

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The production possibility frontier (PPF) shows output maximisation with the available inputs.

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True

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Positive externalities are evidence of social efficiency.

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True

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Negative externalities show that social inefficiency has occurred.

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True

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Social efficiency occurs when resources in a society are optimally distributed taking into account all the benefits and costs.

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True

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