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Unit 1

Introduction to Economics

Overview
This Unit serves as an introduction to economics, laying the groundwork for your study of the discipline, in essence answering the question, what is economics? You will therefore find little economic analysis here. The main objectives of this Unit are to introduce you to some fundamental issues and concepts in economics, and to explain the methodology of economic analysis. The Unit is divided into two sessions as follows: Session 1: Core Concepts Session 2: Thinking like an Economist The first session highlights and examines the core concepts that economists use when they discuss their discipline. The second session describes the approach economists use in an attempt to answer fundamental economic questions. Together, these sessions provide a brief discussion of the discipline, and draw attention to the central questions with which economists are concerned and how these questions are answered.

Unit 1 Learning Objectives


At the end of this Unit, you will be able to: state the standard definition of economics; explain the core concepts that underpin the study of economics; differentiate between positive and normative economics;

explain why economists disagree.

Session 1

Core Concepts
Introduction
Economics is a subject that people must confront in their everyday lives. People already spend a great deal of their time thinking about economic issues: prices, buying decisions, use of their time, to name a few. The word economics comes from the Greek word oikonomikos meaning one who manages a household. This makes some sense since in economics we are faced with many managerial decisions just as a household is. Now that you are getting started, you are no doubt interested in getting some clear answers to our original question, what is economics? In this Session, we will seek to define the term economics and to clarify our understanding of the core concepts which underpin our basic definition.

Objectives

At the end of this Session, you will be able to: define economics using the standard definition established in the discipline; identify and explain the core concepts underpinning that definition; establish the relationship among these core concepts.

What is Economics?
The fundamental economic problem is: resources are scarce. Scarcity is the condition where the wants of individuals and societies are greater than the limited resources available to satisfy them. Several definitions of economics have been offered over time. They include, among others: 1. Alfred Marshall (1842-1924): Economics is a study of mankind in the ordinary business of life. 2. Lionel Robbins: Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. 3. Milton Friedman: Economics is the science of how a particular society solves its economic problems.

To avoid any confusion and to standardise and clarify the meaning of the term, economics will be defined in this course as: the science of how individuals and societies deal with the fact that wants are greater than the limited resources available to satisfy those wants. Implicit in the latter definition is the assumption that if there were an infinite supply of everything that human beings required, there would be no need for the study of economics. According to this definition, the study of economics is essentially based on the idea that resources are in short supply, and that there are not enough to meet the needs and wants that human beings have. As you continue your study of this discipline, you will certainly encounter discussions that are informed by this basic thesis. However, you are also likely to deal with ideas which differ from this basic thesis. Nonetheless, at this juncture, the definition provides a useful base from which to launch our exploration of the discipline. As we look more closely at the definition, an obvious question that comes to mind is, what are resources?

Resources
Resources are the elements which an individual, organization, company or a country use to provide for its wants and needs, normally categorized as: Natural resources or endowments, that is, those elements in our environment which we human beings are endowed with and which we make use of, but whose creation did not involve any effort on our part. Human resources, which refers to the capabilities that we have, both mental and physical. Manufactured aids to production, such as tools, machinery and buildings. Economists also refer to these resources as factors of production, an expression that highlights the fundamental use to which the resources are put, which is to facilitate the production of other elements. Further, you will often see the factors of production listed as land, labour and capital, three concepts which more or less are synonymous with the three categories of resources described above. Land: Often, when this term is used as one of the factors of production, it encompasses not only land but all the other natural resources, that is air, sea, trees, minerals and so on. Given this wide scope, some economists prefer to retain the broader term natural resources. Labour: This term carries the same meaning as human resources, as described above. It is important to note that its use covers both the physical and the mental, unlike its usage in everyday speech, where labour is normally associated with physical activity. Capital: Capital is the stock of material assets that are produced and accumulated by a society to facilitate further production. It can also be described as anything that is produced, to be used subsequently for the production of goods and services (to be dealt with in Unit 2). Any resource is capital if it satisfies two criteria:

1. The resource must have been produced. 2. The resource can be used to produce other goods and services. Plant and machinery are the most obvious forms of capital, but roads, schools and hospitals also represent capital. The latter three are more specifically described as social capital. Can you figure out how they contribute to the production of goods and services? All three factors of production are the inputs which combine to produce the outputs that people require to satisfy their needs. Outputs may be of two forms: There are the tangible items (that can be touched), known as goods, and the intangible items (that cannot be touched) known as services. Examples of goods are bed, stove, motor car; examples of services are hairdressing services, insurance services, education. An important characteristic of both goods and services is that they are valued; they are considered essential in satisfying needs and wants. Another way of saying it is that goods and services are produced to facilitate consumption by human beings. Human beings are therefore the consumers of the goods and services that are the outputs of the production process.

Outputs or Inputs?
Having clarified these definitions, an interesting issue comes to mind. Do you think it is always possible to categorize an element exclusively as an input or as an output in the production process? Take education for example. We just identified it as a service (output) of the production process. However, a question that comes to mind is, is it appropriate to view the outputs of the education system also as human resources that can serve as inputs, feeding into the production process? Does that therefore mean that the same element is simultaneously a factor of production (input) and an output of production? The intention here is to alert you to the fact that you must always be clear about the conceptual understandings that you bring to your study of the discipline. And when you take a position you must always be able to support it with a clear and precise rationale.

Scarcity
Any discussion of resources must also deal with the issue of scarcity. Many economists maintain that scarcity is a real phenomenon in todays world. Why? Based on our definition given earlier, it is because resources are limited while wants are unlimited. This means that at any given time we have only so much available resources which are not sufficient to satisfy the needs and wants being expressed at that time. It is important to note that scarcity in the economic sense does not necessarily imply the existence of conditions of poverty and deprivation (although, of course, poverty arises as a result of extreme scarcity of resources within a specific sector of a population). The point being made here is that whatever the standard of living of the individual or population grouping, or the level of development of the organization, company or country, the issue of scarce resources will always apply.

Choice
Scarcity creates a situation in which we are forced to choose among alternative options. Consider, for example, a stretch of land running alongside a highway. Let us assume that this land is currently being used for the planting of short-term crops. Should it remain as agricultural land or should the State acquire it to expand the highway, thus easing traffic congestion at peak hours? Or, take for example the case of a multi-storey parking facility that was built in Port of Spain, Trinidad, to relieve the parking problems in that city. Should it retain its original function or should it be converted to provide shelter for the growing number of homeless people roaming the city streets? And what about the situation on the west coast of Barbados? Should those lands be retained as agricultural land or should they be used for the further development of tourism? Given then that societys resources are limited, but that wants are unlimited, a choice must be made, that is, a decision must be made to have one item or to pursue one course of action rather than another.

Marginal Choices
There is no such thing as a free lunch. Making decisions requires trading off one goal for another. Most of a consumers economic choices are marginal choices. Decisionmaking at the margin is characterized by weighing additional (marginal) benefits of a change against the additional (marginal) costs of a change with respect to current conditions. Take for instance the situation that most consumers find themselves in, of deciding how much of their income to spend on food and clothes. The choice may not necessarily be whether money is to be spent on food or on clothes. Instead, it is a choice as to whether an additional amount of money spent on food or on clothes will give them a greater increase in satisfaction. It is a decision to be made at the margin, that is, a decision to do a little more of something or a little less of something. It is important to note that the concept of choice at the margin focuses attention on small changes rather than on large scale adjustments. In defending this perspective, economists argue that it is at the level of small scale operations that most change actually takes place in a society. For this reason, marginal choices are an important area of study in the field. However, recognizing that tradeoffs exist does not indicate what decisions should be made.

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Opportunity Cost
The decision to have one good or service over another, involves a cost. Not a monetary cost, but what is known in economics as an opportunity cost, that is: the next best alternative foregone. In other words, the cost of any choice that you make, is the value of the best opportunity that you give up in order to make that choice. For example, money that could have been used to finance your first car is instead spent on enrolment in the University of the West Indies distance education programme. The true cost to you of your enrolment in this programme is the value of the new car that you chose not to buy. Similarly, the cost of studying this Unit will be the value of the best other use to which you could have put your time. In Session 2 of this Unit, we will graphically represent the concepts of scarcity, choice and opportunity cost in Model 2: The Production Possibilities Frontier.

Maximizing Utility
All individuals seek to maximize satisfaction received from the consumption of a good or service. The satisfaction that people receive from consuming goods and services is called utility. When choices are made, they are made on the principle that maximum value will be attained despite the inherent constraints faced.

Fundamental Economic Questions


Scarcity, choice and cost are widely regarded as the core concepts in the study of economics, with the first providing the basis for the other two. The problem of scarcity gives rise to three fundamental economic questions: 1. Input Question or Resource Allocation Question: How should the scarce resources be allocated for the production of goods and services? The fundamental question then is: how should goods and services be produced to ensure the efficient use of scarce resources? 2. Output Question: Every society must decide what and how much it will produce with its scarce resources. So the question is: what should be produced and how much? 3. Distribution Question: For whom should goods and services be produced? Who should be the consumers of these goods and services? A decision to have one person receive a good or service usually means it would not be available to someone else. This raises questions about equity and fairness. The first two questions together are often referred to as the Production Question.

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Microeconomics and Macroeconomics


Economics is studied on various levels. Microeconomics is the study of how households and firms make decisions and how they interact in markets. Macroeconomics is the study of economy-wide phenomena. It examines the economy as a whole top down to explain broad aggregates and their interactions. Such aggregates include national income and output, the unemployment rate, and price inflation and sub-aggregates like total consumption and investment spending and their components. It also studies the effects of monetary policy and fiscal policy and of course economic growth. Microeconomics and macroeconomics are closely intertwined because changes in the overall economy arise from the decisions of individual households and firms. Because microeconomics and macroeconomics address different questions, they sometimes take different approaches and are often taught in separate courses. As a student of economics therefore, you must also develop competence in using the tools required for the study of each branch. Interestingly enough, the distinction that we have just made between micro and macro does not necessarily extend to the analytical tools for studying them. In fact, you will eventually find out that there is considerable similarity in the tools used. All of the above concepts underpin the essential thesis that economics is the study of the use of scarce resources to satisfy unlimited wants. However, there are some in the field who, while recognizing the relevance of this definition, are of the view that it does not provide a completely satisfactory basis for the study of the discipline.

Summary
In this Session, we examined a definition of economics that is generally accepted by theorists and practitioners in the field, and analyzed core concepts that derive from that basic definition. The following core concepts were highlighted: It is the use of resources, or their allocation and organization that constitutes the subject matter of economics. Economic resources are the factors of production (land, labour, capital) which may be combined in various proportions to produce goods and services. The concepts of scarcity, choice and cost are at the heart of economics. A good is scarce if it has alternative uses. The existence of alternative uses forces us to make choices. The opportunity cost of any choice is the value of the best alternative we forego in making that choice. Utility is the satisfaction people derive from consuming goods and services.

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Session 2

Thinking like an Economist


Introduction
In Session 1, we examined the core concepts of economics in answer to the question: What is economics? This Session develops how economists approach the three fundamental economic problems outlined in Session 1: Input Question or Resource Allocation, Output Question and Distribution Question. The purpose of this Session therefore is to familiarize you with the dispassionate systematic way economists approach economic problems. With practice, you will learn how to approach similar problems in this way. You will examine how economists employ the scientific method, the role of assumptions in model building, and the application of two specific economic models. You will also learn the important distinction between two roles economists can play: as scientists when we try to explain the economic world and as policymakers when we try to improve it.

Objectives
At the end of this Session, you will be able to: apply scientific methods to given economic problems; explain how assumptions and models can shed light on the world; apply two simple modelsthe circular flow and the production possibilities frontier models; differentiate between positive and normative statements; discuss why economists sometimes disagree with one another.

The Economist as Scientist


The scientific method economists follow is based on observations and data collected for the following two reasons: 1. Observations help to develop theory. 2. Data can be collected and analyzed to evaluate theories. However, it is important to note that using data to evaluate theories is more difficult in economics than in physical science because economists are unable to generate their own data and must make do with whatever data are available. Thus, economists pay close attention to the natural experiments offered by history.

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The scientific method economists follow is also based on assumptions. Assumptions make the world easier to understand. For example: to understand international trade, it may be helpful to start out assuming that there are only two countries in the world producing only two goods. Once we understand how trade would work between these two countries, we can extend our analysis to a greater number of countries and goods. One important role of an economist as scientist is to understand which assumptions one should make. Economists often use assumptions that are somewhat unrealistic but will have small effects on the actual outcome of the answer. Finally, economists use economic models to explain the world around us. Most economic models are composed of diagrams and equations. The goal of a model is to simplify reality in order to increase our understanding. This is where the use of assumptions is helpful. To understand how simple but unrealistic models can be useful, consider a road map. A road map is an unrealistic representation of the real world. For example, it does not show where all the stop-signs, gas stations, or restaurants are located. It assumes that the earth is flat and two-dimensional. But, despite these simplifications, a map usually helps travellers get from one place to another. Thus, it is a good model. Let us take a look at two models in economics: 1. The Circular Flow Diagram. 2. The Production Possibilities Frontier

Model 1: The Circular Flow Diagram


Revenue Goods and services sold MARKETS FOR GOODS AND SERVICES Firms sell Households buy Spending Goods and services bought HOUSEHOLDS Buy and consume goods and services Own and sell factors of production

FIRMS Produce and sell goods and services Hire and use factors of production

Factors of production Wages, rent, and profit

MARKETS FOR FACTORS OF PRODUCTION Households sell Firms buy

Labour, land and capital Income - Flow of inputs and outputs - Flow of dollars

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A circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms. This diagram is a very simple model of the economy. Note that it ignores the roles of government and international trade. There are two decision-makers in the model: households and firms There are two markets: goods market and factor market. Firms are sellers in the goods market and buyers in the factor market. Households are buyers in the goods market and sellers in the factor market. The inner loop represents the flows of inputs and outputs between households and firms.

The outer loop represents the flows of dollars between households and firms.
Model 2: The Production Possibilities Frontier
Quantity of Computers Produced 3000

2,200 C 2,000 A 1,000 B

Production possibilities frontier

300

600

700

1,000

Quantity of Cars produced

The axes show the level of output per year. The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. Consider a country that produces two goods, cars and computers, over the course of a year: If all resources are devoted to producing cars, the economy can produce 1,000 cars and zero computers. If all resources are devoted to producing computers, the economy can produce 3,000 computers and zero cars. If resources are divided between the two industries, the feasible combinations of output are shown on the curve.

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The production possibilities curve depends on two things: (1) the availability of resources; and (2) the level of technology. Production is efficient at points on the curve (for example, points A and C), that is, society is getting the most it can from its scarce resources. This implies that the economy is getting all it can from the scarce resources it has available. Production at a point inside the curve is inefficient (for example, point B). Production at a point outside of the curve (for example, point D) is not possible given the economys current level of resources and technology. The production possibilities frontier reveals the fact that people face tradeoffs (see discussion in Session 1 on Marginal Choices). Suppose the economy is currently producing 600 cars and 2,200 computers. To increase the production of cars to 700, the production of computers must fall to 2,000. The production possibilities frontier also shows the concept of opportunity cost, that is, the cost of something is what you give up to get it. For example, the opportunity cost of increasing the production of cars from 600 to 700 is 200 computers. The shape of the production possibilities frontier indicates that the opportunity cost of cars in terms of computers increases as the country produces more cars and fewer computers. This occurs because some resources are better suited to the production of cars (for example, mechanics) than computers (and vice versa). The production possibilities frontier can shift if resource availability or technology changes.

The Economist as Policy Adviser Positive Versus Normative Analysis


Positive analysis attempts to describe the world as it is. Normative analysis attempts to prescribe how the world should be. Positive statements can be evaluated using data, while normative statements involve personal viewpoints, that is, they are subjective; based on opinion. Examples of positive economic statements: The unemployment rate is lower than last years unemployment rate. The Barbadian economy has lower unemployment than Jamaicas economy. The Trinidadian stock market has boomed in recent years. Examples of normative economic statements: All budget deficits (situation where government expenditures exceed government revenues) are bad for the economy. The world would be a better place if marijuana was legalized. Minimum wage laws are bad. Taxes should be lowered. Note that during political elections, many normative statements are made by candidates.

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Why Economists Disagree


There are two main reasons why economists disagree. These are listed below. 1. Differences in scientific judgement: Economists often disagree about the validity of alternative theories. They disagree because they have different hunches about the validity of alternative theories or about the size of important parameters that measure how economic variables are related. They also disagree about the size of the effects of changes in the economy on the behaviour of households and firms. For example, some economists feel that a change in the tax code that would eliminate income taxes and create a tax on consumption would increase saving. However, other economists feel that such a change would have little effect on saving behaviour and therefore do not support the change. 2. Differences in Values: Economists sometimes disagree about public policy because they have different values. Suppose Patrick and Owen earn incomes of $80,000 and $10,000 respectively. Patrick is taxed 20% of his income, or $20,000. Owen earns income of $6,000, but is not taxed because his income is considered low. Government subsidises Owens income with 20% of the taxes it receives from Patrick and as a result, Owen receives an additional $4,000 of income. Is this policy fair? Suppose Patricks income is as a result of the long hours he put in studying economics and getting a high paying job while Owen dropped out of school and as a result his income is much lower. Is it fair that Patrick is penalised for his hard work while Owen reaps some of the benefits of Patricks labour? These are difficult questions on which people, including economists, are likely to disagree. The science of economics will not tell us whether this policy is fair. Perception Versus Reality: While it seems as if economists do not agree on much, this is in fact not true. The reason for this is probably that the issues that are generally agreed upon are boring to most non-economists. Economists tend to disagree on normative issues which cannot be proven with data. These disagreements usually stem from economists differences in values or personal ideology.

Reading 1.1
Farrell, T. W. (1980). What is Economics?

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Summary
In this Session, we learned how to take a scientific approach to resolving economic problems. The following topics were highlighted: 1. Economists try to address their subject with a scientists objectivity. Like all scientists, they make appropriate assumptions and build simplified models in order to understand the world around them. Two simple economic models are the circular-flow diagram and the production possibilities frontier. 2. A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisers than scientists. 3. Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.

Wrap Up
In this Unit, we examined the definition of economics and discussed the core concepts economists use when they discuss their discipline. This included discussions on resources, scarcity, choice, marginal choices and opportunity cost. We also examined the scientific approach economists use in solving economic problems, paying close attention to the role of assumptions and model building. We looked at the economist as policy adviser and noted the difference between Positive and Normative Analysis and discussed the reasons why economists sometimes disagree.

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