CHAPTER 1: INTRODUCTION

Economics is the study of the economy and the behavior of people in the economy.
Technically, economics can be defined as the study of efficient allocation of scarce resources so

as to attain unlimited human needs.

The following statements are derived from the second definition:

 Economics studies about resources; not about all resources but about scarce resources

only;

 It studies about allocation of resources;

 Allocation should be efficient;

 Human needs are unlimited;

 The aim of economics is to study how to satisfy the unlimited human needs up to the

maximum possible degree by allocating the resources efficiently.

Therefore, the subject matter of economics is strongly related with the concepts of

resource, efficiency and human needs.

All in all, from the above definition, one can drive two basic terminologies which are

necessary for better understanding of the definition of economics.

A. Resources
Resource is anything that can be used to produce goods and services. Resources are also
called inputs or factors of production. Resources (factors or inputs of production) are divided
into four categories, namely land, labor, capital and entrepreneurship.
B. The Fundamental Economic Facts
There are two fundamental facts, which constitute the economizing problems and provide
foundation for the subject economics. These are unlimited wants and limited economic resources.
Society's wants for material goods and services are unlimited: Our needs for goods and services
are insatiable or cannot be fully satisfied because,
i. Wants are multiplicative
ii. Wants are recurrent
iii. Wants multiply endlessly
iv. Human nature is accumulative

Limited economic resources: Economic resources like various types of labor, natural
resources, capital and entrepreneurial ability we use to produce goods and services are limited.
If economic resources are not sufficient to produce all goods and services needed by a
society, then we have to make choice as to which good to produce first. Thus, unlimited wants
and limited resources will give us the problem of scarcity. Because of scarcity, economic
resources must be allocated efficiently. Scarcity 1 implies that resources are insufficient to
produce all goods and services desired by consumers or society as a whole. To solve this and
related issues we have a discipline called Economics.
1.1. The Fundamental Economic Problems and the Alternative Economic Systems
Economic system is the set of organizational arrangement and institutions established to
solve the fundamental economic problems, what, how and for whom to produce. Economic
system is a basic means of achieving economic goals that are inherent in the economic structure
of a society. The fundamental role of an economic system in any society is to provide a set of
rules for allocating resources and/or consumption among individuals who cannot satisfy their
wants, given limited resources. The rules that each economic system provides function within a
framework of formal institutions (e.g., laws) and informal institutions (e.g., customs).
In every nation, no matter what the form of government, what the type of economic system, who
controls the government, or how rich or poor the country is, three basic economic questions must
be answered. They are: (i) What to produce?; (ii) How to produce?; and( iii) For whom to
produce?
Historically, four different types of economic systems are observed. These are:
1. Pure Capitalism (Free Market Economy)
2. Pure Socialism (Command Economy)
3. Mixed Economy (Hybrid Economy)
4. Traditional Economy (Customary Economy)
1.2. Scarcity, Opportunity Cost and Efficiency

1
A resource is said to be scare if it is limited in supply.
 If human desire were fully satisfied, we do not need to worry about the efficient use of
resources. Because all of us could, have as much as we please and no one would care about the
distribution of income among people. But, the reality is somewhat different. Because, we cannot
have all we want from nature without sacrifices. The law of scarcity states that goods are scarce
because there are no enough resources to produce all the goods that people want to consume.
This implies that there is always a tradeoff between alternatives.
As we have mentioned it earlier, because of scarcity, there must be a choice in the use of
economic resources. The important characteristics of economic resources are that they can be put
into alternative uses. Societies or individuals, therefore, must choose the best ways of using
scarce resources. Nations be it rich or poor, developed or under developed, will all face the
problem of choice. Tradeoff here implies the economy can only produce more of one item if it
gives up the production of some other good(s). The value of trade off is called opportunity cost.
Opportunity Cost is the value (amount) that must be sacrificed to attend something.
That is,
𝑡ℎ𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑎𝑐𝑟𝑖𝑓𝑖𝑐𝑒𝑑 𝑜𝑓 𝑜𝑛𝑒 𝑔𝑜𝑜𝑑
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 =
𝑡ℎ𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑 𝑜𝑓 𝑜𝑡ℎ𝑒𝑟 𝑔𝑜𝑜𝑑
Although opportunity cost can be hard to quantify, the effect of opportunity cost is
universal and very real on the individual level. In fact, this principle applies to all decisions, not
just economic ones. Opportunity cost has been seen as the foundation of the marginal theory of
value.
Opportunity cost is one way to measure the cost of something. The forgone profit of the
next best alternative is the opportunity cost of the original choice. A common example is a
farmer that chooses to farm his land rather than rent it to neighbors, wherein the opportunity cost
is the forgone profit from renting. In this case, the farmer may expect to generate more profit
himself. Similarly, the opportunity cost of attending university is the lost wages a student could
have earned in the workforce.
Note that opportunity cost is not the sum of the available alternatives, but rather the
benefit of the single, best alternative. Possible opportunity costs of the city's decision to build the
hospital on its vacant land are the loss of the land for a sporting center, or the inability to use the
land for a parking lot, or the money that could have been made from selling the land, or the loss
 of any of the various other possible uses. However, not all of these in aggregate. The true
opportunity cost would be the forgone profit of the most lucrative of those listed.
1.3. Decision Making Units and the Circular Flow of Economic Activities
The major decision-making units in the economy are households, business firms and
government.
Households: Households are consumers of final goods and services produced in the economy.
Consumers are the owners of economic resources (land, labor, and capital and entrepreneurship).
They earn income from their labor and from the property, they own. Households are generally
assumed to maximize their well-being or what economists call 'utility'.
Business Firms: Business firms are the producing unit in the economy. They hire workers and
pay for the use of various property owned by households. They use economic resources to
produce goods and services needed by households and other firms. Firms come in all size and
forms. However, regardless of their size all firms share common objective, i.e. profit
maximization.
Government: The term government used to broadly include all government and
quasigovernment bodies at the federal, state and local levels. Unlike the households and business
firms, government is not assumed to have a single goal. In a pure market economy, the role of
the government is limited to such activities as law entertainment.
The Circular Flow of Economic Activities

Firms' Expenditure on Economic Resource Income to Resource Owners

Flow of Resources Resource market Flow of Resources

Business Firms Households

Flow of Goods Flow of Goods

and Services and Services
Product Markets

Revenue of Firms Consumption Expenditure

of Goods and
Services