Chapter 1: The Foundations of Economics

Economics is a social science, which is a study of people in society and how they interact with each other. Other
social sciences include sociology, political science, psychology, anthropology, and history.

The Earth is, to all intent and purposes, finite. This means that we only have a finite amount of resources. We
use these resources to produce the goods and services that we need or want, so the quantity of goods and
services available is also finite. Goods are physical objects that are capable of being touched ( tangible) , such
as vegetables, meat, or motorcars. Services are intangible things that cannot be touched, such as motorcycle
repairs, haircuts, or insurance.

Human needs and wants are infinite. Needs are things that we must have to survive, such as food, shelter, and
clothing. Wants are things that we would like to have but which are not necessary for our immediate physical
survival, such as televisions and mobile phones. There is a conflict between the finite resources available and
infinite needs and wants. People cannot have everything that they desire and so there must be some system for
rationing the scarce resources. This is where economics comes in.

There is a conflict between the finite resources available and infinite needs and wants. People cannot have
everything that they desire and so there must be some system for rationing the scarce resources. This is where
economics comes in.
Economics is a study of rationing systems. It is the study of how scarce resources are allocated to fulfill the
infinite wants of consumers.

Economics is a study of rationing systems. It is the study of how scarce.

Economics is a social science that deals with the efficient utilization of scarce resources to satisfy the unlimited
human wants.

Adam Smith (1723-1790)

O Known as father of
modern economics
O Wrote the first and most
important books on the
subject of economics, An
Inquiry into the Nature
and Causes of the
Wealth of Nations (1776)
O Smith believed in “free
market”
(free market is one where
consumers may buy what they
like and producers may produce
what they like, with no
government interference)

Smith suggested that a laissez-faire (don’t interfere) approach should be followed, leaving customers and
producers to make their own decisions

Laissez faire - is an economic environment in which transactions between private parties are free from tariffs,
government subsidies, and enforced monopolies, with only enough government regulations sufficient to protect
property rights against theft and aggression. The phrase laissez-faire is French and literally means "let [them]
do", but it broadly implies "let it be," "let them do as they will," or "leave it alone." Scholars generally believe a
laissez-faire state or a completely free market has never existed.

People often use the words “need” and “want” interchangeably.

NEEDS: are the basic necessities that a person must have in order to survive
e.g. food, water, warmth, shelter and clothing
WANTS: are the desire that people have. Anything not needed for basic survival.
e.g. things that people would like to have, such as bigger homes, iphones, etc.

Scarcity

To the economist, all goods and services that have a price are relatively scarce. This means that they are scarce
relative to people’s demand for them. It may seem that, in your town or city, cars are not scarce as there are a
great number of them around. However, it is certain that not everyone who would like a car in your area has one,
usually because they cannot afford to buy a car. Their ability to purchase a car is affected by the amount of
money they have and the price of the car, so price is being used to ration the cars that are available. Any good
or service that has a price, and is thus being rationed, is known as an economic good. The term scarcity has a
particular meaning in economics that is different from the way that the word is used in everyday life. A normal
person would not say that cars were scarce in Mexico City, but
an economist would be happy to state that they were relatively scarce.

Scarcity and Scarcity Examples, Scarcity Vs. Shortage, Wants Vs. Needs
o Scarcity refers to limitations—insufficient resources, goods, or abilities to achieve the desired
ends.
o A shortage occurs whenever quantity demanded is greater than quantity supplied at the market
price. Scarcity is a naturally occurring limitation on the resource that cannot be replenished.
o Scarcity Examples. Just read the examples on the PPT.

Choice
Since people do not have infinite incomes, they need to make choices whenever they purchase goods and
services. They have to decide how to allocate their limited financial resources and so always need to choose
between alternatives. This leads to one of the key concepts of economics.

Opportunity cost
Opportunity cost is defined as the next best alternative foregone when an economic decision is made. This may
sound quite complicated but simply means that opportunity cost is what you give up in order to have something
else. For example, if you decide to buy a DVD for $1 5 rather than have a meal out, then the opportunity cost of
the DVD is the meal out that you go without. It is not the $1 5, as opportunity cost is never expressed in monetary
terms.
If a good or service has an opportunity cost then it must be relatively scarce, so it will have a price and be
classified as an “economic good”.
There are a few things, such as air and salt water, that are not limited in supply and so do not have an opportunity
cost when they are consumed. We do not have to give up something else in order to breathe. These things are
known as “free goods”, as they are not relatively scarce and so will not have a price.

Trade-off denotes the option we give up to obtain what we want. Opportunity cost is the cost of the second-
best alternative given up to make a choice. The value of time, money, goods, and services given up in an
economic choice.

In practice, economists tend not to talk about early birds and greener grasses. They've developed their own
more technical vocabulary to describe the world of scarcity and choice.

For example, when we sacrifice one thing to obtain another, that's called a trade-off. Only have enough cash
to buy a bike or a snowboard, but not both? That's a trade-off. Trying to decide whether to take the Fourth of
July off to spend with your family, or to go to work and make extra overtime? That's a trade-off.
Trade-offs create opportunity costs, one of the most important concepts in economics. Whenever you make
a trade-off, the thing that you do not choose is your opportunity cost. To butcher the poet Robert Frost,
opportunity cost is the path not taken (and that makes all the difference). You bought that bike? Then the
snowboard was your opportunity cost. Decided to work on the Fourth of July? Your opportunity cost was a
relaxing day hanging out with the fam at the BBQ.

Opportunity cost is the cost of missing out on the next best alternative. In other words, opportunity cost
represents the benefits that could have been gained by taking a different decision.

All businesses have to make choices - and those choices have implications.

In business, resources are usually scarce or limited. Decision are made under circumstances of uncertainty and taking
one course of action or decision may affect business ability to take an alternative action.
Opportunity cost measures the cost of a choice made in terms of the next best alternative foregone or sacrificed.

Examples of Opportunity Cost in the Business & Economic Environment

• Work-leisure choices

The opportunity cost of deciding not to work an extra ten hours a week is the lost wages given up.

• Government spending priorities

The opportunity cost of the government spending an extra £10 billion on investment in National
Health Service might be that £10 billion less is available for spending on education or defence
equipment.

• Investing today for consumption tomorrow

The opportunity cost of an economy investing resources in new capital goods is the production of
consumer goods given up for today.

• Use of scarce farming land

The opportunity cost of using farmland to grow wheat for bio-fuel means that there is less wheat
available for food production, causing food prices to rise

A free good is a good with zero opportunity cost. This means it can be consumed in as much quantity as
needed without reducing its availability to others. Economic goods have an opportunity cost (goods that
use resources which could have been put to use producing something else)

Types of Products

• Consumer goods- products sold to general public

• Durable goods- products that last a long time and can be used repeatedly
• Non-durable goods- products that need to be consumed very shortly after purchase
• Capital good or producer’s goods- products purchased by other businesses to produce other
goods and services
• Services- intangible products provided by businesses

The basic economic problem

We have already seen that resources are relatively scarce and wants are infinite, which leads to choices to be
made. These choices are often expressed in terms of three questions and represent the basic economic problem.
The questions are:
 • What should be produced and in what quantities? Using these scarce resources, how many computers
should be produced, how many bicycles, how much wheat, and how much milk? This has to be decided
for all economic goods.
• How should things be produced? There are many different ways of producing things and there are
different combinations of resources that may be used in production. Should sports shoes be produced
by an automated production line or by manual workers? Should crops be grown with a high usage of
fertilizer or organically?
• Who should things be produced for? Should they go to those who can afford them or be shared out in
some fair manner? How will the total income ( the national income) of the economy be distributed? Will
teachers get higher incomes than nurses?

Whatever the system used to allocate resources, it needs to be able to answer these questions. There are two
theoretical allocation (rationing) systems the free market system and the planned economy. In reality, all
economies are mixed economies, which are a combination of the free market and planning. The extent to
which governments should intervene in any economy is a constant source of debate and will be addressed
throughout this companion.

Factors of Production
• LAND- Land refers to all the natural resources. These resources are gifts that are given by nature. Some common
examples of natural resources are water, oil, copper, natural gas, coal, and forests.
• Labor- Labor, as a factor of production, involves any human input. The quality of labor depends on the workforce’s
skills, education, and motivation.
• Capital- Here capital refers to manufactured resources such as factories and machines. These are man-made goods
used in the production of other goods.
• Physical and Human Capital
• Entrepreneur- He is the brain behind the business. An entrepreneur’s first task is to assemble the factors of
production: land, labor, and capital.

Production Possibilities Frontier

PPF - Is a graph that shows the different rates of production of two goods and/or services that an economy
can produce efficiently during a specified period of time with a limited quantity of productive resources.

A production possibility frontier (PPF) shows the maximum possible output combinations of two goods or
services an economy can achieve when all resources are fully and efficiently employed

In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two
commodities that could be produced using the same total amount of the factors of production. It shows the
maximum possible production level of one commodity for any production level of another, given the existing
levels of the factors of production and the state of technology.

PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight
line. An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to
produce more of one good without decreasing the production of the other good. For example, if an economy
that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed
in order to produce more butter. If production is efficient, the economy can choose between combinations (i.e.,
points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of butter and guns
is required.
Production Possibilities Frontier: If production is efficient, the economy can choose between combinations on
the PPF. Point X, however, is unattainable with existing resources and technology if trade does not occur.

If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated
in order to produce more of one or both goods without decreasing the quantity of either. Points outside the curve
are unattainable with existing resources and technology if trade does not occur with an outside producer.

The PPF will shift outwards if more inputs (such as capital or labor ) become available or if technological progress
makes it possible to produce more output with the same level of inputs. An outward shift means that more of one
or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift
inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock
of physical capital.

Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier
is also the consumption possibilities frontier. Trade enables consumption outside the production possibility
frontier. The world PPF is made up by combining countries’ PPFs. When countries’ autarkic productions are
added (when there is no trade), the total quantity of each good produced and consumed is less than the world’s
PPF under free trade (when nations specialize according to their comparative advantage).

Economic System

Definition: The method used by a society to produce and distribute goods and services. The way in which
humankind has arranged for its material provisioning

• Types of Economic System

• Traditional Economy- Economic questions are answered by habits and customs (the way it has
always been done)
• Command Economy- The government answers the basic economic questions
• Market Economy- Economic questions are answered by individual buyers and sellers.
• Mixed Economy- refers to the economic system where the economic activities are directed by
both private and the government
The Central Themes in Economics
Having introduced several of the topics you will study in this course we can now look at some of the major
themes that will underlie all sections of the course. These include:

Theme #1: The role of product and resource

markets in the modern economy

In the market system, there exists

interdependence between all individuals.
• Households (that’s us) depend on the
goods and services produced by
business firms, and the incomes they
provide us, for our survival
• Business firms depend on households
for the workers, the capital, the land
resources they need to produce the
goods they hope to sell us and make
profits on.

These exchanges all take place in one of two categories of market present in all market economies

Product Markets Resource Markets

Where households buy the goods and services
we desire from firms. Examples:
• The market for private schools
• The market for dental services
• The market for airline travel
• The market for football merchandise
Where business firms buy the productive
resources they need to make their products:
• The market for teachers
• The market for dentists
• The market for pilots
• The market for football players

In Resource Markets:

• Households supply productive resources (land, labor, capital)

• Firms buy productive resources from households. In exchange for their productive resource, firms pay
households:
• Wages: payment for labor
• Rent: payment for land
• Interest: payment for capital
• Profit: payment for entrepreneurship
• Firms seek to minimize their costs in the resource market
• Firms employ productive resources to make products, which they sell back to households in the product
market
In Product Markets:

• Consumers buy goods and services from firms

• Households use their money incomes earned in the resource market to buy goods and services
• Expenditures by households become revenues for firms
• Firms seek to maximize their profits
• Households seek to maximize their utility (happiness)
Notice the circular flow of money payments from one market to the other

The Circular Flow Model of the Market Economy

Market economies are characterized by a circular flow of money, resources, and products between households
and firms in resource and product markets. Notice:
• Money earned by households in the resource market is spent on goods and services in the product
market
• Money earned by firms in the product market is spent on resources from households in the resource
market.
The incentives of Households: Maximize Utility
The incentive of Firms: Maximize Profits!

Resource Payments (Incomes for households)

In exchange for their land, labor, capital and entrepreneurship, households receive payments. The payments for
the four productive resources (which are costs for firms) are…

Firms pay households RENT. Landowners have the option to use their
land for their own use or to rent it to firms for their use. If the landowner
For Land: Rent
uses his land for his own use, the opportunity cost of doing so is the rent
she could have earned by providing it to a firm.

Firms pay households WAGES. To employ workers, firms must pay

workers money wages. If a worker is self employed, the opportunity cost
For Labor: Wages
of self-employment is the wages he could have earned working for
another firm.

Firms pay households INTEREST. Most firms will take out loans to
acquire capital equipment. The money they borrow comes mostly from
households’ savings. Households put their money in banks because they
For Capital: Interest earn interest on it. Banks pay interest on loans, which becomes the
payment to households. If a household chooses to spend its extra
income rather than save it, the opportunity cost of doing so is the interest
it could earn in a bank.

Households earn PROFIT for their entrepreneurial skills. An entrepreneur

Entrepreneurship: Profits who takes a risk by putting his creative skills to the test in the market
expects to earn a normal profit for his efforts.
Key Theme #2: The Price Mechanism

Prices are how resources are allocated between competing interests in a market economy. Without tradition or
command determining the allocation of resources, prices send the signals to producers and consumers
regarding what should be produced, how it should be produced, and for whom.

Examples of how prices allocate resources: Imagine a city with two types of street food, hot dogs and
kebabs. How would price assure that the right amount of these two foods is produced based on consumer
demand?
At present,
• The price of a hot dog is $2
• The price of a kebab is $3
Due to a report on the negative effects of hot dogs on health, consumers now demand more kebabs. How will
each of the two systems assure that the increased demand for kebabs is met?

Prices are signals from buyers to sellers!

As the demand for kebabs rises, they will become more scarce, causing the price to rise. Sellers will realize
there are more profits in kebabs and hot dog vendors will switch to kebabs.
The price mechanism led to a reallocation of resources!

Theme #3: The distinction between Economic Growth and Economic Development

The emerging market economies of the world have achieve amazing economic growth for decades; but at what
cost? Is increasing income and output the only thing the market system is good for? Does getting richer assure
we will be happier, live longer and healthier lives, and live in a just society? Two of the key areas of study in
economics are those of growth an development. Sometimes these concepts are thought of as the same, but
they are not.

Economic Growth: This refers to the increase in the total

output of goods and services by a nation over time.
• It is also sometimes defined as an increase in
household income over time.
• It is purely a monetary measure of the increases in the
material well being of a nation.
• On a PPC growth can be shown as an outward shift of
the curve.

Economic Development: This refers to the improvement in

peoples’ standard of living over time.
• Measured by improvements in health, education,
equality, life expectancy and so on
• Incorporate income as well, but is a much broader
measure than growth
• On a PPC development can be shown by a movement
towards the production of goods that improve peoples’
lives