CHAPTER 1 – FOUNDATION OF ECONOMICS
1.1 Understanding the Nature of Economics
• Social sciences – academic disciplines that
study human society and social relationships
• Economics – study of choices leading to the
best possible use of scarce resources in
order to best satisfy unlimited human needs
and wants
• Microeconomics – examines the behavior of
individual decision making units in the
economy.
o Two main groups – consumer (or
households) and firms (or
businesses)
• Macroeconomics – examines the economy
as a whole to obtain a broad or overall
picture of the economy.
• Key concepts:
o Scarcity – refers to the idea that
resources are insufficient to satisfy
unlimited human needs and wants
o Choice – refers to the ability of a
consumer or producer to decide
which good, service or resource to
purchase or provide from a range of
possible options
o Efficiency – refers to making the best
possible use of scarce resources to
avoid market waste
§ Allocative efficiency – scarce
resources are used to produce
the goods and services that
mostly satisfy society’s needs
and wants
o Equity – idea of being fair or just
o Economic well-being – refers to
levels of prosperity, economic
satisfaction and standards of living
among members of a society
o Sustainability –refers to the ability of
a consumer or producer to decide
which good, service or resource to
purchase or provide from a range of
possible options
o Change
o Interdependence – refers to the idea
that economic decision-makers
interact with and depend on each
other,
o Intervention (government
intervention) – refers to the
government being involved with the
workings of markets.
• Fundamental problem of economics:
Scarcity and Choice
o Limited/ Finite resources, unlimited/
infinite wants
o Factors of Production – all resources
or inputs used (land, labor, capital,
entrepreneurship) to produce goods
or services.
• 4 Factors of Production
o Land – all natural resources (land,
minerals, oil, underground water,
forests, rivers and lakes)
o Labor – physical and mental effort
that people contribute to the
production of goods and services
o Capital – physical capital also
referred to as capital good or
investment good (manmade factor
of production like machinery, tools,
airports, buildings)
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o Entrepreneurship – management;
organizes the other three factors of
production and takes on the risks of
success or failure of a business
• Capital – refers to resources that can
produce a stream of benefits
o Physical capital – used to produce
more goods and services in the
future
o Human capital – increases the
amount of output that can be
produced in the future by people
who embody skills, education and
good health.
o Natural capital – necessary to
humankind’s ability to live, survive
and produce in the future
o Financial capital – income for
holders, or owners, of the financial
instruments
• Opportunity cost – defined as the value of
the next best alternative that must be
given up or sacrificed in order to obtain
something else.
• Free good – any good that is not scarce,
has zero opportunity cost; free good not
always equal to goods that are free of
charge
• Economic good – scarce, have opportunity
costs
1.2 Resource Allocation and Output/ Income
Distribution
• Basic economic questions
o What / how much to produce
(Resource Allocation)
o How to produce (Resource
Allocation
o For whom to produce (Distribution
of output and income)
• Resource allocation – refers to assigning
available resources or factors of production,
to specific to specific uses chosen among
many possible alternatives.
• Distribution of Income – concerned with
how much of an economy’s total income
different individuals or group receive
• Market Method
o Resources owned by private
individuals
o Consumer or firms who make
economic decisions
• Command Method
o Resources owned by the government
o Economic decisions made by the
government
o Government intervention –
government interfering in markets by
reallocating resources and
redistributing income, preventing the
functionality of a free market, to
achieve a certain economic or social
objective
• Free market economy vs planned economy
vs mixed economies
o Resource ownership : public or
private sector
o Economic decision making
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o Rationing system – price rationing or
non-price rationing
• Rationing – method used to make resource
allocation and income distribution
decisions
o Price rationing usually occurs when
there is a market for resources, goods
and services
o Example of non-price rationing:
national defense, public healthcare
system
1.3 Production Possibility Curve/ Frontier
• Production Possibilities Curve/ Frontier –
represents all combinations of the maximum
amounts of two goods that can be
produced by an economy, given its
resources and technology, when there is full
employment of resources and productive
efficiency.
• For the economy to produce the greatest
output/ to lie somewhere on the PPC:
o All resources must be fully
employed
o All resources must be used
efficiently
• The greater the unemployment or
inefficiency in production, the further away
the point is from the PPC.
• Illustration of scarcity on the production
possibility curve
o Not able to produce outside of its
PPC (point F)
o Must make a choice on which
combination of goods will be
produced
o Choices will involve opportunity
costs
§ Only happened if the point is
on the curve or near the curve
§ If the economy is at a point
inside the curve, it can
increase production of both
goods with no opportunity
cost by reducing
unemployment or increasing
efficiency in production
• Shape of PPC
o PPC bends outward and to the right
(concave)
§ Opportunity costs change as the
economy moves from one point on
the PPC to another
§ Specialization of factors of
production, making them not
equally suitable for the production
of different goods and services
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o PPC is a straight line
§ Opportunity costs are constant
as economy moves from one
point on the PPC to another
§ Factors of production are
equally well suited to the
production of both goods
(similar goods)
• Circular flow of income model in a closed
economy with no government

• Economic growth – refers to increases in the

quantity of output produced in an economy
over a period of time

• Actual growth – caused by reduction in
unemployment and increases in efficiency of
production; movement towards the PPC
• Growth in production possibilities – caused
by increases in quantity of resources,
improvements in the quality of resources
and technological improvements; outward
shift of the PPC
• Factors leading to this outwards shift of the
PPC:
o Increases in the quantity of resources or
factors of production in the economy
o Improvements in the quality of
resources e.g. more educated labor
o Technological improvements
• Circular flow of income – shows that in any
given time period, the value of output
produced in an economy is equal to the
total income generated in producing that
output, which is equal to the expenditure
made to purchase that output
• Injections – refer to the entry into incoming
flow of fund corresponding to investments,
government spending or exports.
• Leakages – refer to the withdrawal from the
incoming flow of funds corresponding to
saving, taxes and imports.

• Non parallel shifts may also occur because

of a technological change favoring the
production of one good increases

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• If leakage > injection, the size of the
circular flow becomes smaller (e.g. saving >
investment then fewer goods and services
produced and purchased)
• If leakage < injection, the size of the circular
flow becomes larger (e.g. imports < exports
then more goods and services produced
and purchased)
1.4 The Method of Economics
• Positive vs normative economics
o Positive economics – study of
economics based on scientific
method, used to arrive at knowledge
about the economic world. It includes
descriptions, models, hypotheses,
• 19th Century – classical economics
theories and laws.
o Normative economics – forms the
basis of judgements about what the
economic goals and policies ought to
be. It is based on value judgements
as it identifies important economic
problems that should be addressed
and prescribes what should be done
to solve them
1.5 A Brief History of Economics
• 18th Century – Adam Smith and laissez faire
o Father of economics
o Book: The Wealth of Nations
o Invisible hand of markets – decisions
that are self-regulated through
interaction in markets without the
presence of a government; more
efficient use of resources due to
competition
o Laissez faire – free market without
government intervention
o Government roles: to take care of
national defense, oversee security and a
system of justice, and to provide public
infrastructure
o Economic growth depends on the
division of labor/ specialization of labor
o Developed philosophy of ethic known
as utilitarianism according to which an
action is right if it promotes the most
happiness for the largest number of
people
o Concept of utility or satisfaction or
pleasure derived from consuming
something is central to an idea of value
that helps determine process
o What matters Is not the total utility od
consuming something but rather the
extra or additional utility of consuming
one more unit of the good, marginal
utility
o Say’s law – supply creates its own
demand, a theory that claims that the
economy tends toward full employment
in the absence of any government
intervention
o Karl Marx – Capital: Critique of Political
Economy (downfall of capitalism);
developed a theory that capitalism
would eventually be replaced by
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communism because of the market
system’s internal contradictions
• 20 Century
th

o Keynesian Revolution (John Maynard

Keynes)
§ Idea that an economy left on its
own will not necessarily lead to
full employment, thus requiring
government intervention to
ensure that full employment will
be achieved
o Monetarism – role of money in the
economy
o New classical economics – importance
of ‘rational expectations’ of inflation
and government policy actions
o These two theories share a unifying
principle – government intervention
prevents the economy from reaching a
state of full employment on its own

• 21st Century
o Behavioral economics – psychology to
economics offering alternative ways of
understanding how consumers make
decisions with a view to influence
consumer choices toward socially
desirable outcomes
o Growing awareness of sustainability:
economy, society and environment
( profit, people and planet)
o Linear economy – take-make-dispose
model
o Circular economy – goods should be
repaired rather than thrown out, made
of biological materials so that once
discarded they can go back to the
biosphere and prevent pollution