SCARCITY, CHOICE AND OPPORTUNITY COST Economics as a social science: It is concerned with human beings and the social systems by which they organize their activities to satisfy basic material needs (eg, education, knowledge, food, golf and shelter) Economics: Concerned with the production of goods and services, and the consumption of these goods and services. Every country whether rich or poor has to make choices and is confronted with the key economic problem of scarcity. Scarcity: A situation where unlimited wants exist but the resources available to meet them are limited. Resource allocation: The way that resources within an economy are split between their various uses – the way in which resources are used. Factors of Production: Land: natural resources, i.e trees, ocean, fertile land, minerals, sunshine Labor: human resources, physical or mental Capital: capital resources, man-made resources used in the production process i.e. machines in a factory Enterprise: organizing the above three in the production of goods or services Ceteris Paribus: All things being equal – one of the assumptions used in many economic models, where an individual factor is changed while all others are held constant. (Use it!!) Choice: The result of the economic problem of scarcity, and how you allocate resources to deal with the economic problem. Utility: Benefits or satisfaction gained from consuming goods and services – hard to measure but we assume consumers make decisions based on maximizing utility.
THE FOUNDATION OF ECONOMICS Opportunity Cost: Cost measured in terms of the next best alternative forgone. Economic Good: Things people want that are scarce – there is an opportunity cost involved. Free Good: Commodities that have no price and no opportunity cost, i.e fresh air and sunshine Production Possibility Curve: A curve showing all the possible combinations of two goods that a country can produce within a specified time with all its resources fully and efficiently used. The boundary between what is attainable and what is unattainable, given the current resources.
1.1 SCARCITY, CHOICE AND OPPORTUNITY COST The fundamental problem of economics: scarcity and choice Economics is about scarcity and those things that are scarce. Goods and services that are scarce are known to be economic goods. If they’re not scarce, they are considered as being free goods. As the world develops, more free goods are becoming into economic goods (such as sea animals, tropical rain forests etc.). Due to scarcity, humans have created the economic system that aims to figure out what to do with scarce resources. NB: If there is no demand, there is no scarcity THE PROBLEM IS: CHOICE, RESOURCES AND USES WILL NEVER BE EQUAL. We try to develop a system where people can make a choice that will maximise their utility (satisfaction). The study of economics arises because people’s needs and wants are unlimited, or infinite. Yet it is not possible for societies and the people within them to produce or buy all the things they want. This is because there are not enough (limited) resources. Resources are the inputs used to produce goods and services wanted by people (known as factors of production).
THE FOUNDATION OF ECONOMICS TL;DR: Scarcity Is the situation in which available resources, or factors of production, are finite, whereas wants are infinite. There are not enough resources to produce everything that human beings want and need. The issue of choosing what to do with economic goods will always exist, no matter what the wealth or level development of an economy. Since people cannot have everything they want, they must make choices. Resource scarcity forces society to make a choice between available alternatives. Economics is therefore a study of choices. Since resources are scarce, it is important to avoid waste in how they are used. If resources are not used effectively and are being wasted, they will end up producing less: or they may end up producing goods that people do not really need or want. Economics must try to find how best to use scarce resources so that waste can be avoided. THE DEFINITION OF ECONOMICS: The study of choices leading to the best possible use of scarce resources in order to best satisfy unlimited human needs and wants. Economics is the social science that deals with the allocation of earth’s scarce resources among the competing wants and needs to society
Three basic economic questions: resource allocation and output/income distribution Due to scarcity, an economy must always answer three basic questions:
What to produce (what particular goods and services and at what quantities of these they should produce) How to produce (how to use their resources in order to produce goods and services- e.g. more human labor, less machines, or more machines and less labor)- different combinations of factors of production, using different skill levels of labor and different technologies For Whom to produce (the distribution across the population. Who will be prepared to pay for it? Should some get more than others or an equal amount?
What to produce and How to produce are about resource allocation For whom to produce is about income/output distribution
THE FOUNDATION OF ECONOMICS Resource allocation refers to assigning available resources to specific uses chosen among many possible alternatives.
Resources as factors of production There are four broad categories in which factors of production come under:
Land
includes all natural resources, including all agricultural and non-agricultural land, as well as everything that Is under or above the land (Examples: minerals, oil reserves, underground water, forests, rivers and lakes. Natural resources are also called ‘gifts of nature) Labour includes the physical and mental effort that people contribute to the production of goods and services (Examples: teachers, construction workers, economists, doctors, taxi drivers and plumbers all contribute to producing goods and services)
Capital
also known as physical capital is a man-made factor of production used to produce goods and services. (Examples: machinery, tools, factories, buildings, road systems, airports, harbours, electricity generators and telephone supply lines. Entrepreneurship (management) includes a special human skill possessed by some people, involving the ability to innovate by developing new ways of doing things, to take business risks and to seek new opportunities for opening and running a business. Entrepreneurship organises the other three factors of production and takes on the risks of success or failure of a business.
Opportunity cost Opportunity cost is defined as the value of the next best alternative that must be given up or sacrificed in order to obtain something else. In other words, it refers to the next best alternative that was foregone as a result of selecting to use resources in a particular way. Opportunity cost refers to the cost of the next best alternative that is foregone (given up) as a result of selecting to use resources in a particular way. It asks us to consider the next best thing we would have used the resources for if we hadn’t used them the way we did. It does not mean all of the alternative uses, just the thing we would have done next. All resources are finite in quantity and by definition are at the core of the economic problem of scarcity. Any economic system is concerned with how we allocate a finite quantity of resources to an infinite and competing number of different uses.
THE FOUNDATION OF ECONOMICS
The production possibility model (PPC/PPF) The production possibilities model is a simple model of the economy illustrating some important concepts. The production possibilities curve (or frontier) (PPC/PPF) represents all combinations of the maximum amounts of two goods that can be produced by an economy, given its resources and technology, when there is full employment of resources and productive efficiency. All points on the curve are known as production possibilities. The PPC illustrates the possible combinations of goods or services that can be produced by a single nation, firm or individual using resources efficiently In order for the economy to produce the greatest possible output (anywhere on the PPC), two conditions must be met: All resources must be fully employed This means that all resources are being fully used. If there were unemployment of some resources, in which case they would be unused, the economy would not be producing the maximum it can produce.
THE FOUNDATION OF ECONOMICS All resources must be used efficiently. There must be
productive efficiency. The term ‘efficiency’ in a general sense means that resources are being used in the best possible way to avoid waste. Productive efficiency means that output is produced by use of the fewest possible resources; alternatively, we can say that output is produced at the lowest possible cost. If output were not produced using the fewest possible resources, the economy would be wasting some resources.
If the economy is anywhere INSIDE the PPC, it means that there is either unemployment of resources or productive inefficiency (or both). TL;DR: An economy’s actual output, or the quantity of output actually produced, is always at a point inside the PPC, because in the real world all economies have some unemployment of resources and some productive inefficiency. The greater the unemployment or the productive inefficiency, the further away is the point of production from the PPC. Law of increasing opportunity cost: As the production of a particular good increases, the opportunity cost of producing an additional unit rises. This is because economic resources are not completely adaptable to alternative uses. Many resources are better at producing one type of good than ta producing others The concept of opportunity cost can be illustrated using the production possibility curve (frontier) model. This model has the following assumptions: The economy has a fixed quantity of resources The resources can be used to create two alternative products The economy does not trade An economy cannot produce outside the PPC The PPC (points on the curve) represent the maximum possible output combinations of goods and services (and thus maximum satisfaction possible) from the available resources Points within the PPC are indicative of an inefficient use of resources (unemployment) and that it would be possible to increase the efficiency of resource use. This would result in a movement towards the PPC and an increase in the total level of satisfaction experienced in the economy The PPC can move out ‘over time’ as a result of one of or both of the follower: o Discovery of new resources within the economy o Discovery/creation of new technology or production techniques that increase the efficiency of resource use meaning that for any given quantity of input (resource) there is an increase output (quantity of production)
THE FOUNDATION OF ECONOMICS The production possibilities curve and scarcity, choice and opportunity cost
The condition of scarcity does not allow the economy to produce outside its PPC The condition of scarcity forces the economy to make a choice about what particular combination of goods it wishes to produce The condition of scarcity means that choices involve opportunity costs, If the economy were to move at any point on the curve, it would be impossible to increase the quantity produced of one good without decreasing the quantity produced of the other good. Four key components necessary for a successful transition from a command to a market economy Liberalization: The process of allowing most prices to be determined in markets and lowering trade barriers that had shut off contact with the price structure of the world’s market economies Macroeconomic stabilization: Primarily the process through which inflation is brought under control and lowered over time Restructuring and privatization: The processes of creating a viable financial sector and reforming the enterprises in these economies to render them capable of producing goods that could be sold in free markets and of transferring their ownership into private hands Legal and institutional reforms: These are needed to redefine the role of the state in these economies, establish the rule of law, and introduce appropriate competition policies Product and Resource Markets Product Market: Consumers buy goods and services from firms Households use their money incomes earned in the resource market to buy goods and services Expenditures by households become revenues for firms Firms seek to maximize their profits Households seek to maximize their utility (happiness) Resource Market: Households supply productive resources (land, labor, capital) Firms buy productive resources from households. In exchange for their productive resource, firms pay households:
THE FOUNDATION OF ECONOMICS
o Wages: payment for labor o Rent: payment for land o Interest: payment for capital o Profit: payment for entrepreneurship Firms seek to minimize their costs in the resource market Firms employ productive resources to make products, which they sell back to households in the product market
Buyers Sellers Bought/sold Money flow Goals for F and H Reason for benefits
Product markets Households Firms Goods and services Households -> firms Maximize profit (F) and utility (H) Exchanges are mutual and voluntary
Resource markets Firms Households Capital, land, labour Firms -> households Minimize costs (F) and maximize income (H) Exchanges are mutual and voluntary
THE FOUNDATION OF ECONOMICS Product Market Resource Market - Firms employ productive - Productive resources: resources to make finished Households provide firms with the goods and services. They sell productive resources they need to their products to households in produce goods and services (i.e. exchange for money land, labor, capital and - Households spend their entrepreneurship) income from the sale of their - Resource payments: Firms pay resources households for their resources, - Households make using revenue from the sale of expenditures on goods and their goods and services, which services creates income for households - Firms earn revenue, which is (i.e. rent, wages, interest and needed to cover their costs. Any profit) revenue earned beyond all costs is considered economic profit - The goal of households is to maximize happiness (utility) - The goal of firms is to maximize profit
THE FOUNDATION OF ECONOMICS Utility In economics we will assume that all behaviour is considered rational. That means that we can logically assume that no one will undertake an action unless it is going to benefit them. Utility can be measured in two ways: Total utility- this is the total satisfaction (benefit) gained from consuming a certain quantity of a product Marginal utility- this is the additional utility gained from consuming one additional product (it is the difference between total utility prior to consuming the item and total utility immediately after consuming the additional product). We would normally observe that as the consumption of a product increases that the utility gained from the next consumed starts to fall. This means, that there is less utility from each extra item consumed up to the point it becomes negative. This concept is known as diminishing marginal utility. It would be irrational to consume any item that results in negative or disutility, as total utility would start to fall. Model building Economists use models to try and understand bigger and more complex concepts and to illustrate their theories. The models are manipulated to consider the impact of changes in a variable on other phenomenon. This is done in a controlled manner so that it is the effect of the change in a chosen variable that is being assessed and not a whole range of factors. In economics this is done by ‘holding all other things constant’- this is referred to as the condition of ‘ceteris paribus’. It means that we consider the change in ONE/CHOSEN variable on the model while keeping all other components stable/static. This means that any impact that is observed will be as a result of the change in the chosen variable. We understand that models are simplistic representations of more complex and complicated systems that that they are usually accompanied by sets of assumptions that may limit their applicability to real world situations and events.
DEFINITIONS Macroeconomics: The branch of economics which studies the working of the economy as a whole, or large sections such as all households, all business and government. The focus is on aggregate situations such as economic growth, inflation, unemployment, distribution of income and wealth, and external viability.
THE FOUNDATION OF ECONOMICS Microeconomics: The branch of economics that studies individual units i.e. sections of households, firms and industries and the way in which they make economic decisions. (both macro and microeconomics look at the three basic questions below) Positive Statement: A statement that can be verified by empirical observation i.e. Brazil has the largest income gap in Latin America. Normative Statement: a value judgment about what ought or should happen, i.e. more money should be spent on teacher’s salaries and less on WMD’s. Public sector: That part of the economy where goods and services are provided by the government, i.e. public hospitals, roads, schools, parks and gardens. Private sector: That part of the economy that is characterized by private ownership of the means of production by profit seeking individuals. Command Economy: An economy where all economic decisions are made by a central authority. Usually associated with a socialist or communist economic system Free Market Economy: an economy where all economic decisions are taken by individual households and firms, with no government intervention. Mixed Economy: an economy where economic decisions are made partly by the government and partly through the market. (nearly every economy in the world) Sustainable Development: Development that meets the needs of the present without compromising the ability of future generations to meet their own needs. (a key definition – from the UN in 1987) Economic Growth is the increase in a country’s output over time; that is an increase in national income. Economic Development is a much broader concept that purely economic growth, involving non-economic and often quite intangible improvements in the standard of living, for example freedom of speech, freedom from oppression, health care, education and employment It is very difficult to totally define as it involves normative or value judgments (always state this!!), but remember some areas can be quantified as well.
THE FOUNDATION OF ECONOMICS Market: an organization or arrangement through which goods and services are exchanged – do not have to physically meet – markets can be local (bikes in Fort Bonifacio), national (cars in the Philippines) or international (mobile phone market for the world) Price mechanism: is the process by which prices rise or fall as a result of changes in demand and supply. Signals and incentives are given to producers and consumers to produce more or less or consume more or less. Perfect competition: A market structure where there are many firms, where there is freedom of entry into the industry, where all firms produce an identical product, and where all firms are price takers – figure 4.1 shows the industry and the firm. Monopolistic competition: a market structure where, like perfect competition there are many firms and freedom of entry, but where each firm produces a differentiated product, and thus they have some control over the price. Examples: restaurants, hairdressers Oligopolistic competition: a market structure dominated by only a few firms or where a product is supplied by only a few firms (there may be many firms but it is dominated by only a few) examples: car industry in the USA, mobile phone industry. Monopoly: where is there is only one dominant firm in the industry – remember they don’t have to control 100%, example: Microsoft is a monopoly – sometimes hard to define. A bus company may have a monopoly over bus travel in a city but not all forms of transport – extent of monopoly power depends on the closeness of substitutes.
1.2 ECONOMICS AS A SOCIAL SCIENCE The nature and method of economics The social sciences are academic disciplines that study human society and social relationships. They are concerned with discovering general principles describing how societies function and are organised. Economics is a social science because it deals with human society and behaviour, and particularly those aspects concerned with how people organise their activities and how they behave to satisfy their needs and wants. It is a social science because its approach to studying human society is based on the social scientific method
The scientific method
THE FOUNDATION OF ECONOMICS Economics tries to explain in a systematic way why economic events happen in the way they do, and attempts to predict economic events likely to occur in the future. The social scientific method consists of the following steps:
1. Make observations of the world around us, and select an economic question we want to answer. 2. Identify variables we think are important to answer the question 3. Make a hypothesis about how the variables are related to each other 4. Make assumptions 5. Test the hypothesis to see if its predictions fit with what actually happens in real life 6. Compare the predictions of the hypothesis with real-world outcomes Economists as model builders Models are often closely related to theories, as well as laws. Models are often built on the basis of well-established theories or laws, in which case they may illustrate, through diagrams or mathematical questions, the important features of the theory or law. NB: MODELS ARE NOT ALWAYS REPRESENTATIONS OF THEORIES.
Ceteris paribus: ‘other things equal’. This means that all other things are assumed to be constant or unchanging.
Positive and normative concepts
Positive statements About something that is, was or will be. May describe something o E.g. the unemployment rate is 5%; industrial output grew by 3% May be about a cause and effect relationship, such as in a hypothesis o E.g. If the government increases spending, unemployment will fall May be statements in a theory, model or law o E.g. a higher rate of inflation is associated with a lower unemployment rate May be true or they may be false Plays an important role in positive economics, where they are used to describe economic events and to construct theories and models that try to explain these events.
THE FOUNDATION OF ECONOMICS Economists use positive statements in order to describe, explain and predict Normative statements About what ought to be (subjective about what should happen) o E.g. The unemployment rate should be lower o Health care should be available free of charge o Extreme poverty should be eradicated Cannot be true or false Assessed relative to beliefs and value judgements Used in normative economics, where they form the basis of economic policy- making Government actions that try to solve economic problems
MICROECONOMICS AND MACROECONOMICS Microeconomics: examines the behaviour of individual decisionmaking units in the economy. The two main groups of decision makers we study are consumers (households) and firms (businesses). Microeconomics is concerned with how these decision-makers behave, how they make choices and how their interactions in markets determine prices. Macroeconomics: examines the economy as a whole, to obtain a broad or overall picture, by use of aggregates, which are wholes or collections of many individual units, such as the sum of consumer behaviours and the sum of firm behaviours, and total income and output of the entire economy, as well as total employment and the general price level.
Microeconomics - Individual markets - Behaviour of firms and consumers - Allocation of land, labour and capital resources - Supply and demand - Efficiency of markets - Product markets - Profit maximization - Utility maximization - Competition - Resource markets - Market failure
Macroeconomics -
National markets - Total output and income of nations - Total supply and demand of the nation - Taxes and government spending - Interest rates and central banks - Unemployment and inflation - Income distribution - Economic growth and development - International trade
THE FOUNDATION OF ECONOMICS ECONOMIC GROWTH AND ECONOMIC DEVELOPMENT Economic growth: When the quantity of output changes, if it increases there is economic growth. If it decreases, there is economic contraction or negative economic growth. Economic development: Raising the standard of living and well-being of people. This means increasing incomes and outputs, reducing poverty among very poor people, redistributing income so that the differences between poor and rich become smaller, reducing unemployment and increasing provision of important goods and services (food, shelter, sanitation, education and health care services) Difference between the economic growth and economic development Economic growth is the quantity of output of goods and services produced. The quantity of output produced by countries increases over long periods of time, but there are differences between countries in how much output they produce and in how quickly or slow this increases over time. The World Bank has organized them into “more developed” and “less developed” according to their income levels, which are related to quantities of output produced. Whereas economic development refers to raising the standard of living and well being of people by increasing output and incomes and reducing poverty. Redistributing income so that the difference between the very rich and very poor is minimalized High levels of output and low provision of social service (e.g. health care services and sanitation) vs. low levels of output and high provision of social services Countries with lower levels of output and higher provision of social services are more developed. Although there are several benefits that come with having higher levels of output which indicates economic growth, issues such as healthcare, employment and other social services should also have priority as these are necessities that can improve quality of life and possibly solve issues that revolve around this. However, by having higher provision of social services, the country can then focus on improving levels of output.
SUSTAINABLE DEVELOPMENT Sustainability: Sustainability involves using resources in ways that do not reduce their quantity or quality over time for future generations. Sustainable resources such as forests and air quality are able to reproduce themselves should be used at a rate that will give them enough time to reproduce themselves, so that depletion of the resource is avoided.
THE FOUNDATION OF ECONOMICS Sustainable development: Development that meets the needs of the present without compromising the ability of future generations to meet their own needs. It occurs when societies grow and develop without leaving behind fewer or lower-quality resources for future generations. Threats to sustainability arise from the ways that societies answer mainly the first two of the three basic economic questions. Major threats come from our current patterns of resource allocation, in other words, from the ways societies are choosing to answer the ‘what to produce’ and ‘how to produce’ questions. What to produce: the issue in high income societies involves consumption relying strongly in fossil fuels that pollute the environment How to produce: methods of production (industrial production) that also rely on heavy use of fossil fuels.
THE EXTENT TO WHICH GOVERNMENTS SHOULD INTERVENE IN THE ALLOCATION OF RESOURCES There are two main methods that can be used to make choices (what, how and for whom to produce): the market method and the command method. Market method: resources are owned by private individuals or groups of individuals, and it is mainly consumers and firms who make economic decisions by responding to prices that are determined in markets. Command method: resources are owned by the government, which makes economic decisions by commands. In practice, commands involve legislation and regulations by the government, or in general any kind of government decision-making that affects the economy. In the real word, there has never been an economy that is entirely a market economy or entirely a command economy. Real world economies combine markets and commands in many different ways, and each country is unique in the ways they combine them In communist systems, they lean towards the command economy In market-oriented economies, they lean towards the market economy. In mixed market economies (economies that are strongly based on markets but also have some command methods), the command methods of making allocations and distribution decisions are referred to as government intervention.
