CHAPTER 1: Introduction to Economics

Economics is a social science that examines how people choose among the
alternatives available to them. It is social because it involves people and their
behavior. It is a science because it uses, as much as possible, a scientific
approach in its investigation of choices.

Origin of the Terms “economics”

Greek Term Oikonomia or Oikonomus

Oikos- Household; Nomus- system or management

Therefore, Oikonomia (Greek Term) or Economics is management of household

In present times, economics is described in several definitions:

 It is a science that deals with the management of scarce resources.

 A scientific study on how individuals in the society generally make choices.
 It is a study of the problem using available economic resources as efficiently
as possible as to attain the maximum fulfilment of society’s unlimited
demand for goods and services.’
 It is simply scarcity and choice

 Economics and Scarcity

 Are the goods ready to be used are too few to satisfy individual desires
and needs.
 The amount or size of scarcity is constantly changing.
 Limited resources but unlimited wants or needs lead to scarcity. With
that, Economics will interfere through Allocation.

Note:

If there is no scarcity, there is no need for economics. Yet, reality confirms that
humans have unlimited needs and insatiable wants given resources limited and
inadequate. The science of economics was principally established to answer scarcity
thereby resolving the issue thru proper apportionment and distribution of resources.

 Ceteris Paribus

In the study of economics, there is a need to understand situations

separately from the rest of the other factors. The assumption ceteris paribus is a
latin term literally translated in English would mean “with all other things the
same”. Providing a better translation, it would also mean “all else equal” or “all
other things held constant”. The presumption is used in economics to analyze and
explain variables by isolating them. It also allows comparing and contrasting two
variables while the other factors remain the same. It simplifies the study of
complicated situations.

Examples:

1. An increase in interest rate will “ceteris paribus or constantly” cause the

demand for loans to fail. Higher interest rates increase the cost of borrowing
so there will be less demand for loans.
2. Higher oil prices should lead to less demand for oil.
1
 3. Higher prices of coffee should encourage growers to try and increase the
supply of coffee

 Brief History of Economics

A. Classical Economics

Economic Theory started during the mid 1700s and 1800s. One of the most
important personalities in the history of economics is Adam Smith from Scotland.
He wrote and published the book “Wealth of Nations” in 1776 which became
known as the bible of economics” from which economic fundamentals are found.
He contributed the analysis on the relationship between households and firms
through demand and supply and their interaction in the market without
government intervention known as the concept of “invisible hand”.

The importance of distribution and allocation of factors of production to

each area of economic activity in relation to profitability and comparative
advantage and world welfare used in international trade was presented by the
British political economist, David Ricardo.

John Stuart Mill, a British philosopher and economist, developed the basic
analysis of the political economy. He defined the importance of the role of the state
in the national economy.

B. Marxian Economics

In the period of Industrial revolution emerged the German Economist who

wrote the concept of socialism. Karl Marx authored Das Kapital, a work centering
on the theory of the capitalist system and the impact of the working class in the
development of an economy.

C. Neoclassical Economics

Leon Walras was a French economist who developed the mathematical

model of free competition in market wherein productive factors, goods and prices
adjust automatically as they reach equilibrium point and the analysis of
equilibrium in several markets.

A prominent British economist not only in his country but in the field of
economics who wrote the book Principle in Economics was Alfred Marshall. He
specialized on the study of microeconomics emphasizing on the notion that price
and output of goods are determined by both supply and demand. Moreover, the
model on consumer surplus and dynamism of economics were also explained in
his woks.

D. Keynesian Economics

John Maynard Keynes was an English economist who expounded on the

relationship of unemployment to prices and money supply as he authored the
famous and influential book, The General Theory of Employment, Interest and
Money. He was an influential personality changing the perspective of economics on
classical theories but rather focussing on monetarism, and monetary policies,
interest rates, investment, unemployment and fiscal policy.

2
 E. Non Walrasian Economics

The British economist John Hicks was known for his four important
contributions. First is his idea of elasticity of substitution which in simple
explanation insists that technology does not necessarily reduce labor’s
contribution in national income but rather just a transfer of sector in production.
Second is the graphical depiction of Keynesian argument on equilibrium with less
than full employment commonly known as IS-LM model. Third is his book, Value
and Capital proposing why goods have value or the value theory or how markets fit
together and reach equilibrium. And finally, his fourth contribution is the idea of
compensation test or a welfare theory testing the policy which measures if the help
given to some outweigh the hurt to others.

F. Post Keynesian Economics

The major contribution of Post Keynesian economists were the theories of

distribution, pricing, and growth bringing about policy development and decision
making in politics and economics providing guides on the development of rules
and regulations pertaining to private and public institutions. The recognized
economists in this era are Paul Samuelson, James Tobin, Kenneth Arrow,
Lawrence Klein, Joan Robinson, and Milton Friedman.

G. New Classical Economics

The development of economics as a non-stagnant science of ever-changing

situations and conditions lead to the New Classical Economics focussing on the
synthesis of all economic concepts applicable to the concerns of developing
countries. The concepts of economic growth and development particularly human
development and common good are its primary concern.

 Thinking Like an Economist

The study of economics use statements that define the role of an economist.
The language used by economists can help identify the role they are playing.
Economists play the roles of both policy advisers and scientists yet each role
portrays different goals.

Economic statements in general come in two forms. One is positive. Positive

statements are descriptive. They consider economic conditions as they are. They
use objectives and logical statements in evaluating different transactions in the
economy. They answer the question what is and considers the world as it is.
The other type is normative. Normative statements are prescriptive. They declare
how the world ought to be. They examine economic conditions as how they
should be. They attempt to recommend how the world must be.

The main distinction concerning positive and normative statements is the

assessment of their validity. Positive statements may be proven or contested based
on evidences. By contrast, judging normative statements implicates values and
realities.

Example of Positive statement:

The Philippine economy is experiencing a slow down due to issues of corruption and
too much politicking.

3
Example of Normative statement:

The Philippine government must initiate moves toward reform and must act
according to the dictate of conscience.

 Four Basic Economic Questions

To answer the society’s eternal problem of scarcity, the four basic economic
questions must be studied.

1. What to produce?
2. How to produce?
3. How much to produce?
4. For whom to produce?

Note:

- Resources are allocated to the production of goods and services that are
relatively low input cost but high profit yields.
- The society decides on either labour intensive production, example: use of
human resource especially on highly populates society or capital intensive
production, example: use of technology or capital goods such as machineries
and equipment for countries with high level of capital stocks available.
- The society avoids waste and allocates scarce resources
- Target markets are determined to maximize profits.

 Important Economic Concepts

A. Wealth
- Anything that has functional value (can be traded for goods or services)
- Stock of net assets owned by individuals or households
- Physical and financial assets which are mainly and relatively liquid( easily
converted into cash)
B. Consumption
- Direct utilization or usage of available goods and services by the buyer or
consumer
- Satisfaction obtained by consumers for the use of goods and services
C. Production
- Formation by firms of an output (products or services)
- Combination of land, labor, and capital in order to produce goods and
services
D. Exchange
- Process of trading goods or services for money and/or its equivalent
- Buying of goods and services
E. Distribution
- Process of allocating or apportioning scarce resources to be utilized by
household, business sector and the rest of the word.

 The Concept of Opportunity Cost

Economics does not only measure the outlay or the spending of resources
but also the value of what was given up in order to get what one wants.
Opportunity cost is the forgone value of the next best alternative.

4
Factors of Production

1. Land
- All natural resources found in nature and not made by humans
- All materials and things available beneath o above the soil including forest,
mountains, rivers, oceans, air and sunshine
- Compensation for the use of land is known as rent
2. Labor
- Any form of human effort exerted in the production of goods and services
- Includes a wide range of skills, abilities, and characteristics
- Reward for labor rendered is either wage (amount paid per output) or salary
(fixed amount paid for effort exerted)
3. Capital
- All goods used in production of goods and services made by humans
- Includes buildings, machineries, furniture and fixtures used in the
production process
- Reduction of productive capacity of capital leads to depreciation yet it yields
what is known as interest
4. Entrepreneurship or entrepreneurial skills
- Human effort exerted in production but specifically characterized by the act
of planning, organizing, managing, evaluating and assuming the risk of
doing business
- An economic good that commands price referred to as profit ( gain from
human effort exerted in an economic activity) or loss (cost or deficit from
human effort exerted in an economic activity)

Basic Economic Decision Problems

1. Consumption
- Humans have unlimited needs and wants to satisfy
- People encounter variety of choices on what to purchase
- Individuals and firms face the option of buying publicly or privately provided
goods and services
2. Production
- Firms determine the needs, wants and demand of consumers and decide
which is most profitable
- Producers allocate resources and match technologies available for
production
3. Distribution
- Firms face the primary question as to whether they deliver supply or
circulate goods from one market to another or remain in the same area as
they are
- Business owners also decide on the mode of transportation they will utilize
as they allocate their products and services.
4. Growth Over Time
- Populations continue to rise as well as expenses incurred to sustain human
existence
- Resources are divided according to needs and wants of the growing
population

 Types of Economic System

1. Traditional Economy
5
- Group of persons or families produce goods for their own consumption
- The head of the group or the family decides on the different questions such
as what, how, how much and for whom are the goods to be produced.
- Groups or families follow a long existing pattern of living with which they are
static and are very predictable the practice include working on different
tasks for the group and receiving equal shares in the output.

2. Feudalism
- An economic system in which tradition rule. It influence the Western world
from about the 8th to 15th century.

3. Mercantilism
- Is an economic system in which government determine the what, how and
for whom decisions by distributing the rights to do certain economic
activities.

4. Command Economy
- People produce the goods and services for communal consumption.
- The central state or the government exists to decide on the different
questions such as what, how, how much and for whom are the goods to be
produced.
- Production and allocation of resources are decided by the government.

5. Market Economy
- Market allows and provides incentives to business entities to produce goods
- Price moves competition towards efficiency and quality of products
- Production and allocation of resources are decided by the business entities
and consumers

6. Socialist Market
- A market economy characterized by regulated economic control and central
planning by the state, provided greater social welfare and decreased
business fluctuations

7. Free Market or laissez-faire

- A market economy characterized by little or no government intervention,
quantities of goods determined solely by supply and demand or market’s
invisible hand

8. Capitalists Market
- A market economy characterized by economic freedom and efficiency,
consumer choice, economic growth and expansion, resources mostly
privately owned.

9. Mixed Economy
- Combination of privately-owned and state-owned enterprises exists in the
market
- Firms and household experience sovereignty
- Market forces prevail yet government closely monitors economic activities

 Branches of Economics
6
 1. Microeconomics
- Micro means small.
- Deals with individual decisions of the units of the economy.
- The central concepts are market, buyers and sellers.
- The main goal is to understand behaviour and interaction of consumers and
producers.
- Main Factors are household and firms, supply and demand, and price.

2. Macroeconomics
- Macro means large.
- Deals with relationship among broad economic aggregates.
- The central concepts are aggregate household or consumption, aggregate
business or investment, policies and projects of the government or
government investment and spending, external foreign economic agents or
imports and exports.
- The main goal is to understand behaviour of economy as a whole
- Main Factors are consumption, investment, income, government investment
and spending, imports and exports, money supply, inflation, interest rate,
and employment.

 Ten Principles of Economics

How people make decisions:

1. People face tradeoffs.

2. The cost of something is what you give up to get it.
3. Rational people think at the margin.
4. People respond to incentives.

How people interact:

5. Trade can make everyone better off.

6. Markets are usually a good way to organize economic activities.
7. Government can sometimes improve market outcomes.

How the economy as a whole works:

8. A county’s standard of living depends on its ability to produce goods.

9. Prices rise when the government prints too much money.
10. Society faces a short-run trade-off between inflation and
unemployment.

 Other Important Economic Concepts

1. Economic Reasoning- Economists compare the costs and benefits of every
issue and make decisions based on those costs and benefits.
2. Marginal Cost- This is the additional cost to you over and above the cost
you have already met.
3. Sunk Costs- Costs that have already been incurred and cannot be gained
from the relevant costs when making a decision
4. Marginal Benefit- This is the additional benefit above what you have
already gained

7
  Economic Decision Rule
- If the marginal benefits of doing something is greater than the marginal
costs, do it.
- If the marginal costs of doing something is greater than the marginal
benefits, don’t do it.

 Economic and Market Forces

1. Economic Forces- This is the indispensable reaction to scarcity such as
rationing mechanism.
2. Market Forces- This an economic force that is given relatively free rein
society to work through the market. When there is a shortage, the price goes
up. When there is a surplus, the price goes down.
3. Social and Cultural Forces- These are operative in all parts of your life. A
country’s social norms determine whether the invisible hand will be allowed
to work.
4. Political Forces- These influence many of your ordinary actions.

 Economic Insights

Theories- are insights based on generalizations

Economic Model- A framework that places the generalized insights of the theory
in a more specific contextual setting.

Economic Principle- A commonly held economic insight stated as law or general

assumption.

Invisible Hand Theory

- The analysis on the relationship between households and firms through

demand and supply and their interaction in the market without government
intervention.
- A market economy , through the price mechanism, will allocate resources
efficiently
- Efficiency means achieving a goal as cheaply as possible utilizing few inputs
as possible.