Chapter 1

The Art and Science of

Economics

DR. NORZALINA ZAINUDIN

norzalina@upm.edu.my
DEPARTMENT OF RESOURCE MANAGEMENT & CONSUMER
STUDIES FACULTY OF HUMAN ECOLOGY UNIVERSITY PUTRA
MALAYSIA

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 The Economic Problem

q Economics examines how people use

their scarce resources to satisfy their
unlimited wants

q Scarce resource
q Not freely available  when its price
exceeds zero
q Resources
q Inputs
q Factors of production
q Used to produce goods and services
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NORZALINA
 Resources

q Goods and services are scarce

because resources are scarce

q Four general categories

q Labor
q Capital
q Land
q Entrepreneurial Ability

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 Labor and Capital
q Labor: broad category of human effort
q Physical and mental
q Time
q Scarcity of time  scarcity of labor

q Capital: Human creations used to

produce goods and services
q Physical capital: factories, machines, tools,
buildings, airports, highways and other
manufactured items employed to produce
goods and services
q Human capital: consists of the knowledge and
skill people acquire to enhance their labor
productivity
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Land & Entrepreneurial Ability

q Land
q Land and other natural resources
q Gifts of nature including bodies of water,
trees, oil reserves, etc.

q Entrepreneurial Ability
q Special kind of human skill
q Talent required to dream up a new
product or find a better way to produce
an existing one

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 Payments for Resources

q Wages  payment for use of labor

q Interest  payment for the use of capital

q Rent  payment for use of land

q Profit  reward for entrepreneur’s reward

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 Micro and Macro “economics”
q Microeconomics
q Examines the factors that influence individual
economic choices
q Studies the individual pieces of the economic
puzzle
q Eg. What do I want for breakfast? Shall we
produce rice or computer?

q Macroeconomics
q Studies the performance of the economy as a
whole
q Focuses on the big picture
q Eg. What is the unemployment rate?
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 Goods and Services
q Goods
q Tangible items
q Services
q Intangible items

q Good or service is scarce if the amount

people desire exceeds the amount that is
available at a zero price  we must
continually choose among them
q Choices in a world of scarcity implies we must pass
up some goods and services

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Economic Decision Makers
q Four types of decision-makers in the economy
q Households
q Demand the goods and services produced
q Supply labor, capital, labor, and entrepreneurial
ability

q Firms, governments, and the rest of the world

q Demand the resources
q Supply the goods and services
q Rest of the world  foreign households, firms and
governments

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Our Economic Problem
Revisited
o Limited resources versus unlimited
wants
o There are NOT enough resources to
produce everything that everyone
wants
o Therefore, CHOICES must BE MADE!
o Every choice has an “opportunity cost”
associated with it!

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What is
“opportunity cost”?

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 Opportunity Cost: An Important,
Fundamental Concept in Economics
o Because we cannot have everything we want,
we must make choices
o The thing we give up (our second-best
choice) is called the opportunity cost of our
choice
n This is the foregone value of the next best
alternative
o In the economic world, “both” is not an
admissible answer to a choice of “which one”

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 Highest Valued Alternative
o Options

n Watch TV
n Talk on the telephone
n Sleep in your room
n Study economics
o Opportunity cost is the highest valued
alternative that could have been chosen
(i.e., study economics)
o Opportunity cost may or may not have a
dollar value

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 Inherit RM40,000
Two choices – buy a car or go to college

o Bought the car

n (Paid $40,000)
o Can’t go to college

College graduate (lifetime earnings) $1,300,000

High School graduate (lifetime earnings) 800,000
Opportunity Cost $ 500,000
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 The Production Possibilities Curve
o PPC shows the various possible combinations of
goods and services produced within a specified
time with all its resources fully and efficiently
employed.

o Represents our economy at

n Full employment - Five percent
unemployment rate
n Full production - Eighty five to ninety
percent utilization rate

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 The Production Possibilities Curve
o Assumptions to illustrate the PPC
n The economy is operating at full
employment and full production capacity.
n The amount of resources available is
fixed
n Technology does not change throughout
production.

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 Production Schedule
Production Possibilities Curve
Table 1 :
Point Units of Butter Units of Guns
A 15 0
B 14 1
C 12 2
D 9 3
E 5 4
F 0 5

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o Points A and F = amount of consumer goods and
capital goods that can be produced per year if all
resources are used efficiently

o Points between A and F = other possible combinations

of the two goods produced when all resources are
efficiently employed

o Points inside the curve, I, = combinations that do not

employ resources efficiently or fully

o Point C yields more consumer goods and no fewer

capital goods than I, while point E yields more capital
goods and no fewer consumer goods than I, and all
points between C and E yield more of both goods
o
o Points outside the PPF, such as U, = unattainable
combinations  PPF serves as the frontier between
unattainable and attainable combinations.

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Exercise !!
From the table below, draw the PPC.

Table 1 :
Point Consumer goods Capital goods
A 50 0
B 48 10
C 43 20
D 34 30
E 20 40
F 0 50

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 Movements along the PPF
o Law of Increasing Costs
n Dictates the bowed-out shape of the PPF
n When the economy uses all resources efficiently, each
additional increment of one good requires the economy
to sacrifice successively larger and larger increments of
the other good
n Occurs because resources drawn away from consumer
goods are those that are increasingly better suited to
producing consumer goods 
o First 10 million units of capital goods have an opportunity
cost of only 2 million units of consumer goods while
o Final 10 million (points E to F) have an opportunity cost of
20 million units of consumer goods

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 Factors that can Shift the PPF
o Changes in Resource Availability
n Increases / Improvements in Quality  rightward
shift
n Decreases /Reductions in Quality  leftward shift

o Increases in the Capital Stock

n Increases  rightward shift
n Decreases  leftward shift

o Technological Change
n Employs available resources more efficiently

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 Shifts in the Economy’s PPF

qAll of the following would lead to a

rightward shift in the PPF from A to A‘:
qIncrease in the size or health of
the labor force
qImprovement in the skills of the
labor force
qIncreases in the amount of capital
qDecreases in any of the above factors
would shift the PPF from A' to A  shift
to the left

qThe parallel shift implies the change

that occurred affected the production of
both goods equally

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 Shifts in the Economy’s PPF

qA leftward shift from A to A" could be

caused by any of the following:

qDecrease in the size or health of the

labor force
qDecline in the skills of the labor
force
qDecreases in the amount of capital

qThe parallel shift implies the change

that occurred affected the production of
both goods equally

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 Shifts in the Economy’s PPF

qIncrease in resources or
technological change that benefits
consumer goods would rotate the
PPF outward from the horizontal
axis, from A to A'

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Shifts in the Economy’s PPF
qIncrease in resources or
technological advance that
benefits capital goods would
rotate the PPF outward from
the vertical axis, F to F'

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Lessons of PPF
q Efficiency  PPF represents the
combinations of output that are possible,
given the economy’s resources and
technology
q Scarcity  Given the stock of resources
and technology, the economy can produce
only so much
q Economic Growth  rightward shift or
rotation of PPF
q Choice

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 Questions

q How an economy selects the most preferred

combination will depend on the decision-
making rules employed

q Regardless of how decisions are made, each

economy must answer three fundamental
questions
q What goods and services will be
produced?
q How will they will be produced?
q For whom will they be produced?

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 Markets

q Means by which buyers and sellers

carry out exchanges
q Product markets
q Markets in which goods and services are
bought and sold
q Resource Markets
q Markets in which the resources are
exchanged
q Labor, or job, market is the most
important of the resource markets

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 Marginal Analysis

q Comparison of expected marginal cost

and the expected marginal benefit of
the action under consideration

q Marginal
q Incremental
q Additional
q Extra

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 Science of Economic Analysis

q Economic theory or model

q Simplification of economic reality

q Used to make predictions about the real world

q Focuses on the important elements of the

problem under study

q More details  more unwieldy

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