University of Liberia

P.O Box 10-9020

Microeconomics and Macroeconomics (ECON) 531

Prepared By: Sam K. Flomo, Jr

Submitted To: Cllr. Ramses T. Kumbuyah,

August 7, 2022
1. Discuss and analyze the five fundamental economic questions:

A. What will be produced? 

1. In order to be profitable, businesses must respond to consumers' (individuals, other businesses,

2. Consumer Sovereignty and "dollar votes"

Using the economy's scarce resources to produce one thing requires giving up another.
Producing better education, for example, may require cutting back on other services, such as
health care. A decision to preserve a wilderness area requires giving up other uses of the land.
Every society must decide what it will produce with its scarce resources.

This also mainly depends on consumers in a free market. The consumers choose the product they
like and thus their choices direct the types of production that should be carried out. The firms
will follow this because this is the most profit maximizing combination. Sometimes the
government too can decide what to produce. The government may decide to produce an essential
good or service which everyone ought to have.

B. How will the goods and services be produced?

1. The market system encourages and rewards those producers who are achieving least-cost
production.

2. The most productively efficient technique will be the one that produces a given amount of
output with the smallest input of limited resources.

There are all sorts of choices to be made in determining how goods and services should be
produced. Should a firm employ a few skilled or a lot of unskilled workers? Should it produce in
its own country or should it use foreign plants? Should manufacturing firms use new or recycled
raw materials to make their products?

This question will be answered by those supplying the goods and services. If the supplier is a
private firm, it will seek to use the method which will give the maximum profit. For example,
production can be done using labor intensive method and capital intensive method. The private
firm will decide on the method which will give lowest average costs.
If the government is the supplier, it may try to use the method which promotes welfare of the
society rather than maximizing the profit.

C. Who will get the goods and Services?

1. Determined by how the income is distributed

2. Products go to those who are willing and able to pay for them.

3. The productivity of the resources, the relative supply of particular resources, and the
ownership of the resources will determine the income of individuals and households.

4. The resulting distribution of income may not be the most equitable (fair).

If a good or service is produced, a decision must be made about who will get it. A decision to
have one person or group receive a good or service usually means it will not be available to
someone else. For example, representatives of the poorest nations on earth often complain that
energy consumption per person in the United States is many times greater than energy
consumption per person in the world's scores of poorest countries. Critics argue that the world's
energy should be more evenly allocated. Should it? That is a "for whom" question.

For whom to produce will also depend on the suppliers (government and private firms). The
consumers are the target of production, but the kind of consumers the firm or the government
wants to target is the question. The government usually produces for the general public whereas
the private firms can seek to maximize profit by producing for the high and rich level customers
as well as the general public. In simple words, the production is done for those who are willing to
pay.

D. How will the system accommodate change?

1. Markets are dynamic - what is efficient today may not be efficient tomorrow as tastes,
technology, and resource supplies change.

2. Prices help signal those changes and the market will respond. This guiding function of prices
is essential to a well-functioning market system.
3. In the absence of such signals, government or some similar institution would have to decide
where resources are allocated, but without knowing what people in society want, the result would
most likely be allocatively inefficient.

E. How will the system promote progress?

1. The market system promotes technological improvements and capital accumulation (economic
growth).

2. An entrepreneur or firm that introduces a popular new product will be rewarded with increased
revenue and profits.

3. New technologies that reduce production costs, and thus product price, will spread throughout
the industry as a result of competition.

4. Creative destruction occurs when new products and production methods destroy the market
positions of firms that are not able or willing to adjust.

1. Discuss and analyze the following concepts?

a. Economics as a science

Economics is the scientific study of the ownership, use, and exchange of scarce resources often
shortened to the science of scarcity.

Economics is regarded as a social science because it uses scientific methods to build theories that
can help explain the behavior of individuals, groups and organizations. Economics attempts to
explain economic behavior, which arises when scarce resources are exchanged. It is also
considered a social science because it seeks to explain how society deals with the problem
of scarcity.

As the social sciences have evolved over the last 100 years or so, they have become increasingly
specialised. This is true for economics, as witnessed by the development of many different
strands of investigation including microeconomics and macroeconomics, pure and applied
economics, international economics, development economics and industrial and financial
economics. What links them all is the attempt to understand how and why exchange takes place,
and how exchange creates benefits and costs for the participants.
b. Scarcity, Choice and opportunity cost

All choices mean that one alternative is selected over another. Selecting among alternatives
involves three ideas central to economics: scarcity, choice, and opportunity cost.

Scarcity
Our resources are limited. At any one time, we have only so much land, so many factories, so
much oil, so many people. But our wants, our desires for the things that we can produce with
those resources, are unlimited. We would always like more and better housing, more and better
education - more and better of practically everything.

If our resources were also unlimited, we could say yes to each of our wants - and there would be
no economics. Because our resources are limited, we cannot say yes to everything. To say yes to
one thing requires that we say no to another. Whether we like it or not, we must make choices.

Our unlimited wants are continually colliding with the limits of our resources, forcing us to pick
some activities and to reject others. Scarcity is the condition of having to choose among
alternatives. A scarce good is one for which the choice of one alternative use of the good
requires that another be given up.

Virtually everything is scarce. Consider the air we breathe, which is available in huge quantity at
no charge to us. Could it possibly be scarce?

Opportunity Cost
It is within the context of scarcity that economists define what is perhaps the most important
concept in all of economics, the concept of opportunity cost. Opportunity cost is the value of
the best alternative forgone in making any choice.

The concept of opportunity cost must not be confused with the purchase price of an item.
Consider the cost of a college or university education. That includes the value of the best
alternative use of money spent for tuition, fees, and books. But the most important cost of a
college education is the value of the forgone alternative uses of time spent studying and
attending class instead of using the time in some other endeavor. Students sacrifice that time in
hopes of even greater earnings in the future or because they place a value on the opportunity to
learn. Opportunity cost is the value of the best opportunity forgone in a particular choice. It is not
simply the amount spent on that choice.
The concepts of scarcity, choice, and opportunity cost are at the heart of economics. A good is
scarce if the choice of one alternative requires that another be given up. The existence of
alternative uses forces us to make choices. The opportunity cost of any choice is the value of the
best alternative forgone in making it.

Choice

Economics is the study of choice because resources are scarce and many needs and wants cannot
be satisfied. As such, choices must be made, and whenever a choice is made an opportunity
arises. Households, businesses and governments are always making choices between alternatives
competing with each other. The consequences of such choices, present and future, is in
Economics.

c. Consumer sovereignty

Consumer sovereignty refers to the freedom of choice which the consumers get in the market when there
is open competition in the market with minimal government intervention. Such a situation is possible
only under a free market economy, or a mixed economy.

To understand consumer sovereignty you must also understand consumers and their demand.
Everyone is a consumer and demands not only products such as food, or commodities like oil or
gas, but also production factors such as time, and all other possible things. When a worker wants
to have more leisure time, his demand for leisure is confronted with the demand of the society
for his work. Only after the worker outbids the society for his leisure, can he consume it as he
wishes. According to Hutt, the poor understanding of consumers and their demand led to some of
the early criticisms of this concept

d. The “invisible hand theory” in a market system

The invisible hand concept was an idea proposed by economist Adam Smith that illustrates the
hidden forces behind people's economic choices. It is a foundational concept for rational choice
theory, which states that people will make decisions based on their own personal self-interest and
benefits. 

The invisible hand concept is closely related to laissez-faire economics, which proposes that
government interference in the economy should be minimal and should run its own course.
Based on these ideas, as people act based on their own self-interest, it creates a need for supply
and demand and can create a competitive and robust marketplace. 

"Smith's invisible hand theory shows that an optimal distribution of goods and services among a
number of producers and consumers can be achieved without a 'visible hand' directing them to do
so," says Edesess. "In fact, a visible hand that does things like dictating prices of goods can cause
the end result to be suboptimal. This mistake was made crystal clear in the Communist-era
Soviet Union."

e. The circular flow (the resource market, goods and services market, the role of firms
and households, and the financial and foreign sector, and the role of government)

There are two primary actors in the economy, households and businesses. These two actors
interact with each other in two markets, the product market and the factor/resource market. In the
product market, households act as buyers purchasing the goods and services businesses are
willing to sell. In the resource market, the roles are reversed with businesses paying households
for their resources: land, labor, capital and entrepreneurship. The model clearly demonstrates
interdependence, a recurring theme in economics.

The Firm Sector

We know that the total flow of dollars from the firm sector measures the total value of
production in an economy. The total flow of dollars into the firm sector equals total expenditures
on GDP. We therefore know that

Production = consumption + investment + government purchases + net exports.

This equation is called the national income identity and is the most fundamental relationship in
the national accounts.

The Household Sector

The household sector summarizes the behavior of private individuals in their roles as
consumers/savers and suppliers of labor. The balance of flows into and from this sector is the
basis of the household budget constraint. Households receive income from firms, in the form of
wages and in the form of dividends resulting from their ownership of firms. The income that
households have available to them after all taxes have been paid to the government and all
transfers received is called disposable income. Households spend some of their disposable
income and save the rest. In other words,
Disposable income = consumption + household savings.

This is the household budget constraint. This equation corresponds to the fact that the flows
into and from the household sector must balance.

The Government Sector

The government sector summarizes the actions of all levels of government in an economy.
Governments tax their citizens, pay transfers to them, and purchase goods from the firm sector of
the economy. Governments also borrow from or lend to the financial sector. The amount that the
government collects in taxes need not equal the amount that it pays out for government
purchases and transfers. If the government spends more than it gathers in taxes, then it must
borrow from the financial markets to make up the shortfall.

The circular flow figure shows two flows into the government sector and two flows out. Since
the flows into and from the government sector must balance, we know that

Government purchases + transfers = tax revenues + government borrowing.

Government borrowing is sometimes referred to as the government budget deficit. This equation
is the government budget constraint.

The Foreign Sector

The circular flow includes a country’s dealings with the rest of the world. These flows include
exports, imports, and borrowing from other countries. Exports are goods and services produced
in one country and purchased by households, firms, and governments of another country. Imports
are goods and services purchased by households, firms, and governments in one country but
produced in another country. Net exports are exports minus imports. When net exports are
positive, a country is running a trade surplus: exports exceed imports. When net exports are
negative, a country is running a trade deficit: imports exceed exports. The third flow between
countries is borrowing and lending. Governments, individuals, and firms in one country may
borrow from or lend to another country.

Net exports and borrowing are linked. If a country runs a trade deficit, it borrows from other
countries to finance that deficit. If we look at the flows into and from the foreign sector, we see
that

Borrowing from other countries + exports = imports.

Borrowing from other countries = imports − exports = trade deficit.

Whenever our economy runs a trade deficit, we are borrowing from other countries. If our
economy runs a trade surplus, then we are lending to other countries.

The Financial Sector

The financial sector of an economy summarizes the behavior of banks and other financial
institutions. The balance of flows into and from the financial sector tell us that investment is
financed by national savings and borrowing from abroad. The financial sector is at the heart of
the circular flow.

Households divide their after-tax income between consumption and savings. Thus any income
that they receive today but wish to put aside for the future is sent to the financial markets. The
household sector as a whole saves so, on net, there is a flow of dollars from the household sector
into the financial markets.

1. The flow of money from the financial sector into the firm sector provides the funds that
are available to firms for investment purposes.

2. The flow of dollars between the financial sector and the government sector reflects the
borrowing (or lending) of governments. The flow can go in either direction. When
government expenditures exceed government revenues, the government must borrow
from the private sector, and there is a flow of dollars from the financial sector to the
government. This is the case of a government deficit. When the government’s revenues
are greater than its expenditures, by contrast, there is a government surplus and a flow of
dollars into the financial sector.

3. The flow of dollars between the financial sector and the foreign sector can also go in
either direction. An economy with positive net exports is lending to other countries: there
is a flow of money from an economy. An economy with negative net exports (a trade
deficit) is borrowing from other countries.