Chapter 1: The foundations of economics

1.1 understanding the nature of economics

What is economics?
- Economics uses scientific methods to build theories that can help the behaviour of
individuals, groups and organisations.
- Economics attempts to explain economic behaviour; based on observation,
deduction and construction of abstract models.
Microeconomics:
- Examine the behaviour of individual decision-making units e.g. consumers
(households) and producers (firms)
- Look at their choices, consequences of those choices and price determination of
prices on the markets.
Macroeconomics:
- Examines the behaviour of the economy as a whole- looking at aggregates of ‘the
sum of’
- Examples: total output of the economy, GDP/GNI, unemployment, inflation.
Key economic concepts:
- Scarcity- the basic economic problem
- Choice- how and where to allocate resources
- Efficiency- allocate resources in the best way possible
- Equity- being fair to different groups in the society
- Economic well-being- who becomes better or worse off
- Sustainability- preserving resources for future generations
- Change- sthe study of economics is always changing
- Interdependence- how one decisions maker will affect another due to lack of self
sufficiency
- Intervention- the need for government intervention to achieve specific economic
goals.
What is Scarcity?
- There are insufficient resources to satisfy all needs and wants i.e. Unlimited wants vs
limited resources
- Scarcity of resources cause scarcity of goods and services
- Example of goods: cars, clothes, food
- Examples of services: health care, travel, banking
What is choice?
Due to limited resources and scarcity, we have to think about:
1. What to produce= choose the types of goods and services to produce and in what
quantities
2. How to produce= how to get maximum use out of the resources available and satisfy
as many wants as possible
3. For whom to produce= is everyone going to have a more or less equal share of what
is produced or will some have more than others.
How are choices made?
- Consumers- they will buy good and services based on maximising their total
satisfaction or total utility
- Producers- they will produce goods and services that can maximise profits
- Governments- objectives include redistributing income and wealth, provide public
goods and correct market failure.
What is opportunity cost?
- results from the condition of scarcity that forces a choice between competing
alternatives
- The value of the next best alternative foregone to obtain something else.
Scarcity: unlimited wants vs limited resources- we cannot satisfy everyone’s wants
- In an attempt to satisfy as many wants as possible, we end up producing more and
more goods and services which reduces the amount of resources available e.g. less
natural resources.
Sustainability= meeting our own needs without compromising the ability of future
generations to meet their own needs

Sustainable resources use = preservation of the environment over time

Factors of production
- The factor inputs that are used in the production of goods or services in the attempt
to make an economic profit
- Also known as resources

Types of factors of production

1. Land
2. Labour
3. Capital
4. Enterprise

Land:
- Natural resources available for production that comes from land
- Examples: common land or natural resources like water, oil, copper, natural gas and
forests
- Land resources are the raw materials in the production process.

Labour
- The physical and mental effort that people contribute to the production of goods and
services
- The human input in the production process

Capital (physical capital):

- The machinery, tools and building that labour use to produce goods and services
- Man-made inputs that aid in the production of process
- Differs based on the worker and the type of job done
- Capital is NOT money as it is not a productive resource i.e. it does not produce
goods and services directly
- Money can be used to buy capital

Other types of capital:

- Human capital= skills, attitude and knowledge acquired by people which helps to
increase productivity
- Natural capital= expanded meaning of land, necessary for humans to live, survive
and produce in the future
Enterprise:
- Happens when a person (an entrepreneur) combines all factors of production to earn
an economic profit
- Innovate and develop new ways of doing things

Free goods
Characteristics:
- Not referring to goods with no market price ( free in the financial sense)
- unlimited supply
- Zero opportunity cost- it can be produced or obtained without having to sacrifice any
resources
- Example: oxygen in the air, sunlight
- Not to be confused with public goods and common pool resources that are free of
charge
- Public goods - goods that can be consumed by anyone e.g. roads and street light-
involves opportunity cost as providing them requires tax revenue and resources
- Common pool resources e.g. lakes and forests- not owned by anyone thus there is
overconsumption leading to scarcity and opportunity cost
Economic goods
Characteristics
- Goods with a market price
- Limited in supply due to limited resources for production
- Opportunity cost is greater than zero- limited resources are sacrificed to produce
more of these goods
- Example: cars, clothing, televisions

1.2 The three basic economic questions: Resource allocation, output/income

distribution
The basic economic questions:
1. What to produce
2. How to produce
3. For whom to produce

Resource allocation
- Resources or factors of production of production are assigned to specific uses and
productive activities while answering the three basic economic questions

Overallocation
- Too many resources diverted to the production of certain goods and services (socially
undesirable)
Underallocation
- Too few resources diverted to the production of certain goods and services (socially
desirable)
Output is distributed by depending on how income is distributed e.g. higher income earners
will be able to afford more goods and services compared to lower income earners.
Government intervention
- Free market economy=no government intervention, demand and supply determine
price and how resources are allocated
- Sometimes, the markets fail to allocate resources efficiently thus there is a need for
government intervention i.e. deliberate government attempt to influence the market to
reach certain social objectives
- Command economy= the government is the central planner and decides how all
resources are allocated
- No country has a pure free market economy or a pure command economy- most are
a mix of both
- Examples of government intervention: provision of public health care and education,
provision public goods such as roads and public transport

Problems with government intervention:

- May not achieve efficient allocation of resources i.e. government intervention may
cause misallocation of resources and worsen the situation

Economic systems- free market economy

- No government intervention in economic activities
- Decisions on resource allocation are made by both the consumers and producers
- Interact as buyers and sellers
- Prices act as an indication of the market value of the resources

The invisible hand by Adam Smith

- The natural force that guides free market capitalism through competition for scarce
resources brings together private and social interests in a harmonious way

In other words…
- If each consumer is allowed to choose freely what to buy and each producer is
allowed to choose freely what to sell and how to produce it, the market will settle on a
product distribution and prices that are beneficial to all.
- The market (consumers and producers) act based on their own self-interests which
leads to a situation where the resulting outcome maximizes the collective satisfaction
of both the consumers and producers

Features of a free market economy:

- Resources are owned by the private sector ( individuals and firms) and not the
government
- Price mechanism is present where demand and supply determine the prices of
resources and goods and services.
- All economic activities are guided by the motive of profit- unprofitable goods and
services will no longer be produced and resources are reallocated to the production
of more profitable goods and services.
- Competition creates choices and opportunities- consumers have a wide variety of
choices due to many firms producing goods and services that help to improve the
quality of goods and prices are competitive.
Features of planned economy
- The government has a central role (central planner) in all decision making
- The government influences resource allocation and determine the collective
preferences of consumers and producers
- Take responsibility of the distribution of income and determination of wages
- Tries to minimise the disparity within the social classes
- Takes ownership of the most productive resources and property.
- Plan the long term growth of the economy which may include sacrificing current
consumption and standards of living to enhance future well-being
Features of a mixed economy
- Involves a both private and public sectors in the process of decision making and
resource allocation
- Private ownership of productive resources work hand in hand with public ownership
- Government may take control of merit goods e.g. healthcare and education which
may have experienced underconsumption
- Government is a basic employer and provides basic services like education
- Government agencies regulate certain important services like transport water and
electricity
- Indirect support given to certain strategic companies e.g. pharmaceutical companies
to create vaccines and medicine

1.3 Understanding the world by the use of models

What is a model?
- A hypothetical construct that embodies economic procedures using a set of variables
in a logical and/or quantitative correlations
- It is a simplistic method using mathematical and other techniques created to show
complicated processes - may have many constraints

Why do we use economic models?

- To predict economic activities in which conclusions are drawn based on assumptions
- To prescribe new economic guidelines that will change future economic behaviours
- To provide logical defence to justify economic policies at three levels:
national/political, organizational, amd household
- For planning and allocating resources.

Production Possibilities Curve (PPC)

Definition:
- A visual representation of all the possible combinations of two types of goods
and services that can be produced with the existing quality and quantity of
resources (and level of technology)
To produce on the frontier of the PPC ( on the graph), two conditions must be met:
- All resources must be fully employed
- All resources must be used efficiently- goods are produced using the least amount of
resources i.e. productive efficiency

All points on the PPC frontier achieve

 - Productive efficiency-Producing goods and services with the optimal combination of
inputs to produce maximum output for the minimum cost
- The economy can no longer produce additional amounts of a good without lowering
the production level of another product
However ,actual output is always below the frontier
- In the real world, there will always be unemployment of resources (not all resources
are used up)
- The higher the unemployment, the further away is the point from the frontier thus
higher inefficiency of resources
- E.g. point G has higher unemployment than F

Scarcity:
- Because there are limited resources, scarcity will not allow the economy to produce
beyond its PPC i.e. point H is unobtainable
- Remember the assumption of the quantity of resources are held fixed

Choice:
- Assuming full employment of resources (operating at full capacity) and there is
productive efficiency, the economy should choose to produce on its frontier either at
point C, J or K
Opportunity cost:
- At point C, 5000 computers and 4000 cars are being produced
- To produce more cars, resources have to be diverted from computers to car
production
- At point K, 3000 cars and 5000 computers are now being produced
- Opportunity cost of producing 1000 extra cars means sacrificing the production of
2000 computers

PPC can shift outwards from PPC 1 to PPC 2 and it is caused by:
- Increase in the quantity of resources e.g. discovery of oil fields or mines or mineral
deposits
 - Increase in the quality of resources e.g. invest in education and training to increase
skill levels of workers
- Advancements in technology will help to increase efficiency and productivity i,e can
produce more within a shorter period of time

What is the circular flow of income?

- The circular flow of income and spending shows connections between different
sectors of an economy which includes
- Flows of goods and services and factors of production between firms and households
- How national income or GDP is calculated

Four sectors of the economy that contribute to the circular flow of income:
1. Households- consumers
2. Firms- producers
3. Government
4. International trade- exports and imports

Households supply domestic firms with needed factors of production - land, human, capital,
real capital and enterprise
- The factors are supplied by factor owners in return for a reward
- Land is supplied by landowners

Human capital is provided by labour and real capital by capitalists

Enterprise is provided by entrepreneurs- entrepreneurs combine the other three factors, and
bear the risks associated with production
Firms produce goods and services and results in incomes being generated for factors of
production:
- Land -rent
- Labour - wages and salaries
- Capital - interest
- Entrepreneurship - profit

Injections into the circular flow:

Injections are additions to investments, government spending or exports or boosting the
circular flow of income leading to a multiplied expansion of output
- Capital spending by firms i.e. investment expenditure e.g. on new technology
- The government i.e. government expenditure e.g. on healthcare or national defence
- Overseas consumer buying our goods and services i.e. exports
- An economy is an equilibrium when the rate of injections = the rate of withdrawals
from the circular flow

What are open and closed economies?

- An open economy= an economy that engages international trade
 - A closed economy= an economy that does not export or import goods and services

The circular flow in relation to leakages and injections:

An economy is an equilibrium when the rate of injections= the rate of withdrawals from the
circular flow
- If leakages is more than injections, saving into financial markets does not come back
into the flow as investment thus less good and services purchased, less production
and output by firms, more unemployment and less household income
- If injections are smaller than leakages, the income flow becomes smaller
- If injections are greater than leakages, spending and exports is greater than
spending on imports, then the expenditure flow increases since the injection is larger
than the leakage
- Foreigner consumers demand more goods and services thus more output and
production by firms to meet increases demand, less unemployment and more
household incomes
- If injections are larger than leakages, the income flow becomes larger
Chapter 1.4
The method of economics
Ceteris Paribus
- In latin ceteris paribus means with other things remain the same.
- To isolate the effect of one variable as a result in change in another variable.
- Example: examining how a change in price can affect the quantity demanded for a
good.
 - Examples: a fall in the price of the good causes an increase in the quantity
demanded according to the Law of Demand, ceteris paribus
- This means that non-price factors are held constant like consumers taste and
preferences, income, price of substitutes and complements.
Positive statements
- Positive statements are objective statements that can be tested, amended or rejected
by referring to the available evidence
- Positive economics deals with objective explanation and the testing and rejection of
theories.
- Example: if the government raises the tax on cigarettes this will lead to a fall in profits
of the cigarette producers
Normative statements
- A value judgement is a subject.ive statement of opinion rather than a fact
- Normative statements are subjective statements i.e. they carry value judgements
- Examples- unemployment is more harmful than inflation
- This sentence is subjective so it is a normative statement because it depends on the
situation.
1.5 a brief history of economic thought: the origins of economic ideas
Adam Smith ( 1723-1790)
- Known as the father of economics
- Published a book called wealth of nations in 1776- introduced the concepts of the
invisible hand and free market
- Supported the idea of non-government intervention in economic activities
- Consumers and producers make decisions based on self-interest
- Proposed that the division and specialisation of labour would increase production and
earn maximum return thus increasing economic well-being
- Stated that wages could not be equal as different jobs required different level of skills
- higher wages were to compensate people for learning higher level of skills
- The government’s role included taking care of national defense, national security,
building infrastructure and creating a legal system to follow
- Believed in the importance of competition to encourage efficiency and innovation-
helps to reduce the power of large firms.