Introduction to Economics

Chapter 1: Basics of Economics

 Learning intentions
• Define ‘Economics’.
• Explain the fundamental economic problem of scarcity
(because resources are scarce while people’s wants (not
needs) are unlimited).,
• Explain the need for individuals, firms and governments to
make choices (due to scarcity of resources).
• Define opportunity cost and explain how it results from the
need to make choices.
• Explain the basic questions of resource allocation.
 Definition of economics
• Economics is one of the most exciting disciplines in social sciences.
• The word economy comes from the Greek phrase “one who
manages a household”.
• There is no universally accepted definition of economics.
• This
• is because different economists defined economics from different
perspectives:
a. Wealth definition,
b. Welfare definition,
c. Scarcity definition, and
d. Growth definition
• Hence, its definition varies as the nature and scope of the
subject grow over time. But, the formal and commonly
accepted definition is as follow.
 Definition of economics
• Economics is a social science which studies about
efficient allocation of scarce resources so as to attain
the maximum fulfillment of unlimited human wants.
• As economics is a science of choice, it studies how
people choose to use scarce or limited productive
resources (land, labour, equipment, technical
knowledge and the like) to produce various
commodities.
 Definition of economics
• Social science that
– studies how society efficiently allocates scarce/limited
resources to the production of goods and services so as to
attain the maximum fulfillment of unlimited human needs.
– Studies the production, distribution, and consumption of
goods and services.
– Focuses on the behavior and interactions of economic
agents and how economies work.
 Definition of economics
• The ‘social’ aspect is because economics looks at
human behavior, particularly in relation to satisfying
human needs and wants.
• Economics is also a ‘science’. This is because of the
way that economists put forward and investigate
theories in the same way as scientists.

Figure 1.1: Economics as a science

 Definition of economics

Adam Smith (1723–1790) Karl Marx (1818–1883) John Maynard Keynes (1883–1946)

Alfred Marshall Lionel Robbins …

 The rationales of economics
 Two fundamental facts that provide the foundation
for the field of economics.
 Human (society‘s) material wants are unlimited.
 Economic resources are limited (scarce).
 The basic economic problem is about scarcity and
choice since there are only limited amount of
resources available to produce the unlimited amount
of goods and services we desire.
 The rationales of economics
 Thus, economics is the study of how human beings
make choices to use scarce resources as they seek to
satisfy their unlimited wants. Therefore, choice is at
the heart of all decision-making. for the field of
economics.
 As an individual, family, and nation, we confront
difficult choices about how to use limited resources
to meet our needs and wants.
 Scope of Economics
 The field and scope of economics is expanding
rapidly and has come to include a vast range of
topics and issues.
 In the recent past, many new branches of the subject
have developed, including development economics,
industrial economics, transport economics, welfare
economics, environmental economics, and so on.
 However, the core of modern economics is formed
by its two major branches: microeconomics and
macroeconomics.
 Branches of Economics
Microeconomics Macroeconomics
 a branch of economics that is  a branch of economics that is
concerned with the analysis of concerned with the analysis of
individual parts of the economy. the whole economy/looks at the
 looks into economic behavior of big picture of the economy.
individual decision making units  deals with the effects and
such as households, firms, consequences of the aggregate
markets and industries. behavior of all decision making
Eg. factors determining the behaviour of units in a certain economy.
a consumer/a firm, the demand for/the Eg. factors determining aggregate
supply of a good, the price of a good, the variables such as aggregate demand,
quantity of a good, the performance of a aggregate supply, national output,
market, etc. unemployment, inflation, the balance of
payments, etc.
 Positive versus Normative Analysis
Positive economics Normative economics

• concerned with analysis of facts • A matter of opinion / value

and is verifiable. It doesn’t have judgments. It can be true or false,
to be necessarily true. but can not be tested.
• attempts to describe the world as • It tells us what should be/what
it is and answer the questions ought to be?
what was; what is; what will be?
• It evaluates the desirability of
• Disagreement over positive alternative outcomes based on
economics can be settled by an one‘s value judgments about
appeal to facts. what is good or what is bad.
• Deciding what is good or bad
policy is not just a matter of
science. It also involves our views
on ethics, religion, and political
philosophy.
Examples
• “Inflation is rising in Ethiopia.” • “Paying people who do not work
is wrong and unfair.”
• “Welfare programs reduce the
incentive for people to work” • The government should raise
taxes on the wealthy to pay for
• Raising taxes on the wealthy
helping the poor.”
slows economic growth.
• “A redistribution of income from
• “A decrease in personal income
the rich to the poor will increase
tax will lead to a rise in
social welfare.”
unemployment.”
It is a normative statement as it is
The above statement is a positive not verifiable (Though redistribution
statement as it is verifiable (both of income is measurable, social
personal income tax and welfare is not).
unemployment are measurable)
 Method of Economic Analysis
An economic theory derives laws/generalizations through two methods:
 Inductive Method/Empirical method (bottom-up approach)
– Logical method of reaching at a correct general statement or theory based on several
independent and specific correct statements. / deriving a principle or theory by moving
from facts to theories and from particular to general economic analysis.
Eg. Formulation of the generalization of diminishing returns.
The Malthusian theory of population - human population grows more rapidly than the food supply
until famines, war or disease reduces the population.

 Deductive Method (top-down approach)

– Logical way of arriving at a particular/specific correct statement starting from a correct
general statement.
– It deals with conclusions about economic phenomenon from certain fundamental
assumptions or truths or axioms through a process of logical arguments.
Eg. any supply and demand analysis you do is the application of generally accepted principles about
demand and about supply

 Both methods have weaknesses, so we cannot rely exclusively in one method.

They are complementary.
 Economic resources
Four categories of resources used to produce goods and services:
1. Labor: refers to the physical as well as mental efforts of human
beings in the production and distribution of goods and services.
(Reward – wage)
2. Land: refers to the natural resources or all the free gifts of nature
usable in the production of goods and services. (Reward – rent)
3. Capital: refers to all the manufactured inputs that can be used to
produce other goods and services. (Reward – interest)
4. Entrepreneurship: refers to a special type of human talent that
helps to organize and manage other factors of production to
produce goods and services. (Reward – profit)
Factors of production
 Key issues in economics
The rationales of economics:
– Human material wants are unlimited
– Economic resources are limited
– The basic economic problem is about scarcity and choice
 Key issues in economics
 Scarcity
• Scarcity is the fundamental economic problem. It is
natural phenomenon that refers to a state when a
resource is available in a finite quantity. It is permanent.
• Shortage is a market phenomenon (which occurs
whenever quantity demanded is greater than quantity
supplied at the market price) and is temporary.
 Key issues in economics
 Choice
• Choice is the decisions individuals and society make
(about the use of scarce resources) because they cannot
have everything.
• Choice is at the heart of all decision-making
– How choices are made in various settings;
– Evaluate the outcomes in terms of criteria such as efficiency,
equity, and stability;
– Search for alternative forms of economic organization that
might produce higher living standards or a more desirable
distribution of material wellbeing.
 Key issues in economics
Scarcity → limited resource → limited output →
we might not satisfy all our wants → make choice
→ choice involves costs → explicit and
implicit/opportunity cost
Opportunity Costs - shows the real cost of
choices.
• It is the amount or value of the next best
alternative that must be sacrificed (forgone) in
order to obtain one more unit of a product.
 The Production Possibilities Frontier or Curve
(PPF/ PPC)
• PPF shows the various possible combinations of goods and
services that the society/economy can produce given its
resources and technology.

• Assumptions:
– quantity and quality of resource available for use during the year is fixed.
– There are two broad classes of output to be produced over the year.
– The economy is operating at full employment & is achieving full production
– Technology does not change during the year.
– Some inputs are better adapted to the production of one good than to the
production of the other.
 Examples
Eg. 1. constant opportunity cost

Eg. 2. Increasing marginal opportunity cost

 Examples
• Suppose a hypothetical economy produces food and computer given its
limited resources and available technology
 Examples

The production possibility frontier (PPF)

 The production possibility frontier (PPF)
The PPF describes four important concepts:
• Scarcity: the society cannot have unlimited amount of outputs even if it
employs all of its resources and utilizes them in the best possible way.
• Choice: any movement along the curve indicates the change in choice.
• Efficiency: all points on the PPF are efficient
• Opportunity cost: when the economy produces on the PPF, production of
more of one good requires sacrificing some of another product which is
reflected by the downward sloping PPF.
– Law of increasing opportunity cost: This law states that as we produce more
and more of a product, the opportunity cost per unit of the additional output
increases. This makes the shape of the PPF concave to the origin.
 PPF & OC
• Calculating opportunity cost:

Say the economy is initially operating at point B,

What is the opportunity cost of producing one more unit of computer?

Solution: Moving from production alternative B to C we have:

320−420 −100
𝑂𝐶 = = = 0.2
1000−500 500

The economy gives up 0.2 metric tons of food per computer.

 Economic Growth and the PPF
• Economic growth or an increase in the total output level
occurs when one or both of the following conditions occur.
– Increase in the quantity or/and quality of economic resources
– Advances in technology
• Economic growth is represented by outward shift of the PPF.
 Asymmetric growth and the PPF
• An economy can grow because of an increase in productivity
in one sector of the economy. For example, an improvement
in technology applied to either food or computer would be
illustrated by a shift of the PPF along the Y- axis or X-axis.
 Basic economic questions
The fundamental economic problem leads to three important
questions related to the allocation of resources.
1. What to Produce? - the problem of allocation of resources.
2. How to Produce? - the problem of choice of technique.
3. For Whom to Produce? - the problem of distribution of
national product.
 What to Produce?
 Economies cannot produce everything, so they must decide
what to produce and in what quantities.
 The economy must make choices such as
 consumption goods versus capital goods,
 civil goods versus military goods, and
 necessity goods versus luxury goods.
 Generally, the final choice of any economy is a combination of
the various types of goods but the exact nature of the
combination depends upon the specific circumstances and
objectives of the economy.
 How to Produce?
 Once an economy has chosen what to produce , the economy
must decide how to produce them.
 choosing between alternative methods or techniques of
production.
 For example, cotton cloth can be produced with hand
looms, power looms, or automatic looms.
 Similarly, wheat can be grown with primitive tools and
manual labor, or with modern machinery and little labor.
 How to Produce?
 Broadly speaking, the various techniques of
production can be classified into two groups:
1. labour-intensive techniques ,and
2. capital-intensive techniques
 The choice between different techniques depends on
the available supplies of different factors of
production and their relative prices.
 Making good choices is essential for making the best
possible use of limited resources to produce
maximum amounts of goods and services.
 For Whom to Produce?
 This problem is also known as the problem of distribution of
national product.
 It relates to how a material product is to be distributed among
the members of a society.
 The economy must decide, for example, whether to produce
for the benefit of the few rich people or for the large number
of poor people.
 An economy that wants to benefit the maximum number of
persons would first try to produce the necessities of the
whole population and then to proceed to the production of
luxury goods.
 Activity
In 2019, 28% of Japan's population was aged 65 years and over;
by 2050, this figure is estimated at 38%. Total population is also
projected to fall from 125m in 2019 to 100m in 2050. Suggest the
likely effect of these changes on
a) what to produce
b) how to produce
c) For whom to produce.
 Economic systems
 The way a society tries to answer the above fundamental
questions is summarized by a concept known as economic
system.
 An economic system is a set of organizational and institutional
arrangements established to answer the basic economic
questions.
• Three types of economic system based on resource allocation
mechanisms / ownership of means of production:
– Capitalism/Free market economy/laissez faire
– Command/Socialistic/Planned economy
– Mixed economy
 Capitalist economy
 In this economic system,
 all means of production are privately owned,
 and production takes place at the initiative of individual
private entrepreneurs who work mainly for private profit.
 Government intervention in the economy is minimal.
 resource allocation decisions are largely driven by the market
mechanism, whereby individuals and firms take these
decisions without government intervention.
 resources are allocated by the forces of demand and supply
through the price mechanism
How the price mechanism works
.
 Role of the government in a market economy
.

The market economy

 Role of the government in a market economy
 In principle, the government should have no direct role in
the workings of the market economy and should not
interfere in the operation of the price mechanism.
 As long as the price mechanism is working efficiently, the
government’s role is to watch what is happening and
only intervene when the price mechanism does not
provide the best allocation of resources.
 When the price mechanism does not work efficiently, the
market ‘fails’.
 Role of the government in a market economy
 Examples of market failure are
 where the government provides goods such as healthcare
which would be underprovided, fire services which would not
be provided at all,
 and where it seeks to regulate situations to prevent firms using
their power to control the market for excessive gain.
 The true market economy is in certain respects an ideal.
 No actual economy operates as a pure market economy.
 Hong Kong SAR provides an interesting case of a near-perfect
example of a market economy. All businesses are privately
owned and Hong Kong’s bus, rapid transit rail service (MTR) and
road tunnels are operated by private companies.
 Features of Capitalistic Economy
1. The right to private property
2. Freedom of choice by consumers
3. Productive activity is guided by the motive of profit-making
and self-interest
4. Competition among economic agents prevail
5. All basic economic problems are solved through the market
or price mechanism
6. Minor role of government
7. Inequalities of income
8. Existence of negative externalities
 Capitalist Economy
Advantage Disadvantage
• Flexibility/adaptability • Merit goods are under-
• Decentralized economic power provided / demerit goods
are overprovided. Eg. Junk
• Increase in per-capita income
food
and standard of living
• Unbalanced economic
• Diversified types of consumer
activity
goods and services
• Inequality of income
• Growth of entrepreneurship
• Exploitation of labor
• Optimum utilization of
productive resources • Negative externalities
• High rate of capital formation • Excessive market power
 Command economy
 Command economy is also known as socialistic economy.
 In this economic system,
 The economic institutions that are engaged in
production and distribution are owned and controlled
by the state.,
 the government has a central role in all decisions that are
made.
 The choices in terms of what to produce, how to produce
and for whom to produce are all centralized.
 Unlike the market economy, the preferences of consumers
and manufacturing organizations in a planned economy
are controlled centrally.
Main Features of Command Economy
1. Collective ownership: All means of production are owned by the
society as a whole, and there is no right to private property.
2. Central economic planning: Planning for resource allocation is
performed by the controlling authority according to given socio-
economic goals.
3. Strong government role: Government has complete control over
all economic activities.
4. Maximum social welfare: Command economy aims at maximizing
social welfare and does not allow the exploitation of labor.
5. Relative equality of incomes: Private property does not exist in a
command economy, the profit motive is absent, and there are no
opportunities for accumulation of wealth. All these factors lead to
greater equality in income distribution, in comparison with
capitalism.
 Command economy
Advantage Disadvantage
• Absence of wasteful • Absence of automatic price
competition determination
• Balanced economic growth • Absence of incentives for
• Elimination of private hard work and efficiency
monopolies and inequalities • Lack of economic freedom
• Controls labor exploitation • Red-tape
and negative externalities
 Mixed economy
 Incorporates some features of both capitalist & command economy
 Co-existence of public and private sectors
 Economic welfare where public sector tries to remove regional
imbalances, provides large employment opportunities and seeks
economic welfare through its price policy
 Economic planning to achieve co-ordinated rapid economic
development, making use of both the private and the public sector.
 Price mechanism
Mixed market systems
 Mixed economy

Advantages Disadvantages
• Private property, profit • Ineffectiveness and
motive and price inefficiency
mechanism • Economic fluctuations
• Adequate freedom • Corruption and black
• Rapid and planned markets
economic development
• Social welfare and fewer
economic inequalities
Decision making units and the circular flow model
 Decision making units

Agents Who is? Decisions /roles

1.Household One person or more who live - Selling of their resources
under one roof and make - Buying of goods and
joint financial decisions services

2. Firm Production unit that uses - Buying of economic

economic resources to resource
produce goods and - Selling of their products
services
3. Government An organization that has legal - Provide public goods and
and political power to control services
or influence households, firms - Create enabling business
and markets environment
- Regulation, law and order
Decision making units and the circular flow model

 Markets

• Product market: it is a market where goods and services are

transacted/ exchanged. That is, a market where households
and governments buy goods and services from business firms.

• Factor market (input market): it is a market where economic

units transact/exchange factors of production (inputs). In this
market, owners of resources (households) sell their resources
to business firms and governments.
Circular-flow of the economy
Circular-flow of the economy