Management of Economics

Novela, Stephanie Leigh R.

Mr. R. Tiambeng
What is Economics?

Economics is a social science concerned with the production, distribution, and

consumption of goods and services. It studies how individuals, business, governments,
and nations make choices on allocating resources to satisfy their wants and needs,
trying to determine how these groups should organize and coordinate efforts to achieve
maximum output.

Division of Economics

Macroeconomics – is the economies that deals with the behavior of the whole or entire
economy. This branch of economics is concerned about the level of production, the rate
of unemployment as well as in the gross national product and others.

Microeconomics – is the economics that deals with the behavior of a specific segment
such as the consumer, different business firms, the prices of products in the market and
others. It is concerned with the individual unit and not as a whole.

Economics is divided into certain divisions these are: Production, Consumption,

Distribution, Exchange, and the Public Finance.

Production in terms of economics as the manufacturing process of goods to provide

and satisfy the different needs of consumers, utilization of products, goods and services
by the consumers in a given amount of time.

Consumption is the branch of economics that is concerned with spending by

households and firms on goods and services.

Distribution means the way the products, goods or services are delivered to the
consumers, as well as the way the products, goods and services are allocated to the
consumers through different economic outlets.

Exchange means the way the products, goods or services are transferred to one
person to another.
The Public Finance means the way the government implement financial activities such
as on taxation, expenditures and other else.

Basic Economic Problem

The fundamental economic problem is the issue of scarcity and how best to produce
and distribute these scare resources.

Scarcity means there is a finite supply of goods and raw materials. Finite resources
means they are limited and can run out.

Unlimited wants mean that there is no end to the quantity of goods and services
people would like to consume. Because of unlimited wants – people would like to
consume more than it is possible to produce.

Factors of Production

There are certain factors that involved in the production in economics these are: Land,
Labor, Capital, and Entrepreneur.

The Land is one of the important factors in production. Land refers to the natural
resources that are going to be utilized in order to produce products or goods.

Labor refers to the effort expended by an individual to bring a product or service to the
market.

Capital is short for capital goods. These are man-made objects like machinery,
equipment, and chemicals that are used in production.

An entrepreneur is a person who combines the other factors of production – land, labor
and capital to earn a profit.
Production Possibilities Frontier

Production possibility frontier is the graph which indicates the various production
possibilities of two commodities when resources are fixed. The production of one
commodity can only be increased by sacrificing the production of other commodity. It is
also called the “production possibility curve” or “product transformation curve.”

Opportunity Costs

Opportunity costs represents the benefits an individual, investor or business misses

out on when choosing one alternative over another. While financial reports do not show
opportunity cost, business owners can use it to make educated decisions when they
have multiple options before them because by definition they are unseen, opportunity
costs an be easily overlooked if one is not careful. Understanding the potential missed
opportunities foregone by choosing one investment over another allows for better
decision-making.

Opportunity Cost Formula and Calculation:

Opportunity Cost = FO – CO

Where:

FO = Return on best foregone option

CO = Return on chosen option

Trade-Off

In economics, the term trade-off is often expressed as an opportunity cost, which is

the most preferred possible alternative. A trade-off involves a sacrifice that must be
made to get a certain product or experience. A person gives up the opportunity to buy
‘good B,’ because they want to buy ‘good A’ instead. For a person going to a baseball
game, their economic trade-off is the money and time spent at the ballpark, as
compared to the alternative of watching the game at home and saving their money, plus
the time spent driving to the ball game.

Economic System

Economic systems are the means by which countries and governments distribute
resources and trade goods and services.

The Four Types of Economies

1. Traditional Economic System

The traditional economic system focuses exclusively on goods and services that
are directly related to its beliefs, customs, and traditions. It relies heavily on
individuals and doesn’t usually show a significant degree of specialization and
division of labor. In other words, traditional economic systems are the most basic
and ancient type of economies.
2. Command Economic System
A command economic system is characterized by a dominant centralized power
(usually the government) that control a large part of all economic activity. This
type of economy is mostly commonly found in communist countries. It is
sometimes also referred to as a planned economic system because most
production decisions are made by the government and there is no free market at
play.
3. Market Economic System
A market economic system relies on free markets and does not allow any kind of
government involvement in the economy. In this system, the government does
not control any resources or other relevant economic segments. Instead, the
entire system is regulated by the people and the law of supply and demand.
4. Mixed Economic System
A mixed economic system refers to any kind of mixture of a market and
command economic system. It is sometimes also referred to as a dual economy.
Although there is no clear-cut definition of a mixed economic system, in most
cases the term is used to describe market economies with strongly regulatory
 oversight and government control in specific areas such as public goods and
services.

Mixed Economy

A mixed economy is a combination of different types of economic systems. This

economic system is a cross between a market economy and command economy. In the
most common types of mixed economies, the market is more or less free of government
ownership except for a few key areas like transportation or sensitive industries like
defense and railroad. However, the government is also usually involved in the regulation
of private businesses. The idea behind a mixed economy was to use the best of both
worlds – incorporate policies that are socialist and capitalist.

Advantage of Mixed Economy:

 There is less government intervention than a command economy. This results in

private businesses that can run more efficiently and cut costs down than a
government entity might.
 The government can intervene to correct market failures. For example, most
governments will come in and break up large companies if they abuse monopoly
power. Another example could be the taxation of harmful products like cigarettes
to reduce a negative externality of consumption.
 Governments can create safety net programs like healthcare or social security.
 In a mixed economy, governments can use taxation policies to redistribute
income and reduce inequality.

Disadvantage of Mixed Economy

 There are criticisms from both sides arguing that sometimes there is too much
government intervention, and sometimes there isn’t enough.
 A common problem is that the state run industries are often subsidized by the
government and run into large debts because they are uncompetitive.
Types of Economic Development

Economic development is usually the focus of federal, state, and local governments to
improve our standard of living through the creation of jobs, the support of innovation and
new ideas, the creation of higher wealth, and the creation of an overall better quality of
life. Economic development is often defined by others based on what is trying to
accomplish, these objectives include building or improving infrastructure such as roads,
bridges, etc.; improving our education system through new schools, enhancing our
public safety through fire and police service, or incentivizing new businesses to open a
location in a community.

Economic development is categorized into the following three major areas:

1. Government working on big economic objectives such as creating jobs or

growing an economy. These initiatives can be accomplished through written
laws, industries’ regulations and tax incentives or collections.
2. Programs that provide infrastructure and services such as bigger highways,
community parks, new school programs and facilities, public libraries or
swimming pools, new hospitals, and crime prevention initiatives.
3. Job creation and business retention through workforce development programs to
help people get the needed skills and education they need. This also includes
small business development programs that are geared to help entrepreneurs get
financing or network with other small businesses.

Sectors of an Economy

The three main sectors of the economy are:

1. Primary sector – extraction of raw materials – mining, fishing and agriculture.

The primary sector is sometimes known as the extraction sector – because it

involves taking raw materials. These can be renewable resources, such as fish wool
and wind power or it can be the use of non-renewable resources such as oil extraction
and mining for coal.
 2. Secondary/Manufacturing sector – concerned with producing finished goods,
e.g. factories making toys, cars, food and clothes.

The manufacturing industry takes raw materials and combines them to produce a
higher value added finished product. For example, raw sheep wool can be spun to form
a better quality wool. This wool can then be threaded and knitted to produce a jumper
that can be worn.

3. Service/ ‘Tertiary’ sector – concerned with offering intangible goods and

services to consumers. This includes retail, tourism, banking, entertainment and
I.T. services. offering intangible goods and services to consumers. This includes
retail, tourism, banking, entertainment and I.T. services.

The service sector is concerned with the intangible aspect of offering services to
consumers and business. It involves retail of the manufactured goods. It also provides
services, such as insurance and banking. In the twentieth century, the service sector
has grown due to improved labor productivity and higher disposable income. More
disposable income enables more spending on ‘luxury’ service items, such as tourism
and restaurants.

Capital Goods and the Consumer Goods

Capital goods and consumer goods are classified based on how they are used. A
capital good is any good used to help increase future production. Consumer goods are
any goods used by consumers and have no future productive use.

The same physical good could be a consumer good or a capital good. It just depends
on how it will be used. An apple bought at a grocery store and immediately eaten is a
consumer good. An identical apple bought by a company to make apple juice is a
capital good. The difference, again, lies in its utilization.

Capital Goods
Capital goods are any tangible assets used by one business to produce goods or
services as an input for other businesses to produce consumer goods. They are also
known as intermediate goods, durable goods, or economic capital. The most common
capital goods are property, plant, and equipment (PPE), or fixed assets such as
buildings, machinery and equipment, tools, and vehicles.

Capital goods are different from financial capital, which refers to the funds companies
use to grow their businesses. Natural resources not modified by human hands are not
considered capital goods, although both are factors of production.

Businesses do not sell capital goods. That means capital goods do not directly create
revenue like consumer goods. To financially survive the accumulation of capital goods,
businesses rely on savings, investments, or loans.

Economists and businesses pay special attention to capital goods because of the role
they play in improving the productive capacity of a firm or country. In other words,
capital goods make it possible for companies to produce at a higher level of efficiency.
For example, consider two workers digging ditches. The first worker has a spoon and
the second worker has a tractor with a hydraulic shovel. The second worker can dig
much faster because he has the superior capital good.

Consumer Goods
A consumer good is any good purchased for consumption and not used later for the
production of another consumer good. Consumer goods are sometimes called final
goods because they end up in the hands of the consumer or the end user. When
economists and statisticians calculate gross domestic product (GDP), they do so based
off consumer goods.

Examples of consumer goods include food, clothing, vehicles, electronics, and

appliances. Consumer goods fall into three different categories: durable goods,
nondurable goods, and services. Durable goods have a lifespan of more than three
years and include motor vehicles, appliances, and furniture. Non-durable goods are
meant for immediate consumption with a lifespan of less than three years. They include
items like food, clothing, and gasoline. Consumer services are not tangible and cannot
be seen, but can still give consumers satisfaction. Haircuts, oil changes, and car repairs
are examples of services.

Consumer goods can be classified in four ways:

 Convenience goods are consumed and purchased regularly, such as milk.

 Shopping goods require more thought and planning and include appliances and
furniture.
 Specialty goods are typically more expensive and cater to a niche market. Items
like jewelry fall into this section.
 Unsought goods are only purchased by some consumers to serve a specific
need. Life insurance falls into this section.

Function of Prices

The price mechanism plays three important functions in a market:

1. Signaling function
 Prices perform a signaling function – they adjust to demonstrate where resources
are required, and where they are not.
 Prices rise and fall to reflect scarcities and surpluses
 If prices are rising because of high demand from customers, this is a signal to
suppliers to expand production to meet the higher demand
 If there is excess supply in the market, the price mechanism will help to eliminate
a surplus of a goods by allowing the market price to fall
2. Transmission of preferences
 Through their choices consumers send information to produce about the
changing nature of needs and wants
 Higher prices act as an incentive to raise output because the supplier stands to
make a better profit
  When demand is weaker in recession then supply contracts as producers cut
back on output
 One of the features of a market economy system is that decision-making is
decentralized i.e. there is no single body responsible for deciding what is to be
produced and in what quantities. This is a remarkable feature of an organic
market system
3. Rationing function
 Prices serve to ration scarce resources when demand in a market outstrips
supply
 When there is a shortage, the price is bid up – leaving only those with the
willingness and ability to pay to purchase the product.
 The popularity of auctions as a means of allocating resources is worth
considering as a means of allocating resources and clearing a market

Circular Flow of Economic Activity

The all pervasive economic problem is that of scarcity which is solved by three
institutions (or decision-making agents) of an economy. They are households (or
individuals), firms and government. They are actively engaged in three economic
activities of production, consumption and exchange of goods and services. These
decision-makers act and react in such a manner that all economic activities move in a
circular flow.

First, we discuss their nature and role in decision-making.

Households:

Households are consumers. They may be single-individuals or group of

consumers taking a joint decision regarding consumption. They may also be families.
Their ultimate aim is to satisfy the wants of their members with their limited budgets.
Households are the owners of factors of production—land, labour, capital and
entrepreneurial ability. They sell the services of these factors and receive income in
return in the form of rent, wages, and interest and profit respectively.

Firms:
The term firm is used interchangeably with the term producer in economics. The
decision to manufacture goods and services is taken by a firm. For this purpose, it
employs factors of production and makes payments to their owners. Just as
household’s consumer goods and services to satisfy their wants, similarly firms produce
goods and services to make a profit. The term ‘firm’ includes joint stock companies like
DCM, TISCO etc., public enterprises like IOC, STC, etc., partnership concerns,
cooperative societies, and even small and big trading shops which do not manufacture
the commodities they sell.

Government:
The government plays a key role in all types of economic systems—capitalist,
socialist and mixed. In a capitalist economy, the government does not interfere. It simply
establishes and protects property rights. It sets standards for weights and measures,
and the monetary system.

In a socialist economy, the role of the government is very extensive. It owns and
regulates the entire production and consumption processes of the economy, and fixes
prices of goods and services. In a mixed economy, the government strengthens the
market system.

It removes its defects by regulating the activities of the private sector and by
providing incentives to it. The government also uses resources to produce goods and
services itself which are sold to households and firms. These decision-making agents
take economic decisions to produce goods and services and to exchange them in order
to consume them for satisfying the wants of the whole economy.

Production, consumption and exchange are the three main activities of the
economy. Consumption and production are flows which operate simultaneously and are
interrelated and interdependent. Production leads to consumption and consumption
necessitates production.

In other words, production is a means (beginning) and consumption is the end of

all economic activities. Both production and consumption, in turn, depend upon
exchange. Thus these two flows are interrelated and interdependent through exchange.

The Circular Flow in a Two-Sector Economy:

In a simplified economy with only two types of economic agents, households or
consumers and business firms, the circular flow of economic activity is shown in Figure
10. Consumers and firms are linked through the product market where goods and
services are sold. They are also linked through the factor market where the factors of
production are sold and bought.

Consumers and firms have a dual role, and exchange with one another in two
distinct ways:
(1) Consumers or households own all the factors of production, that is, land, labour,
capital and entrepreneurship, which are also called productive resources. They sell
them to firms for producing goods and services.

In the diagram, the sale of goods and services by firms to consumers in the
product market is shown in the lower portion of the inner circle from left to right; and the
sale of their services to firms by households or consumers in the factor market is shown
in the upper portion of the inner circle from right to left. These are the real flows of
goods and services from firms to consumers which are linked with productive resources
from consumers to firms through the medium of exchange or barter.

(2) In a modem economy, exchange takes place through financial flows which move in
the reverse direction to the “real” flows. The purchase of goods and services in the
product market by consumers is their consumption expenditure which becomes the
revenue of the firms and is shown in the outer circle of the lower portion from right to left
in the diagram.

The expenditure of firms in buying productive resources in the factor market from
the consumers becomes the incomes of households, which is shown in the outer circle
of the upper portion from left to right in the diagram.

The Circular Flow in a Three-Sector Economy:

So far we have been working on the circular flow of a two-sector model of an
economy. To this we add the government sector so as to make it a three-sector closed
model of circular flow of economic activity. For this, we add taxes and government
purchases (or expenditure) in our presentation.

Taxes are outflows from the circular flow and government purchases are inflows
into the circular flow. The circular flow in a three-sector economy is illustrated in Figure
11.
 First, take the circular flow between the household sector and the government
sector. Taxes in the form of personal income tax and commodity taxes paid by the
household sector are outflows (or leakages) from the circular flow. But the government
purchases the services of the households, makes transfer payments in the form of old
age pensions, unemployment relief, sickness benefit, etc., and also spends on them to
provide certain social services like education, health, housing, water, parks and other
facilities.

All such expenditures by the government are inflows (injections) into the circular
flow. Next take the circular flow between the business sector and the government
sector. All types of taxes paid by the business sector to the government are leakages
from the circular flow.

On the other hand, the government purchases all its requirements of goods of all
types from the business sector, gives subsidies and makes transfer payments to firms in
order to encourage their production. These government expenditures are injections into
the circular flow.
 Now we take the household, business and government sectors together to show
their inflows and outflows in the circular flow. As already noted, taxes are a leakage
from the circular flow. They tend to reduce consumption and saving of the household
sector. Reduced consumption, in turn, reduces the sales and incomes of the firms.

On the other hand, taxes on business firms tend to reduce their investment and
production. The government offsets these leakages by making purchases from the
business sector and buying services of the household sector equal to the amount of
taxes. Thus inflows (injections) equal outflows (leakages) in the circular flow.

Figure 11 shows that taxes flow out of the household and business sectors and
go to the government. The government purchases goods from firms and also factors of
production from households. Thus government purchases of goods and services are an
injection in the circular flow and taxes are leakages in the circular flow.

If government purchase exceeds net taxes then the government will incur a
deficit equal to the difference between the two, i.e., government expenditure and taxes.
The government finances its deficit by borrowing from the capital market which receives
funds from the household sector in the form of saving.

On the other hand, if net taxes exceed government purchases the government
will have a budget surplus. In this case, the government reduces the public debt and
supplies funds to the capital market which are received by the business sector.

The Circular Flow in a Four-Sector Economy:

So far the circular flow has been shown in the case of a closed economy. But the
actual economy is an open one where foreign trade plays an important role. Exports are
an injection or inflows into the circular flow of money. On the other hand, imports are
leakages from the circular flow.

They are expenditure s incurred by the household sector to purchase goods from
foreign countries. These exports and imports in the circular flow are shown in Figure 12.
 Take the inflows and outflows of the household, business and government
sectors in relation to the foreign sector. The household sector buys goods imported from
abroad and makes payment for them which is a leakage from the circular flow of money.
The householders’ ma receives transfer payments from the foreign sector for the
services rendered by them in foreign countries.

On the other hand, the business sector exports goods to foreign countries and its
receipts are an injection in the circular flow or money. Similarly, there are many services
rendered by business firms to foreign countries such as shipping, insurance, banking,
etc. for which they receive payments from abroad.

They also receive royalties, interests, dividends, profits, etc. for investments
made in foreign countries. On the other hand, the business sector makes payments to
the foreign sector for imports о capital goods, machinery, raw materials, consumer
goods, and services from abroad. These are the leakages from the circular flow of
money.
 Like the business sector, modern governments also export and import goods and
services, and lend to and borrow from foreign countries. For all exports of goods, the
government receives payments from abroad.

Similarly, the government receives payments from foreigners when they visit the
country as tourists and for receiving education, etc., and also when the government
provides shipping, insurance and banking services to foreigners through the state-
owned agencies.

It also receives royalties, interests, dividends, etc. for investments made abroad.
These are injections into the circular flow of money. On the other hand, the leakages
are payments made to foreigners for the purchase of goods and services.

Figure 12 shows the circular flow of money of the four sector open economy with
saving, taxes and imports shown as leakages from the circular flow on the right hand
side of figure, and investment, government purchases and exports as injections into the
circular flow, on the left side of the figure.

Further, imports, exports and transfer payments have been shown to arise from
the three domestic sectors—the household, the business and the government. These
outflows and inflows ass through the foreign sector which is also called the “Balance of
Payments Sectors”.