The Foundationof

Economics
Ms. Mahimi Kanchana
Faculty of Engineering
University of Moratuwa
LearningOutcomes
- Basic EconomicConceptsof Scarcity
- Basic Economic Problems& Factors of Production
- Opportunity Cost
- Toolsof Economic Analysis
- Economicsystems& Methodology
 AdamSmith (1723–1790)
O Knownas father of moderneconomics.
O Wrote the first and most important books on the subject of economics,
Nature and Causesof the Wealthof Nations(1776).
 Positive and Normative
Economics
▪ Health care can be improvedwith more
➢ Positive Statements:
tax funding
➢ Capable of being verified or refuted by
▪ Pollution control is effective througha
resorting to fact or further investigation
system of fines

➢ Normative Statements:
▪ Society ought to provide homes for all

➢ Contains a value judgement which

▪ Any strategy aimed at reducing factory
closures in deprived areaswould be cannot be verified by resort to

helpful investigation or research

What is Economics?

Def. The study of how people satisfy their needs and

wants.

We tend to use money to purchase our needs and wants.

Bartering (trading one thing for another) and making
yourself are other methods.
Microeconomics Vs.Macroeconomics

“Microeconomics focuses on explaining the behavior of

individual firms, consumers, or product market….” In
short, microeconomics looks at a small part of the
economy.
(Lipsey, 1997)

“Macroeconomics looks at the output of the economy as

a whole and is concerned with aggregate questions
relating to inflation, unemployment, the balance of
payment and business cycles.”
(Lipsey, 1997)
 Microeconomics Vs.Macroeconomics
Contd.
Microeconomics Macroeconomics
It studies the individual unit It studies the whole economy or large
group
Laws related to marginal analysis are Problems related to whole economy like
included in its scope employment, public finance, national
income etc.
Microeconomics provides the Macroeconomics provides the
information relating to the individual information relating to national income,
prices, individual consumption and total output, total consumption and
production general price level
Microeconomic analysis is simple Macroeconomics complex due to the
study of large groups
Microeconomics particularly focus on Macroeconomics particularly focus on
price analysis income analysis
Microeconomics studies individual Macroeconomics studies the problems
problems and it is less important for relating to the economy and its
comparative study importance is growing 8
 Human Needs & Wants
NEEDS: are the basic necessities that a person must have in order to
survive
e.g. food, water, warmth, shelter and clothing

WANTS: are the desire that peoplehave

e.g. things that people would like to have, such as bigger homes,
iphones, etc.
The Economic Problem

Unlimited Wants
Scarce Resources –
Land, Labour, Capital
Resource Use
Choices
The Economic Problem
 The Economic Problem
O What goods and services should an economy produce? – should the
emphasis be on agriculture, manufacturing or services, should it be on
sport and leisure or housing?

O How should goods and services be produced? – labour intensive,

land intensive, capital intensive? Efficiency?

O Who should get the goods and services produced? – even distribution?
more for the rich? for those who work hard?
SCARCITY
The excess of wants resulting from having limited
resources (land, labor, capital and entrepreneurs) in
satisfying the endless wants ofpeople.
It is a universal problem for societies – it is not limited to
poor countries.
To the economist, all goods and services that have a price
are relatively scarce. This means that they are scarce
relative to people’s demand for them.
Choices
▪The problem of scarcity and choice lies at the very heart of
economics, which is the study of how individuals and society choose
to allocate scarce resources.

▪Since people do not have infinite income, they need to make choices
whenever they fulfil their infinite wants.

▪They have to decide how to allocate their limited financial resources

between unlimited alternatives.
 Factors of Production
Land
- natural resources available for production
- renewable resources: those thatreplenish
- non-renewable resources: cannot be replaced

Labor -physical and mental effort of people used in production

Capital -all non-natural (manufactured) resources that are used inthe

creation and production of otherproducts

Enterprise (Entrepreneurship) -refers to the management, organization and

planning of the other three factors ofproduction
 Factors of Production

Land Labor Capital Enterprise

Payments
to factors
of
Production
Rent Wages Interest Profit

INCOME
Economic Goods Vs. Free
Goods
✓Economic goods are those goods which use scarce resources in
their production. For example, to produce simple good such as a
paper clip, scarce resources are used including the material itself -
usually steel wire, the machinery the shapes the clip, the machine
operatives, the boxes to pack the clips in, and so on.
✓The use of scarce resources to produce one paper clip creates a
cost to the producer, called the marginal cost. While this would be
extremely small, the fact that the marginal cost is greater than zero
means that scarce resources are being used, and the good is an
economic good.
✓In contrast, a free good is one that does not require scarce
resources for its production, and hence has a marginal cost of zero.
The classic example of a free good air. Air exists as a 'gift of nature'
and is a free good.
Opportunity Costs

All economic questions and problems arise from

scarcity. Economics assumes people do not have the
resources to satisfy all of their wants. Therefore, we
must make choices about how to allocate those
resources. We make decisions about how to spend
our money and use our time.
Opportunity Costs Cont.
-The cost of the next best use of your time or money when
you choose to do one thing rather than another is opportunity
cost.

-Let's say you have five dollars. What would you like to spend it
on? There are a million things you would love to spend five
bucks on, but let's imagine there are only three things out
there you really want to buy: gum, soda, and movie tickets.
Look at the price chart below and answer the questions.
Look at the price chart below and answer
the questions.

Good Price
1. How many sodas can you buy
instead of one movie ticket?
Gum $ .50 2. How many pieces of gum can
you buy instead of one soda?

Soda $1.00

Movie Ticket $5.00

What is the Opportunity Cost of
Going to College?
Benefits Opportunity Costs
◦ Higher Income ◦ Costs a LOT of money

◦ More Job opportunities ◦ Student loans for years

◦ Job opportunities in a career I ◦ 4 (or more) years of school
enjoy ◦ No guarantee of a job when I get

◦ Job opportunities in more places out

◦ What if I change my mind?

Trade Offs
Decisions involve tradeoffs. When you make a choice, you give up an
opportunity to do something else.

The highest-valued alternative you give up is the opportunity cost of your

decision.
Trade off: Sleep vs. Study
Options Benefit Opportunity
Cost
1 hour of extra Grade of C on 1 hour of sleep
study time test
2nd hour of Grade of B on 2 hours of
extra study test sleep
time
3rd hour of Grade of B+ 3 hours of
extra study on test sleep
time
Trade Offs
Def. When you choose between two possible uses for a resource,
giving up one alternative for another.

Ex. Bridge vs. Building

I can either buy this book or pizza, but not both.
 Trade Offs
➢You won a radio station contest and you are now $300 dollars richer. You can
finally start looking for a new system in your car. Determine what criteria you
think are important for choosing a system and identify the tradeoffs made
when selecting one stereo over another.
➢You will encounter similar decisions for the rest of your life – what college to
attend, what house to purchase, what kind of car to purchase, when to have
children, how many children do you want to have, what school to send your
children to, etc.
➢Researching opportunity cost of all options in any decision making process is
vital in order to make the best available choice.
➢Also keep this in mind, Americans spend 85% of their financial resources on
things that will not last for more than three years…
Identical twins Ashley and Mary Kate graduate with
Bachelors degrees and receive the same job offer. Ashley
passes up the job offer to pursue a Masters degree while
Mary Kate takes the job offer and begins working.
Two years pass and Ashley graduates and begins working.
By this time Mary Kate has been promoted to a position
that is comparable to Ashley’s starting position, and Mary
Kate’s salary has increased to an amount that is comparable
to Ashley’s starting salary.
So who made the better decision, Ashley
or MaryKate?

In business and in life, every choice In the example, one could argue that
we make comes at a cost since we Ashley made the better decision since
forgo other possible alternatives in a Masters degree would be valuable if
the process; this cost — whetherit’s both lost their jobs and found
money, time, education, health, et themselves in a competitive job
cetera — is known as an opportunity market. Yet when you look at the
cost. situation in terms of opportunity
costs, Ashley’s Masters degree came
at a cost of two years salary. If Ashley
and Mary Kate stay on equal career
paths from here on out, Mary Kate
ends up making the better decision.
An opportunity cost is the value or benefit of the next best alternative.
Opportunity costs even come into
play in the pursuit of happiness

✓Opportunity costs are all around us and they differ from

individual to individual. Take one look at Steve Jobs and Bill
Gates and think of the opportunity costs if they had decided to
forgo their entrepreneurial pursuits and continue their college
education instead.
✓ Things would be very different now.
✓Ultimately, opportunity costs apply to anything which is of
value to a person and being conscious of how they apply to your
situation can help in making a satisfactory choice/decision by
considering the value or benefit of the next best alternative.
Types of Goods Available in an
Economy
Consumer Goods

•Definition: Consumer goods are products that are directly purchased and
consumed by individuals and households to satisfy their needs and wants.
•Characteristics:
• These goods are typically used for personal consumption and enjoyment.
• Consumer goods can be further classified into durable goods (e.g.,
appliances, cars) and non-durable goods (e.g., food, clothing).
• Demand for consumer goods is influenced by consumer preferences,
income levels, and economic conditions.
•Examples: Clothing, electronics, food products, automobiles, furniture, and
entertainment items like books and movies.
Types of Goods Available in an
Economy Cont.
Capital Goods

•Definition: Capital goods, also known as producer goods or intermediate

goods, are items used by businesses and industries to produce other goods
and services. They are not for immediate consumption but are essential for
the production process.
•Characteristics:
• These goods are used to create wealth by producing other goods and
services.
• Capital goods can include machinery, equipment, factories,
infrastructure, and technology.
• Their value lies in their contribution to increasing the efficiency and
productivity of a business or industry.
•Examples: Manufacturing equipment, construction machinery,
transportation vehicles, computers, and commercial real estate.
Types of Goods Available in an
Economy Cont.
Services

•Definition: Services are intangible products or actions provided by individuals

or businesses to meet specific needs, desires, or tasks of consumers. They do
not result in a physical product.
•Characteristics:
• Services are often labor-intensive and involve human skills and
expertise.
• They encompass a wide range of activities, from healthcare and
education to professional services like legal counsel and consulting.
• Services are consumed at the time of production and do not typically
leave a tangible product behind.
•Examples: Healthcare services, education, legal advice, hairdressing,
transportation services (e.g., taxi rides), financial consulting, and entertainment
(e.g., movies, concerts).
Command Economy
A command economy, also known as a planned economy or centrally planned
economy, is an economic system in which the government or a central authority
has significant control over the production, allocation, and distribution of goods
and services within an entire economy. In a command economy, most economic
decisions are made by the government, and individual consumers and producers
have limited influence over these decisions.
 Command Economy
Key characteristics of a command economy include:
1.Central Planning: The government or a central planning authority creates detailed plans and
directives outlining what and how much should be produced, the methods of production, and
how resources should be allocated. These plans often cover various sectors of the economy,
such as agriculture, industry, and services.
2.Ownership: In many command economies, the government or state owns and controls major
industries, enterprises, and resources. Private ownership and entrepreneurship may be limited
or heavily regulated.
3.Resource Allocation: Central authorities determine the allocation of resources, including
labor, capital, and natural resources, based on the priorities set in the central plan. This can lead
to a focus on specific industries or sectors deemed essential for the country's development.
4.Price Controls: Prices for goods and services are often set or controlled by the government
to maintain stability and prevent inflation. These prices may not necessarily reflect market
demand and supply dynamics.
5.Limited Consumer Choice: In command economies, there may be limited consumer choice
in terms of available products and services. Consumers may have access to a narrower range of
options compared to market-driven economies.
6.Minimal Competition: Competition is often limited or nonexistent in command economies
since the state typically controls major industries. This can lead to reduced innovation and
efficiency.
Command Economy &
Economic Decisions
1. What goods to produce:
Determined by the central planning authority based on
national priorities and objectives.

2. How to use resources in the production process:

Allocation of resources is centrally planned, optimizing
resource use for state-defined goals.

3. Who receives the finished goods:

Distribution is controlled by the central authority, often
involving state-run mechanisms and rationing.
Traditional Economy
A traditional economy is an economic system in which economic decisions,
production, and distribution of goods and services are primarily based on
customs, traditions, and historical practices. In traditional economies,
economic activities are often shaped by long-standing cultural and social
norms, and there is limited reliance on modern technology or external trade.
Traditional Economy & Economic
Decisions
1.What goods to produce:
In a traditional economy, goods to produce are determined by customs,
traditions, and historical practices. Production is guided by the needs of the
community, and goods typically have cultural or subsistence significance.

2.How to use resources in the production process:

Resource allocation is based on customary practices and community needs.
Resources are typically used in ways that have been passed down through
generations, emphasizing self-sufficiency and sustainability.

3.Who receives the finished goods:

Finished goods are primarily distributed within the community or among
community members. Distribution is often based on communal norms and
social ties, with an emphasis on meeting basic needs rather than profit or
market exchange.
Market Economy
A market economy, also known as a free-market economy or capitalism, is an
economic system in which most economic decisions and resource allocation are
determined by supply and demand in a competitive market. In a market economy, the
production, distribution, and pricing of goods and services are primarily driven by
private individuals and businesses, rather than by government central planning.
Key characteristics of a market economy include:

1.Private Ownership: Individuals and businesses have the right to own, control, and
dispose of property, including land, capital, and businesses. Private property rights are
a fundamental feature of a market economy.
2.Market Forces: Prices, production quantities, and resource allocation are
determined by market forces of supply and demand. Prices serve as signals that guide
economic decisions.
3.Competition: Markets are characterized by competition among businesses and
individuals. Competition encourages efficiency, innovation, and the pursuit of profit.
4.Limited Government Intervention: In a pure market economy, government
intervention in economic affairs is limited. The government typically plays a role in
enforcing property rights, contracts, and regulations that promote fair competition.
Market Economy & Economic
Decisions
1.What goods to produce:
Driven by consumer demand and profit incentives; producers prioritize
goods with high demand and profit potential.

2.How to use resources in the production process:

Resource allocation based on market forces; resources flow to industries
with high returns.

3.Who receives the finished goods:

Distributed through voluntary exchange in the market; received by those
who can afford and choose to purchase them.
 Mixed Economy
A mixed economy is an economic system that combines elements of both market economies
and planned or command economies. In a mixed economy, there is a blend of private
ownership and government intervention, with both the market forces of supply and demand
and government policies playing significant roles in shaping economic activity.

Key characteristics of a mixed economy include:

1.Private Ownership: Individuals and businesses have the right to own, control, and
operate private property, including businesses, land, and capital. Private enterprise is a
fundamental feature of a mixed economy.
2.Market Forces: Prices, production quantities, and resource allocation are influenced by
market forces of supply and demand. Producers and consumers interact in competitive
markets to determine prices and production decisions.
3.Government Regulation: The government plays a role in regulating and overseeing
economic activities to ensure fair competition, protect consumers, and address market
failures. Regulations can cover areas such as safety standards, environmental protection, and
consumer rights.
4.Public Goods and Services: Governments provide and finance public goods and services
that are essential but may not be efficiently provided by the private sector. Examples include
infrastructure, education, healthcare, and national defense.
Mixed Economy & Economic
Decisions
1.What goods to produce:
Influenced by market demand and consumer preferences, with some
government guidance and regulation.

2.How to use resources in the production process:

Combination of market-driven allocation for efficiency and government
intervention for addressing societal goals and market failures.

3.Who receives the finished goods:

Distributed through voluntary market transactions based on consumer
choices and purchasing power, with government safety nets to address
social needs.
 Disadvantages of Market
Economy
1.Income Inequality: Market economies can lead to significant income
inequality, with a concentration of wealth and income among a small
percentage of the population. This can result in disparities in living
standards and access to opportunities.
2.Lack of Basic Services: In pursuit of profit, some essential services and
goods may be undersupplied in certain areas or to certain groups of
people. For example, remote or low-income areas may have limited access
to healthcare, education, or infrastructure.
3.Boom-Bust Cycles: Market economies can be prone to economic
cycles, including recessions and financial crises. Periods of economic
downturn can lead to job losses, financial instability, and social hardship.
4.Market Failures: Markets may not always allocate resources efficiently
or address certain societal needs. Market failures can occur when
externalities, public goods, or information asymmetry lead to suboptimal
outcomes.
 Disadvantages of Market
Economy Cont.
5. Monopoly and Oligopoly Power: In unregulated markets, businesses may gain
excessive market power, leading to monopolies or oligopolies that can stifle competition,
limit consumer choice, and drive up prices.
6. Short-Term Focus: Businesses in market economies may prioritize short-term profit
maximization over long-term sustainability or societal well-being. This can lead to
environmental degradation and disregard for social responsibilities.
7. Environmental Concerns: Market economies can sometimes neglect environmental
concerns and sustainability as firms may prioritize profit and growth over ecological
conservation.
8. Insecurity: The absence of strong safety nets can leave individuals vulnerable to
economic shocks, job loss, or unforeseen circumstances. The fear of instability can create
stress and anxiety in society.
9. Overemphasis on Materialism: Market-driven societies often emphasize material
success and consumption, which can lead to shallow values and neglect of non-material
aspects of well-being.
 Disadvantages of Command
Economy
1.Lack of Efficiency: Centralized planning can result in inefficiencies in resource
allocation, production, and distribution. The absence of market forces and competition may
lead to overproduction or underproduction of goods and services.
2.Bureaucratic Inefficiency: Central planning often involves extensive bureaucracy,
which can lead to red tape, slow decision-making, and misallocation of resources.
Bureaucrats may not always have the expertise to make optimal economic decisions.
3.Lack of Innovation: Command economies may stifle innovation and technological
progress because they often discourage entrepreneurship and individual initiative. There
may be less incentive for businesses to innovate when there is no competition.
4.Shortages and Surpluses: Central planning can result in shortages of certain goods and
surpluses of others. These imbalances can lead to consumer dissatisfaction and waste of
resources.
5.Consumer Choice and Variety: Command economies may offer limited consumer
choice, as goods and services are typically standardized and produced according to the
central plan. This can lead to a lack of diversity in products and services.
 Disadvantages of Command
Economy
6. Lack of Individual Freedom: Command economies often restrict individual economic
freedom and decision-making. Choices about where to work, what to produce, and how to
spend one's income may be limited.
7. Incentive Problems: When wages are fixed or centrally determined, there may be little
incentive for workers to improve their productivity, leading to inefficiencies.
8. Resource Misallocation: Central planners may prioritize certain industries or sectors
based on political or ideological considerations rather than economic efficiency. This can
lead to misallocation of resources.
9. Information Gaps: Command economies may struggle with information gaps and
inadequate data on supply and demand, making it difficult to plan accurately.
10. Resistance to Change: Command economies are often resistant to change and adapt
slowly to evolving economic conditions or technological advancements.
11. Lack of Consumer Sovereignty: Consumer preferences may not be adequately
considered in the planning process, leading to mismatches between supply and demand.
12. Potential for Corruption: Centralized planning can create opportunities for corruption
and rent-seeking among government officials and bureaucrats.
Production Possibility Frontiers
✓Show the different combinations of goods and services
that can be produced with a given amount of resources
✓ No ‘ideal’ point on the curve
✓Any point inside the curve – suggests resources are not
being utilised efficiently
✓ Any point outside the curve – not attainable with the
current level of resources
✓Useful to demonstrate economic growth and opportunity
cost
 Production Possibility Frontiers
If it devotes all resources
If the country is at
to capital goods it could
point A on the PPF It
produce a maximum of
can produce the
Capital Goods Ym.
combination of Yo
If it devotes all its capital goods and Xo
resources to consumer consumer goods
Ym
goods it could produce a
maximum of Xm Assume a country can
produce two types of
Yo A goods with its
resources – capital
goods and consumer
goods

Y1 B If it reallocates its
resources (moving round
the PPF from A to B) it can
produce more consumer
goods but only at the
expense of fewer capital
goods. The opportunity
Xo X1Xm cost of producing an extra
Xo – X1 consumer goods
is Yo – Y1 capital goods.
Consumer Goods
 Production Possibility Frontiers
Production inside the
Capital Goods PPF – e.g. point B
means the country is
not using all its
resources

Y1
C It can only produce at
points outside the PPF
A if it finds a way of

.
Yo
expanding its
resources or improves
the productivity of
B those resources it
already has. This will
push the PPF further
outwards.

Xo X1 Consumer Goods
 Main Shapes of a Production
Possibility Frontiers

1. Constant opportunity cost (A straight line)

2. Increasing opportunity cost (Concave)

3. Decreasing opportunity cost (Convex)

 Shift in the Production
Possibility Frontiers
1. Expansion of resources. (increase in the availability of
resources)

2.Technological improvements. (technological improvement

increases the productivity of resources)

3. More Education or Training